UNITED STATES OF AMERICA 

 COMMODITY FUTURES TRADING COMMISSION 

 AGRICULTURAL ADVISORY COMMITTEE MEETING 

 Washington, D.C. 

 Thursday, December 6, 2007 
 2 

 1 PARTICIPANTS: 

 2 WALTER LUKKEN 

 3 JILL SOMMERS 

 4 MICHAEL DUNN 

 5 BART CHILTON 

 6 WILLIAM FERRETTI 

 7 DAVE MILLER 

 8 DAN BROPHY 

 9 TOM FARLEY 

 10 MIKE GORHAM 

 11 DON HEITMAN 

 12 DAVID KASS 

 13 JOHN FENTON 

 14 TOM COYLE 

 15 TOM ERIKSON 

 16 DOUG SOMBKE 

 17 RYAN WESTON 

 18 DAVID LEHMAN 

 19 LEROY WATSON 

 20 RANDY STEVENS 

 21 NEAL GILLEN 

 22 
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 1 PARTICIPANTS (CONT'D): 

 2 LARRY MITCHELL 

 3 JIM BAIR 

 4 ELDON GOULD 

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 4 

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

 2 MR. DUNN: First of all, I want to 

 3 welcome everybody from the Agricultural Advisory 

 4 Committee here. This is the 31st meeting of the 

 5 Agricultural Advisory Committee. 

 6 This is an advisory meeting, this is not 

 7 a hearing, and if it works out right, you're going 

 8 to hear very little from the commissioners here. 

 9 It's really what you have to say to us, this is a 

 10 learning process for us. So it's not a hearing, 

 11 it's an opportunity for you to hear a panel, to 

 12 give a reaction to that panel, to answer those 

 13 questions. 

 14 You notice I'm not touching this 

 15 microphone or leaning forward into it or anything 

 16 else, and that's one of our requests herin which 

 17 is to leave the microphones alone. We've got 

 18 great technicians here, and they're going to 

 19 adjust it so that you can be heard. 

 20 And one of the reasons why we need to 

 21 have the microphones here is because of the three 

 22 subject matters that we've got out here, the role 
 5 

 1 of speculation, the agricultural markets, the 

 2 over-the-counter agricultural markets, and the 

 3 global carbon markets. On a couple of these we've 

 4 got some federal register notices out, and so 

 5 we're actually in a comment period on this. 

 6 Everything that the Advisory Committee tells us on 

 7 these subject matters today will be part and 

 8 parcel of that record that we review from the 

 9 federal register. So it's very, very important 

 10 that when you get recognized, that you give us 

 11 your name and who you're representing so that we 

 12 have that in the record, I appreciate that. 

 13 I'd like to just take a quick 

 14 opportunity here to ask our commissioners to 

 15 welcome you, as well, and we'll start with our 

 16 Acting Chairman, Walt Lukken. 

 17 MR. LUKKEN: Good morning. I apologize 

 18 for being slightly late. I realized when I got 

 19 down here I didn't have my opening remarks, and 

 20 now that I've read my opening remarks, I'm going 

 21 to ignore them and just talk to you. 

 22 So I appreciate everybody being here. 
 6 

 1 And I want to welcome all the panelists that are 

 2 participating today, especially my former 

 3 colleague, Tom Erikson, who, I'm not sure if Tom's 

 4 here yet, but -- who, when I first got to the 

 5 Commission in 2002, he was a commissioner and 

 6 helped me sort of get up to speed and taught me a 

 7 lot in his time here, so I appreciate Tom's 

 8 participation today, as well as my former 

 9 colleague and good friend, Mike Gorham, who was 

 10 our Division of Market Oversight Director for 

 11 several years. And Mike is one of the most 

 12 intellectually curious people I know, and that's 

 13 what makes him a great asset to us both here at 

 14 the Commission and to the industry itself. 

 15 So Mike has put together, Commissioner 

 16 Dunn, I apologize, who is Chairman of the day, has 

 17 put together a great presentation, both timely and 

 18 relevant to what we're looking at here at the 

 19 agency. 

 20 Obviously, these markets have gone 

 21 global as they've grown. This has provided a 

 22 great benefit to the agricultural markets and 
 7 

 1 added liquidity. But this added liquidity also 

 2 presents challenges as we try to figure out 

 3 whether our regulatory structure is still meeting 

 4 the mission that it was set out to meet: spec 

 5 limits, the tiered categories that differentiate 

 6 between energy and agricultural products and the 

 7 oversight that comes with those distinctions, 

 8 whether those are continuing to be met. And 

 9 obviously carbon markets, something that's on the 

 10 front of everybody's minds around the globe. 

 11 So I'm looking forward to the hearing 

 12 and stop talking and listening for the rest of the 

 13 day. But thank you so much for participating. 

 14 And I commend Chairman Dunn and his staff for 

 15 putting this together today. 

 16 MR. DUNN: Thank you. Commissioner 

 17 Sommers. 

 18 MS. SOMMERS: Good morning. Thank you 

 19 all for being here. I think that throughout my 

 20 tenure in this industry, the agricultural industry 

 21 has been such an important constituency to the 

 22 futures markets. I really appreciate your 
 8 

 1 participation here today and look forward to the 

 2 important issues, and again, thank Commissioner 

 3 Dunn and all of our staff for putting together 

 4 such a great agenda, and I'm looking forward to 

 5 listening to your important views; thanks. 

 6 MR. DUNN: Thank you, Jill. 

 7 Commissioner Chilton. 

 8 MR. CHILTON: I'm not going to touch 

 9 this because you told me not to touch it even 

 10 though it's pointed away. This guy is a friend 

 11 and mentor and I do exactly what he says, and he 

 12 told me not to touch it, I'm not going to touch 

 13 it. 

 14 MR. DUNN: Good; my house needs 

 15 painting. 

 16 MR. CHILTON: Yes, sir. Good morning, 

 17 everybody, and thank you for everyone being here, 

 18 in particular, Doug and others who have traveled 

 19 from so far away. It's important work that we're 

 20 doing and I think we can do good together. When I 

 21 woke up this morning, I sort of nudged my wife and 

 22 looked out and we had left the holiday lights on, 
 9 

 1 and the snow was all over them, and I thought, you 

 2 know, how pretty is that, and it made me think of 

 3 that song, the Turn, Turn, Turn song, to 

 4 everything there is a season, and I'm sort of 

 5 humming that in my head on the way in, not 

 6 listening to the radio, and the next line, there's 

 7 a time for every purpose, and I started thinking 

 8 about this rich history in agriculture and how 

 9 there was a time for the purpose 155 years ago, 

 10 and people wanted consistent supply and demand, 

 11 and farmers and ranchers wanted a consistent 

 12 price, and we didn't want food to rot, and that's 

 13 still important today, what we're doing, but 

 14 there's also a lot of opportunities, and I'm 

 15 pleased that Mike has put on the agenda the global 

 16 carbon markets. 

 17 That is such an exciting and new 

 18 opportunity for us to address global warming. 

 19 When I say "us", I mean the collective world us. 

 20 And the futures industry has really taken a 

 21 proactive role on that issue. 

 22 Lewis Redshaw, the head of Barclays in 
 10 

 1 London, said that he expects that carbon will be 

 2 the number one commodity market, if not the number 

 3 one market in the world at some point in the not 

 4 too distant future. In London, carbon is a $30 

 5 billion industry. And carbon credits, carbon 

 6 products are trading on the European Energy 

 7 Exchange, they're settling at €23 and €25. 

 8 But in the United States, as we'll hear 

 9 later, you know, it's about $2. And I know Doug 

 10 will speak about that. 

 11 But, you know, the reason is, because 

 12 they've got a cap and trade system, they took the 

 13 Kyoto Protocol seriously, and we need to do more 

 14 work here. So, for everything there's a season, 

 15 and for every time, there's a purpose, and 

 16 hopefully that purpose is sooner rather than 

 17 later. Thank you. 

 18 MR. DUNN: Okay. Before we get going 

 19 with our first panel, what I'd like to do is, have 

 20 all the members on the Ag Advisory Committee to 

 21 identify who you are and who you're representing. 

 22 And, Doug, why don't we start with you? 
 11 

 1 We'll do the inner table and then we'll do the outer 

 2 ring. 

 3 MR. SOMBKE: My name is Doug Sombke, I'm 

 4 President of the South Dakota Farmers Union 

 5 representing National Farmers Union. 

 6 MR. COYLE: My name is Tom Coyle, and I 

 7 represent National Grain and Food Association. 

 8 MR. FENTON: My name is John Fenton, and 

 9 I'm the Director of Markets -- 

 10 MR. HEITMAN: Don Heitman, I'm with the 

 11 Division of Market Oversight. 

 12 MR. KASS: And David Kass, also with the 

 13 Division of Market Oversight, from the Chicago 

 14 office. 

 15 MR. GORHAM: I'm Mike Gorham, Director 

 16 of the IAT Center for the -- Markets, working -- 

 17 MR. LEHMAN: Dave Lehman, CME Group. 

 18 MR. FARLEY: Tom Farley, I'm the 

 19 President and CEO of Vice Futures US, formerly the 

 20 New York Board of Trade. 

 21 MR. BROPHY: Dan Brophy representing 

 22 Commodity Markets Council. 
 12 

 1 MR. STEVENSON: Randy Stevenson 

 2 representing Mark -- USA. 

 3 MR. GILLEN: I'm Neil Gillon, American 

 4 -- Association. 

 5 MR. MITCHELL: Larry Mitchell, American 

 6 -- 

 7 SPEAKER: Jack (off mike) Managed Funds 

 8 Association. 

 9 SPEAKER: Francis (off mike) National 

 10 Swaps Association. 

 11 MR. YONKERS: Robert Yonkers with the 

 12 International Dairy Foods Association. 

 13 SPEAKER: (off mike) with the National 

 14 Range. 

 15 MR. WILLET: Sam Willet, National -- 

 16 Association. 

 17 SPEAKER: Alan (off mike) Assistant to 

 18 the Administrator of the Risk Management Agency. 

 19 MR. GOULD: Eldon Gould, Administrator 

 20 of the Risk Management Agency. 

 21 SPEAKER: Mark (off mike) Minneapolis 

 22 Grant Exchange. 
 13 

 1 SPEAKER: Tom (off mike) National -- 

 2 Association. 

 3 MR. DUNN: The other members of the Ag 

 4 Advisory Commission? 

 5 MR. McGUIRE: John McGuire, National -- 

 6 Council. 

 7 MR. LUSTON: Brian Luston, American -- 

 8 MR. DUNN: Remember, I said this is to 

 9 inform the commissioners, so theoretically, we 

 10 wouldn't ask many questions, although my 

 11 colleagues are prepared to ask -- but it really is 

 12 to the Advisory Committee to get off what's on 

 13 their chest, to bring forward -- and with that, 

 14 I'd like to start with our first panel here, and 

 15 it's the role of speculation and agricultural -- I 

 16 think from the very beginning this has been 

 17 something that -- whole term of the Ag Advisory 

 18 Committee -- agriculture trading has become 

 19 increasingly more global -- in there. There is a 

 20 need to understand what's happening in the market 

 21 with price discovery mechanism and how is all this 

 22 effecting things. I think we have a tremendous 
 14 

 1 first panel here to begin talking about those 

 2 issues. I'm looking forward to it. After they 

 3 finish, then we'll open it up for the Advisory 

 4 Committee to ask them questions or to do comments. 

 5 Our first presenter on this is somebody who literally 

 6 flew in from India, Mike Gorham. And as our Acting 

 7 Chairman has said, Mike is an alumni from here at the 

 8 CFTC, he's worked the federal reserve, he's been with 

 9 exchanges, he's an academia, this is a great person to 

 10 give us a broad oversight. So, Mike, could we start 

 11 with you and your presentation? 

 12 MR. GORHAM: Absolutely; Walt said that 

 13 I was an intellectually curious guy, and the thing 

 14 is, if you don't know much, you've got to be 

 15 intellectually curious, because you'll never learn 

 16 anything otherwise. 

 17 So I was asked to address this issue of 

 18 price discovery and market -- changes in price 

 19 discovery and market structure. And I have to 

 20 confess something, I hate the term, price 

 21 discovery. I know it's in the act, and so I know 

 22 we've got to use it and we've got to know what it 
 15 

 1 means. But quite -- the reason I don't like the 

 2 term is because it's always been a fuzzy term, 

 3 it's always been a somewhat complex term, and if 

 4 you talk to different people, they really mean 

 5 different things by it. So what I'm going to do 

 6 is kind of structure this just slightly 

 7 differently. 

 8 So I'm going to start with talking about 

 9 structural changes in the way exchanges operate, 

 10 and then I'm going to talk about what the 

 11 implications are for those structural changes on 

 12 both the pricing of futures, the price of 

 13 transactions, as well as the fees that are charged 

 14 by exchanges for those transactions. 

 15 We are probably in the midst of the 

 16 biggest transformation of derivatives and 

 17 securities exchanges in our history. For those of 

 18 us that thought we knew what exchanges were ten 

 19 years ago, we've had to totally rethink what these 

 20 things are. 

 21 And there are a number of different 

 22 changes, but the three that I want to focus on 
 16 

 1 today and the three that I think are most 

 2 important is the shift from floors to screens, the 

 3 shift from private clubs to public companies, the 

 4 shift from smaller to larger via mergers and 

 5 acquisitions. Let me take each one of those. 

 6 So this move towards electronic trading 

 7 is not new. In fact, I don't know if people in 

 8 this room realize it, you'd have to be kind of old 

 9 like I am to know this, but the first attempt at 

 10 electronic trading was actually an attempt to buy 

 11 an exchange called Intex in Bermuda back in 1984. 

 12 And what happened in that case is that 

 13 there was a guy from Merrill Lynch named Eugene 

 14 Grohmer, who was tired of getting abused by the 

 15 floor, and he decided that he wanted to create an 

 16 electronic exchange where you had transparency, 

 17 you saw what the bids and offers were, and he 

 18 actually came, I guess not to this building, I 

 19 don't know where the CFTC was back in 1982/'83, 

 20 but he came to the commission, and the commission 

 21 -- and he explained what he wanted to do, the 

 22 commission loved it, I mean because this actually 
 17 

 1 gives you much better -- I don't know if you 

 2 remember, but we had this audit trail concept that 

 3 we didn't really have much of an audit trail, and 

 4 this actually made that thing precise and crystal 

 5 clear. 

