[Federal Register Volume 62, Number 110 (Monday, June 9, 1997)]
[Proposed Rules]
[Pages 31375-31383]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-14890]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 32


Trade Options on the Enumerated Agricultural Commodities

AGENCY: Commodity Futures Trading Commission.

ACTION: Advance notice of proposed rulemaking.

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SUMMARY: Generally, the offer or sale of commodity options is 
prohibited except on designated contract markets. 17 CFR 32.11. One of 
several specified exceptions to the general prohibition on off-exchange 
options is for ``trade options.'' Trade options are defined as off-
exchange options ``offered by a person having a reasonable basis to 
believe that the option is offered to'' the categories of commercial 
users specified in the rule, where such commercial user ``is offered or 
enters into the transaction solely for purposes related to its business 
as such.'' 17 CFR 32.4(a). Trade options, however, are not permitted on 
the agricultural commodities which are enumerated in the Commodity 
Exchange Act, 7 U.S.C. Sec. 1 et seq. (Act).
    The Division of Economic Analysis of the Commodity Futures Trading 
Commission recently completed a study of the prohibition on the offer 
or sale of off-exchange trade options on the enumerated agricultural 
commodities. Based upon the Division's analysis and recommendations, 
the Commission is seeking comment on whether it should propose rules to 
lift the prohibition on trade options on the enumerated agricultural 
options subject to conditions and, if so, what conditions would be 
appropriate.

DATES: Comments must be received by July 24, 1997.


[[Page 31376]]


ADDRESSES: Comments should be mailed to the Commodity Futures Trading 
Commission, Three Lafayette Centre, 1155 21st Street, N.W., Washington, 
D.C. 20581, attention: Office of the Secretariat; transmitted by 
facsimile at (202) 418-5521; or transmitted electronically to 
[[email protected]]. Reference should be made to ``Prohibition on 
Agricultural Trade Options.''

FOR FURTHER INFORMATION CONTACT: Paul M. Architzel, Chief Counsel, 
Division of Economic Analysis, Commodity Futures Trading Commission, 
Three Lafayette Centre, 1155 21st Street, N.W., Washington, D.C. 20581, 
(202) 418-5260, or electronically, [PA[email protected]].

SUPPLEMENTARY INFORMATION: The Commodity Futures Trading Commission 
(Commission or CFTC) directed its Division of Economic Analysis 
(Division) to study the prohibition on the offer or sale of off-
exchange trade options on the agricultural commodities enumerated in 
the Act and to report on the Division's findings. On May 14, 1997, the 
Division forwarded to the Commission its study entitled, ``Policy 
Alternatives Relating to Agricultural Trade Options and Other 
Agricultural Risk-Shifting Contracts.'' Based upon the Division's 
analysis and recommendations, the Commission is seeking comment on 
whether it should propose rules to lift the prohibition on trade 
options on the enumerated agricultural options subject to conditions 
and, if so, what conditions would be appropriate. An abridged version 
of those portions of the Division's study which might be most useful to 
commenters in identifying the issues for comment follows. The complete 
text of that study is available through the Commission's internet site 
and can be accessed at http://www.cftc.gov/ag8.htm.

I. Statutory and Regulatory Background

A. Options on Commodities Subject to the 1936 Act

    In 1936, responding to a history of large price movements and 
disruptions in the futures markets attributed to speculative trading in 
options, Congress completely prohibited the offer or sale of option 
contracts both on and off exchange in all commodities then under 
regulation.1 Over the years, this statutory bar continued to 
apply only to the commodities regulated under the 1936 Act. The 
specific agricultural commodities regulated under the 1936 Act 
included, among others, grains, cotton, butter, eggs and potatoes. 
Later, fats and oils, soybeans and livestock, as well as others, were 
added to the list. Together, they are referred to as the ``enumerated'' 
agricultural commodities. Any commodity not so enumerated, whether 
agricultural or not, was not subject to regulation. Thus, options on 
such non-enumerated commodities were unaffected by the 
prohibition.2
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    \1\ Commodity Exchange Act of 1936, Public Law No. 74-675, 49 
Stat. 1491 (1936). See, H. Rep. No. 421, 74th Cong., 1st Sess. 1, 2 
(1934); H. Rep. No. 1551, 72d Cong., 1st Sess. 3 (1932).
    \2\ Examples of non-enumerated commodities would include coffee, 
sugar, gold, and foreign currencies. Before 1974, the Act covered 
only those commodities enumerated by name. The 1936 Act regulated 
transactions in wheat, cotton, rice, corn, oats, barley, rye, 
flaxseed, grain sorghum, mill feeds, butter, eggs and Solanum 
tuberosum (Irish potatoes). Act of June 15, 1936, Public Law No. 74-
675, 49 Stat. 1491 (1936). Subsequent amendments to the Act added 
additional agricultural commodities to the list of enumerated 
commodities. Wool tops were added in 1938. Commodity Exchange Act 
Amendment of 1938, Public Law No. 471, 52 Stat. 205 (1938). Fats and 
oils, cottonseed meal, cottonseed, peanuts, soybeans and soybean 
meal were added in 1940. Commodity Exchange Act Amendment of 1940, 
Public Law No. 818, 54 Stat. 1059 (1940). Livestock, livestock 
products and frozen concentrated orange juice were added in 1968. 
Commodity Exchange Act Amendment of 1968, Public Law No. 90-258, 82 
Stat. 26 (1968) (livestock and livestock products); Act of July 23, 
1968, Public Law No. 90-418, 82 Stat. 413 (1968) (frozen 
concentrated orange juice). Trading in onion futures on United 
States exchanges was prohibited in 1958. Commodity Exchange Act 
Amendment of 1958, Public Law No. 85-839, 72 Stat. 1013 (1958).
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B. Options on Commodities Not Subject to the 1936 Act

