Testimony

of the

National Grain and Feed Association

before the

Senate Committee on Agriculture, Nutrition and Forestry

U.S. Senate

March 10, 1999

Chairman Lugar and members of the committee. We appreciate the opportunity to present our views on broad risk management issues confronting agriculture. I am Tom Coyle, Vice President with Continental Grain and co-chair of NGFA's Risk Management Committee.

The National Grain and Feed Association is a U.S.-based nonprofit trade association of 1,000 grain, feed and processing firms comprising 5,000 facilities that handle more than two-thirds of all U.S. grains and oilseeds. Founded in 1896, our membership encompasses all sectors of the industry, including country, terminal and export elevators, feed mills, cash grain and feed merchants, livestock integrators, grain and oilseed processors and futures commission merchants. Our industry, as the first purchaser of grains and oilseeds, has traditionally provided marketing and risk management services to farmers through a variety of cash contracts.

If there is a single resounding message embedded in the fundamental changes made to farm law in 1996 ("FAIR" Act), it is that farmers need to assume more responsibility over marketing and risk management in their business. For farmers to accomplish this, they need freedom, flexibility and training.

Does the private marketplace, through crop insurance or other private marketplace mechanisms currently offer tools to the farmer to adequately replace traditional mechanisms of income stabilization? We believe the answer to that question is a clear no! While the U.S. has made progress in development of federally-sponsored crop insurance programs, there are significant gaps. There are also some risk management tools that hold considerable promise that have not been permitted to develop, most notably of which are agricultural trade options. Because of legal and regulatory impediments, many of which still exist, agricultural trade options are not available to farmers today.

Based upon our analysis, we offer the following recommendations on policy direction:

1. Crop insurance is an important risk management tool and government should continue to support it. It would, however, be a mistake for government to maintain a singular focus on crop insurance. Expanded crop insurance cannot satisfy all the risk management needs of farmers, and in fact may act to perpetuate "gaps" in the farm safety net that can be addressed by private enterprise, if given the opportunity. The government should support policies that foster development and offering of a wider range of risk management tools---both government-sponsored and private initiatives. Government should encourage the development of private programs (such as private insurance products or agricultural trade options) that compete directly with its own crop insurance offerings---in the interest of strengthening the safety net and keeping the costs to government reasonable. This can be done through changes in law, regulation and/or subsidization practices.

To encourage broader use of cash contracting in managing risk, the government needs to affirmatively address the barriers to forward contracting caused by the LDP program.

2. Government needs to guard against policy actions that penalize private companies that are attempting to offer risk management services. Poorly reasoned or ill-timed government policy shifts can unnecessarily "crowd out" or displace private initiatives.^{(1) Government can also limit private offerings of risk management tools by ad hoc changes in the regulatory framework. Unless government can provide a reasonable regulatory framework and be supportive of private market initiatives in risk management services, the dependence of U.S. agriculture on government may grow at significant cost to U.S. taxpayers, rather than be reduced as was envisioned under the 1996 farm bill.}

3. We urge the government to proceed cautiously in considering expansion of government programs in the area of price insurance. Price risk management traditionally has been a function of futures and options markets, with many cash contract risk management tools based upon such exchange products. While new crop insurance products like Crop Revenue Coverage (CRC) has been successful and well-received, had the CFTC provided a reasonable regulatory structure for agricultural trade options, risk management tools offering revenue protection similar to CRC could already be available. Exchanges already provide a sound basis for managing price risk. Thus in offering insurance-based products to manage price risk, caution needs to be exercised to assure government-subsidized programs do not "crowd out" non-subsidized exchange products or reward poor management practices that make inadequate use of market-based risk management tools already available.

4. As government begins to consider increased subsidization of current insurance products and the expansion of insurance tools into other crops, livestock, multi-year risk tools and other areas, great care should be taken not to create programs that ultimately impede the competitive position of U.S. agriculture. Excessive, broad-based subsidies delivered through insurance programs have the potential to: 1) create surplus production that depresses market prices; 2) subsidize certain crops at the expense of others, thus impeding the ability of markets to manage relative supplies among crops (controversies involving durum and rice crop insurance programs are examples of problems that can occur); and 3) contribute to inflationary-based agricultural economy that can drive up the cost of inputs and interfere with the global competitive position of the U.S. farmer. The government has a budget surplus today so additional funding to spend on agriculture may be easier to legislate. However, care should be taken not to initiate programs that cannot be sustained in future years when funds are not readily available. To do so may expose farmers to an even harder landing in some future year.

5. The government should continue to support and encourage educational programs for farmers on risk management. The National Grain and Feed Foundation received a grant from USDA to conduct an educational program for farmers through grain elevators and other grain purchasers. The goal of that program is to instruct farmers on appropriate use of combinations of risk management tools like cash contracts, futures and insurance. This program should reach a large number of farmers this year, and hopefully can become self-sustaining in future years. Education is a key ingredient for success with new farm programs. However, education will fall on deaf ears unless government somehow convinces farmers that ad hoc disaster programs will not "always be there" to bail them out of difficult circumstances. To the extent that farmers have tools available to manage such risks, they should assume that responsibility. Ad hoc programs have cultivated complacency among farmers toward risk management in their businesses, and educational programs will be severely challenged to overcome that.