 6 But the commission actually gave him 

 7 some informal advice, and the informal advice was, 

 8 don't do it in the U.S., do it offshore, because 

 9 even though the commission thought it was a great 

 10 idea, they said the big floor based exchanges will 

 11 never let you get this done, it'll take you years 

 12 and years and years to get regulatory approval, 

 13 not because we don't think it's a good idea, but 

 14 just because entrenched interest in floor based 

 15 trading will keep it from happening. 

 16 The exchange started, it was done in 

 17 Bermuda. Because these guys were pioneers, they 

 18 did everything wrong, there were all kinds of 

 19 mistakes, I mean it's tough being the pioneer, and 

 20 they started in -- they opened in October of '84, 

 21 and it really just lasted a matter of months, it 

 22 really was not a success. 
 18 

 1 There were -- in the 1980's, there were 

 2 actually six other -- or there were six total 

 3 attempts to create exchanges, electronic 

 4 exchanges. Virtually every one of those was de 

 5 novo, it was brand new, in other words, new 

 6 exchanges were being created, because you really 

 7 could not get mutually owned, member owned 

 8 exchanges to vote to put themselves out of 

 9 business on trading floors and to go behind 

 10 screens. 

 11 So the funny thing is that the first 

 12 successful one took place about as far offshore as 

 13 you can get, in a little country that's about half 

 14 the size of Chicago, and that's New Zealand. So 

 15 there were seven wool guys in New Zealand that 

 16 wanted to create a wool futures market, but each 

 17 of these guys was in a different part of the 

 18 country, and of course, each one of them wanted 

 19 the exchange to be in their own town. Well, it 

 20 turned out that electronic trading was a perfect 

 21 solution, because you didn't have to have it 

 22 anywhere, it was really everywhere if it was an 
 19 

 1 electronic exchange. 

 2 They got some bankers involved, and they 

 3 opened that, and that was a very successful 

 4 exchange. It doesn't -- that name doesn't exist 

 5 anymore, the New Zealand Futures and Options 

 6 Exchange, because it was taken over by another 

 7 exchange, which was taken over by another 

 8 exchange, and this is all part of the Australian 

 9 exchanges now. 

 10 The only exchange back then that went 

 11 from -- that was member owned that actually made 

 12 the transition was the Tokyo Grain Exchange. And 

 13 as you know, the government in Japan is a little 

 14 more involved in telling people what to do than 

 15 the commission here. So it was basically -- it's 

 16 what happened in that case. 

 17 So most of the world is now converted. 

 18 China has been fully electronic for 17 years; 

 19 India has been fully electronic for five years. 

 20 The CME and the Board of Trade are now about 70 

 21 something percent electronic. So even though the 

 22 U.S. was a dinosaur, it's made this move. And the 
 20 

 1 biggest dinosaur in the U.S., and I don't think 

 2 anybody is here from the exchange, but it wouldn't 

 3 matter anyway, was Nimex. I mean Nimex, while 

 4 everybody was trying to move towards electronic 

 5 trading, they were sitting up floors in Europe. I 

 6 mean it was just kind of a crazy thing. But they 

 7 finally realized that they weren't going to 

 8 survive unless they went to electronic trading. 

 9 So this is all history, so what does 

 10 this really mean from the point of view of pricing 

 11 the products that you're selling? Well, first of 

 12 all, it has created unprecedented transparency. 

 13 In other words, what you guys get now is 

 14 information that was only available to floor 

 15 brokers when we had floor based trading. 

 16 You can see, depending upon what the 

 17 exchange is, you can see either all or some 

 18 substantial proportion of the resting bids and 

 19 offers, so you see the full book, and you know 

 20 something about the structure of the market. That 

 21 just didn't exist before and that's just an 

 22 unmitigated wonderful thing, that that has 
 21 

 1 happened. 

 2 It also has made possible things like a 

 3 technique that's known as smart order routing. 

 4 So, for example, let's say that you want to take a 

 5 position in sugar, and I don't know if this is 

 6 still the case, but both life and nightbite (?) 

 7 had active sugar contracts. And so what would -- 

 8 what I'm told, I've never been involved in this 

 9 myself, is that there were programs that basically 

 10 if you wanted to cover yourself in sugar, 

 11 basically the program would take the position to 

 12 the exchange at which you could get the best 

 13 price. A lot of that happened with Nimex and Ice, 

 14 as well, where there were multiple contracts 

 15 traded in each of the exchanges. 

 16 So despite these wonderful things, there 

 17 are a couple of concerns. Number one, liquidity 

 18 vacuums, I don't know if you remember, but back 

 19 when electronic trading started, the electronic 

 20 stock indexes at the Board of Trade and at the 

 21 CME, you would find that sometimes on the day 

 22 before a holiday, when there was not a lot of 
 22 

 1 liquidity, the market would be going along, and 

 2 then suddenly it would plunge for a matter of a 

 3 few seconds or a few minutes, and then come back 

 4 up again. 

 5 And essentially what was happening is 

 6 that orders would come in, market orders, that 

 7 were bigger than could be accommodated with the 

 8 resting buy orders, and they would actually hit 

 9 some sell stops and cause the thing to plummet. 

 10 Now, this hasn't -- I think this has basically 

 11 been taken care of because it hasn't occurred in a 

 12 while, but that was an initial problem. Number 

 13 two, high frequency algorhythmic trading. At my 

 14 university, we've got -- one of the most popular 

 15 things that students are studying is how to build 

 16 black boxes, how to build black boxes for trading. 

 17 And these systems are such that you can really -- 

 18 you can actually put -- you can put in hundreds of 

 19 orders per second. 

 20 Now, this is wonderful from the point of 

 21 view -- because most of this is arbitrage. So 

 22 from the point of view of getting markets in line, 
 23 

 1 from making markets efficient, you know, where if 

 2 something is a little too low and another one is 

 3 too high, people that are doing this trading bring 

 4 things back into line, that's all good. 

 5 But having spent two years here and 

 6 worrying about what John Fenton worries about all 

 7 the time, and Dave Kass, about manipulation, just 

 8 -- I just have a gut feeling that this could be 

 9 used in a way that's not the best, and so I just 

 10 think that's something that needs to be looked at. 

 11 The third thing has to do with deceptive 

 12 trading. Now, I said that this is a great thing, 

 13 that we have all of this transparency and you can 

 14 see all of the orders in the market. The problem 

 15 is, is that sometimes those orders are not real 

 16 orders, and here's the scan. Somebody goes in, 

 17 and let's say that you believe, not that anybody 

 18 in this room would ever do this, but let's say 

 19 that you believe that the market is actually going 

 20 to go down, and what you want to do is, you want 

 21 to put on a relatively large short position. What 

 22 you do initially is that you put in a bunch of buy 
 24 

 1 orders, limit buy orders, and people look at those 

 2 and they say, you know, these buys must know 

 3 something, the fact that you've got so many buy 

 4 orders in there, so they start coat tailing or 

 5 piggybacking, and they start putting -- they start 

 6 putting buy orders in, as well, and then what 

 7 happens is, as soon as you see all these other buy 

 8 orders come in, you cancel all your buy orders and 

 9 you take the other side of all the guys that you 

 10 tricked into the market. 

 11 So it's a complicated thing. I mean we 

 12 should think of trading as poker, because that's 

 13 what it really is, I mean from the point of view 

 14 of bluffing and all the things that take place. 

 15 So these are just a couple of the things that we 

 16 have to be concerned about. 

 17 So the other two factors, the other two 

 18 shifts, private club to public company, now, we 

 19 all know what that's about, and we -- basically 

 20 this means that you've gone -- that we're going 

 21 from member owned exchanges to what we call 

 22 demutualized exchanges, and then ultimately doing 
 25 

 1 IPO's and listing stock. This has been an 

 2 incredible thing for anybody who's a member at the 

 3 Board of Trade or the CME. I mean they've really 

 4 been able to unlock the value of the memberships 

 5 in these things. 

 6 But I'm going to make a bold statement, 

 7 and that is that I think that this move is 

 8 actually a very positive move from the point of 

 9 view of customer service. These exchanges have 

 10 basically been private clubs, and they have acted 

 11 in the interest of their members, I mean there's 

 12 no pretention about that, I mean they are 

 13 associations of members, and the idea is, they 

 14 want to do things that will enhance the revenues 

 15 to the members. 

 16 What that means is that sometimes 

 17 customers really don't get the kind of service 

 18 that they ought to get. And I -- we don't have 

 19 time for this now, but there is -- one of the best 

 20 stories in finance has to do with this miraculous 

 21 transformation of markets in India by the creation 

 22 of a new stock exchange that was stockholder owned 
 26 

 1 and went -- basically took all the business away 

 2 from this really old Bombay Stock Exchange, 

 3 finally, the shift from smaller to larger. 

 4 Now, there's so many exchanges 

 5 world-wide that no longer carry their original 

 6 names because they were swallowed up by a larger 

 7 exchange, it's happening everywhere. In the U.S., 

 8 Ice has taken over Nibot, Eurex has taken over the 

 9 International Securities Exchange, the NYSC has 

 10 merged with Archipelago and then again with 

 11 Euronext. And, of course, in the mother of all 

 12 mergers, the Board of Trade and the CME, well, the 

 13 CME has either merged with or taken over the Board 

 14 of Trade, depending upon how you want to sort of 

 15 spin that. 

 16 This really does raise a pretty 

 17 interesting issue. I didn't read the Justice 

 18 Department's analysis of this situation. And I 

 19 mean I know, I just took a look, I know that 

 20 during the first three-quarters of this year, 87 

 21 percent of all futures and options trading in the 

 22 U.S. took place at this combined exchange, or it 
 27 

 1 took place at the two exchanges and the 

 2 combination of the two. 

 3 Eighty-seven percent is quite a bit. I 

 4 believe that what Justice decided is that, yeah, 

 5 that's a big number, but there really is 

 6 competition from outside the U.S., and we know 

 7 that's the case, because back in 2004, Eurex 

 8 attacked the Board of Trade, and Euronext attacked 

 9 the CME. Both were failures, but that exists. 

 10 And the exchanges also argue that there is a lot 

 11 of competition from OTC, so that might be the 

 12 case. But the last point that I want to leave 

 13 here has to do with the structure of these 

 14 markets, in other words, whether 87 percent is a 

 15 big number or not, and I just want to make sure 

 16 we're all on the same page on this, futures -- a 

 17 market for a particular futures contract is really 

 18 a liquidity driven, naturally occurring monopoly. 

 19 As an example, when the CME and the 

 20 Board of Trade merged, I want you to guess how 

 21 many contracts they had in common, how much of an 

 22 overlap was there between the two exchanges; does 
 28 

 1 anybody know? It was zero. 

 2 And what that says is that, if you've 

 3 started a contract and you've developed liquidity 

 4 in that contract, nobody is going to take it away 

 5 from you, nobody is going to really make any end 

 6 roads into getting market share, and the only 

 7 exception to that is, for example, when you have 

 8 an electronic exchange that comes and offers all 

 9 of the advantages of electronic trading and they 

 10 compete directly with a floor based exchange. 

 11 So that's why Ice was able to get a huge 

 12 part of the market share of Nimex's contracts. 

 13 That's why the Board of Trade was able to get a 

 14 huge market share in silver and gold when they 

 15 were offering their electronic versions. So I 

 16 think as we go forward, there are a number of 

 17 really interesting structural issues in which 

 18 economics and politics are really intertwined, and 

 19 I can't wait to watch what you guys do with all 

 20 this. 

 21 MR. DUNN: All right. Thank you very 

 22 much. You'll observe that you do not have Mike's 
 29 

 1 paper in your packet that we had sent out to you 

 2 over here. And it's the fact that he literally 

 3 was flying back from India and put it together 

 4 last night or in his head earlier, I'm sure. But 

 5 as soon as we get that, we will get copies to you. 

 6 So anything that you're missing, when we get hard 

 7 copies, we'll get them out to you. 

 8 The next three panelists, I'm going to introduce all 

 9 three of them right now and their subject matter so we 

 10 can just go right on through. I was recently in 

 11 Chicago, at the industry meeting, and person after 

 12 person got up and said how great the CFTC is and what 

 13 a great job we do, and there's a reason for that. 

 14 I think we have some of the most professional, the 

 15 most dedicated group of employees of any agency in 

 16 government. And you'll see that these next three 

 17 gentlemen, not only are they knowledgeable, they've 

 18 got a lot of institutional knowledge, as well. I'm 

 19 not saying their old, but they have. And we're going 

 20 to start off with Dave Kass, who is going to give us 

 21 an update on our commitment of trader's report and how 

 22 that's worked. This was a big topic, a subject from 
 30 

 1 our last meeting, and I think it's worked very well, 

 2 but Dave will give us an update on that. Dave, I have 

 3 treated him like a member of my staff. He's been one 

 4 of the greatest advisors I've had on the Agricultural 

 5 Advisory Group. 

 6 The next person who's going to make a presentation, 

 7 and not sitting in this order, is John Fenton. 

 8 John is the heart and soul of our surveillance 

 9 program. And this guy we rely on to tell us what's 

 10 happening in the market place. If there's something 

 11 that looks odd, he's the first one to notice it, and 

 12 again, somebody that has had a great deal of knowledge 

 13 and background, and he's going to talk about the 

 14 increase and speculative position limits for numerated 

 15 agricultural commodities. 

 16 And last, but not least, Don Heitman, who is going to 

 17 discuss the commission's proposal to allow certain 

 18 Risk Management positions, in an exempt from federal 

 19 position limits. Don's name you might see. He signs 

 20 many of those federal register pieces, and that allows 

 21 him to get a lot of strange email. But these three 

 22 guys are tremendous assets to the commission. And so 
 31 

 1 with that, I'm just going to let all three of them go 

 2 right into their presentation, one following the 

 3 other. Dave, if you will, please. 

