United States 

Department 

of Agriculture 

www.ers.usda.gov 

 A Report from the Economic Research Service

The Dodd-Frank Wall Street 

Reform and Consumer 

Protection Act

Changes to the Regulation of 

Derivatives and Their Impact on 

Agribusiness

Abstract

The Dodd-Frank Wall Street Reform and Consumer Protection Act makes significant 

changes to Federal regulation of the U.S. over-the-counter (OTC) derivatives markets. 

With the goals of improving market transparency and reducing systemic default risk, 

the act calls for swaps to be centrally cleared and traded on an exchange or execution 

facility and for dealers and major participants that trade these derivatives to be subject 

to collateral requirements. Although the act exempts certain types of swaps and traders 

from these clearing, collateral, and trading venue requirements in order to preserve 

market efficiency, all swaps will be subject to new recordkeeping and reporting rules. 

In this article, we review some important features of the new law and discuss their 

potential impact on agribusiness, much of which will depend on how the rules are 

written and implemented by regulators. 

Keywords: financial reform law, derivatives, over-the-counter markets, swaps,

clearing, position limits, risk management, price discovery

Acknowledgments

The authors received helpful comments from Erik Dohlman, Ron Durst, Andrew 

Morton, and Linwood Hoffman of USDA’s Economic Research Service; Steve Neff, 

formerly of USDA’s Farm Services Agency; Thomas Worth of USDA’s Risk Management Agency; David Stallings of USDA’s World Agricultural Outlook Board; and 

Eugene Kunda of the Office for Futures and Options Research at the University of 

Illinois, Urbana-Champaign. Thanks also to Courtney Knauth and Susan DeGeorge 

for editorial and design assistance.

Michael K. Adjemian, madjemian@ers.usda.gov

Gerald E. Plato, gplato@ers.usda.gov

AIS-89

November 2010

Contents

Approved by USDA’s 

World Agricultural 

Outlook Board

Introduction..........................2

Derivatives Markets .............3

Derivatives in U.S. 

 Agriculture ........................7

Important Dodd-Frank Reforms

for Agribusiness...............8

Regulation of Swaps........8

Clearing and Collateral

 Requirements ...............10

Position Limits and

 Hedging Exemptions....11

Agricultural Swaps.........12

Conclusions........................14

References..........................15

Glossary ............................17
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A severe credit crunch in the United States in 2007 marked the beginning 

of a global financial crisis, which was symbolized by a series of surprising 

bank acquisitions and failures.1 In spite of repeated efforts by the United 

States Federal Reserve Board and Federal Open Markets Committee to boost 

liquidity by lowering the primary credit rate and the Federal funds rate target, 

the American economy slid into a deep recession beginning in December 

2007 (National Bureau of Economic Research, 2008). In 2008, Bear Stearns 

and Merrill Lynch, two investment banks in business for a century, collapsed 

and were bought out. In September of that year, the financial services firm 

Lehman Brothers, founded in 1850, filed for Chapter 11 bankruptcy protection. Because the Federal National Mortgage Corporation (Fannie Mae) and 

the Federal Home Loan Mortgage Corporation (Freddie Mac) were deeply 

involved in the home mortgage derivatives market, which lay at the heart of 

the financial crisis, the Federal Government took conservatorship of both, 

and it acquired an ownership stake in American International Group (AIG) 

to provide confidence to the financial system. In the agricultural sector, the 

credit squeeze, in combination with a concurrent price boom in commodities markets, may have contributed to difficulties for some established cotton 

merchants to finance margin calls,

2 forcing them into bankruptcy or mergers.

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street 

Reform and Consumer Protection Act (2010) (hereafter referred to either 

as “the act” or “Dodd-Frank”), with the aim of confronting problems that 

precipitated the financial crisis. Among the provisions in the legislation, 

Congress mandated a tightening of financial market regulation, to improve 

transparency and reduce systemic default risk in the over-the-counter (OTC) 

derivatives trade. Such derivatives, which will be subject to enhanced regulation under the act, are a major component of the hedging activities of modern 

agribusiness. In this article, we review some important features of the new 

law and discuss their potential impact.

Introduction

1 See the Federal Reserve Bank of St. 

Louis website for a thorough timeline 

of the financial crisis.

2 The Commodity Futures Trading 

Commission (CFTC, 2010) makes this 

point in a staff report on the March 

2008 cotton price spike, although other 

factors covered in the report and by 

Carter and Janzen (2009) may be more 

directly tied to observed defaults

Note: Margin calls and other italicized 

terms are defined in the Glossary at the 

end ot the report. 
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A derivative is a financial instrument whose value is based on the value of 

an underlying asset (Hull, 1993). In the United States, the history of derivatives is closely tied to agriculture. Initially established as a cash market in 

1848, the Chicago Mercantile Exchange (CME) Group’s Chicago Board of 

Trade (CBOT) recorded the earliest forward contract, for the future delivery 

of 3,000 bushels of corn, in 1851 (Chicago Board of Trade, 2006).3 Forward 

contracts for wheat and other commodities soon followed. In 1864, the 

CBOT traded the first standardized “exchange-traded” forwards, which were 

called “futures contracts.” Following the success of futures trading in agricultural markets, derivatives trading eventually expanded to minerals, metals, 

and, beginning in the 1970s, financial instruments. Today, derivatives markets 

serve two essential economic functions for the global economy: price 

discovery and risk management.