6. It appears that the policy debate on risk management is moving toward an important "fork in the road." Are we going to develop extensive government-sponsored programs that attempt to protect farmers from every conceivable risk? Minimizing government intrusion into markets with such programs, while also treating equitably all farmers across all types of enterprises and businesses would appear to be a formidable task, regardless of the size of the agency charged with the responsibility. At the same time, an important policy question is whether it is fair to only subsidize the income protection of specific crop farmers?

The National Grain and Feed Association is not prepared at this stage to make a final recommendation on this matter, but among many alternatives, it would seem that the federal government has at least three distinct choices:

a) Government can decide which farmers are most-deserving of risk management subsidization and fashion the best programs for those "preferred" farmers using whatever funds Congress will appropriate. It seems unlikely that Congress would be willing to fund a program that would cover all forms of risk for every farmer in the U.S., and the size of bureaucracy that would be needed to administer such program;

b) Government can choose a more targeted approach, more base upon need. The disaster program legislated in 1998 confirms again that Congress is very likely to implement future ad hoc disaster programs. Everyone understands that such government activity is a significant impediment to the crop insurance industry and others to market viable risk management tools. We don't have an answer to this dilemma, but maybe a partial solution lies in creating a more structured program for unexpected disasters, so that ad hoc legislation is more easily avoided except in the most extreme circumstances. Some legislative ideas being circulated include a "revolving fund" approach that would not come into effect every year, only in those years in which a "large" disaster occurs, and only under prescribed circumstances of demonstrated need. The distribution of benefits---and the differential treatment of those actively using risk management services versus those that do not---would be prescribed in advance of disaster benefits distribution. At least with such a program, crop insurers and others could more fully explain the expected benefits of purchasing crop insurance and the potential consequences of not doing so; or

c) A third policy alternative is for the federal government, if it is going to continue to subsidize risk management programs, to move toward a more neutral incentive system, that doesn't create an imbalance in the offering and selection of appropriate tools. Despite best efforts by government, crop insurance doesn't work for everyone (even when heavily subsidized)---it is not always the most economical means of managing production or revenue risk. Futures and options may not "work" for other farmers for whatever reason. And while cash forward contracts are popular, they are actively used by less than half the crop farmers. Given individual preferences of farmers and individual farming situations that favor certain forms of risk management, increased farmer use of such tools seems more likely to be achieved through a more generalized system of incentives that recognizes the wide array of alternatives available.

A more neutral system of incentives, because it would permit more new product development in a less regulated environment, also would be more likely to generate more comprehensive risk management tools encompassing all principal risks: yield, futures price, basis, and physical marketing. Such products could conceivably be offered within a framework based upon insurance and/or agricultural trade options. While some of these new tools may become inherently more complex, the fact that they can be more tailored to specific crop situations of the individual farmer will make the risk profile confronting the farmer more straightforward and easier to understand.

On pages 6 and 7 is contained a chart summarizing most of the major risk management tools available to farmers:

1) Exchange-based tools---futures, options;

2) Cash contracts (for crops)---fixed price, minimum price, and other;

3) Crop insurance products---MPCI and CRC; and

4) Agricultural trade options.

A. Exchange-based tools. As the undisputed centerpiece of price discovery and price risk management in grain-based agriculture, exchange futures contracts remain the single-most important tool and also provide the foundation for many other risk management tools. Virtually all cash contracts offered to grain farmers are designed so as to permit hedging the risk through exchange instruments. Thus, a high percentage of cash contracting activity establishes a price risk to the buyer that is ultimately "laid off" in futures markets. Farmers may use futures markets directly to price products and hedge risk, and such tools have distinct advantages that are available only on regulated exchanges: 1) highly liquid markets allowing rapid adjustments in strategies, and are very cost-efficient; 2) guaranteed counter-party performance; 3) transparent pricing of the futures portion of cash price; and 4) offers mechanisms to price now or later and during periods of "carry" in the market, and offer assured returns to farmers for grain storage activities. Exchange options require an up-front premium payment, but have the added feature of locking in an assured minimum futures price while giving the farmer an opportunity to participate in upward price swings. Options, unlike futures, do not require ongoing margining and the total cost is known in advance.

