Trade Options on the Enumerated Agricultural Commodities

COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 32

Trade Options on the Enumerated Agricultural Commodities

AGENCY: Commodity Futures Trading Commission.

ACTION: Advance notice of proposed rulemaking.

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SUMMARY: Generally, the offer or sale of commodity options is

prohibited except on designated contract markets. 17 CFR 32.11. One of

several specified exceptions to the general prohibition on off-exchange

options is for ``trade options.'' Trade options are defined as off-

exchange options ``offered by a person having a reasonable basis to

believe that the option is offered to'' the categories of commercial

users specified in the rule, where such commercial user ``is offered or

enters into the transaction solely for purposes related to its business

as such.'' 17 CFR 32.4(a). Trade options, however, are not permitted on

the agricultural commodities which are enumerated in the Commodity

Exchange Act, 7 U.S.C. Sec. 1 et seq. (Act).

The Division of Economic Analysis of the Commodity Futures Trading

Commission recently completed a study of the prohibition on the offer

or sale of off-exchange trade options on the enumerated agricultural

commodities. Based upon the Division's analysis and recommendations,

the Commission is seeking comment on whether it should propose rules to

lift the prohibition on trade options on the enumerated agricultural

options subject to conditions and, if so, what conditions would be

appropriate.

DATES: Comments must be received by July 24, 1997.

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ADDRESSES: Comments should be mailed to the Commodity Futures Trading

Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington,

D.C. 20581, attention: Office of the Secretariat; transmitted by

facsimile at (202) 418-5521; or transmitted electronically to

[[email protected]]. Reference should be made to ``Prohibition on

Agricultural Trade Options.''

FOR FURTHER INFORMATION CONTACT: Paul M. Architzel, Chief Counsel,

Division of Economic Analysis, Commodity Futures Trading Commission,

Three Lafayette Centre, 1155 21st Street, N.W., Washington, D.C. 20581,

(202) 418-5260, or electronically, [PA[email protected]cftc.gov].

SUPPLEMENTARY INFORMATION: The Commodity Futures Trading Commission

(Commission or CFTC) directed its Division of Economic Analysis

(Division) to study the prohibition on the offer or sale of off-

exchange trade options on the agricultural commodities enumerated in

the Act and to report on the Division's findings. On May 14, 1997, the

Division forwarded to the Commission its study entitled, ``Policy

Alternatives Relating to Agricultural Trade Options and Other

Agricultural Risk-Shifting Contracts.'' Based upon the Division's

analysis and recommendations, the Commission is seeking comment on

whether it should propose rules to lift the prohibition on trade

options on the enumerated agricultural options subject to conditions

and, if so, what conditions would be appropriate. An abridged version

of those portions of the Division's study which might be most useful to

commenters in identifying the issues for comment follows. The complete

text of that study is available through the Commission's internet site

and can be accessed at http://www.cftc.gov/ag8.htm.

I. Statutory and Regulatory Background

A. Options on Commodities Subject to the 1936 Act

In 1936, responding to a history of large price movements and

disruptions in the futures markets attributed to speculative trading in

options, Congress completely prohibited the offer or sale of option

contracts both on and off exchange in all commodities then under

regulation.1 Over the years, this statutory bar continued to

apply only to the commodities regulated under the 1936 Act. The

specific agricultural commodities regulated under the 1936 Act

included, among others, grains, cotton, butter, eggs and potatoes.

Later, fats and oils, soybeans and livestock, as well as others, were

added to the list. Together, they are referred to as the ``enumerated''

agricultural commodities. Any commodity not so enumerated, whether

agricultural or not, was not subject to regulation. Thus, options on

such non-enumerated commodities were unaffected by the

prohibition.2

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\1\ Commodity Exchange Act of 1936, Public Law No. 74-675, 49

Stat. 1491 (1936). See, H. Rep. No. 421, 74th Cong., 1st Sess. 1, 2

(1934); H. Rep. No. 1551, 72d Cong., 1st Sess. 3 (1932).

\2\ Examples of non-enumerated commodities would include coffee,

sugar, gold, and foreign currencies. Before 1974, the Act covered

only those commodities enumerated by name. The 1936 Act regulated

transactions in wheat, cotton, rice, corn, oats, barley, rye,

flaxseed, grain sorghum, mill feeds, butter, eggs and Solanum

tuberosum (Irish potatoes). Act of June 15, 1936, Public Law No. 74-

675, 49 Stat. 1491 (1936). Subsequent amendments to the Act added

additional agricultural commodities to the list of enumerated

commodities. Wool tops were added in 1938. Commodity Exchange Act

Amendment of 1938, Public Law No. 471, 52 Stat. 205 (1938). Fats and

oils, cottonseed meal, cottonseed, peanuts, soybeans and soybean

meal were added in 1940. Commodity Exchange Act Amendment of 1940,

Public Law No. 818, 54 Stat. 1059 (1940). Livestock, livestock

products and frozen concentrated orange juice were added in 1968.

Commodity Exchange Act Amendment of 1968, Public Law No. 90-258, 82

Stat. 26 (1968) (livestock and livestock products); Act of July 23,

1968, Public Law No. 90-418, 82 Stat. 413 (1968) (frozen

concentrated orange juice). Trading in onion futures on United

States exchanges was prohibited in 1958. Commodity Exchange Act

Amendment of 1958, Public Law No. 85-839, 72 Stat. 1013 (1958).

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B. Options on Commodities Not Subject to the 1936 Act

In the years following passage of the 1936 Act, the off-exchange

offer and sale of commodity options on the non-enumerated commodities

was subject to fraud, abuse and sharp practice. That history was one of

the catalysts leading to enactment of the Commodity Futures Trading

Commission Act of 1974 (1974 Act), which substantially strengthened the

Commodity Exchange Act and broadened its scope. The Act's scope was

broadened by bringing all commodities under regulation for the first

time. Congress accomplished this by adding to the list of enumerated

commodities an expansive catchall definition of ``commodity'' which

included all ``services, rights or interests in which contracts for

future delivery are presently or in the future dealt in.'' 3

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\3\ The definition of commodity is currently codified in section

1a(3) of the Act.