Market participants trade derivatives for a variety of reasons. Commercial 

firms that deal in the underlying commodity use derivatives in hedging operations both as temporary substitutes for a cash transaction that will occur 

later and to manage price risk (Peck, 1985), effectively reducing the firms’ 

exposure to shifts in the commodity price level.4 Speculators, in contrast, 

attempt to benefit from the same price-level changes that hedgers avoid.5

Through this profit-seeking behavior, speculators provide the market with 

essential liquidity, willingly taking the opposite side of contracts that hedgers 

may otherwise have difficulty establishing, making the market much more 

efficient. By determining a commodity price competitively, liquid exchangetraded derivatives markets instantaneously transmit fundamental economic 

information worldwide. In general, derivatives do not magnify or reduce risk, 

but spread it among the parties most willing to shoulder the variations in the 

price of the underlying asset (Hieronymus, 1977). For example, a derivatives 

market does not make grain production any more or less variable, but it does 

allow producers to insulate themselves from, say, a falling price of corn.6

Examples of derivatives contracts include forwards, futures, options, and 

swaps, summarized below. In each case, the contract is established between 

two willing parties, and the returns are zero-sum, before transaction costs. 

Gains for one side offset losses to the other. 

•	Forward contracts are agreements to exchange a specified asset for a 

certain price at a future date; they are typically made between private 

parties and, for commodities, generally result in physical delivery. 

•	Futures contracts are similar to forward contracts, except that their terms, 

such as quality and delivery location, are standardized to facilitate rapid 

trading on an exchange. Further, the terms of futures contracts specify 

whether they are cash settled or instead settled by physical delivery at 

contract expiration, although most are offset by an opposite position prior 

to expiration. Futures contracts also require that daily contract losses and 

gains from price changes be paid and received each day to guard against 

the risk that one of the firms that enters the contract will not perform its 

obligations (also known as counterparty default risk).

3 Modern CBOT corn contracts are 

traded in 5,000-bushel units.

4 Hedging is done to manage risks 

rather than to avoid them. Even if fully 

hedged, a commercial firm is exposed 

to basis risk, from which it seeks to 

profit. Basis risk is the unanticipated 

change in the difference between cash 

and derivative prices. To avoid risk entirely, the firm would operate only in the 

cash market as it established forward 

contracts for its output. 

6 There is no free lunch, though. 

Whether in the form of an option 

premium or an opportunity cost, derivatives are not costless.

Derivatives Markets

5 Many traders cannot easily be classified as either hedgers or speculators, but 

blend features of both and operate on a 

continuum between the two categories.
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•	 Options—In contrast to futures and forward contracts, which carry the 

obligation to trade an asset for an agreed-upon price—an option represents the right to purchase or sell an instrument for a previously determined strike price. The buyer of a put (call) option has the right, but not 

the obligation, to sell (buy) the underlying asset at the strike price regardless of the asset’s market price. To purchase this right, the buyer pays a 

premium to the writer of the option contract, who is responsible for satisfying the contract if it is exercised. 

•	Swaps are agreements to exchange assets, usually cash flows (Bailey, 

2005). The most common, a “plain vanilla” swap, involves the exchange 

of a fixed interest payment for a variable one, with the difference to be 

paid in cash at contract settlement. A commodity swap is one in which the 

payout is based on the price of a commodity or the level of a commodity 

index.

Derivatives can be traded on a regulated, organized exchange or through a 

less formal dealer network. If search costs are not prohibitive, two willing 

parties can even write and trade derivatives without the aid of a dealer. Trades 

that are not executed on an organized exchange are said to occur in the 

over-the-counter (OTC) market. Swaps and hybrid “swaptions,” which are 

options on swap agreements, are the most common off-exchange derivatives 

(Lang, 2009).7 As shown in figure 1, the notional amount of outstanding OTC 

derivatives is estimated to be about $615 trillion worldwide (Bank for International Settlements, 2010) (fig. 1), of which $300 trillion is in the United 

States alone (FCIC, 2010).8 In comparison, the entire gross domestic product 

of the United States is less than $15 trillion (Bureau of Economic Analysis, 

2010). Nonmetal commodity derivatives, including those for agricultural 

crops, amounted to almost $2.5 trillion in notional value last year (Bank for 

International Settlements, 2010).

7 Throughout the text, the terms 

“swaps” and “OTC derivatives” are 

used interchangeably, since swaps 

are such a prominent component of 

the OTC market. Title VII of the act 

includes swaptions in its definition of 

swaps.

8 The notional amount outstanding 

is the face value, in dollars, of the 

underlying asset upon which the derivative is based. The value of funds at 

risk is a considerably smaller figure.

12/2007 6/2008 12/2008 6/2009 12/2009

0

100

200

300

400

500

600

700

800

0

2

4

6

8

10

12

14

Figure 1

Size of the OTC derivatives market

Trillion dollars Trillion dollars

Source: Bank for International Settlements, 2010.

All assets

Non-metal commodities (right axis) 
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Once transacted by a buyer and seller, futures and options contracts must 

be registered with and processed by a clearing member, who assumes the 

default risk of the original parties, and cleared by a clearing house (a financial entity that splits the original contract, acting as buyer to all sellers and 

seller to all buyers) that stands between the counterparties until the contract is 

settled. The clearing house pools the risk that a clearing member will default 

on a contract among all its members and requires them to provide collateral 

in the form of a margin account, from which daily gains or losses are posted 

(clearing members, who are Futures Commission Merchants, in turn, collect 

margin from their nonmember customers, or from their own funds if they are 

trading on their own account). Daily gains and losses are calculated through 

a process known as marking to market, bringing trading positions in line with 

their current market value.9

The role of the clearing house is to remain adequately capitalized, so that 

it can cancel a contract in case a clearing member cannot meet its margin 

requirements and remunerate the counterparty, centralizing default risk. 

