[Federal Register Volume 62, Number 213 (Tuesday, November 4, 1997)]
[Proposed Rules]
[Pages 59624-59639]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-29037]
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Proposed Rules
Federal Register
________________________________________________________________________
This section of the FEDERAL REGISTER contains notices to the public of
the proposed issuance of rules and regulations. The purpose of these
notices is to give interested persons an opportunity to participate in
the rule making prior to the adoption of the final rules.
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Federal Register / Vol. 62, No. 213 / Tuesday, November 4, 1997 /
Proposed Rules
[[Page 59624]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 3, 32, and 33
Trade Options on the Enumerated Agricultural Commodities
AGENCY: Commodity Futures Trading Commission.
ACTION: Notice of proposed rulemaking.
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SUMMARY: Generally, the offer or sale of commodity options is
prohibited except on designated contract markets. 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'' a person or entity within 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.'' Trade options, however, are not permitted on
the agricultural commodities which are enumerated in the Commodity
Exchange Act (Act).
The Commodity Futures Trading Commission (Commission or CFTC) is
proposing to remove the prohibition on off-exchange trade options on
the enumerated agricultural commodities pursuant to a three-year pilot
program. The Commission is proposing initially to permit agricultural
trade options which, if exercised, will result in delivery of the
commodity and which may not be resold, repurchased, or otherwise
cancelled other than through the exercise or natural expiration of the
contract. The Commission is also proposing to permit only those
entities which handle the commodity in normal cash market channels to
offer to buy or sell such options. Such entities, in order to sell
agricultural trade options (puts and calls), would be required to
become registered as agricultural trade option merchants, to report to
the Commission on their transactions, to provide their customers with
disclosure statements, and to safeguard their customers' premiums. The
Commission is also proposing to exempt from the prohibition and these
proposed rules individuals or entities which meet a substantial
financial requirement. Finally, the Commission is proposing to remove
the prohibition on the offer or sale of exchange-traded options on
physicals on these commodities.
DATES: Comments must be received by December 4, 1997.
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 at
[secretary@cftc.gov]. Reference should be made to ``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 transmitted electronically at [PArchitzel@cftc.gov].
SUPPLEMENTARY INFORMATION:
I. Background
A. The Prohibition of Agricultural Trade Options
In 1936, responding to a history of large price movements and
disruptions in the futures markets attributed to speculative trading in
options, Congress completely prohibited the offer or sale of option
contracts both on and off exchange in all commodities then under
regulation.1 Over the years, this statutory bar continued to
apply only to the commodities originally regulated under the 1936 Act.
The specific agricultural commodities originally 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 of enumerated agricultural commodities.
Any commodity not so enumerated, whether agricultural or not, was not
subject to regulation. Thus, options on such nonenumerated commodities
were unaffected by the prohibition.2
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\1\ Commodity Exchange Act of 1936, Pub. L. 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 nonenumerated 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, Pub. L. 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,
Pub. L. 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, Pub. L. 818, 54 Stat. 1059
(1940). Livestock, livestock products, and frozen concentrated
orange juice were added in 1968. Commodity Exchange Act Amendment of
1968, Pub. L. 90-258, 82 Stat. 26 (1968) (livestock and livestock
products); Act of July 23, 1968, Pub. L. 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, Pub. L. 85-839, 72 Stat. 1013 (1958).
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A history of abusive practices and fraud in the offer and sale of
off-exchange options in the nonenumerated commodities 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 by bringing all
commodities under regulation for the first time.3 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, nonenumerated commodities.4 The
Act's statutory prohibition on the offer and sale of options on the
enumerated agricultural commodities was retained.
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\3\ Congress accomplished this by adding to the list of
enumerated commodities an expansive catch-all definition of
``commodity'' which included all ``services, rights, or interests in
which contracts for future delivery are presently or in the future
dealt in.'' The definition of commodity is currently codified in
section 1a(3) of the Act.
\4\ Section 4c(b) of the Act provides that no person ``shall
offer to enter into, or confirm the execution of, any transaction
involving any commodity regulated under this Act'' which is in the
nature of an option ``contrary to any rule, regulation, or order of
the Commission prohibiting any such transaction or allowing any such
transaction under such terms and conditions as the Commission shall
prescribe.'' 7 U.S.C. 6c(b).
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Shortly after its creation, the Commission promulgated a
comprehensive regulatory framework applicable to off-exchange commodity
option transactions in the
[[Page 59625]]
nonenumerated commodities.5 This comprehensive framework
exempted ``trade options'' from most of its provisions except for a
rule prohibiting fraud (rule 32.9).6 In contrast, 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.
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\5\ 17 CFR part 32. See, 41 FR 51808 (Nov. 24, 1976) (Adoption
of Rules Concerning Regulation and Fraud in Connection with
Commodity Option Transactions). See also, 41 FR 7774 (February 20,
1976) (Notice of Proposed Rules on Regulation of Commodity Option
Transactions); 41 FR 44560 (October 8, 1976) (Notice of Proposed
Regulation of Commodity Options).
\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
commercial users of the underlying commodity 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 nonenumerated commodities.
See, 41 FR 44563, ``Report of the Advisory Committee on Definition
and Regulation of Market Instruments,'' appendix A-4, p. 7 (January
22, 1976).
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The attempt to create a regulatory framework to govern the offer
and sale of off-exchange commodity options was unsuccessful. Because of
continuing, persistent, and widespread abuse and fraud in their offer
and sale, the Commission in 1978 suspended all trading in commodity
options, except for trade options.7 Congress later codified
the Commission's options ban, establishing a general prohibition
against commodity option transactions other than trade and dealer
options.8
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\7\ 43 FR 16153 (April 17, 1978). Subsequently, the Commission
also exempted dealer options from the general suspension of
transactions in commodity options. 43 FR 23704 (June 1, 1978).
\8\ Pub. L. 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 30 calendar days of continuous session
of Congress after such transmittal had passed.
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The Commission subsequently permitted the introduction of exchange-
traded options on the nonenumerated commodities by means of a three-
year pilot program. 9 Based on that successful experience,
Congress, in the Futures Trading Act of 1982, eliminated the statutory
bar to transactions in options on the enumerated commodities,
permitting the Commission to establish a similar pilot program to
reintroduce exchange-traded options on those agricultural commodities.
10 When establishing the pilot program, the Commission
declined to relax the prohibition on off-exchange trade options on
these commodities. 11
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\9\ 46 FR 54500 (November 3, 1981).
\10\ Pub.L. No. 97-444, 96 Stat. 2294, 2301 (1983).
\11\ Although the Commission noted that ``there may be possible
benefits to commercials and to producers from the trading of these
`trade' options in domestic agricultural commodities,'' it
determined that ``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,'' ``proceeding
in a gradual fashion by initially permitting only exchange-traded
agricultural options'' was the prudent course. 48 FR 46797, 46800
(October 14, 1983).
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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. 12 On December 19, 1995, the
Commission hosted a public roundtable (December Roundtable) to consider
this issue once again and to provide a forum for members of the public
to provide their views. Subsequently, the Commission instructed the
staff to study this issue and to forward its analysis to the
Commission.
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\12\ For example, 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.
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B. The Advance Notice of Proposed Rulemaking
On June 9, 1997, the Commission published an advance notice of
proposed rulemaking (advance notice) in the Federal Register 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 (62 FR
31375). The Commission based the advance notice on a study by the
Commission's Division of Economic Analysis (Division). 13
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\13\ The complete text of that study, entitled ``Policy
Alternatives Relating to Agricultural Trade Options and Other
Agricultural Risk-Shifting Contracts,'' was forwarded to the
Commission by the Division on May 14, 1997. It is available through
the Commission's Internet site at http://www.cftc.gov/ag8.htm.
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The advance notice discussed the potential benefits and risks that
may result from lifting the prohibition on agricultural trade options.
The benefits include greater customization, a known cost of the
instrument at the outset, and an increase in possible types of vendors,
permitting greater convenience and more flexible financing
arrangements. The risks identified in the study include fraud, credit
risk, liquidity risk, operational risk, systemic risk, and legal risk.
In addition, the advance notice offered a variety of regulatory
protections or conditions which could be used to address many of the
risks identified in the study. Those conditions included possible
restrictions on the parties permitted to enter into these transactions,
restrictions on the instruments or their use, and/or regulation of
their marketing. The advance notice noted that several of the risks
could be reduced by imposing eligibility limitations, such as to
restrict the availability of agricultural trade options to
sophisticated individuals or entities; to require that those marketing
these instruments be registered with, or identify themselves to, the
Commission or be commercial users themselves; and/or to impose an
education requirement on either buyers or agricultural trade option
vendors or both.
The advance notice also discussed possible restrictions on the
types of options permitted as a possible means of ensuring that
commercials enter into such transactions ``solely for purposes related
to (their) business as such.'' Moreover, the possible regulation of
marketing, including disclosure requirements and account confirmation
requirements, was considered. Additional issues addressed by the
advance notice included possible requirements for cover or other
methods for limiting the risk of possible default and requirements
regarding the establishment of appropriate internal controls. In order
to focus comment on these issues, the advance notice invited commenters
to respond to 30 specific questions relating to the above topics.
II. Comments Received
In response to its request for public comment, the Commission
received a total of 76 comment letters from 82 commenters. The
commenters were almost evenly divided with 35 commenters in favor and
36 opposed to lifting the ban.14 Those favoring lifting the
prohibition on agricultural trade options included a futures exchange
(with qualifications); a futures industry association; a derivatives
industry association; five risk management firms; a commodity trading
advisor; a bank; six agriculture-related businesses; 15 trade and farm
associations, including both
[[Page 59626]]
national organizations and state-level affiliates; three individuals;
and an accounting firm. Those opposed included two futures exchanges; a
futures industry trade association; ten futures professionals; two
producer associations; a grower-owned marketing cooperative; a country
elevator; an academician; and 18 individuals, eight of whom were
producers.
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\14\ Five letters offered commentary on the issue without taking
a position on the overall wisdom of lifting the prohibition.
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Commenters opposed to lifting the ban generally expressed the view
that existing exchange-traded products are adequate to manage
agricultural risk and that agricultural trade options are likely merely
to replicate those existing products but in a less safe environment. In
this regard, the commenters stressed the higher likelihood of fraud
occasioned by the unsophisticated nature of the possible counterparties
to agricultural trade option transactions, the decentralized nature of
the market, and the lack of regulatory oversight of possible
agricultural trade option vendors. Several commenters also opined that,
as a result of operating in a less regulated environment, agricultural
trade options would enjoy an unfair competitive advantage over
exchange-traded instruments, thereby adversely affecting exchange
liquidity. Others expressed the concern that problems arising as a
consequence of the less regulated environment for the trading of
agricultural trade options could damage public confidence in all risk
management products, including exchange-traded instruments. A final
concern expressed by several commenters was that lifting the
prohibition on agricultural trade options will advantage larger, more
sophisticated agricultural companies over smaller, independent
businesses, hastening a trend toward greater consolidation and
concentration in agricultural markets.
Those commenters favoring lifting the prohibition on agricultural
trade options generally expressed the view that recent developments in
domestic and foreign agricultural markets have increased the need for
agricultural trade options. In particular, several commenters noted
that agricultural trade options already are being offered outside of
the United States to the competitive advantage of foreign producers and
agricultural businesses.
