Good morning Mr. Chairman and members of the Committee. I am David Lehman, Group Manager of Commodity Products at the Chicago Board of Trade (CBOT®), and I am pleased to be here today representing the Chicago Board of Trade.

The CBOT is the world's leading futures exchange, trading over 224 million contracts in 1996, covering a broad range of agricultural products and financial instruments. The CBOT's agricultural contracts include futures and options on prices for corn, wheat, soybeans, soybean meal, soybean oil, oats and rice. In addition, the CBOT trades futures and options on state level yields for corn for the states of Iowa, Illinois, Indiana, Nebraska and Ohio and is approved to trade wheat yield contracts for the states of Kansas and North Dakota and soybean yields for Illinois.

Implementation of the new commodity programs contained in the 1996 Federal Agricultural Improvement and Reform (FAIR) Act has given U.S. producers greater opportunity to produce for expanding world markets. However, it has also required that they assume more responsibility for price and yield risk management. Annual acreage reduction programs and the target price and deficiency payment programs were eliminated due to escalating costs and unintended market distortions resulting in inefficient allocation of resources. In addition private market risk management tools and hedging strategies have developed, allowing Congress to recognize that government's role in risk management could be reduced.

The FAIR Act also provides for a relatively lengthy transition period of seven years, during which time producers can continue to receive subsidies in the form of market transition payments while learning to adapt to markets free of government intervention and without subsidies. In addition, the Act authorizes several pilot programs related to risk management education, futures and options, crop insurance and revenue insurance (Subtitle H, Miscellaneous Commodity Provisions, Sections 191-195).

Nearly a year after the FAIR Act was passed by Congress, only the risk management education pilot program required in Section 192 has been implemented. The CBOT has been working with the RMA on this pilot program and recently presented testimony to the House Agriculture Subcommittee on Risk Management regarding the progress of this effort.

Section 191 of the FAIR Act authorizes the Secretary of Agriculture to "...conduct a pilot program for one or more agricultural commodities...to ascertain whether futures and options can provide producers with reasonable protection from the financial risks of fluctuations in price, yield, and income inherent in the production and marketing of the commodities". The CBOT recommends that the Secretary exercise this authority and work with producers groups and the futures industry to develop a pilot program to give producers experience in the use of futures and options for risk management. The CBOT would be happy to participate in the development and implementation of such a program as we did with the Options Pilot Program Act of 1990. Section 195 of the FAIR Act amended the Federal Crop Insurance Act by requiring the Secretary to implement a revenue insurance pilot program by December 1996. According to USDA's Risk Management Agency, this requirement was satisfied by its existing revenue insurance products, Crop Revenue Coverage (CRC) and Income Protection (IP). While these products appear to satisfy the general intent of Section 195, they do not meet the requirement of being actuarially sound due to the government subsidies involved.

CRC and IP are designed to insure producers against declines in total crop revenue as a result of reductions in either price or yield. As you are aware, the CRC product was developed by a private insurance company, and the IP product was developed by FCIC. However, all crop insurance companies which sell these products to producers are subsidized by the Federal government through premium subsidies, administrative expense reimbursements and the Standard Reinsurance Agreement (SRA) available to all federally reinsured crop insurance companies. However, the level of these subsidies is difficult to calculate with any certainty.

The CBOT commends American Agrisurance and the FCIC for recognizing the need for innovative new risk management tools and developing them in response to that market need. However, the Federal subsidies available for these crop insurance products create substantial disincentives for the development of alternative revenue insurance products and the use of exchange-traded futures and options contracts to achieve revenue assurance. The CBOT's crop yield insurance futures and options contracts mentioned above were designed specifically to provide producers with an additional tool to manage production risk and to help the Federal government reduce its expenditures for crop insurance subsidies and ad-hoc disaster programs. Crop yield insurance futures and options contracts can be combined with traditional price futures and options contracts to provide a flexible mechanism for hedging crop revenue, either directly by the producer or by crop insurance companies who may need to hedge the risk of revenue insurance products offered to producers. Furthermore, as was recently suggested in an article in the American Journal of Agricultural Economics, Hedging With Crop Yield Futures (Vukina, Li and Holthausen), development of futures on crop revenue may allow more effective hedging than is possible with separate price and yield contracts.

The use of exchange-traded futures and options for insuring crop revenue has been limited, however, for four primary reasons. First, exchange-traded futures and options must compete with the subsidized revenue insurance products currently offered by crop insurance companies. Second, state insurance regulations effectively prevent crop insurance companies from using futures and options contracts for stop loss protection. Third, non-insurance entities which would be most likely to use exchange instruments to hedge their risk are prevented from offering revenue assurance on agricultural production because of the CFTC's agricultural trade option ban. (The comparable insurance product is not considered a trade option.) Fourth, the tax treatment of commercial hedging transactions involving crop yield futures and/or options contracts is uncertain at this time. Internal Revenue Service regulations which provide ordinary treatment to gains or losses from the use of futures and options for hedging refer explicitly to "prices" and not yields or quantities.

To help overcome the regulatory and institutional barriers to the use of private market revenue insurance/assurance strategies, USDA should use the pilot program authority provided in the FAIR Act to develop a revenue assurance pilot program utilizing exchange-traded futures and options. Such a program could be structured to test the use of combining price and yield futures and options as well as exploring how futures and options could be used in combination with insurance products (i.e., combining price futures and options with multi-peril crop insurance) to insure revenue.

