Testimony of Steven Manaster, Ph.D. before the
United States Senate Committee on Agriculture Nutrition and Forestry Wednesday, May 5, 1999
Introduction
I want to thank the committee for the opportunity to express my views on regulatory policy regarding agricultural trade options. Although my professional interest in options and other risk-shifting financial instruments began in the late 1970's, I have no financial interest in the final disposition of any agricultural trade option regulatory policy. My understanding of financial risk-shifting is based on my scholarly research, university level teaching, and on my experience as a two-time Commodity Futures Trading Commission (CFTC) Chief Economist. In my academic career, I have written several published papers regarding the pricing and trading of futures and options. On two separate occasions this academic activity attracted the attention of the CFTC. I have served as CFTC Chief Economist twice: first in 1989-90 and again in 1998. Currently, I am the Director of the Financial Risk Management Center of the Pamplin College of Business, Virginia Tech University. Starting in September 1999 I will become the Dean of the University of Colorado - Boulder College of Business. I believe this background is unbiased with respect to the evaluation of agricultural trade option policies. I hope that you will find my testimony useful.
CFTC Fundamentals
In general, any CFTC should policy should be mindful of three closely related fundamental objectives:
Ideally, the commission will pursue these objectives in the least burdensome manner. In general, rules permitting agricultural trade options are fully consistent with the three fundamental objectives. In my testimony, following this general discussion of how agricultural trade options relate to these three objectives, I will consider some specific rules relating to the pilot program. For these specific rules I will discuss how, in some cases the pilot programs rules advance these objectives. I will also point out where, in my opinion, the regulations are over-burdensome and thereby reduce the potential for beneficial risk-shifting, and are detrimental to the objectives.
Agricultural Trade Options - A General Overview
The Credit Risk Objective
The most prominent credit risk concern for the CFTC is futures clearinghouse financial integrity. However, the presence or absence of agricultural trade options should not have any impact on the clearinghouse financial integrity. By definition trade options do not trade on-exchange. These secondary effects can occur if participants in the agricultural trade options market also trade in the exchange market. It is possible that losses in the trade option market could threaten a participant's ability to make good on its exchange based obligations. But this is no different from the routine contra-party risk that faces the clearinghouse with or without trade options. Moreover, in the current environment the clearinghouses and other regulatory authorities have adequate tools to monitor and protect against the risk of default by any member of an exchange. These tools include margin requirements, position limits, price limits, and authority to examine the off-exchange positions of traders whose on-exchange positions exceed the prevailing speculative limit. Furthermore, in the non-agricultural markets the existence of trade options is not thought to present clearinghouses with an additional financial risk. From these considerations, I conclude that the use of agricultural trade does not pose a threat to the financial integrity of the futures clearinghouses.
Apart from the risk to the clearinghouse there exists the bilateral credit risk to the trade options participants. The regulatory question becomes this: Do farmers need regulatory protections against the potential default of the potential trade option dealers? The CFTC pilot program has addressed this question by requiring agricultural trade option merchants (hereinafter ATOMs) to become CFTC registrants subject to a variety of CFTC regulations.
To summarize, agricultural trade options do not add any direct risk to clearinghouse financial integrity. The exchanges already have tools in place to deal with potential indirect risk. Finally, it is a matter of regulatory philosophy whether the bilateral financial risk in these instruments should be a regulatory concern. The CFTC pilot program has taken steps to protect producers against ATOM defaults.
Price Discovery Objectives
Futures exchanges frequently argue that if off-exchange options are allowed to compete with the exchange traded ones, then the on-exchange market will become fragmented. The argument is then made that a fragmented market will result in reduced liquidity and inferior price discovery. But with physical settlement in both markets, absent any squeeze or corner, price convergence is assured. Moreover, if a squeeze were to effect the underlying commodity, the exchange-based surveillance and oversight would discover it and take corrective actions. Therefore the argument that off-exchange trading is injurious to price discovery is questionable, and the ability to settle by physical delivery greatly mitigates any possible injury to price discovery.
The effect of agricultural trade options on-exchange-based liquidity is hard to predict. On the one hand if the trade option market reduces on-exchange volume, then exchange based liquidity could be reduced. On the other hand, if ATOMs are laying off some of their risk with exchange trading, the exchange liquidity might even improve. I believe the success of agricultural trade options will result in improved exchange-based liquidity.
Summarizing, the introduction and success of agricultural trade options should not be injurious to the CFTC's price discovery objectives.