Other commenters noted that the recent removal of many of the long-
standing government support programs may result in increased price
uncertainty and volatility, thereby increasing the need for a variety
of risk-management and marketing tools. In this regard, the Division
staff in its study noted that the overall impact of the Federal
Agricultural Improvement and Reform Act of 1996 likely will be to leave
farm incomes more exposed to changes in market prices and that in
response to these changes ``new risk management tools are being
developed, a trend which is likely to continue.'' 15
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\15\ See the Division's study at pp. 23-24, 28.
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The greater interest by some segments of the agricultural sector in
managing risks that was noted in the Division's study is also reflected
in many of the comments. Several commenters who favor lifting the ban
generally noted that the increasing size and complexity of producers'
operations also have given rise to the need for more innovative and
flexible risk management products. For example, one commenter noted
that:
All facets of agricultural production whether grain, cotton,
fruits, vegetables or livestock are becoming more specialized and
targeted toward niche markets. Producing for these markets often
requires a greater degree of coordination and long-term commitment
between the producer and processor. Having the flexibility to write
marketing contracts that are now banned would be of great benefit in
facilitating the coordination required.
These rapid and profound changes taking place in these markets are a
key factor in the Commission's determination to propose these
rules.16
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\16\ Id. at p. 31.
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In addition to the written comments, the Commission received oral
comments during two public field meetings at which members of the
public had an opportunity to address the Commission and to answer its
questions regarding these issues. One of the meetings was held in
Bloomington, IL, and the other was held in Memphis, TN. A third
informational meeting was held in conjunction with a general membership
meeting of the National Cattlemen's Beef Association. Transcripts of
the proceedings at all three events were included in the Commission's
comment file and are available through the Commission's internet web
site. Generally, the participants in these meetings reflected the range
of views expressed in the written comments and were likewise equally
divided in their support or opposition to lifting the prohibition on
agricultural trade options.
III. The Proposed Rules
A. Three-Year Pilot Program
Based upon the analysis in the Division's study and the comments
filed in response to the advance notice, including the comments
presented to the Commission during its field meetings, the Commission
is proposing to promulgate rules establishing a pilot program to permit
the offer and sale of trade options subject to a number of strict
regulatory conditions. Many commenters expressed the view that the
potential risk of permitting trade options clearly outweighed any
benefit which they might provide. These commenters, however, typically
assumed that agricultural trade options would be offered under the same
level of regulation currently applicable to other trade
options.17 An approximately equal number of commenters
expressed the view that the prohibition on trade options should be
lifted, particularly in response to the new challenges agriculture
faces as a result of changes in government programs. Nevertheless, the
vast majority of commenters, both those favoring and opposing lifting
the prohibition of agricultural trade options, urged caution.
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\17\ Currently, trade options and those offering them are
subject only to regulations regarding fraud. See, 17 CFR 32.4.
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The Commission successfully permitted the reintroduction of
exchange-traded options under a three-year pilot program after their
nearly half-century ban. See, 46 FR 54500 (November 13, 1981). Many at
that time expressed concerns similar to those expressed in connection
with the Commission's consideration of lifting the prohibition on
agricultural trade options. The Commission determined that a pilot
program best addressed those concerns, permitting the introduction of
exchange-traded options subject to strict regulatory controls. By
structuring its action as a pilot program, the Commission was able to
test the efficacy of its regulations and to adjust them as experience
warranted. The use of a pilot program proved to be a highly successful
means of reintroducing exchange-traded options. Today, those markets
constitute an important part of the futures industry.18
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\18\ Overall year-to-date volume through July 1997 for exchange-
traded futures and option contracts is 314,068,673 contracts. Of the
total number of contracts traded, approximately 20 percent are
option contracts.
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Based upon that successful experience, the Commission is proposing
to lift the ban on agricultural trade options under a similarly
structured pilot program. As under the previous pilot options program,
the program being proposed for agricultural trade options will run for
three years. During that time the Commission will closely monitor the
efficacy of its rules and their implementation by the industry.
Although the Commission currently intends that the rules promulgated by
the Commission under
[[Page 59627]]
the pilot program will remain in effect at the termination of the pilot
program, it will amend them as experience warrants.19
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\19\ In this regard, the Commission anticipates that, if it
promulgates final rules, it will promulgate them as ``interim final
rules,'' denoting its intention to revisit them three years after
implementation. It is not proposing to limit the time during which
the rules will remain effective in order to avoid issues of
contracts extending beyond the three-year period. Instead, it will
evaluate the efficacy of the interim final rules at the conclusion
of the pilot program and reissue them if amendments are needed. Any
such amendments would not affect the validity of contracts entered
into prior to the issuance of such amendments.
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During the course of the pilot program, the Commission anticipates
that it will direct the Division to conduct at least two reviews of
trading experience. The conduct of such reviews may require the
issuance by the Division of industry-wide special calls for information
from agricultural trade option vendors. Such information requests,
although used sparingly, were an integral part of the Commission's
successful monitoring of the prior pilot program and can be expected in
connection with the Commission's evaluation of the relative success of
this pilot program as well.
B. Overall Structure of Proposed Rules
The advance notice identified a number of risks associated with
lifting the prohibition on options on the enumerated agricultural
commodities and the possible regulatory responses to those risks,
ranging from little or few regulatory protections to the full panoply
of protections mirroring those that are applicable to exchange-traded
options. It also identified likely immediate uses for trade options on
these commodities and a number of more theoretical possible uses. In
proposing the structure for this pilot program, the Commission
determined to include within the pilot program initially those forms of
trade options the terms of which are likely to be most widely
understood and which are closest to current cash market practices.
Accordingly, the Commission is proposing to lift the trade option ban
on enumerated agricultural commodities for physically-settled contracts
between commercial parties in the normal merchandising chain for the
underlying commodity. Exercise of an option between these parties would
involve the delivery of the underlying commodity from one party to the
other either by immediate transfer of title to the commodity or by
transfer of a forward contract commitment.
Since at least 1985, when the Commission's General Counsel issued
an interpretative statement entitled, ``Characteristics Distinguishing
Cash and Forward Contracts and `Trade' Options,'' 50 FR 39656
(September 30, 1985) (1985 OGC Interpretation), there has been wide
understanding that one form of trade option prohibited by the ban
involved a transaction whereby a producer, in return for payment of a
premium, would have the right but not the obligation to deliver his
crop to an elevator at the specified price. The producer would have the
choice to deliver the commodity elsewhere or at the original elevator
for a higher price.20 In addition to being commonly
understood, this form of trade option is a logical extension of other,
permitted cash market practices.21
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\20\ The 1985 OGC Interpretation described this form of trade
option as a contract that ``establishes a minimum contract price
determined when the contract is written, and [for which] a premium
is collected, either at the initiation of the contract, during the
life of the contract or, together with interest accumulated over the
life of the contract, at the time of settlement. In return for the
premium, the producer has the right to require the merchant to
accept delivery of and pay a minimum contract price for the crop.
However, the producer may forfeit the premium and seek a higher
price for, and deliver, the crop elsewhere.'' 50 FR 39656, 39660.
\21\ For example, the same 1985 OGC interpretation discussed two
other examples of delivery contracts having minimum price
characteristics, finding them to be within the forward contract
exclusion of the Act. Section 1a(11) of the Act, the forward
contract exclusion, provides that futures contracts which are
regulated under the Act do ``not include any sale of any cash
commodity for deferred shipment or delivery.'' These two contracts,
although having some option pricing characteristics, were determined
to be forward contracts because, unlike option contracts, they were
intended to be a means of merchandizing the commodity, obligating
the parties to the contract to make or take delivery. 50 FR 39660.
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Option contracts can be used for a variety of purposes depending on
the structure and settlement characteristics of a particular contract
and the nature of the option customer's cash market commitments or
position. Upon exercise, options can settle either by physical delivery
of the underlying commodity or by cash payment. Cash-settled options
upon exercise result only in the exchange of cash; a separate marketing
arrangement is necessary to merchandize the underlying commodity. In
this respect, because they are distinct from marketing contracts, cash-
settled options bear a resemblance to exchange-traded contracts. In
contrast, upon exercise of a physical delivery option, the purchaser of
a put or the seller of a call actually delivers the underlying
commodity to the counterparty. Thus, like a forward contract, a
physical delivery trade option can be used as a means of merchandizing
the commodity.22
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\22\ This is not to suggest that the pay-out characteristics of
forwards and futures resemble those of physically-delivered or cash-
settled options, respectively. To the contrary, futures and forwards
share a similar risk/return profile which differs markedly from the
risk/return profile shared by all options. Rather, the resemblance
between forwards and physical-delivery options is the ease of their
use as a form of marketing arrangement that can also be used to
hedge price risk.
For those not wishing to combine a merchandizing arrangement
with a risk-management function, cash-settled options offer greater
settlement ease. This is true whether settlement is a result of the
option's offset or its exercise.
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Commenters suggested a number of additional reasons for inclusion
of physical delivery options within the pilot program. Several
commenters opined that one of the primary benefits of agricultural
trade options will be to permit producers to enter into such agreements
directly with those with whom they share trusted cash market business
relationships. A second often suggested benefit of agricultural trade
options is the producer's ability to enter into enhanced forms of
merchandizing agreements. Several commenters, for example, expressed
the desirability of being able to enter into option contracts that
would give them the right but not the obligation to deliver on the
contract. Such individual could ``walk away'' from delivery to avoid
the purchase or sale of the commodity at too high or low a price during
a production shortfall or for any other reason. The ability to avoid
delivery in the case of a production shortfall, in the view of these
commenters, would allow producers to contract (through options) for a
higher percentage of their expected production. Including first
handlers of the commodity underlying agricultural trade options within
the pilot program and including all physical delivery agricultural
trade options as eligible for the pilot program would allow producers
to achieve these benefits.
Several commenters registered their concern that, if permitted,
trade options would merely replicate exchange-traded options in all
respects, but in a less-regulated environment. They argued that on that
basis the risks associated with trade options do not outweigh their
potential benefits. Physical delivery trade options, however, will not
simply replicate exchange-traded instruments. As noted above,
physically-settled trade options offer the opportunity to combine a
marketing and risk management tool. In this respect, physical delivery
trade options on the enumerated commodities would be similar in
character to forward contracts in that each would be an individually
[[Page 59628]]
negotiated contract involving, if exercised, the merchandising of the
commodity through normal marketing channels. This potential additional
cash market function 23 of physical delivery trade options
argues in favor of their inclusion under the pilot program.
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\23\ Although, as discussed below, the Commission also is
proposing to permit exchanges greater flexibility in offering
agricultural options, physical-delivery trade options entered into
between those who have a cash-market relationship are apt to be
different in nature than exchange-traded contracts--that is, they
are more likely to be more highly customized, including calling for
delivery at widely scattered facilities.