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Under the 1974 amendments, the newly created CFTC was vested with

plenary authority to regulate the offer and sale of commodity options

on the previously unregulated, non-enumerated commodities.4

The Act's statutory prohibition on the offer and sale of options on the

enumerated agricultural commodities was retained.

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\4\ Section 4c(b) of the Act provides that no person ``shall

offer to enter into, enter into or confirm the execution of, any

transaction involving any commodity regulated under this Act'' which

is in the nature of an option ``contrary to any rule, regulation, or

order of the Commission prohibiting any such transaction or allowing

any such transaction under such terms and conditions as the

Commission shall prescribe.'' 7 U.S.C. 6c(b).

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Shortly after its creation, the Commission promulgated a

comprehensive regulatory framework applicable to off-exchange commodity

option transactions in the non-enumerated commodities.5 This

comprehensive framework exempted ``trade options'' from most of its

provisions.6 Trade options on non-enumerated commodities are

exempt from all of the requirements applicable to off-exchange

commodity options except for a rule prohibiting fraud (rule 32.8) and a

rule prohibiting manipulation (rule 32.9).

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\5\ 17 CFR Part 32. See, 41 FR 51808 (Nov. 24, 1976) (Adoption

of Rules Concerning Regulation and Fraud in Connection with

Commodity Option Transactions. See also, 41 FR 7774 (Feb. 20, 1976)

(Notice of Proposed Rules on Regulation of Commodity Options

Transactions); 41 FR 44560 (Oct. 8, 1976) (Notice of Proposed

Regulation of Commodity Options). Options were not traded on futures

exchanges at this time, see p. 18 infra.

\6\ As noted above, trade options are defined as off-exchange

options ``offered by a person having a reasonable basis to believe

that the option is offered to the categories of commercial users

specified in the rule, where such commercial user is offered or

enters into the transaction solely for purposes related to its

business as such.'' Id. at 51815; Rule 32.4(a) (1976). This

exemption was promulgated based upon an understanding that

commercials had sufficient information concerning commodity markets

insofar as transactions related to their business as such, so that

application of the full range of regulatory requirements was

unnecessary for business-related transactions in options on the non-

enumerated commodities. See, 41 FR 44563, ``Report of the Advisory

Committee on Definition and Regulation of Market Instruments,''

Appendix A-4, p. 7 (Jan. 22, 1976).

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In contrast to the regulatory framework for commodity options on

the non-enumerated commodities, commodity options on the enumerated

commodities--the domestic agricultural commodities listed in the Act--

were prohibited both as a consequence of the continuing statutory bar

as well as Commission rule 32.2, 17 CFR 32.2. This prohibition made no

exceptions and applied equally to trade options.

The attempt to create a regulatory framework to govern the offer

and sale of off-exchange commodity options was unsuccessful. Because of

continuing, persistent and widespread abuse and fraud in their offer

and sale, the Commission in 1978 suspended all trading in commodity

options, except for trade options.7 Congress later codified

the Commission's option ban,

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establishing a general prohibition against commodity option

transactions other than trade and dealer options.8

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\7\ 43 FR 16153 (April 17, 1978). Subsequently, the Commission

also exempted dealer options from the general suspension of

transactions in commodity options. 43 FR 23704 (June 1, 1978).

\8\ Public Law No. 95-405, 92 Stat. 865 (1978). Pursuant to the

1978 statutory amendments, option transactions prohibited by new

Section 4c(c) could not be lawfully effected until the Commission

transmitted to its Congressional oversight committees documentation

of its ability to regulate successfully such transactions, including

its proposed regulations, and thirty calendar days of continuous

session of Congress after such transmittal had passed.

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C. Reintroduction of Exchange-Traded Options

The Commission subsequently permitted the introduction of exchange-

traded options on the non-enumerated commodities by means of a three-

year pilot program.9 Based on that successful experience,

Congress, in the Futures Trading Act of 1982, eliminated the statutory

bar to transactions in options on the enumerated commodities,

permitting the Commission to establish a similar pilot program to

reintroduce exchange-traded options on those agricultural

commodities.10

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\9\ 46 FR 54500 (Nov. 3, 1981).

\10\ Public Law No. 97-444, 96 Stat. 2294, 2301 (1983).

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D. Retention of Ban on Off-Exchange Options on Enumerated Commodities

In 1984 the Commission permitted exchange trading of options on the

enumerated commodities under essentially the same rules that were

already applicable to options on all other commodities.11 In

proposing these rules, the Commission noted that section 4c(c) of the

Act and Commission rule 32.4 permitted trade options on the non-

enumerated commodities and that ``there may be possible benefits to

commercials and to producers from the trading of these `trade' options

in domestic agricultural commodities.'' 12 However, ``in

light of the lack of recent experience with agricultural options and

because the trading of exchange-traded options is subject to more

comprehensive oversight,'' the Commission concluded that ``proceeding

in a gradual fashion by initially permitting only exchange-traded

agricultural options'' was the prudent course.13

Nevertheless, the Commission requested comment from the public

concerning the advisability of permitting trade options between

commercials on domestic agricultural commodities. Citing past abuses

associated with off-exchange options, the consensus among commenters

was that the Commission should proceed cautiously and retain the

prohibition on such off-exchange transactions.

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\11\ 49 FR 2752 (January 23, 1984).

\12\ 48 FR 46797, 46800 (October 14, 1983) (footnote omitted).

\13\ Id.