 4 MR. KASS: Thank you, Commissioner. 

 5 First of all, and I'm sure I'm speaking for the 

 6 three of us staff opinions, we always have to do 

 7 the disclaimer, any opinions that might sort of 

 8 creep in or leak out are those of the staff, not 

 9 necessarily those of the commission. 

 10 And unlike my colleague here that is no 

 11 longer a commission member, who has obviously 

 12 expressed many opinions, we, like I say, we speak 

 13 for ourselves here. 

 14 I have sort of a task of bringing us up 

 15 to date. Well, actually 16 months, when this 

 16 committee last met, in August of 2006, of course, 

 17 as Commissioner Dunn said, a big topic was getting 

 18 input on whether we should, and if so, in what 

 19 form we should add more transparency to the market 

 20 through this disclosure of index trading. 

 21 And I made a presentation at that panel, 

 22 and of course, we could only talk about 
 32 

 1 hypotheticals, because we -- although we had the 

 2 data in-house, it would have been, you know, a 

 3 felony violation for somebody like myself to 

 4 disclose sorts of confidential data to the public. 

 5 So our hands were tied a great deal talking about 

 6 hypotheticals, and maybe it's this sort of a, you 

 7 know, big share of the market, without getting 

 8 into any kind of specifics. Well, now, of course, 

 9 those sort of fedders (?) are removed to some 

 10 degree. 

 11 There is data out there; we did begin 

 12 publishing a report this past January of '07, and 

 13 we published a year's worth of data going back, so 

 14 that's out there, and it sort of frees my hands a 

 15 bit in that I can talk more about that and say 

 16 some things about, you know, who's in the market, 

 17 again, in general terms, nothing too specific. 

 18 So with that, let me get started. 

 19 Commodity indices, and people talk about them, and 

 20 we talked about them, again, 16 months ago, is 

 21 sort of an amorphous thing, it's a commodity 

 22 index, it's -- the S&P -- commodity index, or it's 
 33 

 1 the Dow Jones IAG, and they treated it just sort 

 2 of a lump of, you know, you're exposed to 

 3 commodities, and you're sort of in the whole 

 4 thing. 

 5 And that's certainly true, and there's a 

 6 lot of institutions, and people in the financial 

 7 world that treat it that way and could care less 

 8 about things like corn. Did I lose my -- no, here 

 9 we are, things like, you know, individual 

 10 commodities. Oh, there we go. 

 11 But we, as commission staff, particular 

 12 in the markets, do worry about things like what's 

 13 happening in corn, or what's happening in -- you 

 14 see cotton here and some of the other ones. Not 

 15 only -- apart from what's happening in the index 

 16 as a whole, but what's happening to each of these 

 17 individual markets. So we do not lose sight of 

 18 the individual markets and focus a lot on the 

 19 individual markets. 

 20 And, of course, we don't want what's 

 21 happening in the commodity indices somehow, that 

 22 trading -- to somehow work us back down into, in 
 34 

 1 effect, these very real products. 

 2 They're not real necessarily to a big 

 3 pension fund or insurance company, but they're 

 4 certainly real to the people that you all 

 5 represent in this room, and to the people that 

 6 produce it, process it, export it, you know, use 

 7 it, whatever it is. And I can assure you, we 

 8 don't lose sight of that fact. 

 9 We started with the individual markets 

 10 before they were indices, and that's, you know, we 

 11 still -- that's what we work with, so -- 

 12 So now, like I said, last -- I want to 

 13 talk a little bit about market transparency, and 

 14 hopefully we've added some transparency through 

 15 our publication, and that was the purpose of it. 

 16 But some of the other regulatory implications 

 17 that, again, we couldn't talk about a lot, only 

 18 more in general terms, and I can be a little more 

 19 specific not. In terms of position limits, both 

 20 the federal and the exchange, and in terms of the 

 21 potential impacts, our concerns about impacts on 

 22 not only the prices themselves, but spreads. 
 35 

 1 First is sort of a background. This I 

 2 think -- I find a lot of information in this 

 3 particularly graphic. If we start over here, this 

 4 is -- there's groups of folks out there, 

 5 institutional investors, maybe some high net worth 

 6 individuals, that we're going to get exposure to 

 7 commodities, and again, this sort of morphous 

 8 thing, not the corn necessarily, or cattle, or 

 9 anything else, as an asset class, and then there's 

 10 various ways they can do that, and they do that 

 11 through these indices. 

 12 And so here's a pension fund, and they 

 13 want to get this exposure, their reps and folks 

 14 trying to sell them products that said things 

 15 like, if you get, you know, put two percent, five 

 16 percent, whatever it is, of your assets into 

 17 commodities during certain markets when maybe 

 18 equities aren't doing so well, or bonds, or 

 19 foreign currencies, or real estate, or all the 

 20 other things they invest in, there's certain 

 21 advantages, portfolio advantages and things like 

 22 that. I'm not going to go into all that, but they 
 36 

 1 get into it as another asset class. And they 

 2 might go to somebody like a financial services 

 3 firms, and you know, I'm sure you're all familiar 

 4 with, and some of you, you know, may deal with 

 5 some of these folks, swaps, dealers, banks, you 

 6 know, whatever these folks deal with, and there 

 7 are other investments, and there are other asset 

 8 classes they're going to these folks to get 

 9 involved in the equities and debts and other 

 10 things, and they might do a swap with them. 

 11 And there is a standard swap, where 

 12 they're getting the return then on this index, 

 13 whether it be one of the major ones. I think, you 

 14 know, anecdotally, I guess the Goldman Sacks and 

 15 the Dow Jones AIG are the two largest, and there's 

 16 lots of sub indices of those main ones and then 

 17 other proprietary indices and what not, and 

 18 they'll do a swap to get this returned. 

 19 And then this group here that we have in 

 20 this first blue box has then created a short 

 21 position for themselves. Their client is long 

 22 commodities in the form of this index, they're 
 37 

 1 short, we consider that a hedge. They now want to 

 2 cover that market exposure by going over here. 

 3 This is where you're going to get coverage. 

 4 You're going to go to a designated contract 

 5 market, which are generally U.S. Futures 

 6 exchanges, you might go to some OTC thing, where 

 7 there's a highly developed over-the-counter 

 8 market, or in some cases you might go to another 

 9 exchange, a non-regulated exchange of something. 

 10 Another way they might go is, there's certain 

 11 essentially mutual funds and others that have set 

 12 up a fund, just like the -- just to pick one out 

 13 of the air, the Vanguard S&P 500, which replicates 

 14 the S&P, well, there's funds out there that say if 

 15 you want exposure, this fund will do that, it will 

 16 mimic the Goldman or the Dow Jones, and if you 

 17 give us money, you're going to get that return, 

 18 and it should be a part of your portfolio, blah, 

 19 blah, blah. 

 20 But these guys, since they're getting 

 21 money that essentially wants to get exposure to 

 22 the markets, they're not trying to cover a hedge, 

 38 

 1 their clients may be thinking of this as sort of a 

 2 hedge against inflation, but nonetheless, they 

 3 want to get market exposure. 
 4 So to the extent they go directly into 

 5 these markets, that's considered not a hedge, but 

 6 a non-commercial type of position, and they do not 

 7 get relief through bona fide hedging through 

 8 speculative limits. 

 9 But if they were to run afoul of 

 10 speculative limits or approach at least 

 11 speculative limits and wanted to still -- they've 

 12 got more money coming in, want to get even larger 

 13 positions, they can then do a swap up here to 

 14 these guys, and then the money finds its way back 

 15 into the markets, well, particularly, in our case, 

 16 designated contract markets, which is where you'd 

 17 run afoul of spec limits. 

 18 So there's various ways that they can. 

 19 And that's why they could go up here and convert 

 20 what wouldn't be eligible for spec limits relief 

 21 up to these guys, who then would do a swap, and do 

 22 get -- and want to cover market exposure, then 
 39 

 1 they can transfer it from something that wouldn't 

 2 get relief to something that would. 

 3 Or an institutional investor can say, 

 4 well, I can bypass these big financial guys who 

 5 are obviously going to earn a commission and do it 

 6 myself. Some of these indices are published. 

 7 They'll tell you what proportions of what markets, 

 8 when they get role from the nearby future, the 

 9 next deferred, and all these things. 

 10 Well, I can pull out this manual and 

 11 just do it myself and manage the trading 

 12 strategies and all that, and do the direct. 

 13 Again, if a pension fund is doing this as part of 

 14 a gaining exposure to market, again, maybe in 

 15 terms of their whole portfolio they consider this 

 16 as an offset to something else, but nonetheless, 

 17 from the perspective of our commodity market, 

 18 they're gaining market exposure, not covering 

 19 exposure, so again, this is a non-commercial 

 20 position, and if they stay within speculative 

 21 limits, they're free to do that themselves, if 

 22 they run afoul, they could then, again, go back up 
 40 

 1 here, this route, and go through a swap dealer to 

 2 supplement what they're doing or do it 

 3 exclusively. So that's sort of the characters in 

 4 the market and how they operate and how they're 

 5 treated from our regulatory perspective in terms 

 6 of spec limits or non-spec limits. 

 7 We're going to hear in the next couple 

 8 panelists some things we're doing in terms of spec 

 9 limits and a new exemption category that address 

 10 some of these issues. 

 11 Now, what markets, all these markets, 

 12 and as you see here in this little note, for eggs 

 13 and the soft, coffee, cocoa, sugar, things like 

 14 that, they primarily use designated contract 

 15 markets, because they really don't have good ways 

 16 to use OTC or other exchanges, they're just not 

 17 highly developed. 

 18 In something like cattle, there's really 

 19 not a real strong OTC or certainly another 

 20 exchange, unlike crude oil, or silver, or gold, 

 21 where they're very highly developed. 

 22 So in the energies and the metals, they 
 41 

 1 tend to use all three, which tied our hands as 

 2 staff in terms of how we were able to publish 

 3 data. To the extent that most of commodity index 

 4 trading finds its way into this category, we have 

 5 a pretty good handle on it because we see that's 

 6 our extra reporting system. 

 7 To the extent -- in these other markets, 

 8 where there's lots of other options for them to do 

 9 things, and OTC and others, we're not seeing much 

 10 of it in our markets, so we were unable to publish 

 11 data for those. 

 12 All right. Now -- so then, to add 

 13 transparency again, we listen to what you all had 

 14 to say 16 months ago and we began publishing. 

 15 This is the way commitments looked, and still 

 16 looks, we do still publish the traditional one. 

 17 Where you have reportable traders, we divide the 

 18 market into essentially non-commercial speculative 

 19 and commercial. 

 20 And, of course, the concern was that, 

 21 you know, particularly on the long side, these 

 22 long funds, here we're seeing commercials. It 
 42 

 1 looks like they're about, if you look at the long 

 2 and short, they're net long, what, about 16,000 

 3 contracts, yeah, almost exactly 16,000 contracts. 

 4 So if this is all you had, this is all you had up 

 5 until January of this year, it would look like 

 6 commercials were net long 16,000. Now, of course, 

 7 we all knew that the index money was in here, we 

 8 just didn't know, well, you didn't know how much, 

 9 we sort of had a better handle on it because we do 

 10 get the data. Well, this is what -- beginning in 

 11 January, we started publishing this additional 

 12 category. And particularly, to zone in on, let's 

 13 look at that long now, there's nearly 205, nearly 

 14 206,000 contracts that we are now seeing long. 

 15 And now look at the long with its left 

 16 over here. Remember, we were about 16,000 net 

 17 long commercial. By taking some out of the 

 18 commercial account, in fact, specifically, this 

 19 205,000, almost 206,000, it was -- 178,000 of it, 

 20 or about 86 percent of its number, came out of 

 21 that commercial category, and the other 14 

 22 percent, about 27,000 or so, came out of the 
 43 

 1 non-commercial side. 

 2 Now, remember, back -- that flow 

 3 diagram, you could go different ways. If you went 

 4 up through the swaps dealer and they were hedging, 

 5 that would have come out of the commercial 

 6 category. If you come through doing it yourself 

 7 or doing it through a fund of some sort that wants 

 8 to gain exposure, that would be coming out of this 

 9 category. But this now is dated, we weren't able 

 10 to disclose before that here we have 206,000, the 

 11 commercials are now obviously way net short, not 

 12 net long, the more traditional commercials, to the 

 13 tune of about 150,000 contracts net short, and 

 14 here's the proportions coming. This is all now 

 15 public data, of course, and this is the most 

 16 recent report that's out there in the public 

 17 domain. 

 18 So that's the transparency now that you 

 19 all asked for and now you all have, and obviously 

 20 we'll be interested in any comments. We've gotten 

 21 comments over the past year, of course. 

 22 Now let's see how this breaks out. 
 44 

 1 We're, of course, publishing data for 12 markets. 

 2 These are the 12 markets depicted here along the 

 3 bottom, live cattle, hogs, wheat, feeders, et 

 4 cetera. These are the markets where the data was 

 5 best in terms of not clouding it by adding metals 

 6 and energy where we really weren't seeing much of 

 7 the picture. 

 8 And some of these firms that are -- do 

 9 index trading were also doing lots of other 

 10 things, proprietary trading in metals or 

 11 individual markets swaps and things like that. 

 12 The blue bars, which the scale is over 

 13 on this side, is the thousands of contracts. So 

 14 in live cattle, and this is as of the 27th, the 

 15 date that we published the most recent data, you 

 16 can see it looks like about 120,000 contracts. 

 17 And you've got little feeder cattle down here, 

 18 maybe 10,000 contracts or so, and you can see the 

 19 numbers of contracts. The red represents -- what 

 20 those contracts represent in terms of percent of 

 21 open interest, because it tells a lot different 

 22 story. Here's feeder cattle, which if you just 
 45 

 1 looked at the bars, looks like it's very small, 

 2 but that's a small market. And that represents, 

 3 it looks like about 33 percent of the feeder 

 4 cattle market. 

 5 So what you end up with is sort of 

 6 grouping things. You've got these three markets 

 7 way over here on the left, and they're grouped by 

 8 size or percent, cattle hogs and wheat with fairly 

 9 high percentages, at least relative to the other 

 10 12 markets, 40 percent, 45, you know, and slightly 

 11 above 45 percent. 