Customer Protection Objectives
Because option contracts are complex and subtle there is a potential for unscrupulous opportunists to take advantage of poorly informed market participants. Since the use of agricultural trade options may be a new activity for many producers, regulatory authorities concerned with customer protection need to be especially vigilant. But this vigilance is no different than what would be required by introduction of any complex product to a new audience of consumers. The information made available by the CFTC to producers has been particularly responsive to this challenge.
Summarizing, because of their complexity and their introduction to a new audience, the agricultural trade option program poses a challenge to the CFTC's customer protection objective. However, this challenge is neither unusual nor unique. The CFTC through its information dissemination has responded to this challenge in a pro active, responsible manner.
Conclusion
Agricultural trade options are fully consistent with the three fundamental objectives. However, care must be taken to assure there are sufficient consumer protections available to protect the novice option purchaser.
Agricultural Trade Options - Two Specific Regulations
The following subsections discuss the pros and cons of some of two specific aspects of the CFTC agricultural trade option pilot program.
Registration
Agricultural trade option merchants (ATOMs) are required to register with the CFTC and to maintain a net worth of $50,000. The ATOMs owners and their sales agents must not have been convicted of a felony or a similar type of violation. In addition, the ATOMs owners and sales agents must be trained in the use of agricultural trade options and the rules governing their offer.
These regulations are designed to advance the CFTC's credit risk and customer protection objectives. When taken in the context of a local elevator registering as an ATOM and offering agricultural trade options as part of its customer service, this registration requirement seems reasonable. It may be superfluous, but not overly burdensome. The agricultural trade option training may be worth the time spent and screening for felons has minimal cost.
Although the $50,000 net worth requirement is a small protection against financial default, the registration requirement makes the ATOMs subject to the CFTC reparations program. If the reparations program is superior to other methods of customer protection and dispute resolution, then the registration requirement will be serving the objectives as intended.
However, it is possible the registration requirement may be retarding the development of a secondary market for agricultural trade options. Imagine a well developed market for agricultural trade options. Retail ATOMs sell options and bear the risk the producers seek to avoid. What do the retail ATOMs do with their risk? They will hedge the risk by "keeping a book" that allows them to offset their accumulated risks, or by laying off the risk using exchange traded instruments, or by trading with other larger wholesale ATOMs. The retail ATOMs are not as well equipped to "keep a book" as other larger firms with deep pockets and financial engineering experience and expertise.
These larger firms are likely doing a large business in CFTC regulatory exempt commodity and financial swaps. They may fear that by becoming CFTC registrants they will jeopardize their exempt status in a prominent part of their current business activity. Thus, while the registration requirements may be appropriate for the retail ATOM business, it may be limiting the potential for the agricultural trade option market to attract wholesalers. Without wholesalers the agricultural trade option market will not evolve to its full potential.
No offset
The pilot program rules do not permit option holders to offset their positions with a cash transaction prior to maturity. The reason for these rules appears to be to differentiate between trade options, which can be customized and must be used as part of the purchaser's ordinary business operations, and the more traditional, on-exchange risk-shifting options which can be used for speculation. The inability to offset makes trade options less liquid than exchange traded counterparts. The requirement of physical settlement is designed to guarantee the option holders are actually in the business using the underlying commodity and not the option market exclusively for speculation. Although these rules help create a distinction between trade options and exchange traded options, a reasonable question is this: "Does making this distinction advance any of the three fundamental CFTC objectives?" If it does not, then the rule is merely for dividing turf between the on-exchange and off-exchange options in a way that puts the off-exchange options at a disadvantage. Furthermore, the lack of offset produces economic inefficiencies. Consider a case where a producer buys a put, as the harvest approaches the put is deep in-the-money, but the producer faces a crop failure. Without offset the farmer must either forfeit the value of the put, or purchase the product from a neighbor with a successful harvest and then use that product to exercise his put. Direct offset is much more reasonable.
Too much regulatory energy is spent attempting to draw distinctions between off-exchange and on-exchange instruments. The prohibition against offset serves to help differentiate between trade options from speculative options -- but beyond making that distinction the rule has no economic value and promotes inefficient use of resources.
Conclusions
Agricultural trade options can provide a valuable risk-shifting service to producers. This service can be provided without injury to the liquidity and price discovery of current on-exchange products. The lack of success of the pilot program is discouraging. Nonetheless, I am hopeful that with modest adjustments a regulatory framework can be established that will permit a robust and secure agricultural trade option market to develop and succeed.