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After having determined, for the above reasons, that trade options
between counterparties in normal cash market channels requiring
physical delivery are appropriate for inclusion within the pilot option
program, the Commission has matched the level of regulation being
proposed to the risks associated with those instruments. Not only is
this approach intended to strike the appropriate balance of regulation
of the instruments included within the pilot program, but it provides a
solid foundation for analyzing and comparing the regulatory approaches
which should be applied in the future when considering other possible
uses of trade options. Accordingly, were the Commission to propose to
permit additional forms of trade options, it would re-examine the
adequacy of the proposed regulatory provisions of the pilot program.
The major components of the proposed regulations governing the pilot
option program are as follows: regulation of agricultural trade option
vendors, including net capital, recordkeeping and streamlined
registration, and proficiency testing requirements; required risk
disclosure to option customers; and several restrictions on the market
strategies or contract structure. These proposed components of the
pilot regulations are discussed below.
C. Regulation of Agricultural Trade Option Merchants
A primary regulatory protection of the pilot program is its
restriction of option counterparties to agricultural commercial
participants. Thus, agricultural trade option vendors--those persons or
entities engaged in the business of the offer or sale of agricultural
trade options--as a matter of course, will be businesses active in
agricultural cash markets. Agricultural trade option vendors, by virtue
of their cash market operations, should have achieved some level of
financial soundness and proficiency with respect to risk management
strategies. In addition, the Commission is proposing streamlined or
targeted requirements relating to agricultural trade option vendors'
financial soundness, competency, and probity, including the requirement
that such vendors be registered with the Commission under the new
registration category of ``agricultural trade option merchant.''
1. Net Asset and Other Financial Requirements
By their nature, agricultural trade options, like all commodity
futures or option instruments, involve risk, particularly the risk
arising from the need for performance at a future date by the
counterparty to the contract. Typically, the greatest financial risk
assumed by an option purchaser is credit risk. Credit risk is the risk
that the seller of the option may fail to perform on the obligation if
the purchaser chooses to exercise the option contract. In the event of
such nonperformance, the option purchaser stands to lose the option
premium if it has already been paid plus any opportunity gain that
would have been achieved if the option were exercised.24
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\24\ For example, consider the case of a producer who had paid a
premium of $.10 per bushel for a put option giving him the right to
sell corn at a price of $2.80 per bushel. At harvest the price of
corn is $2.70 per bushel, and the producer decides to exercise the
option. If the option seller defaults on the contract, the producer
stands to lose the $.10 per bushel paid for the option. In addition
the producer loses the opportunity to sell corn at $2.80 per bushel,
instead having to accept the market price of corn at $2.70 per
bushel.
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In an exchange environment, the clearinghouse and regulations
requiring minimum net capital for market intermediaries reduce
counterparty credit risk. Off-exchange transactions do not have the
safety of the clearinghouse to reduce credit risk. In an off-exchange
environment, counterparties can take a variety of steps to help assure
that a counterparty is able to perform and performs on its obligation.
Sophisticated counterparties may have the means formally to evaluate
the creditworthiness of their counterparties. They also may require the
posting of collateral or a third party guarantee. Less sophisticated
counterparties may simply rely on trust, choosing to deal only with
known counterparties with whom they have ongoing business
relationships. Another approach to enhancing an agricultural trade
option merchant's ability to perform on a trade option is to require
the merchant to manage the market risk of trade options through
exchange-traded options.
Because many agricultural trade option customers will not have the
resources to conduct formal creditworthiness evaluations of their
counterparties, some degree of regulatory financial protections are
desirable. Accordingly, the Commission is proposing a requirement that
agricultural trade option merchants maintain a minimum level of net
worth. In addition, the Commission is proposing that agricultural trade
option merchants segregate from their own funds premiums paid by
customers at initiation of an option contract. The Commission, however,
is not proposing specific forms of covering the agricultural trade
option merchant's market exposure.
a. Net Worth. Minimum financial requirements have been used by
government regulators to establish a base level for entry or access to
a market by individuals and companies. Such requirements are intended
to assure that companies or entities conducting business offer some
assurance of having the financial wherewithal to perform on their
obligations. The Commission places minimum financial requirements on
futures commission merchants (FCMs) and introducing brokers (IBs) as a
condition of registration with the Commission. The United States
Department of Agriculture (USDA) and various states impose minimum
financial requirements in the cash grain markets on federally-licensed
grain warehouses.25
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\25\ A number of states require entities to meet a specified net
worth requirement as a condition of obtaining a state grain
warehouse's or grain dealer's license. The minimum net worth
requirements range up to a minimum of $50,000 in Illinois. Some
states also require that grain warehouses obtain a surety bond and
have established indemnity funds to offset producer losses on grain
stored in warehouses. Such indemnity funds, depending upon the
state, are funded either by the producers or the elevators. For
example, the indemnity fund in Illinois is funded by grain elevator
contributions, while in Indiana producers contribute to the fund.
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Although many commenters favored minimum financial
requirements,26 others opposed them on the grounds that such
minimum financial requirements would exclude smaller entities from the
agricultural trade option business, possibly accelerating a trend to
greater concentration in cash grain markets. Some commenters argued
that the financial requirements currently imposed by the various states
would be sufficient to foster financial integrity in the trade option
markets. However, not all states have minimum financial requirements
for those involved in the cash trade, and the requirements of those
that do vary widely. Accordingly,
[[Page 59629]]
the Commission believes that a common federal minimum standard should
apply to all those involved in the business of offering agricultural
trade options, regardless of geographic location or the agricultural
commodity.
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\26\ Of those favoring minimum financial requirements, some
specifically suggested that trade option vendors be required to meet
the same financial requirements currently applicable to FCMs and
IBs.
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Accordingly, the Commission is proposing that agricultural trade
option merchants, as a condition for offering such contracts, have and
maintain a minimum of $50,000 of net worth.27 This
requirement corresponds to the overall minimum financial requirement
established by USDA as a condition of obtaining a federal grain
warehouse license. The Commission is proposing this minimum net asset
level based upon the observation that these warehouses already enter
into forward contracts as part of their cash business and that the USDA
requirement appears to have been adequate. As noted above, the physical
delivery agricultural trade options being included under the pilot
program are similar in nature to forward contracts, including the
financial risk to the warehouse or other first handler.28
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\27\ The minimum net worth requirement, as proposed, is a
continuing requirement. If an agricultural trade option merchant's
net worth falls below this amount, the merchant would not be
permitted to offer to buy or to sell additional trade options until
coming into compliance with the requirement. Moreover, in such a
situation the agricultural trade option merchant must immediately
cease offering or entering into new option transactions and must
notify customers having premiums which the agricultural trade option
merchant is holding under Sec. 32.13(a)(4) of the proposed rules
that such customers can obtain an immediate refund of that premium
amount, thereby closing the option position.
\28\ That is not to suggest that the risks to the first handler
are precisely the same between trade options and forward contracts.
In the case of options, the first handler is not assured of actually
receiving delivery of the commodity in contrast to a forward
contract. However, the means available to the first handler to cover
the financial risk of the transactions are similar.
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As noted above, the proposed net asset requirement is ongoing in
nature. Accordingly, agricultural trade option merchants would be
required to maintain the specified level of net worth in order to enter
into new trade option contracts and to notify the Commission at any
time if they have fallen below prescribed levels. The Commission is
also proposing that agricultural trade option merchants be required to
perform a reconciliation of their financial position at least monthly
to determine compliance with this requirement.\29\ Because agricultural
trade option merchants are primarily engaged in a cash market business,
this proposed rule does not require them to change accounting
procedures to conform to specific Commission accounting requirements,
provided they use ``fair value'' accounting under generally-accepted
accounting principles.\30\ It is the Commission's understanding that
this accounting method is used by most firms in the cash market
business.
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\29\ At least three commenters urged that daily mark-to-market
of all positions should be required. The Commission is not proposing
this requirement at the current time, although that is certainly the
best practice and should be encouraged.
Under the proposed rules, agricultural trade option contracts
can be exercised only by delivery and cannot be purchased back,
resold or otherwise offset before the expiration of the contracts.
While the net value of an agricultural trade option merchant's
option position will fluctuate on a daily basis, the option
contracts themselves will tend to be long term commitments similar
to forward contracts. In this respect, an agricultural trade option
merchant will not be faced with the daily potential of large shifts
in its option position due to rapid changes in market prices.
Moreover, the price risk to the agricultural trade option merchant
of an unhedged option position will be similar to that of an
unhedged forward contract position. For example, elevators selling
unhedged put options to producers face the risk that prices fall,
thereby resulting in the elevator purchasing a commodity at a
relatively high price when producers exercise their options. This is
the same risk faced by an elevator entering into unhedged forward
contracts.
Because of the similarities in long-term price risk between the
options which can be offered under the proposed rule and forward
contracts, the availability of hedging tools and the expectation
that agricultural trade option merchants will hedge their option
positions in a manner similar to their forward contract positions
and because of varying levels of sophistication among those who may
be involved in offering agricultural trade options, the Commission
is not now proposing a daily net worth calculation. Nonetheless, the
Commission seeks comments on this issue, asking commenters to focus
in particular on the needed sophistication of potential agricultural
trade option merchants to mark assets and liabilities to market on a
daily basis, whether daily marking-to-market is desirable or
necessary in light of the long-term nature of the option positions
and whether current standards used by these entities in operating in
forward markets are sufficient for operating in the market for
physical options given the similarity in the risks faced by the
merchants.
\30\ The Commission believes that the guidance provided in the
American Institute of Certified Public Accountant's Audit and
Accounting Guide, entitled, ``Brokers and Dealers in Securities,''
provides the relevant guidance which should be followed in
connection with assigning a fair value to agricultural trade
options. It states: ``Under generally accepted accounting
principles, fair value is measured in a variety of ways depending on
the nature of the instrument and the manner in which it is traded.
Many financial instruments are publicly traded, and end-of-day
market quotations are readily available. Quoted market prices, if
available, are the best evidence of the fair value of a financial
instrument. If quoted market prices are not available, management's
best estimate of fair value should be based on the consistent
application of a variety of factors available to management.'' A
complete discussion of the factors is provided in the audit guide.
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b. Segregation of Customer Premiums. The Commission is proposing an
additional financial protection--requiring that agricultural trade
option merchants segregate customer premiums from their own capital.
The advance notice noted the potential financial and regulatory
concerns which arise from the asymmetric credit risk of option
contracts. That asymmetry exists when the party purchasing the option
pays the cost of the option--the option premium--in advance of the
counterparty's having to perform on its obligation.\31\ The purchaser
then faces the risk that the seller of the option might fail to perform
on the contract, if exercised. Under such circumstances, not only does
the option purchaser lose the opportunity gain that would have been
realized through the exercise of the option, but also would be subject
to the out-of-pocket loss of the option premium. This is in contrast to
forward contracts, where both parties have reciprocal obligations and
neither makes a payment in advance of performance. The ability to
collect an up-front payment of premiums may also give merchants an
incentive to sell options in order to generate option premiums for
immediate use as operating funds.
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\31\ Generally producers have used forward contracts as a means
of hedging price risk (in addition to merchandizing the commodity),
obviating the need for the producer to maintain a futures position
or incur out-of-pocket expenses. Under this arrangement, the
elevator generally covers the price risk of the forward contract by
entering into a futures position and paying the required margin
obligations on the position. The elevator may then recoup this cost
implicitly. To the extent first handlers structure agricultural
trade options in this manner as well, there will be no up-front
payment, and no funds will be segregated. Of course, because under a
trade option a producer may elect not to deliver the commodity, the
elevator would be expected to establish some other means of
recovering the cost of the option premium if it is not paid up
front.