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Since then, the Commission has reconsidered the issue of whether to

remove the prohibition on the offer and sale of trade options on the

enumerated commodities several times. In 1991, the Commission proposed

deleting the prohibition on trade options on the enumerated commodities

and including them under the same exemption applicable to all other

commodities. 56 FR 43560 (September 3, 1991). The Commission never

promulgated the proposed deletion as a final rule.14 Most

recently, on December 19, 1995, the Commission hosted a public

roundtable (December Roundatable) to consider this issue once again and

to provide a forum for members of the public to provide their views.

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\14\ By letter dated January 30, 1997, the National Grain and

Feed Association (NGFA) petitioned the Commission to repeal

immediately the prohibition on agricultural trade options in its

entirety. NGFA's petition advocated that the Commission proceed to

promulgate final rules on the basis of the 1991 Notice of Proposed

Rulemaking. The Commission, in light of its publication of this

Advance Notice of Proposed Rulemaking and consideration of whether

to lift the prohibition subject to conditions, denied that petition

by letter dated May 23, 1997.

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II. Possible Benefits of Trade Options on the Enumerated Agricultural

Commodities

The Division in its study identified a number of benefits that may

result from lifting the prohibition on agricultural trade options. One

such benefit is the potential for a greater supply of, and competition

in offering, option contracts.15 Currently, only

standardized, exchange-traded options are available for agricultural

product hedging. Presumably, lifting the ban would encourage

competition between customized contracts and financing arrangements

offered by various off-exchange counterparties and the more

standardized but highly liquid, low credit-risk products offered by

exchanges.

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\15\ Options provide a highly effective tool for hedging and

have unique pay-out characteristics. Options differ from futures

contracts in that they are a limited price-risk instrument. That is,

the purchaser of an option contract can profit from a price rise (in

the case of a call) or price fall (in the case of a put), but limit

any losses on the contract to the price of the premium paid for the

contract.

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Moreover, lifting the ban would permit a greater variety of option

vendors, which could reduce the informational search costs to certain

hedgers. Hedging can be a complex matter involving knowledge by the

hedger of his market position, delivery timing, quantities and

qualities of commodity production, inventory, financial wherewithal and

marketing objectives. In addition, a hedger must be cognizant of risks

associated with the counterparty on the cash commodity, particularly

default risk.

To reduce search costs, many hedgers may choose to rely on

established cash market trading channels to gather information on

contracting methods. Established cash trading partners may have a

greater understanding of the hedger's marketing position and needs than

others. These cash trading partners may, therefore, be better situated

to recommend particular hedge strategies and contracts. In addition,

ongoing business relationships with these parties may have instilled a

level of trust between counterparties, allowing hedgers to make

informed assessments as to credit risk and possibly to use cash market

obligations as collateral for trade option positions.

In competing to offer option contracts, option vendors may offer

customers a greater variety of desired attributes or services. For

example, futures commission merchants (FCMs) can compete by offering

exchange-traded options which offer a high degree of liquidity and low

credit risk. They may also offer trade options, to the extent

permissible, that have features currently unavailable on any exchange,

such as average-price options.16 Elevators and other first-

handlers, on the other hand, presumably may offer option contracts

having terms or financing arrangements more closely tailored to the

hedging or other needs of the customer. Through such competition, a

hedger may have a greater number of alternatives from which to choose

in deciding which contract source best suits his or her hedging needs,

balanced against his or her tolerance for credit risk.

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\16\ For example, on May 29, 1991, the Commission issued a no-

action letter to Gelderman, Inc., a registered FCM, to offer

averaging European-style off-exchange options on agricultural

commodities to certain commercial purchasers. See CFTC Letter No.

91-1, Comm. Fut. L. Rep. (CCH) para. 25,065 (May 29, 1991). However,

under Commission rule 1.19, appropriate haircuts to FCMs' net

capital requirements would have to be promulgated before FCMs could

offer such trade options generally.

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The potentially greater array of contracts and services may enable

hedgers to achieve more precise hedging in a variety of ways. For

example, more efficient hedges may be attained by more closely matching

the size of the option contract to the underlying cash market position.

The standard size of exchange-traded option contracts may not

correspond to the spot or forward obligations of a hedger. If the

contract size is not a multiple of a producers's

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output, the hedger is forced to under- or over-hedge.17

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\17\ ``Under-hedging'' means that the hedger has a futures or

option position that is less than the total cash market position.

This, in essence, leaves the cash market commitment, in part,

without price protection. ``Over-hedging'' means that the futures or

options position is greater than the cash market commitment.

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Trade options also allow a hedger to specify expiration or delivery

dates to coincide more closely with harvest dates, processing schedules

or the timing of forward contracts. This reduces a hedger's exposure to

the risk from mismatching the expiration date of an exchange-traded

contract. Basis risk also can be reduced for the hedger by allowing a

closer match to the grade of crop or livestock at a particular delivery

location.

In addition to tailoring contracts to match more closely the

underlying commodity, customers, through the bundling of various

options, can also gain access to contracts which hedge multiple risks.

Producers, for example, face production risks and price risk associated

with inputs and outputs. Currently, a producer can hedge these risks

separately by purchasing, to the extent that they exist, separate

options on the inputs and outputs and either purchasing crop insurance

or possibly an option on crop yield futures. However, a counterparty

might be able to offer at a lower price a single trade option contract

that hedges all of these risks.18

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\18\ Under certain conditions, a contract that bundles options

on multiple commodities has a lower premium than the total premia of

the individual options on those commodities.

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Trade option contracts also may address the need for sufficient

cash flow to maintain margins on open futures contracts or to prepay

option premiums. Although trade options typically are not margined,

depending on the terms of the contract, they may allow the option

purchaser to delay payment of the premium. In certain cases the option

may be collateralized implicitly by linking the option and a contract

to deliver the crop or livestock to the same counterparty. The premium

can then be incorporated into the cash contract by deducting it from

the final price of the commodity at delivery.