 12 You've sort of got this middle group, 

 13 eight more markets in here that range from, oh, 21 

 14 to, what, 32 percent, just looking at broad 

 15 numbers. And then you've got cocoa over here 

 16 which is markedly less. But again, so these are 

 17 data we couldn't show a year ago, and this is all 

 18 public data, let's see if we can get this out of 

 19 our report, just put the numbers together in the 

 20 right way. So again, this is all adding 

 21 transparency to the markets, what proportions. 

 22 Okay. If you look over time, going back to -- 
 46 

 1 now, we had this data going back, but the data 

 2 deteriorates as you go back because traders were 

 3 doing different things. But let's look at where 

 4 we've published data since January 6th. Here 

 5 you've got the Board of Trade, wheat, in terms of 

 6 thousands of contracts, and you can see it's 

 7 fairly, you know, it's a little bit less over 

 8 time, it's grown a little bit recently. 

 9 We just sort of picked different sort of 

 10 market sectors. Here's a soft market, sugar. 

 11 Now, this big jump up here and this sort of 

 12 decline here during this time frame, these are 

 13 market readjustments, rebalancings at the end of a 

 14 year when a market, you know, the dollar value of 

 15 sugar in '06 dropped very dramatically. 

 16 The price of sugar was off, it may have 

 17 been off as much as 50 percent. So to get the 

 18 same dollar exposure, you've got to add a lot of 

 19 futures contracts to get that same dollar exposure 

 20 that the index market required, and that's why you 

 21 see this big leap up. 

 22 And similarly, wheat, which had 
 47 

 1 increased in price, had to come down a bit and 

 2 that sort of thing. So some of that we're aware 

 3 of why this is happening. 

 4 Just to look at it in another way, this 

 5 is as percent of open interest, same data, and 

 6 these are all data you can -- although this is 

 7 maybe daily data, so it's something you wouldn't 

 8 normally see, but it doesn't change that much day 

 9 to day. So this is -- percent, and you can see 

 10 wheat going, in the earlier period, January 

 11 through May, was well above 50 percent at times, 

 12 and it's down more, rising a little bit very 

 13 recently, it's approaching 50 percent. 

 14 And then you've got cattle up here, and 

 15 you can see where sugar is in terms of percentages 

 16 of markets. So these are all now added 

 17 transparencies. 

 18 Now, what are some of the other 

 19 regulatory issues about this data? Now, this next 

 20 graph you cannot get out of our report. This is 

 21 semi-confidential data. I guess it's obviously 

 22 not confidential anymore because this is a public 
 48 

 1 thing, but this is not something you would 

 2 normally see. But I wanted, within the bounds of 

 3 not being cartered off to jail for disclosing 

 4 confidential market -- within those sort of 

 5 bounds, I hope, we can say a little bit more, and 

 6 so you're going to -- and I have used this at a 

 7 couple other conferences. 

 8 What this represents, the green bar is 

 9 the positions, and this is futures and options 

 10 combined, in the December wheat futures contract 

 11 individually. Now, remember when we publish the 

 12 data, it's across all futures, so you're not 

 13 seeing what's in -- you're seeing what's in the 

 14 whole collections of futures contracts and options 

 15 combined, not in any one individual future. 

 16 And, of course, we all know, if you know 

 17 anything about these index, they tend to load in 

 18 the front, not exclusively anymore or as much as 

 19 it was in the early days, but they tend to front 

 20 load, and then they roll on a prescribed schedule, 

 21 and you certainly see that here. 

 22 Look at all the contracts in dese (?) 
 49 

 1 meanwhile, this is the next deferred contract, the 

 2 march, and you can see it going down at a much 

 3 lower level. Now, you say, well, Mr. Kass, 

 4 where's the scale over here; you know, I'm not 

 5 what -- how many thousands of -- well, that's the 

 6 part where I don't want to be cartered off to jail 

 7 and those sorts of things, so that I've left off. 

 8 But it's not important for the meaning 

 9 of what this is to see the open interest in the 

 10 dese coming down quite sharply, and march, all of 

 11 a sudden you get to this five day roll period and 

 12 you're seeing it come down very, very sharply, 

 13 you're in that five day window, and it's standard, 

 14 it's published, and it's the fifth through ninth 

 15 business days of the month prior, so for the dese 

 16 contract, fifth through ninth business days are 

 17 the 7th, the 8th, the 9th, 10th, and 13th of, in 

 18 this case, November. And this red line now, I've 

 19 left out one of the major lines in this, is the 

 20 spread, because as you roll, of course, you're 

 21 going to sell, you're going to sell the nearby the 

 22 deferred, so what's happening to the spread. 
 50 

 1 Well, they're pretty much locked in up 

 2 here, the -- and this red represents the spread. 

 3 Now, this scale I can certainly disclose, that's 

 4 public information. That's the deeds mark spread 

 5 and this is the zero line, so that would be if it 

 6 happened to touch this line, this red line, that 

 7 would mean they were equal in price. 

 8 To the extent this is below means the 

 9 dese is below march, it's a carry, and to the 

 10 extent it rises above this line, it's a premium, 

 11 it's an inverse. They say contango (?) and stuff 

 12 in the east coast; mid west guys tend to say carry 

 13 and inverse. 

 14 You can see what happened here, in 

 15 wheat, you had a lot of news came out about -- if 

 16 you remember the conditions in October of a year 

 17 ago, a lot of news was coming out about the 

 18 devastation to the Australian wheat crop and what 

 19 not, and wheat prices were going up, and this 

 20 would tell you they were going up 

 21 disproportionately into December versus March. 

 22 The spread, which had been at a carry down here of 
 51 

 1 about, oh, let's say 18 cents, all of a sudden 

 2 went as far as an inverse of several cents. And 

 3 what's happening, here you've got these guys, long 

 4 only, who might have been a source of selling to 

 5 liquidate at an advantageous time. 

 6 These folks know they've got to roll 

 7 from this nearby future, and they're going to roll 

 8 up hill. They're going to roll from a low price 

 9 to a high price. And if you go and move a long 

 10 position from a low price to a high price, 

 11 obviously that's not particularly advantageous. 

 12 If you had rolled here, that would have 

 13 been very -- you're rolling down hill essentially, 

 14 you're selling something at a high price and 

 15 buying something at a lower price. So it would 

 16 have made a lot of sense, if they would have been 

 17 allowed to, for them to take -- particularly if 

 18 they thought it was a short term phenomena. Of 

 19 course, nobody knew at the time whether that 

 20 spread might, you know, continue, and then it 

 21 might have looked like a terrible decision. 

 22 But in any event, that's sort of the 
 52 

 1 economics. And so one regulatory concern that was 

 2 expressed to us at the time was these folks, these 

 3 commodity index traders, or CIT's, were somehow a 

 4 drag on the market. They were not a natural 

 5 source of selling that may have reduced some of 

 6 this pressure of people on -- who wanted to buy 

 7 the dese because of what was going on in Australia 

 8 and some other things going on around the world. 

 9 They weren't there as somebody -- a willing seller 

 10 of a long position at an advantageous time, 

 11 because most of them are locked in. 

 12 Remember, this is a hedge, they have to 

 13 guarantee a return, and the best way to do that is 

 14 simply mechanically passably follow the rules of 

 15 their index, which dictates that they roll during 

 16 this five day window. 

 17 So that was a concern that was expressed 

 18 of us at the time, and it's something we're 

 19 certainly interested in and are looking at. The 

 20 other thing kind of to note here, here's the 

 21 spread prior to this, and then during the roll 

 22 itself, the traded spread was remarkably stable. 
 53 

 1 Here you have this massive roll, and 

 2 remember, wheat we saw was up in the area of 45 -- 

 3 50 percent of total open interest, and again, 

 4 without giving you specific numbers, it does tend 

 5 to concentrate in the nearby, in this case, the 

 6 December. 

 7 So here's a whole bunch, so it would 

 8 have been even a higher percentage of the dese of 

 9 a single month. Here's this huge percentage of 

 10 open interest being liquidated, and a short 

 11 window, and they're all doing the same thing, 

 12 selling dese, buying march, and here's the traded 

 13 spread, you know, not showing much reaction, so 

 14 that's probably a good thing, although recently, 

 15 and we may hear from a panelist or two, concerns 

 16 have been brought to our attention that we're not 

 17 looking at the right thing necessarily, but if you 

 18 just look at the traded spread, because these guys 

 19 don't get their role on the traded spread, they 

 20 get the settlement price each day, that's what 

 21 they have to replicate, so they go into the pit, 

 22 and the pit difference is, if you look at the 
 54 

 1 calculated spreads, can be way different, they can 

 2 be all over the map here. 

 3 So that's something we're looking at, 

 4 and we're very concerned about that prospect. Of 

 5 course, as pit trading becomes less and less, and 

 6 if ultimately the exchange were to -- because 

 7 settlement prices are based on pit trading, not 

 8 electronic. 

 9 Even though electronic trading is the 

 10 majority of trading, it still doesn't fix the 

 11 settlement price, and it's the settlement price 

 12 that drive the index, et cetera, et cetera, so 

 13 that's why they use the pit. Ultimately, of 

 14 course, the settlement price is as they converted 

 15 in treasuries and other things, will be determined 

 16 presumably on the electronic market, and that may 

 17 make the problem go away, but I'm starting to 

 18 bleed over into that opinion thing, so I better 

 19 stop while I'm ahead and not get myself into too 

 20 much trouble. But at this point, I guess John is 

 21 next. 

 22 MR. DUNN: John, before you start, I did 
 55 

 1 see Bryan Dieriam walk in from Congressman 

 2 Goodlatte's office; Bryan, if you'd stand up. 

 3 There he is, okay, I thought he was out here 

 4 somewhere. Thank you, Bryan, for being here. Are 

 5 there any other congressional staff members that 

 6 are here? All right. John, if you will. 

 7 MR. FENTON: Good morning, everyone. 

 8 I'd like to thank our guests for coming and 

 9 visiting us. I'm looking forward to hearing your 

 10 views on the various topics and I hope you find 

 11 today's meeting useful to you. 

 12 The last time we revised federal 

 13 position limits was May of 2005. We raised them 

 14 to higher levels basically on the size of the 

 15 market. And at that time, we said we would try to 

 16 keep them up to date. They've changed fairly 

 17 infrequently through the years, so we're trying to 

 18 be a bit more proactive and keep the position 

 19 limit levels commensurate with the size of the 

 20 underlying market. So in November of this past -- 

 21 a couple weeks ago, we published a federal 

 22 registry notice proposing to, among other things, 
 56 

 1 increase the federal limits in all the markets 

 2 that have limits, except for OATS, and that's what 

 3 I'm going to talk about today. 

 4 Now, the purpose of position limits are 

 5 stated in -- Exchange Act, Section 4A(a), and it's 

 6 to prevent excessive speculation that could cause 

 7 sudden or unreasonable fluctuations or unwarranted 

 8 changes in the price of a commodity, so big 

 9 positions that -- not necessarily an attempt to 

 10 manipulate the market, but just the size of the 

 11 position, the size of putting them on or taking 

 12 them off or rolling them could cause destructions 

 13 in the market. 

 14 And also, the core principal five, which 

 15 is Section 5D5 of the act, also speaks to position 

 16 limits, in this case really to exchange said 

 17 limits. And there it's -- the rationale is to 

 18 reduce the potential threat of market manipulation 

 19 or congestion, especially during the delivery 

 20 month or the spot month. So slightly different 

 21 rationals, but in both cases, it gets to the size 

 22 of the position and the potential impact in the 
 57 

 1 market. The federal -- the position limit 

 2 structure in the futures industry is basically two 

 3 pronged. There are federal limits in a group of 

 4 agricultural commodities, a relatively small 

 5 group, the Chicago Grain and Soybean Complex, the 

 6 Ice Cotton contract, the Kansas City Wheat and the 

 7 Minneapolis Wheat. 

 8 And the reason there are federal limits 

 9 really is just a legacy of -- that there were 

 10 limits imposed prior to the creation of the 

 11 commission back in 1974, they were for the markets 

 12 that were regulated at that time by the Commodity 

 13 Exchange Authority. And then in '74 or '75, when 

 14 the commission started, many additional markets 

 15 were brought in, Nettles (?) and the beginnings of 

 16 financial markets, and later the energy markets. 

 17 And initially, there was no requirement 

 18 for the exchanges to set position limits. But in 

 19 1982, probably mostly as a result of the Hunsilver 

 20 (?) episode, the commission published regulations 

 21 requiring exchanges to have position limits, and 

 22 that's evolved through the years, and now 
 58 

 1 positions are -- exchanges are allowed to have 

 2 position accountability rules in place of position 

 3 limits. 

 4 But most position limits in the futures 

 5 industry are set by and administered by the 

 6 exchanges, although the commission does have 

 7 enforcement authority, so a violation of an 

 8 exchange position limit would be a violation of 

 9 the Commodity Exchange Act and could be pursued by 

 10 our enforcement folks. 

 11 For the markets with federal limits, 

 12 it's basically there are really three parts to how 

 13 we police them; one, we set the limits, and there 

 14 are separate limits for the spot month, any single 

 15 month, and all months combined. 

 16 And then we have the aggregation policy, 

 17 which is the way we will combine positions for the 

 18 applications of position limits, so any commonly 

 19 owned positions. So if a corporate entity has 

 20 several trading units that it owns, those 

 21 positions would be combined for purposes of 

 22 position limits. Also, any commonly controlled 
 59 

 1 positions would be aggregated for position limits. 

 2 And then we have exemptions to position 

 3 limits, and the main one there is for bona fide 

 4 hedging, and there are some other limited 

 5 exemptions that are permitted. 

 6 So the current proposal is to increase 

 7 the single month and the all month combined 

 8 limits, as I mentioned, in all commodities except 

 9 the Chicago Board of Trade OATS contract. As I'll 

 10 get into in a couple of minutes, the reason we're 

 11 increasing the limits, the reason we're proposing 

 12 to increase the limits is because the underlying 

 13 size of the market has grown since two and a half 

 14 years ago when they were most recently set. So 

 15 all months combined limits would be increased 

 16 based on the same formula that we used two and a 

 17 half years ago, now applied to a higher open 

 18 interest. 