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In order better to safeguard customers' up-front premium payments
and to discourage the writing of trade options in order to generate
immediate operating funds by a firm experiencing financial
difficulties, the Commission is proposing that option premiums be held
in segregation while an option contract is open, and that option
premiums not be available to the agricultural trade option merchant for
use in its business during the period an option is open. The Commission
is proposing that the premium associated with an option must be
separately accounted for and segregated in an account held for the
benefit of option customers. Such funds, when deposited in a bank,
trust company, or other financial institution, must be deposited under
an account name which clearly identifies them as segregated customer
funds and shows that they are segregated as required by Commission
regulations.
c. Cover of Market Risk. The advance notice posed several specific
questions relating to whether the Commission should require that
agricultural trade option merchants cover the market risk of the
agricultural trade options which
[[Page 59630]]
they write. One commenter, a futures exchange, suggested that the
Commission require that agricultural trade option merchants be required
to cover the market risk of their trade options one-for-one with
exchange-traded options. Other commenters, however, disagreed, pointing
out that agricultural trade options may be offered for commodities in
which there is no actively-traded exchange market or may be written for
a form, grade, expiration, or delivery location not provided under
exchange-traded instruments. In such instances, a one-to-one cover
requirement using exchange-traded instruments may be economically
inefficient or impossible.
In general, it is the Commission's view that the market risks faced
by entities offering trade option contracts will be similar to those
currently associated with the offer of forward contracts. For example,
an elevator entering into a forward contract to purchase grain from a
producer faces the risk that the price of grain at the time of delivery
will be lower than the contract price, requiring the elevator to pay
the producer a higher price than the elevator can obtain when it
resells that grain. Balancing this risk is the possibility that prices
will rise making the contract price relatively cheap. Elevators may
choose to bear this risk, chancing the fall in cash prices against the
opportunity to profit if cash prices rise, or they may offset the
market exposure of rising prices by selling a futures contract on one
of the futures exchanges.
An elevator selling a put option to a producer faces similar market
risk as one entering a forward contract; that is, that spot market
prices will be lower than the price at which the option is exercised.
As with forward contracts, the elevator may choose to bear the market
risk or to cover the market risk by purchasing an exchange-traded put
option. Whether or not the elevator chooses to bear the market risk
associated with the trade option, however, it always receives the
premium from the producer regardless of whether prices rise or fall.
The Commission assumes that current cover practices common to
forward contracting will be applied to agricultural trade options. The
Commission is aware of no reason why those offering trade option
contracts would be any less likely to cover market exposure on trade
option contracts than is currently the case with those offering forward
contracts. In light of the similarities of such option contracts to
forward contracts as discussed above, the Commission is of the view
that elevators can determine individually the manner in which they will
cover their exposure to market risk, if at all.
2. Probity and Competency Requirements for Agricultural Trade Option
Merchants
a. Registration. Registration of commodity professionals is an
important means by which the Commission polices the futures and option
industry and is the primary mechanism for reassuring the public of the
futures professional's probity and proficiency.32
Registration is an indisputably important safeguard to the public and
will be critically important in the decentralized market permitted
under the pilot program. However, the offer and sale of trade options
will be a complement to the first-handler's existing cash market
businesses, to some extent offsetting the need for extensive
registration requirements. Accordingly, the Commission is proposing
that those engaged in the business of the offer and sale of
agricultural trade options must register under the new registration
category of ``agricultural trade option merchant.'' The Commission is
proposing a streamlined form of registration covering both the
agricultural trade option merchant as an entity and its authorized
sales force.33
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\32\ In this regard, by virtue of the required registration of
their counterparty as agricultural trade option merchants, customers
will have available to them under section 14 of the Act the
Commission's reparations program for the resolution of disputes
arising under agricultural trade option contracts. As proposed,
customers will be apprised of this right in the disclosure document.
\33\ The Commission has not proposed to permit FCMs to
substitute FCM registration for registration as an agricultural
trade option merchant based on the assumption that few, if any, FCMs
would qualify to be an agricultural trade option merchant by virtue
of the requirement that such entities also be a commercial user of
the underlying commodity. The Commission requests comment on whether
this assumption is not correct and, if so, whether registration as
an FCM should be permitted in lieu of registration as an
agricultural trade option merchant. The Commission also requests
comment on whether Commission rule 1.19 should be amended to permit
FCMs to conduct such a business.
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The streamlined registration requirement being proposed consists of
the single filing of a form identifying the agricultural trade option
merchant, its principals (if the agricultural trade option merchant is
an entity), and on separate pages, information identifying its sales
agents, a certification that none of the individuals is statutorily
disqualified from engaging in a commodity-related business under the
statutory disqualification provisions of section 8a(2) or 8a(3) of the
Act, a set of fingerprints for each individual, a copy of the entity's
certified financial statements completed within the prior 12 months,
and evidence that individuals have completed successfully a proficiency
test specifically geared toward agricultural trade options. Amendments
of such registration applications for new associated persons can be
filed as necessary.
The Commission is seeking comment on whether this registration
function should be delegated to the National Futures Association (NFA).
NFA has been delegated responsibility by the Commission to administer
the registration procedures for all futures industry professionals. The
possible delegation to NFA of responsibility for processing the
registration applications of agricultural trade option merchants would
be consistent with this practice and, should NFA agree to accept this
responsibility, this delegation would conserve Commission resources, as
well.
b. Competency Testing. A second important customer protection is
competency testing of futures professionals. Because agricultural trade
option merchants will not be engaged in other facets of futures and
option sales, the series 3 examination which is generally required for
futures professionals would not be necessary. Accordingly, the
Commission is proposing that a specialized examination targeted at
agricultural trade options be developed.34 The Commission,
as it has with all other similar testing programs, proposes to delegate
this testing function to the NFA. In light of the proposed competency
test for agricultural trade option merchants, the Commission is not
proposing an explicit educational requirement. Successful completion of
this targeted examination would evidence proficiency in those areas
relevant to the offer and sale of agricultural trade
options.35
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\34\ Although agricultural trade option merchants would only be
required to pass the more specialized agricultural trade option
examination, passing the series 3 examination would also be
acceptable as a condition of registration.
\35\ Many commenters opposed mandatory educational requirements
for either agricultural trade option merchants or customers. The
Commission is of the view that customers have the right to expect
that such merchants and their sales forces will have successfully
demonstrated mastery of the issues relevant to the offer or sale of
these instruments. Although the Commission is not proposing an
educational requirement for customers, it strongly urges private
sector organizations to provide a variety of means of fulfilling
this need. The success of the pilot program will depend, in part, on
the success of various organizations in educating potential trade
option customers. In this regard, a participant at the Commission's
open meeting in Memphis, Tennessee, representing the National Grain
and Feed Association stressed her organization's commitment to these
efforts.
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[[Page 59631]]
c. Ethics Training Requirement. The final protection relating to
both probity and competency is the ethics training requirement
applicable to all Commission registrants. A few commenters expressed
concern that without this requirement, if the prohibition on
agricultural trade options were lifted, regulatory oversight of
agricultural trade option merchants could be inadequate. The Commission
carefully considered what degree of ethical instruction would be
necessary and appropriate for registered agricultural trade option
merchants and is proposing to apply to agricultural trade option
merchants the same mandatory ethical training requirements currently
required by the Act for all other registrants. See, 17 CFR
3.34.36
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\36\ In 1992, section 210 of the Futures Trading Practice Act of
1992 (FTPA) amended section 4p of the Act to mandate ethics training
for persons required to be registered under the Act. On April 15,
1993, the Commission adopted regulation 3.34 to implement the
requirements of FTPA section 210. 58 FR 19575. Commission regulation
3.34 requires natural persons registered under the Act to attend
ethics training to ensure that they understand their
responsibilities to the public under the Act.
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Under this requirement, Commission registrants are required to
attend ethics training within six months of being granted registration
and, thereafter, every three years. This ethics training must be at
least four hours in duration for the initial session and one hour in
duration for subsequent periodic sessions. Training is available from a
variety of sources and can be undertaken through videotape, computer
programs, or other similar means, in addition to attendance in person.
See, 17 CFR 3.34(b)(3)(iii). These requirements apply equally to all
Commission registrants and are being proposed to apply to agricultural
trade option merchants as well.37
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\37\ Those functions relating to ethics training delegated to
NFA for all Commission registrants will also be proposed to be
delegated to NFA for agricultural trade option merchants.
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D. Restrictions on the Instruments or Market Strategies
The Commission posed a series of questions in the advance notice
related to restrictions on the use of option contracts by various
parties. In particular, the Commission asked whether it would be
appropriate under a trade option exemption for producers to write
covered calls and whether agricultural trade options should be
permitted to be bundled to create risk-return payouts different from a
simple put or call.
Several commenters expressed the opinion that option customers
should have unfettered freedom over the types of options available and
the manner of their use, ceding only the restriction that trade options
should be related to a business purpose. Others, however, expressed
concern that more complex instruments or trading strategies might lead
to high levels of fraud and abuse. Although many of these commenters
favored a continuance of the prohibition as the remedy, their concern
over fraud and abuse was shared by many commenters who favored lifting
the prohibition. These commenters accepted the wisdom of some
limitations or conditions on the types of options and trading
strategies that might be used, particularly in connection with a pilot
program.
The Commission remains concerned that, in lifting the prohibition
on agricultural trade options, it not also open the door to fraudulent
dealing. Although additional risk management instruments may assist the
agricultural sector in meeting the new challenges which it faces,
opening up this long-restricted market to all types of options may
unnecessarily expose participants to abuse. In order to balance these
concerns, the Commission is proposing several limitations on the
structure of option contracts and on permitted trading strategies or
uses. First, the Commission is proposing a prohibition on the writing
of covered call options by producers. Covered call options are short
call positions written by an individual who has a long position in the
underlying commodity. The option is covered in the sense that, if the
option is exercised, the writer of the option has the commodity in his
or her possession to deliver on the contract. While an individual
writing a covered call has limited risk in the sense that he or she
possesses a commodity which can be delivered against the option
contract, the call does not provide downside price risk protection on
the long commodity position except to the extent that a premium has
been paid by the purchaser. Moreover, the short call caps any gains
that the producer might earn on the long commodity position. Although
such a strategy may be appropriate in certain instances, it is
susceptible to abuse to the extent that producers do not appreciate the
extent to which downside price protection and upside pricing potential
is surrendered for a premium payment and is not appropriate for
inclusion in the pilot program. It is also the Commission's opinion
that the writing of put options by agricultural producers is not an
appropriate business-related use of options. The Commission, therefore,
is proposing a prohibition on the writing of such options.
However, trade option customers would be permitted to enter into
options that simultaneously combine long put and short call option
positions only to the extent that the size of the delivery quantity
associated with the short call option position does not exceed the size
of the delivery quantity associated with the long put option position.