Because it concentrates the default risk of all counterparties, the stability 

of the clearing house is essential to a well-functioning clearing system. A 

stable clearing house that maintains adequate access to financial resources 

reduces the counterparty default risk faced by nonmember traders, and 

can ultimately lower systemic default risk by guaranteeing performance of 

member contracts (Squam Lake Working Group on Financial Regulation, 

2009). Another advantage of the clearing house is that it monitors all trades, 

which increases market transparency, and nets10 them so that credit exposure 

is reduced. Before the act, there was no legal requirement for clearing OTC 

swaps. The traders could, however, volunteer OTC derivatives contracts to 

firms with a clearing house function like CME or IntercontinentalExchange 

(ICE) for clearing, provided the firm agreed to assume the default risk 

responsibility.11

Clearing highly customized OTC derivatives is more time-consuming 

and expensive than for traditional, standardized exchange-traded derivatives. Moreover, the clearing system is not without its drawbacks, which 

are discussed in detail by Pirrong (2010). For example, clearing reduces 

the potential for counterparty defaults as well as the losses associated with 

those defaults, improving the allocation of default risk—but those benefits 

may lead to an expansion of trading and a greater level of risk-taking. This 

is referred to by economists as a moral hazard: even partial insulation from 

default risk makes a trader more likely to engage in riskier trading. Moral 

hazard can be limited by the clearing house by increasing margin or setting 

position limits (capping the number of contracts a member may hold), but 

these tools may result in a less efficient situation than existed in the original, 

bilateral OTC market. Another concern about the clearing process is that if 

it is fragmented through the establishment of multiple specialized clearing 

houses, the benefits of netting are reduced, while counterparty and systemic 

default risks are increased (Squam Lake Working Group on Financial Regulation, 2009). 

OTC derivatives offer some unique advantages over exchange-traded instruments. To facilitate trading expediency, exchanges standardize futures and 

9 Marking to market is sometimes done 

more frequently than once per day.

10 Netting is the process of calculating a 

trader’s actual position in a commodity. 

For example, a net position in corn futures equals the number of long minus 

short contracts. Margin requirements 

are based on the net position. 

11 See Morrison (2010) for an overview 

of existing OTC clearing houses and 

the types of derivatives in which they 

currently specialize or are planning to 

implement.
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options contracts. OTC swaps, on the other hand are more flexible because 

they can be customized to meet the risk management desires of the individual traders. In the past, OTC swaps had lower margin requirements—and 

less frequent, if any, marking-to-market requirements—which may be more 

convenient for those who face constraints on their access to capital. Finally, 

parties to OTC derivatives have greater freedom to bargain contract terms, 

including collateral and price, based on the creditworthiness of the traders. 

In contrast, futures trades must be executed at the current market price. 

Although many swaps are priced with respect to a related futures contract, 

some do not have a corresponding exchange-traded counterpart and represent 

an entirely new market. Swap dealers bridge the OTC and exchange-traded 

markets, using futures contracts to manage the risks they incur by trading 

customized swaps (CFTC, 2008). 
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Many American agribusinesses use derivatives to manage the risks associated 

with their commercial interests. Millers and packers hedge against a rise in 

grain or livestock prices, since these are production inputs. Similarly, large 

grain and livestock producers, concerned that prices may fall before they 

can sell their output, hedge against commodity price decreases and rising 

fuel prices. Fertilizer, herbicide, biotechnology, and farm machinery firms 

use derivatives to shield their returns. For example, a tractor exporter can 

use currency instruments to hedge against an adverse change in exchange 

rates. Few small farmers use exchange-traded derivatives to hedge price risk 

because of the cost of trading, including the risk of margin calls and production uncertainty (Pannell et al., 2008), although some pool together into 

cooperatives to buy and sell futures and options. Many individual producers 

prefer to avoid margin calls and basis risk, contracting their production 

forward with grain elevators, processors, and packers, who in turn assume the 

price risk originally faced by producers.12

Derivatives for agricultural commodities tend to be uniquely designed around 

crop features. For example, five futures contracts for corn and five for wheat 

are traded on the CBOT each calendar year, expiring around planting time, 

during the growing season, and bracketing the harvest. Rather than being 

cash-settled, agricultural futures contracts generally specify physical settlement (delivery of the underlying commodity), directly tying together the cash 

and futures markets. Delivery points are selected based on the commodity 

flow, and contract specifications usually call for a specific grade of the 

product and method of delivery. Futures and options contracts for certain 

agricultural commodities are subject to CFTC-mandated limits for speculative positions. Traders who do not possess a hedging exemption are limited 

to a specified number of contracts, aggregated across futures and options, 

for each single contract month and all months combined. OTC agricultural 

swaps tend to be highly customized derivatives, with terms based on the 

commercial interests of the traders. For example, a soybean producer can 

enter into a swap agreement with a grain elevator operator, securing a fixed 

payment of $350 per metric ton to be paid at harvest. At expiration, the swap 

is settled by cash payment; the farmer will pay the elevator operator the 

difference if the agreed-upon benchmark price per ton of soybeans is more 

than $350, and if the price is lower, the operator will pay the farmer. In the 

end, each party realizes a price of $350 and is free to purchase or sell grain in 

the local cash market. 

12 Harwood et al. (1999) describe 

the tools and strategies that farmers use to manage risk. MacDonald 

and Korb (2005) provide results of a 

related USDA survey.

Derivatives in U.S. Agriculture
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The financial reform act makes significant changes to the regulation of derivatives (table 1). We describe those changes below, as well as their potential 

effects on agribusiness. Throughout, we stress that much of the act’s impact 

will depend on the implementation of the law in the form of regulatory rulemaking. Because this article is concerned with agribusiness and its related 

commodities, the relevant regulator is the CFTC. The CFTC’s rulemaking 

process is open to the public; like other agencies responsible for rulemaking 

prescribed in Dodd-Frank, CFTC includes public commentary in its draft and 

final rulemaking efforts. The process is further described in the box, “Federal 

Rulemaking Procedures.” Successful regulation will strike the right balance 

between increasing transparency while protecting market participants against 

systemic default risk and maintaining the efficiency of OTC markets.