III. Risks of Trade Options on the Enumerated Commodities

The Division also identified a number of potential risks which may

cause heightened concern if the prohibition on agricultural trade

options were lifted. These include fraud, credit risk, liquidity risk,

operational risk, systemic risk and legal risk. Trade options on the

enumerated commodities, as with all commodity-related over-the-counter

instruments, would trade in a less-regulated environment than exchange-

traded options. The Act imposes legal requirements on an exchange,

mandating that it police itself and its participants for illicit

activity. In addition, the regulatory structure imposes a variety of

prophylactic protections against egregious forms of fraudulent and

abusive conduct. When trading is conducted on a centralized market with

standardized trading instruments and procedures, it is possible for the

government to offer a broad level of customer and market protection by

applying relatively modest levels of its resources.

In contrast, much of the appeal of trade options stems from the

desire to deal with known counterparties or to customize the contracts.

However, regulatory oversight and enforcement is limited in such

circumstances to the extent that vendors of the instrument are not

themselves regulated. Although the vendors in a decentralized market

could be subject to a regulatory scheme, the absence of a centralized

market and a self-regulatory organization reduces the effectiveness of

any such regulatory protections. Because transactions in trade options

would be decentralized, the resources necessary to surveil that

activity would be far greater than those necessary to oversee the

operations of a centralized market. Finally, the ability of the

government to police such activity directly, without the assistance of

a self-regulatory organization, would require a commitment of greater

resources.

Customization of particular contracts also increases the

possibility of fraud. The lack of standardization may make the

oversight and policing of trade practices more difficult. Providing

prophylactic protections, as well as establishing general rules of

appropriate conduct, is more difficult when contract terms are not

standardized. Moreover, where practices vary greatly from one vendor to

another, enforcement is made more difficult.19

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\19\ For example, during the late spring and summer of 1996, the

Commission received many complaints concerning so-called HTA

contracts. As the Commission noted at the time, because the terms

and circumstances surrounding each contract varied so much, it could

only make a case-by-case determination regarding the legality of the

contracts. Such an approach requires a relatively large commitment

of Commission resources.

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Just as a lack of standardization may make it more difficult to

police trading in these instruments, it may also make it more difficult

for customers to protect themselves from fraudulent or wrongful

practices. Initially, it is expected that agricultural producers and

users would enter into put and call options that were very similar to

those already offered on-exchange. However, to the extent that the

terms of the contracts or financing arrangements for them became more

complex, greater time will be required for individuals to become

familiar with a particular product. Moreover, individuals will by

necessity progress through a learning curve as they become familiar

with a particular product and how it interacts with their set of

circumstances. During the early stages of this process, individuals may

be more susceptible to fraudulent activity. This, and the possible

variation among instruments from one source to another and the time it

takes to familiarize oneself with each new or different product,

increase the chance that certain individuals will exploit the

opportunity to commit fraud.20 Of course, educational

efforts aimed at potential participants in such instruments might, to

some degree, ameliorate these effects. Conversely, this problem may be

exacerbated to the extent that the fraudulent activity is carried out

through the guise of providing education on these

instruments.21

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\20\ A good example of this learning process has been the recent

experience with flexible hedge-to-arrive contracts. These contracts

had been entered into by elevators and producers for several years

before recent variations in practice coupled with an inversion in

the corn markets exposed the weaknesses associated with these

contracts.

\21\ Concerns about potential fraudulent activity are not

limited to option vendors. They also extend to those rendering

advisory or educational services in connection with such

instruments.

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In such a decentralized market, participants find it more difficult

to detect possible fraudulent conduct by their counterparty. The lack

of transparent prices may make it difficult for parties to accurately

ascertain a reasonable value for the contract. Moreover, to the extent

that there is a lack of daily marking of positions to market or

reporting of account position statements, as a matter of practice or

regulatory requirement, it may make it more difficult for a

counterparty to uncover possible fraudulent activity. These weaknesses

may exacerbate other information inequalities and create a climate

where fraudulent or sharp practices are made easier.

Finally, certain counterparties, particularly those who are also

Commission registrants, could have conflicts of interest and customers

may be confused as to the role of the counterparty. For example, to the

extent that FCMs are permitted to offer trade options as principals,

but also to act as fiduciaries in relation to executing exchange-traded

options, confusion on

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the part of the customer may result as to the FCM's role and

responsibilities. Of course, where the counterparty is a Commission

registrant, the potential conflicts could be addressed through required

disclosures or other mechanisms.

In the past, the Commission has found fraud in connection with the

offer and sale of off-exchange option contracts to be a serious

problem. In 1978 the Commission adopted a rule that suspended the offer

and sale of commodity options to the general public. 22 In

adopting the rule, the Commission noted that ``[t]he Commission's

experience to date indicates that the offer and sale of commodity

options has for some time been and remains permeated with fraud and

other illegal or unsound practices notwithstanding a substantial

investment of the Commission's resources in attempting to regulate

rather than prohibit option trading.'' The Commission also expressed

its view that the absence of exchange trading in the United States at

that time may have contributed to problems with option trading.

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\22\ 43 FR 16153 (April 17, 1978).

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Credit risk is the risk that a counterparty will be unable to

perform on an obligation. In the case of an option, where a purchaser

pays the premium up-front, the credit risks faced by the purchaser and

the writer differ. The writer of an option faces significant market

exposure, such that the writer's out-of-pocket losses may exceed the

premium paid by the purchaser. Thus, the purchaser is at risk that the

writer will not perform. The writer of an option typically does not

face credit risk, however, because, unless the premium is financed or

deferred, the purchaser has already performed on the contract by paying

the premium. 23 An option purchaser, therefore, must take

particular care to assure himself or herself that the option writer is

able and will be willing to perform on the contract under all market

conditions.

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\23\ This lack of credit exposure may create a greater

likelihood of fraudulent practices. For example, an enterprise may

sell options with no intention of performing on the contracts.

Because a period of time passes between the time options are written

and when they expire, the enterprise may be able to collect a

substantial amount of funds before its intentions not to perform are

discovered.

