UNITED STATES OF AMERICA 

 COMMODITY FUTURES TRADING COMMISSION 

 AGRICULTURAL ADVISORY COMMITTEE MEETING 

 Washington, D.C. 

 Tuesday, July 29, 2008 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 2 

 1 C O N T E N T S 

 2 Welcome and Introduction: 

 3 COMMISSIONER MICHAEL V. DUNN 

 Commodity Futures Trading Commission 

 4 

 Opening Remarks: 

 5 

 WALTER L. LUKKEN, Acting Chairman 

 6 Commodity Futures Trading Commission 

 7 COMMISSIONER JILL SOMMERS 

 8 COMMISSIONER BART CHILTON, Committee Member 

 9 Introductions Panel Presentation: 

 History and Current Fundamentals of 

 10 Convergence and Basis Problems 

 11 DAVE KASS 

 Division of Market Oversight 

 12 Commodity Futures Trading Commission 

 13 TOM BUIS 

 National Farmers Union 

 14 

 TERRY REINHART 

 15 Advance Trading 

 16 TOM COYLE 

 National Grain and Feed Association 

 17 

 ROGER CRYAN 

 18 National Milk Producers Federation 

 19 Panel Presentation: 

 Exchanges 

 20 

 DAVID LEHMAN 

 21 CME Group 

 22 MARK BAGAN 

 Minneapolis Grain Exchange 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 3 

 1 Discussion Panel Presentation: 

 Settlement Prices, Margin Requirements and Credit 

 2 

 TOM FARLEY 

 3 ICE Futures U.S. 

 4 JEFF BORCHARDT 

 Kansas City Board of Trade 

 5 

 STEVE HURST 

 6 Merchants' Exchange 

 7 EUGENE KUNDA 

 University of Illinois 

 8 

 DAN BROPHY 

 9 Commodity Markets Council 

 10 

 PHIL DIPROFI 

 11 Co-Bank 

 12 SAM MILLER 

 American Bankers Association 

 13 

 Discussion Lunch 

 14 

 15 Panel Presentation: 

 16 Agricultural Swaps 

 17 DON HEITMAN 

 Commodity Futures Trading Commission 

 18 

 TOM FARLEY 

 19 

 TOM LEHMAN 

 20 

 JULIE WINKLER 

 21 CME Group 

 22 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 4 

 1 Discussion Panel Presentation: 

 Ongoing Research 

 2 

 ERIC JUZENAS 

 3 Office of Commissioner Dunn 

 Commodity Futures Trading Commission 

 4 

 JEFF HARRIS 

 5 Office of Chief Economist 

 Commodity Futures Trading Commission 

 6 

 JULIE WINKLER 

 7 

 Agricultural Advisory Committee Members: 

 8 

 MARK BAGAN 

 9 Minneapolis Grain Exchange 

 10 DAN BROPHY 

 Commodity Markets Council 

 11 

 TOM BUIS 

 12 National Farmers Union 

 13 TOM COYLE 

 National Grain and Feed Association 

 14 

 ROGER CRYAN 

 15 National Milk Producers Federation 

 16 BOB DINNEEN 

 Renewable Fuels Association 

 17 

 JACK GAINE 

 18 Managed Funds Association 

 19 ELDON GOULD 

 U.S. Department of Agriculture 

 20 

 PAUL GREEN 

 21 North American Millers Association 

 22 DAVID KASS 

 Commodity Futures Trading Commission 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 5 

 1 

 2 

 3 

 4 

 5 

 6 

 7 

 8 

 9 

 10 

 11 

 12 

 13 

 14 

 15 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 6 

 1 DAVID LEHMAN 

 CME Group 

 2 

 SAM MILLER 

 3 American Bankers Association 

 4 JOE NICOSIA 

 American Cotton Shippers Association 

 5 

 TERRY REINHART 

 6 Advanced Trading 

 7 MARK SCANLAN 

 Independent Community Bankers 

 8 

 FRED STOKES 

 9 National Grange 

 10 LEROY WATSON 

 National Grange 

 11 

 STEVE WELLMAN 

 12 American Soybean Association 

 13 JULIE WINKLER 

 CME Group 

 14 

 15 * * * * * 

 16 

 17 

 18 

 19 

 20 

 21 

 22 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 7 

 1 P R O C E E D I N G S 

 2 (9:00 a.m.) 

 3 MR. DUNN: We had an excellent meeting 

 4 in April with the Commission at a roundtable and 

 5 it set the groundwork for this particular meeting. 

 6 I am going to go through and ask each of the 

 7 members of the Commission to make their opening 

 8 statements and then I'm going to ask for a real 

 9 quick run around the table here so the members of 

 10 the Advisory Committee can introduce themselves 

 11 and who they're with before we get going. The 

 12 other little piece of maintenance here is that you 

 13 have to press the button to be able to speak, and 

 14 I'm told that I can cut you off from up here if I 

 15 need to, and if that's not enough I've got the 

 16 traditional mallet. 

 17 With that, welcome to the Agricultural 

 18 Advisory Committee of the CFTC. This is the 

 19 thirty-second meeting of the Advisory Committee 

 20 and probably is one of the most important that we 

 21 have ever had. The lack of convergence between 

 22 the futures and cash price in some contracts has 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 8 

 1 shaken the confidence in the ability of the 

 2 futures markets to act as a price discovery 

 3 mechanism. This lack of confidence has resulted 

 4 in major problems for those who use the futures 

 5 markets to hedge risk. In your packet there is an 

 6 article from the "Minneapolis-St. Paul Star 

 7 Tribune" that really outlines what the problem 

 8 have been out in the countryside as a result of 

 9 this. 

 10 For instance, many have expressed great 

 11 concern regarding wheat markets where convergence 

 12 has been particularly problematic. At our April 

 13 22 Agricultural Roundtable we began a dialogue 

 14 with participants on the futures industry to 

 15 address those concerns and explore solutions. The 

 16 CFTC took a number of actions as a result of this 

 17 meeting. The Agricultural Advisory Committee was 

 18 asked to follow-up on a number of issues 

 19 identified at that meeting including development 

 20 of solutions to improve convergence in the futures 

 21 and cash markets, discussing practices of 

 22 exchanges for determining margin daily price 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 9 

 1 limits and methodologies in setting settlement 

 2 prices, facilitating discussions on the role and 

 3 size of over-the- counter agricultural swaps, and 

 4 determining whether there are additional studies 

 5 agricultural market users believe the Commission 

 6 should undertake relevant to current commodity 

 7 prices. 

 8 Since that meeting I have a spent great 

 9 of time with many of you who are here today 

 10 discussing the issues that we will address today. 

 11 I want to thank all the members and the presenters 

 12 for your time, effort, and advice on these 

 13 matters. What we will discuss today is vitally 

 14 serious to the agricultural markets. We must do 

 15 everything we can to protect futures markets' 

 16 hedging and price discovery. If recent 

 17 convergence problems are the canary in the coal 

 18 mine, we need to take action now. Again I thank 

 19 you for your participation. I will now welcome 

 20 our Acting Chairman and fellow Commissioners for 

 21 any comments. Mister Chairman? 

 22 MR. LUKKEN: Thank you, Mike, Mister 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 10 

 1 Chairman, for hosting this morning's meeting, and 

 2 thank you all for participating. 

 3 Since this Committee last met last 

 4 December we've obviously seen unprecedented prices 

 5 across the board in all commodities. These higher 

 6 energy and commodity prices are painfully felt by 

 7 all Americans. Specifically, these record prices 

 8 have put considerable strain on agricultural 

 9 producers and commercial participants in these 

 10 markets due to higher and unexpected costs of 

 11 inputs and margining. Although recent prices have 

 12 come off their highs, regulators cannot be 

 13 complacent. Protecting the integrity of these 

 14 markets as well as the public who relies on the 

 15 pricing that comes from these market lies at the 

 16 heart of the CFTC's core mission, and today we 

 17 look to you the experts to help us and give us 

 18 expertise and assistance. 

 19 Most if not all of you participated and 

 20 attended the Agricultural Forum on April 22 when 

 21 the CFTC brought together a broad cross-section of 

 22 the agricultural industry in an effort to form a 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 11 

 1 collective understanding of what was occurring in 

 2 these markets. Our goal was and continues to be 

 3 to work closely with the industry not only to help 

 4 us identify problems in the markets, but also to 

 5 partner with us in finding consensus solutions 

 6 should it be determined that the markets are not 

 7 functioning properly. As you know, following the 

 8 Agricultural Forum as Commissioner Dunn mentioned, 

 9 the CFTC announced a number of initiatives the 

 10 agricultural markets. First, the Commission 

 11 announced that it would use its special call 

 12 authorities to collect additional information from 

 13 swap dealers regarding the amount of off-exchange 

 14 pension and index funds that are flowing through 

 15 these institutions into our markets and provide a 

 16 report by September 15 on whether these traders 

 17 should be reclassified for regulatory and 

 18 reporting purposes. Commission staff is making 

 19 substantial progress on this unparalleled 

 20 undertaking. 

 21 In addition, the Commission announced 

 22 that it would examine greater risk-management 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 12 

 1 options for farmers and agribusinesses. The 

 2 Commission also announced publicly and unveiled 

 3 the existence of an ongoing cotton investigation 

 4 which is continues to vigorously pursue. Also 

 5 announced, the Commission continues to facilitate 

 6 discussions with banking authorities to ensure 

 7 that proper credit lines are available to 

 8 agricultural entities during these times of higher 

 9 prices and margins. 

 10 As Mike mentioned, a number of these 

 11 issues arising from the Agricultural Forum 

 12 required greater market expertise and input and 

 13 were referred to this committee for discussion. 

 14 One issue is the lack of convergence between the 

 15 futures and cash prices of certain commodities. 

 16 This matter is of great concern to me and the 

 17 entire Commission. Some commercial participants 

 18 have lost confidence in the ability to hedge in 

 19 certain of these markets and it is critical that 

 20 market participants work with the Commission to 

 21 address this matter aggressively and head on. 

 22 Moreover, we must continue to work together to 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 13 

 1 ensure that producers and merchandisers have 

 2 proper margin financing and alternative 

 3 risk-management options in order to promote proper 

 4 hedging in our markets. These issues are on 

 5 today's agenda and I look forward to hearing from 

 6 market participants. Again, Mike, thank you so 

 7 much for hosting this incredible agenda and I look 

 8 forward to hearing from all of you today. 

 9 MR. DUNN: Thank you very much, Walt. 

 10 Commissioner Sommers? 

 11 MS. SOMMERS: Good morning, and thank 

 12 you, Commissioner Dunn for holding this important 

 13 meeting of the Agriculture Advisory Committee. 

 14 These are extraordinary times in the 

 15 agriculture commodity markets. Our mission is to 

 16 make sure that the agricultural futures markets 

 17 are discovering prices and are providing an 

 18 opportunity for producers and commercial entities 

 19 to hedge their price risk. We have devoted 

 20 significant time and effort this year to examining 

 21 conditions in the agricultural futures markets. 

 22 On April 22, as you've heard, and most of you were 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 14 

 1 here for, the Commission held their special 

 2 Agricultural Forum and brought together 

 3 government, academic, and industry experts to 

 4 discuss these important issues. And on June 3 we 

 5 announced a series of agricultural initiatives 

 6 that Walt just went over to improve the oversight 

 7 of the futures markets and to bring greater 

 8 transparency to the marketplace. 

 9 Today's meeting is the latest step in 

 10 this ongoing process and I'm looking forward to 

 11 the discussion particularly regarding the 

 12 convergence of futures and cash prices. Some 

 13 argue that the convergence problem may be due to 

 14 futures contract terms or conditions, delivery 

 15 costs, or capacity issues. Whatever the cause, it 

 16 appears that the increased futures price 

 17 volatility and uncertainty about basis 

 18 relationship has raised the cost of hedging. 

 19 Throughout this process we have received valuable 

 20 input from a wide array of people who have a 

 21 tremendous amount of experience and knowledge of 

 22 the agricultural futures markets. I appreciate 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 15 

 1 all of your input. It's extremely valuable to 

 2 this Commission and I thank you all for taking 

 3 time out of your busy schedules today to be with 

 4 us, and I am looking forward to the discussion. 

 5 Thank you. 

 6 MR. DUNN: Thank you, Commissioner. 

 7 Commissioner Chilton? 

 8 MR. CHILTON: Thanks, Mister Chairman, 

 9 and thank you and the staff for setting this up, 

 10 and also thank you to the presenters, both CFTC 

 11 presenters, Mr. Kass, and others who I know have 

 12 taken a lot of time to put something together. 

 13 Thank you for being here to help educate us. Will 

 14 Durant is a respected philosopher. He said, 

 15 "Education is the progressive discovery of our own 

 16 ignorance." It's a progressive discovery of our 

 17 own ignorance, so we've got a robust agenda that 

 18 Commissioner Dunn has put forward and will help 

 19 educate us. 

 20 But what do you do when you get 

 21 information and you have conflicting results, when 

 22 you've got a dataset and it's analyzed and the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 16 

 1 results are published and you're not sure if 

 2 they're the same? What do you do when something 

 3 impedes progress on your education whether or not 

 4 it's politics or spin which also happens in this 

 5 town as we all know all too often? I think the 

 6 answer is you look to a third party. You look for 

 7 an independent analysis. You look for somebody 

 8 who is respected in a field so that you can get 

 9 the right information or get a second take on 

 10 information. So among other questions that I have 

 11 for you all, the members of the Ag Advisory 

 12 Committee is, do you think given what you know 

 13 about the emerging disagreement over 

 14 noncommercial's role in these markets about the 

 15 potential of a speculative bubble? Do you think 

 16 it's time that we in government have sort of a 

 17 blue ribbon panel, somebody independent, the best 

 18 and brightest minds in academia for example, so 

 19 look at this and give us an independent different 

 20 view? 

 21 Does that mean that I want to wait until 

 22 we get some exhaustive study before we do 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 17 

 1 anything? Absolutely not. No way. That's why I 

 2 think things like the House bipartisan bill that 

 3 passed out of the Agriculture Committee makes a 

 4 whole lot of sense. If gives us more information 

 5 that we don't have now that could be impacting the 

 6 markets, it gives us the potential to use 

 7 additional regulatory tools if we think it's 

 8 needed, if we think that there's not true price 

 9 discovery, and it gives us the resources here at 

 10 the Commission to actually do that job. Now might 

 11 not be a bad time also to say if there are 

 12 enterprising economists, that people have thoughts 

 13 on what's going on in these markets, go to 

 14 cftc.gov. Look at the interim report that we 

 15 issued last week. Look at what other people are 

 16 saying on these sorts of issues. I'm sure we'd 

 17 all welcome those comments. But I'll sort of take 

 18 Durant's advice today and try to progressively 

 19 educate myself of some my ignorances and listen to 

 20 the best and brightest, and in that regard I'll 

 21 listen to you guys. Thanks. 

 22 MR. DUNN: Thank you, Commissioner. If 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 18 

 1 we will now quickly go around and introduce 

 2 yourselves and who you represent, and Sam, if we 

 3 could start with you. 

 4 MR. MILLER: Thank you, Commissioner. 

 5 My name is Sam Miller. I'm with M&I Bank in 

 6 Appleton, Wisconsin, and I'm here representing the 

 7 American Bankers Association. I serve as their 

 8 vice chair of the Ag and Rural Affairs Committee. 

 9 MR. NICOSIA: I'm Joe Nicosia and I'm 

 10 Executive Vice President with Louis Dreyfuss and 

 11 I'm here representing the American Cotton Shippers 

 12 as its president. 

 13 MR. WELLMAN: I'm Steve Wellman. I'm 

 14 the American Soybean Association treasurer, a 

 15 full-time farmer, and I'm accompanied by Bev Paul. 

 16 MR. SCANLAN: I'm Mark Scanlan with the 

 17 Independent Community Bankers of America here in 

 18 Washington. 

 19 MR. STOKES: I'm Fred Stokes, the 

 20 Executive Officer for OCM. I'm here representing 

 21 RKF USA. 

 22 MR. WATSON: I'm Leroy Watson, 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 19 

 1 Legislative Director with the National Grange here 

 2 in Washington, D.C. 

 3 MR. BAGAN: I'm Mark Bagan, CEO of the 

 4 Minneapolis Grain Exchange. 

 5 MS. WINKLER: I'm Julie Winkler, 

 6 Managing Director of Research and Product 

 7 Development at CME Group. 

 8 MR. LEHMAN: Dave Lehman. I'm Director 

 9 of Commodity Research and Product Development, CME 

 10 Group. 

 11 MR. KASS: David Kass, Senior Economist 

 12 out of the Chicago office for the Commission's 

 13 Division of Market Oversight. 

 14 MR. REINHART: Terry Reinhart, Advance 

 15 Trading out of Bloomington, Illinois. I'm a 

 16 broker, vice president and a board member. 

 17 MR. COYLE: I'm Tom Coyle with Nidera 

 18 Holdings in Chicago. I'm representing the 

 19 National Grain and Feed Association. 

 20 MR. GREEN: I'm Paul Green. I'm an 

 21 agricultural economist consulting to the North 

 22 American Millers Association. I'm actually 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 20 

 1 replacing Jim Behr who is not available today. 

 2 MR. GOULD: Eldon Gould, risk-management 

 3 agency administrator, Department of Agriculture, 

 4 and also a producer from Northern Illinois of 

 5 corn, soybeans, and a hog operation as well. 

 6 MR. GAINE: I'm Jack Gaine representing 

 7 the Managed Funds Association. 

 8 MR. DINNEEN: I'm Bob Dinneen, President 

 9 of the Renewable Fuels Association representing 

 10 the U.S. ethanol industry. 

 11 MR. CRYAN: I'm Roger Cryan representing 

 12 the National Milk Producers Federation. 

 13 MR. BUIS: Tom Buis, President of the 

 14 National Farmers Union. 

 15 MR. BROPHY: Dan Brophy representing the 

 16 Commodity Markets Council. 

 17 MR. DUNN: Are there other members in 

 18 the audience who are part of the Advisory 

 19 Committee or are there other presenters out there 

 20 who would like to be introduced at this time? 

 21 If not, we'll go forward. Again, please 

 22 press your button when you speak and turn it off 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 21 

 1 when you're finished speaking. Speak into the 

 2 microphone. This will assist our court reporter. 

 3 It will also help those who are home who are 

 4 listening either via telephone or video 

 5 conference. 

 6 With that I'd like to introduce quickly 

 7 the first panel. I'm not going to you any of the 

 8 background. It's in the biographical information 

 9 that you received. So in the interests of time 

 10 I'll just tell you that our first panel is going 

 11 to talk about the history and current fundamental 

 12 of convergence and basis problems. We have Dave 

 13 Kass from the CFTC, Tom Buis, Terry Reinhart, Tom 

 14 Coyle, Roger Cryan. Then for the exchange 

 15 presentation we'll have David Lehman and Mark 

 16 Bagan. Then we will have open discussion. With 

 17 that I'd like to turn it immediately over to Dave 

 18 to begin. 

 19 MR. KASS: Good morning. Of course, 

 20 this is an advisory committee to advise the 

 21 Commission, particularly the Commissioners, our 

 22 policymakers. They hear from me all the time so 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 22 

 1 they don't need to hear a lot from me, but I do 

 2 hope to spend at least a few minutes here to 

 3 establish some factual background on where we are 

 4 in terms of basis and convergence. Of course, 

 5 basis is based on fundamentals and a regional 

 6 convergence are sort of the Holy Grail of what 

 7 makes the markets work. You could have really a 

 8 no more important issue. 

 9 I've got some slides here. This is an 

 10 update from the one I presented at the 

 11 Agricultural Forum showing some of the broad price 

 12 changes year to year. The markets with the little 

 13 asterisks after them are those that are published 

 14 commodity index trading for, and I think the same 

 15 point I made at that forum holds true today, that 

 16 there doesn't seem to be much correlation between 

 17 the percentage held by index trading versus some 

 18 of the price rises. You've got some markets, 

 19 cattle, hogs, feeder cattle, they all have very 

 20 large if not the largest percentages of commodity 

 21 index trading and yet you can see they're among 

 22 the weakest prices, and you've got something like 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 23 

 1 rice and oats that again have very little if any 

 2 index trading involved and yet they're among the 

 3 highest prices. So just to kind of throw that out 

 4 that there doesn't seem to be much correlation 

 5 there. 

 6 This is another chart to update you on 

 7 where we are in terms of broad price trends over 

 8 the last several months. Obviously we had quite a 

 9 bit of volatility. You can see back in the 

 10 February period we set all-time record high prices 

 11 for the three wheat contracts, rice in late April, 

 12 and much more recently we had the soybeans, corn, 

 13 and oats hitting all-time record high prices, but 

 14 generally you can see most prices have been in a 

 15 bit of a decline of late. The other thing of note 

 16 is if you look at these three, these are the three 

 17 wheat futures contracts, over the last couple of 

 18 weeks or so they've come into a much more 

 19 traditional stack of the spring wheat, the hard 

 20 winter wheat, and the soft winter wheat, and they 

 21 look a lot like they did let's say about last 

 22 November. So with quite a bit of volatility in 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 24 

 1 between, some 8 months or so ago we're back into a 

 2 more historic, traditional sort of a relationship. 

 3 First I want to talk about market 

 4 composition. Again, those who have followed these 

 5 proceedings in the past should be familiar with 

 6 this. This light blue line represents net number 

 7 of contracts held by index traders and you can see 

 8 that's been fairly flat, actually in terms of 

 9 number of contracts, a bit of a decline of late. 

 10 The red line represents the price movement, and 

 11 that scale is over here. The green line 

 12 represents managed money, and here again you can 

 13 see quite a big decline in the holds of managed 

 14 money, again long, and the negative numbers 

 15 represent short positions, of course on the 

 16 opposite side of all of that are our commercial 

 17 traders and you can see they're reduced their 

 18 short position. There is a similar chart for 

 19 soybeans and a similar sort of result where you 

 20 see a bit of a decline in the index trading, kind 

 21 of flat to declining. The scales are different so 

 22 you got to be a little careful when you look at 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 25 

 1 this just because of the size of these markets. 

 2 And finally in this regard, wheat again flat to a 

 3 bit of a decline. Managed money is about out of 

 4 the market now at least on a net basis. You can 

 5 see here's the zero line meaning net even and 

 6 they're slightly above that, so not much there in 

 7 terms of participation. If you looked across the 

 8 three markets you'd have to say at least over the 

 9 last several weeks, index trading has declined, 

 10 managed money has declined both from the long 

 11 side, and commercial trading while still huge 

 12 shorts, have also liquidated a bit. 

 13 Just to establish a key fundamental in 

 14 determining basis relationships are fuel prices. 

 15 This happens to be the diesel price, and we're at 

 16 now around $4.80 a gallon. Obviously we all see 

 17 the reality of this particularly in the farm 

 18 community when they fill their farm equipment, and 

 19 anything that moves agriculturally whether it be 

 20 by truck, rail, barge, ocean vessel, it's all 

 21 related to diesel prices. You can see at $4.80 

 22 more or less and compared to let's call it $3.00, 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 26 

 1 that's a 60- percent increase. Presumably if what 

 2 I'm seeing at the gas pumps in the national 

 3 averages, we should be seeing some decline on 

 4 that. These are monthly prices, so hopefully 

 5 we'll see some decline. Then of course barge as I 

 6 mentioned particularly for the corn and soybean 

 7 contracts which are essentially an Illinois River 

 8 barge contract, these are the barge rates 

 9 historically. Again the bars represent a fairly 

 10 long historical period, in this case 11 years, and 

 11 then I highlight the median as the red and then I 

 12 highlight the last few years, and here is the 

 13 green line representing 2008. The thing to note 

 14 is that we're at about 75 cents or so per bushel 

 15 barge rate to carry something down the river. Of 

 16 course, barge rates are also very much affected 

 17 not just by fuel prices but the logistics of the 

 18 river transportation. We had flooding this spring 

 19 which of course created a bit of havoc when you 

 20 close down navigation and restrict navigation. 

 21 Then just last week of course there was a fuel 

 22 spill down near New Orleans which also put 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 27 

 1 restrictions. So barge rates are affected by a 

 2 lot of other things as well as the supply and 

 3 demand of barges. 

 4 Corn basis, this is for the third week 

 5 of July where we're at. Again the range is 

 6 representing the vertical line, the red 

 7 representing the median, and then I highlight the 

 8 last 2 years with the green diamond representing 

 9 this year. You can see at the gulf which is 

 10 clearly a big price determinant for the Illinois 

 11 River type contract we're talking about here on 

 12 the futures is actually above median, a bit below 

 13 last year, but historically well within the range 

 14 and slightly above the median. Then you have the 

 15 Illinois River at about 46 cents let's call it 

 16 under, and this is maybe around 28 cents over. 

 17 That difference of 76 cents is virtually equal to 

 18 the barge rate down there so even though the 

 19 Northern Illinois River is quite weak 

 20 historically, it's not surprising given the very, 

 21 very large barge diesel prices and of course barge 

 22 rates. Similarly for soybeans. This year at the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 28 

 1 gulf we're actually quite, quite strong 

 2 historically outside the range, and compared to 

 3 last year which was just the opposite, it was 

 4 outside the range but on the weak side, and again 

 5 for 2008 we're looking pretty good in terms of 

 6 where we've been historically and again 

 7 particularly in contrast to 2007 which were 

 8 extremely weak. Again the difference here between 

 9 the two rates is largely reflecting the difference 

 10 in barge rate. In this case I think the 

 11 difference is roughly 80 cents. So quite good 

 12 this year and the difference representing barge 

 13 rates. 

 14 Soft red wheat on the other hand can't 

 15 say the same sorts of things. It's a different 

 16 kind of contract. It's not an Illinois River 

 17 export contract. It's a storage contract with 

 18 Toledo being the primary delivery point in terms 

 19 of historically where we see the stocks and where 

 20 we see the deliveries. Of course, a number of 

 21 deliveries come out of Chicago as well. Here you 

 22 see the historical ranges, and then where it was a 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 29 

 1 year ago are the triangles, and this year it's 

 2 abysmally weak compared to last years, certainly 

 3 not explained by transportation issues or 

 4 something like that. When you can deliver in 

 5 Toledo at part and theoretically at least make a 

 6 dollar and a half a contract, it certainly raises 

 7 very strong issues that aren't explained strictly 

 8 by the normal sorts of fundamentals in the market. 

 9 Historically this is the corn spot basis 

 10 week to week going back through 1998. I think it 

 11 started in year 2000 where we switched to the 

 12 Illinois Waterway System delivery points, and you 

 13 can see where we've been historically. We've had 

 14 some weak basis, but this year we're still a bit 

 15 on the low side, but again this year's seem to be 

 16 reflecting barge rates. Soybeans, we've had some 

 17 spikes at times. A lot of that is typically going 

 18 to be end of crop year sorts of spikes and very 

 19 unusual situations. But here's the situation for 

 20 soybeans and you can see currently we're at least 

 21 over the last few years looking pretty good. Then 

 22 just as with the other chart, when you get to 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 30 

 1 wheat it's an entirely different story. There you 

 2 see the difference historically on wheat. We had 

 3 an Ag Advisory Committee meeting in late 2006 

 4 where we were trying to explain what was going on 

 5 when the basis had gotten down to around a dollar 

 6 or so at Toledo, a dollar under, it's difficult to 

 7 explain this kind of basis at less than a dollar 

 8 and a half. It certainly doesn't represent the 

 9 normal sorts of fundamentals and you have to look 

 10 I believe toward structural types of issues in the 

 11 contract. 

 12 What's the effect on hedging? Again 

 13 this all boils down to the use of the contract and 

 14 it real reason for being is the hedging. This 

 15 shows new crop hedging, so this would be for corn, 

 16 the DEES (?) contract and all those months beyond, 

 17 the comparison of total aggregate positions, again 

 18 the bars representing an historical range for a 7- 

 19 year period, and then we have 2007 and 2008 and 

 20 you can see we're very much above not only 

 21 historically, but even last year, so there's quite 

 22 a bit of new crop hedging still going on in corn. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 31 

 1 Similarly for soybeans. Even though soybeans 

 2 while rising in terms of amount of new crop 

 3 hedging, and you can see that's typical 

 4 historically where you see a bit of a rise, we've 

 5 fallen below a year ago but still at very, very 

 6 high levels of short hedging and this would be the 

 7 November future and those beyond, and this goes up 

 8 to pretty current. 

 9 What. This is a little bit different 

 10 time period. It ends at the end of April as we're 

 11 finishing out the crop year, and this was for the 

 12 July 2008 and beyond at that point in time so it 

 13 would represent the new crop wheat as we were 

 14 winding down the harvest of the old crop wheat. 

 15 Again you see 2007 wasn't much different 

 16 historically, 2008 we had had quite a bit of grow 

 17 short hedging. So you wouldn't know it by the 

 18 amount of hedging going on here. Perhaps it's in 

 19 wheat. Of course you don't have a lot of 

 20 alternatives necessarily. Where else are you 

 21 going to hedge? But that's the situation and that 

 22 concludes my remarks and I look forward to hearing 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 32 

 1 from the rest of the panel members on that. 

 2 MR. DUNN: We appreciate that primer and 

 3 I appreciate the assistance from the Acting 

 4 Chairman. I've heard a great deal from producers 

 5 out there who are seemingly very frustrated, not 

 6 seemingly, they are very frustrated from not being 

 7 able to deliver at the futures price, that they're 

 8 unable to do forward contracts as they have in the 

 9 past. I've asked Tom Buis to tell us some of the 

 10 concerns that we're hearing from producers. Mr. 

 11 Buis? 

 12 MR. BUIS: Thank you, Commissioner Dunn, 

 13 and Commissioners for this opportunity. I don't 

 14 have any fancy PowerPoints or charts, but I do 

 15 have a phone and an email and it's been busy all 

 16 winter and spring regarding this issue. 

 17 I've heard from a number of farmers 

 18 beginning last winter that they were being 

 19 precluded from the market primarily when the 

 20 markets have reached their historical highs. And 

 21 while farmers love to get that higher price, they 

 22 were often precluded from the market. The rapid 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 33 

 1 increase in margin calls from many elevators 

 2 forced them to literally quit offering contracts 

 3 anything beyond 60 days and some even more 

 4 restrictive than that. 

 5 Ironically, the ability to market wheat 

 6 got better when wheat prices ended up being about 

 7 one-half of this historical highs. So when it got 

 8 down to $8, then the farmers were able to market 

 9 it. The same has happened in some of the spring 

 10 planted crops, most recently corn when corn got up 

 11 to the high $7 range, almost $8, many of the 

 12 elevators, ethanol plants and others quit offering 

 13 contracts. Now that the prices have come down 20 

 14 percent, that may be changing. But I think the 

 15 end result in all this is the persons probably 

 16 most affected are the producers themselves which 

 17 is the beginning of this whole process. They're 

 18 producing the products that all these entities, 

 19 whether it's hedge funds or speculators or other 

 20 commercial users to take and either add value or 

 21 purchase or make money off of. 

 22 A couple other concerns that keep 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 34 

 1 popping up is the extremely wide basis. Farmers 

 2 like everyone else follow the futures contracts 

 3 and then they go try to market and there's this 

 4 never-ending drumbeat that there's all this demand 

 5 for this product yet the basis doesn't demonstrate 

 6 there's that demand. I don't know where that 

 7 breakdown in the linkage has been, but those bases 

 8 have been historically high even in areas where 

 9 normally you have a very narrow basis year round. 

 10 Another concern that I hear over and 

 11 over is something fairly new, that you can only 

 12 trade for about a 4-hour period, in central Kansas 

 13 from 9 o'clock until 1 o'clock which I think 

 14 corresponds with the opening of the markets. The 

 15 concern is why can the producers only contract 

 16 during that timeframe, yet the markets have 24- 

 17 hour electronic trading. 

 18 Finally, a big concern that I hear again 

 19 and again is that if you're going to be given a 

 20 contract, there's a minimum number of bushes, and 

 21 it's often 5,000 bushels. Many family farmers, 

 22 many retired farmers who operate on shares often 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 35 

 1 don't have volumes big enough and are being forced 

 2 out of the market. 

 3 What can we do about all this? You guys 

 4 have studied this for quite some time. Thankfully 

 5 Congress is weighing in. Hopefully there will be 

 6 some new legislation passed maybe this week that 

 7 will help. But my opinion since last March or 

 8 April, whenever you had that first hearing down 

 9 here, is it's pretty tough to say what's going on 

 10 if you can't count what's going on. And with the 

 11 exemptions and the foreign exchange and the swaps 

 12 and the over-the-counter trades that you don't 

 13 really have a handle on, it's difficult and I 

 14 think it's not fair to say that nothing out of the 

 15 ordinary is happening. I was intrigued by 

 16 Commissioner Chilton's call for maybe an 

 17 independent, objective analysis of what's going on 

 18 because we really need the answers. I don't think 

 19 anyone has a true handle on what's going on and 

 20 what's needed, and until we do that we may be 

 21 missing the boat and a lot of people's livelihoods 

 22 are at stake. In American agriculture today we're 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 36 

 1 at greater risk than we've ever been because of 

 2 the skyrocketing inputs which may relate back to 

 3 another item that you regulate, energy prices. 

 4 The high price of fuel has driven up the input 

 5 costs of agriculture to historical levels. If you 

 6 talk to producers today, and I was back home at my 

 7 farm in Indiana and heard an earful from my 

 8 neighbors, $5 corn today is like $2.50 corn was 2 

 9 years ago. They're not doing any better. Again I 

 10 would urge you to do everything possible to make 

 11 sure you have a handle on this because the 

 12 livelihoods of many are at stake. Thank you. 

 13 MR. DUNN: Thank you, Mr. Buis. Our 

 14 next presenter is Terry Reinhart who is with 

 15 Advanced Trading. Terry is someone who has 

 16 followed this for a long period of time and has a 

 17 specific recommendation. Terry, if you will, 

 18 please. 

 19 MR. REINHART: Thank you very much to 

 20 the committee for their service and for the 

 21 invitation to be here. 

 22 As the Commissioner stated, I'm here to 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 37 

 1 convince you to double the premium charge on the 

 2 futures contracts for grains and soybeans traded 

 3 on the CME, KCBOT, and the MGE, and further, to 

 4 make these changes effective with the January 2009 

 5 contracts. The current terms of these futures 

 6 contracts has served the U.S. and the world well a 

 7 few years ago. Simply stated, the premium charge 

 8 often to as the storage charge which is inaccurate 

 9 but more descriptive has not kept pace. You may 

 10 review the details of this chart later, but in the 

 11 interests of time I will point out that the 

 12 current cost of building grain storage space is 

 13 325 percent of its cost in 1970, and the premium 

 14 charge is only 4 percent higher than it was in 

 15 1970. Using USDA numbers, the dollar value of the 

 16 U.S. corn, soybean, and wheat crop in 2006 was $61 

 17 billion, and in 2008 it's projected to be $122 

 18 billion, or double. Pointing out the obvious, the 

 19 increase in the value of those crops is equal to 

 20 the total value of those crops back in 2006. 