    In the years following passage of the 1936 Act, the off-exchange 
offer and sale of commodity options on the non-enumerated commodities 
was subject to fraud, abuse and sharp practice. That history was one of 
the catalysts leading to enactment of the Commodity Futures Trading 
Commission Act of 1974 (1974 Act), which substantially strengthened the 
Commodity Exchange Act and broadened its scope. The Act's scope was 
broadened by bringing all commodities under regulation for the first 
time. Congress accomplished this by adding to the list of enumerated 
commodities an expansive catchall definition of ``commodity'' which 
included all ``services, rights or interests in which contracts for 
future delivery are presently or in the future dealt in.'' 3
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    \3\ The definition of commodity is currently codified in section 
1a(3) of the Act.
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    Under the 1974 amendments, the newly created CFTC was vested with 
plenary authority to regulate the offer and sale of commodity options 
on the previously unregulated, non-enumerated commodities.4 
The Act's statutory prohibition on the offer and sale of options on the 
enumerated agricultural commodities was retained.
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    \4\ Section 4c(b) of the Act provides that no person ``shall 
offer to enter into, enter into or confirm the execution of, any 
transaction involving any commodity regulated under this Act'' which 
is in the nature of an option ``contrary to any rule, regulation, or 
order of the Commission prohibiting any such transaction or allowing 
any such transaction under such terms and conditions as the 
Commission shall prescribe.'' 7 U.S.C. 6c(b).
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    Shortly after its creation, the Commission promulgated a 
comprehensive regulatory framework applicable to off-exchange commodity 
option transactions in the non-enumerated commodities.5 This 
comprehensive framework exempted ``trade options'' from most of its 
provisions.6 Trade options on non-enumerated commodities are 
exempt from all of the requirements applicable to off-exchange 
commodity options except for a rule prohibiting fraud (rule 32.8) and a 
rule prohibiting manipulation (rule 32.9).
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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 (Feb. 20, 1976) 
(Notice of Proposed Rules on Regulation of Commodity Options 
Transactions); 41 FR 44560 (Oct. 8, 1976) (Notice of Proposed 
Regulation of Commodity Options). Options were not traded on futures 
exchanges at this time, see p. 18 infra.
    \6\ As noted above, trade options are defined as off-exchange 
options ``offered by a person having a reasonable basis to believe 
that the option is offered to the categories of commercial users 
specified in the rule, where such commercial user is offered or 
enters into the transaction solely for purposes related to its 
business as such.'' Id. at 51815; Rule 32.4(a) (1976). This 
exemption was promulgated based upon an understanding that 
commercials had sufficient information concerning commodity markets 
insofar as transactions related to their business as such, so that 
application of the full range of regulatory requirements was 
unnecessary for business-related transactions in options on the non-
enumerated commodities. See, 41 FR 44563, ``Report of the Advisory 
Committee on Definition and Regulation of Market Instruments,'' 
Appendix A-4, p. 7 (Jan. 22, 1976).
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    In contrast to the regulatory framework for commodity options on 
the non-enumerated commodities, commodity options on the enumerated 
commodities--the domestic agricultural commodities listed in the Act--
were prohibited both as a consequence of the continuing statutory bar 
as well as Commission rule 32.2, 17 CFR 32.2. This prohibition made no 
exceptions and applied equally to trade options.
    The attempt to create a regulatory framework to govern the offer 
and sale of off-exchange commodity options was unsuccessful. Because of 
continuing, persistent and widespread abuse and fraud in their offer 
and sale, the Commission in 1978 suspended all trading in commodity 
options, except for trade options.7 Congress later codified 
the Commission's option ban,

[[Page 31377]]

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\ Public Law No. 95-405, 92 Stat. 865 (1978). Pursuant to the 
1978 statutory amendments, option transactions prohibited by new 
Section 4c(c) could not be lawfully effected until the Commission 
transmitted to its Congressional oversight committees documentation 
of its ability to regulate successfully such transactions, including 
its proposed regulations, and thirty calendar days of continuous 
session of Congress after such transmittal had passed.
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C. Reintroduction of Exchange-Traded Options

    The Commission subsequently permitted the introduction of exchange-
traded options on the non-enumerated commodities by means of a three-
year pilot program.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
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    \9\ 46 FR 54500 (Nov. 3, 1981).
    \10\ Public Law No. 97-444, 96 Stat. 2294, 2301 (1983).
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D. Retention of Ban on Off-Exchange Options on Enumerated Commodities

    In 1984 the Commission permitted exchange trading of options on the 
enumerated commodities under essentially the same rules that were 
already applicable to options on all other commodities.11 In 
proposing these rules, the Commission noted that section 4c(c) of the 
Act and Commission rule 32.4 permitted trade options on the non-
enumerated commodities and that ``there may be possible benefits to 
commercials and to producers from the trading of these `trade' options 
in domestic agricultural commodities.'' 12 However, ``in 
light of the lack of recent experience with agricultural options and 
because the trading of exchange-traded options is subject to more 
comprehensive oversight,'' the Commission concluded that ``proceeding 
in a gradual fashion by initially permitting only exchange-traded 
agricultural options'' was the prudent course.13 
Nevertheless, the Commission requested comment from the public 
concerning the advisability of permitting trade options between 
commercials on domestic agricultural commodities. Citing past abuses 
associated with off-exchange options, the consensus among commenters 
was that the Commission should proceed cautiously and retain the 
prohibition on such off-exchange transactions.
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    \11\ 49 FR 2752 (January 23, 1984).
    \12\ 48 FR 46797, 46800 (October 14, 1983) (footnote omitted).
    \13\ Id.
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    Since then, the Commission has reconsidered the issue of whether to 
remove the prohibition on the offer and sale of trade options on the 
enumerated commodities several times. In 1991, the Commission proposed 
deleting the prohibition on trade options on the enumerated commodities 
and including them under the same exemption applicable to all other 
commodities. 56 FR 43560 (September 3, 1991). The Commission never 
promulgated the proposed deletion as a final rule.14 Most 
recently, on December 19, 1995, the Commission hosted a public 
roundtable (December Roundatable) to consider this issue once again and 
to provide a forum for members of the public to provide their views.
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    \14\ By letter dated January 30, 1997, the National Grain and 
Feed Association (NGFA) petitioned the Commission to repeal 
immediately the prohibition on agricultural trade options in its 
entirety. NGFA's petition advocated that the Commission proceed to 
promulgate final rules on the basis of the 1991 Notice of Proposed 
Rulemaking. The Commission, in light of its publication of this 
Advance Notice of Proposed Rulemaking and consideration of whether 
to lift the prohibition subject to conditions, denied that petition 
by letter dated May 23, 1997.
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II. Possible Benefits of Trade Options on the Enumerated Agricultural 
Commodities