Regulation of Swaps

Before Dodd-Frank was passed, no formal regulatory structure or recording 

mechanism existed for swap derivatives. The act mandates that securitybased swaps be regulated by the Securities and Exchange Commission 

(SEC). Most other swaps (which the law refers to as simply “swaps”—we 

use the same designation) fall under CFTC jurisdiction; swaps and securitybased swaps are defined in the act.13 CFTC and SEC are to cooperate to 

ensure regulatory consistency. Title VII of the act gives CFTC the responsi13 Dodd-Frank defines “mixed 

swaps” as a third class of transactions that share features of both 

swaps and security-based swaps. 

SEC and CFTC share regulatory 

and rulemaking authority over these 

swaps.

Important Dodd-Frank Reforms 

for Agribusiness

The Dodd-Frank Act expresses the intent of Congress concerning financial 

market regulation. Federal agencies tasked with implementing the act must draft 

specific rules and regulations according to the Administrative Procedures Act. 

Proposed rules and regulations must be posted in the Federal Register for public 

comment. After the public comment period, and after weighing the comments 

and congressional intent, the agencies involved draft final rules and regulations, 

which are also posted in the Federal Register. Final rules and regulations, which 

are subject to judicial and congressional review, often include input both from the 

public comments and from public meetings sponsored by the agencies involved.

Public participation in the rulemaking process has increased as the Internet has 

lowered search costs and made information easier to obtain; agency websites 

and the regulation.gov website are used to solicit public comments and to track 

the rulemaking activities (Reilly, 2010). 

Rulemaking in support of Dodd-Frank can be followed on http://www.regulation.

gov, including requests for comments, meeting notices, proposed rules, and final 

rules. The CFTC posts topics, attendees, and summaries of all meetings that 

its staff has with outside groups regarding implementation of the act, public 

comments, and updates to its rulemaking efforts on its website, at http://www.

cftc.gov/. 

 Federal Rulemaking Procedures
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bility of reviewing all groups, categories, types, or classes of swaps to determine whether they should be cleared. This review process can be initiated 

by the derivatives-clearing organization (DCO), or by CFTC itself. The act 

does not alter rules pertaining to other derivatives, i.e., forward contracts or 

exchange-traded futures and options. Various sections of the act stipulate that 

information regarding swap transactions be reported to CFTC after being 

recorded by a DCO, a board of trade, a swap execution facility, or a swap 

data repository, each of which must register with CFTC. In addition, the act 

calls for CFTC and SEC to conduct a study on international swap regulations, 

Table 1

Potenial impact of the Dodd-Frank derivatives regulation on agribusiness

Before Dodd-Frank Dodd-Frank legislation Potential benefits Potential costs

Regulation 

of swaps

Very little regulatory 

authority.

CFTC is responsible for 

all (non-security-based) 

swaps and will determine 

which swaps must be 

cleared. Cleared swaps 

will trade on a contract 

market or swap facility.1

Regardless of the clearing 

requirement, all swaps 

must be reported.

The law brings oversight 

and transparency to an 

unregulated market. 

Establishing CFTC as the 

single regulator centralizes rulemaking.

If highly customized derivatives are forced to clear, OTC 

trades may be hampered. 

Reporting and recordkeeping increases transparency, 

although it may be more 

expensive for certain swaps.

Clearing and 

collateral 

requirements

Clearing and margin were 

mandatory for exchangetraded derivatives, but were 

not required in the OTC 

markets. 

Margin accounts must be 

created for cleared swaps, 

but will not be required for 

end users who exercise a 

clearing exemption. However, their counterparties 

are often swap dealers and 

major swap participants, 

who will still need to post 

collateral.

Clearing and margin 

requirements increase 

market transparency, 

reduce counterparty risk, 

provide for collateral to 

cover losses, and ultimately may help lower 

systemic default risk. 

Clearing requirements may be 

inefficient, and can increase 

systemic risk if not well-designed. Overly strict clearing 

and/or collateral requirements 

may make certain OTC derivatives less attractive for swap 

dealers and other counterparties to traditional hedgers, 

reducing market liquidity.

Position limits

CFTC set position 

limits for non-hedgers 

of exchange-traded ag. 

commodities, but no limits 

existed for OTC derivatives. Certain nontraditional financial traders were 

granted hedging exemptions. 

CFTC is responsible for 

setting aggregate position 

limits across derivative 

types (including OTC) 

for the same commodity. 

Position limits are still 

exempted for bona fide 

hedgers.

Position limits are intended to prevent market 

concentration, manipulation, and “excessive 

speculation,” although 

empirical evidence of 

their benefits is sparse.

Limiting the ability of the 

largest speculators to trade 

derivatives can decrease 

liquidity, making trading—

and risk management 

efforts—more expensive. 

Hedging 

exemptions

Part 1 of the CFTC regulations defined a bona fide 

hedge. CFTC granted 

hedging exemptions to 

some nontraditional financial traders in agricultural 

markets.

The Commodity Exchange 

Act is amended to add a 

similar definition.

CFTC may be less likely 

to give hedge exemptions 

to nontraditional financial 

traders, enforcing a more 

narrowly defined bona 

fide hedge.

Combined with position 

limits, more stringent rules for 

hedge exemptions could force 

large financials overseas and/

or into domestic commodity 

cash markets.

Agricultural 

swaps

Agricultural swaps were 

allowed between “eligible 

swap participants,” as 

defined by Part 35 of the 

CFTC regulations. There 

was no clearing or margin 

requirement for these 

swaps.

Agricultural swaps can 

be made only by eligible 

contract participants, or 

as otherwise expressly permitted by CFTC rules. All 

other trade in such swaps 

is banned.

Continuing to limit 

agricultural swaps to 

eligible contract participants guarantees that the 

market is available only 

to “informed” traders.

Constraining the agricultural 

swaps market limits risk management options of participants who do not meet trading 

threshholds.

1Unless a hedging exemption is excercised, or no transaction facility will accept the swap for clearing
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identifying similar areas of regulation, including those where U.S rules could 

be harmonized with those of other countries. 