 19 The single month limits would also be 

 20 increased, maintaining the ratio between the 

 21 single month limit and the all month combined 

 22 limits. And the spot month limits would not be 
 60 

 1 changed, because the spot month limit analysis is 

 2 different. 

 3 In the spot month, we're very concerned 

 4 about the potential to squeeze or corner a market, 

 5 so the level there is primarily focused on the 

 6 deliverable supply, and the size of position that 

 7 could potentially be used to squeeze the market. 

 8 So even when the overall size of the 

 9 futures market and futures trading grows, it 

 10 doesn't necessarily mean the amount of deliverable 

 11 supply has increased, so we're leaving those 

 12 unchanged. 

 13 We're also proposing to aggregate 

 14 positions that are in contracts that share 

 15 substantially identical terms that are trading on 

 16 two different exchanges. Back in 2005, we first 

 17 -- this concept that similarly -- contracts with 

 18 similar terms should be combined, but only at the 

 19 same exchange. Now we're saying that if there are 

 20 two contracts that have substantial identical 

 21 terms at different exchanges, those -- and the 

 22 existing contract has a federal limit, then the 
 61 

 1 federal limit would apply to the other contract, 

 2 as well. 

 3 And one example of this is the New York 

 4 Merchantile Exchange. Not too long ago, they 

 5 started a contract that was cash settled to the 

 6 Ice Cotton contract, and so that's obviously 

 7 substantially identical terms, and so we're 

 8 proposing that that contract -- positions in that 

 9 contract be combined. The Nimex contract would be 

 10 combined with the Ice contract for compliance with 

 11 position limits. 

 12 So the overall all combined limits are 

 13 based on a formula that is in Section 150.5C of 

 14 the commission's regulations. And the way it 

 15 works is, we apply the formula to the average 

 16 combined futures and delta-adjusted open interest 

 17 for each month for the most recent calendar year, 

 18 so in this case, 2006. At the end of each month, 

 19 we take what the open interest is, and the options 

 20 are on futures equivalent, and they're an option 

 21 that's at the money has a future equivalent of 

 22 half a futures contract, and the money is more 
 62 

 1 than half out of the money, it's less than a half. 

 2 So we take that open interest, average it for the 

 3 year, and then apply the formula. Now, the 

 4 formula is that the limits shouldn't be greater 

 5 than ten percent of the average month end open 

 6 interest up to 25,000 contracts, and then an 

 7 additional two and a half percent of any open 

 8 interest above 25,000. So there's kind of a kink 

 9 in the curve that -- it rises at a ten percent 

 10 rate until 25,000, and thereafter, it rises at a 

 11 two and a half percent rate. 

 12 So using this formula for corn, the 

 13 average month end open interest in corn for 2006 

 14 was 1.6 billion contracts. 

 15 And then the ten percent of the first 

 16 25,000 contracts would be equivalent to 2,500 

 17 contracts. Two and a half percent of the 

 18 remaining open interest of just under 1.6 million 

 19 would be equivalent to 39,808 contracts. And so 

 20 the addition of those two is the proposal for the 

 21 limit of 42,308, we've rounded up. 

 22 So here you can see what we're proposing 
 63 

 1 to adjust the limits to. Corn would be 42,400 in 

 2 all months, and the single month would be 26,000. 

 3 So that would retain the existing relationship 

 4 between the single month and the all month limit. 

 5 So it would be the same ratio as the 13,500 in a 

 6 single month to the 22,000 in the all months 

 7 combined. So the same analysis has been done for 

 8 all of these markets. And the one exception is 

 9 that we have traditionally had parody in the wheat 

 10 contracts between the Minneapolis Grain Exchange 

 11 Wheat contract, Kansas City Board, and the Chicago 

 12 Board Wheat contracts, and we're maintaining that, 

 13 and the level is based on the size of the Chicago 

 14 Board of Trade Wheat contract. 

 15 So that is a brief overview of what 

 16 we're proposing to do. And I'll be interested to 

 17 hear views of the members of the committee. Thank 

 18 you very much. 

 19 MR. DUNN: Thank you very much, John. 

 20 Don. 

 21 MR. HEITMAN: I was going to try to keep 

 22 this to ten minutes, but I was rehearsing last 
 64 

 1 night with my fiance', and after five minutes she 

 2 screamed, I can't take it, I can't take it, and 

 3 tried to throw herself off the balcony, so I 

 4 didn't get to do my entire rehearsal. 

 5 MR. DUNN: What folks don't understand 

 6 is, Don also does stand-up comedy. 

 7 MR. HEITMAN: Actually, I appreciate 

 8 that David and John made some of the points 

 9 already that are in this presentation, because 

 10 this involves spec limits, as well. On November 

 11 27th, the Commission proposed a risk management 

 12 exemption from spec limits, and this involves the 

 13 statutory basis for spec limits that John already 

 14 discussed, and the regulatory structure of spec 

 15 limits. There are three elements: The levels of 

 16 the limits; the exemptions for hedging, spreading, 

 17 arbitrage and other positions; and then the policy 

 18 on aggregating commonly owned or controlled 

 19 accounts and applying the limits. 

 20 And there are the federal spec limits 

 21 for certain agricultural commodities that are on 

 22 the slide, and then the exchange limits for the 
 65 

 1 others. And as John explained, that's kind of a 

 2 historical anomaly. 

 3 So looking at the current exemptions, to 

 4 get an exemption from the hedge limits, currently 

 5 the most obvious examples are, first, if you have 

 6 a bona fide hedging transaction. Well, if you're 

 7 a hedger, you're not a speculator, so you can be 

 8 granted an exemption from the spec limits. 

 9 Another example is multi-advisor pools with 

 10 independent account controllers, and John 

 11 explained that, as well. 

 12 The exemptive rules were last amended in 

 13 1991. And this is the situation that was in 

 14 David's slide, that big complicated slide, where 

 15 say you're a pension fund, and you want to get 

 16 commodities exposure because you want to diversify 

 17 your portfolio. So you would go to a swap dealer 

 18 and do a swap for the index, so that as the index 

 19 goes up, the swap dealer is paying you money. The 

 20 swap dealer now has short exposure; the swap 

 21 dealer goes to the futures market to offset that 

 22 exposure by taking a long position in the futures 
 66 

 1 market. 

 2 Well, as the swap dealer's long position 

 3 that tracks the commodities in the index, as that 

 4 position goes up, at some point -- say the index 

 5 is at 60 percent energy commodities, 30 percent 

 6 metal, ten percent agricultural, and the ten 

 7 percent is five percent corn and five percent 

 8 wheat, well, if the pension fund wants a big 

 9 enough index position, as the swap dealer's hedge 

 10 of this goes up -- at some point that five percent 

 11 of wheat in the swap dealer's portfolio of long 

 12 futures positions is going to hit the speculative 

 13 position limit. 

 14 And that actually happened in 1991 with 

 15 a particular swap dealer that was hedging an OTC 

 16 transaction with a pension fund, and the swap 

 17 dealer came to us, and we said, "yeah, that 

 18 qualifies for a hedge exemption," so we granted a 

 19 hedge exemption to the swap dealer. And in the 

 20 years since then, we've done the same for other 

 21 swap dealers, as well. 

 22 We also included conditions in there to 
 67 

 1 protect the market. The swap dealer's futures 

 2 positions must offset specific price risk. The 

 3 dollar value of the futures positions can't exceed 

 4 the dollar value of the underlying risk. And you 

 5 can't carry a position into the delivery month 

 6 when, as John pointed out, we're most concerned 

 7 about squeezes and market congestion. So since 

 8 1991, we've been granting these hedge exemptions. 

 9 Well, recently, we started to get 

 10 inquiries about an additional type of index 

 11 trading, and again, this was on David's slide. 

 12 That's where, rather than a pension fund, say 

 13 you've got an individual that wants to add 

 14 commodities exposure to his or her portfolio, a 

 15 commodities component to balance the financial 

 16 instruments and securities. 

 17 So the individual can go to -- well, 

 18 actually it starts the other way around, an index 

 19 trader creates a fund, and he offers it to the 

 20 individuals who want to add this commodities 

 21 component. And the fund has an agricultural 

 22 component, and so that as the fund grows, and 
 68 

 1 different individuals buy shares in the fund, then 

 2 the fund has to increase its futures position to 

 3 offset its exposure to the individuals. Well, at 

 4 some point that fund is going to bump up against 

 5 the spec limits too. The five percent of corn in 

 6 that index that underlies the fund is going to hit 

 7 the spec limit. But that's a slightly different 

 8 situation than the hedge exemptions that we've 

 9 been doing since 1991, because the index funds are 

 10 offering exposure by agreeing to track an index, 

 11 as opposed to the swaps position, which is 

 12 directly linked to the index. 

 13 And these two situations were different 

 14 enough that we didn't feel comfortable granting a 

 15 hedge exemption for these types of index-related 

 16 positions. Nevertheless, they're a perfectly 

 17 legitimate investment strategy, and we wanted to 

 18 allow it to go forward, so we wrote a couple of 

 19 no-action letters in 2006, to allow this type of 

 20 strategy to go forward. 

 21 The purpose of the proposed amendments 

 22 that are now out for comment is essentially to 
 69 

 1 create a structure so that everybody that wants to 

 2 do this type of trading will know what the rules 

 3 are, and I won't have to write 20 no-action 

 4 letters, which is really the most important point 

 5 of having a rule. 

 6 There are basically six conditions in 

 7 here to protect the marketplace from speculative 

 8 ill effects. The first is, we define a risk 

 9 management position as a position that results 

 10 from a fiduciary obligation to track an index or a 

 11 portfolio diversification plan. A fiduciary 

 12 obligation to track an index would basically 

 13 involve the individual who buys a share of this 

 14 index fund. The index fund has agreed with the 

 15 individual that they're going to track the index 

 16 -- that the investment will track the index that 

 17 they gave the guy, and the disclosure statement 

 18 says it'll be five percent wheat, five percent 

 19 corn, 30 percent crude oil, et cetera. So they've 

 20 got a fiduciary obligation to track that index, 

 21 whether it goes up or down, so that's -- that's 

 22 set out in the definition. 
 70 

 1 The other element of a risk management 

 2 position is a portfolio diversification plan, 

 3 which is to say the pension fund. That's the 

 4 pension fund that always could have gone to the 

 5 swap dealer to do the swap, and then the swap 

 6 dealer takes his exposure to the futures market 

 7 and gets a hedge exemption. Well now, under these 

 8 rules, the pension fund doesn't have to go through 

 9 the swap dealer. 

 10 It can go ahead and put on this 

 11 commodities position directly to balance the 

 12 commodities element of its portfolio. So those 

 13 are the two different types of trading that would 

 14 qualify as a risk management position. 

 15 The second element is, it has to be a 

 16 "broadly diversified" index. That's defined as 

 17 not having more than 15 percent of the index in 

 18 any one agricultural commodity, and not more than 

 19 the 50 percent of the entire index can be 

 20 agricultural commodities. And there are a couple 

 21 other little rules: Wheat is considered one 

 22 commodity, so you can't have 15 percent of the 
 71 

 1 index in Kansas City wheat, 15 percent in 

 2 Minneapolis, and 15 percent in Chicago. Wheat 

 3 counts as one commodity -- 15 percent for wheat, 

 4 regardless of where it's traded. And the same 

 5 rule applies to the soybean complex. You can't 

 6 have 15 percent in soybeans, 15 in meal, and 15 in 

 7 oil -- you've got 15 percent for the whole soybean 

 8 complex. 

 9 The third condition is that the 

 10 positions must be passively managed. They have to 

 11 track the index with limited discretion as to 

 12 trading -- as to your trading decisions -- so that 

 13 the portfolio is managed with an eye toward taking 

 14 advantage of short term market trends. 

 15 So, for example, you can rebalance the 

 16 portfolio, because as the prices of commodities 

 17 change, if you want wheat to be five percent, you 

 18 might have to sell some wheat contracts or buy 

 19 some wheat contracts to keep five percent of your 

 20 portfolio in wheat. But you cannot say, "oh well, 

 21 I think wheat is going to go up, so next month I'm 

 22 going to put ten percent of the index in wheat and 
 72 

 1 only five percent, or only three percent in corn, 

 2 and after that, maybe the month after that, it'll 

 3 be 14 percent corn and six percent wheat." You 

 4 can't do that because then you're trading to take 

 5 advantage of short term market trends, you're not 

 6 hedging. That condition is the primary element of 

 7 this rule that disqualifies so-called "hedge 

 8 funds." Hedge funds are not going to qualify for 

 9 this exemption because hedge funds are, in fact, 

 10 not passively managed, they're actively managed. 

 11 They're trying to take advantage of short term 

 12 market trends and get a better return. So hedge 

 13 funds are not going to be able to use this 

 14 exemption. 

 15 The fourth requirement for the exemption 

 16 is, positions must be unleveraged; they have to be 

 17 fully offset by cash or profits on the positions. 

 18 In other words, people holding these positions are 

 19 not going to be getting margin calls that are 

 20 going to force them out of the market because 

 21 they're fully hedged, they're unleveraged. 

 22 Fifth, the positions may not be carried 
 73 

 1 into the spot month, when squeezes and 

 2 manipulation and congestion are the most serious 

 3 concern. And finally, positions must be 

 4 established and liquidated in an orderly manner. 

 5 There's a couple of other conditions. 

 6 The regs have a listing of the information that 

 7 you have to give us in applying for an exemption, 

 8 so everybody can see, here's the information we 

 9 have to put in our letter to the CFTC. 

 10 And finally, entities that are holding 

 11 positions under a risk management exemption have 

 12 to report to us if they know or have reason to 

 13 know that anybody holds more than 25 percent of 

 14 the position. So if somebody has got 50 percent 

 15 of the index, that can, in fact, turn out to be a 

 16 pretty significant position, and we wanted to be 

 17 alerted if somebody is attempting to use the 

 18 exemption as a way of avoiding speculative 

 19 position limits. 