    The Division in its study identified a number of benefits that may 
result from lifting the prohibition on agricultural trade options. One 
such benefit is the potential for a greater supply of, and competition 
in offering, option contracts.15 Currently, only 
standardized, exchange-traded options are available for agricultural 
product hedging. Presumably, lifting the ban would encourage 
competition between customized contracts and financing arrangements 
offered by various off-exchange counterparties and the more 
standardized but highly liquid, low credit-risk products offered by 
exchanges.
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    \15\ Options provide a highly effective tool for hedging and 
have unique pay-out characteristics. Options differ from futures 
contracts in that they are a limited price-risk instrument. That is, 
the purchaser of an option contract can profit from a price rise (in 
the case of a call) or price fall (in the case of a put), but limit 
any losses on the contract to the price of the premium paid for the 
contract.
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    Moreover, lifting the ban would permit a greater variety of option 
vendors, which could reduce the informational search costs to certain 
hedgers. Hedging can be a complex matter involving knowledge by the 
hedger of his market position, delivery timing, quantities and 
qualities of commodity production, inventory, financial wherewithal and 
marketing objectives. In addition, a hedger must be cognizant of risks 
associated with the counterparty on the cash commodity, particularly 
default risk.
    To reduce search costs, many hedgers may choose to rely on 
established cash market trading channels to gather information on 
contracting methods. Established cash trading partners may have a 
greater understanding of the hedger's marketing position and needs than 
others. These cash trading partners may, therefore, be better situated 
to recommend particular hedge strategies and contracts. In addition, 
ongoing business relationships with these parties may have instilled a 
level of trust between counterparties, allowing hedgers to make 
informed assessments as to credit risk and possibly to use cash market 
obligations as collateral for trade option positions.
    In competing to offer option contracts, option vendors may offer 
customers a greater variety of desired attributes or services. For 
example, futures commission merchants (FCMs) can compete by offering 
exchange-traded options which offer a high degree of liquidity and low 
credit risk. They may also offer trade options, to the extent 
permissible, that have features currently unavailable on any exchange, 
such as average-price options.16 Elevators and other first-
handlers, on the other hand, presumably may offer option contracts 
having terms or financing arrangements more closely tailored to the 
hedging or other needs of the customer. Through such competition, a 
hedger may have a greater number of alternatives from which to choose 
in deciding which contract source best suits his or her hedging needs, 
balanced against his or her tolerance for credit risk.
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    \16\ For example, on May 29, 1991, the Commission issued a no-
action letter to Gelderman, Inc., a registered FCM, to offer 
averaging European-style off-exchange options on agricultural 
commodities to certain commercial purchasers. See CFTC Letter No. 
91-1, Comm. Fut. L. Rep. (CCH) para. 25,065 (May 29, 1991). However, 
under Commission rule 1.19, appropriate haircuts to FCMs' net 
capital requirements would have to be promulgated before FCMs could 
offer such trade options generally.
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    The potentially greater array of contracts and services may enable 
hedgers to achieve more precise hedging in a variety of ways. For 
example, more efficient hedges may be attained by more closely matching 
the size of the option contract to the underlying cash market position. 
The standard size of exchange-traded option contracts may not 
correspond to the spot or forward obligations of a hedger. If the 
contract size is not a multiple of a producers's

[[Page 31378]]

output, the hedger is forced to under- or over-hedge.17
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    \17\ ``Under-hedging'' means that the hedger has a futures or 
option position that is less than the total cash market position. 
This, in essence, leaves the cash market commitment, in part, 
without price protection. ``Over-hedging'' means that the futures or 
options position is greater than the cash market commitment.
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    Trade options also allow a hedger to specify expiration or delivery 
dates to coincide more closely with harvest dates, processing schedules 
or the timing of forward contracts. This reduces a hedger's exposure to 
the risk from mismatching the expiration date of an exchange-traded 
contract. Basis risk also can be reduced for the hedger by allowing a 
closer match to the grade of crop or livestock at a particular delivery 
location.
    In addition to tailoring contracts to match more closely the 
underlying commodity, customers, through the bundling of various 
options, can also gain access to contracts which hedge multiple risks. 
Producers, for example, face production risks and price risk associated 
with inputs and outputs. Currently, a producer can hedge these risks 
separately by purchasing, to the extent that they exist, separate 
options on the inputs and outputs and either purchasing crop insurance 
or possibly an option on crop yield futures. However, a counterparty 
might be able to offer at a lower price a single trade option contract 
that hedges all of these risks.18
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    \18\ Under certain conditions, a contract that bundles options 
on multiple commodities has a lower premium than the total premia of 
the individual options on those commodities.
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    Trade option contracts also may address the need for sufficient 
cash flow to maintain margins on open futures contracts or to prepay 
option premiums. Although trade options typically are not margined, 
depending on the terms of the contract, they may allow the option 
purchaser to delay payment of the premium. In certain cases the option 
may be collateralized implicitly by linking the option and a contract 
to deliver the crop or livestock to the same counterparty. The premium 
can then be incorporated into the cash contract by deducting it from 
the final price of the commodity at delivery.