Making CFTC the swap regulator centralizes rulemaking and brings oversight to what was essentially an unregulated market. Although OTC derivatives serve an important risk management role, amounting to trillions of 

dollars in value, until now regulators had no authority to monitor the market 

and set or alter trading rules. The comprehensive reporting and recordkeeping 

requirements are intended to enhance market transparency, providing CFTC a 

real-time surveillance of trends in the swap market. The law further requires 

CFTC to provide reports on transaction and pricing data for OTC derivatives, keeping the general public informed about market developments, as 

is currently the case for other derivatives like futures and options. The act 

authorizes the CFTC to decide the timing and manner in which the swap 

transactions data are made available to the public, with the intention of 

enhancing price discovery.

Although the law sets guidelines, CFTC is responsible for rulemaking 

that will establish regulatory oversight and directly affect the efficiency of 

the swap markets. The benefits of improved market transparency must be 

weighed against the possibility that burdensome new trading rules could 

reduce the attractiveness of OTC derivatives and limit their usefulness 

for hedging. Real-time public reporting of cleared swap transactions may 

increase the competitiveness and efficiency of swap markets, but could 

increase costs for dealers, who may choose to pass those costs on to endusers (Ackerman, 2010). Conversely, a long delay in the publication of swaps 

transactions will produce only modest gains in market transparency. In the 

short term, until the practice becomes routine, recordkeeping for customized 

derivatives may be more expensive than for standardized transactions made 

on an exchange. One goal of the review process for new OTC derivatives 

will be to avoid slowing innovation in and development of new risk management products.

Clearing and Collateral Requirements

OTC markets did not have mandatory clearing or margin rules for swaps 

before passage of the act. Now, once CFTC determines which types of swaps 

must clear, these must be cleared through a derivatives-clearing organization—if one is available—that stands between the counterparties and guarantees trades. The DCO must establish capital and margin requirements for 

swaps it clears, such as marking them to market at least once per day, to 

protect its own financial integrity and the integrity of the transactions it clears 

in case a large participant defaults.

 As nonfinancial firms with a bona fide commercial hedging interest in 

the underlying asset, end users may be exempted from the new mandatory 

clearing requirements. To gain this exemption, they must demonstrate to 

CFTC how they meet financial obligations associated with trading uncleared 

swaps, although they can volunteer a swap for clearing at the DCO of their 

choosing. An example of an agribusiness end-user could be a producer that 

uses interest rate swaps to hedge against financial risks it encounters in the 

course of its normal commercial business.14

14 Because specific rules have yet to 

be written, this is only a potential 

example.
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A swap can also go uncleared if no derivatives-clearing organization chooses 

to clear it. When trading uncleared swaps, swap dealers and other major swap 

participants must meet minimum capital and margin requirements set by 

CFTC; the act specifies that these participants are to register with the regulator within a year of enactment. When trading cleared swaps, swap dealers 

and other major swap participants are to follow the capital and margin guidelines set by the derivatives-clearing organization. 

Clearing and margin requirements can act as safeguards for the performance 

of the OTC derivatives markets. Ideally, clearing eliminates counterparty 

credit risk between the original traders. As a result, market participants may 

be more confident in their ability to manage risk, which, in turn, should 

improve market liquidity and lower transaction costs. Moreover, requiring 

margin accounts to be sufficient to cover potential losses could reduce 

systemic default risk. Given adequate collateral requirements, a default by 

one trader is less likely to lead to a domino effect of cascading, market-wide 

defaults on derivative contracts. 

The clearing process has some drawbacks, however. It may be that clearing 

did not develop organically in the OTC market for many swaps because of 

informational problems that make clearing less efficient than bilateral execution for these types of derivatives (Pirrong, 2010). Moreover, forcing swaps 

to clear could actually increase systemic default risk. According to Duffie et 

al. (2010), the clearing house should maintain adequate financial resources to 

cover a broader set of risks than just a default by its largest participant, such 

as the ability to offset potential losses equal to the market’s largest historical 

price swing. If it cannot cover its losses, the likelihood of which may be 

heightened by moral hazard or the difficulty of clearing highly customized 

derivatives, a clearing house poses a risk to the financial system overall.

 Provided they meet the definition of an end user, agribusinesses and other 

nonfinancial firms that use swaps to hedge commercial risks are exempt from 

clearing and margin requirements (Dodd and Lincoln, 2010). Swap dealers 

and other major swap participants, who often take the other side of these 

OTC trades, will, however, need to post collateral before trading uncleared 

swaps with exempted parties. At the option of the end user, that collateral will 

be segregated with an independent third party. If the margin requirements 

are too stringent, swap dealers and major swap participants may find certain 

highly customized derivatives—like agricultural swaps—less attractive. In 

that case, reduced market liquidity would increase transaction costs for agribusinesses engaged in customized swap trading.

Position Limits and Hedging Exemptions

Among agricultural commodities, CFTC previously set position limits only 

for derivatives traded on an exchange. Title VII of the act authorizes CFTC 

to set aggregate position limits across derivatives that are based on the same 

underlying commodity. This regulation includes swaps that perform a significant price discovery function, as defined in the law. Bona fide hedgers are 

exempt from these limits if they can demonstrate a commercial interest to 

CFTC. The act revises the Commodity Exchange Act to include the existing 

definition of a bona fide hedger in CFTC regulations. CFTC is also charged 
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with conducting a study on the impact of position limits on “excessive speculation” and the movement of transactions from domestic to international 

markets.

Limits on the size of trading positions are intended to prevent market concentration, manipulation, and “excessive speculation.” By establishing position 

limits, the CFTC attempts to cap the net positions for traders who do not have 

a direct commercial interest in the underlying commodity. Speculators reduce 

transaction costs to hedgers by boosting trading volume, spreading the fixed 

costs of market operation across many more trades. A derivatives market 

composed only of hedgers would make risk management much 

more expensive (Working, 1970). Although tight position limits can be 

effective at preventing market manipulation (Kyle, 1984), they can also 

constrict the ability of the largest speculators to trade derivatives, decreasing 

market liquidity. Empirical evidence of the effect of position limits is thin, 

but Irwin et al. (2007) conclude that price volatility in CBOT corn, soybeans, 

and wheat did not measurably increase after speculative limits on these 

contracts were relaxed in 2005.