 21 These value changes have taxed all elements of 

 22 agriculture. One result has been the leveraging 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 38 

 1 of assets of all agriculturally involved parties 

 2 including warehousemen, lenders, farmers, 

 3 ranchers, and in many cases are leveraged out. 

 4 One clear example of the resulting 

 5 problem is with grain farmers. Grain farmers are 

 6 being trapped into locking in their expenses for 

 7 2009 and beyond crops and this is the result of 

 8 the need for longer-term leases, buying farmland, 

 9 upgrade machinery, and specifically to sign 

 10 purchase contracts for 2009 for inputs like 

 11 fertilizer and seed in order to be assured of 

 12 supply. The farmer is hard pressed to find a 

 13 buyer for his 2009 and beyond production because 

 14 the buyers do not have the tools necessary to 

 15 hedge the risk. The result is the farmer is being 

 16 forced to take career-ending risk, and this can be 

 17 fixed. 

 18 A little elementary stuff here, but if 

 19 the cash price is not offset by the futures price 

 20 change, hedging did not occur. In the grain 

 21 merchandising arena, the test of whether or not 

 22 there is a hedge occurs during each delivery month 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 39 

 1 and at the delivery point and only at the delivery 

 2 point. If cash and futures converge at these 

 3 times and at those places, there is or was a 

 4 hedge. If they don't converge, there is not or 

 5 was not a hedge. 

 6 On July 1, 2008, using FOB barge values 

 7 at Peoria, Illinois, corn was 56 cents a bushel 

 8 from convergence. The July futures price could 

 9 not get down to the cash price because the July 

 10 SEPS (?) spread was wide enough to pay the owner 

 11 of the spread at a rate that exceeded the return 

 12 on T bills or FDIC-insured CDs. This is the 

 13 economic condition referred to as full carry. I 

 14 know this because on July 1 I was one of those 

 15 people. While this investment opportunity may be 

 16 good for people looking for short-term places to 

 17 invest, it is injuring those using short futures 

 18 as a hedge. These economics allow investors to 

 19 buy in this case July corn because of its relative 

 20 value to September corn and ignore the value of 

 21 July corn futures relative to the underlying value 

 22 of the cash grain resulting in nonconvergence. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 40 

 1 This has been a reoccurring event and has lowered 

 2 the usefulness of hedging with futures. The 

 3 reason is not reliably occurring is that the 

 4 premium charge is not large enough. In recent 

 5 times the physical commodity price has been well 

 6 belong the futures contract price because the 

 7 applicable futures month price cannot get lower 

 8 than that represented by a low-risk spread to the 

 9 next futures month. Every penny that the premium 

 10 charge is raised is a penny closer to allowing 

 11 convergence. For CME corn futures, currently the 

 12 premium is $7.50 per contract per day or about 

 13 4-1/2 cents a bushel per month. Using the 56 

 14 cents per bushel in the example above which his 

 15 the amount the cash grain was under futures, i.e., 

 16 lack of convergence, the equilibrium charge for 

 17 the premium charge would be $53.40 per contract 

 18 per day or about 32 cents per bush per month, or 

 19 about 7 times the current charge. Some would 

 20 argue that raising the charge sevenfold is crazy 

 21 and irresponsible. I would argue that leaving it 

 22 unchanged or only raising it to $8.25 per contract 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 41 

 1 per day as was done for example with Chicago corn 

 2 starting in December 2008 is crazier and more 

 3 irresponsible. 

 4 This chart tells the history. The axis 

 5 on the left is the spot corn truck basis at 

 6 Ottawa, Illinois, which is an Illinois waterway 

 7 delivery system delivery location on first notice 

 8 day versus the spot month starting back in March 

 9 1998. The axis across the bottom is the spot 

 10 futures month to the next futures month expressed 

 11 as a percentage of full carry. Each blue diamond 

 12 marks what the basis was in relation to the 

 13 percentage of full carry. The black trend line 

 14 clearly shows that the closer the spread is to 

 15 full carry the less the convergence, and you can 

 16 see down at the bottom is the July 2008 contract. 

 17 Based on this history as carrying approaches or 

 18 exceeds 80 percent, convergence is so bad that in 

 19 a low-margin, high-volume industry such as grain 

 20 merchandising, hedging did not occur. At 

 21 100-percent of full carry, convergence has never 

 22 occurred. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 42 

 1 We implore your support and ask to raise 

 2 the premium charge to $16.50 per day which is 

 3 approximately 10 cents per bushel per month, and 

 4 relative to history and what's going on in the 

 5 rest of agriculture, we view that as a modest 

 6 change. This change, due to the shortage of time 

 7 today, we understand that there is opposition to 

 8 it and that's fine. While I'm here, we have the 

 9 spirit of our convictions that we think this 

 10 change will make a difference and are prepared to 

 11 debate it as long as there continues to be 

 12 progress. Generally, however, with objections to 

 13 this we think that there's a tendency to 

 14 overcomplicate it, and one of the things in favor 

 15 of doing this is we've done before. When the 

 16 Illinois waterway delivery system was started, the 

 17 premium charge was $5 a contract per day or 

 18 approximately 3 cents per bushel month and issues 

 19 similar to those being discussed this morning 

 20 developed. The premium charge was increased 50 

 21 cents to the current $7.50 per contract per day or 

 22 approximately 4- 1/2 cents per bushel per month 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 43 

 1 and again we had convergence. The July 17, 2008, 

 2 NGFA newsletter reported a proposal by Co-Bank to 

 3 create a new loan guarantee program to be 

 4 administered by the USDA's Commodity Credit 

 5 Corporation. The article went on to say the 

 6 presumption is that the participating banks would 

 7 be able to lend grain to hedgers at higher ratios 

 8 on -- grain on forward-contracted grain. I hope 

 9 this presumption is correct. I hope banks are not 

 10 losing confidence in the value of the futures 

 11 hedge against their collateral. While we can 

 12 support a taxpayer guarantee to the extent to make 

 13 more capital available in the short-run to allow 

 14 companies time to strengthen their balance sheets 

 15 to a level that banks are comfortable lending 

 16 against, if we do this, this in fact increases the 

 17 burden on the CFTC, the exchanges, and you and me 

 18 to achieve convergence in fact. The collateral 

 19 for inventory financing is the grain, the 

 20 collateral for forward- contracted grain financing 

 21 is the cash grain contract. The reason the banks 

 22 take a security interest in the grain elevators 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 44 

 1 futures account is because the futures are the 

 2 price offset thus security to the cash grain 

 3 position. If the value of the collateral does not 

 4 converge with the value of the futures, the 

 5 efficiencies are lost. The price risk transfers 

 6 tool we are talking about today is hedging with 

 7 futures contracts, and for there to be a hedge 

 8 there must be convergence in fact. We urge the 

 9 CFTC and the exchanges to double the premium 

 10 charge effective with the January 2009 contracts 

 11 to improve convergence. We think it's efficient, 

 12 effective, low risk, and simple. This action will 

 13 restore efficiency to America's agriculture 

 14 industry. Thank you. 

 15 MR. DUNN: Thank you very much, Terry. 

 16 That was an excellent presentation. Tom Coyle 

 17 with the National Grain and Feed Association is 

 18 someone who has been as active as anyone who I 

 19 know in this particular arena. I have had many 

 20 phone calls one-on-one with Tom, on conference 

 21 calls, and I know he and his committee has been 

 22 very, very active in this. They've actually put 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 45 

 1 together some pros and cons of the various 

 2 solutions for convergence, and I think we'll all 

 3 find this very interesting. 

 4 MR. COYLE: Thank you, Commissioner 

 5 Dunn. Chairman Lukken, Commissioners Dunn, 

 6 Sommers, and Chilton, the NGFA thanks the 

 7 Commission once again for their continued efforts 

 8 to understand the issues facing our industry and 

 9 to pursue ways to enhance market performance. I 

 10 have presented a number of times before the 

 11 Commission including the recent open forum to 

 12 discuss the topic of convergence and its 

 13 importance to elevator operators in a 

 14 smooth-functioning market. The NGFA's core 

 15 position related to this issue has not changed, 

 16 transparency and periodic adjustments to the 

 17 contract specifications are critical to allow 

 18 market participants to respond to changes in the 

 19 risk-management landscape. What has changed is 

 20 the sense of urgency for a solution. 

 21 Mr. Kass's charts once again clearly 

 22 demonstrate particularly for wheat that 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 46 

 1 convergence does not exist and is creating an 

 2 unmanageable risk for elevator operators and 

 3 creating a burden for financial liquidity. In my 

 4 comments today I fill focus on identifying the 

 5 issue with a single slide and then focus on the 

 6 pros and cons of various solutions we have 

 7 considered. 

 8 Convergence is not occurring in wheat 

 9 because futures are leading rather than the cash 

 10 leading the futures. Wheat futures today are 

 11 trading $1 to $1.50 higher than they should and 

 12 the wheat basis levels are compensating by trading 

 13 $1 to a $1.50 lower than they should. The net 

 14 price to the consumer is actually not going up 

 15 because the basis is offsetting the higher price 

 16 in futures. Futures are trading at $8, but the 

 17 price of a barge delivered to New Orleans is $6.50 

 18 to $6.75. The consumer is actually paying the 

 19 value of cash and not the value of futures. They 

 20 used to be similar adjusted for transportation 

 21 costs. Essentially we have a situation where we 

 22 have demand for futures contracts rather than 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 47 

 1 demand for physical bushels. These numbers are so 

 2 far out of line that traditional relationships for 

 3 risk management are lost resulting in lost 

 4 confidence in hedge performance leading to a 

 5 reduction in liquidity selling from hedgers and 

 6 also risk to reduced financial liquidity. Even 

 7 more concerning is that lack of convergence has 

 8 reduced our industry's ability to provide forward 

 9 cash contracts to our producer customers. 

 10 Why are futures leading and why is 

 11 convergence deteriorating? Generally, tighter 

 12 U.S. oil supplies combined with higher 

 13 transportation costs and demand for biofuels has 

 14 led to more volatile futures and a greater 

 15 tendency for futures to price future supply and 

 16 demand rather than current cash values. The 

 17 traders are generally able to manage these trends 

 18 during droughts and things like that. This seems 

 19 to be a systemic shift. 

 20 What is causing the lack of convergence 

 21 in wheat is the high percentage of futures that 

 22 are owned by index funds that have a longer-term 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 48 

 1 horizon for investment and are therefore not 

 2 responsive to short-term supply-and- demand 

 3 fundamentals. As this slide will show, it 

 4 actually addresses a question that asked by 

 5 Commissioner Chilton in the open forum when we 

 6 looked at the numbers somewhat different than Dave 

 7 Kass did in his presentation. If we just look at 

 8 the wheat for a second, there has been a lot of 

 9 dispute or discussion about what share of open 

 10 interest is really owned by a passive law and you 

 11 can draw different conclusions based on what that 

 12 percentage is. If you take the yellow columns, 

 13 those are the longs in the wheat, and then you'll 

 14 notice to the far right is the total longs. If 

 15 you take the green which is the short positions, 

 16 you'll get the total shorts and as you can see 

 17 they match. Then you have the spread positions 

 18 and if you add the spreads to either the longs or 

 19 the shorts, you're going to get the total open 

 20 interest. Often times the index ownership is 

 21 compared to the total open interest but it's a bit 

 22 misleading because the spreads really don't have 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 49 

 1 an impact on the flat price per se. If the market 

 2 goes up, a spread trader is not going to sell one 

 3 and take advantage of the rally, if he does, he's 

 4 going to sell one and buy another, so he's really 

 5 not providing liquidity in a bullish market and 

 6 the same happens in a lower market. So there are 

 7 three numbers that I use on top. One is the CIT 

 8 long share of total open interest which is 48 

 9 percent in wheat. If you take their net, the long 

 10 and the short, it's only 40 percent. But if you 

 11 take the net long position and compare to the open 

 12 interest excluding spreads, it's 56 percent and 

 13 that's a huge percentage of the open interest. 

 14 What's more compelling is the number below it. If 

 15 you look at the net long percent, their ownership, 

 16 the total number of contracts they own as of the 

 17 most recent reports, their total number of 

 18 contracts represents 145 percent of U.S. Wheat 

 19 production, and this year's wheat production is a 

 20 record or almost a record. So you can imagine how 

 21 big an issue that is. If you go farther down 

 22 you'll see that in corn that same number is only 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 50 

 1 15 percent and in the case of soybeans it's 29 

 2 percent. So you can appreciate that the number of 

 3 145 percent in a nutshell demonstrates why we have 

 4 a problem in wheat. 

 5 There are those who would conclude that 

 6 the easiest solution is to simply ban in some way 

 7 long-term commodity investors from the market. 

 8 Fundamentally we believe that this is the wrong 

 9 approach. First, any limitation could simply 

 10 result in more administratively complicated 

 11 solutions to allow individual investor accounts to 

 12 be established so they can still enter the market 

 13 which means just a more costly way to enter the 

 14 market but we still get the market participation. 

 15 Second, bears the question why should a long 

 16 passive investor who has no intention to 

 17 manipulate the market be precluded from using the 

 18 market to manage portfolio risk? Rather than 

 19 limit performance, we believe it is more logical 

 20 even if more difficult to modify contract terms or 

 21 specifications to protect the hedging value for a 

 22 traditional hedger while accommodating the new 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 51 

 1 market participant. The CME has implemented 

 2 changes to contract specs at our request, but it 

 3 appears those changes are insufficient to assure 

 4 regular and dependable convergence. There are 

 5 ways to either dramatically improve or assure 

 6 convergence. What I'd like to do now is go 

 7 through some of the things we've considered and 

 8 the pros and cons of each of those and hopefully 

 9 that will lead to more discussion. 

 10 One of the first things we looked at was 

 11 the idea of adding more delivery points. When I 

 12 say par, it means that the same value as 

 13 Chicago-Toledo elevator in the case of wheat, but 

 14 just add it to a broader geographic area. What 

 15 this would likely do, for instance if you added a 

 16 delivery point in Memphis or somewhere along the 

 17 mid-south is that it would improve the local 

 18 basis. Today their basis is 200 under, but if you 

 19 had a guaranteed sale to the CME at option price, 

 20 clearly the local elevator would be able to 

 21 provide a guaranteed bid to their local producers 

 22 if they could store the grain. It provides 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 52 

 1 certainly better stability in the basis in that 

 2 trade area. It also reduces the volatility in 

 3 that area. And with the introduction of shipping 

 4 certificates, if a facility in the river can offer 

 5 that, they can branch that out and provide service 

 6 to -- elevators as well. That's the positive 

 7 side. 

 8 The negative side of that is it does not 

 9 resolve the problem with convergence, and also the 

 10 market is not suffering from lack of deliveries. 

 11 We've been able to get to full carry as it's 

 12 calculated with the current storage rates at full 

 13 carry with a limited amount of storage and it 

 14 would represent a disadvantage for the stopper. 

 15 So a long hedger, for instance a mill that's 

 16 nowhere neat the mid- south that ends up with 

 17 ownership in that area would actually be 

 18 disadvantaged so it would be a reason for them not 

 19 to use it as a hedge. So while you've benefited a 

 20 short hedger in the mid-south or the Ohio River, 

 21 you would be disadvantaged in the long. 

 22 A second way of looking at that would be 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 53 

 1 to use these additional delivery points as a 

 2 safety valve at a significant discount to the 

 3 current price of delivery. Let's say we would use 

 4 Toledo and figure the transportation cost from 

 5 Memphis to Toledo and it would be significant. 

 6 Maybe it's 60 or 70 cents a bushel, but in today's 

 7 environment that would still provide a safety net 

 8 for the local elevators, they would still be able 

 9 to improve the stability of the basis in their 

 10 area which means that they would likely have 

 11 better access to capital and more confidence in 

 12 their bankers. By having the delivery points at a 

 13 discount, you remove one of the big obstacles to 

 14 having the additional delivery points in that it 

 15 is no longer a disadvantage for a stopper. If 

 16 you're a mill that's getting ownership of 

 17 inventories in an area you really would prefer not 

 18 to have but it's at a big enough discount, you 

 19 really don't have an economic disadvantage. That 

 20 was one of the key areas, adding delivery points. 

 21 The second key area that we looked at 

 22 was changing storage rates. We've had a range of 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 54 

 1 ideas there. One would be a modest increase in 

 2 storage rates, kind of the processing we've been 

 3 seeing the CME use for the last few years. 

 4 Certainly if we increased the storage charges, and 

 5 it's something that we requested at the ag forum 

 6 in April, is that it would better reflect the 

 7 current value of storage and that's a minor shift 

 8 in storage, maybe it's a penny, maybe it's 2 

 9 cents. Again the negative side of that is it does 

 10 not solve the problem with convergence. It just 

 11 better reflects the value of storage capacity. 

 12 The second alternative that we looked at 

 13 which is something Mr. Reinhart was promoting a 

 14 few minutes ago was a large increase in storage 

 15 rates, maybe doubling of the storage rates. This 

 16 certainly would allow more of the volatility to 

 17 shift to the spreads in the futures markets and 

 18 away from the basis levels. Second, it would 

 19 enhance convergence in surplus years. The 

 20 negative side of that is that it would make the 

 21 market less responsive to bullish fundamentals in 

 22 the years when you have tight supplies but you 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 55 

 1 have this economic incentive to tender shipping 

 2 certificates with high storage rates and the 

 3 market would be less responsive when the market 

 4 needed to go higher. Second, it would create 

 5 potential for, again, the opposite imbalance in 

 6 tight years. In the summer when you're expecting 

 7 spreads to invert and you're looking for flat 

 8 prices to rally, if there's an economic incentive 

 9 to tender shipping certificates, the market simply 

 10 wouldn't respond, people would calculate the 

 11 storage costs and the storage costs would be so 

 12 great from July to August when you harvest and in 

 13 that period the market wouldn't respond in the way 

 14 that it needs to. It also would create a 

 15 situation where they actually have an incentive to 

 16 produce for storage or produce for the CME as 

 17 opposed to producing for the consumer. Finally, 

 18 it increases the burden on the long hedger. If 

 19 they do need the inventories that they need to get 

 20 to a mill, they're paying a very high price for 

 21 that so a genuine hedger, a long hedger, would 

 22 have a disadvantage. I would say that there's one 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 56 

 1 other risk of something which has significant 

 2 higher storage rates. If capital really wants to 

 3 chase agriculture, if they really want to own raw 

 4 materials and grains being one of them, if they 

 5 find that going to the futures market is too 

 6 expensive then their next alternative would be to 

 7 find a way to get into country and to buy grain, 

 8 physical bushels, in the country and most don't 

 9 want to do that today for a number of reasons, but 

 10 if they did that you can imagine today if they 

 11 owned 880 million bushels of wheat in a market 

 12 that only produces 670, if they own that and then 

 13 the market got tight later, you can imagine the 

 14 kind of imbalances that could be created. 

 15 The third thing we looked at in terms of 

 16 storage was seasonal rates which might be 

 17 significantly higher during the peak storage 

 18 periods but more reasonable or market based during 

 19 the other times of the year. This certainly would 

 20 better reflect the value of storage during those 

 21 peak periods. Again the negative side of that is 

 22 it does not resolve the convergence. It improves 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 57 

 1 things so you can get more of the risk in the 

 2 futures market away from the basis, but it doesn't 

 3 solve the underlying problem of convergence. 

 4 The other novel concept that we had 

 5 looked at, we talked about it in the forum in 

 6 April and frankly it was the idea of compelled 

 7 load-out. We surveyed our committee to ask 

 8 different scenarios. One is that it was 

 9 unlimited, that a delivery elevator that tendered 

 10 shipping certificates if they found that they 

 11 couldn't find demand, if they could compel the 

 12 long to load the bushels out to make space for us 

 13 to buy more bushels in the country. The benefit 

 14 is it would immediately create convergence. The 

 15 spread may go to a $1.50, but we would definitely 

 16 get convergence. The problem is that it creates 

 17 an unmanageable risk for the long hedger, it 

 18 creates an imbalance in favor of the short hedger, 

 19 it could dramatically reduce liquidity as long 

 20 hedgers find some other alternative, OTC market or 

 21 some other way to avoid the risk that they now 

 22 have by being long, the same risk that a short 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 58 

 1 hedger might have today. Again it also could 

 2 force the current on-exchange volume to the OTC 

 3 market and then we wouldn't have the transparency 

 4 that we want, but recognizing that the real 

 5 benefit is that it would solve convergence which 

 6 is the problem. 

 7 We asked the next question, if you added 

 8 that feature but with some limits, and I can talk 

 9 about some ideas of limits, that it would force 

 10 convergence in cash in futures, it would restore 

 11 confidence and dependability for short hedgers. 

 12 This would represent a material change that could 

 13 destabilize the market. All the comments I 

 14 mentioned about having an unlimited ability to 

 15 compel load-out would be true unless this was 

 16 structured properly. So it's not something that 

 17 could happen overnight, but I suspect that the CME 

 18 working with the trade over the next 60 to 90 days 

 19 could probably find some way to structure a 

 20 limited ability to compel load-out that would be 

 21 able to restore balance. 

 22 The other possibility that has been 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 59 

 1 talked about periodically is the idea of a cash 

 2 settle index. Certainly this is a potential 

 3 solution at convergence. The problem is that it 

 4 represents a radical change with unknown 

 5 consequences. It creates new basis exposure for 

 6 elevator operators and it eliminates the delivery 

 7 system as the ultimate source of grain and also 

 8 the ultimate market for grain. It could also 

 9 create an advantage for companies that have large 

 10 networks of elevators and a disadvantage to small 

 11 elevator operators who are in one area of the 

 12 country. Finally, there is no guarantee that it 

 13 would create convergence. 

 14 One of the other ideas that was 

 15 considered is the concept of serial futures where 

 16 you would have futures every month as opposed to 

 17 every other month that's currently the case, or 

 18 every 3 months. Certainly this would create 

 19 enhanced hedging opportunities and it would reduce 

 20 the timeframe in the event that there was an 

 21 imbalance in the market, but it's not a solution 

 22 for convergence. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 60 

 1 We have surveyed our risk committee and 

 2 also some of the members of our country elevator 

 3 committee. I would say that first there were a 

 4 couple of key areas of consensus, although no one 

 5 can agree to all the specific issues. The 

 6 consensus was that some action needed to be taken 

 7 now and that there was an interest to encourage 

 8 early implementation of any changes that were 

 9 determined to make sense by the Commission or the 

 10 CME. In terms of general biases, there was some 

 11 consensus on adding delivery locations or wheat at 

 12 least. There was also a general view that 

 13 increasing storage rates somewhat would make 

 14 sense. There was a range. Some people think that 

 15 it should be modest, and as we heard Mr. Reinhart 

 16 say, some say that it should be significant or 

 17 doubling of the rates. The other I would say 

 18 consensus is that there is a sense of support for 

 19 some form of compelled load-out, a demand 

 20 certificate of some type. There was unanimous 

 21 agreement that having it unlimited would be a 

 22 problem, but there was general support for adding 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 61 

 1 some feature to compel load-out. What's 

 2 interesting about that is this was an idea that 

 3 was dead on arrival when we did our task force a 

 4 year ago, and even when we met in April we had 

 5 talked about it but there was absolutely no 

 6 support. But we've gotten to the point right now 

 7 where there is such an imbalance between the cash 

 8 and the futures that something fundamental needs 

 9 to change to allow that to happen. Those are my 

 10 comments. I'd be happy to answer any questions. 

 11 MR. DUNN: Thank you very much, Tom. We 

 12 appreciated the overview and the pros and cons. 

 13 That certainly is going to help the Commission, 

 14 but I think it gives a lot of food for though for 

 15 the advisory committee and for our discussion. 

 16 Roger Cryan who represents the National 

 17 Milk Producers Federation has a particular view of 

 18 this from an industry that relies very heavily on 

 19 having protein available. Roger, if you could, 

 20 please. 

 21 MR. CRYAN: I'm Roger Cryan. I'm with 

 22 the National Milk Producers Federation. The 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 62 

 1 National Milk Producers Federation represents 31 

 2 dairy farmer co-ops whose owners produce 

 3 three-fifths of the nation's milk and we 

 4 appreciate the opportunity to express our concerns 

 5 about futures markets and their regulation through 

 6 our participation in this committee. 

 7 NMPF does not believe that speculators 

 8 in the futures markets are substantially 

 9 distorting feed prices. Farm prices reflect 

 10 supply-and-demand fundamentals even when futures 

 11 markets do not. However, National Milk does 

 12 believe that overwhelming speculative volume in 

 13 these markets is causing the poor performances in 

 14 the futures markets for feedstuffs and that this 

 15 is undermining both livestock and crop farmers' 

 16 ability to manage their price risks. This has 

 17 substantial costs for farmers, for the food 

 18 industry, and for the public. 

 19 Dairy farmers feed 7-1/2 billion pounds 

 20 of soy meal and 46 billion pounds of corn to their 

 21 cows every year. Feed represents a half to 

 22 two-thirds of their cost of production. Like hog 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 63 

 1 farmers, poultry growers, and beef operators, they 

 2 depend heavily upon forward pricing opportunities 

 3 to hedge these costs. Some participate directly 

 4 in the futures markets and others participate 

 5 indirectly through their cooperatives or their 

 6 feed and grain dealers. Our members have shared 

 7 their grave concerns about the explosion of their 

 8 basis risk when futures prices fail to converge 

 9 predictably with the prices they pay for feed. 

 10 Dairy farmers are very heavily capitalized with 

 11 much of their capital fixed and firmly sunk into 

 12 dairy farming and only dairy farming for its 

 13 productive life. They have all this at stake in 

 14 the effective operations of these futures markets. 

 15 Crop farmers face an obvious and 

 16 dramatic loss when their short contract goes off 

 17 the board a dollar above the expected convergence 

 18 price, but a volatile basis moves in both 

 19 directions and livestock operators can face an 

 20 equal risk once basis expectations shirt upward 

 21 and the basis on their long contracts moves back 

 22 down. Those who hedge feed costs directly through 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 64 

 1 the futures market suffer direct losses. More 

 2 importantly, over time feed dealers and grain 

 3 elevators are unwilling to forward contract feed 

 4 or will do so only at a substantial additional 

 5 cost to feed buyers. Forward price discovery for 

 6 swaps and forward contracting becomes ineffective, 

 7 and in some, a lack of convergence in these 

 8 markets is just as serious for livestock producers 

 9 as it is for crop farmers. 

 10 Farmers need effective price discovery 

 11 through futures markets that respond to 

 12 fundamentals of supply and demand. It has always 

 13 been assumed that liquidity is a good thing. On 

 14 recent occasions though it seems clear that 

 15 commercial interests have been drowning in 

 16 speculative liquidity. Speculate interest in 

 17 commodity markets has grown so large and with so 

 18 little concern for day-to-day market fundamentals 

 19 that their noise appears to overwhelm the ability 

 20 of the physical side of the market to achieve 

 21 arbitrage. Futures markets must be structured to 

 22 carry out the public interest for which they are 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 65 

 1 legalized. This means that they must work for the 

 2 true hedgers, those with a meaningful connection 

 3 to the physical market to the benefits of buyers, 

 4 sellers, and consumers in the physical market. 

 5 Protecting farmers lies at the 

 6 historical root of the CFTC's mission to maintain 

 7 the integrity of these markets. Agricultural 

 8 commodity futures markets need substantial 

 9 dedicated and sustained attention from the CFTC. 

 10 That function is as important as ever and remains 

 11 a key reason for CFTC's continued independence. 

 12 As I said, we do not believe that this excessive 

 13 speculation in the futures markets is causing the 

 14 exceptionally high feed prices that farmers are 

 15 paying, but at just the time that price risk 

 16 management tools are of especial importance to 

 17 farmers, those tools have been badly blunted by an 

 18 excess of mindless speculative interest. 

 19 Recent months have demonstrated the 

 20 havoc that can ensure from unbalanced commodity 

 21 futures markets and the economic literature is 

 22 beginning to explain the cause and effect. We 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 66 

 1 applaud the Commission's initial steps to address 

 2 these structural issues and we urge the Commission 

 3 to continue its examination of these issues and to 

 4 seek additional remedies to reassert the soundness 

 5 of structure that these markets need in the public 

 6 interest. 

 7 There are a few things that came in the 

 8 packet and one of the things that I thought was 

 9 most significant was the testimony by Mr. Masters 

 10 specifically about the differences between 

 11 traditional speculators and these index 

 12 speculators and the way that index speculators 

 13 consume liquidity instead of adding liquidity. I 

 14 think that's a very important point that deserves 

 15 consideration by everybody here. I think there 

 16 are structural issues that need to be addressed by 

 17 the CFTC because nobody else necessarily is in a 

 18 position to fix it or who has an interest in 

 19 fixing it. So I thank you on behalf of National 

 20 Milk for the opportunity to express our concerns. 

 21 MR. DUNN: Thank you very much, Roger. 

 22 I appreciate your appearance here today. I don't 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 67 

 1 know if we've got all our technology quite put 

 2 together, so I just want to take a quick break and 

 3 recognize a former commissioner here, Tom 

 4 Erickson. Thank you. 

 5 With that let's hear from the exchanges 

 6 themselves on what they've been doing to look at 

 7 this problem area. I must say I have been very, 

 8 very impressed with the openness that the 

 9 exchanges have taken in addressing this problem. 

 10 They have not been sitting on their hands since 

 11 our meeting in April. I know they've gone through 

 12 a number of different steps to take a look at how 

 13 can they fix the convergence problem. They have 

 14 tried some things. They have not been successful 

 15 on some things. But I do feel that the 

 16 relationship between the industry and the 

 17 exchanges is probably as close as it's ever been 

 18 because I know they've been talking to each other 

 19 tremendously during this period. With that I'll 

 20 ask David Lehman give the CME overview. 

 21 MR. LEHMAN: Thank you, Commissioner 

 22 Dunn, and thanks to all the Commissioners, and for 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 68 

 1 the Agricultural Advisory Committee for giving us 

 2 the opportunity to be here today and hear from you 

 3 about what you think needs to be done to help us 

 4 improve performance of our contracts. It's the 

 5 number-one priority for us obviously that our 

 6 contracts work for you, for our customers, and we 

 7 recognize that they've fallen short a little bit. 

 8 I also thought Commissioner Chilton's mention of a 

 9 blue ribbon panel to do a study was an interesting 

 10 coincidence. Yesterday what I consider a pretty 

 11 blue ribbon study came out of Purdue University 

 12 and I hope you all get a chance to read it. I got 

 13 it on the plane last night. I was grounded at 

 14 O'Hare Airport for about 4 hours so I spent a 

 15 little too much time traveling and not enough time 

 16 being able to look at this, but it's out from 

 17 Professor Hurt (?) and the Farm Foundation was 

 18 involved in sponsoring that and it sounds like 

 19 they reached conclusions that energy prices are 

 20 probably worth $3 of our corn price increase, 

 21 biofuels a dollar, and they don't see that 

 22 speculation has any long- term effect on prices. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 69 

 1 But certainly read the study and draw your own 

 2 conclusions. 

 3 We were here in December of last year, 

 4 CME Group was, to talk about swaps primarily, but 

 5 at that time we had just announced changes in our 

 6 wheat contract that were referenced by other 

 7 speakers this morning, an increase in the storage 

 8 rate, a modest increase of about 10 percent. We 

 9 also changed the delivery instrument to a shipping 

 10 certificate. The goal of those changes was to 

 11 improve convergence and better reflect the 

 12 underlying cash market storage cost and also how 

 13 grain flows in the cash markets, not really 

 14 flowing into storage as much as going directly 

 15 from production to consumption. 

 16 At that time we actually saw very good 

 17 convergence on the December contracts. The 

 18 December 2007 wheat contract looked excellent in 

 19 terms of convergence. In fact, I'll flip ahead to 

 20 that. That's the chart showing basis in Chicago, 

 21 the lower blue line, and Toledo is the red line. 

 22 So Toledo went off at maybe 10 under but we talk 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 70 

 1 about convergence really as a band and not futures 

 2 and cash coming together exactly, and of course 

 3 this band I think has probably widened because of 

 4 transportation cost increases and other 

 5 transaction costs, but we had very good 

 6 convergence. Why? I think we had a very strong 

 7 cash market, that the U.S. became the supplier of 

 8 wheat to the world market, the world market really 

 9 was fearing it was running out of wheat and that's 

 10 why we saw what we saw. 

 11 Since December we'd had 6 or 7 months of 

 12 significant fundamental changes in the markets. 

 13 We did see world wheat stocks fall to 30-year lows 

 14 early in 2008, U.S. Stocks fell to 60-year lows, 

 15 sharp increases in input costs led by fuel and 

 16 fertilizer, and then as Dave Kass showed earlier 

 17 in his slide, significantly higher prices in corn, 

 18 beans, and wheat, record prices in fact in those 

 19 three markets. 

 20 What we've done to address or ensure 

 21 contract performance in this period of extremely 

 22 dynamic fundamentals, we worked with the three 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 71 

 1 exchanges, and I know Jeff is going to talk about 

 2 that a little later, in coordinating price limit 

 3 increases in our wheat contracts. This occurred 

 4 in February in wheat and then in March in corn and 

 5 beans, and what we were seeing is really the 

 6 markets became very volatile and we were really 

 7 shutting them down too often with our price 

 8 limits. So we worked on a coordinated expansion 

 9 and certainly with the Commission and Commission 

 10 staff to get that in place quickly, and we 

 11 appreciate the support from the Commission and all 

 12 three exchanges in getting that done. 

 13 As I mentioned, we made the changes in 

 14 the wheat contract that went into effect in July 

 15 of this year, so we've just gone through the first 

 16 expiration with the new delivery instrument and 

 17 with the higher storage rates, and I'll show the 

 18 results of that in a minute. Then as we got into 

 19 the new crop, the market really kind of turned and 

 20 in March we saw increased plantings of wheat 

 21 obviously in response to high prices, and one of 

 22 the sayings in the markets around the Board of 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 72 

 1 Trade where I've been for 20 years is that the 

 2 best cure for high prices is high prices. So what 

 3 that means is as prices move higher, consumers 

 4 start to use less, they look or substitutes, they 

 5 reduce consumption as we're all doing with our 

 6 gasoline consumption now, and then supply 

 7 increases as well. So we saw a big increase in 

 8 soft red winter wheat acreage and it looks like 

 9 our crop is going to be about 70 percent higher 

 10 this year than last. 