III. Risks of Trade Options on the Enumerated Commodities

    The Division also identified a number of potential risks which may 
cause heightened concern if the prohibition on agricultural trade 
options were lifted. These include fraud, credit risk, liquidity risk, 
operational risk, systemic risk and legal risk. Trade options on the 
enumerated commodities, as with all commodity-related over-the-counter 
instruments, would trade in a less-regulated environment than exchange-
traded options. The Act imposes legal requirements on an exchange, 
mandating that it police itself and its participants for illicit 
activity. In addition, the regulatory structure imposes a variety of 
prophylactic protections against egregious forms of fraudulent and 
abusive conduct. When trading is conducted on a centralized market with 
standardized trading instruments and procedures, it is possible for the 
government to offer a broad level of customer and market protection by 
applying relatively modest levels of its resources.
    In contrast, much of the appeal of trade options stems from the 
desire to deal with known counterparties or to customize the contracts. 
However, regulatory oversight and enforcement is limited in such 
circumstances to the extent that vendors of the instrument are not 
themselves regulated. Although the vendors in a decentralized market 
could be subject to a regulatory scheme, the absence of a centralized 
market and a self-regulatory organization reduces the effectiveness of 
any such regulatory protections. Because transactions in trade options 
would be decentralized, the resources necessary to surveil that 
activity would be far greater than those necessary to oversee the 
operations of a centralized market. Finally, the ability of the 
government to police such activity directly, without the assistance of 
a self-regulatory organization, would require a commitment of greater 
resources.
    Customization of particular contracts also increases the 
possibility of fraud. The lack of standardization may make the 
oversight and policing of trade practices more difficult. Providing 
prophylactic protections, as well as establishing general rules of 
appropriate conduct, is more difficult when contract terms are not 
standardized. Moreover, where practices vary greatly from one vendor to 
another, enforcement is made more difficult.19
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    \19\ For example, during the late spring and summer of 1996, the 
Commission received many complaints concerning so-called HTA 
contracts. As the Commission noted at the time, because the terms 
and circumstances surrounding each contract varied so much, it could 
only make a case-by-case determination regarding the legality of the 
contracts. Such an approach requires a relatively large commitment 
of Commission resources.
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    Just as a lack of standardization may make it more difficult to 
police trading in these instruments, it may also make it more difficult 
for customers to protect themselves from fraudulent or wrongful 
practices. Initially, it is expected that agricultural producers and 
users would enter into put and call options that were very similar to 
those already offered on-exchange. However, to the extent that the 
terms of the contracts or financing arrangements for them became more 
complex, greater time will be required for individuals to become 
familiar with a particular product. Moreover, individuals will by 
necessity progress through a learning curve as they become familiar 
with a particular product and how it interacts with their set of 
circumstances. During the early stages of this process, individuals may 
be more susceptible to fraudulent activity. This, and the possible 
variation among instruments from one source to another and the time it 
takes to familiarize oneself with each new or different product, 
increase the chance that certain individuals will exploit the 
opportunity to commit fraud.20 Of course, educational 
efforts aimed at potential participants in such instruments might, to 
some degree, ameliorate these effects. Conversely, this problem may be 
exacerbated to the extent that the fraudulent activity is carried out 
through the guise of providing education on these 
instruments.21
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    \20\ A good example of this learning process has been the recent 
experience with flexible hedge-to-arrive contracts. These contracts 
had been entered into by elevators and producers for several years 
before recent variations in practice coupled with an inversion in 
the corn markets exposed the weaknesses associated with these 
contracts.
    \21\ Concerns about potential fraudulent activity are not 
limited to option vendors. They also extend to those rendering 
advisory or educational services in connection with such 
instruments.
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    In such a decentralized market, participants find it more difficult 
to detect possible fraudulent conduct by their counterparty. The lack 
of transparent prices may make it difficult for parties to accurately 
ascertain a reasonable value for the contract. Moreover, to the extent 
that there is a lack of daily marking of positions to market or 
reporting of account position statements, as a matter of practice or 
regulatory requirement, it may make it more difficult for a 
counterparty to uncover possible fraudulent activity. These weaknesses 
may exacerbate other information inequalities and create a climate 
where fraudulent or sharp practices are made easier.
    Finally, certain counterparties, particularly those who are also 
Commission registrants, could have conflicts of interest and customers 
may be confused as to the role of the counterparty. For example, to the 
extent that FCMs are permitted to offer trade options as principals, 
but also to act as fiduciaries in relation to executing exchange-traded 
options, confusion on

[[Page 31379]]