 20 So those are the conditions. The last 

 21 two slides are just the questions that are in the 

 22 Federal Register notice, and I'm not going to run 
 74 

 1 through all of those, but you've got them in your 

 2 written materials. And the first three are -- 

 3 well, maybe I will run through them just real 

 4 quickly. The first three are the major ones: Are 

 5 any of the conditions for getting an exemption 

 6 unnecessary or should we impose even more 

 7 conditions; is there anything else, in addition to 

 8 those, that should be imposed as a prerequisite to 

 9 get an exemption, and if so, what; and is there 

 10 any type of index trading that should be covered 

 11 that we left out. So anyway, that's what the 

 12 proposed rules look like, and we're hoping to get 

 13 a lot of comments, hopefully not the same number 

 14 and type of comments that we got on the 

 15 Commitments of Traders Report a couple years ago. 

 16 My favorite of that group was the guy 

 17 who ended his comment by saying, "if you do decide 

 18 to stop publishing the Commitments of Traders, FU, 

 19 die, and go to hell." 

 20 SPEAKER: Pardon the interruption; Mr. 

 21 Dunn has reentered the conference. 

 22 MR. HEITMAN: Thank you, Commissioner. 
 75 

 1 Apparently your mind wandered there for a moment, 

 2 Commissioner, and they picked up on it 

 3 electronically. Commissioner Dunn is now back 

 4 with us in spirit, as well as body, and that 

 5 concludes my remarks. 

 6 MR. DUNN: Thank you very much, Don. 

 7 The last member of our panel, and certainly not 

 8 the least, is David Lehman. I have been very, 

 9 very fortunate to be on a number of panels with 

 10 him the last couple of years, and also have been 

 11 at meetings where he has given presentations; he 

 12 is an excellent representative. He was with the 

 13 Chicago Board of Trade, and is now with the CME 

 14 Group. After the 2005 changes in the spec limits, 

 15 the Chicago Board of Trade actually commissioned a 

 16 paper to take a look at some of the impacts that's 

 17 going on there, and also touched on one of the 

 18 questions on the convergence that a lot of people 

 19 brought to our attention last year. And so, 

 20 David, if you will, please. 

 21 MR. LEHMAN: Well, thank you, 

 22 Commissioner Dunn, and thank you to all the 
 76 

 1 commissioners for your attendance today. Thanks 

 2 for calling this meeting of the Ag Advisory 

 3 Committee, and thanks to the members of the 

 4 committee for their attendance, as well as the 

 5 other guests. 

 6 I think there are some important issues 

 7 that are on the agenda today and that will have an 

 8 impact on the competitiveness of the markets, the 

 9 agricultural market specifically. 

 10 We've heard a lot about speculative 

 11 position limits and the increases that are 

 12 currently being proposed. What this chart shows 

 13 is the previous increases that were implemented in 

 14 two stages in 2005; and June of '05 was an initial 

 15 implementation, and then a second implementation 

 16 in December of '05. When these were implemented, 

 17 there were some pretty significant increases. As 

 18 you can see, the all months combined limit in corn 

 19 was increased from 9,000 contracts to 22,000, 

 20 soybeans from 5,500 to 10,000, and wheat from 

 21 5,000 to 6,500. That's in the kind of center 

 22 section there. And the old limit was the limit 
 77 

 1 prior to the beginning of that two-phased 

 2 increase. Phase one was the initial increase, and 

 3 then phase two, the final limits in December of 

 4 '05. 

 5 Following these increases, some market 

 6 participants began to talk to us, and I think 

 7 Mike's comment about one of the effects of the 

 8 conversion of exchanges from kind of clubs and 

 9 membership based organizations to for profit 

 10 corporations, driving them to be more responsive 

 11 to their customers, it's something that CBOT had 

 12 implemented well before our conversion to being 

 13 for profit. 

 14 We do stay in very close touch with our 

 15 customers to the extent that we can and to the 

 16 extent that we know who they are. But we did 

 17 begin to hear of some changes in the pattern of 

 18 convergence of futures and cash, contract 

 19 expiration in corn, soybeans, but particularly in 

 20 wheat futures. So we discussed this with the 

 21 University of Illinois and a few of their 

 22 professors, and I believe this full study that was 
 78 

 1 conducted by U of I is in your packet. And we 

 2 asked them to take a look at specifically did the 

 3 increases in spec positions limits have an impact 

 4 in how the market was performing in terms of three 

 5 specific areas, liquidity in the futures 

 6 contracts, volatility in those products, and then 

 7 convergence, expiration convergence between cash 

 8 and futures. 

 9 And so we asked them to look at these 

 10 characteristics of the market before the increases 

 11 in limits went into effect and following the 

 12 increase. And just to caveat, there's a limit 

 13 amount of data, or there was at that time, to look 

 14 at following the increases. 

 15 As I said, the final increase went in in 

 16 December of '05, and they began their study in 

 17 July of '06, so they just had a few months at that 

 18 point. But what U of I did is, look at volume and 

 19 how that had changed, looked at the structure of 

 20 open interest, they did an analysis of volatility, 

 21 and then looked at convergence both in position at 

 22 the delivery points and also out of position at 
 79 

 1 some other locations, primarily the New Orleans 

 2 Gulf, other points in Illinois, and they came back 

 3 with some recommendations of additional research. 

 4 The look at liquidity found that market 

 5 activity had increased significantly in 2006, and 

 6 that much of this was likely due to increased 

 7 activity by non-traditional market participants, 

 8 by index funds, as David showed. The level of 

 9 participation by that new profile of trader in the 

 10 markets was growing very rapidly at that time, and 

 11 also by other hedge funds and large speculators. 

 12 The increased position limits obviously 

 13 helped accommodate this growth by non-traditional 

 14 participants, although as -- I thought it was 

 15 really interesting to see Dave's chart on the 

 16 change in the commitments of traders categories 

 17 once the index trader report was implemented, 

 18 showing that about 85 percent of the index trader 

 19 positions in wheat came from the commercial 

 20 category. 

 21 So the change in spec limits really 

 22 didn't drive that at all. These were traders that 
 80 

 1 were -- many of whom were classified as 

 2 commercialists who had come in and saw hedge 

 3 exemptions from the commission and from the 

 4 exchange. 

 5 The growth index fund participation may 

 6 have caused the markets to be less price 

 7 sensitive, and that's also something I think was 

 8 illustrated well in one of Dave's charts, that 

 9 these are passively managed positions, they're 

 10 established by prospectives for these funds, the 

 11 public documents that state how the funds will be 

 12 invested in the markets prescribed, exactly how 

 13 they will be moved from one expiration to another, 

 14 and the fact that in early October of '06, it was 

 15 an advantageous time for rolling forward 

 16 positions, they couldn't do it. The index funds 

 17 were required to wait and roll later, in early 

 18 November. 

 19 So we think there obviously are some 

 20 temporary changes in market structure. And what 

 21 you'll see is more flexibility incorporated into 

 22 these index fund perspectives that allow them to 
 81 

 1 roll earlier, and I believe that's recognized in 

 2 the exemption that was proposed by CFTC last week. 

 3 We also noticed, or U of I did, that the 

 4 increased limits led to increased activity and 

 5 deferred months, and I think that's something that 

 6 all of our customers are happy to see and a reason 

 7 why we've established the ratios between single 

 8 month limits and all month limits, is to ensure 

 9 that some of that position be established in 

 10 deferred months and lead to greater activity in 

 11 those months, greater liquidity. 

 12 In terms of volatility, the results of 

 13 the study found that in corn, the range of daily 

 14 returns, and they're just taking the percentage 

 15 change in settlement prices each day, during the 

 16 post change period was higher than in the period 

 17 before the change in spec limits. In soybeans and 

 18 wheat, they found no significant change in the 

 19 range of those average daily returns, so really no 

 20 change; in fact, there was a slight decline in the 

 21 absolute numbers in wheat and soybeans, a little 

 22 increase in corn. They looked at volatility in 
 82 

 1 another way, just looking at the scanner deviation 

 2 of the daily nearby futures by calendar month, so 

 3 that they were able to take seasonality out of any 

 4 changes. 

 5 Obviously, the agricultural markets do 

 6 have different levels of volatility in different 

 7 times of the growing season. So they compared 

 8 like months, and it was a similar result. There 

 9 was a small increase in volatility in corn, but 

 10 slight decreases in wheat and soybeans. 

 11 So the overall conclusion of the 

 12 professors was that there was little evidence that 

 13 the increase in spec limits had a significant 

 14 impact on price volatility. Convergence was the 

 15 final area looked at, and probably one that we're 

 16 hearing the most about, and perhaps a very 

 17 important issue for some sectors of the market. 

 18 The study found that there were periods 

 19 of wheat basis in corn in 2006, but again, didn't 

 20 describe it as a failure of convergence. 

 21 Soybeans, a similar notation of wheat basis, but 

 22 not a failure of convergence. And I think one of 
 83 

 1 the things that's really been difficult for the 

 2 market to deal with has been the higher 

 3 transportation costs that are effecting the 

 4 agricultural markets. And, of course, this period 

 5 of time that we're looking at was one of 

 6 particular volatility in that component of the 

 7 markets. The hurricanes in the late summer of 

 8 2005 obviously effected transportation on the 

 9 Illinois River. 

 10 And you'll find in the study that's in 

 11 your packets a chart of those barge freight rates 

 12 for the Illinois River. It's actually converted 

 13 into cents per bushel. And you can see normal 

 14 cost to ship grain from Peoria, Illinois to the 

 15 New Orleans Gulf, we're in the 20 to sometimes 50 

 16 cents per bushel range for corn and soybeans, 

 17 historically going back -- I think they went back 

 18 to 2001 with the data. 

 19 And we saw in the fall of 2005, right 

 20 after the hurricanes, that went to $1.20 per 

 21 bushel. We've had even higher rates since then. 

 22 We've had -- barge freight is quoted in the market 
 84 

 1 as a percentage of tariff, and earlier this year 

 2 we were hearing of rates at 800 percent on the 

 3 Northern Illinois River, and we heard of rates of 

 4 1,000 or 1,200 percent in other locations. 

 5 So the demand for freight, in addition 

 6 to the kind of disruptions of the hurricanes, has 

 7 played a significant factor. And the increased 

 8 cost of freight via higher energy costs and fuel 

 9 costs is effecting transportation throughout the 

 10 system, even domestically, and also was cited in 

 11 the study as one of the primary reasons for the 

 12 weak basis that we're seeing. Wheat probably had 

 13 a little more stark result than corn and beans in 

 14 terms of convergence that they really identified a 

 15 lack of convergence from July of '05 through 

 16 September of '06. 

 17 Now, why -- what are the reasons? And 

 18 as I mentioned, higher barge freight rates, higher 

 19 futures values, and you know, some are kind of 

 20 quick to point the finger at index funds or the 

 21 speculative traders in the market, however, one of 

 22 the things that U of I really found is, especially 
 85 

 1 with regard to the wheat contract, is that the 

 2 contract is a world price benchmark, and it's used 

 3 to cross hedge wheat by producers and consumers 

 4 around the world, in Europe, in the southern 

 5 hemisphere, in Australia, in Argentina, and 

 6 therefore, with the changes in supply demand 

 7 factors that were going on in other parts of the 

 8 world, the crop failures in Australia, export 

 9 restrictions out of the Black Sea, or most 

 10 recently we've had a closing of exports out of 

 11 Argentina temporarily. 

 12 The CBOT wheat contract, because of its 

 13 liquidity, is trying to incorporate all of those 

 14 fundamental factors into its price structure, and 

 15 at the same time, the delivery component is 

 16 domestic, it's softer winter wheat, and the area 

 17 attributary to Toledo, Ohio, and we've had good 

 18 supplies of softer winter wheat while the world 

 19 market was undergoing these very significant 

 20 changes in economics. 

 21 The large carry in the futures markets, 

 22 Dave's slide on the -- particular slide on wheat 
 86 

 1 showing that during the role, the spread stayed 

 2 pretty constant, around 21 cents, I think that was 

 3 a dese march of 2006, and that's essentially full 

 4 carry. 

 5 So when the carry in the agricultural 

 6 futures contracts is really determined by a 

 7 specified storage rate that's a term of the 

 8 contract, it's fixed, and the cost of money or 

 9 what someone is willing to consider as an 

 10 opportunity cost of money in the market. 

 11 So that carry or storage rate in the 

 12 contract had been 15 100's of a cent per bushel, 

 13 that's been increased, will go into effect in July 

 14 of next year, July of '08, to 16 and a half, and 

 15 that should let those spreads widen a little 

 16 further, that certainly benefits the domestic 

 17 grain industry who are carrying grain and paying 

 18 storage to do that. What it does is that it kind 

 19 of adds an additional hurdle for the index funds 

 20 who are long, the nearby rolling to the next 

 21 deferred, they'll pay a little higher penalty to 

 22 engage in that roll. But we think that will help 
 87 

 1 with convergence issue. Limited expiration 

 2 arbitrage is the last factor that U of I noticed 

 3 in wheat. And we've also done something to 

 4 address this. And the limited expiration 

 5 arbitrage is probably do the fact that the market 

 6 was in fully carry. 

 7 The warehousemen can earn the full cost 

 8 of storage by simply rolling his short position 

 9 forward, and therefore, there's less incentive for 

 10 the delivery warehouses to make delivery. Those 

 11 who take delivery can also earn the full cost of 

 12 carrying those receipts or certificates to the 

 13 next month by also hedging in the next month, so 

 14 they have less incentive to redeliver those 

 15 certificates -- markets to provide liquidity when 

 16 commercial is needed for hedging. 

 17 Convergence analysis revealed different 

 18 convergence patterns before and after the changes, 

 19 but determine again that there were many factors 

 20 that were at work, and that's always the 

 21 difficulty in a study like this, is, you know, 

 22 economists like to say all things equal, this 
 88 

 1 change will produce this effect. Well, in 

 2 reality, everything else isn't equal, and there 

 3 are a lot of things changing at the same time. 

 4 The researchers did recommend changes in the 

 5 delivery process for wheat be investigated. And I 

 6 mentioned, we have made a couple of those, 

 7 changing the storage rate, also changing the 

 8 delivery instrument from a warehouse receipt to a 

 9 shipping certificate. That also goes into effect 

 10 in July of '08. This gives the warehousemen more 

 11 flexibility in how they manage their delivery 

 12 capacity. They don't have to have the wheat in 

 13 store in the elevator to make delivery, so this 

 14 will effectively increase the delivery capacity. 