 11 We've talked about full carry spreads 

 12 and this is the spread for the DEES March when we 

 13 had excellent convergence. The blue line is the 

 14 percent of full carry. It started at an inverse 4 

 15 months before expiration, moved to near full carry 

 16 in November, and then went into delivery period at 

 17 about 75 percent of full carry. So when the 

 18 spread is inside full carry, you tend to see 

 19 deliveries. Those deliveries did come out. I 

 20 think we had about 9,000 deliveries, I've got that 

 21 in a chart a little later, and we achieved 

 22 convergence. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 73 

 1 This is the July 2008. This is the 

 2 contract that I just mentioned that was the first 

 3 expiration with the new delivery instrument and 

 4 the higher storage rate. As Dave Kass showed in 

 5 his slide, cash prices are about a $1.50 under 

 6 futures at first notice day. I should have 

 7 pointed out this heavy vertical black line is the 

 8 first delivery day on the contract. That's when 

 9 we expect to see prices in the cash market 

 10 approaching futures because at that time you can 

 11 convert a futures position into a position in the 

 12 physical market. If you're short you can deliver 

 13 against your short, and if you're long you get 

 14 assigned delivery and it's an electronic piece of 

 15 paper when the delivery occurs in the market, but 

 16 it's a right to load out grain or a right to 

 17 ownership of grain in a warehouse. So that's the 

 18 convergence theory of futures and cash coming 

 19 together. Obviously we didn't see it in July. We 

 20 were disappointed in this performance. We thought 

 21 we would see better performance with these changes 

 22 in storage rate and delivery instrument and we 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 74 

 1 didn't. Why? Again we have a crop that's almost 

 2 70 percent larger than last year's crop so we've 

 3 got a very good crop coming on, not finished yet 

 4 certainly in terms of soft red winter wheat 

 5 harvest, but getting close. And then as Tom Coyle 

 6 mentioned, the spreads went to full carry and that 

 7 takes away the incentive to make delivery or take 

 8 delivery and this is the result. This is a chart 

 9 of the spread on the July- September contract. 

 10 The top blue line is that percent of full carry, 

 11 and as you can see, it hit 100 percent just before 

 12 delivery and then came off some. 

 13 I mentioned the quantity of deliveries 

 14 and this is something that shipping certificates 

 15 do. They allow the warehouseman to more 

 16 effectively use their space and increase the 

 17 effective capacity and even though the storage may 

 18 not increase, you're able to issue certificates up 

 19 to your full storage capacity regardless of the 

 20 wheat that's in the elevator. So July 2008 is in 

 21 the middle, and what this chart shows is average 

 22 number of contracts delivered over the last 5 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 75 

 1 years versus the most recent expiration in that 

 2 month. So in March on average we have about 9,000 

 3 to 9,500 contracts of deliveries over the last 5 

 4 years, in March of this year we had 3,000. In May 

 5 of this year we had 3,500, compared to 6,000 or 

 6 7,000 on average. So this is what this is telling 

 7 us, and if we looked at each one of these 

 8 expirations you could see that spreads have moved 

 9 near full carry on each of these expirations and 

 10 that then could be one of the explanations for 

 11 lower deliveries. In July of this year we had 

 12 about 2,500 deliveries, and our average for July 

 13 over the last 5 years has been close to 6,000. So 

 14 here's the month that we thought we would see 

 15 additional deliveries of the change in the 

 16 instrument, the shipping certificate, and also the 

 17 higher storage rate which is really an earning to 

 18 the issuing warehousemen, they're paid that 

 19 storage rate when a delivery is made and we didn't 

 20 see it. Index funds are something that is talked 

 21 about in almost every conversation about the grain 

 22 markets these days and about commodity markets in 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 76 

 1 general. This is a chart that we put together and 

 2 it kind of mirrors one of the charts that Dave 

 3 Kass showed of the percentage of open interest 

 4 held by index funds. Of course you can look at 

 5 this in many different ways and I compliment Tom 

 6 for noting those ways, that you can look at it as 

 7 a percentage of open interest, it's about 41 

 8 percent today, or you can look at it as a 

 9 percentage of the long side of open interest, or 

 10 you can take the spreads out. So we look at it as 

 11 a percentage of total open interest and just 

 12 plotted this against price of the near-by wheat 

 13 futures contract and over the last 2 years since 

 14 January 2006 when this data become available, 

 15 index fund percentage has declined from 49 percent 

 16 to 41 percent while wheat prices increased 151 

 17 percent. So that tells us that there are 

 18 economics behind the wheat price increase and it's 

 19 not index funds. 

 20 What's the CME Group doing to address 

 21 the convergence issue? We've had a number of 

 22 meetings. We started last fall with an industry 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 77 

 1 meeting with trade associations, with commercial 

 2 market participants, to look at contract 

 3 performance. That led to the recommendation from 

 4 the National Grain and Feed Association which we 

 5 implemented to increase storage rates and 

 6 implement the shipping certificate delivery 

 7 instrument. We then saw the extreme volatility in 

 8 February and March of this year in the wheat 

 9 markets. The Commodity Markets Council sponsored 

 10 meetings with the three exchanges and their 

 11 customers, one- on-one meetings, to discuss 

 12 contract performance and identify potential 

 13 solutions and following those discussions we 

 14 participated in the Commission's roundtable here 

 15 in early April. Then in June we worked with the 

 16 National Grain and Feed Association to develop 

 17 another storage rate survey and go out and find 

 18 out really where the market was in terms of the 

 19 cost of storage. In July after the July 

 20 expiration just last week we held an industry 

 21 meeting in Chicago with a little more urgency, I 

 22 think, that we felt the changes we were 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 78 

 1 implementing in July were going to help address 

 2 the problem and they didn't seem to, that we 

 3 really now need to take stronger action to improve 

 4 the performance of the contract. So the areas 

 5 that we discussed, and Tom gave a pretty good 

 6 overview of what his committee or the Risk 

 7 Management Committee at NGFA is looking at and it 

 8 happens to be very similar to what we looked at 

 9 last week, and it is to look at a seasonal storage 

 10 rate, a different rate during harvest than during 

 11 the rest of the year, looking at the safety valve 

 12 delivery points, Memphis, actually the whole 

 13 Mississippi River from St. Louis to Memphis. It's 

 14 got about 80 million bushels of storage capacity 

 15 compared to about 70 million that we've got in our 

 16 current Chicago-Toledo-Burns Harbor-St. Louis 

 17 areas. Central Ohio is another location that 

 18 we're looking at. Then we're looking at the 

 19 possibility of serial futures or expirations every 

 20 month. The delivery certificate or mandatory 

 21 load-out concept is something that we're going to 

 22 study. We think it does have a benefit of 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 79 

 1 assuring convergence but if not structured 

 2 properly it could be detrimental to the long 

 3 hedging side of the market, but that's something 

 4 we certainly are going to look at very closely. 

 5 Changing the quality of the contract, upgrading 

 6 that again by lowering the vomatixin limit to 2 

 7 parts per million. And then looking at the 

 8 potential for cash index settlement. 

 9 Our timetable on moving forward from 

 10 here is over the next 30 days we intend to vet 

 11 more broadly with the marketplace two issues that 

 12 we think could be implemented relatively soon, 

 13 seasonal storage rates, and additional delivery 

 14 locations we think have very good consensus within 

 15 the industry or at least within the roundtable 

 16 that we held last week and we think that's a 

 17 pretty microcosm of the broader industry. The 

 18 delivery receipted or forced load- out we think as 

 19 I said is going to take more research and more 

 20 time to come up with a way that that can be 

 21 implemented and maintain balance in the contract 

 22 between buyers and sellers. We intend to do this 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 80 

 1 via a broader industry meeting in September and 

 2 then also move forward in a little longer 

 3 timetable obviously on the compel load-out and 

 4 cash index settlement methodologies. One thing 

 5 that I know we're going to need is certainly to 

 6 work very closely with the Commission and staff to 

 7 look at how we can implement some of these changes 

 8 maybe in a more timely fashion than normally would 

 9 be considered, but I think I've spoken with some 

 10 of your staff and briefed them and will be looking 

 11 to having that discussion soon. Thanks very much. 

 12 MR. DUNN: Thank you very much, Dave. 

 13 It does appear that you have been extremely busy. 

 14 One of the things that you're considering is a 

 15 cash settlement contract and I know that's 

 16 something that the Minneapolis Grain Exchange has 

 17 implemented. Mark Bagan is here as head of the 

 18 Minneapolis Grain Exchange. Certainly this is the 

 19 exchange that experienced probably the most 

 20 volatile wheat market last year. So Mark, if we 

 21 could get your thoughts and comments, please. 

 22 MR. BAGAN: Thank you, Commissioner 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 81 

 1 Dunn, as well as the Agricultural Advisory 

 2 Committee participants here. The Minneapolis 

 3 Grain Exchange is pleased to have the opportunity 

 4 to address this group today. I also thank 

 5 Commissioners Lukken, Sommers, and Chilton. 

 6 I am Mark Bagan. I am the CEO of the 

 7 Minneapolis Grain Exchange, and as a designated 

 8 contract market, the Minneapolis Grain Exchange 

 9 works very closely with the Commodity Futures 

 10 Trading Commission. As designated contract 

 11 markets, it's out job to ensure that our risk- 

 12 management products are working properly for the 

 13 marketplace. We take that obligation very, very 

 14 seriously. Thank you for convening this forum 

 15 today as we in the industry gather and work as a 

 16 group toward addressing the challenging facing our 

 17 marketplace. The exchanges, the CFTC, and the 

 18 Agricultural Advisory Committee has market 

 19 integrity to protect and we at the Minneapolis 

 20 Grain Exchange are pleased to be part of the forum 

 21 today. 

 22 At the Minneapolis Grain Exchange we're 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 82 

 1 very familiar with the concept of convergence and 

 2 monitoring that convergence particularly as it 

 3 relates to our hard red spring wheat contract. As 

 4 Commissioner Dunn mentioned, we also became 

 5 experts in monitoring volatility in the 

 6 marketplace this past winter. Hard red spring 

 7 wheat prices went from under $10 to $25 in a very 

 8 short amount of time and Mr. Borchardt will be 

 9 talking later about what the exchanges did in 

 10 conjunction with one another to increase those 

 11 price limits. 

 12 I'm pleased to report that there was 

 13 nearly total convergence between the futures and 

 14 cash price prior to our first notice day in our 

 15 delivery contract for our May hard red spring 

 16 wheat contract. Convergence was evident very 

 17 early on. The July hard red spring wheat contract 

 18 moved toward convergence prior to the first 

 19 delivery day as well. This is an important fact 

 20 because the July contract month for the 

 21 Minneapolis Grain Exchanges are last cold crop 

 22 month and there were relatively small amounts of 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 83 

 1 supply of hard red spring wheat at that time. 

 2 Additionally, the wheat conditions for the hard 

 3 spring wheat market were uncertain at that point 

 4 as well. 

 5 From our perspective, we believe we've 

 6 got some alternatives here for this group and the 

 7 marketplace to consider here today. It's my 

 8 pleasure to offer some thoughts on the convergence 

 9 problem that brings us all here. Grain futures, 

 10 while they're a traditional hedging vehicle, 

 11 they've also become an important investment 

 12 vehicle in the marketplace today. In today's 

 13 market, commodity investors accumulate permanent 

 14 long positions well ahead of the delivery period, 

 15 but they do not net sell these positions out. 

 16 Instead, they roll these positions from month to 

 17 month. In my opinion, this is the essence of the 

 18 convergence problem. The Minneapolis Grain 

 19 Exchange is not among those who see these 

 20 investment flows as manipulation or unjustified 

 21 speculation. Consequently, the Minneapolis Grain 

 22 Exchange does not support regulatory or 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 84 

 1 legislative action designated to penalize these 

 2 selected market participants. 

 3 We at the Minneapolis Grain Exchange 

 4 believe we have an alternative toward this 

 5 solution and that is the cash-settled index 

 6 futures contracts that Commissioner Dunn mentioned 

 7 earlier. These products currently are listed on 

 8 the Globex platform and are traded side by side 

 9 with the Chicago Board of Trade and the Kansas 

 10 City Board of Trade grain contracts. What we 

 11 think we could do in terms of bringing in 

 12 additional solutions is to link these products as 

 13 single interexchange spread products, and we're 

 14 working with the CME to do so. So half of the 

 15 solution is complete in my opinion today. The 

 16 fact is that these products are traded on the same 

 17 platform, the Globex platform, as the other 

 18 agricultural contracts. 

 19 The Minneapolis Grain Exchange's 

 20 cash-settled index contracts differ from 

 21 traditional grain futures in a number of ways. 

 22 These contracts are financially settled and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 85 

 1 represent the national interior or country origin 

 2 price of grain. They trade exclusively 

 3 electronically and we have contract months 

 4 available in all 12 calendar months. Most 

 5 notably, the Minneapolis Grain Exchange's 

 6 cash-settled index contracts guarantee 

 7 convergence. All parties can participate in the 

 8 futures market without disrupting the settlement 

 9 mechanism. As Mr. Coyle mentioned earlier, cash 

 10 settlement for agricultural contracts is a radical 

 11 change and it's one that the Minneapolis Grain 

 12 Exchange has battled with and struggled with over 

 13 the last 5 years as we've tried to gain market 

 14 acceptance with these products. The educational 

 15 curve on these products is steep. 

 16 It's vital to understand the distinction 

 17 though. The Minneapolis Grain Exchange's index 

 18 design does differ from the physical delivery 

 19 design because no market participant can influence 

 20 the convergence process since the financially 

 21 settled products settle into the average price 

 22 that producers are being paid at their local 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 86 

 1 elevators across the nation. The traditional 

 2 basis hedged reduced risk in the past may actually 

 3 increase the risk today. Hedge effectiveness has 

 4 become a bigger issue as basis predictability has 

 5 dropped. Today the grain industry hedging 

 6 instrument is represented by the horizontal line 

 7 on one of the charts that we'll have here. This 

 8 graph shows the collapsing basis of the wheat 

 9 contract. The severity of this convergence 

 10 problem has prompted an array of solutions brought 

 11 forth that industry participants are considering 

 12 making as well as exchanges are considering making 

 13 in changes to our current physical delivery 

 14 contracts. The Minneapolis Grain Exchange's soft 

 15 red wheat index contract and the national average 

 16 cash price are one and the same which again 

 17 guarantees near perfect convergence. Soybeans are 

 18 beginning to have some of the similar challenges 

 19 that the wheat contracts have and it's our belief 

 20 that the corn basis at times may be weakening 

 21 there as well. 

 22 Back to the national products that the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 87 

 1 Minneapolis Grain Exchange offers, the data that 

 2 comprises each one of these contracts is collected 

 3 by DTN. It's compiled from the cash bids at the 

 4 grain-handling facilities across the country, 

 5 elevators, terminals, and so forth. With these 

 6 index products there are no storage costs, no 

 7 delivery concerns, and no grain differentials on 

 8 grain load-out. Financial settlement of grain 

 9 futures contracts is a model that accommodates all 

 10 players in the marketplace, short and long 

 11 hedgers, speculators, index, and financial 

 12 investors, and we're convinced that it could be a 

 13 powerful tool in combination with the traditional 

 14 physical delivery products that the Chicago Board 

 15 of Trade offers. As I mentioned earlier, the 

 16 Minneapolis Grain Exchange is working closely with 

 17 the CME in an effort to provide single-click, 

 18 single-product electronic spread trading between 

 19 the traditional grain futures and our cash- 

 20 settled futures on the Globex platform. Once 

 21 available, we believe that single-click spread 

 22 trade volume will gradually build, improve 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 88 

 1 liquidity, and bring greater transparency to cash 

 2 basis values for every market participant. This 

 3 all-important transparency is something not 

 4 offered in all products that are out there today, 

 5 particularly the OTC products and the swap 

 6 markets. In contrast, trades of the Board of 

 7 Trade's current contracts spread against the MGEX 

 8 products will take place on an exchange in a fully 

 9 transparent public marketplace with instant price 

 10 and volume dissemination and worldwide market 

 11 access. 

 12 The Globex interexchange spread product 

 13 gives the market a new and appealing 

 14 risk-management tool. A few examples for its use, 

 15 hedgers and speculators will be able to rotate 

 16 positions in and out of both contracts based on 

 17 basis risk perceptions, basis expectations, 

 18 position sizes, and position limits. Those who 

 19 choose to trade exclusively in the traditional 

 20 contracts and accept the basis volatility risk can 

 21 do so, but we expect interest in these spread 

 22 trades to be high, contributing to significant 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 89 

 1 liquidity for both hedgers interested in trading 

 2 and in our of the two contract markets. Index 

 3 managers facing constant demand for new grain 

 4 investment products who can't obtain hedge 

 5 exemptions today from the CFTC can initiate their 

 6 hedges in the Board of Trade grain contracts and 

 7 spread those positions over to our financially 

 8 settled products in Minneapolis. Initial index 

 9 buying at the CBOT will be followed by selling 

 10 which is a vast change from the situation we have 

 11 today where they just generally roll their 

 12 positions over. Similarly, index investors 

 13 worried about political or regulatory risk for 

 14 their existing Board of Trade long positions can 

 15 roll into MGEX contracts, earning the premium 

 16 between the cash and the futures that has created 

 17 the convergence. Here again the Board of Trade 

 18 contracts will see a net selling from index 

 19 investors which is a huge change as opposed to the 

 20 continuing roll of the positions. Just this 

 21 activity alone in my opinion will improve 

 22 convergence perhaps substantially for the short 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 90 

 1 hedgers. Let me emphasize that the MGEX index 

 2 contracts are a complementary product and not a 

 3 competitive product to the traditional grain 

 4 products. They represent a risk- management 

 5 opportunity needed by our traditional customer 

 6 base. 

 7 Let me conclude my comments in saying as 

 8 designated contract markets, each exchange has a 

 9 vested interest in bringing innovative market 

 10 solutions to the marketplace and on behalf of all 

 11 of the exchanges let me assure you that we all 

 12 take that responsibility extremely seriously. 

 13 Thank you, Commissioner Dunn, for giving the 

 14 Minneapolis Grain Exchange an opportunity to take 

 15 part in this forum today. 

 16 MR. DUNN: Thank you very much, Mark. I 

 17 appreciated that. And I note that Mark's 

 18 presentation is not in the handouts that we gave 

 19 you. We're going to try to get those reproduced 

 20 and distributed before you leave here today. 

 21 With that I'd like to open it up for 

 22 discussion, and at this period rather than having 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 91 

 1 the Commissioners having Q and A and making their 

 2 comments, I would like to have the Advisory 

 3 Committee and folks in the audience who have 

 4 questions or comments on any of the presenters 

 5 that we had this morning. Please identify 

 6 yourself when you get ready to ask a question. 

 7 Also folks at the table, if you have a question, 

 8 please do so by holding your name up so that I can 

 9 see who is requesting to speak. Dan Brophy? 

 10 MR. BROPHY: I'm going to ask some 

 11 questions of Dave Lehman and Dave Kass in relation 

 12 to what Mark just said which would seem to 

 13 contradict my understanding of your slides, 

 14 although I had difficulty seeing them from my 

 15 vantage point here or my lack of vantage point 

 16 here. 

 17 The way I interpreted Dave Lehman's and 

 18 Dave Kass's slides both is that you do not think 

 19 there is a correlation between index activity and 

 20 in one case wheat prices. I agree with that, but 

 21 Mark thinks there's a correlation between the 

 22 convergence problem and the index activity which 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 92 

 1 to me is pretty well demonstrated on that first 

 2 slide that Mark showed on soft red wheat which 

 3 appears to indicate that 3, 4, 5 years ago, I 

 4 couldn't quite see it, but a couple of years ago 

 5 there was no convergence problem and now there is, 

 6 and of course we know that the index investing 

 7 trend started about 4 years ago and has gotten 

 8 bigger except for the last couple of weeks. If 

 9 you can comment on that or not as you wish, but I 

 10 happen to accept Mark's thesis and I think 

 11 somebody else here said the same thing, that the 

 12 correlation to problem is due to that, and it's 

 13 also due, Tom Coyle mentioned as well, to a lack 

 14 of net selling. So I wonder if we could have some 

 15 discussion about, A, whether that is the case, and 

 16 B, if it is the case that the index investment 

 17 trend presents a problem, are they speculative or 

 18 are they not speculative? The Commodity Markets 

 19 Council which I represent has argued in the past 

 20 that it's financial hedging by one definition or 

 21 another and if anybody in the index market, index 

 22 management business, is speculating around other 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 93 

 1 than a one-to-one matched book against a security 

 2 product that has been sold, that's a different 

 3 matter and that is speculation. But the Commodity 

 4 Market Council's view on this has been that they 

 5 have the right to participate in our markets. 

 6 So what I'm getting at is this. I think 

 7 that they are the cause of the convergence 

 8 problem. I don't think it would be healthy for 

 9 futures market liquidity or for the exchanges or 

 10 for the users of the exchanges to run one segment 

 11 of the market out, in this case index investors, 

 12 by revoking all their hedge exemptions and 

 13 imposing very restrictive speculative limits on 

 14 them. So I wish we could come out of this meeting 

 15 with that as an agreement and if that is the 

 16 agreement or a consensus, then we have to find a 

 17 way to deal with this investment trend and also 

 18 allow our physical delivery contracts to survive. 

 19 I think that's the challenge to this group and the 

 20 Commission, and actually I think Mark has come up 

 21 with a very powerful idea which probably needs 

 22 further explanation. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 94 

 1 MR. LEHMAN: Thanks for your comments, 

 2 Dan, and just in terms of the correlation between 

 3 index fund trading and prices, the point that I 

 4 was making in the slide that I showed is that we 

 5 don't see a correlation between price levels and 

 6 index funds. In fact, we ran the correlation 

 7 coefficient on index fund percentage of open 

 8 interest and price changes from January 2006 to 

 9 July 2008 and it shows a minus.59 correlation, so 

 10 they're actually inversely correlated. 

 11 Your real question though I think is a 

 12 good one, Dan, is that participation affecting 

 13 convergence and if so is there a way we can adjust 

 14 the contract specifications to allow that 

 15 participation to remain in the market, because I 

 16 think we all know that if we restrict it, it's 

 17 going to get into the market some way. It's going 

 18 to find a way through the over-the-counter market, 

 19 it's going to find a way in non-U.S. exchange 

 20 markets which are less transparent to all of us. 

 21 And I think this is one thing that we all really 

 22 appreciate the Commission having accomplished a 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 95 

 1 little over a year ago, to create new commitments 

 2 of traders report, the supplemental report, that 

 3 shows their positions in our markets. We can 

 4 argue about how accurate that category is, but I 

 5 think everyone agrees that it's certainly an 

 6 improvement over not having it. So we can begin 

 7 to see their activity and if we restrict it some 

 8 way then we'll lose that transparency again and I 

 9 don't think we want to see that happen. 

 10 I think there are a lot of reasons for 

 11 convergence occurring less consistently, and 

 12 that's what I think we're seeing. We saw great 

 13 convergence in December wheat, we saw terrible 

 14 convergence in July wheat, so it's not that we 

 15 can't converge, but it's that we're not doing it 

 16 consistently. I know others have looked at this, 

 17 the University of Illinois has, and they presented 

 18 here in April at the forum and I think found the 

 19 same result. Obviously transportation costs and 

 20 changes in transportation are a big part of this 

 21 relationship. Flat price levels at record highs 

 22 certainly have to be a part of the relationship. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 96 

 1 Should basis be 20 cents when wheat prices are $5 

 2 as when wheat prices are $10? Is basis a 

 3 percentage of the flat price? These are some of 

 4 the questions I think that we're all struggling 

 5 with intellectually to understand. But I think 

 6 there are changes in contract design, in contract 

 7 specifications, that can be made to address this 

 8 problem. I think I outlined a couple of those 

 9 that we see good industry support for, and 

 10 National Grain and Feed seem to agree with that. 

 11 We are working with the Minneapolis 

 12 Grain Exchange on spread trading functionality 

 13 between our contracts and theirs. It seems pretty 

 14 easy or on the surface it seems pretty easy when 

 15 you have two products traded on the same platform 

 16 on Globex as Mark mentioned to allow intermarket 

 17 spread trading between those, but of course we're 

 18 separate self-regulatory organizations, we don't 

 19 clear at the same clearinghouse, and then really 

 20 just the functionality of integrating order books 

 21 in the component legs with the spread order book 

 22 is something that takes quite a bit of work on the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 97 

 1 matching engine. So we're working on it and, Dan, 

 2 those are my comments. I think you make some good 

 3 observations. I think that the convergence issue 

 4 is more complicated than just saying it's index 

 5 funds. 

 6 MR. KASS: Dan, I guess I would echo 

 7 that. It's I think not so much that we've 

 8 eliminated index trading as having any influence 

 9 on convergence even though we've not seen any 

 10 demonstrable correlation between the size. 

 11 Sometimes the amount of index trading has been 

 12 large and we get excellent convergence and 

 13 sometimes it's small and we don't get convergence. 

 14 I think the point is that it's not the smoking 

 15 gun. There needs to be more research done. It's 

 16 the data on it, and I thank Dave Lehman for the 

 17 observation that we have added this transparency 

 18 and we hope to add some additional transparency 

 19 with this special call project that we're working 

 20 on and we owe a report by mid-September. 

 21 It's a confluence of so many things. 

 22 It's a world wheat contract, the Australians come 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 98 

 1 in here, the Canadians, the Europeans, anybody who 

 2 wants to hedge wheat, they go to where there's 

 3 liquidity and all that influence. But as Mr. 

 4 Coyle said, the bottom line is at some point it 

 5 has value and it's being reflected in the basis 

 6 and the actual price that it's exported and 

 7 traded, that represents the value and the futures 

 8 price is something above that as it turns out. 

 9 So, no, we're not seeing a high 

 10 correlation between the amount of index trading. 

 11 I think more research needs to be done and I 

 12 understand there are some efforts now and that 

 13 researchers don't like to work with 6 months or a 

 14 year's worth of data, even 2 or 3 years is really 

 15 a scant amount of information to do research, but 

 16 that's what we're left with in terms of this. I 

 17 think there are a lot of things happening here. 

 18 It's what we're not seeing. It's not the smoking 

 19 gun, it's not a clear correlation, and I think 

 20 that's where we come out. 

 21 MR. DUNN: Mark? 

 22 MR. BAGAN: I want to follow-up on a 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 99 

 1 point that both the two Daves just made here and 

 2 that is the unintended consequences of limiting 

 3 passive money in the marketplace. That money is 

 4 going to be in the marketplace regardless of 

 5 whether the CFTC limits passive money in there or 

 6 not. The real question is one of transparency in 

 7 my eyes and that is if the CFTC further limits 

 8 passive money coming into the agricultural 

 9 markets, that's just going to go to the OTC market 

 10 or to the swap market and it's my belief, and a 

 11 very strong belief of mine, that all market 

 12 participants including producers, elevators, grain 

 13 companies, they're all better served by having 

 14 those transactions take place on a regulated 

 15 market. 

 16 MR. DUNN: Roger, on this same subject? 

 17 MR. CRYAN: On defining hedging? 

 18 MR. DUNN: One moment because 

 19 Commissioner Chilton I believe wanted to address 

 20 this particularly. 

 21 MR. CHILTON: I just wanted to mention 

 22 two things. I agree with Mr. Kass who is just an 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 100 

 1 exceptional public servant and gives us great 

 2 information every Friday but that we need some 

 3 more research. Dave Lehman you've mentioned this 

 4 Purdue study and it's just possible that Purdue is 

 5 about the best school in the universe, so I 

 6 couldn't let it go without saying something. But 

 7 I don't agree with the conclusion that you read. 

 8 I read the report and it doesn't say speculators 

 9 have no impact, it says, "While the effects of 

 10 supply and demand on commodity prices are clear, 

 11 the effect of changes in the structure of the 

 12 commodity markets, in particular increased 

 13 speculative activity, are not. There is no doubt 

 14 that the amount of hedge funds and other new 

 15 monies in the commodity markets has mushroomed. 

 16 Price volatility has increased partly due to 

 17 trading volume. Based on existing research it's 

 18 impossible to say, it's impossible to say, whether 

 19 price levels have been influenced by speculative 

 20 activity." The sort of questions that Dan is 

 21 asking is where I was going earlier in my 

 22 comments, that people feel very strongly like you 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 101 

 1 do that it's not having an impact, but smart 

 2 people disagree on this and we're the ones who are 

 3 supposed to be making policy and I'd rather have 

 4 some pretty good information. That was my point 

 5 about some blue ribbon study, somebody who's not 

 6 connected with anybody, the best and brightest in 

 7 academia. That was my point. Thanks. 

 8 MR. DUNN: Thank you, Commissioner. 

 9 Dan, if I could get you to turn off your 

 10 microphone. Thank you very much. Let's go to 

 11 Roger and then we'll go to Joe. 

 12 MR. CRYAN: I wanted to make the point 

 13 about the hedge exemptions and the speculative 

 14 limits. I think that as the CFTC has moved toward 

 15 a lot more work on financial stuff there's been 

 16 kind of a fuzzing of the understanding of what 

 17 hedging is and I thought that this had been 

 18 addressed by the Commission I had hoped for good, 

 19 but there's a difference between financial hedging 

 20 and physical hedging on the commodities markets 

 21 and I think the Commission has recognized that and 

 22 I think it's very important to recognize that the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 102 

 1 speculative limits and these hedge exemptions were 

 2 established a long time ago for reasons that 

 3 really didn't anticipate exemptions or there isn't 

 4 really a justification for exemptions for 

 5 financial hedging on the commodity markets as 

 6 having exemptions. That's all I waned to say. 

 7 MR. DUNN: Thank you, Roger. Joe? 

 8 MR. NICOSIA: A couple comments about 

 9 what we just heard. One is I think that we're 

 10 kind of missing the point a little bit on some of 

 11 the research being done on index flows and index 

 12 positions. It's not a question of whether they're 

 13 causing high prices or not and to the correlation 

 14 -- if you get a negative correlation against high 

 15 prices is really useless. The question isn't are 

 16 index funds causing high prices. The question is 

 17 are they causing higher prices. Therefore, the 

 18 correlation to price in and of itself doesn't tell 

 19 you the answer to that whatsoever. So the 

 20 research really has to be done on whether if 

 21 anyone can honestly believe that by creating an 

 22 additional demand point the only way to bring any 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 103 

 1 selling against that is to bring in additional 

 2 risk takers, those risk points of equilibrium that 

 3 take place at higher levels, they have to take 

 4 place at higher price levels. Otherwise the 

 5 conclusion would be that at any point in time you 

 6 can bring in any amount of buying and it would not 

 7 change prices whatsoever and we all know that's 

 8 not true. 

 9 The convergence problem issue comes to 

 10 really rear its head in some of the smaller and 

 11 medium markets and when we see the index money 

 12 that becomes such an overwhelming percentage of 

 13 both the open interest or the crop sizes, that's 

 14 where the convergence stars to break down 

 15 severely. It happened in cotton to a great 

 16 extent, it's happened to wheat to a great extent, 

 17 and in both of those cases the index fund position 

 18 alone exceeded the crop size or the carry-outs 

 19 that existed at that time and it was simply a 

 20 cornering of the marketplace. 

 21 When the index funds position, and some 

 22 people say if they're not in the delivery market 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 104 

 1 they don't necessarily maintain any effect on cash 

 2 price. We saw earlier I think in Terry's study 

 3 showing that the cash-and- carry situation, even 

 4 if you're in the second month or the third month 

 5 out, those long positions create demand points and 

 6 they do draw the necessity for supply and it can 

 7 draw in the form of capital being moved forward. 

 8 So the fact that they're not in the delivery 

 9 market doesn't really remove the issue from it. 

 10 Lastly, I thought it was interesting 

 11 what Mark just said about the passive money and 

 12 where it's going to go and that if we try to rein 

 13 it in or limit it that just like water it's going 

 14 to seek another level, go to the OTC marketplace 

 15 or the swap marketplace, and I agree with that 

 16 which is why it's so critical for the CFTC to take 

 17 a leadership role in being able to aggregate these 

 18 positions, to get all the information from them, 

 19 and to not allow people to circumvent the laws and 

 20 the rules simply by trying to go to a marketplace 

 21 that is unregulated or is unaccumulated. So if 

 22 you're not going to turn around watch the OTC 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 105 

 1 marketplaces or the swap marketplaces or 

 2 accumulate them, then remove position limits 

 3 totally because the only person you're hurting is 

 4 the person who is playing by the rules and who 

 5 stays in the commodity. 

 6 MR. DUNN: Thank you, Joe. I know we've 

 7 got a couple folks in the audience who would like 

 8 to say something. Are there any other ag 

 9 advisers? Let me go back to the back here and 

 10 then I'll come back to you. 

 11 MR. COYLE: I want to make a comment on 

 12 a couple of things. One, referring to what Joe 

 13 said, I think we might be able to make an 

 14 observation that the sheer size of the index 

 15 length is actually reducing liquidity in the 

 16 market which as a result is increasing the 

 17 volatility. Secondly, the sheer size is also 

 18 adding to an overall base in prices that is 

 19 creating the convergence problem. But the 

 20 statistics in your report are kind of interesting 

 21 and maybe answers Dave's question related to why 

 22 the charts from the CME demonstrate how the price 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 106 

 1 is going up while the index share of open interest 

 2 is actually going down. If you look at the open 

 3 interest from CIT when the report was started back 

 4 in January 2006 and then compare that to right 

 5 before the open forum it shows a small increase, 

 6 probably a 10-percent increase, in the index 

 7 length. Since that time there's been a reduction 

 8 in that, but during the same time from January 

 9 2006 to right before the forum we actually saw a 

 10 significant increase in the noncommercial position 

 11 which went from a significant short of 33,000 to 

 12 basically an even position. So during that 2-year 

 13 timeframe we actually saw the noncommercial length 

 14 buying and actually was twice as big as the index 

 15 funds. That would explain why the share of the 

 16 index funds actually went down and also might be 

 17 able to explain why the prices rallied to the 

 18 extent they did, also supported by the commercial 

 19 factors with right supplies around the world, but 

 20 you had this noncommercial buying. 

 21 It's interesting that since the forum 

 22 we've actually seen a reduction in everything, but 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 107 

 1 the biggest change in the open interest is that 

 2 we've seen these noncommercials which were even, 

 3 they're now short 29,000 contracts which is three 

 4 times a big a change as saw in the reduction in 

 5 the CITs which means you had the noncommercials 

 6 getting short again. That may again describe why 

 7 the futures market is significantly lower than it 

 8 was 3 months ago again supported by the 

 9 fundamentals that have changed as well. But I 

 10 think the breakdown of the numbers do demonstrate 

 11 why the market does what it does in hindsight. 

 12 MR. DUNN: Yes? 

 13 MS. LUDLUM: Kelli Ludlum with American 

 14 Farm Bureau. I just wanted to comment on 

 15 particularly Dave's comments about CME moving to 

 16 implement additional safety valve delivery points 

 17 and that's something that we've worked with you on 

 18 for a while, and particularly our Illinois Farm 

 19 Bureau has worked with you on as well. I would 

 20 also note that part of the problems that we hear 

 21 from producers is not just the availability of 

 22 delivery points but the availability to actually 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 108 

 1 deliver to those delivery points. So I think that 

 2 we also need to revisit the certificate process 

 3 and examine some other options maybe could go into 

 4 that. We would also like to see some additional 

 5 biofuels delivery points added since that's an 

 6 option that more and more of our producers are 

 7 using. We're very appreciative that we've been 

 8 calling for additional delivery points for a while 

 9 and appreciate you looking into that, but as you 

 10 move forward those are two additional things that 

 11 we think need to be taken into account to make 

 12 sure that what we do really does address the 

 13 problem of producers being able to deliver on a 

 14 hedge and with the possibility that will also help 

 15 with the Commission problems. 