the part of the customer may result as to the FCM's role and 
responsibilities. Of course, where the counterparty is a Commission 
registrant, the potential conflicts could be addressed through required 
disclosures or other mechanisms.
    In the past, the Commission has found fraud in connection with the 
offer and sale of off-exchange option contracts to be a serious 
problem. In 1978 the Commission adopted a rule that suspended the offer 
and sale of commodity options to the general public. 22 In 
adopting the rule, the Commission noted that ``[t]he Commission's 
experience to date indicates that the offer and sale of commodity 
options has for some time been and remains permeated with fraud and 
other illegal or unsound practices notwithstanding a substantial 
investment of the Commission's resources in attempting to regulate 
rather than prohibit option trading.'' The Commission also expressed 
its view that the absence of exchange trading in the United States at 
that time may have contributed to problems with option trading.
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    \22\ 43 FR 16153 (April 17, 1978).
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    Credit risk is the risk that a counterparty will be unable to 
perform on an obligation. In the case of an option, where a purchaser 
pays the premium up-front, the credit risks faced by the purchaser and 
the writer differ. The writer of an option faces significant market 
exposure, such that the writer's out-of-pocket losses may exceed the 
premium paid by the purchaser. Thus, the purchaser is at risk that the 
writer will not perform. The writer of an option typically does not 
face credit risk, however, because, unless the premium is financed or 
deferred, the purchaser has already performed on the contract by paying 
the premium. 23 An option purchaser, therefore, must take 
particular care to assure himself or herself that the option writer is 
able and will be willing to perform on the contract under all market 
conditions.
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    \23\ This lack of credit exposure may create a greater 
likelihood of fraudulent practices. For example, an enterprise may 
sell options with no intention of performing on the contracts. 
Because a period of time passes between the time options are written 
and when they expire, the enterprise may be able to collect a 
substantial amount of funds before its intentions not to perform are 
discovered.
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    Liquidity enables customers quickly to enter into a transaction 
without significantly raising or lowering the purchase or sale price in 
the process. The market for trade options differs markedly in liquidity 
from exchange markets. Exchange markets permit trading among a diverse 
group of participants. Moreover, contracts are standardized and 
fungible, allowing any contract to be traded with any participant. The 
potential pool of participants for a specific trade option is much more 
limited. An individual entering into a trade option will likely have 
only a handful of offerors from which to choose. In addition, because 
trade options are typically not fungible, once one is entered into, the 
holder of the option can exit only by returning to the offeror. This 
may result in a higher cost to the hedger than would be the case with a 
more liquid, exchange-traded instrument.
    Operational risk is the risk that the monitoring and control of 
operations cannot be sufficiently maintained and that financial losses 
occur as a result. Exchange-traded contracts are highly standardized. 
As a result, the terms and conditions of the contracts and the 
environment in which they are traded are well understood. In addition, 
familiarity with these contracts has become highly developed over the 
years. Familiarity with exchange-traded options tends to reduce the 
operational risk associated with their use. This risk is further 
reduced because of exchange and CFTC disclosure rules and other 
requirements, including daily marking-to-market of positions and 
regular customer position statements, which keep individuals informed 
of accruing losses.
    In contrast, trade options are not traded in a transparent 
environment or on a continuous basis. As a result, prices may not 
regularly be reported, and positions may not be marked to market on a 
regular basis. Thus, it may be more difficult to monitor the market 
value of a position,24 thereby increasing the degree of 
operational risk.
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    \24\ Based upon observation of forward contracting and 
associated hedging practices, it is anticipated that, although the 
terms of agricultural trade options will be individually negotiable, 
they nonetheless would be expected initially to resemble closely the 
terms of exchange-traded options with respect to exercise dates, 
delivery grades and strike prices. To the extent that the terms are 
similar, it will be easier to monitor the financial condition of a 
position by observing prices on the exchange markets. In addition, 
for individuals who have purchased an option, the price of the 
option is determined up-front, reducing the need to monitor the 
value of the position.
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    It should also be noted that, in the case of agricultural trade 
options, the most likely counterparty to producers is the local country 
elevator. Adding option contracts, particularly those with unusual 
terms, to the marketing mix of contracts already offered by an elevator 
may increase the complexity of the elevator's overall position and make 
it more difficult to hedge. Thus, the elevator's operational risk 
related to the use of trade options may be higher than under the 
current situation.
    Generally, systemic risk is the risk of a broader collapse of 
entities or contracts that can be traced back to the collapse of an 
initial contract or group of contracts. While the repercussions from a 
widespread default can be problematic wherever it occurs, they can be 
particularly troublesome in rural areas where the economies of a town 
or region can be relatively isolated and highly dependent on 
agriculture. Thus, a default relating to agriculture could potentially 
spread quickly to other sectors of the local or even regional economy.
    Lifting the ban on trade options on the enumerated commodities 
would provide an additional exemption from the general rule requiring 
commodity futures and option contracts to be traded only on designated 
contract markets. To the degree that the current prohibition is removed 
or relaxed, entities choosing to operate pursuant to that exemption 
would have to take care to conform their activities to the terms of the 
exemption. Failure to do so might expose such an entity to the legal 
risk that a particular over-the-counter derivative contract offered by 
it was not covered by the exemption and that its offer or sale violated 
either that exemption or some other provision of the Act or Commission 
rules.
    The degree of risk of this occurring would depend upon the extent 
to which a simple option contract were modified. In a simple option 
position, the holder of the option has the right but not the obligation 
to make or take delivery of a commodity at a given price. However, as 
has been seen in the development of derivative contracts in the 
financial markets, this simple contract can evolve into more 
complicated instruments with payout structures significantly different 
from those associated with a simple option. These structures give rise 
to the risk that the resulting instrument comes more closely to 
resemble a futures contract, rather than an option contract. 
Accordingly, in order to avoid a violation, those offering option 
contracts in reliance on the trade option exemption would have to 
assure themselves that the instruments they offer adhere closely to the 
terms of that exemption.

IV. Possible Regulatory Restrictions

    The Division in its study identified and analyzed a variety of 
regulatory protections or conditions which could be fashioned to 
address many of the risks noted above. These conditions could apply to 
the nature of eligible

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parties, conditions on the instrument or its use and regulation of 
marketing.

A. Nature of the Parties

    As the Division noted, an indirect means of discouraging 
unsophisticated individuals from entering into trade options would be 
to use transaction size as a proxy for sophistication. A high minimum 
transaction size effectively would bar smaller, less well-capitalized--
and presumably less sophisticated--commercials from participating. This 
approach has been a stipulated condition of transactions permitted 
under several Commission and staff no-action letters.25 
Transaction size limitations are a clear, easily applied--albeit 
crude--means of measuring sophistication.26 Similarly, the 
net worth of the customer counterparty could be used as proxy for 
determining sophistication.
---------------------------------------------------------------------------

    \25\ The Commission, in May 1991, issued a no-action letter to 
Gelderman, Inc., with respect to the offering of agricultural trade 
options. See, n. 39, supra. A condition of the letter was that the 
options be offered in units of no less than 100,000 bushels. 
Subsequently, in June 1992 the staff issued a no-action letter to a 
commodity merchant and processor to allow the offer of agricultural 
trade options. A condition of that letter was that the minimum 
transaction size of an option be at least 1,000,000 bushels. See, 
CFTC Letter No. 92-10, Division of Trading and Markets, Comm. Fut. 
L. Rep (CCH) para. 25,309 (June 9, 1992).
    \26\ The minimum appropriate transaction size levels would have 
to be considered as part of a notice and comment rulemaking 
procedure.
---------------------------------------------------------------------------

    Proxy limitations may be over- or under-inclusive. In the case of 
size restrictions, they may limit hedging flexibility. As mentioned 
above, many producers do not use exchange-traded contracts because they 
prefer not to post margin, do not have brokers to sell them exchange-
traded options or must arrange financing for the position. Entering 
into a trade option contract with a local elevator may address these 
producer concerns. Using these proxy limitations, however, may make 
trade options unavailable to the smaller entities that might otherwise 
find them the most useful. Conversely, such proxy limitations may also 
be a crude, though clear, means of distinguishing among entities when 
determining to which, if any, various conditions for lifting the ban on 
agricultural commodities should not apply.
    Another method of limiting access to agricultural trade options as 
a means of maintaining regulatory oversight is to limit those entities 
or individuals which may become trade option vendors. For example, 
option vendors could be required to register in some capacity with the 
Commission as a condition of doing business.27 
Alternatively, the Commission could consider creating new requirements 
that would be applicable only to the offer and sale of agricultural 
trade options.28 Such requirements could establish a new 
category of special registration or could simply require that those 
offering such instruments identify themselves by notifying the 
Commission. In lieu of, or in combination with, required registration, 
the Commission could restrict vendors of trade options to commercial 
entities involved in the handling or use of the commodity.
---------------------------------------------------------------------------