Thus, for example, an agricultural trade option could give the producer
the right to deliver 5,000 bushels of corn at harvest time at a price
of $2.50 per bushel and the elevator the right to call for the delivery
of 5,000 bushels at $3.00 per bushel. Under such an option, if at
harvest time the price of corn was below $2.50, the producer would
exercise the option to deliver the 5,000 bushels of corn at $2.50 per
bushel. If, however, the price of corn was above $3.00 per bushel, the
elevator would exercise its option to call for the delivery of 5,000
bushels of corn at $3.00 per bushel. If the price of corn was between
$2.50 and $3.00, it would not be economically rational for either party
to call for or to make delivery of corn. In this example, the producer
has purchased a put option from the elevator for 5,000 bushels of corn
with a strike price of $2.50 per bushel. The producer has also sold a
call option to the elevator for 5,000 bushels of corn at a strike price
of $3.00. This transaction would be permissible under the proposed
restriction that the delivery amount of the short call option portion
of the contract cannot exceed the delivery amount of the long put
option. However, the elevator could not obtain the right to call for
the delivery of more than 5,000 bushels of corn. Moreover, the
Commission is proposing that under no circumstances would a producer be
permitted to write a put option, even if such option was combined with
a long call option.
In addition, the Commission is proposing to limit the termination
and reestablishment of agricultural trade option positions. Some
commenters expressed the view that agricultural trade options should
not be used as a means to speculate in commodities. One manner in which
speculation might be possible would be to move into and out of trade
option positions based on updated predictions of expected price moves.
Although some commenters argued that such strategies could enhance the
price of the commodity being merchandised, the ultimate success of such
a strategy would depend upon one's ability accurately to foresee
[[Page 59632]]
future price movements. Limiting the ability to enter and exit trade
option contracts is consistent with the Commission's desire to include
within the pilot program those trade options which are closest in
nature to forward contracts, contracts for which offset is not
permitted. Thus, the Commission is proposing that, once a trade option
contract is purchased or sold, that position cannot be offset prior to
expiration.
E. Risk Disclosure, Required Contract Terms and Required Account
Information
1. Risk Disclosure Statements
The Commission in its advance notice noted that required risk
disclosures are a customer protection generally used in the regulation
of futures and option trading and requested comment on whether, and in
what form, risk disclosure should be required if the prohibition on
agricultural trade options were lifted. The majority of the commenters
responding to these questions agreed that mandated written risk
disclosure would be appropriate, but varied in their view of the degree
of detail which should be required. Some commenters suggested that the
mandated risk disclosure statement should disclose all financial risks,
including a description of worst possible scenarios. Others were of the
view that a more general statement of risk would be sufficient.
The Commission is of the view that a mandatory written risk
disclosure statement for agricultural trade options is necessary and
appropriate. Such a written statement is essential to ensuring that
trade option customers receive knowledge of and understand the risks
involved in entering into such transactions. Because of the current ban
on agricultural trade options, customers initially will have had no
experience using such instruments. Moreover, agricultural trade options
may attract customers with little or no experience trading on
designated futures or option markets. In light of this, the risk
disclosure statement being proposed by the Commission addresses the
full range of risks that were identified in the Division's study. This
disclosure statement has two parts. The general disclosure is brief and
is intended to cause a customer to ask additional questions of the
agricultural trade option merchant or to seek additional information
from other sources, as necessary. For example, the Commission is
proposing that the disclosure statement include mandatory language
regarding the requirement that trade options must be entered into in
connection with the conduct of the business of the agricultural trade
option merchant and its customers. This discussion would also provide
producers in particular with guidance regarding prudent, business-
related uses of trade options.
In addition, a transaction-specific portion of the disclosure is
designed to provide specific information relating to the terms of a
particular transaction. In this portion of the disclosure statement,
the Commission is proposing to require that, where the full option
premium or purchase price of the option is not collected up front or
where through amendments to the option contract it is possible to lose
more than the amount of the initial premium, the agricultural trade
option merchant must disclose the worst possible financial outcome that
could be suffered by the customer. In this regard, the provision of the
mandatory risk disclosure statement will not relieve the agricultural
trade option merchant of the responsibility to avoid material
misstatements or omissions or any other form of fraudulent misconduct.
This Commission and the courts have repeatedly stated that provision of
a mandatory risk disclosure statement will not necessarily cure what is
otherwise fraud. See, e.g., Clayton Brokerage Co. v. Commodity Futures
Trading Commission, 794 F.2d 573, 580-581 (11th Cir. 1986). In
particular, agricultural trade option merchants may need to make such
additional disclosures as necessary in light of all the particular
circumstances, including the nature of the instrument and the customer.
The Commission is proposing that the full disclosure statement must
be delivered to the customer prior to the customer's first transaction
with the particular agricultural trade option merchant, as is customary
with respect to current practice in futures and option trading. In
subsequent transactions, only the transaction-specific portion need be
provided. The Commission is requesting comment on whether this
requirement should allow its fulfillment through electronic media.
Moreover, the agricultural trade option merchant must retain a written
acknowledgment which has been signed and dated by the customer
evidencing receipt of the disclosure statement by the customer.
2. Required Contract Terms
In addition to delivery of the required disclosure statement, the
Commission is also proposing to require that the option contract itself
(a) be written and (b) contain certain specified provisions. Generally,
the terms of designated futures and option contracts are contained in
the rules of an exchange, which under the Act are required to be
approved by the Commission. In the case of trade options, like forward
contracts, the particular terms are left to individual negotiation
between the counterparties. However, in connection with its issuance of
guidance relating to ``hedge-to-arrive'' contracts, CFTC Interpretative
Letter No. 96-41, Comm. Fut. L. Rep. para. 26,091 (May 15, 1996), the
Division observed that such contracts often contained few or
insufficiently expressed terms and conditions. The lack of written
terms and conditions in these contracts led to widespread disagreement
among parties over the terms of the instruments, complicating the
resolution of various issues. To reduce the chance for disputes over
vaguely defined contract terms in connection with agricultural trade
options, the Commission is proposing to require that the trade option
contracts be written and include a number of specified terms. In
particular, the Commission is proposing that such contracts must
include terms specifying the procedure for exercise of the option
contract, including the expiration date and latest time on that date
for exercise; total quantity and grade of commodity to be delivered if
the contract is exercised and any adjustments to price for deviations
from stated quality or grade; listing of elements comprising the
purchase price to be charged, including the premium, mark-ups on the
premium, costs, fees, and other charges; the strike price(s) of the
option contract; additional costs, if any, which may be incurred if the
commodity option is exercised; and delivery location, if the contract
is exercised.
An important means of safeguarding the public from abusive
transactions is the requirement that transactions be confirmed in
writing at the time of contract initiation. This provides the customer
effective notice of the terms of the agreement, permitting the customer
to object to transactions. Moreover, such a requirement likely would be
beneficial to the merchant as well by providing an effective means of
avoiding disputes over the terms initiating the transaction. The
Commission, therefore, is proposing that agricultural trade option
merchants provide trade confirmation and verification of information
relating to specified contract terms within 24 hours of executing a
contract. See, proposed Sec. 32.13(a)(6).
[[Page 59633]]
3. Report of Account Information to Customers
The Commission is proposing that agricultural trade option
merchants be required to furnish a monthly account statement to all
customers with open option positions. This statement would include a
complete listing of all individual agricultural trade option
transactions entered into by the customer, all outstanding requests to
enter into an agricultural trade option at the time of issuance of the
statement, a current commodity price related to all open option
positions or open orders held by the customer and the amounts of any
funds owed by or to the customer related to the purchase or sale of
option contracts or to the delivery of physical commodity related to
the exercise of an option.
Agricultural trade option merchants will also be required to
indicate clearly expiration dates of options and to highlight those
options which will expire within the next month. This may be done by
highlighting the expiration information on such account statements, by
using boldface type for such information, by separating these contracts
from other contracts on the account statement, or by listing contracts
chronologically by expiration date or by some similar method. The
Commission is proposing this requirement as a means to assist
agricultural trade option customers in managing their option accounts.
Even though agricultural trade options cannot be offset, it is
important for customers to know the current status of their option
contracts with respect to which options may be approaching expiration
and whether options are in or out of the money.
In addition, the Commission is proposing to require that
agricultural trade option merchants supply current commodity price
quotes or other information relevant to an option customer's positions
within 24 hours of a request. In the case of options that may be
exercised at any time, it is important that customers obtain timely
commodity price quotes in order to be able to make decisions regarding
exercise of the options. Although the Commission anticipates that price
information typically would be available immediately, other information
might require the agricultural trade option merchant to search its
records to obtain the requested information. The Commission believes
that a 24-hour period should be sufficient to enable agricultural trade
option merchants to retrieve the information and to respond to the
customer.
F. Recordkeeping and Reporting Requirements
1. Required Books and Recordkeeping
The maintenance of full, complete, and systematic books and records
by agricultural trade option merchants is crucial to the Commission's
ability to respond to complaints of customer abuse arising from such
transactions and is necessary to the agricultural trade option
merchant's establishment of appropriate internal controls of their
financial operations. Although most merchants will already have
recordkeeping systems in place, the proposed pilot program for
agricultural trade options involves a number of regulatory protections,
such as furnishing customers with disclosure statements, which may
require records which have not been customary for first handlers as
part of their cash market businesses. Accordingly, the Commission is
proposing to require that records relating to agricultural trade
options including covering transactions must be kept and maintained for
a period of five years and must be readily accessible during the first
two years of that five-year period. See, 17 CFR 1.31.
Specifically, the Commission is proposing that trade option
merchants be required to maintain full, complete, and systematic
records of all agricultural trade option transactions. Such books and
records should include all orders (filled, unfilled, or cancelled),
books of record, journals, ledgers, cancelled checks, copies of all
statements of purchase, exercise or lapse, and reports, letters,
disclosure statements required by proposed Sec. 32.13(a)(7),
solicitation or advertising material or other such communications with
agricultural trade option customers or potential customers. All such
books and records must be kept for a period of five years from the date
of their creation and must be readily accessible during the first two
years of the five-year period. All such books and records must be open
to inspection by any representative of the Commission or the U.S.
Department of Justice or the NFA in connection with functions delegated
to it.
2. Routine Reports
In addition to the maintenance of books and records, the Commission
is proposing to require quarterly reporting by all agricultural trade
option merchants of information relating to their agricultural trade
option transactions. These reports are intended to enable the
Commission to evaluate the success of the pilot program on an ongoing
basis. The information required to be reported will enable the
Commission to determine the overall size of the market, the types of
contracts being offered, the costs to customers, the amount of
commodity being merchandized through options, and the number of
customers using trade options. Routine quarterly reporting from all
agricultural trade option merchants also will permit the Commission to
construct a more complete picture of the market and will better allow
the Commission to evaluate the impact of activity in the trade option
market on that in the cash and exchange-traded markets.
Specifically, the Commission is proposing that reports shall be
filed quarterly by any registered agricultural trade option merchant
having an open trade option contract during the reporting period. The
Commission is proposing to delegate to the NFA responsibility for
receiving and maintaining these reports. NFA will make the information
in this data base available to the Commission upon request. Initially,
the Commission anticipates that such reports may be filed manually,
including by facsimile or electronically, by dial-up transmission or
via the Internet. Commenters are requested specifically to address
issues relating to the means of filing reports and their capability to
file electronically.