Market liquidity may also be decreased if Congress intends for CFTC to 

apply the hedging exemption more scrupulously. Since the late 1980s, the 

exemption has been interpreted to apply to nontraditional financial firms, 

like swap dealers and commodity index fund traders. For example, swap 

dealers have been able to obtain an exemption from position limits for futures 

markets in order to manage the risks they incurred in the OTC markets, 

and index funds have obtained an exemption if they tracked an index of 

commodity prices. Under new rules, tighter hedge exemptions, combined 

with position limits, could drive index funds into cash markets (Irwin and 

Sanders, 2010) or into overseas derivatives markets. The spirit of position 

limits could be indirectly circumvented if tighter hedging exemptions were 

to cause large financial traders to split into numerous smaller funds, leaving 

the total speculative position in place, but losing economies of scale and 

increasing trading costs to fund participants. 

Agricultural Swaps

Before Dodd-Frank’s passage, agricultural swaps were permitted for trading 

between eligible swap participants under Part 35 of CFTC regulations, 

which was adopted pursuant to section 4(c) of the Commodity Exchange Act 

(CEA). The Part 35 provision allows the CFTC to exempt transactions from 

the exchange-trading requirement or other provisions of the CEA. Title VII 

of Dodd-Frank expressly bans all transactions in agricultural swaps, unless 

they are pursuant to an exemption under CEA section 4(c). In addition, a 

swap execution facility must follow to-be-determined rules before it can list 

an agricultural swap for trading. Under Dodd-Frank, swap transactions are 

limited to eligible contract participants (ECPs)—that is, to large investors, 

like a commodity pool, an insurance company, or an individual with over 

$10 million in assets. The ECP category most likely to apply to agricultural 

producers includes a corporation, partnership, proprietorship, organization, trust, or other entity that has a net worth exceeding $1 million and is 

hedging. Ongoing trade in agricultural commodity swaps under current Part 

35 is grandfathered under the act, although future CFTC revisions to Part 35 
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will presumably affect regulation of these swaps (Heitman, 2010). Currently, 

trade in agricultural swaps is permitted only to relatively informed traders 

with access to capital. Market participants who do not meet these eligibility 

requirements are unable to engage in agricultural swaps for investment or 

risk management, but may still engage in forward contracts for commercial 

purposes.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act makes 

important regulatory changes that will affect the operation and efficiency 

of OTC derivatives markets, which serve as an important hedging forum 

for modern agribusiness. Although the act provides a general guide to the 

derivative reforms, much of the impact on agribusiness will become known 

only after the rules are written and implemented by the regulators. There are 

clearly benefits to improving market transparency and attempting to reduce 

the likelihood of systemic default. The goal for the regulating agencies 

will be to balance those benefits against the potential costs associated with 

mandating clearing, establishing capital and margin requirements, limiting 

contract positions, and instituting standards for reporting and recordkeeping 

in the OTC markets.

Conclusions
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Ackerman, A. “CFTC, SEC Roundtable Considers Lags for Reporting Big 

Swaps Trades.” The Bond Buyer, September 15, 2010.

Bailey, R. E. The Economics of Financial Markets. Cambridge, MA: 

Cambridge University Press, 2005. 

Bank for International Settlements. “Semiannual OTC derivatives statistics 

at end-December 2009,” on 7/12/2010. Web Address: http://www.bis.org/

statistics/derstats.htm. 2010.

Bureau of Economic Analysis. Gross Domestic Product: First Quarter 

2010 (Third Estimate). U.S. Department of Commerce, Washington, DC, 

2010.

Carter, C. A., and J. P. Janzen. The 2008 Cotton Price Spike and Extraordinary Hedging Costs. ARE Update 13, no. 2. University of California at 

Berkeley: Giannini Foundation of Agricultural Economics, 2009.

Commodity Futures Trading Commission (CFTC). Commodity Swap 

Dealers & Index Traders with Commission Recommendations. CFTC 

Staff Report. Washington, DC, September 2008.

Commodity Futures Trading Commission (CFTC). Staff Report on Cotton 

Futures and Options Market Activity During the Week of March 3, 2008. 

CFTC Staff Report. Washington, DC, 2010.

Chicago Board of Trade. Handbook of Futures and Options. New York: 

McGraw-Hill, 2006.

Dodd, C., and B. Lincoln. Letter from the Chairmen of the Senate Financial Services and Agriculture Committees to the Chairmen of the House 

Financial Services and Agriculture Committees, 6/30/2010.

Dodd-Frank Wall Street Reform and Consumer Protection Act. Public Law 

No. 111-203. 111th United States Congress, 2010. 

Duffie, D., A. Li, and T. Lubke. Policy Perspectives on OTC Derivatives 

Market Infrastructure. Federal Reserve Bank of New York Staff Reports, 

2010.

FCIC. “Testimony of CFTC Chairman Gary Gensler Before the Financial 

Crisis Inquiry Commission,” 7/1/2010 Hearing, www.fcic.gov.

Harwood, J., R. Heifner, K. Coble, J. Perry, and A. Somwaru. Managing 

Risk in Farming: Concepts, Research and Analysis. USDA, Economic 

Research Service, Agricultural Economics Report No. 774. Washington, 

DC, 1999, http://www.ers.usda.gov/Publications/AER774/.

Heitman, D. “Agriculture and the Dodd-Frank Bill,” a presentation before 

the CFTC Agricultural Advisory Committee, City Futures Trading 

Commission, 8/5/2010, Washington, DC.

References
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Hieronymus, T. A. Economics of Futures Trading for Commercial and 

Personal Profit, 2nd ed. New York, NY: Commodity Research Bureau, 

1977.