Why aren't exchange-based tools used by more farmers? With all the advantages that exchange-based products offer---many of which cannot be duplicated off-exchange---the question is often asked: Why don't more farmers use futures and options directly? The biggest disincentive to farmer use of futures has been the fact that past (and

Summary of Major Risk Management Tools for Grain/Oilseed Producers

even some current) government programs contain features that give a free competitive alternative to exchange products. If government continues to deregulate commercial agriculture, there will be some growth in the direct use of futures markets by farmers, but there are reasons to expect the growth to be slow, at best: 1) The government loan rate continues as a free "put" option to the farmer; thus there is little need for the farmer to duplicate (and pay for) this position in the market unless prices are at a level moderately higher than the loan rate; 2) Futures markets only address the "futures" price portion of cash prices; basis levels (difference in central futures price and local cash price) remains a risk to be managed through the use of a separate tool (such as a basis contract); and 3) In the case of futures, the fact that daily "mark-to-market" occurs is beneficial in that the hedger knows his/her position every day, but the accompanying need to finance margin requirements which can be annoying, or a potential financial risk to protect a hedge in a rapidly changing market. Possibly the most significant disadvantage of direct farmer use is that futures only address a portion (albeit the most significant portion) of price risk. Thus to utilize futures within a comprehensive risk management program (a comprehensive program would be one that addresses physical commodity marketing, has a mechanism to establish the cash price (including futures and basis levels) and yield loss protection) requires that the farmer to enter multiple contracts and understand how individual risk management products interact to shape the risk profile. Analyzing and understanding interactive risk management profiles of combinations of tools---futures, cash contracts and insurance---is not a simple task, and may require highly sophisticated analytical skills. This will be an important factor driving risk management decisions of farmers in the future. There will be an inherent advantage for those risk management products that are more complete (cover most factors of risk) but which also can be easily explained and understood by the purchaser. For this reason, we expect that the "bundling" of the risk management features of exchange futures and options with other products to create more complete risk management tool will become more successful.

B. Cash Contracts. In the grain and feed industry, cash contracts that are statutorily exempt from CFTC regulation have traditionally been used to: market physical grain, establish the price (both regulatory futures and basis), and manage price risk within a single product. The defining feature of "exempt" cash contracts (in contrast with regulated futures) is that physical delivery is required and generally occurs. A number of cash contracts are in wide use today, several of which are described in the chart on pp. 6-7. Fixed price cash contracts give the farmer the ability to establish a firm cash price weeks, months, or even years ahead. (The ability to establish forward prices would be greatly impeded, if not impossible, without the existence of the futures markets that offer price quotes and a liquid hedging vehicle for delivery periods months/years in advance.) Minimum price contracts permit the establishment of a minimum cash price but allow the farmer to participate in upward movements in market prices prior to delivery. Because of an embedded "put" option contained in this contract, it also offers some "weak" yield risk protection. The mini-max contract, establishes both a minimum and maximum price, thus the farmer knows in advance the best and worst cash price that he can receive for a given crop. Why would a farmer want to set a maximum price? By being willing to "cap" upside potential, the farmer can effectively reduce the premium cost to establish a price floor.⁽²⁾ The basis contract allows the farmer to establish a fixed basis (difference in futures and local cash price), but permit the establishment of the reference futures price at a later date (presumably when futures are more favorable).

The hedge-to-arrive (HTA) contract is the mirror image of the basis contract: it permits the establishment of a futures contract reference price, and allows the farmer to set a basis level at a later date. Both the basis contract and the HTA are designed to offer "a la carte" marketing flexibility to the farmer---to be able to set futures and basis levels at separate times during the marketing year in an effort to "optimize" both components of the cash price. The delayed price (DP) contract is shown in the table to demonstrate that not all contracts have risk management features. The DP contract is used to transfer title and provides an alternative to storage. It contains no risk management features for farmers.

While all the contracts described here (with the exception of DP) manage some risks of adverse price movement, the market outcomes of each contract can be very different. For example, early forward contracting last year (in February-April, 1998) with fixed price, minimum price, or HTA contracts would have worked well for grains and oilseeds, because these contracts locked in an early-season futures price that trended down through much of the growing season. The market outcome for an early-season basis contract was considerably worse. Fixing basis does nothing to manage the futures price risk and farmers that used basis contracts were hurt by the falling futures prices.

Why don't more farmers use forward cash contracts? Farmers use cash contracting more frequently than they directly use futures products. There are two principal reasons for this: 1) The ability to do business with someone "local" (the counter-party risk inherent in cash contracts, which is not present in futures, seems generally insufficient to offset this "local" market advantage); and 2) Cash contracts can provide a more complete risk management/marketing product through a bundling of services. (The most popular product---fixed price forward contract---addresses physical commodity marketing and establishes cash price---both futures and basis. It also includes financial services of margining the account and credit cost exposure.) Even so, farmers do not make as frequent use of forward cash contracts as might seem prudent. One likely reason for this is the requirement to deliver. In the event of crop failure, the farmer's obligation to physically deliver remains in place. If there is a widespread crop failure, such as occurred in the 1983 and 1988 U.S. corn crops, the farmer may be required to purchase new crop corn for delivery at a loss under the contract. This is one of the reasons that many farmers that use cash forward contracts also may use crop insurance tools like MPCI or CRC (see below) to assure a minimum level of capacity to acquire physical bushels to be delivered. This is another reason to believe that risk management tools that bundle the features of cash contracts with popular yield insurance products (or their equivalent) would be more widely used by farmers---in particular in the early growing season when prices may be buoyed by occasional crop scares.