3. Special Calls for Information
During the course of the pilot program, in addition to routine
quarterly reports, the Commission anticipates that it will direct the
Division to conduct two special calls for information from agricultural
trade option merchants during the course of the pilot program. The
Commission will use the information it gathers through these special
calls to conduct a study to evaluate the success of the pilot program.
Under a special call, every agricultural trade option merchant will
be required to provide the Commission with the information specified in
the special call. Such information may include: (a) Positions and
transactions in agricultural trade options; (b) positions and
transactions in commodity options and/or futures on all contract
markets entered to cover agricultural trade options; (c) positions and
transactions in cash commodities, their products, and by-products and;
(d) customer identification information. Such information may include
the name, address, and position of each
[[Page 59634]]
customer of the agricultural trade option merchant. All agricultural
trade option merchants should maintain a current listing of such
customer identification information.38
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\38\ Of course, such information is a routine business record
and is required to be maintained as such by the agricultural trade
option merchant. This information would be available to the
Commission by special call for information or through inspection on
an as needed basis. The separate listing would be encouraged as a
means of responding to a request for a total enumeration of this
information relating to an in-depth analysis in connection with
evaluating the pilot program.
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G. Internal Controls
The Commission noted in the advance notice that generally
requirements regarding internal controls are 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 also noted that
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 nor are they subject
to a regulatory scheme requiring such controls.39
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\39\ 62 FR 31381.
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The Commission posed a series of questions on this issue in the
advance notice, asking specifically for comment on the minimum types of
internal controls that an agricultural trade option merchant should
have in place; the regulatory oversight mechanisms that would be
necessary to assure implementation of such minimum levels of internal
controls; and the most cost-effective means by which such internal
controls could be implemented. Of the 13 commenters responding to these
questions, the majority were of the opinion that, although prudent
business practice necessitates use of internal controls, the Commission
should not require them. Several commenters, however, supported
Commission-mandated audits of agricultural trade option merchants. In
this regard, one commenter, noting that state grain warehousing
agencies may already require annual audits and that state and Federal
warehouse regulators already visit every licensed grain dealer,
suggested that the Commission consider developing audit procedures
which existing agencies can implement on the Commission's behalf.
The Commission is proposing to mandate an internal controls
requirement for agricultural trade option merchants similar to that
applicable to FCMs. In mandating such a requirement, the Commission
believes that agricultural trade option merchants will be made aware of
the importance of maintaining internal controls without being subjected
to regulations that are unduly burdensome. As proposed, agricultural
trade option merchants will be required to be audited on a yearly basis
in accordance with generally-accepted accounting principles and to
inform the Commission within three business days of the discovery by a
certified public accountant of any material inadequacies in the
agricultural trade option merchant's internal controls. As proposed,
the agricultural trade option merchant must file a written report with
the Commission stating what steps have been taken or are being taken to
correct the material inadequacy within five days of such a
notification.
In addition, the Commission is proposing to require that the
agricultural trade option merchant must maintain and preserve a written
record of internal trading and supervisory controls. Such internal
controls must include any systems and policies that the agricultural
trade option merchant has for supervising, monitoring, reporting and
reviewing trading activities in agricultural trade options, any
policies it has for covering, hedging or managing risk created by
trading activities, including a description of the reviews it conducts
to monitor positions, and policies that relate to restrictions or
limitations on trading activities.
H. Regulatory Oversight
Several commenters expressed the concern that the Commission would
not be able to provide adequate regulatory oversight of trading in
agricultural trade options. Specifically, commenters questioned whether
the Commission's existing staff and financial resources would be
sufficient to monitor trading activity effectively in such a
decentralized market.
The Commission is proposing this three-year pilot program based, in
part, on its belief that it will be joined in its efforts to promote a
safe and responsible trading environment by many sectors of
agriculture. During the Commission's public hearings, several producer
associations and other agriculture industry associations pledged their
assistance in promoting sound practices by both merchants and
producers. The Commission has also determined to seek the assistance of
NFA in undertaking responsibility for performing certain specified
functions. These delegations should do much to aid the Commission in
maintaining adequate levels of oversight, given its resource
limitations. In addition, the various states and USDA conduct oversight
of warehouses, and the Commission will cooperate with them in those
efforts. The Commission will also devote an appropriate level of its
resources to the conduct of sales practice audits and other forms of
oversight.
In this regard, the Commission is seeking comment on the number of
entities which may offer such contracts under the rules as proposed.
Should this potentially create too large a burden on Commission
resources, the Commission will explore additional delegations of
oversight or other means of conserving its resources while providing
adequate oversight coverage. The Commission is optimistic that, with
these cooperative efforts, it will be able to foster the growth of
responsible trading of agricultural trade options using its available
resources and without harming existing programs or compromising its
ability to achieve its overall regulatory mission. It would not proceed
with the pilot program if it thought otherwise.
I. Exemption for Sophisticated Entities
Some commenters expressed the opinion that the prohibition on
agricultural trade options should be lifted with few or no constraints.
These commenters maintained that participants in these markets possess
sufficient sophistication with respect to contracting so as not to
require regulatory oversight. The agricultural sector, however,
includes a diverse group of entities with different levels of
sophistication, ranging from the small family farmer to highly
sophisticated multinational corporations. Although any one of these
individuals or entities might be entirely capable of understanding and
managing the risks associated with entering into a trade option
contract, only the larger and better financed entities will
consistently have available the legal and financial resources needed to
protect their interests in an unregulated environment. The Commission
is of the view that an exemption from regulatory conditions similar to
that available for trade options on other commodities may be
appropriate for those entities having a very high net
worth.40 However, a greater level of regulatory protection
is appropriate for transactions involving less well-financed entities.
Congress adopted a similar approach for Commission determinations of
the
[[Page 59635]]
availability of exemptive relief under section 4(c) of the Act.
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\40\ Such an exemption would be from the requirements relating
to agricultural trade options being proposed. Any such transaction,
however, would not be exempt from the prohibition of fraud contained
in 17 CFR 32.9.
---------------------------------------------------------------------------
In setting the eligibility requirements for exemption from these
rules, the Commission considered the current levels of net worth or
total worth required of eligible participants under parts 35 and 36 of
its rules. Under parts 35 and 36, corporations or partnerships having
total assets exceeding $10 million or net worth of $1 million in cases
where the transaction was entered into in connection with the conduct
of its business or to manage the risk of an asset or liability, are
considered eligible for the exemption. Some have observed, however,
that these qualifying amounts when applied to entities in agriculture
are too low given the relatively large investment in land and equipment
needed to operate a farm. The concern is that a relatively large number
of individuals engaged in agriculture might meet these financial
criteria based not so much on their investment sophistication and
ability to gather and manage a sizable asset portfolio, but rather
simply reflecting the need to acquire a threshold level of land and
machinery to operate successfully a farm or agricultural enterprise.
Accordingly, the Commission is proposing that, to qualify for this
exemption, individuals or entities should have a net worth of at least
$10 million.
In order to qualify for this proposed exemption, both
counterparties must meet the eligibility requirements. If any one
counterparty is not eligible for this exemptive relief, the
counterparties must comply with all of the regulatory requirements.
J. Relief for Exchange-Traded Instruments
Representatives of several futures and option exchanges have
expressed the concern that lifting the ban on agricultural trade
options would put the exchanges at a competitive disadvantage. They
note that exchanges are currently prohibited from offering options on
physicals for these same commodities.41 They further
maintain that the current prohibition on exchange trading of options on
physicals for the enumerated commodities restricts their ability to
offer more flexible exchange-traded instruments that would be
competitive with agricultural trade options.42
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\41\ Commission rule 33.4 provides in part that ``The Commission
may designate any board of trade located in the United States as a
contract market for the trading of * * * options on physicals in any
commodity regulated under the Act other than those commodities which
are specifically enumerated in section 1a(3) of the Act * * * ''.
\42\ Flex options on futures on the enumerated agriculture
commodities have recently been proposed by exchanges and approved by
the Commission under current rules. These options are flexible in
terms of strike prices, last trading days, the underlying futures
months, and the style of exercise--American or European. Additional
types of flexible terms involving physical delivery would be
permitted if the Commission's rule is amended.
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The Commission agrees that the restriction on options on physicals
in these commodities can be removed. At the time of the pilot program
for exchange-traded options on agricultural commodities, based on
comments received from industry participants and the U.S. Department of
Justice and taking into consideration the history of abuse in option
markets, the Commission followed a cautious approach by not allowing
options on physicals for agricultural commodities.43 The
Commission, however, did express its willingness to revisit the
possibility of allowing exchange-traded options on physicals for
agricultural commodities after gaining experience in the trading of
options on agricultural futures. Given the success of exchange-traded
options on futures, the lack of widespread abuse in these markets, the
permissible flexibility of many option terms under current rules, and
the exchanges' desire to experiment with offering new forms of more
flexible, physical delivery option contracts, the Commission is
proposing to amend Sec. 33.4 to permit exchanges to trade options on
physicals on the enumerated agricultural commodities.
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\43\ See, 49 FR 2752 (January 23, 1984).
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IV. Other Matters
A. Paperwork Reduction Act (PRA)
When publishing proposed rules, the PRA of 1995 (Pub. L. 104-13
(May 13, 1996)) imposes certain requirements on federal agencies
(including the Commission) in connection with their conducting or
sponsoring any collection of information as defined by the PRA. In
compliance with the Act, the Commission, through this rule proposal,
solicits comments to:
1. Evaluate whether the proposed collection of information is
necessary for the proper performance of the functions of the agency,
including the validity of the methodology and assumptions used.
2. Evaluate the accuracy of the agency's estimate of the burden of
the proposed collection of information including the validity of the
methodology and assumptions used.
3. Enhance the quality, utility, and clarity of the information to
be collected.
4. Minimize the burden of the collection of the information on
those who are to respond, including through the use of appropriate
automated, electronic, mechanical, or other technological collection
techniques or other forms of information technology; e.g., permitting
electronic submission of responses.
The Commission has submitted the proposed rule and its associated
information collection requirements to the Office of Management and
Budget. The burden associated with this new collection, including these
proposed rules, is as follows:
Average burden hours per response--5.359
Number of respondents--5105
Frequency of response--Daily
Persons wishing to comment on the information which would be
required by this proposed/amended rule should contact the Desk Officer,
CFTC, Office of Management and Budget, Room 10202, NEOB, Washington, DC
20503, (202) 395-7340. Copies of the information collection submission
to OMB are available from the CFTC Clearance Officer, 1155 21st Street,
NW, Washington, DC 20581, (202) 418-5160.