 15 And also, the researchers recommended 

 16 that CFTC begin reporting trading activity -- 

 17 activity of non- traditional funds. They found in 

 18 their analysis of the data that they were having 

 19 difficulty in really identifying from the 

 20 commitment traders report to who is in the market, 

 21 so that's been implemented, and we commend the 

 22 CFTC on that. So again, thanks very much, 
 89 

 1 everyone, I look forward to a discussion. 

 2 MR. DUNN: Thank you very much, David. 

 3 After our break, we do have a follow-up panel of 

 4 industry members that are going to zero in on a 

 5 lot of these issues. But right now it's an 

 6 opportunity for our Advisory Committee members to 

 7 ask questions of this first panel or to make any 

 8 comments they might have. So, members of the 

 9 Advisory Committee, it's your time. 

 10 MR. GILLEN: Don Heitman -- 

 11 MR. DUNN: Neal, please identify 

 12 yourself. 

 13 MR. GILLEN: Neil Gillen, American 

 14 Cotton Shippers Association. Don, in explaining 

 15 the hedge exemptions, you put a limit on 50 

 16 percent for ag commodities; can you explain why, 

 17 the composition of a fund. 

 18 MR. HEITMAN: Yeah, Neal; I should have 

 19 made clear, the 50 percent does not apply to all 

 20 agricultural commodities; it's 50 percent of 

 21 commodities that are subject to the federal spec 

 22 limits, which are corn, wheat, the soybean complex 
 90 

 1 and cotton. 

 2 Well, I would not say that that was the 

 3 subject of a big, gigantic scientific study to 

 4 determine that number; it just seemed kind of 

 5 intuitively about right to us, and we're hoping 

 6 that we can get some comments from people that 

 7 agree with it or question it or have a different 

 8 number in mind. 

 9 But the basic purpose was to avoid 

 10 somebody using an index, structuring an index, 

 11 that would basically be a substitute for the 

 12 commodity itself. So -- and the extreme example 

 13 is -- what if somebody says, "all right, I've got 

 14 a diversified index and it's 95 percent corn and 

 15 one percent crude oil, one percent silver, et 

 16 cetera." Obviously, that would really just be a 

 17 substitute for the corn contract, and you wouldn't 

 18 allow that. Maybe 50 percent isn't the right 

 19 number, but that was what we were aiming at, just 

 20 something that would keep out an index that's just 

 21 a sham to replace an individual commodity that 

 22 you'd otherwise have spec limits in. 
 91 

 1 MR. BAIR: Jim Bair, Miller's; I want to 

 2 ask Dave Lehman a question, on the second to the 

 3 last point there on the Illinois study. Can you 

 4 give us some more insight as to what the 

 5 researchers envision in terms of -- world contract 

 6 delivery points, and also anymore detail on why or 

 7 what the recommended delivery process for CBOT? 

 8 MR. KASS: I'll actually answer the 

 9 second one first, because that one is easier. 

 10 They did recommend an increase in the storage rate 

 11 for the current contract. They recommended that 

 12 we look at additional delivery locations for the 

 13 current contract. 

 14 We did a pretty exhaustive review of 

 15 locations that we thought could augment the 

 16 current location in Toledo and St. Louis, and look 

 17 along the Ohio River, looked at some other more, 

 18 you know, domestic oriented locations, and just 

 19 didn't find anything that we felt would add enough 

 20 to help the convergence issue or to add delivery 

 21 capacity while not being, you know, kind of an 

 22 unacceptable cost in terms of what's the contract 

 92 

 1 pricing and that side of the equation. So what we 

 2 did, we went to the shipping certificate delivery 

 3 instrument, which we do feel will increase the 
 4 effective capacity of the delivery system. 

 5 With regard to the world wheat contract, 

 6 that's kind of the dilemma that I think U of I 

 7 found and it's one that we've recognized for some 

 8 time, that the Chicago Wheat contract is pricing 

 9 world-wide supply and demand factors, but yet it 

 10 has a domestic U.S. delivery component. 

 11 In fact, a domestic component, it's one 

 12 of the smaller grades of wheat, the hard red 

 13 winter wheat cash market is bigger, the hard 

 14 spring cash market is bigger, both than the softer 

 15 wheat cash market. 

 16 How to design a wheat contract is 

 17 something that we've been thinking about for a 

 18 number of years at the Board of Trade. We had a 

 19 task force in the mid '90's of probably the most, 

 20 you know, leading international grain trading 

 21 company representatives, along with some very 

 22 successful traders at the CBOT look at this, and 
 93 

 1 we couldn't come up with a consensus on how to 

 2 structure it. It probably would have to be an 

 3 index, meaning it would need to be cash settled, 

 4 and the availability of prices in some regions is 

 5 not acceptable, or the lack of availability. If 

 6 it was a physically delivered contract, you might 

 7 think it could be, like the world -- contract, 

 8 which specifies delivery in any one of -- I think 

 9 around 30 or so origins around the world, but 

 10 again, there was not a consensus that that would 

 11 be a workable construct. 

 12 One idea that we think does have some 

 13 merit is creating an alternative product that's an 

 14 index of North American wheat markets. So a cash 

 15 settled index that would use CBOT, Minneapolis, 

 16 Kansas City wheat futures prices as the settlement 

 17 mechanism for a cash settled index. 

 18 This may be something that some of the 

 19 non- traditional users would prefer, because they 

 20 wouldn't have to worry about delivery and rolling 

 21 hedges, I guess it wouldn't qualify for a higher 

 22 position limit, but that's something that we do 
 94 

 1 have under review. 

 2 MR. BAIR: Because of biofuels and other 

 3 reasons you probably know that we harvested fewer 

 4 acres of wheat last year than we did in 1898, and 

 5 I think that's a trend that's going to continue, 

 6 so I would encourage you not to give up on this 

 7 concept, because I think it's going to grow in 

 8 accordance. 

 9 MR. KASS: Thanks. 

 10 MR. STEVENSON: Randy Stevenson with -- 

 11 USA. I don't recall if it was John or Don that 

 12 was talking about when the index funds are orderly 

 13 moving their positions forward, and then you had 

 14 mentioned that a year ago in October, they 

 15 couldn't move forward, there was an opportunity, 

 16 market opportunity, and they were locked in by the 

 17 perspectives. If they alter that to give them 

 18 more flexibility, do you perceive some problems 

 19 with that, where they can be watching market 

 20 fundamentals roll and cause good or bad problems, 

 21 more challenges I guess would be a proper way for 

 22 you? 
 95 

 1 MR. KASS: Well, the way we described it 

 2 in the proposed rules is, we said the definition 

 3 contemplates the position holder could exercise 

 4 some discretion as to when to roll futures forward 

 5 into the next month without violating the 

 6 passively managed requirement, providing nothing 

 7 was carried in its spot month. 

 8 The commission believes that limited 

 9 discretion as to when a position must be rolled 

 10 forward can mitigate the market impact that might 

 11 otherwise result from large positions being rolled 

 12 forward on a pre-determined date, and consequently 

 13 help to avoid liquidity problems. So, you know, 

 14 if everybody knows that all the funds have to roll 

 15 forward on X day, then the market is going to be 

 16 waiting for them and they're going to pay a 

 17 penalty, so they can spread it out, but not to the 

 18 point where you would roll over, you know, six 

 19 weeks out. 

 20 And so there's a balance between being 

 21 passively managed and trading with a view toward 

 22 taking advantage of short term market trends, and 
 96 

 1 if you're doing it six weeks ahead of the roll, 

 2 then I think that would be the latter. 

 3 And it's not an easy -- it's not really 

 4 quantifiable, you can't have a formula, or at 

 5 least I can't figure one out as to when exactly -- 

 6 how close to the roll date, how much legal room 

 7 you should have in that, and we're hoping to get 

 8 some help from that from the comments. 

 9 But the general idea is, as you approach 

 10 the roll, you can't just have it on a single date, 

 11 because then everybody that's in the fund is going 

 12 to wind up getting penalized because everybody is 

 13 waiting for them when they go to make the trade. 

 14 So you've got to have some discretion, but not so 

 15 much that, in fact, you're getting away from the 

 16 idea of this being a passively managed long only 

 17 index line. 

 18 MR. FENTON: Just looking at the facts 

 19 of that particular situation that Dave showed, I 

 20 think it -- we probably would not view trading in 

 21 that situation as being consistent with passively 

 22 managed, it was too far forward of the roll, and 
 97 

 1 it was clearly -- it would clearly have been an 

 2 end reaction to particular pricing activity, and 

 3 so it would not have been -- trying to smooth out 

 4 the -- to the market. 

 5 MR. MITCHELL: Larry Mitchell with the 

 6 American Corn Growers. I want to make a few 

 7 observations, a couple of basic questions, and 

 8 some suggestions from our growers. Our growers 

 9 raise a lot more crops than just corn, so they're 

 10 involved in a lot of commodities. They're 

 11 operative traders, they're not speculative 

 12 traders. 

 13 We're aware of much more volatility in 

 14 the market that's causing some pressure, whether 

 15 it's ethanol or energy or a host of things, but a 

 16 lot of it is a lot more speculative traders in the 

 17 market, which frustrates farmers from time to 

 18 time, you're probably well aware of that. 

 19 Some other observations, according to a 

 20 couple of our board members, recently the basis 

 21 for Chicago, pardon me, Kansas City Wheat was 50 

 22 cents in Kansas City, and the question was 
 98 

 1 basically, you know, where are the delivery points 

 2 in Kansas City, and does it cost 50 cents to 

 3 deliver wheat into the point where it's already 

 4 delivered. These are the sorts of things that are 

 5 driving them crazy, because in an operative world, 

 6 a hedge contract on that wheat, by the time you 

 7 add the volatility of that basis, renders that 

 8 hedge worthless for them to use. 

 9 We've got producers; in fact, one of the 

 10 things we're working on right now is to make it 

 11 easier to borrow at USDA for the on farm storage 

 12 facility loans, so that farms can store more grain 

 13 on the farm. And one of the biggest driving 

 14 factors of that is this basis issue. 

 15 Now, that's going to help them market 

 16 their grain, but it's a long ways home to have to 

 17 build grain storage on your farm just to deal with 

 18 that volatility. And the other side is the big 

 19 traders on the -- within the community. I suspect 

 20 they won't appreciate that lack of transparency in 

 21 the market, when farmers start putting more and 

 22 more grain out there on the farm just to deal with 
 99 

 1 this. 

 2 The suggestions is to allow easier and 

 3 more delivery from a physical delivery from actual 

 4 producers, and to -- and you've mentioned this 

 5 before, and we would ask you to review this some 

 6 more, to find more delivery points for some of 

 7 these actual commodities so that farmers that are 

 8 not the speculative traders, but the operative 

 9 traders, can actually use this as a part of their 

 10 marketing strategy. Any comments from any of you 

 11 would be welcome. 

 12 MR. KASS: Thanks for the comments and 

 13 the recommendations. And we really do appreciate 

 14 the feedback of all of our market participants and 

 15 the members of this Ag Advisory Committee, whether 

 16 they're market participants or not. I can't 

 17 really speak for the Kansas City contract, that's 

 18 not a CME Group product, that's a Kansas City 

 19 Board of Trade wheat contract, in terms of the 

 20 cost or the economics of delivery there. 

 21 I do know -- I believe anyway that 

 22 Kansas City has made some changes to their 
 100 

 1 contract, somewhat similar to the changes we've 

 2 made in terms of increasing storage rates a little 

 3 bit, I believe that should help address the wheat 

 4 basis issue. 

 5 In terms of additional delivery points, 

 6 we actually held an industry meeting yesterday, 

 7 yesterday, day before, Tuesday in Chicago, to 

 8 discuss the performance of the corn and soybean 

 9 contract specifically, and this meeting was really 

 10 based on recommendations made by the National 

 11 Grain and Feed Association. One of their 

 12 recommendations was to consider additional 

 13 delivery points to serve the domestic market. We 

 14 think that deserves additional study. We know 

 15 that the current delivery mechanism is primarily 

 16 export oriented on the Northern Illinois River. 

 17 Chicago is a delivery point, and Chicago does 

 18 serve the domestic market, as well as the export 

 19 market. In terms of whether additional delivery 

 20 points would -- it always seems to -- and I can 

 21 understand, I grew up in Iowa, and I watched, you 

 22 know, our prices, local cash prices relative to 
 101 

 1 the Chicago futures price and saw that there was a 

 2 pretty big difference in it, it seemed like, well, 

 3 I can move my grain to that delivery point for 

 4 less than that price difference, but when you 

 5 really look at -- we've had some farm groups in 

 6 Illinois look at doing this, and we do have a 

 7 producer organization that's a delivery facility 

 8 on the Illinois River, when they look at the 

 9 volume of grain that is required in the contract 

 10 to be moved and the time period that it has to be 

 11 moved, it really isn't as economic as it might 

 12 look on the surface. 

 13 In terms of adding points, east, west 

 14 rail points, something like that, what we would 

 15 have to weigh is, are there greater benefits to 

 16 that than the cost of more complexity of what the 

 17 contract is pricing, is it pricing the Illinois 

 18 River, or is it pricing Nebraska, Lincoln, 

 19 Nebraska. 

 20 And also, the theory of delivery is that 

 21 delivery will occur at the cheapest deliver 

 22 location, so -- where a taker of delivery might 
 102 

 1 want to get delivery, usually he won't, he'll get 

 2 it at a location -- at the location that he 

 3 doesn't want it, because that's the least deer 

 4 commodity for the seller to give up. So when you 

 5 have a multiple delivery point system, it usually 

 6 is -- it's more complex, and you have the cheapest 

 7 delivery issue that also makes it less effective 

 8 as a hedge for some users. But your suggestion is 

 9 well taken, and it is one that the Grain and Feed 

 10 Committee may to look at additional points and -- 

 11 MR. MITCHELL: You've raised one more I 

 12 would like you to consider, and that is for 

 13 operative traders, for these actual producers of 

 14 the physical commodity, if there were a way to 

 15 deliver smaller contract quantities, so that they 

 16 could actually deliver against their own. Just 

 17 something to throw in the hat. 