    \27\ An additional alternative would be to permit registration 
and oversight of option vendors by other federal or state regulators 
to substitute for CFTC registration. For example, under this 
alternative a bank subject to state or federal banking oversight 
could also offer trade options. However, an elevator could not offer 
such options unless it became registered with the Commission as an 
introducing broker or, as discussed below, in a new category of 
Commission registration or was subject to oversight under some other 
specified regulatory scheme.
    \28\ However, there are costs associated with registration 
requirements, both for the registrant and the Commission which must 
be taken into consideration.
---------------------------------------------------------------------------

    As an alternative for, or in conjunction with, other requirements 
and restrictions, the Commission could institute an educational program 
or condition. Many of the participants in the December Roundtable 
expressed the concern that individuals need better education in the use 
of option contracts and in the principles of risk management 
generally.29 The appeal of such a program rests on the 
assumption that better educated individuals can better protect their 
own interests, thereby reducing the need for other regulatory 
restrictions or monitoring procedures.
---------------------------------------------------------------------------

    \29\ December Roundtable, tr. pp. 17, 19, 32, 45, 49, 53 and 62.
---------------------------------------------------------------------------

    Although the Commission currently does not have any educational 
requirements for individuals using futures or option contracts, the 
exchange-traded option pilot program established under the 1990 farm 
bill,30 a program limited to a relatively limited number of 
counties, required persons participating in the program to complete 
educational training. Seminars on marketing and the use of exchange-
traded options were developed by the United States Department of 
Agriculture and presented through the State Cooperative Extension 
Service together with representatives from the State and County 
Consolidated Farm Service Agency. The instruction included an 
introduction to the Options Pilot Program and a review of option 
trading procedures.
---------------------------------------------------------------------------

    \30\ FACT Act--Food, Agriculture, Conservation and Trade Act of 
1990 (P.L. 101-624).
---------------------------------------------------------------------------

    Although an educational program or requirement has great appeal, 
implementing the program could be very costly, especially in light of 
its potential nationwide scope. Moreover, mandatory attendance to 
fulfill an education requirement may not achieve the desired effect of 
raising the level of understanding or sophistication among potential 
participants, however. Unless competency also is tested, an attendance 
requirement alone may not be indicative of the actual sophistication of 
a participant and could lead to a false sense of security by the 
government, potential vendors, and the customers themselves, that those 
who met the education requirement were in fact knowledgeable or 
suitable customers. Finally, to the extent that private providers or 
organizations undertook this role, there would be a risk that 
educational programs could resemble or become marketing seminars.

B. Restrictions on the Instruments or Their Use

    Several restrictions, either direct or indirect, could be placed on 
the use of agricultural trade options, in addition to the requirement 
that they be offered only to commercial entities. Section 32.4 of the 
Commission's regulations requires that trade options be offered only to 
a commercial entity ``solely for purposes related to its business as 
such.'' Although the Commission has not had occasion to address the 
scope of this restriction definitively, the Commission could delineate, 
by either specific restrictions or more general guidance, at least 
initially, those practices which in the context of agricultural trade 
options will ensure that the use of such options remains within the 
intent of the exemption.31
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    \31\ In connection with HTA contracts, the Division of Economic 
Analysis frequently was asked for further specificity concerning the 
extent to which various forms of the contracts fell within the 
boundaries of the Commission's rules or policies or staff no-action 
positions. In response, the Division issued a Statement of Guidance 
on May 15, 1996. This statement provided specific guidance that 
could be applied to contracts or transactions to determine whether 
or not they were ``prudent,'' that is, could be used to reduce price 
risks. Such a format, if applied to trade options, also might prove 
valuable to the industry.
---------------------------------------------------------------------------

    For example, the requirement that trade options be for a business-
related use suggests that the overall size of all agricultural trade 
option contracts and any other derivative positions should not exceed 
the size of the cash or forward market position being hedged. Under 
most circumstances, a position in a derivative contract that exceeds 
the

[[Page 31381]]

size of the underlying cash or forward position increases price risk. 
Other circumstances associated with managing risk include the existence 
of a predictable relationship between the crop produced and the 
commodity on which the option is written, the timing of option 
expiration and harvest of the commodity, and the expiration of the 
option in a crop year which coincides with the delivery period for the 
underlying commodity.
    Consideration should also be given to whether, or under what 
circumstances, the practice of a producer or other agricultural 
business selling options to generate premium income is ``solely for 
purposes related to its business as such.'' While the purchaser of an 
option holds a limited risk instrument, option sellers potentially face 
unlimited price risk. A practice sometimes used by individuals having 
positions in the underlying commodity is to enter into what is known as 
a covered position. A producer enters a covered call position when he 
or she writes a call option that can be satisfied through delivery from 
production. In this sense, if prices fall, a producer writing covered 
calls is better off by the amount of the premium income received than 
if the cash position is not hedged. However, if prices rise, the 
producer is not able to participate in the market rally, although he or 
she may, nonetheless, receive a price sufficient to cover production 
costs and provide a satisfactory profit margin.
    A second practice which generates premium income involves contracts 
which incorporate both written and purchased options. A contract having 
a cap and floor is an example of this practice. In conjunction with a 
long cash position, these contracts set a floor price for the 
commodity. The cost of providing that floor, however, is reduced in 
return for the producer agreeing to limit the upside profit potential, 
essentially incorporating a written call into the contract. To the 
extent that such contracts provide for a ratio of written options in 
excess of purchased options, they raise issues similar to those of 
writing covered calls or naked options. Certain trading strategies, 
such as placing and lifting a ``hedge'' multiple times, also raise the 
issue of whether such practices are consistent with the requirement 
that trade options be for a business purpose.
    In addition, the design of trade option contracts could be 
restricted to assure that they do not violate other provisions of the 
Act or Commission regulations. While a basic option contract is a 
limited-risk financial instrument, options can be bundled to create 
instruments with more complex payout scenarios. Because option 
contracts can be ``bundled'' to create a synthetic futures contract and 
the regulatory treatment of trade options differs substantially from 
that of off-exchange futures contracts, the Commission could delineate 
trade options from futures contracts, either through guidance or as a 
condition of the exemption.