B. Regulatory Flexibility Act (RFA)
The RFA, 5 U.S.C. 601 et seq., requires that agencies, in proposing
rules, consider the impact of those rules on small businesses. The
Commission has not previously determined whether all or some
agricultural trade option merchants should be considered ``small
entities'' for purposes of the RFA and, if so, to analyze the economic
impact on such entities. However, the Commission is proposing that one
of the conditions for registration as an agricultural trade option
merchant is maintenance of a minimum level of net worth. The Commission
previously found that other entities which were required to maintain
minimum levels of net capital were not small entities for purposes of
the RFA. See, 47 FR 18618, 18619 (April 30, 1982).44 The
Commission has also found, however, that one category of Commission
registrant--introducing brokers (IBs)--which is required to maintain a
minimum level of net capital may include small entities for purposes of
the RFA.45 Nevertheless, in addition
[[Page 59636]]
to the $50,000 minimum net worth required for registration as an
agricultural trade option merchant, such registrants must be in
business in the underlying cash commodity so that they are able to take
physical delivery on those option contracts. This will require that
they have additional resources invested in order to qualify as an
agricultural trade option merchant, in contrast to an IB whose
additional investment beyond the minimum net capital may be relatively
small. For this reason, the Commission believes that agricultural trade
option merchants are more appropriately treated as not being small
entities under the RFA. The Chairperson, on behalf of the Commission,
hereby certifies, pursuant to 5 U.S.C. 605(b), that the action taken
herein will not have a significant economic impact on a substantial
number of small entities. This certification is based on the fact that
the proposed rules will remove a complete ban on the offer or sale of
trade options on the agricultural commodities enumerated under the Act.
The proposed rules permitting such transactions subject to the
specified conditions therefore remove a burden for all entities,
regardless of size.
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\44\ Specifically, in April 1982 the Commission found that FCMs
were required to have a minimum net capital of $50,000.
\45\ IBs are required to maintain minimum levels of net capital
in the amount of $30,000. See, 61 FR 19177 (May 1, 1996).
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List of Subjects
17 CFR Part 3
Administrative practice and procedure, Brokers, Commodity futures.
17 CFR Part 32
Commodity futures, Commodity options, Prohibited transactions and
trade options.
17 CFR Part 33
Commodity futures, Consumer protection, Fraud.
In consideration of the foregoing, and pursuant to the authority
contained in the Act, and in particular sections 2(a)(1)(A), 4c, and
8a, 7 U.S.C. 2, 6c, and 12a, as amended, the Commission hereby proposes
to amend parts 3, 32, and 33 of chapter I of title 17 of the Code of
Federal Regulations as follows:
PART 3--REGISTRATION
1. The authority citation for part 3 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 4, 4a, 6, 6b, 6c, 6e, 6f, 6g, 6h, 6i,
6k, 6m, 6n, 60, 6p, 8, 9, 9a, 12, 12a, 13b, 13c, 16a, 18, 19, 21,
23; 5 U.S.C. 552, 552b.
2. New Sec. 3.13 is proposed to be added to read as follows:
Sec. 3.13 Registration of agricultural trade option merchants and
their associated persons.
(a) Registration required. It shall be unlawful for any person in
the business of offering or selling the instruments listed in Sec. 32.2
of this chapter to offer or to enter into transactions in such
instruments except if registered as an agricultural trade option
merchant or a person associated with such a registered agricultural
trade option merchant under this section.
(b) Duration of registration. A person registered in accordance
with the provisions of this section shall continue to be registered
until the revocation or withdrawal of registration.
(c) Conditions for registration. Applicants for registration as an
agricultural trade option merchant and its associated persons must meet
the following conditions:
(1) The agricultural trade option merchant must have and maintain
at all times net worth of at least $50,000 computed in accordance with
generally accepted accounting principles.
(2) The agricultural trade option merchant must certify:
(i) That none of the natural persons who are principals of the
agricultural trade option merchant, directly or indirectly through the
beneficial ownership of ten percent or more of a principal which is a
non-natural person, nor any of the natural persons who are associated
persons is disqualified for the reasons listed in section 8a(2) and (3)
of the Act; and
(ii) That such natural persons successfully complete the series 3
examination or another proficiency test administered by the National
Futures Association.
(3) Provide access to any representative of the Commission, the
U.S. Department of Justice, or the National Futures Association for the
purpose of inspecting books and records.
(d) Application for registration. Application for registration as
an agricultural trade option merchant and its associated persons must
be made on the appropriate form specified by the NFA, in accordance
with the instructions thereto. Such application:
(1) Must include the agricultural trade option merchant's most
recent annual financial statements certified by an independent
certified public accountant in accordance with generally accepted
auditing standards prepared within the prior 12 months.
(2) Must include the fingerprints, on a fingerprint card obtained
from the National Futures Association, of all natural persons who are
principals, or the beneficial owners of ten percent or more of a
principal which is a non-natural person, of the applicant, and of all
natural persons who are to be associated persons of the agricultural
trade option merchant and such other identifying background information
as specified.
(3) Must include separate certification from each natural person
that the person is not disqualified for any of the reasons listed in
section 8a(2) and 8a(3) of the Act.
(4) Must include such other information as may be specified on the
application form.
(5) This application must be supplemented to include changes in
associated persons, a principal, or other required information or
conditions.
(e) Temporary licensing. Notwithstanding any other provision of
this part, the National Futures Association may grant a temporary
license to any applicant for registration under this section upon
filing of a complete application meeting all of the requirements of
paragraph (d) of this section, subject to termination provisions of
section 3.60 of this part, Provided however, that such temporary
license shall terminate:
(1) Immediately upon failure by an applicant to respond to a
written request by the Commission or the National Futures Association
for clarification or supplementation of any information set forth in
the application or for the resubmission of fingerprints.
(2) Immediately upon failure to comply with an order to pay a civil
monetary penalty within the time permitted under sections 6(e), 6b, or
6c(d) of the Act.
(3) Immediately upon failure to pay the full amount of a reparation
order within the time permitted under section 14(f) of the Act.
(4) Five days after service upon the applicant of a notice by the
Commission or the National Futures Association that the applicant may
be found subject to a statutory disqualification from registration.
3. Section 3.34 is proposed to be amended by revising paragraphs
(a), (d)(1), and (e)(1) to read as follows:
Sec. 3.34 Mandatory ethics training for registrants.
(a) Any individual registered as a futures commission merchant,
introducing broker, commodity trading advisor, commodity pool operator,
leverage trading merchant, associated person, floor broker, floor
trader, or agricultural trade option merchant under the Act must attend
ethics training to ensure that he or she
[[Page 59637]]
understands his or her responsibilities to the public under the Act,
including responsibilities to observe just and equitable principles of
trade, rules, or regulations of the Commission, rules of any
appropriate contract market, registered futures association, or other
self-regulatory organization, or any other applicable federal or state
law, rule or regulation.
* * * * *
(d) * * *
(1) Any individual granted registration under the Act as a futures
commission merchant, introducing broker, commodity trading advisory,
commodity pool operator, leverage transaction merchant, associated
person, floor broker, floor trader or agricultural trade option
merchant after April 26, 1993, who has not been duly registered under
the Act at any time during the two year period immediately preceding
the date such individual's application for registration was received by
the National Futures Association, must attend training referred to in
this section within six months after being granted registration, and
thereafter every three years.
* * * * *
(e) Evidence of attendance at ethics training, including evidence
of completion of videotape or electronic training, must be maintained
in accordance with Sec. 1.31 of this chapter by:
(1) An individual registered as a futures commission merchant,
introducing broker, commodity trading advisor, commodity pool operator,
leverage transaction merchant, or agricultural trade option merchant;
* * * * *
PART 32--REGULATION OF COMMODITY OPTION TRANSACTIONS
4. The authority citation for part 32 continues to read as follows:
Authority: 7 U.S.C. 2, 6c and 12a.
5. Section 32.2 is proposed to be revised to read as follows:
Sec. 32.2 Prohibited transactions.
Notwithstanding the provisions of Sec. 32.11, no person may offer
to enter into, confirm the execution of, or maintain a position in, any
transaction in interstate commerce involving wheat, cotton, rice, corn,
oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs,
solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils
(including lard, tallow, cottonseed oil, peanut oil, soybean oil and
all other fats and oils), cottonseed meal, cottonseed, peanuts,
soybeans, soybean meal, livestock, livestock products, and frozen
concentrated orange juice if the transaction is or is held out to be of
the character of, or is commonly known to the trade as an ``option,''
``privilege,'' ``indemnity,'' ``bid,'' ``offer,'' ``put,'' ``call,''
``advance guarantee,'' or ``decline guarantee,'' except as provided
under Sec. 32.13 of this part.
6. New Sec. 32.13 is proposed to be added to part 32 to read as
follows:
Sec. 32.13 Exemption from prohibition of commodity option transactions
for trade options on certain agricultural commodities.
(a) The provisions of Sec. 32.11 shall not apply to the
solicitation or acceptance of orders for, or the acceptance of money,
securities or property in connection with the purchase or sale of any
commodity option on a physical commodity listed in Sec. 32.2 by a
person who is a producer, processor, or commercial user of, or a
merchant handling, the commodity which is the subject of the commodity
option transaction, or the products or byproducts thereof, if all of
the following conditions are met at the time of the solicitation or
acceptance:
(1) That person is registered with the Commission under Sec. 3.13
of this chapter as an agricultural trade option merchant.
(2) The option offered by the agricultural trade option merchant is
offered to a producer, processor, or commercial user of, or a merchant
handling, the commodity which is the subject of the commodity option
transaction, or the products or byproducts thereof, and such producer,
processor, or commercial user of, or merchant is offered or enters into
the commodity option transaction solely for purposes related to its
business as such.
(3) The option can only be settled through physical delivery of the
underlying commodity.
(4) To the extent that payment by the customer of the purchase
price is made to the agricultural trade option merchant prior to option
expiration or exercise, that amount shall be treated as belonging to
the customer until option expiration or exercise as provided under
Sec. 32.6, provided however, that notwithstanding the last sentence of
Sec. 32.6(a), the full amount of such payment shall be treated as
belonging to the option customer.
(5) Producers may not:
(i) Grant or sell a put option; or
(ii) Grant or sell a call option, except to the extent that such a
call option is purchased or combined with a purchased or long put
option position, and only to the extent that the customer's call option
position does not exceed the customer's put option position in the
amount of delivery quantity. Provided, however, that the options must
be entered into simultaneously and expire simultaneously or at any time
that one or the other option is exercised.
(6) All option contracts, including all terms and conditions,
offered or sold pursuant to this section shall be in writing and shall
contain terms relating to the following:
(i) The procedure for exercise of the option contract, including
the expiration date and latest time on that date for exercise;
(ii) The strike price(s) of the option contract;
(iii) The total quantity of commodity underlying the option
contract;
(iv) The quality or grade of commodity to be delivered if the
contract is exercised and any adjustments to price for deviations from
stated quality or grade;
(v) The delivery location if the contract is exercised;
(vi) The separate elements comprising the purchase price to be
charged, including the premium, markups on the premium, costs, fees and
other charges; and
(vii) The additional costs, if any, in addition to the purchase
price which may be incurred by an option customer if the commodity
option is exercised, including, but not limited to, the amount of
storage, interest, commissions (whether denominated as sales
commissions or otherwise) and all similar fees and charges which may be
incurred.