Hull, J. C. Options, Futures, and Other Derivative Securities. Upper Saddle 

River, New Jersey: Prentice Hall, 1993.

Irwin, S. H., P. Garcia, and D. L. Good. “The Performance of Chicago 

Board of Trade Corn, Soybean, and Wheat Futures Contracts after Recent 

Changes in Speculative Limits.” Presentation at American Agricultural 

Economics Association Annual Meeting, July 29-31, 2007, Portland, OR.

Irwin, S. H., and D. R. Sanders. The Impacts of Index and Swap Funds in 

Commodity Futures Markets. Organization for Economic Co-Operation 

and Development Technical Report. Washington, DC, 2010.

Kyle, A. S. “A Theory of Futures Market Manipulations,” in The Industrial 

Organization of Futures Markets, ed. R. W. Anderson. Lexington, MA: 

D.C. Heath, 1984.

Lang, I. “Financial Derivatives: Pricing and Risk Management,” in the Robert 

W. Kolb Series, ed. R. W. Kolb and J. A. Overdahl. Hoboken, NJ: John 

Wiley & Sons Inc., 2009.

MacDonald, J. M., and P. Korb. Agricultural Contracting Update. USDA, 

Economic Research Service, Economic Information Bulletin No. 35, 

2005, http://www.ers.usda.gov/publications/eib35/.

Morrison, J. “The Operational Challenges of OTC Clearing,” Futures 

Industry Magazine, June 2010:27-30.

National Bureau of Economic Research. Determination of the December 

2007 Peak in Economic Activity. Cambridge, MA, 2008.

Pannell, D. J., G. Hailu, S. Weersink, and A. Burt. “More Reasons Why 

Farmers Have so Little Interest in Futures Markets,” Agricultural 

Economics 39(1):41-60, 2008.

Peck, A. E. “The Economic Role of Traditional Commodity Futures 

Markets,” in Futures Markets: Their Economic Role, ed. A. E. Peck. 

Washington, DC: American Enterprise Institute for Public Policy 

Research, pp. 1-81, 1985.

Pirrong, C. The Inefficiency of Clearing Mandates. Cato Policy Analysis No. 

665. Washington, DC: The Cato Institute, 2010.

Reilly, S. “Future of rule making: Pilot project aims to increase public participation,” FederalTimes.com, August 23, 2010.

Squam Lake Working Group on Financial Regulation. “Credit Default 

Swaps, Clearing houses, and Exchanges.” Working paper, Council on 

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Mercantile Exchange, 1970.
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Glossary

Abbreviations

CBOT − Chicago Board of Trade

CEA − Commodity Exchange Act

CFTC − Commodity Futures Trading Commission

CME − Chicago Mercantile Exchange.

DCO − Derivatives Clearing Organization

ECP − Eligible contract participant

ICE − IntercontinentalExchange

OTC – Over-the counter

SEC − Securities and Exchange Commission 

Glossary1

Agricultural swap—A commodity swap in which the payout to at least one 

counterparty is based on the price of an agricultural commodity or the level 

of an agricultural commodity index.*

Basis—The difference between the spot or cash price of a commodity and 

the price of the nearest futures contract for the same or a related commodity 

(typically calculated as cash minus futures). Basis is usually computed in 

relation to the futures contract due to expire next and may reflect different 

time periods, product forms, grades, or locations.

Basis risk —The risk associated with an unexpected widening or narrowing 

of the basis between the time a hedge position is established and the time that 

it is lifted.

Cash settlement—A method of settling futures options and other derivatives whereby the seller (or short) pays the buyer (or long) the cash value of 

the underlying commodity or a cash amount based on the level of an index or 

price according to a procedure specified in the contract. Also called financial 

settlement.

Call option —An option contract that gives the buyer the right, but not the 

obligation, to purchase a commodity or other asset or to enter into a long 

derivatives position at a specified price on or prior to a specified expiration 

date

Cash market—The market for the cash commodity (as contrasted to a derivatives contract) taking the form of: (1) an organized, self-regulated central 

market (e.g., a commodity exchange); (2) a decentralized over-the-counter 

market; or (3) a local organization, such as a grain elevator or meat processor, 

that provides a market for a small region.

1Unless otherwise noted with an asterisk (*), these definitions are drawn 

from the CFTC glossary, which can be 

found on the web at http://www.cftc.

gov/ConsumerProtection/EducationCenter/CFTCGlossary/index.htm
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Clearing house—An entity through which futures and other derivative transactions are cleared and settled. It is also charged with assuring the proper 

conduct of each contract’s delivery procedures and the adequate financing 

of trading. A clearing house may be a division of a particular exchange, an 

adjunct or affiliate thereof, or a freestanding entity. Also called a clearing 

organization, multilateral clearing organization, centralized counterparty, or 

clearing association.

Clearing member—A member of a clearing organization. All trades of a 

non-clearing member must be processed and eventually settled through a 

clearing member.

Commodity Index—An index of a specified set of (physical) commodity 

prices or commodity futures prices.

Commodity Index fund—An investment fund that enters into futures or 

commodity swap positions for the purpose of replicating the return of an 

index of commodity prices or commodity futures prices.

Commodity swap—A swap in which the payout to at least one counterparty 

is based on the price of a commodity or the level of a commodity index.

Derivative—A financial instrument, traded on or off an exchange, the price 

of which is directly dependent upon (i.e., “derived from”) the value of one 

or more underlying securities, equity indices, debt instruments, commodities, other derivative instruments, or any agreed-upon pricing index or 

arrangement.

Efficient market —In economic theory, an efficient market is one in which 

market prices adjust rapidly to reflect new information.

Eligible Contract Participant—An entity, such as a financial institution, 

insurance company, or commodity pool, that is classified by the Commodity 

Exchange Act as an eligible contract participant based upon its regulated 

status or amount of assets. This classification permits these persons to engage 

in transactions not generally available to non-eligible contract participants.