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Liquidity enables customers quickly to enter into a transaction

without significantly raising or lowering the purchase or sale price in

the process. The market for trade options differs markedly in liquidity

from exchange markets. Exchange markets permit trading among a diverse

group of participants. Moreover, contracts are standardized and

fungible, allowing any contract to be traded with any participant. The

potential pool of participants for a specific trade option is much more

limited. An individual entering into a trade option will likely have

only a handful of offerors from which to choose. In addition, because

trade options are typically not fungible, once one is entered into, the

holder of the option can exit only by returning to the offeror. This

may result in a higher cost to the hedger than would be the case with a

more liquid, exchange-traded instrument.

Operational risk is the risk that the monitoring and control of

operations cannot be sufficiently maintained and that financial losses

occur as a result. Exchange-traded contracts are highly standardized.

As a result, the terms and conditions of the contracts and the

environment in which they are traded are well understood. In addition,

familiarity with these contracts has become highly developed over the

years. Familiarity with exchange-traded options tends to reduce the

operational risk associated with their use. This risk is further

reduced because of exchange and CFTC disclosure rules and other

requirements, including daily marking-to-market of positions and

regular customer position statements, which keep individuals informed

of accruing losses.

In contrast, trade options are not traded in a transparent

environment or on a continuous basis. As a result, prices may not

regularly be reported, and positions may not be marked to market on a

regular basis. Thus, it may be more difficult to monitor the market

value of a position,24 thereby increasing the degree of

operational risk.

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\24\ Based upon observation of forward contracting and

associated hedging practices, it is anticipated that, although the

terms of agricultural trade options will be individually negotiable,

they nonetheless would be expected initially to resemble closely the

terms of exchange-traded options with respect to exercise dates,

delivery grades and strike prices. To the extent that the terms are

similar, it will be easier to monitor the financial condition of a

position by observing prices on the exchange markets. In addition,

for individuals who have purchased an option, the price of the

option is determined up-front, reducing the need to monitor the

value of the position.

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It should also be noted that, in the case of agricultural trade

options, the most likely counterparty to producers is the local country

elevator. Adding option contracts, particularly those with unusual

terms, to the marketing mix of contracts already offered by an elevator

may increase the complexity of the elevator's overall position and make

it more difficult to hedge. Thus, the elevator's operational risk

related to the use of trade options may be higher than under the

current situation.

Generally, systemic risk is the risk of a broader collapse of

entities or contracts that can be traced back to the collapse of an

initial contract or group of contracts. While the repercussions from a

widespread default can be problematic wherever it occurs, they can be

particularly troublesome in rural areas where the economies of a town

or region can be relatively isolated and highly dependent on

agriculture. Thus, a default relating to agriculture could potentially

spread quickly to other sectors of the local or even regional economy.

Lifting the ban on trade options on the enumerated commodities

would provide an additional exemption from the general rule requiring

commodity futures and option contracts to be traded only on designated

contract markets. To the degree that the current prohibition is removed

or relaxed, entities choosing to operate pursuant to that exemption

would have to take care to conform their activities to the terms of the

exemption. Failure to do so might expose such an entity to the legal

risk that a particular over-the-counter derivative contract offered by

it was not covered by the exemption and that its offer or sale violated

either that exemption or some other provision of the Act or Commission

rules.

The degree of risk of this occurring would depend upon the extent

to which a simple option contract were modified. In a simple option

position, the holder of the option has the right but not the obligation

to make or take delivery of a commodity at a given price. However, as

has been seen in the development of derivative contracts in the

financial markets, this simple contract can evolve into more

complicated instruments with payout structures significantly different

from those associated with a simple option. These structures give rise

to the risk that the resulting instrument comes more closely to

resemble a futures contract, rather than an option contract.

Accordingly, in order to avoid a violation, those offering option

contracts in reliance on the trade option exemption would have to

assure themselves that the instruments they offer adhere closely to the

terms of that exemption.

IV. Possible Regulatory Restrictions

The Division in its study identified and analyzed a variety of

regulatory protections or conditions which could be fashioned to

address many of the risks noted above. These conditions could apply to

the nature of eligible

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parties, conditions on the instrument or its use and regulation of

marketing.

A. Nature of the Parties

As the Division noted, an indirect means of discouraging

unsophisticated individuals from entering into trade options would be

to use transaction size as a proxy for sophistication. A high minimum

transaction size effectively would bar smaller, less well-capitalized--

and presumably less sophisticated--commercials from participating. This

approach has been a stipulated condition of transactions permitted

under several Commission and staff no-action letters.25

Transaction size limitations are a clear, easily applied--albeit

crude--means of measuring sophistication.26 Similarly, the

net worth of the customer counterparty could be used as proxy for

determining sophistication.

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\25\ The Commission, in May 1991, issued a no-action letter to

Gelderman, Inc., with respect to the offering of agricultural trade

options. See, n. 39, supra. A condition of the letter was that the

options be offered in units of no less than 100,000 bushels.

Subsequently, in June 1992 the staff issued a no-action letter to a

commodity merchant and processor to allow the offer of agricultural

trade options. A condition of that letter was that the minimum

transaction size of an option be at least 1,000,000 bushels. See,

CFTC Letter No. 92-10, Division of Trading and Markets, Comm. Fut.

L. Rep (CCH) para. 25,309 (June 9, 1992).

\26\ The minimum appropriate transaction size levels would have

to be considered as part of a notice and comment rulemaking

procedure.

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Proxy limitations may be over- or under-inclusive. In the case of

size restrictions, they may limit hedging flexibility. As mentioned

above, many producers do not use exchange-traded contracts because they

prefer not to post margin, do not have brokers to sell them exchange-

traded options or must arrange financing for the position. Entering

into a trade option contract with a local elevator may address these

producer concerns. Using these proxy limitations, however, may make

trade options unavailable to the smaller entities that might otherwise

find them the most useful. Conversely, such proxy limitations may also

be a crude, though clear, means of distinguishing among entities when

determining to which, if any, various conditions for lifting the ban on

agricultural commodities should not apply.