(7) Prior to the entry by a customer into the first option
transaction with an agricultural trade option merchant, the
agricultural trade option merchant shall furnish a summary disclosure
statement to the option customer. The summary disclosure statement
shall include:
(i) The following statements in boldface type on the first page(s)
of the disclosure statement:
This brief statement does not disclose all of the risks and
other significant aspects of trading in commodity trade options. You
are encouraged to seek out as much information as possible from
sources other than the person selling you this option about the use
and risks of using option contracts before entering into this
contract. The issuer of your option should be willing and able to
answer clearly any of your questions. If this is not the case,
contact someone else to find answers to your questions before
entering into a contract. Sources of information include the
Commodity Futures Trading Commission (a U.S. Government agency), the
U.S. Department of Agriculture, the National Futures Association (a
self-regulatory
[[Page 59638]]
association in the commodity futures industry), your state extension
service, and various agricultural associations.
APPROPRIATENESS OF OPTION CONTRACTS
Option contracts may subject the user to a high degree of price
risk including total loss of any funds you pay to the issuer of your
option. You should carefully consider whether trading in such
instruments is appropriate for you in light of your experience,
objectives, financial resources and other relevant circumstances.
The issuer of your option contract should be willing and able to
explain the financial outcome of your option contract under all
market conditions.
COSTS AND FEES ASSOCIATED WITH AN OPTION CONTRACT
All costs and obligations associated with your option contract
including the premium, commissions, fees, costs associated with
delivery if the option is exercised and any other charges which may
be incurred should be specified in the terms of your option contract
and are explained in this disclosure statement. Before entering into
an option contract, you should obtain a clear explanation of all of
these costs and fees and understand them.
BUSINESS USE OF TRADE OPTIONS
In order to comply with the law, you must be buying this option
for business-related purposes. As such, the terms and structure of
the contracts should relate to your activity or commitments in the
underlying cash market. If a trade option is exercised, delivery of
the commodity must occur. Delivery dates, grades, quantities, and
delivery locations, which are specified in the contract, should
relate to your ability to make or take delivery of the commodity.
Any amendments allowed to the option contract must reflect changes
to your activity or commitments in the underlying cash market or to
reflect the carrying of inventory. Producers are not permitted to
sell call options unless the producer is also entering into a put
option contract at the same time with the same expiration date. In
those situations, the contracts cannot give the person buying the
call option the right to call for the delivery of an amount of
commodity greater than the producer would have the right to deliver
if he or she exercises the delivery option. Producers are also not
permitted to sell put options, whether alone or in combination with
a call option.
RISK OF FRAUD
You should be aware that trade options are offered in a
relatively unregulated and decentralized environment, which may
allow for a higher incidence of fraud than in a more regulated and
restricted market. You should be aware that you may be able to
obtain a similar contract or execute a similar strategy using an
instrument offered on a more highly regulated futures exchange.
Moreover, exchange products will likely be more transparent and the
current prices on which are likely to be reported on a more regular
basis. In addition, exchange options are highly liquid and may be
offset at any time. In contrast, trade options legally may only be
satisfied if exercised through physical delivery.
COUNTERPARTY PERFORMANCE RISK
If you are purchasing an option contract (i.e., acquiring the
right to sell or purchase the commodity), be aware that you face the
risk that the other party to the contract may not perform on its
obligation to purchase or sell the commodity. If this occurs, you
may lose any price protection the option contract would have offered
you. You should take this risk into account in selecting an
agricultural trade option merchant.
DISPUTE RESOLUTION
If a dispute should arise under the terms of this trade option
contract, you may be able to use the reparations program run by the
Commission in addition to any other dispute resolution forums
provided to you under law or under the terms of your customer
agreement. For more information on the Commission's Reparations
Program contact: Office of Proceedings, Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street, NW.,
Washington, DC 20581, (202) 418-5250.
ACKNOWLEDGEMENT OF RECEIPT
The Commodity Futures Trading Commission requires that all
customers receive and acknowledge receipt of a copy of this
disclosure statement. The Commodity Futures Trading Commission does
not intend this statement as a recommendation or endorsement of
agricultural trade options. These commodity options have not been
approved or disapproved by the Commodity Futures Trading Commission,
nor has the Commission passed upon the accuracy or adequacy of this
disclosure statement. Any representation to the contrary is a
violation of the Commodity Exchange Act and Federal regulations;
(ii) The following additional information must be provided prior to
entry by a customer into every option transaction with an agricultural
trade option merchant:
(A) The procedure for exercise of the option contract, including
the expiration date and latest time on that date for exercise;
(B) A description of the elements comprising the purchase price to
be charged, including the premium, mark-ups on the premium, costs, fees
and other charges, and the services to be provided for the separate
elements comprising the purchase price;
(C) A description of any and all costs in addition to the purchase
price which may be incurred by an option customer if the commodity
option is exercised, including, but not limited to, the amount of
storage, interest, commissions (whether denominated as sales
commissions or otherwise) and all similar fees and charges which may be
incurred;
(D) Where the full option premium or purchase price of the option
is not collected up front or where through amendments to the option
contract it is possible to lose more than the amount of the initial
purchase price, a description of the worst possible financial outcome
that could be suffered by the customer; and
(E) The following acknowledgment section:
I hereby acknowledge that I have received and understood this
risk disclosure statement.
Date-------------------------------------------------------------------
Signature of Customer--------------------------------------------------
(b) Report of account information. Registered agricultural trade
option merchants must provide in writing to customers with open
positions the following information:
(1) Within 24 hours of execution of an agricultural trade option
confirmation of the transaction, including a copy of the written
contract and all information required in paragraph (a)(6) of this
section;
(2) Within 24 hours of a request by the customer, current commodity
price quotes or other information relevant to the customer's position
and account; and
(3) Monthly, a current account statement including a complete
listing of all individual agricultural trade option transactions which
clearly states the expiration date of each option and clearly
distinguishes and draws attention to those options which will expire
within the next month, all orders to enter into such transactions not
yet filled, a current commodity price related to all open option
positions or open orders, and the amount of any funds owed by, or to,
the customer.
(c) Recordkeeping. Registered agricultural trade option merchants
shall keep full, complete and systematic books and records together
with all pertinent data and memoranda of or relating to such
transactions, including customer solicitation and covering
transactions, maintain such books and records for the period specified
in Sec. 1.31 of this chapter, and make such reports to the Commission
as provided for in paragraphs (c) and (d) of this section and as the
Commission may otherwise require by rule, regulation, or order. Such
books and records shall be open at all times to inspection by any
representative of the Commission, the Department of Justice, or the
National Futures Association.
(d) Reports. Registered agricultural trade option merchants must
file reports quarterly with the National Futures Association, in the
form and manner specified by the National Futures Association and
approved by the Commission, which shall contain the following
information:
[[Page 59639]]
(1) By commodity and put, call or combined option:
(i) Total number of new contracts entered into during the reporting
period;
(ii) Total quantity of commodity underlying new contracts entered
into during the reporting period;
(iii) Total number of contracts outstanding at the end of the
reporting period;
(iv) Total quantity of underlying commodity outstanding under
option contracts at the end of the reporting period;
(v) Total premiums collected on options during the reporting
period;
(vi) The value of all fees, commissions, or other charges other
than option premiums, collected on trade options during the reporting
period;
(vii) Total number of options exercised during the reporting
period;
(viii) Total quantity of commodity underlying the exercise of
options during the reporting period.
(2) Total number of customers by commodity with open option
contracts at the end of the reporting period.
(e) Special calls. Upon special call by the Commission for
information relating to agricultural trade options offered or sold on
the dates specified in the call, each agricultural trade option
merchant shall furnish to the Commission within the time specified the
following information as specified in the call:
(1) All positions and transactions in agricultural trade options
including information on the identity of agricultural trade option
customers.
(2) All positions and transactions for future delivery or options
on contracts for future delivery or on physicals on all contract
markets.
(3) All positions and transactions in cash commodities, their
products, and by-products.
(f) Internal controls. (1) Each agricultural trade option merchant
registered with the Commission shall prepare, maintain and preserve
information relating to its written policies, procedures, or systems
concerning the agricultural trade option merchant's internal controls
with respect to market risk, credit risk, and other risks created by
the agricultural trade option merchant's activities, including systems
and policies for supervising, monitoring, reporting and reviewing
trading activities in agricultural trade options; policies for hedging
or managing risk created by trading activities in agricultural trade
options, including a description of the types of reviews conducted to
monitor positions; and policies relating to restrictions or limitations
on trading activities.
(2) The financial statements of the agricultural trade option
merchant must on an annual basis be audited by a certified public
accountant in accordance with generally accepted auditing standards.
(3) The agricultural trade option merchant must file with the
Commission a copy of its certified financial statements within 90 days
after the close of the agricultural trade option merchant's fiscal
year.
(4) The agricultural trade option merchant must perform a
reconciliation of its books at least monthly.
(5) The agricultural trade option merchant:
(i) Must report immediately if its net worth falls below the level
prescribed in Sec. 3.13 of this chapter, and must report within three
days discovery of a material inadequacy in its financial statements by
the independent public accountant or any state or federal agency
performing an audit of its financial statements promptly to the
Commission and National Futures Association by facsimile, telegraphic
or other similar electronic notice; and
(ii) Within five business days after giving such notice, the
agricultural trade option merchant must file a written report with the
Commission stating what steps have been taken or are being taken to
correct the material inadequacy.
(6) If the agricultural trade option merchant's net worth falls
below the level prescribed in Sec. 3.13(c)(1) of this chapter, it must
immediately cease offering or entering into new option transactions and
must notify customers having premiums which the agricultural trade
option merchant is holding under paragraph (a)(4) of this section that
such customers can obtain an immediate refund of that premium amount,
thereby closing the option position.
(g) Exemption. (1) The provisions of this section shall not apply
to a commodity option offered by a person which has a reasonable basis
to believe that the option is offered to a producer, processor, or
commercial user of, or a merchant handling, the commodity which is the
subject of the commodity option transaction, or the products or by
products thereof, and that such producer processor, commercial user or
merchant is offered or enters into the commodity option transaction
solely for purposes related to its business as such, and that both
parties to the contract have a net worth of not less than 10 million
dollars.
(2) Provided, however, that Sec. 32.9 of this part continues to
apply to such option transactions.
PART 33--REGULATION OF DOMESTIC EXCHANGE-TRADED COMMODITY OPTION
TRANSACTIONS
7. The authority citation for part 33 continues to read as follows:
Authority: 7 U.S.C. 1a, 2, 4, 6, 6a, 6d, 6e, 6f, 6g, 6h, 6i, 6j,
6k, 6l, 6m, 6n, 6o, 7, 7a, 7b, 8, 9, 11, 12a, 13a, 13a-1, 13b, 19,
and 21.
8. The first sentence of the introductory text of Sec. 33.4 is
proposed to be revised to read as follows:
Sec. 33.4 Designation as a contract market for the trading of
commodity options.
The Commission may designate any board of trade located in the
United States as a contract market for the trading of options on
contracts of sale for future delivery or for options on physicals in
any commodity regulated under the Act, when the applicant complies with
and carries out the requirements of the Act (as provided in Sec. 33.2),
these regulations, and the following conditions and requirements with
respect to the commodity option for which the designation is sought:
* * * * *
Issued this 29th day of October 1997, in Washington, DC, by the
Commodity Futures Trading Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 97-29037 Filed 11-3-97; 8:45 am]
BILLING CODE 6351-01-P