 16 MR. DUNN: Gregg, I think you had a 

 17 comment that you wanted to make. 

 18 MR. DOUD: Gregg Doud with the 

 19 cattlemen, but I'm old wheat guy as many of you 

 20 know. One of the things that you said, and I 

 21 think, Tom, your comments really hit it in 

 22 reaction to this. One of the things that I would 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 109 

 1 encourage the CFTC to look at is the participation 

 2 in the markets by Australia and Canada and their 

 3 influence on the fact that we have a very wide 

 4 basis level right up until we get ready for 

 5 delivery and then all of a sudden things really 

 6 begin to come together quite quickly when they do 

 7 come together. I'd be curious into a little 

 8 research of the fact that the term nonresponsive 

 9 kind of clicked with me, the fact that these guys 

 10 are hedging but they're not using our grain, 

 11 they're using their own. 

 12 MR. DUNN: Tom, do you have a response? 

 13 MR. COYLE: I can make one comment which 

 14 is quite interesting. A concern for the market is 

 15 that many of these foreign users who currently use 

 16 the CME wheat contract as a hedge for Black Sea 

 17 wheat, Australian wheat, and Canadian wheat, are 

 18 actually finding it more difficult. I know our 

 19 company is having a very difficult time so they're 

 20 less likely to use CME futures as a hedge today 

 21 because as they're long in another origin they're 

 22 finding that because they don't have the -- much 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 110 

 1 like we see in the U.S., they don't see the 

 2 correlation is strong either so they're finding 

 3 that selling futures which is a natural offset for 

 4 let's say an index -- it becomes a risk for them 

 5 so they're more likely to trade OTC or not hedge 

 6 futures. 

 7 MR. DUNN: In this same area, I have 

 8 also heard folks say that if we're going to 

 9 develop new delivery points that perhaps we need 

 10 international delivery points. Is that something 

 11 that's being thought about? 

 12 MR. LEHMAN: I'd like to respond to that 

 13 if I could. The international correlations, we 

 14 ran the correlations domestically and they looked 

 15 very good. I had my staff run them this morning 

 16 for foreign points, Rotterdam.93, Argentina.93, 

 17 Canada.82, and Australia.96. So this is something 

 18 that's another -- I can't think of the term I'm 

 19 trying to use -- but it's ironic that we're 

 20 talking about problems in using the markets, 

 21 problems with hedging effectiveness related to 

 22 convergence, but yet correlations have remained 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 111 

 1 very robust. Just a quick response to the 

 2 question about foreign participation and how the 

 3 markets are working, we are hearing from our 

 4 commercial users that they are doing less hedging 

 5 of their foreign wheat in CBOT wheat futures. I'm 

 6 not sure that it's hedging effectiveness that's 

 7 causing that as much as it might be issues related 

 8 to credit or volatility or a number of factors, 

 9 transportation perhaps. Looking at foreign 

 10 delivery points, they're not easy to design and 

 11 implement. We have some experience with that at 

 12 CBOT in our South American soybean contract but it 

 13 is something in terms of looking at a world wheat 

 14 contract we are actively pursuing. 

 15 MR. DUNN: Thank you. Do we have 

 16 members of the audience who wish to ask questions? 

 17 MR. KUNDA: Thank you very much, Mr. 

 18 Dunn. My name is Eugene Kunda with the University 

 19 of Illinois. If I may have just a few minutes to 

 20 elucidate or to educate a little bit about the 

 21 delivery process and maybe why in some ways we're 

 22 seeing a disconnect here, and then also propose a 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 112 

 1 solution simplistic as it might be, but I think 

 2 it's backed up with some examples that have worked 

 3 in the design of the contract. 

 4 First of all in the delivery process, 

 5 you do have two markets, a futures market and a 

 6 cash market. They two markets are distinct and 

 7 separate. They are however through the shipping 

 8 certificate market or the warehouse receipt market 

 9 or the delivery instrument market if you will. 

 10 That is the process from which you take a delivery 

 11 in the futures market of a delivery instrument 

 12 whether it be a shipping certificate or a 

 13 warehouse receipt and the holder of that has 

 14 rights and he has obligations. His obligations 

 15 are to pay the storage or in the case of a 

 16 shipping certificate where it doesn't actually 

 17 have to be physically stored it's called a premium 

 18 but it's the same effect as storage. Those are 

 19 his rights and obligations. It doesn't then enter 

 20 into the cash market until that holder either 

 21 sells that certificate back to the issuer, he may 

 22 sell a futures contract and redeliver it, so 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 113 

 1 neither of those two options that he has as the 

 2 holder of that certificate bring about that entry 

 3 and connection to the cash market. But until he 

 4 actually cancels that certificate or warehouse 

 5 receipt and requests a load-out does then the cash 

 6 market become involved in what would be a whole 

 7 process of delivery and load-out. 

 8 So first of all, you have to make it 

 9 clear in your mind that there are two different 

 10 markets, a futures market which I think by all 

 11 examination we've had is very successful, volume 

 12 is up, people are content, there are correlations, 

 13 people are using it. The cash market on the same 

 14 side we're hearing the same kinds of maybe the 

 15 sense that it's working fine, cash is providing 

 16 sources of commodities. So the link is the 

 17 certificate market so I'm going to propose a 

 18 solution to help with what may help us in that 

 19 particular segment, just looking at the 

 20 certificate market. The reason I'm proposing it 

 21 is because we've got examples of how we've worked 

 22 out these differences between the issuers and the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 114 

 1 takers and holders of these certificates in the 

 2 past, because there's an asymmetry in the markets, 

 3 I can give a little bit of an example, first of 

 4 all when you have the inversion or when cash is 

 5 greater than futures, there's no problem in 

 6 getting convergence because the long simply stands 

 7 for delivery, receives the shipping certificate or 

 8 warehouse receipt, then cancels it for load-out. 

 9 So you had both steps, delivery and load-out to 

 10 bring about convergence when cash is greater than 

 11 futures. It's a bit of a different situation when 

 12 cash is less than futures because that buyer 

 13 doesn't have the need to stand for delivery, he'll 

 14 just buy it in the cash where it's cheaper. 

 15 So what we did in the rules of the 

 16 Chicago Board of Trade when we designed the river 

 17 delivery system for that holder of less than 11 

 18 certificates was created a little cake auction. 

 19 If you remember back when you were a kid and you 

 20 had one candy bar and it was your sibling who you 

 21 needed to split it with, it was one person cuts, 

 22 the other person chooses, the cake auction. We 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 115 

 1 did that with the less than 11 certificates for 

 2 the holder that you needed 11 certificates, 55,000 

 3 bushels, to load a barge and if you had less than 

 4 11, then you were closed out of any options to do 

 5 anything. So the rules state that the holder of 

 6 less than 11 can present them to the issuer and 

 7 request either that that issuer supply the other 

 8 number of certificates needed to fill the barge or 

 9 buy those that they're holding back at a price, 

 10 and it's one price that's determined by the 

 11 issuer. So the issuer now has in his mind two 

 12 options. Do I want to give them a price that's 

 13 low if I have grain that I can just go ahead and 

 14 load the barge, or if I don't have grain, maybe I 

 15 have to have a higher price so I can buy those 

 16 back. So it's always in the decision to be made 

 17 by the shipper at which price that they want to 

 18 either load the barge or buy them back. 

 19 So let's take this same example and 

 20 apply it now to the situation of the shipper, of 

 21 the issuer, because we're hearing in the solutions 

 22 that are being proposed two general areas of 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 116 

 1 solutions, to either change the storage rates or 

 2 to force a load-out. So let's marry those two 

 3 possibilities into one and give the shipper a call 

 4 on either one. In the previous example it was the 

 5 holder who had the call on whether to load the 

 6 barge or buy their certificates back, now what we 

 7 want to do is keep the symmetry and allow the 

 8 issuer to have the option of either requiring the 

 9 holder to load out or pay a higher storage. So 

 10 you've married the two concepts and it has to be 

 11 in the mind of the holder who has the rights of 

 12 these certificates. They're in his hand and so 

 13 what he is going to now present to the issuer is a 

 14 price, and now the issuer then who is either 

 15 demanding a load-out, that's what he wants, or he 

 16 wants more storage, that's what he wants, and he 

 17 is given a call to the holder to give him a price. 

 18 So the holder now can say I will either give you a 

 19 price in my mind at which I am willing to pay you 

 20 more storage until the next delivery period 

 21 perhaps, so it's just for that increment of the 

 22 month because then it could be another call, or 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 117 

 1 this is the price that I know it's going to cost 

 2 me as the holder because remember I don't have to 

 3 load out, all I have to do is pay the storage 

 4 charge, but if you're going to force me to load 

 5 out, it's going to cost me something so it's going 

 6 to cost me some cents. So I'm going to give you a 

 7 cents number, 5 cents, 10 cents, whatever, for the 

 8 rest of the month because you're talking about 

 9 doubling the storage 4-1/2 cents, I'm going to 

 10 give you that number, and then as an issuer you're 

 11 going to have to decide whether you're going to 

 12 pay me that to load out now or you'll be willing 

 13 to take from me to store it for the rest of the 

 14 month. 

 15 MR. DUNN: Thank you, Gene. I 

 16 appreciate that. If you have that in a written 

 17 piece and could submit it to us. 

 18 MR. KUNDA: -- today. 

 19 MR. DUNN: Thank you. Jack Gaine, and 

 20 then we'll go to Tom Erickson. 

 21 MR. GAINE: Thank you, Commissioner. 

 22 This is a terrific gathering of more expertise on 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 118 

 1 the subject matter than I imagined you could put 

 2 together anywhere. But I can't help conclude as a 

 3 lawyer that it really confirms what Congress did 

 4 in 1974 in creating this Commission as an expert 

 5 independent body. This discussion here, and I 

 6 think I agree with Commissioner Chilton in that of 

 7 course we always need more data, we need more 

 8 analysis, but the complexity of foreign versus 

 9 domestic, who's in, who shouldn't be in, who's not 

 10 in these markets lend itself to this kind of forum 

 11 with this kind of body. I don't see how the 

 12 legislative process ever could grapple in any 

 13 meaningful way the way this group has done it this 

 14 morning and I commend you for that and I hope that 

 15 Congress is appreciative of that fact. That's my 

 16 first point. 

 17 But more importantly, I want to correct 

 18 what I consider a fairly material 

 19 misrepresentation by Commissioner Chilton, and I 

 20 think that this is something that Walt Lukken 

 21 would agree with. Purdue is not even the best 

 22 school in Indiana. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 119 

 1 MR. LUKKEN: It's not in South Bend 

 2 either. 

 3 MR. DUNN: We'll let the Boilermakers 

 4 and the Fighting Irish figure this out later on. 

 5 Tom? 

 6 MR. ERICKSON: Thank you, Commissioner. 

 7 This has been a great discussion and I think the 

 8 last part of this has been pretty insightful as 

 9 well because I know we as a company have expressed 

 10 to you, Dave, and I think others have, that we're 

 11 very concerned about the precarious situation the 

 12 Chicago wheat contract is in today. I think 

 13 that's in part why we're seeing a fair amount of 

 14 sea change as reflected in Tom Coyle's comments as 

 15 well in looking at what can be done now, and I 

 16 think that's one of the things that struck me as 

 17 you, Dave and Tom were both presenting here 

 18 earlier today. 

 19 I think one of the things that brings us 

 20 here is the issue of convergence and in the NGFA 

 21 presentation in going through all the various 

 22 options the one change that gets us to convergence 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 120 

 1 is some kind of a demand certificate or forced 

 2 load-out. I noted, Dave, that there seemed to be 

 3 a little bit of reluctance to move quickly on that 

 4 from the exchange's perspective given that adding 

 5 delivery points and increasing storage rates may 

 6 get us somewhere. Is that a short-term solution 

 7 to really finding a solution to getting us to 

 8 convergence? 

 9 MR. LEHMAN: Thanks, Tom. To be really 

 10 honest with you on that, I think the reluctance on 

 11 implementing a forced load-out or delivery receipt 

 12 mechanism is really one that we aren't sure how 

 13 that concept would work for all sides of the 

 14 market, how it might upset the balance of the 

 15 market between short hedgers and long hedgers, and 

 16 I think we just have to have a better 

 17 understanding of what the implications of that 

 18 would be on the whole market. If we do reach that 

 19 understanding, and this is what I think I'd heard 

 20 Tom say, they'd like to work with us over the next 

 21 60, 90, or 120 days to try to figure out, then we 

 22 have some alternatives in terms of implementation. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 121 

 1 It's something that I don't you could implement on 

 2 the existing contract but there are other ways to 

 3 approach that of listing a side-by-side contract, 

 4 the same would be true if you moved to an index 

 5 settlement contract, it would be such a dramatic 

 6 departure from where we are today that I think you 

 7 would have to come up with an innovative way to 

 8 implement it. So those are some thoughts I have 

 9 on that, Tom. 

 10 MR. DUNN: Neal? 

 11 MR. GILLEN: I agree with John Gaine 

 12 that we've had a very stimulating discussion. But 

 13 overriding the obvious which is brought out by Mr. 

 14 Brophy and Mr. Nicosia that the additional 

 15 speculation may be creating higher prices. We're 

 16 talking about solutions to how to remedy this and 

 17 we're not talking about eliminating it. In its 

 18 findings when Congress created the Commodity 

 19 Exchange Act it indicated right on the first page 

 20 that the primary purpose of the Act was for price 

 21 discovery in hedging and we don't have that in the 

 22 contracts we're discussing this morning. So I 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 122 

 1 think the Commission has to deal with the obvious 

 2 and not make all these little fixes here and there 

 3 in contracts. I think you got to get at the 

 4 overriding issue and that's what the Congress is 

 5 telling you. That's what the people are telling 

 6 the Congress. 

 7 MR. DUNN: Thank you, Neal. Are there 

 8 any questions or comments from the members of the 

 9 Commission? I still start with Commissioner 

 10 Sommers. Commissioner Chilton? 

 11 Let me thank this first panel. You have 

 12 done an excellent job. Mr. Gillen, I think you 

 13 did wrap it up very succinctly for us, that there 

 14 is pressure for some action for some relief out 

 15 there and this is a core principle that the 

 16 exchanges must to adhere to, a normal operation of 

 17 the exchanges and if folks cannot use this for 

 18 price discovery and cannot use it to mitigate the 

 19 risk, then we have a fundamental problem that we 

 20 need to look at. I am encouraged about the amount 

 21 of interaction between the industries of coming up 

 22 and looking at solutions, but I do feel that there 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 123 

 1 is a sense of urgency that something comes out of 

 2 this. 

 3 Our next panel was to look at settlement 

 4 of prices, margin requirements, and credits, and 

 5 we were supposed to have a 20-minute break in 

 6 there and we went through that break process 

 7 because of the intense amount of concern here. 

 8 What I'd like to do is take a 5-minute break to 

 9 allow the next panel to get in place but also 

 10 remind people that our bio break facilities are 

 11 very limited here so if you need to those, feel 

 12 free to do it throughout the time period. But 

 13 let's take about a 5-minute break and try to get 

 14 back near schedule. Thank you. 

 15 (Recess) 

 16 MR. DUNN: We are running a bit behind 

 17 schedule. The Acting Chairman and Commissioner 

 18 Chilton said they're going to be tied up for just 

 19 a few minutes but they will be right back. So 

 20 let's begin with our next panel and talk about 

 21 settlement prices, margin requirements, and 

 22 credit. Again the bios on the presenters are in 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 124 

 1 your packets so I'm not going to go through that, 

 2 but we're going to hear about settlement prices in 

 3 times of high volatility, and Tom Farley will be 

 4 talking about that, with coordinating actions in 

 5 price limits by Jeff Borchardt, so we'll have an 

 6 opportunity here to hit two more of the exchange 

 7 operators right off the bat. Then we're going to 

 8 hear Dan Brophy talk about the role of exchanges 

 9 and clearinghouses and margin requirement. Then 

 10 the issues with margin credit by Phil DiProfi and 

 11 Sam Miller. Phil is with Co-Bank and Sam is with 

 12 American Bankers. With that if we can get 

 13 started. Tom? 

 14 MR. FARLEY: Thanks so much, 

 15 Commissioner Sommers, and especially Commissioner 

 16 Dunn for hosting this meeting and having me here 

 17 today. I appreciate it. 

 18 Back in April, on April 22, I believe it 

 19 was, at the roundtable meeting of the Ag Advisory 

 20 Committee, we at ICE Futures U.S., the former 

 21 NYBOT, were fresh off an interesting experience in 

 22 the cotton market. The cotton market experienced 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 125 

 1 essentially a perfect storm in early March. There 

 2 were three factors or waves if I can extend the 

 3 storm metaphor that crashed into one another. The 

 4 first is the credit crunch in general, tightening 

 5 lending standards as it impacted the cotton 

 6 industry. The second was gradually rising prices 

 7 of all commodities, but cotton in particular. The 

 8 price of cotton went from 52 cents at the end of 

 9 February 2007 to 79 cents at the end of February 

 10 2008. The third factor was as the price of cotton 

 11 increased dramatically, the cash markets for 

 12 cotton largely shut down as buyers were resistant 

 13 to pay this higher price for cash cotton, and 

 14 similarly related, sellers were resistant to sell 

 15 cash cotton for a lower price than was reflected 

 16 in the futures market. So that set the stage for 

 17 trading February 29, March 3, and March 4, where 

 18 the price of cotton in the nearby contract closed 

 19 at 79 cents on February 28 and we used a 

 20 settlement price for margin purposes of 94 cents 

 21 on March 3, just 2 trading days later. So that's 

 22 an increase of 26 cents, greater than 20 percent 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 126 

 1 in just 2 trading days. 

 2 That trading activity raised a few 

 3 fundamental questions which were raised here at 

 4 the roundtable, and the roundtable I should add 

 5 really helped facilitate conversations about both 

 6 of those issue. One question was, were index 

 7 funds and/or speculators behind that dramatic 

 8 price increase, particularly March 3 where the 

 9 price went from 81 cents to 94 cents in a single 

 10 day? Clearly a very dramatic move. We have 

 11 researched that, in part taking feedback at the 

 12 roundtable meeting on April 22, and we found that 

 13 there was no significant buying activity from 

 14 index funds or speculators, inclusive of swap 

 15 dealers, during those days, February 29, March 3, 

 16 March 4. So we've come to some conclusion on that 

 17 question. 

 18 But a second question equally important 

 19 and perhaps more confounding was do we have the 

 20 appropriate margining approach at ICE Futures U.S. 

 21 for margining futures in an extreme price move 

 22 scenario? So please let me explain here if I can 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 127 

 1 flip to the first slide. On the chart you see the 

 2 4 days that I described, February 28, February 29, 

 3 March 3, March 4. The blue line represents the 

 4 limit up price of cotton which is the official 

 5 exchange settlement. But we at the exchange have 

 6 a long-standing clearinghouse role to use 

 7 synthetic prices to margin cotton futures. 

 8 Synthetic prices are the prices being discovered 

 9 in the options pit and it's very easy to derive 

 10 what the equivalent futures price is from looking 

 11 at trading in the options pit. The reason you 

 12 would look at options trading is because we have a 

 13 limit up price for futures on a day where the 

 14 price spikes dramatically, the futures top trading 

 15 so you only have the options markets that are 

 16 still trading. 

 17 So on March 3 we margined at 93.9 cents 

 18 as you can see on the chart as opposed to a limit 

 19 up price of 84.9 cents. Keep in mind the price 

 20 stated that day at 81.9 cents. This move as you 

 21 would expect put extreme stress on the short 

 22 hedging community as they had to pay variation 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 128 

 1 margin for their short hedge positions based on a 

 2 13-cent move. Very, very dramatic. So the 

 3 question from industry was, is that the 

 4 appropriate margin technique or should we consider 

 5 using the limit up price. So we came to this 

 6 April 22 CFTC meeting and we discussed this at 

 7 length. We then went away and caucused with the 

 8 industry. We have a Cotton Contract Committee 

 9 that comprises mainly the leaders of the cotton 

 10 industry, Joe represents Dreyfuss now and -- is 

 11 here today as well as many others on our Cotton 

 12 Contract Committee. Ultimately we revised our 

 13 rules and now we use an approach where in a limit 

 14 up or limit down situation, we use that limit up 

 15 or limit down price to margin futures. The 

 16 clearinghouse as always and as with other 

 17 exchanges reserves the right to use another price 

 18 in some extraordinary circumstance, but by and 

 19 large we don't expect that to be the case. 

 20 This new rule gives the short hedging 

 21 community in a price rise environment more time to 

 22 put together financing to be able to pay their 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 129 

 1 variation margin. Coupled with this change in 

 2 margining policy, we also agreed to expanding 

 3 limits, and I give credit to Jeff here and our 

 4 friends Mark Bagan and Dave Lehman. We followed 

 5 their exchange model for expanding limits into 

 6 certain of their agricultural products and so now 

 7 in cotton if the price is limit up on day one if 

 8 it's a 3-cents limit, if it's limit up on day 2, 

 9 the limit goes to 4 cents and so on. 

 10 Finally, I'd just like to point out that 

 11 we resolved those questions, but there are still 

 12 more questions and it seems like there are always 

 13 difficult questions when it comes to risk 

 14 management, margining, and volatility, but I 

 15 wanted to share a few of those with you. One 

 16 question that we're dealing with actively is how 

 17 best to set margins for options contracts. During 

 18 these limit up, limit down situations, the options 

 19 on our exchange continue to trade freely and that 

 20 provides price discovery. But one thing we're 

 21 considered with the Cotton Committee is is it 

 22 prudent to -- I went out of order so if you're 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 130 

 1 following the slides I hope I didn't confuse you. 

 2 I'm on the third point here. But one thing we're 

 3 considering with the Cotton Committee is the model 

 4 that's used by for instance the CME the best 

 5 approach for setting margins on options contracts. 

 6 A second question, the first question on the 

 7 slide, is how best to set margins for options 

 8 contracts because right now we're in a situation 

 9 where we use the traded prices for options as they 

 10 are in the options pit, but yet we use the limit 

 11 up price for futures. So you can imagine an 

 12 options trader who's long a synthetic future in 

 13 the options pit, he's short a real future, and yet 

 14 our clearinghouse is going to tell him he has risk 

 15 even though in theory he has no risk, he's long a 

 16 future and he's short a future. So it's a bit of 

 17 a screwy situation. 

 18 Finally, the third point is do price 

 19 limits contribute to volatility and even if they 

 20 do contribute to volatility is the positives that 

 21 they bring to the market, namely some more 

 22 financing security and some more time to be able 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 131 

 1 to make these variation margins, does that 

 2 outweigh a potential con of contributing to 

 3 additional volatility. So there are more 

 4 questions for us to consider as a exchange, with 

 5 industry, maybe a future meeting of the 

 6 Agricultural Advisory Committee. Thank you very 

 7 much. 

 8 MR. DUNN: Thank you, Tom. Jeff 

 9 Borchardt, would you give us a little background 

 10 on the coordination of the actions in price limits 

 11 that Tom just mentioned? 

 12 MR. BORCHARDT: Thank you, Commissioner. 

 13 I appreciate the opportunity to brief the 

 14 Committee on the events leading up to and the 

 15 actions taken earlier this year by the Chicago 

 16 Board of Trade, the Kansas City Board of Trade, 

 17 and the Minneapolis Grain Exchange in coordinating 

 18 increased wheat futures price limits. 

 19 The actions taken by the exchanges were 

 20 necessary and prudent to restore the market's 

 21 price discovery and transparency functions. We 

 22 applaud the Commission for recognizing the need 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 132 

 1 for swift action to alleviate the constraints on 

 2 trade and for working closely with the exchanges 

 3 to approve the increased price limits on a very 

 4 fast-track basis. 

 5 The run-up in wheat prices from April of 

 6 last year to February of this year is attributed 

 7 to several factors in what is commonly referred to 

 8 as a perfect storm of events, namely, the Easter 

 9 weekend hard freeze and subsequent flooding in the 

 10 winter wheat belt, the second consecutive year of 

 11 severe droughts in Australia coupled with 

 12 production declines in both the E.U. and Canada, 

 13 projected world grain usage outpacing production 

 14 gains, USDA forecasts of U.S. wheat stocks at 

 15 60-year lows, global wheat stocks at 30-year lows, 

 16 and the lowest grain stocks- to-usage ratio since 

 17 the USDA began tracking this data back in 1960, a 

 18 weaker U.S. dollar resulting in increased wheat 

 19 exports and reduced domestic stocks, and export 

 20 demands or tariffs instituted by other 

 21 governments, namely, Russia, India, China, and 

 22 Argentina, resulting in the U.S. becoming the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 133 

 1 reliable global supplier of wheat. 

 2 As the price of wheat increased last 

 3 year, the three grain exchanges began experiencing 

 4 an increasing frequency of price limit moves, in 

 5 particular, when wheat reached $8 a bushel in 

 6 September of last year. Minneapolis hit their 

 7 limit on 16 of 21 business days in January and 

 8 every business day in February leading up to the 

 9 price limit change. The consecutive limit moved 

 10 days of February 4 through 8, and all three wheat 

 11 exchanges encumbered the market's ability to 

 12 discover price and conduct trade. Something had 

 13 to be done quickly for the critical price 

 14 discovery function to resume. 

 15 Later in the week of February 8 the 

 16 three exchanges began discussions of a coordinated 

 17 increase in daily price limits. All agreed that a 

 18 coordinated price limit effort would best serve 

 19 the industry because of the significant 

 20 intermarket spreading activity that goes on 

 21 between the three wheat contracts and also to 

 22 lessen confusion that might arise from the markets 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 134 

 1 having differing limit provisions. 

 2 As a result, the three exchanges filed 

 3 for identical increased price limits that became 

 4 effective on February 11 and set forth an initial 

 5 price limit of 60 cents per bushel and expanded 

 6 limits provisions that increased by 50 percent 

 7 each time those limits are reached. The trigger 

 8 for the expanded limits was when 2 months within a 

 9 crop year closed limit bidder offer and the 

 10 expanded limits remained in effect until no 

 11 contract closed limit bid or offer for three 

 12 consecutive business days. 

 13 When the markets opened on February 11 

 14 with the new 60-cent price limit, price discovery 

 15 resumed. The new price limit provisions worked 

 16 well and the three wheat markets were once again 

 17 able to conduct business under either the initial 

 18 or expanded price limits. After a few weeks of 

 19 experience with the new price limits, the wheat 

 20 markets compared notes and discussed minor changes 

 21 to the price limit provisions. The catalyst for 

 22 this discussion was input and suggestions offered 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 135 

 1 by both commercial market participants and also 

 2 FCMs. Among the changes discussed were, number 

 3 one, capping the expansion provisions so that 

 4 institutions financing margin requirements would 

 5 have a better idea of the maximum daily amount 

 6 that would be required to fund variation margin. 

 7 Secondly, setting the trigger for expanded limits 

 8 based on contract months where the majority of 

 9 open interest in trade resides thereby eliminating 

 10 the possibility that lesser liquid back months can 

 11 cause the expansion of limits. And finally, the 

 12 ability to contract or decrease the price limits 

 13 as quickly as they expanding resulting in 

 14 additional flexibility in regulating margin 

 15 requirements and current limits that are more 

 16 reflective of actual market pressures. As a 

 17 result of these discussions, Chicago and Kansas 

 18 City agreed to move ahead with coordinated price 

 19 limit amendments. Minneapolis determined that 

 20 they were better served by the existing price 

 21 limit provisions due to the continued extreme 

 22 volatility in hard red spring wheat at the time. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 136 

 1 Chicago and Kansas City filed for and received 

 2 approval from the Commission of price limit 

 3 amendments that became effective on Friday, March 

 4 28. The changes covered all three areas addressed 

 5 by the industry input. We capped the expanded 

 6 limit provisions at $1.35 a bushel maximum. The 

 7 trigger for the expanded limits became now when 

 8 two of the front five months closed limit bid or 

 9 offer. And finally, any day that the market is 

 10 under an expanded price limit level and does not 

 11 close limit bid or offer, the market reverts back 

 12 to the preceding price limit level. That way you 

 13 have price limits that come back down in the same 

 14 fashion that they expand. 

 15 In summary, the coordinated action taken 

 16 by the three wheat exchanges worked well to resume 

 17 the price discovery and transparency functions 

 18 that are of paramount importance to our markets. 

 19 The coordinated effort provided the marketplace 

 20 with a relatively uniform set of price limit rules 

 21 to apply in order to minimize the possibility of 

 22 significant intermarket spread disconnects and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 137 

 1 maximize convenience in application. The 

 2 effective resolution of this market predicament is 

 3 a laudable example of exchanges, regulators, and 

 4 industry working together to recognize and very 

 5 quickly address a significant market issue. Thank 

 6 you. 

 7 MR. DUNN: Thank you, Jeff. With the 

 8 increased price limit there was also a 

 9 corresponding increase in the margin calls. I'd 

 10 like to have Steve Hurst with Merchants' Exchange 

 11 talk about the new concept of margin credit swaps. 

 12 MR. HURST: Thank you, Commissioner 

 13 Dunn, and thanks to the rest of the Commission and 

 14 staff for inviting us to participate in this 

 15 forum. It's always illuminating to be able to 

 16 hear first hand about problems that are facing the 

 17 industry. I have the happy task today of being 

 18 able to tell you about a project that we've 

 19 undertaken that has the promise of bringing a 

 20 solution to the margin credit swap problem that 

 21 has been so much in the news of late. 

 22 The Merchants' Exchange has been working 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 138 

 1 with other members of the industry to develop a 

 2 swap product. We'll describe it here in a little 

 3 more detail in a moment with the help from Gene 

 4 Kunda from the University of Illinois. The 

 5 concept is really quite simple. For a 

 6 merchandiser who has a short position on to hedge 

 7 a cash purchase, when the margin call is made 

 8 there will just by the nature of the market always 

 9 be someone on the other side, a corresponding long 

 10 position. We have developed a financing 

 11 instrument that will enable longs to provide 

 12 financing assistance to the short side to hedgers 

 13 who are in need of financing assistance to be able 

 14 to make margin calls. The point that I want to 

 15 make before we get into the mechanics of this is 

 16 that this has been a solution that has been 

 17 underway for about 6 months. We began working 

 18 with the Chicago Mercantile Exchange, with the 

 19 Kansas City Board of Trade with Jeff's assistance, 

 20 most recently with the Minneapolis Grain Exchange. 

 21 We've had a lot of assistance from the Commission 

 22 and its staff providing us guidance with regard to 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 139 

 1 how our product will be regulated. The National 

 2 Grain and Feed Association has been very active in 

 3 providing input and guidance with regard to the 

 4 structure of this product. And I'm pleased to be 

 5 able to report that we have transactions underway 

 6 as part of a pilot program today. These 

 7 transactions are being conducted in the 

 8 over-the-counter market in preparation for the 

 9 exchanges to be able to accept these trades into 

 10 their clearing systems. 

 11 The concept is that if a hedger needs 

 12 financing in order to be able to get a hedge off 

 13 at the Chicago Mercantile Exchange, that the swap 

 14 will be cleared at the Chicago Mercantile 

 15 Exchange. If the hedge is to be made at the 

 16 Kansas City Board of Trade and financing 

 17 assistance is needed, the swap will be cleared at 

 18 Kansas City. The same at Minneapolis. If it's in 

 19 the wheat product at the Minneapolis Grain 

 20 Exchange, the hedge will be cleared by the 

 21 clearinghouse at the Minneapolis Grain Exchange. 

 22 The message that I'd like to deliver in concluding 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 140 

 1 my remarks is that this truly has been an industry 

 2 effort. It is a work in progress. We are in the 

 3 midst of a pilot program and we thank the 

 4 Commission for providing us with the guidance and 

 5 the ability to move forward with this experiment. 

 6 With that I'd like to introduce Gene 

 7 Kunda from the University of Illinois who is the 

 8 architect of the product. 

 9 MR. KUNDA: Thank you, Steve. Thank 

 10 you, Commissioner Dunn and others who have allowed 

 11 us to again participate in this meeting with what 

 12 we hope would be a potential solution. 

 13 The margin credit swap was again 

 14 inspired by the forum that you had last April in 

 15 addressing some of the issues that were brought up 

 16 then particularly in financing margins. If I 

 17 could have the overhead, please. The description 

 18 of the product is what I'm going to focus on in my 

 19 brief comments here in terms of preserving the 

 20 existing relationships of the cash market between 

 21 the grain elevator, the farmer or producer that 

 22 they're forward contracting with, and their 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 141 

 1 consumers who they will be selling with in yellow, 

 2 as well as the existing exchanges in which they 

 3 use to hedge those positions whether it be at CME, 

 4 Minneapolis, or Kansas City, the designated 

 5 contract market. We want to preserve those 

 6 relationships and not affect the pricing or the 

 7 merchandising activity or the hedging that is 

 8 committed to those purchases. 

 9 What we've done is create an additional 

 10 product called the margin credit swap which would 

 11 mirror those referenced contracts that are being 

 12 hedged so that the contract terms of the swap are 

 13 identical to the contract terms of the underlying 

 14 hedged contract. But what you would take a 

 15 hedger, and in this example uses a short hedger, 

 16 you're short on the futures market, you're long 

 17 cash, you bought from the farmer and you're short 

 18 futures, if you take a long position in the margin 

 19 credit swap you've essentially established a 

 20 spread position. The credit counterparty we've 

 21 identified in our investigations at least four 

 22 different parties that would be available to take 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 142 

 1 the counterparty to that credit, the traditional 

 2 lending provider now whether that's your bank or 

 3 even self- financed, the other would be outside 

 4 credit, another source of credit provided by the 

 5 industry, third, it could be long position 

 6 holders, and of that it could either be another 

 7 long hedger or even a long noncommercial, so that 

 8 those participants would be willing to provide the 

 9 margin to those hedgers. They would do that at an 

 10 interest rate so that is the traded price for the 

 11 product, the interest rate at which a hedger is 

 12 able to obtain margin credit to make margin calls. 

 13 In maintaining the swap since the 

 14 positions are balanced as the prices go up on our 

 15 short hedge and you as a hedger are receiving 

 16 margin calls, you have the long position in the 

 17 margin credit swap and it also then is going up 

 18 and you are receiving a margin collect. That same 

 19 product, the margin credit swap, the counterparty 

 20 if it's short is making the margin call. If that 

 21 counterparty were a long position holder in the 

 22 underlying, they would be making a margin collect. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 143 

 1 It's simply a recycling if you will of the capital 

 2 between the short hedger and the long 

 3 noncommercial through the margin credit swap. 

 4 This would go on whether the market is 

 5 going up or down, the flows of variation margin, 

 6 pays and collects would be balanced across that 

 7 spread. When it comes time to liquidate the swap 

 8 at the time when the merchandiser now has a cash 

 9 market customer or consumer, that sale is made and 

 10 with those funds and at the same time that the 

 11 hedge is lifted since it's no longer needed, 

 12 margin credit swap is also liquidated. What's 

 13 interesting about the margin credit swap though is 

 14 that it is not a price risk managing instrument so 

 15 that the price at which it was put on is going to 

 16 be the exact same price at which it's taken off 

 17 and that results then in a final payment or if you 

 18 will a repayment of the margin credit that was 

 19 borrowed by the hedger and that repayment is made 

 20 from the funds from their cash sale at which point 

 21 the swap counterparty, the credit provider, then 

 22 also is repaid and as a result has earned an extra 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 144 

 1 return from its capital by lending to that short. 