Another method of limiting access to agricultural trade options as

a means of maintaining regulatory oversight is to limit those entities

or individuals which may become trade option vendors. For example,

option vendors could be required to register in some capacity with the

Commission as a condition of doing business.27

Alternatively, the Commission could consider creating new requirements

that would be applicable only to the offer and sale of agricultural

trade options.28 Such requirements could establish a new

category of special registration or could simply require that those

offering such instruments identify themselves by notifying the

Commission. In lieu of, or in combination with, required registration,

the Commission could restrict vendors of trade options to commercial

entities involved in the handling or use of the commodity.

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\27\ An additional alternative would be to permit registration

and oversight of option vendors by other federal or state regulators

to substitute for CFTC registration. For example, under this

alternative a bank subject to state or federal banking oversight

could also offer trade options. However, an elevator could not offer

such options unless it became registered with the Commission as an

introducing broker or, as discussed below, in a new category of

Commission registration or was subject to oversight under some other

specified regulatory scheme.

\28\ However, there are costs associated with registration

requirements, both for the registrant and the Commission which must

be taken into consideration.

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As an alternative for, or in conjunction with, other requirements

and restrictions, the Commission could institute an educational program

or condition. Many of the participants in the December Roundtable

expressed the concern that individuals need better education in the use

of option contracts and in the principles of risk management

generally.29 The appeal of such a program rests on the

assumption that better educated individuals can better protect their

own interests, thereby reducing the need for other regulatory

restrictions or monitoring procedures.

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\29\ December Roundtable, tr. pp. 17, 19, 32, 45, 49, 53 and 62.

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Although the Commission currently does not have any educational

requirements for individuals using futures or option contracts, the

exchange-traded option pilot program established under the 1990 farm

bill,30 a program limited to a relatively limited number of

counties, required persons participating in the program to complete

educational training. Seminars on marketing and the use of exchange-

traded options were developed by the United States Department of

Agriculture and presented through the State Cooperative Extension

Service together with representatives from the State and County

Consolidated Farm Service Agency. The instruction included an

introduction to the Options Pilot Program and a review of option

trading procedures.

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\30\ FACT Act--Food, Agriculture, Conservation and Trade Act of

1990 (P.L. 101-624).

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Although an educational program or requirement has great appeal,

implementing the program could be very costly, especially in light of

its potential nationwide scope. Moreover, mandatory attendance to

fulfill an education requirement may not achieve the desired effect of

raising the level of understanding or sophistication among potential

participants, however. Unless competency also is tested, an attendance

requirement alone may not be indicative of the actual sophistication of

a participant and could lead to a false sense of security by the

government, potential vendors, and the customers themselves, that those

who met the education requirement were in fact knowledgeable or

suitable customers. Finally, to the extent that private providers or

organizations undertook this role, there would be a risk that

educational programs could resemble or become marketing seminars.

B. Restrictions on the Instruments or Their Use

Several restrictions, either direct or indirect, could be placed on

the use of agricultural trade options, in addition to the requirement

that they be offered only to commercial entities. Section 32.4 of the

Commission's regulations requires that trade options be offered only to

a commercial entity ``solely for purposes related to its business as

such.'' Although the Commission has not had occasion to address the

scope of this restriction definitively, the Commission could delineate,

by either specific restrictions or more general guidance, at least

initially, those practices which in the context of agricultural trade

options will ensure that the use of such options remains within the

intent of the exemption.31

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\31\ In connection with HTA contracts, the Division of Economic

Analysis frequently was asked for further specificity concerning the

extent to which various forms of the contracts fell within the

boundaries of the Commission's rules or policies or staff no-action

positions. In response, the Division issued a Statement of Guidance

on May 15, 1996. This statement provided specific guidance that

could be applied to contracts or transactions to determine whether

or not they were ``prudent,'' that is, could be used to reduce price

risks. Such a format, if applied to trade options, also might prove

valuable to the industry.

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For example, the requirement that trade options be for a business-

related use suggests that the overall size of all agricultural trade

option contracts and any other derivative positions should not exceed

the size of the cash or forward market position being hedged. Under

most circumstances, a position in a derivative contract that exceeds

the

[[Page 31381]]

size of the underlying cash or forward position increases price risk.

Other circumstances associated with managing risk include the existence

of a predictable relationship between the crop produced and the

commodity on which the option is written, the timing of option

expiration and harvest of the commodity, and the expiration of the

option in a crop year which coincides with the delivery period for the

underlying commodity.

Consideration should also be given to whether, or under what

circumstances, the practice of a producer or other agricultural

business selling options to generate premium income is ``solely for

purposes related to its business as such.'' While the purchaser of an

option holds a limited risk instrument, option sellers potentially face

unlimited price risk. A practice sometimes used by individuals having

positions in the underlying commodity is to enter into what is known as

a covered position. A producer enters a covered call position when he

or she writes a call option that can be satisfied through delivery from

production. In this sense, if prices fall, a producer writing covered

calls is better off by the amount of the premium income received than

if the cash position is not hedged. However, if prices rise, the

producer is not able to participate in the market rally, although he or

she may, nonetheless, receive a price sufficient to cover production

costs and provide a satisfactory profit margin.

A second practice which generates premium income involves contracts

which incorporate both written and purchased options. A contract having

a cap and floor is an example of this practice. In conjunction with a

long cash position, these contracts set a floor price for the

commodity. The cost of providing that floor, however, is reduced in

return for the producer agreeing to limit the upside profit potential,

essentially incorporating a written call into the contract. To the

extent that such contracts provide for a ratio of written options in

excess of purchased options, they raise issues similar to those of

writing covered calls or naked options. Certain trading strategies,

such as placing and lifting a ``hedge'' multiple times, also raise the

issue of whether such practices are consistent with the requirement

that trade options be for a business purpose.