Loan Deficiency Payments (LDP) and Beneficial Interest: A Barrier to Cash Contracting. It also has become painfully obvious that one requirement under the LDP program actually discourages farmers from using risk-management - contrary to the overarching objective of producer organizations, our industry, USDA and Congress to encourage the increased use of such tools. The policy to which we refer, ironically, is known as "beneficial interest." It requires producers to retain title, control and risk of loss in the commodity until the date an LDP is requested.

In the real world, the application of this so-called "beneficial interest" policy has had a perverse and chilling effect on the ability of producers to use various kinds of cash grain contracts to maximize market returns until after they request an LDP or decide to forego an LDP altogether. Specifically, USDA has ruled that certain types of advance sales contracts, contracts-to-sell, price-later contracts and contracts for future delivery of grain violate the "beneficial interest" rules because these contracts give the buyer an interest in the commodity at a time specified in the contract or at a time implied by law. For example, USDA has stated that: "…If the producer has or will receive a payment in return for the sales contract, 'beneficial interest' is lost when the payment is made or when the producer loses control, risk of loss, or title to the commodity…. In a credit-sale contract, such as a delayed-price or deferred-payment contract, legal title and physical possession of the commodity have transferred. Thus., the producer has lost 'beneficial interest' for the quantity sold under such contracts." [NGFA "Government and Grain" August 27, 1998.]

Once the producer loses beneficial interest, the commodity is forever ineligible for an LDP, even if the producer subsequently regains control, risk, of loss, and title. Clearly, there is something wrong when a government program - LDPs - that is designed to be part of the safety net that supports farm income actually limits the marketing options available to producers and undermines their ability to generate farm income from markets. The NGFA recommends that instead of using beneficial interest to determine a producer's eligibility to receive an LDP, that consideration be given to basing such eligibility on two factors:

whether the producer has signed a production flexibility contract as required under the FAIR Act, and thus is eligible for price support; and

whether the producer has provided acceptable production evidence for the commodity for the crop year for which an LDP is requested, irrespective of whether he or she has "beneficial interest" in the commodity at the precise time an LDP is requested.

Under our proposal, a producer still would be required to retain "beneficial interest" if he or she is pledging the grain as collateral for a marketing assistance loan. But freeing LDPs from this restriction also could have the desired effect of encouraging producers to make use of LDPs instead of the loan program, thereby avoiding potential forfeitures of loan collateral to CCC.

There is evidence that USDA's hands may be tied on this matter. The FAIR Act [7 CFR 1421.5(c)(1)] states, in part, that "…[t]o be eligible to receive loans or loan deficiency payments, a producer must have beneficial interest in the commodity that is tendered to CCC for a loan or loan deficiency payment." If USDA is unable to significantly alter this "beneficial interest" policy through administrative action, the NGFA encourages Congress to consider amending this section of the statute by striking the reference to loan deficiency payments, and to instead require that producers submit acceptable production evidence, such as settlement sheets or load summary sheets, to qualify for LDPs.

Allowing producers to enter into a full array of cash grain contracts earlier in the crop year could improve their revenues and strengthen the producer safety net.

C. Crop Insurance. The chart on pp. 6-7 presents information on the two most popular crop insurance products among the so-called "buy-up coverage": Multi-peril crop insurance (MPCI) and Crop Revenue Coverage (CRC). Catastrophic (CAT) coverage (not shown in the table) is the most widely used crop insurance program, because it is least expensive and is required to participate in disaster programs. MPCI permits the farmer to insure minimum yields within a percentage range of historical own farm proven yields, and the government subsidization of the product makes the pricing more attractive. MPCI can be used effectively with some cash forward contracts to give minimum assurances of both yield and price, thus establishing some assured minimal revenue. However, this revenue "guarantee" is not a firm guarantee. MPCI implicitly assumes an early season price level (this is known in advance by the producer), and therefore if prices do rise substantially, the effective minimal yield protection can be eroded. Crop Revenue Coverage has risk management features that address both yield and price risk. By providing implicit price protection based upon the higher of early season or late season price levels, the CRC policy offers the most protection to the farmer for "replacement bushels." For aggressive cash forward contracting---at or above the limit assured in a CRC contract---the farmer has a more comprehensive product with CRC than with MPCI. Of course, the CRC policy tends to be priced substantially higher. While CRC addresses both yield and price risk, it is not a "complete" risk management tool. Even if the farmer is willing to pay the higher premiums to purchase high levels of coverage, CRC does not establish a minimum value for grain production above the minimum; does not establish a cash price on any portion of the crop; does not accomplish the physical marketing, physical or title transfer.

Why don't more farmers use MPCI and CRC? USDA reports some disappointment at the fact that "only" two-thirds of farmers who have crop insurance purchase any buy-up coverage. While this number could be higher, there are reasons why it may be close to the maximum of market penetration that could be reasonably expected under the current structure. First, it is most challenging within a nationwide program to establish "fair" prices for CRC and MPCI coverage across all counties and states where the products are offered. Even with strong administrative efforts, imperfections that continue to exist make CRC and MPCI relatively more attractive in some regions than others. Secondly, individual farm situations---the most important of which are production consistency (true exposure to yield loss risk which vary widely depending on physical farm characteristics and management skill levels) and financial resources (ability to financially self-insure)---will cause a number of farmers to opt out of the buy-up coverage, even if premiums are made more reasonable through additional subsidies.