 2 Another illustration in a graphic here 

 3 to conclude is that you would start at some period 

 4 in time where the farmer makes a forward sale at 

 5 $6, the elevator hedges it at $6.30 so it has a 

 6 buying basis of 30 under. He also buys the margin 

 7 credit swap at $6.30 and there's a seller of that 

 8 margin credit swap at $6.30. Prices go up 50 

 9 cents, there's margin pays and collects on both 

 10 the hedged contract and on the credit contract 

 11 which even each other out and it would be the same 

 12 when prices go down. The last set of boxes then 

 13 is at liquidation. The consumer who the 

 14 elevator/merchandiser has found buys is at $6.50 

 15 and pays the elevator so the elevator has a net 

 16 gain then from his buying basis of 30 under to a 

 17 selling basis of even. He's made a 30-cent gain 

 18 on his merchandising activity. The elevator buys 

 19 back the hedge at $6.50 and sells the margin 

 20 credit swap back at $6.30, the same original 

 21 price. The 20-cent loss on the futures is less 

 22 than any interest on the margin credit swap. The 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 145 

 1 credit provider goes and sells the position at 

 2 $6.50, buys back the margin credit swap at $6.30 

 3 and had a 20-cent gain on his futures. The farmer 

 4 is paid his $6 at delivery. 

 5 MR. HURST: So if I could just sum up, 

 6 this is very much a work in progress but we have 

 7 made progress since the April 22 forum. We've got 

 8 a product that's been developed. The 

 9 clearinghouses have become actively involved in 

 10 determining how to bring this product into their 

 11 clearing systems. We've received guidance from 

 12 the CFTC. We're now in a pilot program. We have 

 13 one last hurdle and that is working with the FCM 

 14 community to understand and address the risk 

 15 that's embedded in this product. It is a 

 16 different kind of risk than exists for a standard 

 17 futures contract in that in any futures contract 

 18 traded at any of the exchanges, the only risk that 

 19 the clearing firm is asked to undertake is a 1-day 

 20 variation margin move in the underlying product. 

 21 In the margin credit swap, the risk that's 

 22 embedded is very different. Because it acts like 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 146 

 1 a loan and must be repaid, you have the full move 

 2 in the underlying market that results in the 

 3 margin call being made and the loan being given 

 4 and that must be repaid. We think that's an 

 5 important risk to be understood by the industry 

 6 and we're looking forward to working with the 

 7 clearinghouses and their clearing members in terms 

 8 of how we will go about addressing and managing 

 9 that risk. Again thank you for the opportunity to 

 10 appear before you today and we'll be available for 

 11 questions after the session. 

 12 MR. DUNN: Thank you, Steve and Gene, 

 13 for an excellent presentation. I note that this 

 14 presentation isn't in your handout package. We'll 

 15 try to get copies of that made and distributed to 

 16 you all. 

 17 The role of the exchanges and the 

 18 clearinghouses in setting margin requirements are 

 19 extremely important and I'd ask Dan Brophy to 

 20 discuss that. Dan? 

 21 MR. BROPHY: Thank you very much. I'm 

 22 speaking for myself but also I have to admit I'm 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 147 

 1 speaking for the Commodity Markets Council. I 

 2 have experience on the clearing side in Chicago 

 3 with both CME and the former clearing organization 

 4 for CBOT called BOTC that's now called the 

 5 Clearing Corporation. It's an independent entity 

 6 but I've had a number of years of exposure on the 

 7 user side of this and I've also seen it to some 

 8 extent from the perspective of a member of a board 

 9 or a committee in the case of the CME. 

 10 We believe that margin requirements 

 11 should be the exclusive province of exchange-owned 

 12 or independent clearinghouses. Clearinghouses are 

 13 responsible for the financial integrity of their 

 14 clearing members and their customers, and 

 15 certainly not least, the preservation of the 

 16 exchange's own reputation. Clearinghouses know 

 17 their firms, their markets, and their customers. 

 18 They interact with each market traded on the 

 19 exchange minute to minute, they have great 

 20 expertise to assess market risk, the firm risk 

 21 posed to the clearinghouse relative to that firm's 

 22 financial resources, and the total risk 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 148 

 1 underwritten by the exchange's own mutualized risk 

 2 pool. Clearinghouses have highly sophisticated 

 3 risk-assessment capabilities and very good 

 4 software in particular for real-time risk 

 5 assessments. I'm going to give you just a quick 

 6 example. I made a call yesterday across town to 

 7 the folks at the CME which is not to give short 

 8 shrift to our friends in Kansas City, Minneapolis, 

 9 or New York, but just to give you an idea of the 

 10 expertise and the scale of the risk-management 

 11 going on every day at CME, I think it's somewhat 

 12 smaller than the other firms, but as of last 

 13 Friday, the total collateral held by the CME is 

 14 $65 billion. The average daily pay collects, 

 15 intraday margins, those flows are $3.4 billion. 

 16 The highest in history for CME was $10 billion. 

 17 The total security deposit guaranteeing the 

 18 mutualized risk pool, all the firms who sign on 

 19 the bottom line, is $1.6 billion. And the total 

 20 financial safeguards pool which includes security 

 21 deposit and assessment powers and some other links 

 22 is over $6 billion. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 149 

 1 I want to make a remark about our 

 2 smaller exchange friends if you will. Jeff was 

 3 far too modest in describing the risks that were 

 4 so magnificently handled during the wheat market 

 5 explosion this winter, and two exchanges, the 

 6 Minneapolis Grain Exchange and the Kansas City 

 7 Board of Trade, probably saw, I didn't ask either 

 8 Mark or Jeff, flows through their clearinghouse 10 

 9 to 20 times, maybe even 30 or 40 times, on a daily 

 10 basis what they had seen in the past, and you 

 11 don't know about it and that's a great thing and 

 12 that means that they did a beautiful job. So I 

 13 think they really deserve a vote of thanks from 

 14 the entire industry and the Commission as well. 

 15 As CME, we would not like to see any outside 

 16 interferences from regulators or legislative 

 17 bodies to disrupt the clearinghouse systems that 

 18 have been many decades in development and have 

 19 proven so successful in contending with markets 

 20 that are even more stressful than what we're 

 21 seeing right now. 

 22 Margin levels have to be set with great 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 150 

 1 care and attention to the consequences. It's very 

 2 easy to impose high margins with the intent of 

 3 dealing with a specific risk or problem or 

 4 targeting a group of users and thereby unwittingly 

 5 triggering the negative consequence of diminished 

 6 liquidity on the exchange. Loss of liquidity can 

 7 easily exacerbate the risk that's being targeted 

 8 with high margins. So our point is that the best 

 9 decisions about margin levels should be left to 

 10 the exchanges and their clearinghouses who are 

 11 closest to the situation. Thank you. 

 12 MR. DUNN: Thank you, Dan. I appreciate 

 13 that insight as to the clearing corporations and 

 14 the impact that they have. I think this is 

 15 probably as you well point out one of the unsung 

 16 underlying safeguards of our futures industry. 

 17 But the high prices did have a tremendous impact 

 18 on those that were short in the marketplace and 

 19 there was a tremendous demand for credit out 

 20 there. I'd like to have Phil DiProfi from Co-Bank 

 21 talk a little bit about issues with margin credit 

 22 and what they saw during this time period and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 151 

 1 steps that they're taking. Phil, if you will, 

 2 please. 

 3 MR. DIPROFI: I sure will. Thank you. 

 4 I'd like to start by thanking the Commission for 

 5 the opportunity to participate in today's session. 

 6 Co-Bank is clearly committed to working with the 

 7 industries we serve as they continue to navigate 

 8 these very volatile market conditions. I hope 

 9 today's discussion will leave you with an 

 10 understanding of the bank's reaction to its farm 

 11 supply and grain marketing customers as we 

 12 experienced unprecedented demand for credit. 

 13 Again I'm Phil DiProfi and I'm Executive 

 14 Vice President of Co-Bank and I manage their 

 15 Agribusiness Banking Group as well as Strategic 

 16 Relationships Division. As of March 31, the 

 17 portfolio totaled approximately $31 billion 

 18 comprised of the bank's credit relationships with 

 19 its middle-market agribusiness customers, our farm 

 20 credit leasing subsidiary headquartered in 

 21 Minneapolis, as well as our wholesale lending to 

 22 other farm credit entities. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 152 

 1 This chart identifies the Agribusiness 

 2 Banking Group portfolio at the end of the first 

 3 quarter. As you can see, farm supply and grain is 

 4 a prominent segment of our portfolio standing at 

 5 about 72 percent. It makes up just under 28 

 6 percent of the bank's total outstandings as of 

 7 that date. In fact, we have over 750 

 8 customer-owners who operate country elevators and 

 9 farm supply businesses in 37 states, the largest 

 10 concentration of which both in terms of customer 

 11 account as well as loan amount per customer are 

 12 those customers located in the central part of the 

 13 country in the U.S. grain belt. The bank's 

 14 customers in this business segment have 

 15 experienced unprecedented loan demand over the 

 16 past 24 months with loans committed increasing to 

 17 $17.5 billion as of February 2008, from $7.6 

 18 billion just 2 years earlier. This unprecedented 

 19 demand for credit has been the direct result of 

 20 the rise in prices in the three primary 

 21 commodities merchandised by our customer-owners, 

 22 that being corn, soybeans, and wheat. In order of 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 153 

 1 magnitude, our customers have sold short futures 

 2 on more than 2 billion bushels of corn, beans, and 

 3 wheat. Most of those short futures were 

 4 contracted at lower prices earlier in the year and 

 5 have been subjected to substantial margin calls 

 6 over that period of time. 

 7 The tightening of supply and demand over 

 8 such a short timeframe and the rapid price 

 9 increases have challenged the bank's traditional 

 10 lending practices particularly as it relates to 

 11 the relative amount of working capital deemed 

 12 appropriate to support seasonal loan amounts 

 13 secured by current assets. Frankly, the balance 

 14 sheets of many of our local grain customer-owners 

 15 were not constructed to deal with the level of 

 16 high prices and the amount of volatility that's 

 17 occurring in today's marketplace given the 

 18 traditional risk-management practices of forward 

 19 purchase contracting and short futures hedging. 

 20 To illustrate the point, this charts 

 21 shows the substantial increase of credit used by 

 22 our grain customers through May 2008. To further 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 154 

 1 demonstrate the magnitude and velocity of today's 

 2 volatile market conditions as prices reacted to 

 3 weather events in June, loans increased another 

 4 $3.5 billion in addition to what's illustrated on 

 5 this chart. To further demonstrate the amount of 

 6 volatility, those same customers' loan demand 

 7 decreased $4 billion over the past 2 weeks. 

 8 Co-Bank and has continues to support its 

 9 customer-owners as they and we position ourselves 

 10 in our organizations for a high price, highly 

 11 volatile market environment. The undeniable facts 

 12 are that the risks are greater as are the capital 

 13 requirements. In addition to working with our 

 14 customers as they transition, Co-Bank has raised 

 15 third-party outside capital totaling $1.2 billion 

 16 over the past year and 2 months, $700 million of 

 17 which was raised over the past 60 days that was 

 18 both in the form of subdebt as well as preferred 

 19 stock. In addition to strengthening our financial 

 20 capital, the bank has also had to strengthen its 

 21 human capital. The chart that I have illustrated 

 22 for you shows the amount of same-day credit 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 155 

 1 actions that the bank was subjected to in order to 

 2 deal with the credit demands of its 

 3 customer-owners in its grain merchandising 

 4 segment. The bank has actually added 

 5 approximately 8 percent to its staff if you were 

 6 to go back 16 months when the volatility started 

 7 to become very evident that it was going to remain 

 8 for more than a short period of time. 

 9 The bank is also bringing additional 

 10 capacity to our customers and the industry through 

 11 partnering with other lenders on our larger 

 12 credits to local cooperatives. Prudent risk 

 13 management limits the amount of credit we expose 

 14 the bank to in any single borrower. This entails 

 15 a higher threshold on due diligence for our 

 16 customers and it also requires them to enhance 

 17 their financial reporting. Although we work with 

 18 commercial banks on a regular basis, our primary 

 19 partner up to this point in order to provide 

 20 additional capital to the industry and to our 

 21 customer base has come through the farm credit 

 22 system. In our view, there is capacity in the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 156 

 1 farm credit system and this chart indicates that 

 2 farm supply grain currently stands at about a 

 3 7-percent exposure for the entire farm credit 

 4 system. 

 5 In summary, we're adapting an 

 6 asset-based approach to size and credit 

 7 relationships. We've established a borrowing base 

 8 report that establishes prudent loan advance rates 

 9 against various asset classes. We have or will be 

 10 recognizing that the additional risks require a 

 11 modification of our existing loan pricing. We 

 12 will work with farm credit and commercial banks to 

 13 increase overall loan capacity to the industry. 

 14 And we will work with others to source capacity 

 15 from alternative arrangements to provide a relief 

 16 valve if you will in the event of continued market 

 17 disruptions. 

 18 MR. DUNN: Thank you very much, Phil. 

 19 That gives us a great insight as to what was going 

 20 on on the credit side during this particular 

 21 period. I'd now call on Sam Miller with the 

 22 American Bankers Association to talk about the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 157 

 1 perspective of the commercial banks during this 

 2 same time period and actions that they're taking. 

 3 Sam? 

 4 MR. MILLER: Thank you, Commissioner 

 5 Dunn. As you mentioned, I'm with the American 

 6 Bankers Association, but my day job is I'm a 

 7 banker. I work for M&I Bank in Appleton, 

 8 Wisconsin. I head up their agribusiness banking 

 9 and we do business in a number of states in the 

 10 Midwest and finance not only grain elevators and 

 11 farm supply firms but many farmers as well, and 

 12 I'd like to visit with you a little bit about both 

 13 of them. 

 14 I did not have a copy in your packets 

 15 but the Federal Reserve Bank of Kansas City, the 

 16 "Main Street Economist" just published a recent 

 17 paper called "Can Grain Elevators Survive Record 

 18 Crop Prices" and discussed some of the issues that 

 19 Mr. DiProfi just was mentioning and that we've 

 20 been discussing not only today but since the April 

 21 22 meeting. I'd like to read to you the final 

 22 paragraph from that paper. It says, "In 2008, 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 158 

 1 record crop prices and rising input costs have 

 2 strained the short-term financial position of 

 3 grain elevators. To date, creditors at both 

 4 commercial and farm credit banks appear to be 

 5 working effectively with the elevators to ensure 

 6 that financing needs are met. Banks are likely to 

 7 pay careful attention to the strength of the 

 8 risk-management practices at grain elevators when 

 9 deciding to increase cash advances. While the 

 10 sharp rise in agricultural commodity prices has 

 11 eased heading into the summer, unexpected dry 

 12 conditions or strong demand could further boost 

 13 crop prices and rekindle the financial stress at 

 14 grain elevators." I think that summarizes very 

 15 well that the banking and financial sectors have 

 16 met the need of funding margin calls for financing 

 17 inventory accounts receivable on margin calls on 

 18 contracts for future delivery. But this increase 

 19 in agricultural commodities has added a great deal 

 20 of balance sheet and operating leverage to the 

 21 grain and farm supply sectors. As an example, 2 

 22 years ago a bushel of corn which we may lend as 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 159 

 1 Mr. DiProfi said 90 cents on the dollar for, if 

 2 that bushel of corn was worth $2.50 a bushel, that 

 3 means that the country elevator had to come up 

 4 with 25 cents of working capital to fund it. With 

 5 today's current prices as of last Friday, the 

 6 December 2008 contract at $5.99, call it $6, means 

 7 that they needed now 60 cents of working capital. 

 8 That's a significant increase in the working 

 9 capital requirements that that local firm needs in 

 10 order to operate their business. In addition, the 

 11 added debt borrowings have increased their 

 12 underlying leverage or debt to worth of that same 

 13 firm. So that same country elevator may have had 

 14 leverage of 2 to 1 which means for every dollar 

 15 they had invested in equity we would lever up with 

 16 $2 of debt. Today with the same amount of bushels 

 17 that they're operating under, that leverage means 

 18 that for every dollar they have invested, I might 

 19 have $4-1/2 or $5 invested with them. So they've 

 20 really increased the operating of that business as 

 21 well. That puts added financial stress on the 

 22 business, on prudent lending, and regulatory 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 160 

 1 oversight. Much of that added leverage is 

 2 short-term assets in nature like grain inventory, 

 3 but it's also in meeting margin calls on contracts 

 4 for this fall, next year, and beyond. We're 

 5 lending on margin calls for inventory that does 

 6 not exist yet and bankers are going to pay careful 

 7 attention to that. 

 8 A number of grain elevators have added 

 9 term debt in order to adequately provide the 

 10 working capital margin to stay in the borrowing 

 11 formula which has added additional cash-flow 

 12 burden to the underlying business so it's 

 13 imperative that the business remains profitable in 

 14 cash flows to meet the increased interest and 

 15 principal debt service requirements of that added 

 16 borrowing. 

 17 Let me change gears. Given the added 

 18 borrowings and working capital and balance sheet 

 19 leverage of the grain storage and handling 

 20 sectors, risk management and hedging may need to 

 21 be a greater component of the farm operation. 

 22 Historically, marketing decisions and marketing 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 161 

 1 plans have been executed by farmers, but in recent 

 2 years the grain- handling sector began to offer 

 3 contracts as a way to attract and lock up more 

 4 supply to operate their business. A greater 

 5 emphasis should be placed on farmer education of 

 6 risk-management tools such as hedging, options, 

 7 crop insurance, contracts with end users, and 

 8 frankly, combinations of all of the above. The 

 9 grain and livestock producers need to understand 

 10 and control the cost inputs and sales output of 

 11 their business and can benefit from understanding 

 12 and using these tools. Bankers have had a long 

 13 history of advocating and providing 

 14 risk-management education for both its 

 15 constituency and for its farm customers. In fact, 

 16 in 1922, the ABA president at the time who 

 17 happened to be the president of my bank, Marshall 

 18 & Ilsley Bank, John -- had this to say about 

 19 agriculture: "Agriculture at the present time is 

 20 going through a serious crisis. There are many 

 21 problems in production and marketing to be solved. 

 22 There is a call for close any sympathetic 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 162 

 1 cooperation not only between bankers and farmers, 

 2 but between all intelligent citizens of our great 

 3 commonwealth." While agriculture is not in a 

 4 serious crisis at this time, there are problems in 

 5 production and marketing to be solved. ABA has 

 6 provided its membership with risk-management 

 7 training since the early 1900s in many types of 

 8 risk. My bank offers joint marketing sessions and 

 9 crop insurance presentations over the winter 

 10 months to our farm clients to better provide 

 11 information and to understand the tools available. 

 12 And I believe that over the last 56 years American 

 13 Bankers has enjoyed a great working relationship 

 14 with the CME Group, Minneapolis Grain Exchange, 

 15 and Kansas City Board of Trade, to provide 

 16 educational sessions for our ag bankers and our 

 17 farm clients. I propose that we further emphasize 

 18 farm producer education about risk-management 

 19 tools as one way to help address some of the 

 20 issues currently being felt by the industry. 

 21 MR. DUNN: Thank you very much, Sam, and 

 22 that is something I think needs to be taken into 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 163 

 1 serious consideration for the producers to take a 

 2 greater role in assuming some of the risk and 

 3 offsetting that through the futures market. 

 4 With that I'll entertain open 

 5 discussion. Anyone who has comments or questions, 

 6 please be recognized. Joe? 

 7 MR. NICOSIA: I had a question for Gene. 

 8 On your credit swap idea, how do you handle the 

 9 credit risk that's going to take place for the 

 10 individual if you took on the opposite side of 

 11 that credit risk, you had a market blowup and that 

 12 other entity became insolvent? What would happen 

 13 to the other side of that credit risk? 

 14 MR. KUNDA: That's exactly the key point 

 15 as Steve was mentioning that is critical for the 

 16 clearinghouse to be aware of. Having that be a 

 17 cleared product, that credit risk would be managed 

 18 by the clearinghouse. 

 19 MR. NICOSIA: But they're going to 

 20 manage it on an individual 

 21 counterparty-by-counterparty base? 

 22 MR. KUNDA: I'm going to defer that to 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 164 

 1 Steve in terms of how the clearinghouse will 

 2 handle that. 

 3 MR. HURST: That's part of the point of 

 4 conducting a pilot program so that we can learn by 

 5 doing, but the clearinghouses have a built-in 

 6 infrastructure where risk are assumed by the 

 7 clearing member firm that brings the trade into 

 8 the clearinghouse and this is a risk that is 

 9 managed in the marketplace every day in the 

 10 current environment and we think it's going to 

 11 need to be managed every bit as aggressively as 

 12 these products move through the clearing systems. 

 13 But to answer your question directly, that will be 

 14 a risk that will need to be managed by the 

 15 clearing firm that brings the trade to the 

 16 clearinghouse to be cleared. 

 17 MR. NICOSIA: I would only add I guess 

 18 that it is not a new risk, it's a risk that's 

 19 currently being as it exists. 

 20 MR. DUNN: Mr. Coyle? 

 21 MR. COYLE: I'll add a few comments 

 22 there because I've spent a lot of time with Gene 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 165 

 1 and with Steve, and Joe you've really identified 

 2 the key issue. They've developed a product that 

 3 actually makes a lot of sense. There is a need 

 4 for the capital. The capital is available. It 

 5 appears to be reasonably priced. The exchanges 

 6 have the ability to clear and they're working 

 7 through the details on how to clear it. The FCMs 

 8 will have the administrative ability. But the 

 9 single biggest question and it's not resolved yet 

 10 is really related to this exposure. The current 

 11 margining system is well adept at handling day-to- 

 12 day margin requirements but with this product you 

 13 might have a 1-month, 2-month, 3-month, 4-month 

 14 margin issue. So at the end of the day the 

 15 question is whether or not an FCM is willing to 

 16 put that trade on their books because if the CME 

 17 decides or the other exchanges decide they're 

 18 willing to clear it, they're relying on the FCM 

 19 and you may find FCMs that say they're unwilling 

 20 to accept the trades because they don't want to 

 21 have an exposure that there's a $4 margin call 

 22 when the contract expires. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 166 

 1 That brings up a question of whether or 

 2 not there are ways for the government to get 

 3 involved on that support. There are crop 

 4 insurance programs today. The risk is that there 

 5 is a default from a producer to an elevator and if 

 6 the producer defaults because of production to the 

 7 elevator and the elevator then defaults to the FCM 

 8 then the burden is on the FCM and they may be 

 9 unwilling to take that exposure. So the farmer 

 10 has generally been very good in honoring their 

 11 contracts, but these are crazy times and so the 

 12 question is out there using the crop insurance 

 13 system is there some way to embed some kind of 

 14 default protection in the contract? The farmer 

 15 has crop insurance today to protect his revenue. 

 16 Is there some way to use that? Because the 

 17 capital is out there. The people who are long on 

 18 the market today, their liquidity goes up right as 

 19 our industry is losing liquidity so that it makes 

 20 a lot of sense to do what they're trying to 

 21 accomplish. But you're hit the nail on the head. 

 22 It's not solid yet but there certainly is plenty 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 167 

 1 of interest. 

 2 MR. HURST: The only thing I would add 

 3 to that is that the transactions that are going on 

 4 today in the over- the-counter market are being 

 5 done counterparty to counterparty with the risk 

 6 being negotiated and dealt with counterparty to 

 7 counterparty. It is our hope that these products 

 8 when they move into the clearing system will be 

 9 more broadly available because of the 

 10 risk-management protections that are embedded into 

 11 the various clearinghouses. But today the trades 

 12 that are being done are being done with 

 13 counterparty credit. 

 14 MR. DUNN: Are there other questions or 

 15 comments from the Advisory Committee? 

 16 MR. WATSON: I'd like to talk a little 

 17 bit also about the margin credit swap issue. The 

 18 analogy with some of the financing situations that 

 19 arose in the real estate market in the past few 

 20 years is too apparent for me. Essentially, longs 

 21 providing capital to shorts sounds an awful lot 

 22 like the seller of a house providing the down 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 168 

 1 payment through an intermediary so that they could 

 2 buy the house and not reflect what we now know, 

 3 that price discovery should have told us is houses 

 4 should have come down slower than they did in the 

 5 past and saw the cascade of problems that ran 

 6 through financial instruments based on housing 

 7 transactions. Why is this not a similar type of 

 8 inherent risk? I guess the basic question here is 

 9 why do we assume that the clearinghouses are 

 10 smarter than the Wall Street banks who all 

 11 basically collapsed or basically saw financial 

 12 problems related to their sophisticated products, 

 13 very sophisticated people with very sophisticated 

 14 computer systems but yet failed to see for the 

 15 degree of risk? And certainly seller-financed 

 16 down payments are not the only thing that relates 

 17 here, but the analogy for me just seems a little 

 18 bit too close for comfort and to just sort of take 

 19 on a word that smart people are working on this 

 20 and that we're working through it. Why is this 

 21 fundamentally different and why are we going to be 

 22 able to make sure that this type of risk 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 169 

 1 management related to the financing doesn't leave 

 2 us with a similar type of cascading collapse 

 3 problem? 

 4 MR. KUNDA: I'd begin by saying that in 

 5 the sense that it's different, it is not a price 

 6 risk-management tool so it is not meant to be a 

 7 hedge, your hedge is still on in the underlying 

 8 market, so that the risk of any of the failures 

 9 that would result as Tom mentioned either from the 

 10 farmer or at the grain elevator level are the same 

 11 risks that currently exists today, it's just a 

 12 matter of who's bearing that risk. And right now 

 13 it's as we've heard from the banking community 

 14 that that risk that they're bearing is at a point 

 15 now that they're expressing how much it is. So 

 16 this allows that access to capital to be broader 

 17 than that and when it is offered in the senses of 

 18 being from a long hedger for example, it would be 

 19 another participant, or the long noncommercial to 

 20 the short hedger, is an ability for them to 

 21 persist in that position that would be put on for 

 22 a business transaction that if they could have 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 170 

 1 extracted the equity in that rising cash grain 

 2 price they would be able to make those margin 

 3 calls. 

 4 So if you could extract that from a 

 5 rising value that you have on your books, then 

 6 you'd be financially fine. Just because prices 

 7 are going up for a merchandiser doesn't mean that 

 8 he's losing money when he's making those margin 

 9 calls, it's just that he doesn't have a source of 

 10 capital to make those margin calls because he 

 11 can't tap into his rising cash position and so 

 12 this margin credit swap is a substitute for that 

 13 cash position. 

 14 MR. HURST: I would also point out that 

 15 the people who seem to be most heavily impacted in 

 16 the rising prices this summer are not the 

 17 merchandisers who were out on the edge speculating 

 18 in the market but, rather, those who were doing 

 19 everything right. The issue that we're trying to 

 20 address here is simply to provide a new source of 

 21 margin credit financing that stays within the 

 22 clearinghouse system. This is targeted to the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 171 

 1 margin needs of the merchandisers. It never will 

 2 leave the clearinghouse. There is a moral hazard 

 3 and you're correct in pointing that out, that if 

 4 credit becomes too easy that operators who are not 

 5 paying attention to doing things the right way 

 6 might have opportunities for chicanery and that's 

 7 where the infrastructure that's embedded in the 

 8 clearinghouse will be important. The clearing 

 9 firms are going to need to know their customers, 

 10 the customers of the clearing firms, the brokers 

 11 are going to need to know their customers and 

 12 there will be a risk transfer that's going to be a 

 13 part of bringing the product into the 

 14 clearinghouse and that's the way that we think 

 15 that it will be managed, by the people who are 

 16 managing that risk today. 

 17 So it's an excellent question. The only 

 18 point we're trying to make is that it may not be a 

 19 fair analogy. 

 20 MR. WATSON: If I can continue, then 

 21 assuming this risk remains entirely within the 

 22 clearinghouses or on their books, do we know that 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 172 

 1 that is the case or at some point in time because 

 2 this is not a separate and distinct product and 

 3 with a certain amount of time to develop a degree 

 4 of experience with it that we're not going to come 

 5 back here in a couple of years and talk about some 

 6 form of securitization so that the clearinghouses 

 7 are able to in essence bring in additional 

 8 investors and saying we can clear this. It seems 

 9 to me that with this product the natural 

 10 progression would be toward some sort of 

 11 securitization and bringing in even more outside 

 12 sort of investment even if we assume that the 

 13 clearinghouses are maintaining some sort of credit 

 14 management involvement here so that can you keep 

 15 this inside the clearinghouse and provide the 

 16 capital necessary for this product? 

 17 MR. HURST: That's the whole point of 

 18 the pilot program, and if you're interested in 

 19 following it, I'd welcome your participation. 

 20 MR. DUNN: Are there other questions or 

 21 comments? My Coyle again? 

 22 MR. COYLE: I'll make one observation. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 173 

 1 The difference is that this is really not a new 

 2 risk. Traditionally, we buy grain or an elevator 

 3 buys grain from farmers well in advance and then 

 4 has margins on their books every day. It's just 

 5 the magnitude of the demand for the capital. A 

 6 farmer sells grain at $3 a bushel and the market 

 7 goes to $6 a bushel, what happens is you sell to 

 8 the customer later in exchange futures 3 months 

 9 later. When the farmer delivers the bushels you 

 10 then price your sales contract and the grain is 

 11 received, shipped, a nonissue. But in this case, 

 12 the magnitude has gotten so large and there's been 

 13 such a demand for capital so you're just shifting 

 14 how the money gets through the system. The 

 15 capital is available. The same person who's long 

 16 in the futures contract today is basically pulling 

 17 money out of the market every time the market goes 

 18 up so you're just shifting the timing when margins 

 19 are paid. In fact, the clearing is going to take 

 20 money both ways so it's not going to be out the 

 21 money at all. It really ends up being the final 

 22 payment. So instead of the grain elevator having 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 174 

 1 to pay margins every day and eventually collecting 

 2 that when they sell it to a customer, they're 

 3 getting that money every day through their margin 

 4 swap and eventually the same thing happens. It 

 5 doesn't change the fact that there still is the 

 6 exposure because now you have a margin call for a 

 7 month instead of a day. And the reason there's 

 8 never been a breakdown in the system is because 

 9 you have those margin calls that has the checks 

 10 and balances, so this changes that and a lot of 

 11 the clearing firms or a lot of the FCMs will have 

 12 a lot of heartburn with accepting that change. 

 13 MR. DUNN: Are there other questions or 

 14 comments? Mr. Clark? 

 15 MR. CLARK: Maybe you are already, but I 

 16 guess I would just encourage you to work with the 

 17 banking community because my sense is exchange 

 18 clearinghouses are famous for protecting 

 19 themselves and that's why they work. So to the 

 20 extent you get too deep into this and then you 

 21 have a default, my presumption is that the 

 22 exchange clearinghouse is probably going to the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 175 

 1 assets of the defaulted entity before the banks 

 2 have time to do it and I think it raises a lot of 

 3 issues about how financing is provided to the 

 4 whole sector if the underlying value or the equity 

 5 of the enterprise is somehow called into question. 

 6 I presume you're already doing that, but I would 

 7 encourage you to do so if you're not. 

 8 MR. HURST: We have a working group 

 9 that's been meeting on I'd say a monthly basis for 

 10 the past 6 months that's included representatives 

 11 from Co-Bank, we've recently been contacted by 

 12 commercial lenders who have expressed interest in 

 13 joining it, and your point is very well taken and 

 14 it is something that we are attuned to. 

 15 MR. DUNN: Are there other questions or 

 16 comments from the audience? My fellow 

 17 Commissioners? Commissioner Sommers, do you have 

 18 any questions? Let me ask a couple then. In our 

 19 interagency task force study, that interim report 

 20 under the hedgers and speculators portion, there 

 21 was this paragraph that was inserted in there. It 

 22 says, "While hedgers are not generally associated 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 176 

 1 with price discovery activities, these commercial 

 2 interests often do play an important price 

 3 discovery role. In essence, futures prices are a 

 4 consensus of the opinions of those who enter the 

 5 market. Moreover, the actions of those who choose 

 6 not to enter the futures market are also quite 

 7 important in price discovery. For example, a 

 8 commercial trader holding physical inventory but 

 9 choosing not to hedge this inventory with short 

 10 positions in the futures market will withhold a 

 11 downward pressure on the price." My question, has 

 12 the threat of high margin calls been a stimulus 

 13 for commercial traders holding physical inventory 

 14 not to enter into the futures market? Mr. Coyle? 

 15 MR. COYLE: I'll make a couple of 

 16 observations. First, what does happen as a 

 17 general rule, commercials hedge what they buy. I 

 18 would say it's standard operating procedure, but 

 19 what you're finding is because of higher margin 

 20 requirements that people are selling bushels 

 21 earlier than they would like to sell which is 

 22 putting downward pressure on the basis for 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 177 

 1 instance because they simply can't afford to store 

 2 the bushels and yet they can't afford the risk to 

 3 unhedge at $15 beans and watch them go to $13 and 

 4 they're out of business. So I think it is 

 5 changing the marketing patterns. 

 6 The other observation, I don't know if 

 7 it's accurate or not, I saw Mr. Kass's chart where 

 8 he showed deferred hedging in soybeans where you 

 9 showed that there's actually less commercial 

 10 selling in the new crop months compared to what we 

 11 had in 2007. That's a little unusual when you had 

 12 futures prices so much higher than a year ago and 

 13 farmers taking advantage of the higher prices. So 

 14 what that might be is an indication that as 

 15 elevators have reduced their bids and stopped 

 16 bidding for deferred grain because of the fear of 

 17 margin calls or they didn't put a bid out at all 

 18 that they didn't have a need to hedge. That 

 19 doesn't give you the pressure and it also means 

 20 you're not giving a bid to a farmer who you want 

 21 to give a bid to. I don't know if that's accurate 

 22 or not, but that's what the chart indicated to me. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 178 

 1 MR. DUNN: Joe? 

 2 MR. NICOSIA: I think actually the 

 3 opposite is what's taking place. As the capital 

 4 has been withdrawn, and I agree with what Tom said 

 5 a little bit, I don't think you're finding people 

 6 who are continuing to accumulate physical 

 7 positions instead of hedging them. I think you're 

 8 finding that anyone who finds themselves in that 

 9 position at short capital and actually has to 

 10 liquidate inventory and therefore you would be 

 11 selling your physical positions to raise money so 

 12 that you could hedge the balance of it. So I 

 13 think the only place where you're really seeing 

 14 that is maybe in an ETF type situation or another 

 15 group, but that has nothing to do with the 

 16 traditional hedger so I think you're actually 

 17 probably seeing if anything less of what I would 

 18 say is outright pure spec flat price positions by 

 19 holding the commodities than you did 2 years ago 

 20 because of the lack of capital. 