Forward contract—A cash transaction common in many industries, 

including commodity merchandising, in which a commercial buyer and seller 

agree upon delivery of a specified quality and quantity of goods at a specified 

future date. Terms may be more “personalized” than is the case with standardized futures contracts (i.e., delivery time and amount are as determined 

between seller and buyer). A price may be agreed upon in advance, or there 

may be agreement that the price will be determined at the time of delivery.

Futures Commission Merchant—Individuals, associations, partnerships, 

corporations, and trusts that solicit or accept orders for the purchase or sale of 

any commodity for future delivery on or subject to the rules of any exchange 

and that accept payment from or extend credit to those whose orders are 

accepted.

Futures contract—An agreement to purchase or sell a commodity for 

delivery in the future (1) at a price that is determined at initiation of the 

contract; (2) that obligates each party to the contract to fulfill the contract at 
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the specified price; (3) that is used to assume or shift price risk; and (4) that 

may be satisfied by delivery or offset.

Hedger—A trader who participates in hedging.

Hedging—The act of entering into positions in a derivatives market, opposite 

to positions held in a cash market, to minimize the risk of financial loss from 

an adverse price change, or the act of purchasing or selling derivatives as a 

temporary substitute for a cash transaction that will occur later. Cash market 

positions, whether long or short, can be hedged.

Hedging exemption—An exemption from speculative position limits for 

bona fide hedgers and certain other persons who meet the requirements of 

exchange and regulator rules.

Long—The buying side of an open futures contract, a market position that 

obligates the holder to take delivery of the underlying asset. 

Margin—The amount of money or collateral deposited by a customer with 

his broker, by a nonmember broker with a clearing member, or by a clearing 

member with a clearing organization. The margin is not partial payment on 

a purchase. There are two main kinds of margins: (1) Initial margin is the 

amount of margin required by the broker when a futures position is opened; 

(2) Maintenance margin is an amount that must be maintained on deposit at 

all times. If the equity in a customer’s account drops to or below the level 

of maintenance margin because of adverse price movement, the broker 

must issue a margin call to restore the customer’s equity to the maintenance 

level. Exchanges specify levels of initial margin and maintenance margin 

for each futures contract, but futures commission merchants may require 

their customers to post margin at higher levels than those specified by the 

exchange.

Margin call—(1) A request from a futures commission merchant to a 

customer to bring margin deposits up to maintenance levels; (2) a request by 

the clearing organization to a clearing member to make a deposit of original 

margin, or a daily or intra-day variation margin payment because of adverse 

price movement, based on positions carried by the clearing member.

Marking to market—Part of the daily cash flow system used by an 

exchange to maintain a minimum level of margin equity for a given derivatives contract position. The level is determined by calculating the gain or loss 

in each contract position resulting from changes in the price of the derivatives contracts at the end of each trading session. These amounts are added or 

subtracted to each account balance.

Moral hazard—The possibility that insulation from risk will affect agent 

behavior.*

Net position—The difference between the open long contracts and the open 

short contracts held by a trader in any one commodity.

Notional amount—The notional amount outstanding is a snapshot of the 

face value of the underlying asset upon which the derivative is based.*
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Option—A contract that gives the buyer the right, but not the obligation, 

to buy or sell a specified quantity of a commodity or other instrument at a 

specific price within a specified period of time, regardless of the market price 

of that instrument. Also see call option and put option.

Over-the-Counter (OTC)—The trading of commodities, contracts, or other 

instruments not listed on any exchange. OTC transactions can occur electronically or over the telephone. Also referred to as Off-Exchange.

Physical delivery—A provision in a futures contract or other derivative for 

delivery of the actual commodity to satisfy the contract.

Position—An interest in the market, either long or short, in the form of one 

or more open contracts.

Position limit—The maximum position, either net long or net short, in one 

commodity future (or option) or in all futures (or options) of one commodity 

combined that may be held or controlled by one person (other than a person 

eligible for a hedge exemption), as prescribed by an exchange and/or by the 

market regulator.

Price discovery —The process of determining the price level for a 

commodity based on supply and demand conditions. Price discovery may 

occur in a derivatives market or cash market.

Put option—An option contract that gives the holder the right but not the 

obligation to sell a specified quantity of a particular commodity, security, or 

other asset or to enter into a short derivatives position at a given price (the 

strike price) prior to or on a specified expiration date.

Settlement—The act of fulfilling the delivery requirements of a derivatives 

contract.

Short—The selling side of an open futures contract.

Speculator—In commodity derivatives, a trader who does not hedge, but 

who trades with the objective of achieving profits through the successful 

anticipation of price movements.

Strike price—The price, specified in the option contract, at which the underlying futures contract, security, or commodity will move from seller to buyer 

when the option is exercised.

Swap—In general, the exchange of one asset or liability for a similar 

asset or liability for the purpose of lengthening or shortening maturities, 

or otherwise shifting risks. This may entail selling one securities issue and 

buying another in foreign currency; it may entail buying a currency on the 

spot market and simultaneously selling it forward. Swaps also may involve 

exchanging income flows; for example, exchanging the fixed rate coupon 

stream of a bond for a variable rate payment stream, or vice versa, while not 

swapping the principal component of the bond. Swaps are generally traded 

over-the-counter.
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Swap dealer—An entity such as a bank or investment bank that markets 

swaps to end users. Swap dealers often hedge their swap positions in futures 

markets. Alternatively, an entity that declares itself a “Swap/Derivatives 

Dealer” on CFTC Form 40.

Swaption—An option to enter into a swap—i.e., the right, but not the obligation, to enter into a specified type of swap at a specified future date.

Systemic default risk—The risk that a default by one market participant 

will have repercussions on other participants due to the interlocking nature of 

financial markets. For example, customer A’s default in X market may affect 

intermediary B’s ability to fulfill its obligations in markets X, Y, and Z.