D. Agricultural Trade Options: Agricultural Trade Options (ATOs) are not being widely offered today. The CFTC has authorized a pilot program, but no companies or individuals have registered as merchants. (It is possible that even though no registrations have been received, some ATOs are being bought and sold by farmers and commercial entities that have net worth in excess of $10 million, which CFTC legalized as an "exempt" transaction. However, we have no knowledge of such transactions.) Therefore, the chart on pp. 6-7 that describes features, advantages and disadvantages of ATOs can only suggest what might be possible under a more reasonable set of regulations for agricultural trade options.

Agricultural trade options are defined here as contracts that establish the right, but not the obligation to deliver a physical commodity, and which can be cash settled at or prior to expiration. Some examples of the types of agricultural trade option contracts that might be offered under a reasonable regulatory regime are included in the appendix to this testimony. Some of the more important types of "new" cash contracts that might emanate from ATOs are: 1) walk-away contracts that permit the farmer to establish a cost (premium) of unilaterally exiting (walking away) from a contract that calls for the sale and delivery of a farm-raised product. In the event of crop failure, this gives the farmers an easy and less-expensive way of addressing what might otherwise be a catastrophic situation; and 2) revenue "guarantee" contracts that can be cash settled. (While CRC and other "revenue assurance" type products that are cash-settled are offered under USDA authority, cash market revenue products that are strictly cash settled are likely to be declared illegal trade options within the narrow definition of ATOs established in the CFTC's current rule. That rule states that if the option is exercised, the agricultural product must be physically delivered. Thus the CFTC would not recognize cash settlement of crop revenue shortfalls to be legally valid unless also accompanied by physical delivery. This legal requirement is believed to erect huge barriers to the broad-based offering of revenue assurance provisions within the context of cash grain contracts.⁽³⁾⁾

By separating the delivery function that is the defining legal requirement of cash contracts from the contract pricing function, agricultural trade options offer the potential to cover all forms of risk, including non-price forms of risk, within a single risk management tool. ATOs could bundle: the physical marketing, cash market pricing (both futures and basis), yield and price risk management, and logistical risk management into a single package. While such a complete risk management product would require a higher level of sophistication by the ATO offerer, the product itself---and its impact on the risk profile confronting the farmer---could be simpler to explain to farmer customers (See footnote 2, p. 9 to demonstrate why it is reasonable to expect such an outcome.). If such tools can be more easily understood, and can be efficiently priced, it seems reasonable to expect expanded farmer participation in risk management activities. The advantages are believed to be highly significant: 1) While having considerably more flexibility and functionality than other cash contract products, ATOs make it possible to create a more complete, comprehensive, easily understood product; 2) Other, more targeted forms of ATOs would be useful in expanding the number of risk management products available to the newer specialty crops such as high oil corn and the new biotech products---a functionality that will certainly grow in importance; and 3) ATOs provide a competitive and flexible product to the more highly structured insurance products. For example, crop insurance buy-up coverage (MPCI or CRC) has to be purchased by March 15 for much of the U.S. It is reasonable to expect that ATO products could be offered that would provide yield or revenue risk management products that could be purchased well past this initial date. The premium price might be expected to be higher than comparable subsidized crop insurance products in last-half of March and April, but cost would likely decline as the growing season continued, assuming no unusual circumstances or threats to yield surfaced. In this way, ATOs could "bridge" some "gaps" in the current safety net for agricultural producers.

The Commodity Futures Trading Commission, in mid-April 1998, issued its regulations for the 3-year interim program for agricultural trade options (ATOs). As mentioned earlier, as yet, no commercial firms or individuals have registered to be merchants of ATOs. It seems readily apparent that unless significant changes are made in the regulatory structure, ATO tools will not develop or be offered widely to farmers. NGFA has had some informal discussions with the CFTC and other agri-business and agricultural producer organizations concerning needed changes in the regulations for the pilot program, and it does appear that the CFTC is now receptive to considering changes to make the program work. We will be cooperating with CFTC to accomplish this goal. However, if CFTC's willingness to provide regulatory relief falls short of providing a framework to move this program forward, we will ask the Congress for legislation that largely deregulates these risk management tools. If government expects agricultural interests to manage risks in a new market-dependent environment, it must provide a deregulated structure to allow reasonable new product development.

Among policy recommendations we are making to the CFTC to amend this program are the following:

1. Companies that want to participate in the program as ATO merchants should be required to give notice to the CFTC (not the NFA which is the self-regulator of the futures industry), but should not be required to be "registered" under the Commodity Exchange Act. ATOs are cash contracts, not futures, and ATOMs should not be compelled to become subject to CFTC reparations proceedings. Reparations poses as an additional litigation threat to companies and is not acceptable. Cash contracts that come into dispute are governed by state statute (Uniform Commercial Code) or reference commercial arbitration systems for dispute settlement. A pilot program should not interfere with existing state laws or cash market dispute settlement practices. The CFTC would continue to have jurisdiction over fraudulent activities related to ATOs.