 21 MR. DUNN: In Mr. Reinhart's 

 22 presentation this morning he talked about USDA's 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 179 

 1 announcement that we had a $61 billion grain crop 

 2 2 years ago and it's $122 billion today. Has that 

 3 money filtered back to the countryside or is it 

 4 offset on additional production costs? Mr. Coyle 

 5 again? 

 6 MR. COYLE: Sorry to be a hog. I guess 

 7 I'll say both. Costs are higher, fertilizer 

 8 costs, fuel costs, I'm not a farmer but production 

 9 costs I'm sure are significantly higher than they 

 10 were before. On the other hand, we have had some 

 11 underlying change in demand. We have biofuels. 

 12 So there's a genuine increase in consumption for 

 13 instance for corn which is raising price levels. 

 14 We have improved diets around the world 

 15 particularly from China and India which is raising 

 16 demand as well, so that's raising the overall 

 17 price. So I guess I would conclude that the money 

 18 is getting back to the farm community in a number 

 19 of ways, from construction to farming itself, land 

 20 values, but it's also offset by higher costs. I 

 21 hope it's a net gain, but you'd have to ask a 

 22 farmer the answer to that. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 180 

 1 MR. NICOSIA: Plus don't forget that 

 2 although the total value of the crops are higher 

 3 today, whatever portion that was presold or sold 

 4 ahead in years is only benefited by the price that 

 5 they sold. So if they were selling corn or a 

 6 great deal of corn traded hands at $4 and as we 

 7 moved up those levels, that net benefit of $7.50 

 8 corn for those bushels were never received. As we 

 9 go through this cycle as those bushels are 

 10 delivered, as those bales are delivered and the 

 11 producer catches up with the current pries, then 

 12 more of this price will eventually get passed on 

 13 back into the country but a good portion of it has 

 14 not been passed through because of that. 

 15 MR. GOULD: I would agree with my 

 16 producer hat on that I think there's also a 

 17 difference in timing. We have a significant 

 18 increase in commodity prices coming back to the 

 19 farm community in the 2008 crop year. The 

 20 increased costs that we're talking about are 

 21 really going to take effect for the 2009 crop as 

 22 fertilizer and other inputs are priced into that 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 181 

 1 crop. I think that's where the real net is going 

 2 to be magnified or maybe even at risk of being 

 3 negative. I've heard different numbers that $5 

 4 corn is the same as $2.50 corn was 2 years ago 

 5 with increased input costs. 

 6 MR. DUNN: Mr. Wellman? 

 7 MR. WELLMAN: As a producer, I would 

 8 pretty much agree with the three earlier comments 

 9 here, and to tie this back to the credit situation 

 10 that we've discussed is as producers are buying 

 11 our 2009 inputs at this point in time at three 

 12 times the cost that we have paid previously, we're 

 13 also facing a credit crunch because we don't have 

 14 the income yet from the 2008 grain that may or may 

 15 not be priced but we're paying the 2009 inputs at 

 16 this point in time. So I think that ties in with 

 17 the credit, and maybe to Mr. Miller's comments 

 18 here about producer education, I understand that 

 19 but also it ties into if multinational 

 20 corporations with much larger balance sheets and 

 21 better balance sheets than some producers have are 

 22 staying out of the market because of volatility 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 182 

 1 and the cost, how's that going to come back to a 

 2 producer and what makes you think that a producer 

 3 should be in that situation to face those risks? 

 4 Thank you. 

 5 MR. DUNN: Thank you very much. This 

 6 morning's panels have just been fantastic. You've 

 7 given us a lot of insight. I announce that for 

 8 the members of the Ag Advisory Committee, we do 

 9 have a lunch for you up on our ninth floor as we 

 10 usually do. It's the only type of payment we can 

 11 give you, and the panelists as well as advisory 

 12 members. For the remainder of the folks, there 

 13 are restaurants in the front of the building and 

 14 behind the building a new restaurant has opened 

 15 up. What we will do is break for lunch and be 

 16 back here at 1:45. This afternoon we're going to 

 17 talk about agricultural swaps, and we're also 

 18 going to talk about ongoing research. So we will 

 19 see you all at 1:45. Thank you. 

 20 (Luncheon recess.) 

 21 

 22 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 183 

 1 A F T E R N O O N S E S S I O N 

 2 MR. DUNN: I want to thank everyone for 

 3 their participation in this morning's meetings. I 

 4 found them absolutely fascinating and I think this 

 5 afternoon we're going to get more of the same. 

 6 The first issue that we've got are 

 7 agricultural swaps. To begin this we're going to 

 8 have Don Heitman from the CFTC to give us the 

 9 history and current policies on agricultural swaps 

 10 and ATOs or agricultural trade options. Then 

 11 we're going to hear from Tom Farley from ICE and 

 12 Dave Lehman and Julie Winkler from the CME on the 

 13 benefits of clearing agricultural swaps. So if 

 14 you will, Mr. Heitman? 

 15 MR. HEITMAN: I'm going to go through 

 16 this as quickly as I can because I've got way more 

 17 than 10 minutes' worth of material. 

 18 Starting off with swaps, I'm going to 

 19 skip the first slide which is just an introduction 

 20 and the early history of agricultural swaps we're 

 21 going to skip too. In 1993 I think the 

 22 significant thing is that the CFTC adopted Part 35 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 184 

 1 exempting swaps meeting certain criteria from the 

 2 exchange trading requirement of the Commodity 

 3 Exchange Act, and at that time it applied to swaps 

 4 on everything. Then in 2000 the CFMA included a 

 5 new section, 2(g), the swaps exclusion which 

 6 superseded Part 35 for everything else, but 2(g) 

 7 by its terms applies to transactions in a 

 8 commodity other than an agricultural commodity. 

 9 So Part 35 remains in effect for only agricultural 

 10 commodities. The conditions governing 

 11 agricultural swaps are they're between eligible 

 12 swaps participants and then there's a bit long 

 13 list of who's an eligible swap participant in the 

 14 rules. I think for the purposes of the 

 15 agricultural community probably the most important 

 16 eligible swap participant is a person with a net 

 17 worth of a million dollars who enters into the 

 18 swap to manage a risk in connection with its 

 19 business. And the other qualifications are that 

 20 they're not fungible, credit worthiness would be a 

 21 material consideration, and they're not created on 

 22 an exchange. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 185 

 1 Interestingly enough, Part 35 does not 

 2 apply to options. Even though it defines a swap 

 3 agreement, and there's a big long list of 

 4 different kinds of swaps including a commodity 

 5 swap, and then it says, "Including any option to 

 6 enter into any of the foregoing." But when they 

 7 published the ag trade option rules somebody 

 8 specifically asked for clarification that the Part 

 9 35 swaps exemption and not the ag trade option 

 10 rules would apply to off-exchange agricultural 

 11 options and the Commission relied, sorry, any 

 12 off-exchange option on an enumerated agricultural 

 13 commodity has to comply with the ag trade option 

 14 rules and no other exemptive provision is 

 15 available so that if it's an ag option you're 

 16 stuck with the ag trade option rules. 

 17 Under Part 35, probably the most 

 18 significant restriction is you can't clear an 

 19 agricultural swap because you fail two of the four 

 20 criteria, you can't clear something that's not 

 21 fungible, and number two, credit worthiness is not 

 22 a material consideration if you're got a 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 186 

 1 clearinghouse interposed to take the risk. So 

 2 clearing agricultural swaps would require an 

 3 exemption under the Commission's general exemption 

 4 authority at Section 4(c) of the Act. And in 

 5 fact, the CME Group on April 21 petitioned the 

 6 Commission, asking us to exercise 4(c) authority 

 7 to permit the clearing of corn basis swaps and 

 8 corn, wheat, and soybean calendar swaps. That was 

 9 published for comment on July 7, the comment is 

 10 open and the deadline for comments is August 21. 

 11 On May 21 the CME Group made a more general 

 12 petition in asking us to exercise exemptive 

 13 authority to amend the regulation itself to permit 

 14 the clearing of standardized OTC ag swaps which 

 15 would mean you would need to file a petition every 

 16 time you wanted to submit a new cleared swap 

 17 contract, and that has not been published for 

 18 comment yet. I suspect that people are waiting to 

 19 see what the comments look like on the April 21 

 20 petition. 

 21 The last question about swaps is where 

 22 does ethanol fit in? The Commission has already 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 187 

 1 allowed the clearing of ethanol swaps without a 

 2 4(c) petition which represents an implicit finding 

 3 without expressly saying so that ethanol is not an 

 4 agricultural commodity for purposes of the CEA, 

 5 therefore it's within the general swaps exclusion 

 6 and you don't have to worry about Part 35 for 

 7 ethanol. 

 8 So that's the swaps presentation and 

 9 that brings me to agricultural trade options which 

 10 is what I really wanted to talk about. As for ag 

 11 trade option, there's a big long definition in 

 12 32.4. The significant thing about the definition 

 13 is that the option buyer has to be commercial, the 

 14 option seller does not. I don't understand that 

 15 and I never have, but that's the way the rule 

 16 reads. There is a general regulatory exemption 

 17 for trade options. Trade options are exempt from 

 18 all CFTC regs the prohibition against unlawful 

 19 representation and fraud. Then in 32.2 there's a 

 20 prohibition against options in agricultural 

 21 commodities except as provided in the ag trade 

 22 option regulation. So if you want to have an 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 188 

 1 agricultural option, trade options are a special 

 2 case and if you want to trade an agricultural 

 3 trade option you have to do it under a set of 

 4 rules that the CFTC has issued and there's a long 

 5 statutory and regulatory history going back about 

 6 ag trade options which is on the next couple of 

 7 slides. I'm just to skip those except that I 

 8 think probably the most significant point is that 

 9 in 1991 the agency actually proposed lifting the 

 10 ban on ag trade options which would have allowed 

 11 them to trade just like any trade option subject 

 12 only to the fraud and misrepresentation rules. 

 13 When we proposed that we got 16 

 14 comments, nine for, seven against, and the 

 15 opposing commenters included CBTO, National Grain 

 16 Trade Council, National Grain and Feed 

 17 Association, and Cargill, and the proposed rules 

 18 were never acted upon. So the Commission 

 19 basically went back to the drawing board and in 

 20 1995 we had a roundtable and then they got a white 

 21 paper from the staff and then advance notice of 

 22 proposed rules, proposed rules, and finally in 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 189 

 1 1998 they issued the initial set of ag trade 

 2 option regulations with a number of requirements 

 3 including that the trade options had to be settled 

 4 by physical delivery, and nobody signed up for the 

 5 program. So we said we'll go back. We redesigned 

 6 the rules, and in 1999 we streamlined the 

 7 reporting and disclosing requirements and allowed 

 8 cash settlement, and then only one firm in the 9 

 9 years since then has registered as a ag trade 

 10 option merchant, it was Kent Feeds. The gentleman 

 11 was here at a meeting of the Ag Advisory Committee 

 12 a few years ago but they have since withdrawn 

 13 their registration so nobody is participating in 

 14 this program at the moment. 

 15 The as for the current regulatory and 

 16 market situation I don't have to tell anybody in 

 17 this room that the agricultural community needs 

 18 all possible risk- management tools to deal with 

 19 current market conditions. The existing ag trade 

 20 option program clearly isn't helping anybody and 

 21 producers and agribusiness interests have had an 

 22 additional 10 years since the ag trade option 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 190 

 1 rules took effect to develop further 

 2 risk-management expertise. In this environment 

 3 the question is what should the Commission do 

 4 about the ag trade option program? There are 

 5 three possible alternatives. Obviously we can 

 6 just leave things the way they are which doesn't 

 7 really address the ag community's risk-management 

 8 needs. We could modify the ag trade option rules 

 9 to make them more acceptable to potential 

 10 registrants which is fine if it would work, but in 

 11 fact it's really difficult to visualize anything 

 12 we could do to make the program more acceptable. 

 13 The current regulations have really been pared 

 14 down to the bone already. The only logical change 

 15 that people have suggested would be to lower the 

 16 exemption level to a million dollars but all that 

 17 means is you're going to allow more exempt trading 

 18 outside the program, you're certainly not going to 

 19 attract anybody in to participating as an ag trade 

 20 option merchant if you just narrow the universe of 

 21 possible customers. Really all you're doing if 

 22 you lower the exemption level is you're 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 191 

 1 disenfranchising smaller producers and nobody with 

 2 under a million dollars net worth would have 

 3 access to ag trade options. 

 4 So the third option obviously then is 

 5 just revoke the ag trade option rules and allow ag 

 6 trade options to trade like any other trade 

 7 option. The pros to that are it would open up new 

 8 risk-management possibilities for the ag 

 9 community. It resolves the legal uncertainty 

 10 about existing products that may or may not be ag 

 11 trade options because we've heard anecdotally that 

 12 there are products trading out there right now 

 13 that are to put it charitably on thin ice and they 

 14 may or may not be illegal under the ag trade 

 15 option program and if we revoke the rules that 

 16 takes away any uncertainty about those products. 

 17 And it would reverse the Commodity Exchange Act's 

 18 paternalistic attitude and treat farmers like the 

 19 operators of any other business. My first boss at 

 20 the CFTC, Commissioner Heineman, God rest his 

 21 soul, one of the first things he said to me was, 

 22 "Farming isn't a way of life, it's a business, and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 192 

 1 if you can't make a living at it you ought to go 

 2 find another business." And he was a farmer his 

 3 whole life so he had the right to say that. I 

 4 certainly don't, but I'm just quoting him. 

 5 The one big con of revoking the ag trade 

 6 option rules is that it's going to open up the 

 7 possibility of fraud and economic loss in this 

 8 less-regulated environment. We're going to have 

 9 an antifraud rule, but if you're going to legalize 

 10 cars, even you post a speed limit, there are going 

 11 to be car wrecks. If you revoke the rules and 

 12 start trading ag trade options, sooner or later 

 13 there's going to be a scandal. I think that's 

 14 just the price you pay and you have to rely on 

 15 people to have the good sense to deal with trade 

 16 option offerors who they know and trust and in 

 17 fact notwithstanding the possibility of fraud, 

 18 that's the option that the CFTC staff is in favor 

 19 of and we are going to recommend to the Commission 

 20 a proposed rule amendment to withdraw the ag trade 

 21 option rules. If that's approved it would be 

 22 published for comment in the Federal Register and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 193 

 1 we would certainly encourage members of the 

 2 Advisory Committee to comment on that proposal or 

 3 to comment now if you can do it in 10 seconds, 9, 

 4 8, time's up. 

 5 So that's the status. If the ag trade 

 6 option rules are withdrawn, ag trade options would 

 7 be subject to the same conditions as trade options 

 8 on every other commodity, they could be offered 

 9 only to a commercial in connection with its 

 10 business as a commercial, and they would be exempt 

 11 from all CFTC regulations except those prohibiting 

 12 unlawful representation and fraud. So that's my 

 13 pitch for revoking the ag trade option rules. 

 14 MR. DUNN: Thank you, Don. Just a point 

 15 of clarification here. From the April 21 request 

 16 we are under the comment period of that so we have 

 17 to follow the Administrative Procedures Act rule 

 18 and we're under ex parte so anything that is 

 19 communicated here will become part of that record. 

 20 Is that correct? 

 21 MR. HEITMAN: Yes, sir. 

 22 MR. DUNN: Thank you. Our next 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 194 

 1 panelists on the benefits of clearing agricultural 

 2 swaps will be Tom Farley from ICE Futures. Tom? 

 3 MR. FARLEY: Thanks again, Commissioner, 

 4 and thanks for allowing me to say a few words 

 5 about the benefits of clearing agricultural swaps. 

 6 I believe Dave from CME is also going to say a few 

 7 words about agricultural swaps, and I did as well 

 8 back on April 22, so I'll be brief. And I'm also 

 9 going to focus on a slightly different area of 

 10 agricultural swaps than was covered before or I 

 11 expect will be covered later today. 

 12 One of the benefits of clearing OTC 

 13 agricultural swaps, I think these benefits will be 

 14 familiar to you. They're the benefits broadly of 

 15 clearing really any product. You reduce 

 16 counterparty risk is the primary benefit as 

 17 opposed to having a web of bilateral agreements as 

 18 exist currently in the OTC market. By clearing 

 19 swaps, clearing OTC instruments, you substitute a 

 20 highly rated central counterparty, namely an 

 21 exchange clearinghouse, for your multiple 

 22 counterparties. The second benefit is that these 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 195 

 1 OTC instruments level the playing field. What do 

 2 I mean by that? OTC trading occurs now and we all 

 3 know it occurs. It largely occurs between very 

 4 large parties, very sophisticated parties, and by 

 5 bringing OTC trading onto an exchange it allows 

 6 more people to participate, and there are some 

 7 real benefits to trading swaps and some more 

 8 tailored products when I'm going to discuss in 

 9 just a minute here. 

 10 The third benefit is that it provides 

 11 additional transparency to already existing OTC 

 12 markets, and I've highlighted already existing 

 13 because some people nitpick about how much 

 14 transparency will there be with cleared swaps on 

 15 an exchange, and is it precisely equal to futures. 

 16 I think that's largely missing the point. There 

 17 is very little if any transparency with the 

 18 existing OTC markets, certainly some of those 

 19 exist in OTC markets, and bringing OTC instruments 

 20 onto an exchange for clearing, you're 

 21 instantaneously heightening the level of 

 22 transparency that's provided to the marketplace 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 196 

 1 whether it's simply by the act of the 

 2 clearinghouse settling these instruments on a 

 3 daily basis and providing some price transparency 

 4 or disclosing the total volume in these 

 5 instruments or the open interest in these 

 6 instruments, these are all additive to 

 7 transparency. 

 8 Finally, and this is where I would to 

 9 focus for just a minute or two, clearing OTC swaps 

 10 enables more customized risk-management solutions 

 11 for a broader swath of the marketplace. Let me 

 12 give you a few examples. I want to just if I can 

 13 digress and explain to you our intention and what 

 14 we have actually requested of the CFTC and which 

 15 they're considering is clearing look-alike swaps 

 16 in sugar, coffee, and cocoa, and that's our 

 17 initial plan. However, we also have a plan to 

 18 expand that over time into clear swaps in cotton, 

 19 to clear OTC options, to clear basis swaps over 

 20 time. So I just want to focus a minute on a few 

 21 hypothetical instruments and I intentionally chose 

 22 a few that are entirely hypothetical just to give 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 197 

 1 people an idea of how these might benefit a 

 2 customer's risk-management needs. 

 3 For example, in the first instance if 

 4 you have a cotton producer who wants to implement 

 5 a capital expenditure it's going to cost a lot of 

 6 money and there's going to be a 5-year payback, 

 7 and in order to secure financing they need to 

 8 hedge 50 percent of their production going 5 years 

 9 old. That producer could enter into a long- dated 

 10 swap contract and they could clear that on the 

 11 exchange. Our exchange traded contracts don't 

 12 even go out 5 years. In the OTC market they might 

 13 find a counterparty who's willing to do that 

 14 5-year transaction. Now they can clear with a 

 15 central counterparty and they can solve this 

 16 risk-management need. 

 17 A second example, a Chinese mill owner 

 18 purchases cotton from a Chinese free trade zone. 

 19 You could imagine a swap transaction where the 

 20 miller owner can entered into a cash-settled swap 

 21 with a merchant who settles against an index 

 22 that's tied to the price of cotton in that region 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 198 

 1 in China in this example. So the customized 

 2 solution is we clear that swap. Again, it enables 

 3 somebody to more appropriately hedge their 

 4 specific risk. 

 5 A final example is an investment firm 

 6 sells a 2013 principal-protected note with upside 

 7 tied to the price of sugar. Let's say it's a 

 8 wealthy individual planning for their retirement, 

 9 they want to diversify their portfolio, they want 

 10 a principal-protected note long term but they want 

 11 some upside tied to commodities to diversify their 

 12 portfolio. Now that investment firm can purchase 

 13 a 2013 OTC, I've written swaps in here but think 

 14 of it as an option, to hedge that position to be 

 15 able to provide that product and they can again 

 16 clear that with the central counterparty. 

 17 So this was just go give you a few ideas 

 18 of the longer-term benefits of clearing swaps. In 

 19 the near term as I explained we're looking to 

 20 clear coffee, cocoa, and sugar swaps. That's all 

 21 I have. Thank you. 

 22 MR. DUNN: Thank you very much, Tom. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 199 

 1 We'll now hear from Dave Lehman and Julie Winkler 

 2 from the CME Group. 

 3 MR. LEHMAN: Thanks again, Commissioner. 

 4 It's our pleasure to be here again to talk about 

 5 clearing ag swaps. We did make an initial 

 6 presentation as Tom mentioned at the December 2006 

 7 meeting and again in April when we were here at 

 8 the roundtable that coincided with filing our 

 9 petition, and that petition is to allow us to 

 10 clear basis swaps for corn and calendar swaps for 

 11 corn, soybeans, and wheat. 

 12 What's driving this demand for OTC 

 13 products or interest in OCT products? It's we 

 14 think really many of the same factors that are 

 15 driving our commodity prices to more volatile 

 16 levels and high levels. They're listed here, the 

 17 supply-demand factors of weather and disease, 

 18 developing- country demand, falling dollar. That 

 19 is even a bigger factor in some of the more recent 

 20 studies than we though; higher input costs, 

 21 biofuel production. Biofuel is probably the 

 22 biggest factor that's driving the interest among 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 200 

 1 our existing clients in swaps. It's actually our 

 2 first commodity swap cleared product at CME Group, 

 3 and Julie will look at some of the data on that, 

 4 but this sector is also driving the interest in 

 5 the basis swaps for corn. 

 6 As Tom mentioned, our traditional 

 7 futures go out about 3 years. We've listed some 

 8 of our grain futures contracts a fourth year but 

 9 swaps tend to be done farther out than that. 

 10 We're out 10 years in ethanol with those swaps and 

 11 an OTC product gives you the ability to expand out 

 12 the curve. They certainly give participants more 

 13 flexibility in developing tailored risk-management 

 14 solutions that are more effective hedges and 

 15 obviously the dealers in the over-the-counter swap 

 16 market are playing an important role in creating 

 17 these products, and we're having discussions and a 

 18 lot of the demand is coming from those dealers who 

 19 are working directly with end users. So it's kind 

 20 of a way to leverage product development if you 

 21 will. 

 22 Benefits. These are the same that Tom 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 201 

 1 covered for the most part, but we are hearing of 

 2 interest in cleared OTC transactions in our 

 3 enumerated commodities now in the grain contracts 

 4 in dairy and in meat products as well. These are 

 5 trading today in the over-the-counter market. 

 6 They're trading presumably among eligible swap 

 7 participants but without a clearing guarantee. So 

 8 what we can do by bringing these into the 

 9 clearinghouse is help offset that counterparty 

 10 risk, and that's really probably the biggest 

 11 benefit of reducing counterparty risk but also the 

 12 regulatory transparency that comes with these 

 13 products. In our submission seeking an exemption 

 14 from the CFTC we listed the conditions that we 

 15 would be willing to impose on these products of 

 16 large trader reporting, position accountability, 

 17 daily reporting of volume and open interest. So 

 18 the bottom line is the introduction of OTC 

 19 products that are a cleared product will give 

 20 market participants a way to managing increasingly 

 21 volatile risk especially in the basis market and 

 22 also reduce their counterparty exposure. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 202 

 1 This chart shows the growth in the OTC 

 2 market over the last 3 years. This data is from 

 3 the Bank for International Settlement so it's only 

 4 available for commodities broadly and that 

 5 includes energy. It does not include metals, but 

 6 as you can see, this market has grown from a $5 

 7 trillion market to about an $8-1/2 trillion 

 8 market. We estimate that it's about five times 

 9 the size of the exchange-traded commodity markets. 

 10 What is a swap and how is it defined? 

 11 I'd like to note that we just got a white paper on 

 12 our swap products published this morning. It's 

 13 over on the credenza in the back of the room. It 

 14 wasn't here at the beginning of the meeting so I 

 15 encourage you to drop by and pick that up. It's 

 16 about an 8- or 10-page paper. In its simplest 

 17 form it's simply an exchange of cashflows between 

 18 counterparties. These instruments in the interest 

 19 rate markets initially. A commodity swap is very 

 20 similar to an interest rate swap where the two 

 21 counterparties are exchanging a floating price for 

 22 a variable price for the commodity. I'll go 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 203 

 1 through a little example of an ethanol producer. 

 2 This is where we're seeing the demand certainly on 

 3 the product side for a fixed-price product 

 4 supplying it to a blender, but on the input side 

 5 since the ethanol producer is really providing his 

 6 product to a blender at a fixed price, he wants to 

 7 be able to fix a price on his inputs. In this 

 8 example, they agree at a $5 per bushel price for 

 9 corn. The farmer agrees to pay the variable, and 

 10 that's based on the futures price. It adds 

 11 transparency. The settlement for both our 

 12 calendar swaps and basis swaps will be our futures 

 13 price in the case of the calendar swap and that's 

 14 averaged over the final month of settlement. In 

 15 the case of the basis swap, the settlement price 

 16 will be the difference between futures and a cash 

 17 price provided by a well-known cash price 

 18 provider. 

 19 I have included contract specs for one 

 20 of the basis swaps. There are six of them that 

 21 we've asked CFTC for authorization to clear. 

 22 These are all for corn today. Again it's really 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 204 

 1 to respond to the ethanol industry's demand for 

 2 additional risk-management tools. I'm hopeful as 

 3 Mr. Heitman noted that our request for a blanket 

 4 exemption will be considered expeditiously and 

 5 approved and that will allow us to add more tools 

 6 quickly as the market demands them. With that I'm 

 7 going to switch chairs with Julie and I'll let her 

 8 go over the next section. 

 9 MS. WINKLER: Thank you, Dave. I think 

 10 it's important to stress too that how we see these 

 11 products working is continuing to operate as they 

 12 currently do in the OTC market. So what the 

 13 exchanges are trying to do is provide a clearing 

 14 mechanism along with all the benefits that we see, 

 15 primarily that being increased transparency, and 

 16 we do believe that that is going to allow more 

 17 market participants to transact in these OTC swaps 

 18 who cannot currently do that. 

 19 As David mentioned, the exemption that 

 20 we are seeking is looking for both the corn 

 21 calendar swaps in six different basis swap 

 22 contracts. We will be utilizing cash prices 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 205 

 1 collected by grain elevators throughout the 

 2 Midwest as the basis for that. And just to 

 3 clearly make sure everyone understands exactly 

 4 what the exchange and the CME clearinghouse will 

 5 be doing and the services we will be providing is 

 6 that we do intend to publish daily settlement 

 7 prices for all these swaps. We'll be distributing 

 8 daily volume and open interest for all the swaps 

 9 listed for clearing as we currently do for our 

 10 futures products. We have also recommended that 

 11 we adopt position accountability for these 

 12 products both for single months and all months 

 13 combined. And we really believe that this helps 

 14 to provide a certain level of transparency that we 

 15 are clearly not getting in the OTC market now. We 

 16 will continue to provide financial surveillance of 

 17 our firms and oversight of these FCMs that are 

 18 going about clearing these swaps which we believe 

 19 is vitally important utilizing span in the 

 20 clearinghouse as we do not to establish 

 21 appropriate margin levels. And we believe that 

 22 the daily and final mark to marketing of these 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 206 

 1 products is really probably one of the most 

 2 important aspects that we can provide. What that 

 3 allows for is the collecting of a variation margin 

 4 every single day, and certainly the example that 

 5 we've seen in the credit market over the last few 

 6 months with mortgage books and credit default 

 7 swaps not being daily mark to market really 

 8 allowed things to get away from many of the global 

 9 investment banks. We believe that daily mark to 

 10 marketing of these OTC swaps is going to certainly 

 11 prevent that and we believe our clearinghouse can 

 12 do that in a very prudent manner. So I really 

 13 can't underestimate the importance of the CCP in 

 14 how it can provide integrity and transparency to 

 15 these markets. 

 16 CME clearing is also going to provide a 

 17 number of other services they do for existing 

 18 products, multilateral netting, post-trade 

 19 give-up, and the other value that they do provide 

 20 is that they're going to be able to provide market 

 21 participants with margin offsets if they have 

 22 corresponding existing futures positions at CME 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 207 

 1 Group. So if they were enter into a corn calendar 

 2 swap and also have existing corn futures 

 3 positions, there will be a spread credit provided 

 4 to those market participants if they have 

 5 positions in both offsetting contracts. We 

 6 believe that will be a very valuable service to 

 7 the market participants. And as mentioned 

 8 earlier, certainly the financial safeguards 

 9 package of CME Clearinghouse, I think the number 

 10 that was mentioned is now over $6 billion and we 

 11 believe that backing is going to be significant in 

 12 order to protect the clearing of these products. 

 13 This is a graph of our daily ethanol 

 14 swaps and this is the first OTC product that was 

 15 introduced by the board of trade for clearing back 

 16 in December 2006. You've seen some dramatic 

 17 growth over the last 2-1/2 years of this product. 

 18 Average daily volume is now over 780 contracts. 

 19 We see open interest over 22,000. We also have a 

 20 suit of products around this both in terms of 

 21 cash-settled options and also cash-settled 

 22 products based on the forward months swap. It's 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 208 

 1 been a really good example and I think learning 

 2 experience for us as an exchange to go out how to 

 3 margin these and how to learn from other markets. 

 4 The market participants came to us saying we're 

 5 used to doing this in the energy market. Can you 

 6 do a similar thing for us in ethanol? It's really 

 7 been about working with many of the people in this 

 8 room to help make this product even more 

 9 successful and being willing to modify the product 

 10 along the way to truly address the risk-management 

 11 needs that people had. So we've been very happy 

 12 with the success of this product. 

 13 In summary, we see a number of benefits 

 14 that cleared swaps can provide particularly at the 

 15 CME Group. We do see this as a bridge between the 

 16 OTC markets and the futures markets. Certainly 

 17 you've heard us all talk about the increased 

 18 transparency that's going to result as a matter of 

 19 clearing these ag swaps. The market surveillance 

 20 that the exchange can provide, the safety and 

 21 soundness that we bring to the marketplace, and 

 22 certainly the margin benefits could be significant 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 209 

 1 for those customers who are already active in our 

 2 futures markets. In many regards too we see these 

 3 as having the ability to provide risk- management 

 4 tools for really bespoke OTC products that are 

 5 already taking place in the marketplace but 

 6 they're probably too small to actually provide a 

 7 futures market that is a liquid alternative for 

 8 people. So we do believe that this customization 

 9 and individual markets certainly has value. So in 

 10 summary I'd like to thank Commissioner Dunn and 

 11 all the fellow Commissioners for their support on 

 12 this. I think the communication with you and your 

 13 staff has been great and we hope you will 

 14 seriously consider the benefits that clearing ag 

 15 swaps could bring to our marketplace. Thank you. 

 16 MR. DUNN: Thank you, Julie and Dave. 

 17 Now we are open for comments and questions by the 

 18 members of the Advisory Committee. No comments or 

 19 questions by the Advisory Committee. Leroy? 

 20 MR. WATSON: Thank you, Commissioner. I 

 21 just want to ask some details of some of the 

 22 transparency and reporting that we're going to get 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 210 

 1 out of this. One of the things that we've heard 

 2 is that one of the reasons that swaps exist or 

 3 swaps become popular is because they have a larger 

 4 timeframe or a longer timeframe than existing 

 5 futures market products. When you're talking 

 6 about reporting interest on a monthly basis, are 

 7 you talking about potentially reporting monthly 

 8 interest on a June 2018 product out there? Are 

 9 you going to extend that out there so we're going 

 10 to have actually month-to-month add on on what 

 11 swaps bases are 4, 5, even 10 years not depending 

 12 if those are the products that are being offered 

 13 on the exchanges? 

 14 MR. LEHMAN: Yes, Leroy, we would 

 15 publish the volume in open interest no matter how 

 16 far out the curve it is. We do that for ethanol 

 17 today and we've got ethanol swap open interest out 

 18 10 years. As I mentioned, our futures contracts 

 19 are listed out 3 to 4 years so if we're settling 

 20 the swap to the futures then we need to list the 

 21 futures contract to have a settlement price for 

 22 the swap. So that actually will lead to expanding 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 211 

 1 the forward curve in our futures markets, and as 

 2 we do that, at least our experience in ethanol has 

 3 been that the swap participants then become 

 4 interested in a vested way if you want to put it 

 5 in what the futures settlement price is so that 

 6 creates liquidity in futures and the two tend to 

 7 feed off of each other. So it is going to be more 

 8 information farther out to curve than what we see 

 9 today in these grain markets and the other 

 10 agricultural markets. 

 11 MR. WATSON: And as I also understand 

 12 the proposals, unlike a standardized futures 

 13 contract which can only legally be traded on an 

 14 exchange, swaps would still have the legal ability 

 15 to be traded OTC. So that what we've got is we're 

 16 working with two different regulatory programmings 

 17 here in that if you want to trade a futures 

 18 contract you've got to come to an exchange, but 

 19 you continue to have somewhat of the moral hazard 

 20 risk of the fact that the swaps market could leave 

 21 the exchanges at some point in time in the future 

 22 depending on what market or regulatory situations 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 212 

 1 are. Is that correct? 

 2 MR. LEHMAN: Yes, I think that's 

 3 absolutely correct. It's not on the exchanges 

 4 today in the agricultural markets because of the 

 5 regulatory restrictions. You can't clear 

 6 agricultural swaps, as Mr. Heitman mentioned they 

 7 can't have standardized terms, and credit must be 

 8 a material consideration in the negotiations. So 

 9 all of those restrictions prohibit that market 

 10 from being on exchange and we feel that there is a 

 11 demand, we're hearing it from our customers, to 

 12 allow clearing to help with this mark to market, 

 13 with this counterparty risk, and then I think it 

 14 has a dual purposes in that it provides that 

 15 benefit to the marketplace and then it provides a 

 16 benefit to the regulators in giving them a better 

 17 picture of the entire market. 

 18 MS. WINKLER: And it's important to note 

 19 that it wouldn't prevent -- and even suppose that 

 20 all of those OTC swaps would need to come to the 

 21 exchange for clearing. That would certainly be up 

 22 to the two counterparties that had negotiated that 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 213 

 1 swap to determine whether they wanted to bring it 

 2 to the exchange for clearing. I think one thing 

 3 to point out is even though we have an idea that 

 4 this is now an $8-1/2 trillion market, it's not 

 5 even possible to break down of that number how 

 6 much of it is agricultural swaps that also 

 7 includes energy. So we're really talking about 

 8 there not being much transparency at all in terms 

 9 of what these OTC swaps are doing right now so to 

 10 get some of that on the exchange is certainly 

 11 going to make a big difference. 

 12 MR. DUNN: Are there other questions or 

 13 comments? 

 14 MR. CRYAN: What would stop the exchange 

 15 from replacing all the futures contracts with 

 16 equivalent swaps and abandoning regulation by the 

 17 CFTC? How does it become different from a futures 

 18 contract aside from the fact that it's not 

 19 standardized? 