In addition, the design of trade option contracts could be

restricted to assure that they do not violate other provisions of the

Act or Commission regulations. While a basic option contract is a

limited-risk financial instrument, options can be bundled to create

instruments with more complex payout scenarios. Because option

contracts can be ``bundled'' to create a synthetic futures contract and

the regulatory treatment of trade options differs substantially from

that of off-exchange futures contracts, the Commission could delineate

trade options from futures contracts, either through guidance or as a

condition of the exemption.

C. Regulation of Marketing

Required disclosures are a common customer protection. The

Commission, in determining whether required disclosures should be

mandated in connection with lifting the ban on agricultural trade

options, must also determine the nature of the disclosure that is

appropriate to this instrument. A second common protection is the

requirement that customers be provided with periodic information

regarding accounts. Information regarding the value of a customer's

position would be useful to customers in guiding them as to the current

value of their position and determining the prudence of their future

activities.

D. Other Possible Limitations

As the Division noted, a major concern when entering into over-the-

counter transactions is the risk of counterparty default. A variety of

measures have been used in commerce, and on various occasions required

by the Commission, to attempt to ensure that parties to a contract meet

their obligations. These include collateral requirements, minimum

capital requirements, cover requirements in the form of hedges or cash

market inventories, third party guarantees and minimum credit ratings.

For example, under the Commission's Part 34 exemption for hybrid

instruments, as initially promulgated, the eligibility of hybrid

instruments issuers for the exemption was conditioned upon meeting one

of four credit-related criteria. These criteria were that the

instrument be rated in one of the four highest categories by a

nationally recognized investment rating organization, the issuer had at

least $100 million in net worth, the issuer maintained letters of

credit or cover, consisting of the physical commodity, futures, options

or forward contracts for the commodity or interests consisting of

acceptable cover, or that the instrument be eligible for insurance by a

U.S. government agency or chartered corporation. In contrast, a futures

exchange, during the December Roundtable, advocated that parties

offering agricultural trade options be required to maintain cover by

holding a one-to-one hedge with an exchange-traded

contract.32

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\32\ See, December Roundtable, tr. pp. 30, 31, 36, 47, 48 and

78.

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Requiring one-to-one hedging would restrict the flexibility of

certain option vendors. For example, offerors with sufficient capital

reserves might be in a position more effectively to cover the risk

associated with their option contracts in a manner other than by one-

to-one hedging.

Generally, the Commission imposes internal controls requirements as

a condition of registration. These include the requirement that FCMs

provide audited financial statements, have in place a system of

internal controls, and supervise the conduct of all employees. The

Commission could impose similar requirements on agricultural trade

option vendors, with or without mandating their registration. However,

in the absence of a registration requirement and a self-regulatory

organization to assist in enforcing that requirement, such conditions

would be more difficult to mandate and to enforce.

Many country elevators and others at the first-handler level of the

marketing chain do not now have in place adequate internal controls to

engage in a variety of off-exchange transactions,33 nor are

they subject to a regulatory scheme requiring such controls.

Accordingly, a possible condition on those wishing to become vendors of

such instruments might be to require that they have in place systems to

track changes in the value of their positions and to notify customers

periodically of the value of such positions. The adequacy of such

systems could be required to be subject to a review by a certified

public accountant.

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\33\ See, December Roundtable, tr. p. 56.

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V. Related Issues

The Division's study also touched on a number of issues which have

been raised regarding the applicability of other exemptions to

agricultural contracts. Those issues relate to forward contracts having

option-like payment features and to the applicability of the

Commission's exemptions under Part 35 of its rules--for swaps, and Part

36 of its rules--for professional markets. Although the Division's

recommendations with respect to these issues are not directly

applicable to the Commission's determination whether to lift the

prohibition on the enumerated agricultural commodities, and are not the

subject of this Advance Notice of Proposed Rulemaking, the Division

recommended that the Commission

[[Page 31382]]

decide that the prohibition on agricultural trade options does not

limit the scope of the Commission's swaps exemption under Part 35 of

its rules and that staff update a previous interpretative letter of the

Commission's Office of General Counsel.

VI. Issues for Comment

Based upon the Division's study and its recommendation, the

Commission is considering whether to lift the prohibition on

agricultural trade options subject to conditions. The Division

identified an array of possible regulatory conditions for lifting the

prohibition, each having differing benefits and costs. The receipt of

public comment on these issues, particularly an assessment by

commenters of the costs and benefits of the potential regulatory

conditions identified by the Division, will assist the Commission in

considering whether to lift the prohibition and, if so, what conditions

would establish an appropriate regulatory predicate for so doing.

Accordingly, the Commission invites commenters to respond to the

following specific questions, as well as additional comments they may

have on the above analysis.

A. Benefits

1. Are there additional potential benefits of permitting the offer

or sale of trade options on the enumerated agricultural commodities

that were not identified in the Division's analysis?

2. Who, in addition to first handlers, likely would become vendors

of agricultural trade options? Who would likely be purchasers of such

instruments? Would they attract commercials who do not currently engage

in risk-management practices?

3. Would the availability of agricultural trade options likely

result in the introduction of new products, or would such options

merely replicate those already available on-exchange?

4. What factors, if any, suggest that there is a demand for

agricultural trade options? Has the need for such options changed over

the years? If so, in response to what factors?

B. Risks

5. Are there additional potential risks resulting from permitting

the offer or sale of trade options on the enumerated agricultural

commodities that were not identified in the Division's analysis?

6. How transparent is the pricing of the instruments discussed in

response to question No. 3 likely to be?

7. What role can industry or trade groups take in promoting best

sales practices? Is some degree of uniformity in instruments necessary

or desirable to prevent fraud?

8. What are the likely credit relationships in offering such

contracts? Will customers have the bargaining power to address credit

issues arising because of the asymmetrical nature of option-related

credit exposures?