2. Record-keeping requirements are overly extensive in the program. ATO merchants should be subject to an annual CPA audit (or its equivalent); ATO contracts should all be required to be in a written format (however, CFTC should be careful not to make detailed requirements on the ATO contract format or content which might limit the scope and types of ATOs offered); and record-keeping should be required only to be in conformance with generally accepted audit standards (standard for CPA audits), with any other "special" reporting requirements in conformance with common industry-standard computer-based accounting reporting formats for cash commodity accounting.

3. ATOMs should be required to make risk disclosure statements to customers reflecting the types of risk involved in each ATO contract.

4. Cash settlement of ATOs should be allowed. CFTC regulations should recognize that, depending on crop conditions or market circumstances, that ATO purchasers may choose at some time prior to maturity to cash settle an ATO contract and access any remaining time value on the contract. The CFTC regulations should provide ample flexibility to companies that want to offer revenue-assurance ATO products that permit cash settlement, with or without required physical delivery.

5. CFTC should permit anyone or any company that has a net worth of $1 million to be completely exempt from ATO regulations. All other trade options (other than enumerated agricultural commodities) are permitted without any regulation---an effective $0 net worth requirement for exemption. Swap transactions are exempt for any two participants that have $1 million, and swap transactions theoretically expose both parties to the transaction to unlimited risk. The purchaser of the ATO has defined and very limited financial exposure (limited to the up-front premium).

There is another reason for the CFTC to change its current $10 million exemption back to $1 million. The CFTC's rule issued in April 1998 contained a reference to agricultural swaps that had a very chilling effect on that blossoming market (See footnote 4).⁽⁴⁾_This is another example of government inadvertently interfering with the ability of the private marketplace to develop risk management tools. It is time for CFTC to clarify this uncertain regulatory treatment and permit the agricultural swaps market to again move forward. Moving to a consistent $1 million exemption level would be the simplest way to accomplish this.

Regulatory Protections Already in Place for ATOs. Even if the CFTC decided to permit agricultural trade options to be offered without additional regulation, there is well established law and a regulatory structure already in place to give considerable oversight to ATO transactions. As noted previously, agricultural trade options would be considered to be regulated in the same manner as cash contracts, under existing state UCC statutes, commercial law, and commercial trade rules (if referenced in contracts).

In addition, the vast majority of larger grain production states have warehousing regulatory authorities that regulate grain warehouse companies that comprise most of the first purchasers of grain. Such warehousing regulations generally encompass requirements for net worth, accounting standards, and inspections on an annual or more frequent basis. Bonding is generally required to cover a percentage of the grain storage obligations of the warehouse. At least ten states have a "grain indemnity fund" that provides insurance against insolvencies for depositors of grain. Some of these indemnity funds cover cash grain contracting obligations too. Additionally, a number of the states have grain merchandising regulations which specifically regulate spot and cash contract sales of grain.

How much more regulation is needed for ATOs? Agricultural trade options, by definition, are to be done in the "normal commercial channels" for physical commodity transactions and distribution. Thus, it is expected that the group of companies choosing to become ATO merchants will be comprised largely of existing, established merchants and users of such commodities. Such ATO contracts will therefore be offered largely in line with other commercial business interests and to facilitate trade and merchandising of cash commodities.

Under existing law, such firms are offering cash forward contracts that are not regulated by CFTC. How much additional risk is there that such firms would choose to assume un-hedged (naked) risks in the offering of agricultural trade options? This question seems to be one of the paramount issues to regulators concerned about the 1930s-style abuses of options. While no doubt, abuses can still occur, there are ample reasons to discount the potential for widespread problems. Why? If commercial firms want to speculate in options, there is ample opportunity on the regulated futures exchanges to write options. Commercial firms that write cash contracts generally hedge such contracts in futures or in "back-to-back" cash transactions as standard prudent business practice. Such firms could decide to take "naked" speculative positions in forward contracts today (and beyond financial resources to protect such positions) with no CFTC oversight (such activity would, however, come under regulatory purview of many state commodity merchandising laws). But, the record is clear that such activities have been infrequent. In conclusion, there is little evidence available to suggest that ATO contracts should be more highly regulated than existing cash forward contracts. It is, given the history of "options" in general---and the theoretical potential for abuse---understandable for a regulatory agency to take a conservative posture, but being too conservative will keep needed risk management tools from ever being offered. A lifting of the ban is clearly needed.

Will ATOs compete unfairly with futures? Some have argued that the use of ATOs may somehow unfairly compete and take volume away from futures markets. If ATOs prove to be successful risk management tools, we are convinced that the net impact will be to add to, not take away volume from, futures exchanges. ATOs are cash contracts. To the extent that such products contain components that can be hedged on organized, regulated futures exchanges through direct use of futures or options, the commercial ATO merchant is highly likely to do so. This is exactly the observed pattern of predominant market behavior by elevator managers and other first purchasers of commodities from farmers. When an elevator offers a fixed price contract to the farmer, an equivalent bushel volume is "sold" on the futures exchange, or the position is hedged through options. In the case of some contracts, multiple futures transactions are needed to hedge a single cash contract (see footnote 2, p. 9 describing the hedging of a mini-max contract). Thus, expanded use of ATOs could bring the futures exchanges multiples of the business actually done with farmers through ATO cash contracts. Rather than compete with exchange products, such companies are heavy users of exchanges to hedge risks assumed through such cash contracts. If ATOs are successful, regulated exchanges will benefit.