 20 MR. LEHMAN: It's negotiated on a 

 21 bilateral basis so there really isn't a liquidity 

 22 element to the swap market. These are tailored 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 214 

 1 instruments and liquidity is not the primary 

 2 concern. The primary concern is a tailored 

 3 risk-management solution. I think for a lot of 

 4 the marketplace, liquidity is the primary product 

 5 that exchanges provide, and let's be honest, 

 6 that's what we hear every time we go and talk to 

 7 market participants about our product is what can 

 8 we do to expand the liquidity and expand the 

 9 breadth of users of those markets. So I they're 

 10 distinct markets from that sense or they provide 

 11 different benefits. I'm speaking personally here, 

 12 I don't think exchanges would want to see a 

 13 transition away from their centralized price 

 14 discovery markets to a bilateral negotiated swap 

 15 market. I think we envision them complementing 

 16 each other and we see kind of different role for 

 17 each one in my view. 

 18 MS. WINKLER: And I think the 

 19 exchange-traded futures market certainly now with 

 20 the preponderance of that volume being 

 21 electronically traded, you're seeing the depth of 

 22 book out there every single bid and offer and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 215 

 1 trade being made. The way the OTC swaps work is 

 2 that those bilaterally negotiated trade prices 

 3 will not be available to the public and those will 

 4 not get disseminated by the exchange -- that 

 5 end-of-day settlement price so you're really 

 6 talking about two totally different market 

 7 conventions each having distinct value I think to 

 8 the marketplace. 

 9 MR. DUNN: Are there other questions or 

 10 comments from the Advisory Committee? Joe? 

 11 MR. NICOSIA: Not in regard to the 

 12 clearing of the agricultural swaps which I think 

 13 are fine, but just the Commission again and we've 

 14 touched on this in our last meeting. I think it 

 15 is critically important for the Commission to get 

 16 its handle on the size and the participants of the 

 17 activity that's taking place in the swap and OTC 

 18 market and relate it directly to individuals' 

 19 position limits and their other trading activity 

 20 as far as regulation of the marketplace. So 

 21 although this is agricultural swaps, we haven't 

 22 really touched on that as far as any of the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 216 

 1 discussion yet today. I think that as far as 

 2 agricultural swaps go, that is by far much more 

 3 important. 

 4 MR. DUNN: Thank you. Are there other 

 5 questions or comments from the Advisory Committee 

 6 or from the audience? From my fellow 

 7 Commissioners? Commissioner Sommers? 

 8 MR. LUKKEN: The Commission has spent a 

 9 significant amount of time over the years talking 

 10 about the ag trade options program and as Don said 

 11 we've thrown two parties and no one came to either 

 12 one of them. So this is something we I think are 

 13 interested in revisiting in whether we treat ag 

 14 trade options similar to the way we treat energy 

 15 and metal trade options as well. 

 16 I'm interested too before we dive into 

 17 this and try to revisit this issue whether there 

 18 would be demand for this types of instruments. 

 19 Certainly there may be an interest in a fixed-cost 

 20 risk-management option out there. What I'm trying 

 21 to find out maybe from the producers around the 

 22 table or those who might use these ag trade 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 217 

 1 options whether this is something that they think 

 2 might be beneficial in their risk-management 

 3 schemes. Come on. Somebody say something. 

 4 MR. NICOSIA: As far as the use of those 

 5 within the agricultural space, again there are 

 6 ways to get around everything that you have so you 

 7 might as well just move forward as was presented 

 8 where it is because between swaptions in the swap 

 9 market, guaranteed price contracts, minimum-price 

 10 contracts are taking place all over the place. So 

 11 to try to fence in or catch someone who's trying 

 12 to present something wrong is massively 

 13 ineffective, it's regulation that's there that's 

 14 not preventing nor helping anything, so I think 

 15 you should open the marketplace up. 

 16 MR. DOUD: Is there any discussion of 

 17 any of this for the livestock industry? I've 

 18 never heard tell of it for livestock. Have you 

 19 guys? 

 20 MR. HEITMAN: Actually the one person 

 21 who we had who registered as an ag trade option 

 22 merchant was Kent Feeds and they were offering 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 218 

 1 trade options to hog producers who were locking in 

 2 feed prices and it was part of their deal with 

 3 Kent Feeds to lock in price on feed and then 

 4 selling their hogs. So the one example we have of 

 5 an ag trade option under the rules did involve 

 6 livestock in fact. But what's going on, I'm sure 

 7 there are as the other gentleman said all kinds of 

 8 options and swaptions and guaranteed minimum-price 

 9 contracts and so forth going on out there some of 

 10 which are probably technically over the line of 

 11 the ag trade option rules but I'm not aware of 

 12 that and actually I'm glad I'm not because that 

 13 might impose some kind of duty on me to call the 

 14 Division of Enforcement which I'd rather not have 

 15 to do. 

 16 MR. GAINE: I would make two comments. 

 17 As a producer before I came to Washington as a 

 18 part of the Risk- Management Agency I probably did 

 19 participate in some minimum-price contract 

 20 arrangements although I never heard them referred 

 21 to as swaps, they always had some kind of fancy 

 22 title to them that sounded pretty impressive, and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 219 

 1 frankly sometimes they worked pretty well. 

 2 Secondly, I'll respond with my 

 3 Risk-Management Agency hat on now with the 

 4 livestock products, the agency does offer 

 5 gross-margin contracts for basically all species 

 6 of livestock, sheep, hogs, and cattle, and are now 

 7 just about to roll out a dairy gross-margin this 

 8 week as a matter of fact. But frankly, there's 

 9 not a lot of interest in those certainly not 

 10 relative to other aspects of crop insurance. 

 11 Again I guess I'd just throw that out as a point 

 12 of information that those products are available 

 13 but generally speaking of limited popularity. 

 14 MR. DUNN: Yes? 

 15 MR. COYLE: I guess I would just make 

 16 one observation. I see the chart that the CME put 

 17 about the growth in their ethanol swaps. It would 

 18 seem to me that you'd see the same kind of offset 

 19 product in the grains and if you throw basis swaps 

 20 on top of that with the transportation volatility 

 21 it would seem by tying those together you may be 

 22 able to lock in margins that counter basis for 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 220 

 1 ethanol facilities so that would be one use. 

 2 MR. DUNN: Are there any others? Mr. 

 3 Heitman, in the CME's presentation they indicate 

 4 that increased transparency through public 

 5 reporting of volume, open interest, and settlement 

 6 price, and enhanced marketing surveillance of 

 7 over-the-counter activities by requiring position 

 8 accountability and reportable levels of 25 

 9 contracts would be one of the benefits of cleared 

 10 ag swaps. How important is that to the Division 

 11 of Marketing Oversight? And maybe Mr. Kass I can 

 12 get you to come up and talk about our current 1805 

 13 request and what it entails with our staff to go 

 14 through that since you're overseeing a good part 

 15 of that. 

 16 MR. HEITMAN: I would just like to go on 

 17 record as saying that the Division of Market 

 18 Oversight is four- square behind the concept of 

 19 market transparency. So anything that increases 

 20 market transparency is fine with us. As far as 

 21 the details of our current efforts to increase 

 22 transparency in these OTC markets, David is the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 221 

 1 one who's ram-rodding that effort so I'll defer to 

 2 him. 

 3 MR. KASS: Yes, we have gone out on this 

 4 using our 1805 authority which applies only to 

 5 traders currently holding reportable futures 

 6 positions. The original thrust was to talk about 

 7 commodity index investment whether through a swap 

 8 or through direct investment, but we're also 

 9 asking about OTC participation in all the markets 

 10 that they may be involved in but they have to be 

 11 at least reportable in futures before we have that 

 12 authority. Yes, that project is currently 

 13 underway. It's a massive sort of an undertaking 

 14 for this Commission because typically when you go 

 15 after a reportable trader for information you're 

 16 asking one trader, occasionally we've asked for a 

 17 couple I think, and you're asking for one market. 

 18 Here we're asking for quite a large number of 

 19 traders and we're asking it for dozens of markets. 

 20 So it's quite a huge undertaking, but the 

 21 agricultural products are covered as well. 

 22 MR. DUNN: Thank you. Would having this 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 222 

 1 type of information available assist you in this 

 2 effort? 

 3 MR. KASS: It would point to certain 

 4 participants who we would know would be involved 

 5 and so I guess, yes, any additional transparency 

 6 is good for everybody I think and that's what we 

 7 hope to come out of this 1805. We're just getting 

 8 the data in now so it's a little premature to talk 

 9 about what may come from the data, but that's 

 10 clearly something we're going to be dealing with 

 11 is recommendations going forward, any policy 

 12 implications that come out of the data, and beyond 

 13 policy, in terms of future transparency. But the 

 14 additional transparency of that any OTC market is 

 15 I think good for us and good for the industry. 

 16 MR. DUNN: Thank you very much. Thank 

 17 you to that panel. Now we'll have our next panel 

 18 on ongoing research and we'll start off on policy 

 19 issues with identifying and managing commodity 

 20 bubbles. Eric Juzenas of my office will make that 

 21 report. Let me give the disclaimer right now: 

 22 anything he says reflects his own bias and not 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 223 

 1 that of the Commissioner. We have a summary of 

 2 ongoing interagency and CFTC research. Jeff 

 3 Harris from who is our chief economist. And then 

 4 experiences with particular markets from Julie 

 5 Winkler again from the CME. Mr. Juzenas, if you 

 6 will, please. 

 7 MR. JUZENAS: As Mike said, my opinions 

 8 are my own. I think it's no surprise to anybody 

 9 here that the Commission has been getting beat up 

 10 a little bit by certain segments on the Hill about 

 11 whether we're doing enough to address speculation 

 12 which reflects the belief that prices currently 

 13 are not justified by market fundamentals. 

 14 Sometimes I think it's good to step back and 

 15 examine what we're doing and once I looked through 

 16 some of the questions we were getting from 

 17 Congress and looking at some of the newspaper 

 18 accounts, it seemed to me that this was a debate 

 19 about whether or not we're in a commodity bubble 

 20 and there are certainly people who believe that to 

 21 be the case. A lot of the research our own 

 22 economists have been doing is trying to look at 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 224 

 1 the fundamentals and study some of these 

 2 relationships and determine whether that might or 

 3 may not be the case. But I thought maybe it was 

 4 worthwhile just to dig a little deeper into this 

 5 and look to see what we know about asset bubbles 

 6 and how it might apply to commodity markets in the 

 7 hope that better understanding this might point 

 8 the way to both new areas of research that the Ag 

 9 Advisory Committee thinks we might look into, and 

 10 also hopefully help communicate the complexity of 

 11 these issues whether it's to the media, to 

 12 Congress, or the public at large because a lot of 

 13 times it seems when we're up on the Hill we can be 

 14 trying to relate what we see as market information 

 15 and the conversation we're getting back from some 

 16 of the other people just seems to be a totally 

 17 separate conversation. 

 18 Now to deflate any hope that anybody 

 19 has, unfortunately in looking at the research, 

 20 there really is not a whole lot of consensus about 

 21 what causes asset bubbles, what they are, or what 

 22 you should do about them, and this is a quote from 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 225 

 1 an economist who is reviewing it. There's the 

 2 perception held by many that we're in the midst of 

 3 a commodity bubble particularly in energy markets 

 4 and the general theory which is probably not a 

 5 surprise to anyone here is that commodities have 

 6 become an investment class, an asset class, and 

 7 then the influx of investment into there is 

 8 creating an upward pressure on prices which is not 

 9 justified by fundamental market conditions. 

 10 When you look at the definitions of 

 11 bubbles, the central one, the first one is sort of 

 12 common sense in that prices go up and then they 

 13 come down, and of course this can be applied to a 

 14 whole bunch of different economic phenomena, 

 15 Tickle Me Elmo dolls, Hurricane Katrina, or even 

 16 from my childhood Pet Rocks. There are a lot of 

 17 things where initially there can be a lot of 

 18 demand and then it falls off that doesn't 

 19 necessarily have anything to do with the market. 

 20 The second definition that's been used is that 

 21 price departs from fundamental value, i.e., that 

 22 there's a speculative component to prices and this 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 226 

 1 is the one that's probably more relevant to the 

 2 issues that we've been facing. Of course, the 

 3 problems with asset bubbles is that they distort 

 4 the price-discovery function of futures market or 

 5 whatever market they're impacting and then cause 

 6 misallocation of resources. 

 7 In general, if you look at the research, 

 8 it really hasn't been studied that much as to how 

 9 it applies to futures markets. A lot more of the 

 10 research into this has been into asset markets, 

 11 stocks, equities, real estate, and physical 

 12 markets. The existence of an asset bubble once 

 13 you think that it exists almost by definition 

 14 implies that something has gone wrong with price 

 15 discovery in the affected market and there are 

 16 various theories that have been proposed about why 

 17 this might be. The first is the greater fool 

 18 theory and that's that prices are going up but you 

 19 can always sell it to somebody else I guess until 

 20 you can't and then the bubble collapses. The next 

 21 one is investor herding which I think is pretty 

 22 well understood and that's just the idea that 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 227 

 1 investment seems to move together so if markets 

 2 are going up, everybody gets in which can create 

 3 further pressure for prices going up. The third 

 4 one I think which has gotten a lot of attention 

 5 when it comes to deciding what to do about asset 

 6 bubbles or whether they exist is liquidity, too 

 7 much money chasing too few assets, and this has 

 8 certainly been the case I think in the world of 

 9 the Fed when they've looked at whether they should 

 10 have a pro-bubble policy, an anti-bubble policy, 

 11 or neutral and in the stock run-up or in the 

 12 recent real estate markets should the Fed 

 13 intervene and this is probably relevant to what 

 14 we've been talking about and what the Hill has 

 15 been talking about in relationship to the futures 

 16 markets. We heard this morning from one of the 

 17 presenters a theory that wheat futures prices may 

 18 be leading cash prices due to the demand for 

 19 futures contracts and that starts to sound like 

 20 maybe there's a potential liquidity issue there. 

 21 While I doesn't appear to be causing a bubble 

 22 since what we see is that the cash prices are 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 228 

 1 offsetting the futures prices, it clearly causes 

 2 problems for price discovery and I think this may 

 3 be part of the challenge. Even if an increase in 

 4 liquidity or an increase of investment isn't 

 5 leading to a bubble or higher prices, it's gets 

 6 difficult to communicate this message to people, 

 7 you're right, it's having an impact but, no, it's 

 8 not driving prices higher, and it gets even more 

 9 difficult if you have to say it's driving prices 

 10 higher in one part of the market and consequently 

 11 it's lower in another part of a market. Then 

 12 there are some economists who firmly believe there 

 13 is no such thing as a bubble. 

 14 What is a regulator supposed to do about 

 15 bubbles? I think this is the key thing for this 

 16 committee to consider and I think something that 

 17 the Commission needs to get some input from people 

 18 on. There seem to be more than ever at least in 

 19 recent times the thought among many on the Hill 

 20 that we should be doing something to address what 

 21 might be a bubble in energy markets or what some 

 22 people think is a bubble in energy markets. Most 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 229 

 1 of the attention on this issue has been paid to 

 2 the Federal Reserve Bank and there of course the 

 3 general theory is that if you raise interest rates 

 4 you'll contain whatever liquidity is driving the 

 5 bubble and that will deflate the bubble. You can 

 6 look and see that there is a fair amount of 

 7 research looking at historical incidents on the 

 8 Japanese real estate market, the Great Depression 

 9 and the stock market crash of 1929. They talk 

 10 about monetary policy but they really don't talk 

 11 about what other possible interventions there 

 12 might be. A fellow from the Fed Reserve Bank of 

 13 New York proposed a decision tree that I thought 

 14 was interesting. It says, first, can policymakers 

 15 identify a bubble? I think just the debate we've 

 16 had at the Commission and the interactions we've 

 17 had with the public and the Hill show the 

 18 difficulties in coming to agreement on whether a 

 19 bubble exists. Then if you do have a bubble, will 

 20 the fallout be significant hard to rectify after 

 21 the fact which goes to is it something you really 

 22 need to address. Then the third, what tools can 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 230 

 1 deflate the bubble? 

 2 Sorting through all these questions 

 3 isn't easy and part of trying to make these 

 4 determinations implies you have to have some 

 5 pretty good knowledge of the markets that we may 

 6 or may not have. There is a great debate through 

 7 the years about whether the Fed should engage in 

 8 asset bubble popping or whether they should just 

 9 let them be and there have been different chairmen 

 10 who have had different viewpoints. Our current 

 11 chairman, Chairman Bernanke, had said that given 

 12 that there's no generally accepted criteria, who 

 13 is supposed to determine whether the bubble causes 

 14 it? And more importantly, monetary policy is a 

 15 very blunt too. Basically, if you're raising 

 16 interest rates you're saying the approach to 

 17 popping the bubble is going to be slowing the 

 18 economy and I think this leads into the options 

 19 that have been suggested for the CFTC that we 

 20 should consider pursuing and in many respects 

 21 these are similarly blunt options and I think the 

 22 questions then become trying to evaluate these for 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 231 

 1 what their effects might be. Raising margin 

 2 requirements for speculators, position limits, and 

 3 limiting market participation through defining 

 4 acceptable hedging practices have all been 

 5 proposed and these all get to that question again 

 6 of trying to limit liquidity into the markets. 

 7 The questions associated with these are 

 8 first I think going to Chairman Bernanke, can we 

 9 figure out what a commodity bubble is and when it 

 10 exists? Then I think the question is in making 

 11 that determination, you really have to figure out 

 12 what is going to be our objective measure of 

 13 prices, so how do you determine that prices have 

 14 really departed from fundamentals? Then a 

 15 question of these different policy options, are 

 16 they actually going to bring prices lower or if 

 17 there were a bubble, would these be the 

 18 appropriate measures for addressing it? Then 

 19 again is there a potential for detrimental 

 20 impacts? 

 21 For today I thought some of the 

 22 questions were most of the debate on commodity 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 232 

 1 bubbles really seems to be in energy markets, but 

 2 I think it's worthwhile considering whether people 

 3 here are concerned that there might be a commodity 

 4 bubble in agricultural markets or is what we're 

 5 facing just difficulties with price discovery or 

 6 issues that need to be addressed related to the 

 7 efficiency of the markets. And I think this is 

 8 particularly important, if there is further 

 9 research we can do that might help better 

 10 communicate the message or better answer some of 

 11 these questions that we've been facing or maybe 

 12 our research has been fine so far, but it seems 

 13 like there are still people are wanting more from 

 14 us. I hope it's not just the answer that, yes, we 

 15 agree that there's a commodity bubble, but we've 

 16 just tried to do some thinking about what types of 

 17 things we might look at that might hopefully 

 18 address some of these questions. Then I think 

 19 there's this general question for the CFTC that we 

 20 haven't really looked at as much that the Fed has 

 21 examined and that's is there a role for the CFTC 

 22 in doing this and do people expect the CFTC to 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 233 

 1 manage potential commodity bubbles. 

 2 MR. DUNN: Thank you very much, Eric. 

 3 Jeff Harris is our Chief Economist and the team 

 4 leader for the Interagency Task Force. Jeff, if 

 5 you would, please. 

 6 MR. HARRIS: Thanks for having me, 

 7 Commissioner Dunn. In following-up on Eric's 

 8 comments I think what I would like to do is give a 

 9 little overview on what the Interagency Task Force 

 10 has been doing for the last month and a half or 

 11 so, give you a little preview of what we plan to 

 12 do with agricultural markets looking forward, and 

 13 to start off I just wanted to give a little bit of 

 14 an overview of what we do in the Office of the 

 15 Chief Economist. We have a research objective to 

 16 provide basic knowledge for the Commission to make 

 17 decisions on. So we do basic research is the 

 18 bottom line. We try to do systematic analysis of 

 19 market function and part of that market 

 20 functioning is obviously looking at bubbles and 

 21 different types of price patterns to make sure 

 22 that our markets are functioning effectively and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 234 

 1 to do that we employ mostly Ph.D. economists to do 

 2 statistical and econometric analysis. And we also 

 3 have a little bit of a support role in the sense 

 4 that we interface with our market surveillance 

 5 staff and enforcement people, we provide 

 6 independent advice on enforcement cases and some 

 7 expert testimony either as a primary source or as 

 8 a secondary opinion for experts outside the 

 9 Commission. 

 10 From the Interagency Task Force's 

 11 standpoint we have partnered with the USDA, the 

 12 Treasury, the Federal Reserve Board of Governors, 

 13 the Federal Trade Commission, and the SEC, to have 

 14 an examination this summer of conditions in 

 15 commodity markets. It's fairly general, fairly 

 16 wide in scope, but trying to address the price 

 17 concerns and volatility concerns that we see in 

 18 both agriculture and the energy markets. To date 

 19 obviously for those of you who have been keeping 

 20 up we had an interim report on the study of crude 

 21 markets released last Tuesday. The basic outline 

 22 of the report is listed here. We covered demand, 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 235 

 1 supply, and macro factors in these markets, and 

 2 the central role that the CFTC played with that is 

 3 to provide an overview and an analysis of the 

 4 functioning of the futures markets. We looked at 

 5 the past 5-1/2 years, from 2003 to 2008 date up 

 6 through June focusing on the roles of various 

 7 traders and speculators in the markets, looking at 

 8 a little bit of the term structure clues on what 

 9 we see in developing open interest in developing 

 10 long-term contracts in the energy space, and then 

 11 applying some statistical tests, and I just wanted 

 12 to give an overview of that, correlations in 

 13 particular, looking at the detailed trade data 

 14 that we do have within the CFTC for price changes 

 15 on a daily basis and how they relate to position 

 16 changes by various categories of traders each day 

 17 over that timeframe. 

 18 The bullet there for the energy markets 

 19 is that there really hasn't been consistent 

 20 correlations over time. We have that in our 

 21 interim report. Following-up on the correlations 

 22 though, much more interesting is is there any 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 236 

 1 group of traders who are causing price changes. 

 2 The test we employed in the particular interim was 

 3 the Granger causality test. I put it on quotes 

 4 because the Granger causality test is not really a 

 5 test of causality, but it's a statistical 

 6 relationship that asks can we see position changes 

 7 by a particular group that leads price changes? 

 8 So you'd expect that if a group of speculators 

 9 were able to move prices up, then you'd see that 

 10 the buying of those speculative groups would 

 11 precede the price change so they're able to move 

 12 prices up and their trading would be related. In 

 13 the oil markets we've seen little evidence of 

 14 this. It's related to the ag markets because 

 15 we're planning a follow-up study. The final 

 16 product that we do in September, we're updating 

 17 our study and we'll be using some of the same 

 18 techniques that we've applied to the crude oil 

 19 market to a number of different agricultural 

 20 products. In fact, we have another Interagency 

 21 Task Force call in about 20 minutes so we'll be on 

 22 to the next topics there. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 237 

 1 One of the central topics in this report 

 2 that you've heard today and most people are 

 3 familiar with is the issue of commodity index 

 4 trading. Obviously they mimic a broad class of 

 5 commodities. These are traders in our markets 

 6 only for the sake of diversification so they say. 

 7 They look at the correlation, the portfolio theory 

 8 behind risk and return tradeoffs, and perhaps have 

 9 no information whatsoever about the type of 

 10 commodity they're investing in but they want 

 11 exposure as they say to a broad class of assets. 

 12 The flows are estimated to be $100 billion plus in 

 13 the last few years. That is a number under 

 14 considerable debate. One of the issues is again 

 15 with our special call like Dave Kass mentioned, we 

 16 hope to get a better grasp of the flows that are 

 17 going into these index funds through part of that 

 18 special call. So the bottom line again with these 

 19 index traders is they're trying to do portfolio 

 20 enhancement and better risk in return tradeoffs by 

 21 adding commodities to their basket of portfolios. 

 22 This is the major commodity index and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 238 

 1 what I've highlighted in red of course is from our 

 2 surveillance staff. We have identified in our 

 3 agricultural commodities fairly specifically and 

 4 fairly well the 12 agricultural products that are 

 5 in our supplemental commitment of trader reports 

 6 so we keep track of the index flows within those. 

 7 So in the agricultural space we have a fairly good 

 8 understanding of the size of these particular 

 9 traders in a number of the agricultural products. 

 10 To date we've been analyzing these positions on a 

 11 daily basis looking at daily price changes and 

 12 daily position changes and we do see very little 

 13 evidence that these index positions are affecting 

 14 price levels or changes the prices on a daily 

 15 basis. There seems to be very little correlation 

 16 between the CIT market share in the cross-section 

 17 so of you look at the number of agricultural 

 18 commodities that have high levels of index 

 19 trading, they don't seem to have the biggest price 

 20 increases. We don't seem to have a correlation in 

 21 the cross-section that way. They don't also seem 

 22 to be related to increased volatility in our 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 239 

 1 markets either. One of the reasons for that I 

 2 think as we've tried to educate people on the Hill 

 3 is that the supply of contracts in the futures 

 4 market is not a limited supply. We've heard some 

 5 analogies that if five people show up to buy my 

 6 cow I get one price, and if 50 people show up to 

 7 buy my cow I get a higher price. It's not quite 

 8 that same obviously in the futures markets because 

 9 we can write new contracts at the same price and 

 10 so the supply of contracts is a fungible component 

 11 of the futures markets that's not well understood 

 12 I don't think on the Hill and we've been trying to 

 13 educate people that way. 

 14 One of the things again as we've 

 15 mentioned from the Chief Economist's office is we 

 16 have been tracking open interest in particular 

 17 with the eye on the fact that if open interest 

 18 stops going up and prices continue up, that might 

 19 be a sign that we're in a bubble situation or that 

 20 we're in a position where there's no longer 

 21 liquidity being added into the markets and that 

 22 we're all bidding up the current supply. So in 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 240 

 1 the crude oil market in particular we've seen what 

 2 we think is healthy growth in the open interest. 

 3 Some of the other markets like I said in the 

 4 agricultural commodities we still have record open 

 5 interest. But we continue to monitor those levels 

 6 on a day-to-day, week-to-week basis to see if we 

 7 find inflection points or we might see that the 

 8 open interest stops going up and prices continue 

 9 on that there might be evidence for overreaction 

 10 or some sort of bubble behavior in the markets. 

 11 We have anecdotal evidence, we don't 

 12 have a strong set of research here but we're 

 13 working on that this week actually, that commodity 

 14 index traders actually reduce conditional 

 15 volatility. Not to go into too much of the 

 16 econometrics of it, but put in the time series of 

 17 commodity index trading and the series of 

 18 volatility and prices into a model that looks at 

 19 the predicted volatility and then we did the 

 20 simple exercise of dummying out the times when 

 21 index traders are rolling from the near-month 

 22 contract into the next near-month contract and it 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 241 

 1 turns out based on the parameters of those types 

 2 of models that there is a dampening actually of 

 3 volatility in many markets based on index trading. 

 4 The final bullet point in the statement there 

 5 would be that it looks like they're providing some 

 6 liquidity to the market, they're buying when other 

 7 people wouldn't necessarily be there, they're 

 8 providing selling opportunities to people who want 

 9 to get in or out of the market during the roll 

 10 period. We have engaged with people on Wall 

 11 Street and around the world to find out of that's 

 12 true and we have anecdotal evidence that people do 

 13 defer purchase or sale opportunities and we have 

 14 actually seen individual traders taking the 

 15 antiroll positions trying to margin out a little 

 16 bit of profit and taking positions opposite to the 

 17 rolling of the commodity index traders. You've 

 18 maybe seen graphs like this. I pulled this off 

 19 our commitment of trader report last week just to 

 20 plot it out and you can see like in Chicago Board 

 21 of Trade wheat almost 50 percent of the open 

 22 interest is held by the commodity index traders. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 242 

 1 We see that there are a number of markets like 

 2 hogs and the live cattle market where they are 

 3 almost half of the market as well. So this is the 

 4 basis of much of our analysis in looking at the 

 5 cross-section of the level of index trading and 

 6 price changes and if you notice, some of the 

 7 highest, the hogs and the cattle market for 

 8 instance, the index trading even though it's the 

 9 greatest there, those are markets with some of the 

 10 weakest prices. The counterargument to this 

 11 obviously could be that the prices would even be 

 12 lower had these index traders not been in the 

 13 market but from that point on is where we step off 

 14 and say we can look at the simple correlation or 

 15 we can then step in to look at some more 

 16 statistical evidence on the grains or causality 

 17 looking at the dynamics of who's buying each day 

 18 and who's selling each day with the prices that 

 19 are changing on those days. 

 20 Beyond index trading we also look at 

 21 other types of speculators primarily in the ag 

 22 markets. We look at managed-money traders 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 243 

 1 otherwise know by their street names as hedge 

 2 funds. We recall group hedge funds is the general 

 3 term perhaps, but they include CPO, CTAs, as well. 

 4 We can segment out floor brokers and traders to 

 5 look at their trading behavior and other 

 6 nonreporting traders among noncommercial sets. So 

 7 this is the breakdown of the noncommercial 

 8 categories within our public commitment of trader 

 9 reports. Most noncommercial traders are actually 

 10 spread traders and that comes out in our weekly 

 11 reports as well so they're long in September for 

 12 instance and short the December contract so most 

 13 of the noncommercials despite their increased 

 14 participation in our market are taking spread 

 15 positions and taking a position on the curvature 

 16 of the term structure. We can also do the same 

 17 analysis among these speculators and ask the same 

 18 question if they have an overall effect in their 

 19 position changes and price changes are they 

 20 related to price changes in the marketplace. I 

 21 just wanted to point out that I updated this I 

 22 guess over the weekend again for different net 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 244 

 1 speculative positions, one of the things in crude 

 2 oil that we've been tracking for a long time, the 

 3 long-term crude oil average is about 4 percent 

 4 long among noncommercial traders and actually last 

 5 week it's down to 2 percent so there has been a 

 6 little bit of a dip. Then you can see a nice 

 7 breakdown that looks like gold has by far the most 

 8 speculative activity, sugar, cocoa, coffee and 

 9 some of the other ag products haven't changed 

 10 appreciably and if you look at the change from 

 11 February to July in fact most of those speculative 

 12 positions are down and so you could do the same 

 13 analysis with our publicly available data each 

 14 week, but I just wanted to highlight that as the 

 15 prices have weakened here over the last 6 months 

 16 it's not nearly as attractive for speculators to 

 17 be into agricultural products. 

 18 As to other speculators what do we find? 

 19 Some of the correlations between managed money or 

 20 hedge funds in this case have been positive and 

 21 have been seemingly persistently positive at least 

 22 for this year for the last 9 months. Then the 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 245 

 1 question becomes is that positive correlation with 

 2 price changes actually due to causation. Again 

 3 it's not an easy thing to determine whether 

 4 someone's causing the price changes, but we put in 

 5 statistical models looking for whether these 

 6 position changes are leading price changes in any 

 7 way, we don't find much evidence. Once again in 

 8 the ag markets we are still working on that 

 9 particular project as a part of our Interagency 

 10 Task Force but I wanted to point out that we are 

 11 doing this, we're actively engaged each week doing 

 12 new specifications of various combinations of 

 13 different types of traders looking at open 

 14 interest in the near term, the near term plus the 

 15 next month, the full slate of open interest, and 

 16 every combination thereof. 

 17 Related to Eric's talk I think the other 

 18 thing we've engaged with is whether there is any 

 19 herding in our markets. We have a working paper 

 20 where we had a version of this done last fall and 

 21 we're working on updating that where we look at 32 

 22 different markets and the propensity for these 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 246 

 1 particular traders to trade on one side with the 

 2 expectation again that if all the speculators are 

 3 buying or all the speculators are selling that we 

 4 should be looking at that imbalance that there's 

 5 not a fifty-fifty split for instance in the number 

 6 of buyers and sellers in the marketplace. One of 

 7 the things that we have found regularly among 

 8 hedge funds is actually countercyclical, that we 

 9 do see some evidence of herding among hedge funds 

 10 but it's almost always on the other side of the 

 11 market so when prices are going up we see an 

 12 increase in the herding behavior of hedge funds on 

 13 the sell side and as prices are dropping see these 

 14 hedge funds tending to herd on the buy side. With 

 15 herding metrics there is no clear-cut guidance of 

 16 what's a herd and what's not, but the basic metric 

 17 we're using is the propensity of how many of these 

 18 traders are on one side or another of the market. 

 19 So we are engaged there and we're working on 

 20 updating some of that for like I said a broad 

 21 cross-section of agriculture and energy products 

 22 as well. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 247 

 1 You've seen these again earlier this 

 2 morning but I wanted to reiterate that this is one 

 3 of the difficulties I think of determining 

 4 statistical analysis when you look at this as just 

 5 the corn market again. The corn market going up 

 6 through the beginning of March this year and you 

 7 can see the challenges we face. The top line is 

 8 the commodity index traders in the blue, the green 

 9 line is the managed money or hedge funds, and the 

 10 red line is the price change. You see very little 

 11 change in the structure of the participants in the 

 12 marketplace while prices are really changing 

 13 dramatically. So as an econometrician or as a 

 14 statistician or someone who tries to uncover 

 15 what's going on in the market, you can use your 

 16 eye test which is nonspecific where you look at it 

 17 and it looks like not much is going on in the net 

 18 positions of any one of these groups or traders. 

 19 So this is the picture for corn, a similar 

 20 position for wheat. We look at the healthy mix or 

 21 what we think is a healthy mix of different types 

 22 of traders and we don't see dramatic changes in 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 248 

 1 the composition of traders within the market even 

 2 as positions or as prices are changing 

 3 dramatically. 

 4 Where does that leave us? For most of 

 5 the analysis we've done to date is that there is 

 6 strong worldwide demand for most of the 

 7 commodities are leading to higher prices. There 

 8 is little evidence at least in the crude market 

 9 that groups are systematically leading to higher 

 10 prices. There's the conclusion in our interim 

 11 report on crude. There might be some evidence of 

 12 commodity index traders' positions actually 

 13 reducing volatility in some of these markets but 

 14 we continue to engage our data, try to enhance our 

 15 data, and try to look at multiple ways of 

 16 assessing whether something is eluding our view. 

 17 I wanted to wrap up by saying we have 

 18 plans for further study. We continue to look at 

 19 these issues. One of the issues outstanding is 

 20 whether open interest and prices actually respond 

 21 to buying or selling pressure. I mentioned 

 22 earlier that we think that the addition of new 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 249 

 1 open interest provides some litmus test for health 

 2 of the market, that there's liquidity being 

 3 provided, that there are enough people out there 

 4 writing contracts and that we're not all just 

 5 bidding up a fixed amount of contracts in our 

 6 market, but we don't really have a good grasp of 

 7 whether there's a good stable relationship there 

 8 or how the historic levels of interest pricing, 

 9 open interest, and price changes might be 

 10 happening. 

 11 The second point is looking at the 

 12 interaction between futures and options markets. 

 13 This has come out of our work where we've seen 

 14 open interest for instance in crude oil going up 

 15 for most of 2008 but most open interest increases 

 16 come from the options market. So we do think that 

 17 something is happening clearly between the 

 18 tradeoff between using futures or options in 

 19 trading strategies and in fact during the most 

 20 recent run-up in crude for instance we've seen 

 21 most of the open interest, in fact almost all of 

 22 the open interest, is coming from options 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 250 

 1 positions rather than actual new futures 

 2 contracts. So that's something we continue to 

 3 look at. 