Additionally, support should be given to the development of new futures and options products which combine prices and yields to take advantage of the "natural hedge" or inverse correlation between prices and yields. These products could be used by insurance companies and large grain companies to hedge the risks of crop revenue guarantees at the state level, while portfolio diversification would provide reasonable protection against revenue risk at the county level.

Development of the pilot programs and products described above would be an important step in ensuring that appropriate risk management products are in place when transition payments are no longer available. Producers and crop insurance providers would benefit from the development of exchange-traded crop revenue products with their demonstrated advantages of price transparency and financial integrity. Furthermore, such a pilot program enable this pilot programs to compete with Federally subsidized crop insurance products such as CRC, IP and traditional multi-peril insurance, the Federal subsidies available for these products should be transferred to participants in the pilot program.

SUMMARY

From the CBOT's perspective, Congress and USDA should take the following actions with regard to all of the current revenue insurance/assurance products (CRC, IP and Revenue Assurance or RA) and the pilot program provisions in the FAIR Act:

1. Hedge Price Risk in Exchange-traded Instruments - Crop insurance companies providing revenue insurance to producers via the existing CRC and IP products should be required to hedge their price risk in exchange-traded markets. It is understood that this may require an exemption from or clarification of state insurance commission regulations which currently restrict the ability of crop insurance companies to use futures and options. Utilizing exchange-traded markets to reinsure crop revenue will reduce the government's exposure to reinsurance risk by taking advantage of the efficiency and liquidity of mature exchange-traded markets.

2. Consistent CFTC Treatment of Alternative Revenue Insurance Products Under Agricultural Trade Options Ban - Until the CFTC takes action on its agricultural trade option ban, the CBOT recommends that the current CFTC regulations be applied consistently to economically indistinguishable revenue insurance/assurance products without regard to whether they are offered by crop insurance companies or non-insurance companies.

3. Revenue Assurance Pilot Program - USDA should develop and implement a revenue assurance pilot program to test the concept of providing producers with a pre-selected level of crop revenue through a combination of standardized exchange-traded futures and options and insurance products such as customized MPCI. The objectives of this approach would be to provide producers with a minimum level of revenue comparable to that provided through CRC and IP while dispersing the government's exposure to reinsurance risk. DETAILS OF PROPOSED PILOT PROGRAM

Price protection would be provided by purchasing put options or by selling futures and buying call options (a strategy referred to as a synthetic put). Yield protection would be provided by purchasing state yield puts and customized MPCI to localize the farm yield basis. The new state yield contacts traded at the CBOT would provide generalized protection from wide-spread risk of yield losses from catastrophes such as droughts, floods, and freezing. Only specific individual farm losses not correlated to state yield losses would need to be covered by the customized MPCI.

Taken as a whole, the revenue guarantee concept offers a market-based, actuarially sound, and flexible approach to managing financial risks inherent in the production and marketing of agricultural commodities. All the costs for the revenue guarantee are paid up-front, making it similar to traditional insurance while maintaining total control with the producer. Furthermore, producers who participate would receive education in using risk management tools, also mandated by the FAIR Act, from his team of professionals, i.e., banker, commodity broker, and insurance agent. Alternatively, the RMA may elect to package the revenue guarantee strategy as a single product for delivery to the producer.

For example, assume a farm unit is planted with 100 acres of corn on land producing an average historical corn yield of 160 bu/ac. (30 bushels over the state average) and an expected cash price at harvest of $2.85/bu (95% of the current futures price or 15 cents under the futures). An example of the revenue guarantee strategy described above would work as follows:

Target Revenue Guarantee (75% coverage): 160 bu/ac X 100 ac. X $2.85/bu X 75% = $34,200 During February 1997, with price volatility at 15%, yield volatility at 20%, and 8 1/2 months to harvest, the producer would select a combination of out-of-the-money price and yield options with strike prices to target the revenue guarantee.

Buy three 270 Dec 97 corn put options contracts @ $0.07/bu. = $ 600 Buy three 110 Nov 97 Iowa corn yield put options contracts @ 1.64 bu/ac = $ 492 Buy limited MPCI contract @ $4/ac = $ 400 Total revenue guarantee costs are $15/ac or $0.09/bu. = $1,492 The net farm revenue never falls below $34,208 for the entire range of possible price and yield outcomes and the producer enjoys the revenue benefits of higher production and/or prices. a revenue approach to managing risk is advantageous due to the historic inverse correlation between prices and yields of approximately -.4, i.e., when prices are low, yields tend to be high and vice versa, thereby helping to stabilize revenue.

The revenue guarantee described above can be provided lower costs than currently approved government revenue products (based on an estimated cost of $17 per acre for CRC policy of same coverage level). Therefore, government subsidies available to private insurance providers, i.e., premium cost sharing, reimbursements for administrative expenses, and federal reinsurance benefits could be reduced under the proposed market-based program.

The advantages to the government and taxpayers of implementing the revenue guarantee pilot program would be lower reimbursements for administrative expenses and reduced exposure to reinsurance risk. If premium costs for the revenue guarantee pilot program are shared between the producer and government, then funding to operate the program would be available within the existing USDA budget for subsidizing crop insurance, and the pilot program would operate on a nearly budget neutral level. The CBOT supports the development of new innovative risk management tools such as the Crop Revenue Coverage and Income Protection products which were offered on a pilot basis in Iowa and Nebraska. However, from a policy perspective, care should be taken to avoid broadening the government-subsidized programs so rapidly that: 1) any incentive to create more efficient risk management tools or liquidity in exchange-traded markets is quashed; and, 2) significant financial liabilities are created for U.S. taxpayers who are ultimately re-insuring the yield and price risks.