Are ATOs likely to cause another "HTA problem?" The multi-year and rolling HTA contracts entered into in late 1995 and early 1996 that caused so much difficulty when markets inverted, have cast a shadow over the legalization of ATO products. We submit this is an unfair and inappropriate comparison, except to the extent that the HTA problem demonstrated that it is possible get in trouble with any contract if used inappropriately. Correctly analyzing and understanding risk exposure is the key issue. The reason the comparison of HTAs and ATOs is unfair is that the trade option provides a means for the farmer (purchaser of ATO) to define in absolute terms the extent of risk exposure up front---i.e., the premium cost of the contract. HTAs did not provide that same assurance, in particular those HTA contracts that were speculating on crop inter-year price spreads.

ATOs in fact may substantially reduce the type of risk exposure demonstrated in the 1996 HTA problem. A "walk-away" provision (allowing the producer to unilaterally choose not to deliver) added to an existing fixed price contract, minimum price, or HTA contract would effectively reduce the net risk in such contract. Had the ATO program been in place in 1995 and 1996, permitting walk-away HTA contracts, elevators could have hedged such positions on the futures exchanges through options rather than flat futures positions. Then, when the inversions occurred, the producers' losses would have been limited to the initial premium. No question about it---agricultural trade options can be inappropriately used just as with any other contract; but unlike existing cash contracts, ATOs also hold the promise of providing a "relief valve" to mitigate such systemic problems in the future.

We appreciate the opportunity to present our views.

Appendix

Examples of Agricultural Trade Options

Agricultural trade options (ATOs), by separating the pricing and risk management function from delivery, are very flexible tools. They could be used to offer the most complete "bundle" of marketing and risk management services in one package; ATOs can also be targeted to specific needs. They can even be used to manage forms of commercial risk that cannot be hedged under current regulations. A few examples of possible ATO contracts are presented below:

1) Fixed Price Cash Forward/Walk-away option. The fixed price cash forward contract has been a favorite among crop farmers for years. It fixes both the futures and basis level ahead of harvest at a price level at which the farmer can make a profit. One of the primary reasons farmers have been reluctant to enter such contracts early in the growing season (often when prices are better than at harvest) is the issue of production uncertainty---how many bushels will the farmer raise to sell? This contract overcomes this significant deterrent to cash forward contracting. If ATOs had been permitted in early 1998, encouraging more farmers to contract a larger part of the crop ahead, there would have been widespread and significant benefits to realized farm income.

2) Specialty Grain Cash Forward/Walk-away option. As specialty grains grow in importance, agriculture needs more flexible tools to facilitate marketing. High oil corn and other specialty crops are generally priced on the basis of futures markets, just like other grains. However, the basis risk tends to be higher and cash prices more prone to unexpected fluctuations, because the market is more narrow. Thus, if the producer contracted for a specific quantity of bushels in a forward contract, the potential financial penalty of failing to produce a crop are greater. For this reason, the walk-away provision permitted with ATO contracts may be even more important to the development of specialty grains contracts than for standard commodities. Such a contract could also be designed for the producer to "walk-away" in the event that pre-specified intrinsic quality goals were not achieved in the crop.

3) Minimum Revenue Assurance Contracts. Such contracts would need to be designed to be cash settled. If the farmer failed to grow and market a crop that achieved a pre-established value, the elevator or other buyer would be required to compensate for the difference. It is expected that such contracts to be offered efficiently would need a viable yield futures contract traded on exchanges to permit hedging. Unfortunately CBOT yield contracts are presently inactive. When they were initially offered, there was little trading interest. If ATOs are allowed, interest would likely grow. A primary advantage of this contract over an insurance product like CRC is that, by being subject to private negotiation, the time limits for purchasing the policy could be made considerably more flexible than having to purchase in the first two weeks in March. It is unknown whether such a product could be competitively priced to compete against subsidized crop insurance.

4) Minimum Revenue Assurance Contracts/Minimum Price Cash Walk-away Contract. This contract would bundle the features of: minimum revenue assurance, management of futures and basis price risk, and establish a cash grain marketing option on which the farmer could deliver if the ATO writer had the most favorable cash price (assuming market price is above the contract minimum) at harvest. This is an example of a contract that for the ATO writer is fairly complex to hedge on the futures exchange. The ATO writer is managing multiple futures transactions, covering the basis risk, financing the underlying futures transactions for the hedge, and providing a physical delivery location. For the producer, the contract is easy to understand: For a set premium, the farmer knows that minimum revenue is assured and a minimum price is established on an established quantity of expected crop and the farmer will gain on any price upswings. Such comprehensive risk management and marketing tools are very attractive to farmers because the risk profiles and potential risk/reward outcomes and impact on income are more easily understood than trying to purchase several risk management tools to duplicate it.