C. Regulation of Marketing

    Required disclosures are a common customer protection. The 
Commission, in determining whether required disclosures should be 
mandated in connection with lifting the ban on agricultural trade 
options, must also determine the nature of the disclosure that is 
appropriate to this instrument. A second common protection is the 
requirement that customers be provided with periodic information 
regarding accounts. Information regarding the value of a customer's 
position would be useful to customers in guiding them as to the current 
value of their position and determining the prudence of their future 
activities.

D. Other Possible Limitations

    As the Division noted, a major concern when entering into over-the-
counter transactions is the risk of counterparty default. A variety of 
measures have been used in commerce, and on various occasions required 
by the Commission, to attempt to ensure that parties to a contract meet 
their obligations. These include collateral requirements, minimum 
capital requirements, cover requirements in the form of hedges or cash 
market inventories, third party guarantees and minimum credit ratings. 
For example, under the Commission's Part 34 exemption for hybrid 
instruments, as initially promulgated, the eligibility of hybrid 
instruments issuers for the exemption was conditioned upon meeting one 
of four credit-related criteria. These criteria were that the 
instrument be rated in one of the four highest categories by a 
nationally recognized investment rating organization, the issuer had at 
least $100 million in net worth, the issuer maintained letters of 
credit or cover, consisting of the physical commodity, futures, options 
or forward contracts for the commodity or interests consisting of 
acceptable cover, or that the instrument be eligible for insurance by a 
U.S. government agency or chartered corporation. In contrast, a futures 
exchange, during the December Roundtable, advocated that parties 
offering agricultural trade options be required to maintain cover by 
holding a one-to-one hedge with an exchange-traded 
contract.32
---------------------------------------------------------------------------

    \32\ See, December Roundtable, tr. pp. 30, 31, 36, 47, 48 and 
78.
---------------------------------------------------------------------------

    Requiring one-to-one hedging would restrict the flexibility of 
certain option vendors. For example, offerors with sufficient capital 
reserves might be in a position more effectively to cover the risk 
associated with their option contracts in a manner other than by one-
to-one hedging.
    Generally, the Commission imposes internal controls requirements as 
a condition of registration. These include the requirement that FCMs 
provide audited financial statements, have in place a system of 
internal controls, and supervise the conduct of all employees. The 
Commission could impose similar requirements on agricultural trade 
option vendors, with or without mandating their registration. However, 
in the absence of a registration requirement and a self-regulatory 
organization to assist in enforcing that requirement, such conditions 
would be more difficult to mandate and to enforce.
    Many country elevators and others at the first-handler level of the 
marketing chain do not now have in place adequate internal controls to 
engage in a variety of off-exchange transactions,33 nor are 
they subject to a regulatory scheme requiring such controls. 
Accordingly, a possible condition on those wishing to become vendors of 
such instruments might be to require that they have in place systems to 
track changes in the value of their positions and to notify customers 
periodically of the value of such positions. The adequacy of such 
systems could be required to be subject to a review by a certified 
public accountant.
---------------------------------------------------------------------------

    \33\ See, December Roundtable, tr. p. 56.
---------------------------------------------------------------------------

V. Related Issues

    The Division's study also touched on a number of issues which have 
been raised regarding the applicability of other exemptions to 
agricultural contracts. Those issues relate to forward contracts having 
option-like payment features and to the applicability of the 
Commission's exemptions under Part 35 of its rules--for swaps, and Part 
36 of its rules--for professional markets. Although the Division's 
recommendations with respect to these issues are not directly 
applicable to the Commission's determination whether to lift the 
prohibition on the enumerated agricultural commodities, and are not the 
subject of this Advance Notice of Proposed Rulemaking, the Division 
recommended that the Commission

[[Page 31382]]

decide that the prohibition on agricultural trade options does not 
limit the scope of the Commission's swaps exemption under Part 35 of 
its rules and that staff update a previous interpretative letter of the 
Commission's Office of General Counsel.

VI. Issues for Comment

    Based upon the Division's study and its recommendation, the 
Commission is considering whether to lift the prohibition on 
agricultural trade options subject to conditions. The Division 
identified an array of possible regulatory conditions for lifting the 
prohibition, each having differing benefits and costs. The receipt of 
public comment on these issues, particularly an assessment by 
commenters of the costs and benefits of the potential regulatory 
conditions identified by the Division, will assist the Commission in 
considering whether to lift the prohibition and, if so, what conditions 
would establish an appropriate regulatory predicate for so doing. 
Accordingly, the Commission invites commenters to respond to the 
following specific questions, as well as additional comments they may 
have on the above analysis.

A. Benefits

    1. Are there additional potential benefits of permitting the offer 
or sale of trade options on the enumerated agricultural commodities 
that were not identified in the Division's analysis?
    2. Who, in addition to first handlers, likely would become vendors 
of agricultural trade options? Who would likely be purchasers of such 
instruments? Would they attract commercials who do not currently engage 
in risk-management practices?
    3. Would the availability of agricultural trade options likely 
result in the introduction of new products, or would such options 
merely replicate those already available on-exchange?
    4. What factors, if any, suggest that there is a demand for 
agricultural trade options? Has the need for such options changed over 
the years? If so, in response to what factors?

B. Risks

    5. Are there additional potential risks resulting from permitting 
the offer or sale of trade options on the enumerated agricultural 
commodities that were not identified in the Division's analysis?
    6. How transparent is the pricing of the instruments discussed in 
response to question No. 3 likely to be?
    7. What role can industry or trade groups take in promoting best 
sales practices? Is some degree of uniformity in instruments necessary 
or desirable to prevent fraud?
    8. What are the likely credit relationships in offering such 
contracts? Will customers have the bargaining power to address credit 
issues arising because of the asymmetrical nature of option-related 
credit exposures?
    9. What systems do first-handlers currently have in place to 
address operational risk? What oversight is there of their operations, 
and by whom? Are current systems adequate to respond to the demands 
stemming from offering agricultural trade options? Are there 
impediments to first-handlers, and others, developing the necessary 
operational infrastructure?
    10. Are there mechanisms in place to contain possible effects to a 
local or regional economy from the financial failure of a single 
elevator? Does such a failure, if due to adverse experience in trade 
options, have a different result or impact than one due to other 
reasons?

