It is likely that the CFTC will take some actions to address current tension in agricultural markets, and that the days of the prohibitions on clearing of agricultural swaps and restrictions on agricultural options are probably numbered.

On April 22, 2008, the U.S. Commodity Futures Trading Commission (CFTC) held a roundtable meeting on current issues in agricultural commodities. The purpose of the meeting was to solicit comments from the industry on: (i) causes for recent price volatility in U.S. agricultural markets, (ii) the hardships experienced by various segments of these markets and (iii) possible remedies that can be implemented by the CFTC, as a regulator, as well as by other stakeholders, such as exchanges, trade organizations and banks.

Causes for Volatility in Agricultural Markets

At the outset, the members of the CFTC staff and several other industry speakers identified the causes for recent unprecedented price volatility and price increases on grains, beans and cotton. These causes include crop failures, population growth, increase of purchasing capacity in developing countries, reallocation of land to biofuel production as opposed to production of food (partly due to 2007 Energy Act), the credit crisis, higher margins, the weak dollar, energy costs, shortage of storage, and export restrictions in many agricultural producing and exporting countries. In sum, all these factors create the "perfect storm" in the U.S. agricultural markets as well as a "silent tsunami" in agricultural markets globally.

Further, the roundtable participants discussed whether the conversion of trading of agricultural commodities from the open outcry systems to purely electronic trading have contributed to the unprecedented price volatility.

Finally, and most importantly, participants voiced their concern that the entry of the index funds and financial investors and speculators are the main cause for price volatility in the U.S. agricultural markets. However, neither the CFTC staff economists nor the academics provided empirical and statistical evidence demonstrating that, with respect to recent price spikes, specifically those of March 3 and 4 2008, speculators or index funds have contributed to the price volatility. The CFTC was nonetheless requested to research the causes for price spikes on those days.

Questioning if the U.S. Agricultural Market Is "Broken"

As a consequence of price volatility, several speakers identified a number of conditions that in the aggregate may lead to a conclusion that U.S. agricultural markets are currently "broken" and are in need of urgent remedial action.

The first dysfunction in the market is the lack of convergence of futures and cash market prices; one of the speakers said that "the traditional cash [commodity] to futures relationship has ceased to exist." The members of the CFTC staff demonstrated that this lack of convergence is at the highest level in more than 30, and in some cases 60, years in the United States. Some speakers suggested that as a result of this abnormality, the price discovery function in the markets has become less effective (and sometimes meaningless), hedging with futures has become more difficult (since open interest exceeded several times the actual crop production), and the banks that extend collateral have become unable to adequately determine the value of collateral (through marking-to-market on a daily basis).

Secondly, it was noted that high prices and higher price volatility have been commanding much higher margins at the exchanges. Although exchanges and clearing houses do not make money on margin, margin is a critical component of risk mitigation of central clearing houses facing multiple participants in a highly volatile market. A double whammy of higher margins and the acute shortage of credit facilities has put undue burden on many producers, particularly aggregators (elevators) that are experiencing harder times financing forward purchases of crops and hedging their exposures. Several agricultural market participants have already declared bankruptcy. Although several speakers from the banking industry assured participants that the U.S. banking system is safe and sound, and there is "plenty of credit" available to agricultural producers, many participants remained skeptical of banks' willingness to extend credit to fund margin facilities.

Another topic for discussion was the entry of index traders as well as commodities index-tracking or index-replicating hedge funds into commodities markets, and the impact of these new participants on agricultural markets. Given that these traders take purely financial positions in agricultural commodities without having an exposure to physical agricultural commodities, many traditional agricultural hedgers are concerned that new entrants cause excessive volatility by flooding the markets with cash. Again, no concrete evidence was produced that these speculators/investors have contributed to current price volatility. In fact, to the contrary, there was some evidence that their participation contributes to increased liquidity and transparency of the market as a whole.

Proposals for Remedying Current Problems

Speakers proposed several remedial measures to address these problems and the current perceived inefficiencies in the market.

First, with respect to lack of convergence, several market participants focused on inefficient storage and delivery systems for agricultural commodities, and the need to change and modernize these systems.

Secondly, many producers requested that hedge exemptions should be made more restrictive for financial traders (i.e., commodities index-tracking hedge funds) and require that these traders report their cash positions to CFTC on a regular basis. Next, several commentators noted that CFTC should require that over-the-counter (OTC) market participants report their OTC positions in agricultural commodities, such as swaps, options and other OTC-structured instruments, since essentially these instruments constitute the same market as the futures contracts. This proposal echoes the same proposal with respect to energy commodities made during the CFTC energy roundtable in September 2007.

The proposed changes in the speculative position limits were also actively discussed, with participants' comments falling on both sides of the fence—those who supported these changes to increase the liquidity in the markets and take the pressure off of the stressed markets, and those who expressed the view that changing these limits now would be exactly the wrong thing to do, given excessive speculation in the markets. Many producers and agricultural trade associations advocated a moratorium on all hedge exemptions for long-only, passively managed investment capital entering into agricultural futures markets.

Finally, many producers, financial traders and exchanges supported the recommendations to repeal restrictive CFTC regulations on agricultural options (Parts 32 and 33 of the CFTC regulations) and to liberalize the trading of swaps on agricultural commodities (Part 35 of the CFTC Regulations and Sec. 2(g) of the Commodity Exchange Act). Specifically, many market participants noted that centralized clearing of agricultural swaps (be they exchange-traded or executed OTC) would greatly enhance agricultural commodities market transparency and will add useful tools to price and risk management for market participants. CFTC noted that on the day of this roundtable, CME Group Inc. filed for the CFTC's approval to clear OTC grain swap contracts (following an earlier submission in 2008 by The ICE Clear and The ICE Futures to clear "softs"). Recognizing that unless CFTC acts, these OTC markets are likely to move offshore, may participants stressed that it is imperative to modernize regulation of agricultural OTC swaps and options.

In sum, it is certain that the CFTC will take some actions to address current tension in agricultural markets, and that the days of the prohibitions on clearing of agricultural swaps and restrictions on agricultural options are probably numbered.

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