9. What systems do first-handlers currently have in place to

address operational risk? What oversight is there of their operations,

and by whom? Are current systems adequate to respond to the demands

stemming from offering agricultural trade options? Are there

impediments to first-handlers, and others, developing the necessary

operational infrastructure?

10. Are there mechanisms in place to contain possible effects to a

local or regional economy from the financial failure of a single

elevator? Does such a failure, if due to adverse experience in trade

options, have a different result or impact than one due to other

reasons?

C. Nature of the Parties

11. Should restrictions be placed on who could offer trade options?

For example, should vendors be subject to net worth or other financial

capacity restrictions? Should vendors of agricultural trade options be

registered with the Commission? What if any criteria should be

conditions of such registration? If registration is not required,

should vendors be required to notify the Commission? Should option

vendors be limited to commercial agricultural interests or other types

of entities which are subject to a registration requirement or

government oversight--such as CFTC registrants, banks or insurance

companies?

12. Should the use of trade options be limited to sophisticated

users? If so, what criteria are appropriate to determine the

sophistication of a party? Would other restrictions on users (such as

net worth or other measures of financial capacity) be appropriate? If

trade options are not limited to such users, should sophisticated users

be exempt from any or all of the trade option requirements? Are parties

which meet the eligibility requirements of Parts 35 and 36 of the

Commission's rules appropriately defined as sophisticated for this

purpose?

13. Are minimum transaction size requirements a practical means of

limiting access to trade options? If so, what is an appropriate

transaction size in the various commodities that would assure that

options are available to only sophisticated participants? Should

parties be exempt from transaction size limitations if they can

demonstrate sophistication through some other criteria? If so, what

substitute criteria would be appropriate?

14. Is an educational requirement appropriate as a condition to

enter into a trade option contract for customers and/or vendors? What

type of condition would be appropriate with regard to education? Should

an option customer be required to demonstrate some level of proficiency

with respect to option transactions, and if so, how would proficiency

be determined? If trade option vendors were permitted to conduct

educational seminars, what restrictions or disclosures might be

required of vendors to prevent abuses? What resources for offering such

educational opportunities exist or can be made available?

D. Restrictions on the Instruments or Their Use

15. What uses of agricultural trade options should be deemed

appropriate? Should restrictions on the use or design of trade options

be by regulation? Or should the Commission issue general guidance on

this issue?

16. Under what circumstances, if any, should the writing of

agricultural options by producers be considered to be an appropriate

business-related use of a trade option? More specifically, is it

appropriate for producers to write covered calls under the trade option

exemption? To what degree, if any, is the writing of options to offset

the cost of purchasing an option, appropriate?

17. Should the Commission adopt regulations or provide guidance to

restrict trading strategies by option users which result in the

increase of risk? What types of trading strategies might be restricted?

Should trade option customers be allowed to enter and exit a position

multiple times? What means could the Commission use to limit such a

trading strategy? What obligations would be appropriate for the

Commission to place on trade option vendors with respect to monitoring

the appropriateness of the trading activity of their customers?

18. To what extent should option vendors be permitted to bundle

options to create risk-return payouts different from a simple put or

call option?

E. Regulation of Marketing

19. What types of risk disclosure should be required of vendors as

related to the offer and sale of trade options? Should such disclosure

be through a mandated uniform risk-disclosure statement? What

information should be required to be disclosed?

20. What types of information and at what intervals should vendors

be required to notify a customer with

[[Page 31383]]

respect to the financial status of a trade option position? What form

should trade confirmation take?

F. Cover Requirements

21. Should the Commission compel counterparties to cover market

risks, or should the issue of providing cover be left to negotiation

between the counterparties? Should parties be permitted to waive the

right to have a counterparty provide some sort of cover or guarantee?

22. If cover is required, should parties be allowed to combine

different forms of cover--i.e., collateral, hedging, minimum capital,

guarantees, etc.--to satisfy the requirement?

23. Should cover be required on the vendor's gross or net trade

option position? Should parties be allowed to offset their exposure on

a trade option position against other non-trade option positions within

the operation? At what level of a multi-enterprise firm should the firm

be allowed to net their trade option exposure?

24. If the customer has a short option position, should the vendor

have an obligation to ascertain whether the customer has adequately

covered the position?

25. If parties are required to provide cover in the form of a one-

to-one offsetting position in an exchange-traded option, what would

constitute a ``one-to-one'' offset? That is, for trade option

transactions occurring at fractional sizes of exchange contracts, would

parties be required to round a position up or down? Would individual

trade options be required to be offset individually, or could the

overall position of the seller be hedged? How would trade options be

covered for those enumerated commodities which are no longer actively

traded on an exchange? What type of accounting procedure should be

required to match trade options to offsetting exchange contracts?

26. In setting a minimum capital requirement in lieu of or in

combination with various forms of cover, how should the overall level

of market price risk be determined, and what level of capital would be

deemed sufficient to cover the risk?

27. Should third-party guarantees be permitted as a form of cover?

If so, what forms and what level of guarantee would be appropriate as

cover for a trade option position? Should the total potential exposure

on a trade option position be guaranteed? Who are appropriate parties

to supply a guarantee?

G. Internal Controls

28. At a minimum, what types of internal controls should an option

vendor have in place?

29. What is the most cost effective means to assure that vendors

implement the minimum level of internal controls? What regulatory

oversight mechanisms are necessary and in place? Should vendors be

audited to assure compliance, or is a review by a certified public

accountant sufficient?

30. Overall, in light of the above questions, should the Commission

lift the prohibition on trade options on the enumerated agricultural

commodities?

Issued in Washington, DC, this 3rd day of June, 1997, by the

Commission.

Jean A. Webb,

Secretary of the Commission.

[FR Doc. 97-14890 Filed 6-6-97; 8:45 am]

BILLING CODE 6351-01-P