C. Nature of the Parties

    11. Should restrictions be placed on who could offer trade options? 
For example, should vendors be subject to net worth or other financial 
capacity restrictions? Should vendors of agricultural trade options be 
registered with the Commission? What if any criteria should be 
conditions of such registration? If registration is not required, 
should vendors be required to notify the Commission? Should option 
vendors be limited to commercial agricultural interests or other types 
of entities which are subject to a registration requirement or 
government oversight--such as CFTC registrants, banks or insurance 
companies?
    12. Should the use of trade options be limited to sophisticated 
users? If so, what criteria are appropriate to determine the 
sophistication of a party? Would other restrictions on users (such as 
net worth or other measures of financial capacity) be appropriate? If 
trade options are not limited to such users, should sophisticated users 
be exempt from any or all of the trade option requirements? Are parties 
which meet the eligibility requirements of Parts 35 and 36 of the 
Commission's rules appropriately defined as sophisticated for this 
purpose?
    13. Are minimum transaction size requirements a practical means of 
limiting access to trade options? If so, what is an appropriate 
transaction size in the various commodities that would assure that 
options are available to only sophisticated participants? Should 
parties be exempt from transaction size limitations if they can 
demonstrate sophistication through some other criteria? If so, what 
substitute criteria would be appropriate?
    14. Is an educational requirement appropriate as a condition to 
enter into a trade option contract for customers and/or vendors? What 
type of condition would be appropriate with regard to education? Should 
an option customer be required to demonstrate some level of proficiency 
with respect to option transactions, and if so, how would proficiency 
be determined? If trade option vendors were permitted to conduct 
educational seminars, what restrictions or disclosures might be 
required of vendors to prevent abuses? What resources for offering such 
educational opportunities exist or can be made available?

D. Restrictions on the Instruments or Their Use

    15. What uses of agricultural trade options should be deemed 
appropriate? Should restrictions on the use or design of trade options 
be by regulation? Or should the Commission issue general guidance on 
this issue?
    16. Under what circumstances, if any, should the writing of 
agricultural options by producers be considered to be an appropriate 
business-related use of a trade option? More specifically, is it 
appropriate for producers to write covered calls under the trade option 
exemption? To what degree, if any, is the writing of options to offset 
the cost of purchasing an option, appropriate?
    17. Should the Commission adopt regulations or provide guidance to 
restrict trading strategies by option users which result in the 
increase of risk? What types of trading strategies might be restricted? 
Should trade option customers be allowed to enter and exit a position 
multiple times? What means could the Commission use to limit such a 
trading strategy? What obligations would be appropriate for the 
Commission to place on trade option vendors with respect to monitoring 
the appropriateness of the trading activity of their customers?
    18. To what extent should option vendors be permitted to bundle 
options to create risk-return payouts different from a simple put or 
call option?

E. Regulation of Marketing

    19. What types of risk disclosure should be required of vendors as 
related to the offer and sale of trade options? Should such disclosure 
be through a mandated uniform risk-disclosure statement? What 
information should be required to be disclosed?
    20. What types of information and at what intervals should vendors 
be required to notify a customer with

[[Page 31383]]

respect to the financial status of a trade option position? What form 
should trade confirmation take?

F. Cover Requirements

    21. Should the Commission compel counterparties to cover market 
risks, or should the issue of providing cover be left to negotiation 
between the counterparties? Should parties be permitted to waive the 
right to have a counterparty provide some sort of cover or guarantee?
    22. If cover is required, should parties be allowed to combine 
different forms of cover--i.e., collateral, hedging, minimum capital, 
guarantees, etc.--to satisfy the requirement?
    23. Should cover be required on the vendor's gross or net trade 
option position? Should parties be allowed to offset their exposure on 
a trade option position against other non-trade option positions within 
the operation? At what level of a multi-enterprise firm should the firm 
be allowed to net their trade option exposure?
    24. If the customer has a short option position, should the vendor 
have an obligation to ascertain whether the customer has adequately 
covered the position?
    25. If parties are required to provide cover in the form of a one-
to-one offsetting position in an exchange-traded option, what would 
constitute a ``one-to-one'' offset? That is, for trade option 
transactions occurring at fractional sizes of exchange contracts, would 
parties be required to round a position up or down? Would individual 
trade options be required to be offset individually, or could the 
overall position of the seller be hedged? How would trade options be 
covered for those enumerated commodities which are no longer actively 
traded on an exchange? What type of accounting procedure should be 
required to match trade options to offsetting exchange contracts?
    26. In setting a minimum capital requirement in lieu of or in 
combination with various forms of cover, how should the overall level 
of market price risk be determined, and what level of capital would be 
deemed sufficient to cover the risk?
    27. Should third-party guarantees be permitted as a form of cover? 
If so, what forms and what level of guarantee would be appropriate as 
cover for a trade option position? Should the total potential exposure 
on a trade option position be guaranteed? Who are appropriate parties 
to supply a guarantee?

G. Internal Controls

    28. At a minimum, what types of internal controls should an option 
vendor have in place?
    29. What is the most cost effective means to assure that vendors 
implement the minimum level of internal controls? What regulatory 
oversight mechanisms are necessary and in place? Should vendors be 
audited to assure compliance, or is a review by a certified public 
accountant sufficient?
    30. Overall, in light of the above questions, should the Commission 
lift the prohibition on trade options on the enumerated agricultural 
commodities?

    Issued in Washington, DC, this 3rd day of June, 1997, by the 
Commission.
Jean A. Webb,
Secretary of the Commission.
[FR Doc. 97-14890 Filed 6-6-97; 8:45 am]
BILLING CODE 6351-01-P