[Federal Register: June 9, 1997 (Volume 62, Number 110)]
[Proposed Rules]
[Page 31375-31383]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr09jn97-26]
=======================================================================
-----------------------------------------------------------------------
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.
-----------------------------------------------------------------------
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.
[[Page 31376]]
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, [[email protected]].
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.<SUP>1</SUP> 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.<SUP>2</SUP>
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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.'' <SUP>3</SUP>
---------------------------------------------------------------------------
\3\ The definition of commodity is currently codified in section
1a(3) of the Act.
---------------------------------------------------------------------------
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.<SUP>4</SUP>
The Act's statutory prohibition on the offer and sale of options on the
enumerated agricultural commodities was retained.
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
Shortly after its creation, the Commission promulgated a
comprehensive regulatory framework applicable to off-exchange commodity
option transactions in the non-enumerated commodities.<SUP>5</SUP> This
comprehensive framework exempted ``trade options'' from most of its
provisions.<SUP>6</SUP> 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).
---------------------------------------------------------------------------
\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).
---------------------------------------------------------------------------
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.<SUP>7</SUP> Congress later codified
the Commission's option ban,
[[Page 31377]]
establishing a general prohibition against commodity option
transactions other than trade and dealer options.<SUP>8</SUP>
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.<SUP>9</SUP> 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.<SUP>10</SUP>
---------------------------------------------------------------------------
\9\ 46 FR 54500 (Nov. 3, 1981).
\10\ Public Law No. 97-444, 96 Stat. 2294, 2301 (1983).
---------------------------------------------------------------------------
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.<SUP>11</SUP> 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.'' <SUP>12</SUP> 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.<SUP>13</SUP>
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.
---------------------------------------------------------------------------
\11\ 49 FR 2752 (January 23, 1984).
\12\ 48 FR 46797, 46800 (October 14, 1983) (footnote omitted).
\13\ Id.
---------------------------------------------------------------------------
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.<SUP>14</SUP> 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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.<SUP>15</SUP> 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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.<SUP>16</SUP> 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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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
[[Page 31378]]
output, the hedger is forced to under- or over-hedge.<SUP>17</SUP>
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.<SUP>18</SUP>
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.<SUP>19</SUP>
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.<SUP>20</SUP> 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.<SUP>21</SUP>
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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
[[Page 31379]]
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. <SUP>22</SUP> 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.
---------------------------------------------------------------------------
\22\ 43 FR 16153 (April 17, 1978).
---------------------------------------------------------------------------
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. <SUP>23</SUP> 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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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,<SUP>24</SUP> thereby increasing the degree of
operational risk.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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
[[Page 31380]]
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.<SUP>25</SUP>
Transaction size limitations are a clear, easily applied--albeit
crude--means of measuring sophistication.<SUP>26</SUP> Similarly, the
net worth of the customer counterparty could be used as proxy for
determining sophistication.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.<SUP>27</SUP>
Alternatively, the Commission could consider creating new requirements
that would be applicable only to the offer and sale of agricultural
trade options.<SUP>28</SUP> 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.
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.<SUP>29</SUP> 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.
---------------------------------------------------------------------------
\29\ December Roundtable, tr. pp. 17, 19, 32, 45, 49, 53 and 62.
---------------------------------------------------------------------------
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,<SUP>30</SUP> 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.
---------------------------------------------------------------------------
\30\ FACT Act--Food, Agriculture, Conservation and Trade Act of
1990 (P.L. 101-624).
---------------------------------------------------------------------------
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.<SUP>31</SUP>
---------------------------------------------------------------------------
\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.
---------------------------------------------------------------------------
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.<SUP>32</SUP>
---------------------------------------------------------------------------
\32\ See, December Roundtable, tr. pp. 30, 31, 36, 47, 48 and
78.
---------------------------------------------------------------------------
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,<SUP>33</SUP> 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.
---------------------------------------------------------------------------
\33\ See, December Roundtable, tr. p. 56.
---------------------------------------------------------------------------
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
======== RETURN TO INDEX ========