 4 The other bullet point is to look at the 

 5 commodity index trading within ag markets and 

 6 non-ag markets. We continue to try to apply some 

 7 of these statistical techniques to multiple 

 8 different markets to try to get an assessment of 

 9 that the status quo is on markets that maybe 

 10 aren't moving up too much in price so we can get a 

 11 normative view of what the market looks like when 

 12 there are no price changes to compare those 

 13 results with markets where prices are going up a 

 14 lot. We also anticipating hoping to have special 

 15 call data available for the crude oil market so we 

 16 can add to the preliminary report that the 

 17 Interagency Task Force has brought out. And I 

 18 think as to the bottom bullet my office is more 

 19 interested in the basic science. We classify 

 20 traders by the type that they self- report. Are 

 21 they commercial, noncommercial? Are they 

 22 manufacturers or producers? Are they swap 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 251 

 1 dealers? But what we've noticed is that within 

 2 the set of these particular classifications there 

 3 is a variety of different trading strategies so 

 4 we've gone back to some of our basic data and said 

 5 are the CFTC classifications useful? How well do 

 6 they correlate with what you would expect a 

 7 particular group of traders to be trading at? And 

 8 are there alternative ways to try to break down 

 9 the types of traders in our market that would 

 10 provide more insight or better insight into what's 

 11 going on with price changes? With that we'll end. 

 12 MR. DUNN: Thank you very much, Jeff. 

 13 Julie, if you will give us the background on some 

 14 of the experiences with particular markets at the 

 15 CME. 

 16 MS. WINKLER: Thank you. I realize 

 17 we're in the final stretch and you have to listen 

 18 to two economists in a row so I'm going to keep 

 19 this brief. 

 20 When Commissioner Dunn was in Chicago in 

 21 June, one of his questions certainly to us was we 

 22 know what's going on in the agricultural markets, 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 252 

 1 but what is going on in some of these other 

 2 commodity markets and is this something that you 

 3 guys have been looking at? Certainly it is. CME 

 4 Group has taken the education effort on the Hill 

 5 very seriously and with the broader marketplace 

 6 and realizing the futures industry is a difficult 

 7 thing for people to understand it's really up to 

 8 us as experts to help with that education process 

 9 and part of that is understanding the differences 

 10 and some of the fundamental factors that are 

 11 impacting both our markets and other commodities 

 12 so we're just going to go through a couple of 

 13 quick examples today on that. 

 14 This is a graph of some of the events 

 15 that have been impacting corn prices just since 

 16 June 2006. Since 2000, world corn production has 

 17 just met or exceeded use two times over this time 

 18 period. The U.S. corn-to-stocks ratio is now at 

 19 13 percent. The 10-year average ratio for that is 

 20 about 22 percent which really demonstrates the 

 21 declining supply in the U.S. of corn. A lot more 

 22 of that is certainly being used for ethanol. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 253 

 1 Ethanol production is expected to consumer over 30 

 2 percent of the U.S. corn crop in 2008, so over 4 

 3 billion bushels. And certainly we've all seen 

 4 this spring the severe flooding that took place 

 5 across the U.S. and this is really the cause for a 

 6 lot of these price increases in that circled 

 7 portion of the graph both the price spikes and 

 8 declines. In general, historical monthly 

 9 volatilities for corn in 2008 have been averaging 

 10 over 30 percent and this is nearly double what the 

 11 long- term historical averages have been for that 

 12 product. 

 13 We've mentioned it a number of times 

 14 today, but certainly the weak U.S. dollar we 

 15 believe has been a key driver across commodities. 

 16 When we look at our corn, beans, and soybean 

 17 products, that impact just from January through 

 18 July 1, 2008, has been 20 percent. We looked at 

 19 the same thing for crude oil prices and we're 

 20 talking about a 23-percent impact. So it 

 21 certainly is something that has been significant. 

 22 Jeff had shown this a little bit 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 254 

 1 earlier, but just so that people can understand, 

 2 these key commodity indices, the Goldman Sachs 

 3 Commodity Index and also the Down Jones AIG, both 

 4 of these indices have very different constructions 

 5 and while the number is debated over how much is 

 6 indexed to these indexes, right now the number 

 7 that we've heard is somewhere over $150 billion. 

 8 What you see with the GSCI index is certainly a 

 9 much higher concentration in the energy market and 

 10 over 77 percent of that index is currently 

 11 composed of energy products and 40 percent of that 

 12 is crude. The other thing to point out is the 

 13 returns that these indices have had year to date. 

 14 The year-to-date return through the second quarter 

 15 for GSCI has been 23.9 percent compared with the 

 16 year-date-return for the S&P 500 has been negative 

 17 16 percent, for the Dow Jones AIG index, again the 

 18 returns have been over 26 percent. So it's only 

 19 natural that we're going to be seeing investors 

 20 move toward commodities when that is where there 

 21 are positive returns. 

 22 What we wanted to look at was some of 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 255 

 1 the prices in commodity markets where there's 

 2 little or maybe no index participation or 

 3 speculative participation in those markets so 

 4 we've got a few examples here and I'll show graphs 

 5 of all of these trying to look at other unrelated 

 6 markets and in the case of rough rice we do have a 

 7 futures market but in general what has been the 

 8 price performance of these markets given the 

 9 fundamental factors going on in their markets and 

 10 the fact that these index funds or hedge funds do 

 11 not have an ability except going into the cash 

 12 market to gain exposure to these commodities. 

 13 If we look at the rough rice market, 

 14 there certainly has been some significant price 

 15 increases in this product. This is an example of 

 16 a product that is not part of either of the key 

 17 commodity indices but there is an active rice 

 18 futures market that's traded at the Chicago Board 

 19 of Trade and we've got average daily volume of 

 20 about 2,000 contracts and that volume is up over 

 21 38 percent just in 2008 and open interest is about 

 22 15,000 contracts. So again it's a product that's 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 256 

 1 heavily traded electronically and therefore has 

 2 global access through the CME Globex platform. 

 3 The dramatic price increases that you see here 

 4 starting out at more the September timeframe of 

 5 $11 per hundred weight we see this increase all 

 6 the way to over $24 in April 2008 and then we see 

 7 this price retreating that's happened as some of 

 8 these export tariffs in some of these major 

 9 rice-producing countries have been lifted and the 

 10 market is anticipating further lifting of those 

 11 restrictions. To date the rice market has been up 

 12 about 17 percent since the beginning of January 

 13 but as you can see most of that is declining. 

 14 When we look at in this case the North 

 15 American hot rolled coil market, you definitely 

 16 see some very different and interesting price 

 17 charts here of what happens in terms of world 

 18 steel but also I think it speaks to the growing 

 19 world demand in that these commodities are part of 

 20 a larger global marketplace and as China, India, 

 21 and other countries in Asia have continued to 

 22 build their industries, a lot of these core 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 257 

 1 components and inputs to those prices have also 

 2 seen dramatic increases. The weak dollar 

 3 obviously with the exports that go on in this 

 4 marketplace have also certainly fueled a lot of 

 5 these price increases and now we're starting to 

 6 see some excess production causing some of these 

 7 price declines in recent months. So since the 

 8 beginning of January we've seen over a 100- 

 9 percent price increase in the HRC markets. 

 10 We thought one other thing that would be 

 11 interesting to look at would be freight rates so 

 12 what we've done here is taken the Baltic Exchange 

 13 Panamax Index and the Baltic Exchange publishes a 

 14 series of indexes on freight costs across various 

 15 global markets and those are based on prices from 

 16 international shipping brokers. So this index in 

 17 particular is on vessels that are capable of 

 18 fitting through the locks of the Panama Canal and 

 19 are used for dry bulk shipping. This index can 

 20 speak more to the demand for shipping capacity 

 21 versus the supply of the dry bulk. Obviously it's 

 22 not easy to quickly create more cargo ships to 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 258 

 1 carry this type of cargo and it ships so many 

 2 different types of commodities so it really does 

 3 become a leading economic indicator that many in 

 4 the marketplace look at for what the role of 

 5 future commodity prices are going to be. 

 6 Lastly, we looked at hay prices. Again, 

 7 much related to the other commodity products that 

 8 we see in the United States, if you're giving more 

 9 land to corn and soybeans it likely is coming at 

 10 the expense of some other commodity and in this 

 11 case it has been hay. There have been a lot of 

 12 disappointing yields that have taken place that 

 13 are causing a lot of these price increases and 

 14 also a lot of differences in wealth throughout 

 15 different regions, some places that have seen a 

 16 lot of rain and others that haven't seen much at 

 17 all and so for this market even since the 

 18 beginning of January we've seen a 25-percent 

 19 increase in prices. 

 20 In summary, I think very much like Jeff 

 21 had spoken of earlier, there are fundamental 

 22 factors that are impacting these commodity prices 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 259 

 1 and in the case of the commodities looked at in 

 2 this presentation, it's not the presence of the 

 3 index funds that is necessarily driving these 

 4 prices higher, those fundamental supply-and-demand 

 5 factors are really at work and certainly we 

 6 believe that the dollar and the weak dollar has 

 7 had a significant impact on prices as well across 

 8 many commodities and for us making sure that we're 

 9 keeping open and transparent markets is key 

 10 because these commodity markets are not just U.S. 

 11 markets, they're global markets, they're 24-hour 

 12 markets and it is important that we continue to 

 13 monitor them closely and provide them as a 

 14 risk-management tool for the marketplace. Thank 

 15 you. 

 16 MR. DUNN: Thank you very much, Julie. 

 17 I will now open it up for questions or comments 

 18 from the Ag Advisory Committee. Yes, Roger? 

 19 MR. CRYAN: Mr. Harris said that index 

 20 trading seems to reduce volatility and I would ask 

 21 if another way of saying that is that it blunts 

 22 market signals so that there is just less reaction 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 260 

 1 to fundamentals. I think that may be a 

 2 price-discovery undermining explanation for why 

 3 there would be less volatility associated with 

 4 some of that trading. I also want to comment on 

 5 the bubble discussion. It's a very interesting 

 6 discussion. Central banks have enormous resources 

 7 and one of the big things they focus on is just 

 8 that and they still screw it up. So I really 

 9 think that as far as the CFTC is concerned given 

 10 that you really are not fundamentally in the job 

 11 of regulating underlying cash prices and given how 

 12 difficult it is to do that it makes an awful lot 

 13 more sense to just focus on a structure for the 

 14 futures market that tends to avoid bubbles in 

 15 futures by making sure things are transparent and 

 16 that the effective linkages to the cash markets 

 17 are there and to do all the things that we're 

 18 talking about to address the more immediate 

 19 problems and I think those would address the 

 20 bubbles to the extent that there are bubbles in 

 21 futures markets independently of cash markets, and 

 22 go for it. Thank you. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 261 

 1 MR. DUNN: Are there other questions or 

 2 comments? Are there any from the floor? Fellow 

 3 Commissioners? Commissioner Sommers? 

 4 Commissioner Chilton? 

 5 MR. CHILTON: I have one for Mr. Harris, 

 6 one or maybe two, Jeff. I think you've explained 

 7 it to me before but it might be helpful for other 

 8 people, when we talk about speculators essentially 

 9 netting, people say they're long, no, actually 

 10 they're short too. That's what we've said, that 

 11 they're essentially netting, that they're not 

 12 really long in the market? 

 13 MR. HARRIS: I think the one table I did 

 14 show actually showed the net and most speculative 

 15 groups are net long. Crude oil like I said was 

 16 about 4 percent net long down to about 2 percent. 

 17 In most markets there was I guess one on the chart 

 18 that I showed that was net short, but in most 

 19 markets they are net long. 

 20 MR. CHILTON: That's not in the same 

 21 month. Right? That's all of their positions? 

 22 MR. HARRIS: Right. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 262 

 1 MR. CHILTON: So they're probably short 

 2 in the spot month. Right? 

 3 MR. HARRIS: Depends. The way we define 

 4 it, we can look at for instance the crude oil 

 5 market I know for sure they're long dramatically 

 6 in the near-term market because the rolling 

 7 behavior of index funds creates this tremendous 

 8 long position in the near-term contract and you 

 9 look out in the curve and in crude that means that 

 10 they're almost entirely short into 8-year 

 11 contracts. 

 12 MR. CHILTON: Is it generally accepted 

 13 though that they are buying and holding in these 

 14 markets for the long-term? 

 15 MR. HARRIS: For the group of index 

 16 traders, yes, that is exactly what -- statement is 

 17 they don't try to time the market, they don't try 

 18 to analyze the markets, they just simply want 

 19 exposure so they're just buying and holding. But 

 20 people who are holding obviously in the futures 

 21 market requires them to roll. 

 22 MR. CHILTON: People have made this 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 263 

 1 argument that they get out of the market and so it 

 2 doesn't matter and that has a downward effect, but 

 3 if they're immediately rolling it like you're 

 4 saying then maybe it's just -- I think everybody 

 5 knows they're just going to roll so there could 

 6 potentially be the theory goes keeping prices up. 

 7 MR. HARRIS: I think we acknowledge the 

 8 fact that if there are additional flows every 

 9 month and they continue to roll every month that 

 10 that additional flow would create upward pressure 

 11 on markets. In fact, I didn't get into the 

 12 details of what we did there, but we've looked at 

 13 that roll period and we have determined -- 

 14 actually we can discern that there is a price 

 15 effect. The interesting part of that price effect 

 16 is either good or bad in the sense that there 

 17 tends to be a couple pennies price impact up but 

 18 also perhaps a little bit of pressure downward as 

 19 they roll out of the contract they're getting out 

 20 of. I guess the point is we can discern some 

 21 effects of their trading in the marketplace on the 

 22 index fund level but it's on the order of cents 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 264 

 1 and it's not necessarily $2 in corn. 

 2 MR. CHILTON: Thank you. On the 1805, 

 3 we still don't have the information about the 

 4 commercials and noncommercials and that's a big 

 5 group that you would want to look at for this task 

 6 force study. Right? 

 7 MR. HARRIS: Yes. I would say that the 

 8 caveat with the task force study to date is an 

 9 interim report on crude oil. Not to get too much 

 10 into the nuances, but swap dealers are what we're 

 11 analyzing in the speculative groups in crude oil. 

 12 In the energy market space, swap dealers handle 

 13 both index trading and over-the-counter trading 

 14 and so what we don't know is for instance the 

 15 independent effect of the index trading so that 

 16 most of the index trading information that we have 

 17 directly is only from the 12 ag markets where we 

 18 track that closely. 

 19 MR. CHILTON: Is it fair to say we don't 

 20 know for sure yet the impact because we don't have 

 21 the information? 

 22 MR. HARRIS: I would think that's why we 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 265 

 1 called this particular report an interim report. 

 2 We would love to have the full time series. The 

 3 information I would caution is that we're doing a 

 4 one-time call and it's not clear we're going to 

 5 have a good 5 years of time series data to analyze 

 6 on index fund trading in crude oil. 

 7 MR. CHILTON: A lot of times I think 

 8 people are just looking for a quick nugget and 

 9 particularly the media are trying to figure out 

 10 like what is the quick story. I want to make sure 

 11 that people understand that when we put out the 

 12 interim report it was a snapshot, we didn't have 

 13 all the information that we're still getting, and 

 14 what the report said, the bottom line is, that 

 15 fundamentals you think are the major factors? 

 16 They're not necessarily the only factors, there's 

 17 a devalued dollar, there's potentially 

 18 speculators, we haven't ruled it out because we 

 19 don't have all the information yet. And I think 

 20 people focused and sort of glomed onto the first 

 21 part of it without reading further into the 

 22 report. Do you think that's maybe a fair 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 266 

 1 assessment? 

 2 MR. HARRIS: I think to the extent that 

 3 we do identify index traders in the ag products 

 4 and we haven't seen dramatic effects of index 

 5 trading there, there's obviously some of that 

 6 evidence that's not directly related to crude oil 

 7 markets. But, yes, we were trying to be very 

 8 careful in the report to make sure it was an 

 9 interim report, that we were saying that we have 

 10 this call out for more data in the crude oil 

 11 market in particular and the state of the market 

 12 today of the evidence that we have to date would 

 13 suggest that the claims that speculators are 

 14 driving the prices is not necessarily supported 

 15 with what we know today. 

 16 MR. CHILTON: But you don't have the 

 17 information yet so it's not not supported. Right? 

 18 I don't have the information and so I can't tell 

 19 you that it's that? 

 20 MR. HARRIS: Right. We do have 

 21 information on hedge funds so that was one group 

 22 that we did have. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 267 

 1 MR. CHILTON: But on the noncommercial 

 2 speculators we don't have the information so we're 

 3 not blaming them. 

 4 MR. HARRIS: On index traders in 

 5 particular we don't have them identified 

 6 specifically. 

 7 MR. CHILTON: And we're not going to 

 8 blame them because we don't have the information 

 9 yet. Right? 

 10 MR. HARRIS: I guess. 

 11 MR. CHILTON: Thank you. 

 12 MR. DUNN: Mr. Lukken? 

 13 MR. LUKKEN: Just a follow-up question, 

 14 Jeff. You have all futures markets data though. 

 15 Right? We have all the positions of the swap 

 16 dealers. What we're asking for in this special 

 17 call is off-exchange trading. Correct? But you 

 18 did your analysis on all the futures market data 

 19 which the CFTC has complete transparency over. 

 20 MR. HARRIS: The point is I guess we did 

 21 all the analysis and that we couldn't identify 

 22 index traders but we can identify the total 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 268 

 1 trading by swap dealers. To the extent that swap 

 2 dealers handle two different types of markets, 

 3 over-the-trading and index trading, that's lumped 

 4 together in our analysis. That as a group we 

 5 couldn't find as evidence, so, right. One of the 

 6 things I would point out and this is in response 

 7 to the Ag Advisory Committee specifically is that 

 8 2 years ago when we put the supplemental reports 

 9 on index trading in ag products it was in response 

 10 to the idea that there were these new traders in 

 11 the marketplace and we wanted to know what they 

 12 were doing. One of the things that has come out 

 13 of the swap dealer special call and the things 

 14 that we have recognized is that it's a big 

 15 advantage to us to have swap dealers in our 

 16 markets because they are conveying a large degree 

 17 of the information that they do in the 

 18 over-the-counter markets to the organized 

 19 exchanges so that we have now more than ever 

 20 information about what's going on over the counter 

 21 especially in the energy markets where the over- 

 22 the-counter market has been large and in existence 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 269 

 1 for decades well in advance of these active 

 2 participants transferring their risk into the 

 3 organized exchanges. 

 4 MR. DUNN: Thank you, Walt. Jeff, a 

 5 follow-up on the interim report. The interim 

 6 report says that the CIT does not lead the 

 7 movement in the marketplace but comes in actually 

 8 afterwards. Does this then provide a ceiling or a 

 9 floor if you will that reduces the downward 

 10 pressure? 

 11 MR. HARRIS: Just to be clear again, we 

 12 didn't actually identify commodity index trading 

 13 specifically, but the swap dealer order flow 

 14 actually turned out to be responding to price 

 15 changes and it turned out that the net order flow 

 16 of swap dealers is actually the opposite, it's 

 17 actually selling into price increases so when 

 18 prices go up they're actually responding in the 

 19 opposite direction. So that is the result that we 

 20 got in the interim for the task force. 

 21 The other thing we pointed out in there 

 22 is despite the fact that we have this very large 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 270 

 1 influx of index trading in crude oil, the net 

 2 positions for most of 2008 in the swap-dealer 

 3 category has been short so that highlights I think 

 4 the problems of viewing swap dealers as a proxy 

 5 for index trading, it's not a very good proxy at 

 6 all, but it also gives us an indication that the 

 7 over-the- counter market has been short the crude 

 8 oil market and in dramatic size because for all 

 9 the long positions we have reported on index 

 10 trading, they're more than offset for most of 2008 

 11 by short positions in the over-the-counter market. 

 12 MR. DUNN: One other thing. In the 

 13 interim report you do touch on the devaluation of 

 14 the dollar and Julie made mention that they felt 

 15 at the CME that that had a significant impact. 

 16 What was the finding of the interim study? 

 17 MR. HARRIS: We didn't quantify that. 

 18 We've done our own regressions and we found 

 19 regressions on the order of 20 percent or 

 20 something of the price increase a few months ago 

 21 and it was related to the exchange rate. The task 

 22 force I think took the approach of pointing out 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 271 

 1 that these are global markets and that global 

 2 markets trade and flows respond to exchange rates 

 3 and so in that regard we're on the wrong end of 

 4 the exchange rate this year. 

 5 MR. DUNN: Do you have a follow up? 

 6 MR. CHILTON: Yes, I would like to ask 

 7 Mr. Lehman what's your view of the impact of the 

 8 devalued dollar on these markets? 

 9 MR. LEHMAN: We had it in the slides, 

 10 Commissioner Chilton, that against the U.S. dollar 

 11 index it's about 23 percent I think for crude oil, 

 12 20 percent for corn, beans, and wheat since 2006, 

 13 and the U.S. dollar index, the Canadian dollar, 

 14 the British pound, euro, Japanese yen, Swedish 

 15 krona, if you look at it against individual 

 16 currencies, if you look at it against the euro, 

 17 it's like 37 percent. So it depends on what 

 18 currency you're looking at. USDA I think has an 

 19 ag export index that's in the Purdue study and I'm 

 20 anxious to take a look at that and see what they 

 21 actually found. The numbers they found are much 

 22 bigger. They found about a 40-percent impact in 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 272 

 1 the Purdue study using this USDA index but I'm not 

 2 sure what currencies are in that index. 

 3 MR. CHILTON: Thank you. 

 4 MR. DUNN: Jeff, I think this Ag 

 5 Advisory Group is anxiously awaiting phase two 

 6 when you get to the ag commodities in that report 

 7 and we appreciate you and what the Interagency 

 8 Task Force is doing and getting our hands on some 

 9 good empirical data is something that we've longed 

 10 for for a long time. 

 11 I'd like to finish up here asking those 

 12 members of the Advisory Committee who are still 

 13 here whether or not you think there is an 

 14 agricultural commodity bubble and do you have a 

 15 concern about that. Tom, unfortunately you're the 

 16 first one I'm looking at, so if I could start with 

 17 you and go around the table. 

 18 MR. COYLE: I'll answer by saying I'm 

 19 not sure. I can see the level in the case of 

 20 wheat of new participation but I can also see the 

 21 level of fundamental inputs. So if I look for 

 22 corn for instance and I see that we've got 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 273 

 1 ethanol, I see that we've got growth around the 

 2 world from better diets, better consumption, and 

 3 the U.S. Dollar, it would seem to me that it's 

 4 somewhat justified. I can say the same thing with 

 5 soybeans and biofuels and the shift in acres that 

 6 we keep seeing. So I wish I had a better answer, 

 7 but I'm not sure. I like the fact that you're 

 8 looking at the data and I think the data tells you 

 9 something. We continue to see when we look at the 

 10 data that we get with the breakout from the 

 11 supplemental report who's in the market and I 

 12 think that tells the story. So if you match that 

 13 up with the fundamental data I think it can lead 

 14 to a certain conclusion. I had never thought of 

 15 the idea that you could look at the fact that a 

 16 market is rallying and then the open interest is 

 17 not changing which may give you a sense that maybe 

 18 a bubble does exist, so I may look at that in the 

 19 future myself. 

 20 MR. CRYAN: I agree with Tom that a lot 

 21 of the fundamentals seem to be shifting and I've 

 22 written that I think we're at a new plateau on 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 274 

 1 commodity prices. As you were saying, the growth 

 2 in the economies around the world, we've had a 

 3 very successful decade of growth all over the 

 4 world and people are eating better and there is 

 5 just demand for all kinds of raw materials. So 

 6 there is no question that commodities are up and 

 7 are bound to stay up and that that would certainly 

 8 explain the success of commodity investing in 

 9 recent years. Whether they're going to continue 

 10 to rise is another question. I think it's 

 11 certainly possible that we've been in a bubble for 

 12 the futures for some of these commodities in the 

 13 last 6 months and that that may be over or not. 

 14 So it's a question mark but there is no question 

 15 that the days of $2 corn are over but where it's 

 16 going to be a year from now I don't know. 

 17 MR. DUNN: Jack? 

 18 MR. GAINE: I'm particularly unqualified 

 19 inside the Beltway to speculate on the matter, 

 20 Mister Commissioner, but if anybody has inside 

 21 information I'd be delighted to trade on it if 

 22 they give it to me. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 275 

 1 MR. DUNN: Mr. Green? 

 2 MR. GREEN: I feel the same way. It's 

 3 hard though to deny that at the present value of 

 4 the dollar that there are not fundamentals on the 

 5 demand side that are justifying some of the 

 6 speculative activity, so beyond that I wouldn't 

 7 venture to guess how far. These people have done 

 8 an immense amount of examination of that and tried 

 9 to correlate things and I'd say that they've done 

 10 a good job of knowledge of what we can find. You 

 11 have to remember that the market does more than 

 12 just one thing. One of the things the market is 

 13 telling farmers and the agricultural community is 

 14 what should be done in the future, how much 

 15 planting should be done, et cetera. So it's more 

 16 than just price discovery. It's also giving 

 17 signals to the producers of what the next steps 

 18 are and I think that's an important thing to note 

 19 here, that as we have drawn stocks in the world 

 20 marketplace, one of the things it's telling 

 21 farmers is grow more stuff and so that's a 

 22 fundamental part of what the market is saying 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 276 

 1 today. 

 2 MR. DUNN: This is your first meeting 

 3 here, I believe. Welcome. Leroy? 

 4 MR. WATSON: Thank you. I would say 

 5 that from the derivation of are we in a bubble 

 6 situation related to market exuberance or 

 7 irrational application of fundamentals that that 

 8 would be, no, this is not about Pet Rocks or Dutch 

 9 tulips. More fundamentally I think the issue of 

 10 liquidity and probably we ought to be talking 

 11 about it, what we probably are seeing here is a 

 12 commodity-driven inflationary move not only in the 

 13 United States but probably across the world and we 

 14 probably need to be looking more at what has been 

 15 happening with all of the reserves of U.S. dollars 

 16 that have been held by governments around the 

 17 world and now are they being released in order to 

 18 prop up prices for both food and energy and other 

 19 sorts of commodities. So we may be very well 

 20 seeing a flood of dollars onto the market not only 

 21 related to domestic issues done by the Federal 

 22 Reserve but the implicit branch banking which has 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 277 

 1 been done by places like China and other countries 

 2 that have accumulated large dollar reserves and 

 3 where they might be applying right now or how 

 4 those might be applying back and forth. 

 5 I'm also extremely grateful that Mr. 

 6 Harris in his slides made the clear statement that 

 7 there is no evidence of Granger causality so I can 

 8 pretty be assured that I can walk out of here not 

 9 in shackles. 

 10 MR. DUNN: As the representative of the 

 11 Grange we appreciate that. Mr. Wellman? And we 

 12 don't have a soybean causality here. 

 13 MR. WELLMAN: It's been mentioned 

 14 already that the stocks -- ratios on wheat, corn, 

 15 and soybeans are at record or near record lows. I 

 16 would agree that the fundamentals point toward 

 17 these higher prices. Many grain producers have 

 18 invested funds for years to try to develop markets 

 19 and to create more demand for our products which 

 20 in return would create higher prices and I think 

 21 we've done some of that and I think that's 

 22 happened. 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 278 

 1 My concern is that as we have done that, 

 2 now we look at the higher prices and everybody is 

 3 looking at how do we fix this problem. I'm not 

 4 exactly sure that it's a problem for producers if 

 5 that is an accurate price discovery. Then the 

 6 second concern I have is is there still a 

 7 functional, affordable tool for producers to use 

 8 for risk management and I think that's a serious 

 9 question that we don't have an answer to yet. 

 10 Recently there has not been. But what can be done 

 11 to correct that situation I think there have been 

 12 good steps by the CFTC to address those issues. 

 13 And I think another point that has been brought up 

 14 here is all the information isn't out there yet 

 15 and it isn't accessible to everyone who needs the 

 16 information. So I believe that further disclosure 

 17 of who the market participants are and what their 

 18 positions are is very important so we can move 

 19 forward. Thank you. 

 20 MR. DUNN: Mr. Nicosia? 

 21 MR. NICOSIA: You asked the question are 

 22 we in a speculative bubble. I would say, no, 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 279 

 1 we're probably not in a speculative bubble but 

 2 there is no doubt that we are under the bullish 

 3 influences of prices that would be higher than 

 4 they otherwise would be. What people have said is 

 5 correct, the fundamentals have warranted higher 

 6 prices in almost all commodities whether they've 

 7 been part of index and/or not. Those ones that 

 8 are not part of indexes are absolutely influenced 

 9 by the pull of acres away from those that are so 

 10 there is a causality between them and not just the 

 11 index funds. 

 12 However, when you look at it, again I 

 13 think all the work that's been done may be good 

 14 but it's looking at the wrong thing. It's not a 

 15 question of whether index money causes higher 

 16 prices, it is whether the index money has caused 

 17 prices to be higher than they would have been, so 

 18 it's not just the flow of the money that causes 

 19 that. It was an interesting thing to hear about 

 20 the swap dealers being short in the oil market and 

 21 if they didn't have that billion barrels on the 

 22 long side to offset those swap dealer shorts, 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 280 

 1 where would the swap dealers have found buyers and 

 2 if so at what price level if we removed all that 

 3 index money? And the argument that you go through 

 4 convergence in he oil market, we've just dropped 

 5 $25 and then convergence is going to take the 

 6 place just the same at $120 as it was going to be 

 7 at $140 because the market, when you look at it 

 8 the level of balance at delivery time, it's moving 

 9 through and it's setting off a benchmark price and 

 10 not anything else, again just the bullish 

 11 influences causing oil prices to be higher. 

 12 When you look at where we were 5 to 10 

 13 years ago on the CRB and you look at where we are 

 14 today and you track that against the total amount 

 15 of money that has come into our marketplace from 

 16 index funds, they go straight up together, as the 

 17 money has grown so has the CRB gone straight up 

 18 with it. Sure, some of that is explainable by the 

 19 demand factors that we've talked about here, but 

 20 at the same time if you ask USDA or any other 

 21 statistical analysis to run regressions based on 

 22 fundamentals they will get higher prices but not 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 281 

 1 nearly as high as the prices that we've just seen 

 2 in any of the commodities. 

 3 So again what I would really encourage 

 4 the economists to do and Jeff to do is to go back 

 5 and look at what the incremental increase is, not 

 6 whether the total increase or whether any of the 

 7 increase as far as the money flow causes invokes 

 8 the incremental difference between the two. So I 

 9 think that there's no doubt that we're having 

 10 bullish influences but, no, I would not call it a 

 11 bubble. 

 12 MR. DUNN: Thank you, Joe. Are there 

 13 any final remarks from my fellow Commissioners? 

 14 Commissioner Sommers? 

 15 MS. SOMMERS: I just want to say thank 

 16 you to everybody. This has been a great 

 17 discussion today and I've learned a lot about some 

 18 of these different issues and I appreciate you 

 19 being here. 

 20 MR. DUNN: Commissioner Chilton? 

 21 MR. CHILTON: I just want to thank 

 22 everybody for being here and being patient and 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 282 

 1 thank you for the presentations, and particularly 

 2 want to thank your staff and Mr. Juzenas for his 

 3 great bubble presentation. Thank you, sir. 

 4 MR. DUNN: Commissioner Lukken? 

 5 MR. LUKKEN: I just want to echo the 

 6 Commissioners and thank everybody for 

 7 participating today, and Mike's staff and Mike for 

 8 leading a great meeting here today. It was very 

 9 educational for me in particular on the issue of 

 10 convergence, just to express the urgency of trying 

 11 to resolve this issue as quickly as we can. The 

 12 CME seems to be on top of this and we'll continue 

 13 to work with you to make sure that this happens 

 14 quickly and in a timeframe that people can use in 

 15 order to hedge these products. So thank you very 

 16 much, Mike. 

 17 MR. DUNN: Thank you, Mister Chairman. 

 18 I'd like to announce that we will hold the record 

 19 open for a 2-week period for anybody on the 

 20 Commission or the folks who are listening or here 

 21 in the audience here today who want to put in any 

 22 remarks, a little too late for the question side, 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 283 

 1 that you might have. I too want to thank all of 

 2 the participants for what I consider an excellent 

 3 meeting and I also appreciate all of you who I 

 4 have worked with since the April roundtable 

 5 meeting. I know you people have put a lot of time 

 6 in it. The agricultural exchanges, I truly 

 7 appreciate your responsiveness to the Commission 

 8 and to the industry as a whole to try to grapple 

 9 with some of these problems that are really having 

 10 a great of upheaval in the countryside. 

 11 I want to thank the CFTC staff, both the 

 12 staff here who worked so hard in making sure that 

 13 the accommodations are here and that everything 

 14 worked so well as it did. I don't think we had 

 15 any microphone problems today except when 

 16 Commissioner Lukken had to keep turning my mike on 

 17 for me. That's one of his side jobs that he has. 

 18 But also a special thanks to the Chicago staff and 

 19 the Division of Marketing Oversight who I have 

 20 worked to closely with in getting information in a 

 21 period of time when they're doing a lot of extra 

 22 work and with the 1805 requests that you've heard 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 284 

 1 about they have been just absolutely tremendous in 

 2 working not only with me but with the exchanges 

 3 and with constituency groups who have come in to 

 4 talk to them. I know that the Farm Bureau and 

 5 others have gone there and I've gotten great and 

 6 glowing reports on how helpful that staff has 

 7 been. 

 8 Finally I'd like to thank my fellow 

 9 Commissioners for their support in putting this 

 10 together and having what I think is a very 

 11 successful meeting, but I do think that we are 

 12 under a very, very short window of opportunity to 

 13 get ahold of this issue of convergence to ensure 

 14 that the marketplace works orderly and we can get 

 15 back to relying on the futures and options markets 

 16 for price discovery and risk mitigation. Thank 

 17 you all. 

 18 (Whereupon, at 3:50 p.m., the 

 19 PROCEEDINGS were adjourned.) 

 20 * * * * * 

 21 

 22 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190 
 285 

 1 CERTIFICATE OF NOTARY PUBLIC 

 2 

 3 I, Carleton J. Anderson, III do hereby certify 

 4 that the forgoing electronic file when originally 

 5 transmitted was reduced to text at my direction; 

 6 that said transcript is a true record of the 

 7 proceedings therein referenced; that I am neither 

 8 counsel for, related to, nor employed by any of 

 9 the parties to the action in which these 

 10 proceedings were taken; and, furthermore, that I 

 11 am neither a relative or employee of any attorney 

 12 or counsel employed by the parties hereto, nor 

 13 financially or otherwise interested in the outcome 

 14 of this action. 

 15 /s/Carleton J. Anderson, III 

 16 Notary Public # 351998 

 17 in and for the Commonwealth of Virginia 

 18 

 19 My Commission Expires: 

 20 November 30, 2008 

 21 

 22 

 ANDERSON COURT REPORTING 

 706 Duke Street, Suite 100 
 Alexandria, VA 22314 

 Phone (703) 519-7180 Fax (703) 519-7190