5) Average Price Over Pre-established Time Frame. The following was extracted from former CFTC commissioner Joe Dial's recent presentation at USDA's Agricultural Outlook Forum, Feb. 22, 1999:

"The following example is courtesy of Tim Andriesen of Koch Industries, Wichita Kansas. XYZ elevator, which is registered as an ATOM, is offering a "growing season" call option. This option pays off based on the average price of the December Futures contract between May 1 and July 31. This option struck at $2.60 costs 7 cents. At the same time the December $2.60 call is trading at 12.5 cents. The ATO contract between the farmer and XYZ elevator clearly states that the time frame and the absolute level of protection are less with the growing season Asian style option. However, the cost of this ATO is 5.5 cents less than the December call.

Given the random nature of markets there is something to be said in favor of a farmer selling for the average price over a given time frame. Predicting the weather and trying to outguess the market has its limitations. Even for those advisory services with state-of-the-art computer models and Ph.D. analysts."

6) Commercial Basis Option Contract. ATO contracts will not just benefit farmers, but commercial entities as well, by permitting better means to hedge basis risk. However, if such commercial contracts are permitted, the benefits will no doubt be extended to farmers through similar contracts or through more efficient pricing and better logistical risk management in the marketing stream. This example explains one such contract.

A grain processor could offer a "basis option" contract to elevators supplying grain to the processor. Such contract might call for 100,000 bushels of corn at an agreed basis (e.g., 10 cents under December futures), and would give the elevator the option not to deliver in exchange for a premium at the time of contracting.

Why is this contract useful? It is useful for the processor because it will give that company the ability to source more bushels in advance of processing needs by creating a more attractive forward contracting mechanism for elevators. It is useful for the elevator because in one contract, it sets the maximum market basis exposure on delivery. It helps manage: 1) the risks of not originating adequate grain from farmers to meet the contract in a timely way; 2) the risk of failing to secure placement of transportation to make timely delivery; 3) the risk of weather delays in harvest; or 4) quality risks caused by unpredictable disease problems that make the corn undeliverable under contract (aflatoxin, fumonisin, etc.). It is also useful for the elevator in that it provides arbitrage opportunity. If the fixed basis in the contract is not as attractive as other processors or the export market is offering during the delivery period, the elevator has the opportunity to deliver to alternative buyers.

This form of ATO provides elevators another advantage in being able to plan farther in advance on logistics. For example, in today's market, an elevator might be reluctant to sell a rail shipment well in advance, regardless of the attractiveness of the rail bid, due to the uncertainty in the timing of rail freight placement. An ATO that provides a walk-away option makes possible more planning and more aggressive marketing strategies with manageable risks. This should translate back to farmers in the form of better pricing alternatives too.

This type of basis contract, provides a new risk management tool which is not available in the commercial marketplace. In merchandising, basis risk is the largest non-hedgeable price risk for grain elevators. Exchange-traded futures and options do not offer any protection against adverse basis variation. Such a contract is likely to be useful for a wide range of grain users in the marketplace, including elevators, livestock feeders, exporters and processors.

(This is also an example of a for of ATO contract, which if proven to effectively meet a market need for more flexible risk management tools, could in future years, also be "extended" to farmers. Farmers face the same basis risk that the elevator does, and once the elevator enters into such a "basis option" contract with the processor, it would be straightforward for the elevator to offer similarly structured contracts to farmers, to protect against adverse basis change, with the market risk being assumed by the processor.)

1. ¹ A private insurer had planned an offering of unsubsidized crop revenue insurance for corn and soybeans in 4 midwestern states for 1999. That company believed that the product they had invested money to develop privately could compete head-to-head with CRC and similar products. After the disaster program was passed in late 1998 and USDA announced an additional subsidy of 30 percent on federal crop insurance premiums, this company withdrew its newly developed product from the market for 1999, because the additional subsidy made the unsubsidized product uncompetitive.

2. ² The mini-max contract provides a good example of how various risk management services can be bundled to provide a fairly sophisticated and useful risk management tool, but one which is also readily understandable by the farmer. From the farmer's standpoint, a mini-max contract is straightforward: For a pre-established fee, the mini-max sets a fixed range of possible market prices for his/her crop. However, from the elevator's standpoint, this contract requires the bundling of the following services: 1) hedging futures risk which may entail 3 simultaneous transactions in futures and options markets [sell futures, buy a call (to establish minimum futures) and sell a call (to establish maximum futures)]; 2) management of cash basis risk; 3) management of financial risk (maintaining financing on the futures position); and 4) providing a physical delivery location for the commodity. Clearly, this bundling of services, and making the "risk profile" of the contract easy to understand by the farmer improves the likelihood that prudent risk management activities will be utilized.

3. ³ In general, ATO products are expected to be offered in normal course of commercial trade for commercial use. Thus, it is expected that most ATO contracts will be linked to delivery, because delivery (and receipt of) the physical commodity is fundamental to the business of the cash grain buyer.