 18 MR. KASS: We do have -- 

 19 MR. MITCHELL: Right. 

 20 MR. KASS: -- meaning wheat contracts 

 21 that are 1,000 bushels, and those are physical 

 22 delivery contracts, as well. So you can deliver 
 103 

 1 against a 1,000 bushel contract in all of those 

 2 markets. 

 3 MR. DUNN: I gave this information 

 4 earlier. You do have to push the button when you 

 5 speak. That's the only time you can touch the 

 6 microphones. Neal, I believe you have the floor. 

 7 MR. GILLEN: I just want to make an 

 8 observation, with Larry Mitchell's comments noted. 

 9 Commissioner Dunn, you'll recall back in the early 

 10 '90's, we were discussing the xenophobia of the -- 

 11 not only of the producer organizations, but the 

 12 trade with a Chicago proposal to increase 

 13 speculative limits. 

 14 I know for American Cotton Sugars 

 15 Association commission to study by Roger Gray at 

 16 the Blue Ridge Research Institute to determine the 

 17 effect on volatility of the increases in spec 

 18 limits. 

 19 And as a result of all our concerns, you 

 20 will recall that battle we had in Commissioner 

 21 Blair's office with the late great Blake O'Nell 

 22 (?) and -- who was defending an increase in spec 
 104 

 1 limits, and I had Joe Nikosea (?) with me, who was 

 2 probably the best mind I think in the industry, 

 3 and he and Blake going back and forth. 

 4 But the end result was, the increases 

 5 were phased in as a compromise, it had no effect 

 6 on volatility, and here we are, I think it's an 

 7 example of how far we've matured in this industry 

 8 and how far we've come, that we have very little 

 9 concerns now about increases in speculative 

 10 limits, and -- because it's a whole new ballgame, 

 11 and that it used to be supply and demand dictated 

 12 the fundamentals of markets, but now the funds, as 

 13 Tom mentioned outside in our conversation, now the 

 14 funds are part of the fundamentals. And so we 

 15 have extremely liquid markets, and they're now 

 16 world markets, and I think, you know, taking 

 17 slight exception to Mr. Gordon's remarks before, 

 18 yes, they have been exclusive clubs, and they have 

 19 been monopolies, but they have served a purpose 

 20 for farmers and for the trades and for processes 

 21 in that they have provided, and I know he may 

 22 disagree with this, but they have provided a price 
 105 

 1 discovery mechanism. So I know I've come a long 

 2 way in my beliefs, and I think you have, too, 

 3 Mike. 

 4 MR. DUNN: Neal reminds me it was much 

 5 easier when we served together on the Advisory 

 6 Committee, everything seemed to be black and white 

 7 then, it's gotten much grayer from this side. Are 

 8 there other questions that we have; Doug? 

 9 MR. SOMBKE: Going back to what Larry 

 10 and Neal were both talking about, David, I visited 

 11 with a lot of elevator managers in the South 

 12 Dakota/North Dakota Plains area who are concerned 

 13 with the -- if the hedges are actually working for 

 14 them, but they feel that they can't make a price 

 15 if they don't know what they can already sell it 

 16 for, everything is so close. Can you expand on 

 17 that, why they would be so concerned? 

 18 MR. KASS: Well, I think one of the 

 19 concerns is, from the short hedgers perspective, 

 20 and that would be the grain elevator that you're 

 21 referring to, is that this basis pattern has 

 22 changed. They look at historical data, that's how 
 106 

 1 most traders trade, they look at what's happened 

 2 in the past and try to predict what will happen in 

 3 the future. 

 4 And historically, basis would appreciate 

 5 from a weak point at harvest, and you're well 

 6 aware of this, I'm sure, to a stronger level as we 

 7 go through the marketing year. So that -- there's 

 8 been a change in that basis pattern that has 

 9 impacted the effectiveness of the contracts for 

 10 the short hedger. 

 11 I wish I had the slides that I used in 

 12 our industry meeting yesterday, or Tuesday in 

 13 Chicago, because it dispelled this a little bit. 

 14 We have seen, with the exception of a few 

 15 expirations in 2007 anyway, good convergence, good 

 16 basis appreciation from going out six months prior 

 17 to expiration to an expiration. Another thing 

 18 that I'm a little puzzled about, too, with the 

 19 short hedgers perspective is, obviously grain 

 20 prices have risen significantly, they're almost 

 21 twice the level of historical averages. And 

 22 again, you know, comparing to history maybe 
 107 

 1 doesn't serve us too well in this new environment. 

 2 But with price of levels where they are, we're 

 3 still seeing near full carry markets. 

 4 And Dave's slide on the roll between the 

 5 dese march wheat contracts showing that that 

 6 spread went out to 21 cents, that's about full 

 7 carry. So that's really what the short hedger is 

 8 earning from the market as he rolls his futures 

 9 positions forward, they're earning the carry. 

 10 So that's been beneficial to the short 

 11 hedger, while the basis appreciation, when they 

 12 actually sell the cash grain, or the lack of basis 

 13 appreciation, has worked against them. So I think 

 14 that's -- those are two factors that are, you 

 15 know, that are being observed in the market today 

 16 that are a little different. 

 17 I mean we've always had carries at some 

 18 percentage of full carry, but probably not quite 

 19 as wide as we've seen recently. And it's a little 

 20 contradictory based on the falling stocks of grain 

 21 world-wide, and some of the supply shortages or 

 22 disruptions we've had in the wheat market 
 108 

 1 especially. You would think that that would lead 

 2 to narrower carrying charges and even inverted 

 3 markets at times. And I think, you know, 

 4 seasonally, when you look at different points in 

 5 the marketing, you do see some of these other 

 6 patterns in the carrying charge, but in general, 

 7 they've been pretty good. 

 8 MR. DUNN: What I intend to do is start 

 9 the next panel at 11:30, so that'll push things 

 10 back about 15 minutes or so. So those that are on 

 11 the next panel that need to get a bio break, it's 

 12 your opportunity to get out there quickly. 

 13 But let me ask just one fundamental 

 14 question, and this is to Mike and Dave Lehman. 

 15 What's the ramification of not increasing the spec 

 16 limit? In the global market arena that we're in 

 17 today, are we in jeopardy of losing those markets 

 18 to other exchanges? 

 19 MR. KASS: Well, I'm going to go back to 

 20 one of Mike's comments also that he made about the 

 21 merger between CBOT and CME, in that this -- there 

 22 was really very little overlap in the products. 
 109 

 1 There was one exception to that, by the way, you 

 2 said zero, CME has an ethanol contract, it really 

 3 doesn't trade. 

 4 But another point that Mike mentioned is 

 5 that, you know, in the Justice Department review, 

 6 it wasn't -- it was found that there are other 

 7 competitive forces in the market other than CME 

 8 competing with CBOT. And one of those that's very 

 9 significant is the over-the-counter market. Our 

 10 estimates are that one of every six trades occurs 

 11 on a designated contract market. So the 

 12 over-the-counter markets are six times larger than 

 13 the exchange traded markets. And that, I think, 

 14 Commissioner, is one of the effects of not 

 15 increasing spec position limits, is that you would 

 16 force more of this business to go into the 

 17 over-the-counter market, where it's less 

 18 transparent, and actually, that will lead nicely 

 19 into our afternoon session, from my perspective. 

 20 MR. GORHAM: Actually, let me -- is that 

 21 for everything or is that agricultural products, 

 22 the one in six? 
 110 

 1 MR. KASS: That's for everything. 

 2 MR. GORHAM: What about AG only, do you 

 3 know? 

 4 MR. KASS: You know, AG OTC markets are 

 5 hard to quantify, really what the level of those 

 6 is. International Settlements has some data on 

 7 that, but it's commodities generally in a broad 

 8 class, and I think it even includes crude oil. 

 9 We do know there is increasing activity 

 10 in those OTC markets in agricultural, especially 

 11 in the grains. As you will see from the slides 

 12 this afternoon, though, that's expanding into 

 13 dairy and beef in a number of markets, so I just 

 14 don't know the sizes. 

 15 MR. GORHAM: Well, the only thing I 

 16 guess I would say is that I -- I mean I think in 

 17 general that limits ought to be increased whenever 

 18 the markets grow, as long as you're not in any way 

 19 increasing the risk of manipulation. And in terms 

 20 of actually losing business, I mean the 

 21 agricultural markets aren't that viable, I don't 

 22 think, offshore, I mean if we just look at 
 111 

 1 exchange traded stuff. So I don't -- I mean 

 2 nobody else -- has anybody else had the size of a 

 3 -- 

 4 MR. KASS: Yeah, Tokyo Grain Exchange 

 5 has a significant corn contract. Really, wheat, 

 6 there's a contract in Paris, you know, there are 

 7 contracts around the world, but none of them are 

 8 very significant. A new trend into the market, 

 9 though, is China, is -- exchange has a large 

 10 soybean futures market and a large corn futures 

 11 market. 

 12 MR. GORHAM: And Jimjo has wheat. 

 13 MR. KASS: Jimjo has wheat; those 

 14 markets aren't easy to access by those who aren't 

 15 domiciled in China, but that likely will change. 

 16 MR. GORHAM: Right; so my gut feeling is 

 17 that, I don't think we're going to lose -- we 

 18 would lose anything like immediately to China, 

 19 because you really can't even -- I mean outsiders 

 20 can't take positions in Chinese futures markets 

 21 right now, at least not legally. 

 22 MR. KASS: Right; you have to have a 
 112 

 1 joint venture in China -- 

 2 MR. GORHAM: Right. 

 3 MR. KASS: -- to trade on those markets. 

 4 MR. GORHAM: And the wheat market in 

 5 India was just banned by the government because 

 6 they -- it was a wonderful political movement 

 7 since wheat prices and commodity prices generally 

 8 were rising, and it was very convenient to be able 

 9 to blame these commodity exchanges as the cause of 

 10 that, and so that ban is still on, unfortunately. 

 11 MR. DUNN: Do the commissioners have any 

 12 questions? 

 13 MR. CHILTON: Yeah, a quick one. Mr. 

 14 Gorham, one, I think, and I'm sorry I wasn't able 

 15 to work with you when you were here, we certainly 

 16 would have gained a lot from your knowledge. My 

 17 question is, you talked about these three big 

 18 changes, the technology, the demutualization, and 

 19 then the larger exchanges. Do you think that 

 20 there's any relationship between the Commodity 

 21 Futures Modernization Act and those three changes 

 22 taking place? 
 113 

 1 MR. GORHAM: Only -- not the Florida 

 2 screen, not the demutualization, but the -- I mean 

 3 the fact that regulators generally are more open 

 4 to foreign participation, and I think, you know, 

 5 to foreign -- to cross border stuff. I mean I -- 

 6 one of the things that I loved during my stay here 

 7 was the fact that when Eurex came in and was 

 8 driving the Board of Trade and the Merc nuts, the 

 9 commission was just totally country blind, as they 

 10 should have been under the act. 

 11 And they, in fact, Eurex had submitted a 

 12 really good application; the Chicago guys, 

 13 actually, every single letter in the application 

 14 was questioned. But I was really proud of the 

 15 commission, in the way that they sort of did that. 

 16 And I think that this general trend towards sort 

 17 of an opening up, which includes the U.S., is 

 18 making it more possible for these mergers -- for 

 19 cross border mergers to take place. 

 20 MR. CHILTON: You see those sorts of big 

 21 changes; would you extrapolate that to the rest of 

 22 the world also, or is it specific to the U.S.? 
 114 

 1 MR. GORHAM: No, I think it's -- I mean 

 2 I'm really not an expert on regulation and all the 

 3 other countries. But my sense is that, with FSA 

 4 and with some of the other countries, as well, 

 5 there has been a liberalization and an openness to 

 6 -- 

 7 MR. CHILTON: But do you see those same 

 8 three changes; do you see the technology -- 

 9 MR. GORHAM: Oh, those three changes are 

 10 happening everywhere, absolutely, those three 

 11 changes, and there are some other changes, as 

 12 well, but those three, you know, in fact, the 

 13 Florida screen is almost done, I mean it's -- I 

 14 don't know how much longer -- the only things 

 15 that's holding that back is options, because 

 16 people still seem to feel that they can negotiate 

 17 options trades in a more useful fashion on floors 

 18 rather than on screens, that well may change. 

 19 And the -- and for many years, people 

 20 said the AG's will never move to screens, and the 

 21 Board of Trade is what percent now? 

 22 MR. KASS: In the 70's for futures. 
 115 

 1 MR. GORHAM: Right. 

 2 MR. KASS: Actually, some futures are 

 3 approaching percent. 

 4 MR. GORHAM: And for some reason, the 

 5 Merc is behind that, I think, isn't it? 

 6 MR. KASS: Yeah; the livestock contracts 

 7 are -- 

 8 MR. GORHAM: Right. 

 9 MR. KASS: -- haven't moved as quickly. 

 10 MR. GORHAM: And I always puzzle over 

 11 why that was the case. I understand the options 

 12 lagging, and I think the issue there is really the 

 13 AG markets have older guys in them, I mean on the 

 14 floors and, yeah, so -- as well as the 

 15 participants, so they -- 

 16 MR. KASS: Right, Dan? 

 17 MR. DUNN: Getting kind of close here. 

 18 Actually, Dave Kass has some excellent slides on 

 19 this, I don't know if he's updated them recently 

 20 on the move of electronic trading that's taken 

 21 place, and we'll try to get him to get those up on 

 22 our website when he gets a chance to update them 
 116 

 1 so you can take a look at that. With that, let's 

 2 give a big round of applause for this first panel. 

 3 And we'll meet back here in about five or ten 

 4 minutes with the industry group. 

 5 (Recess) 

 6 MR. DUNN: Members of the panel please 

 7 join us up here so we can get started. Our 

 8 industry panel today is Tom Erikson. Okay, Tom's 

 9 got his card there. We have Tom Coyle from the 

 10 National Grain and Feed Association, and Dan 

 11 Brophy from the Commodity Markets Council, and if 

 12 we could get them to come up and be ready for 

 13 their presentation. Who are we missing? We're 

 14 missing Dan, okay. Our Acting Chairman has been 

 15 called to do some testimony next week, and so he's 

 16 doing a little work on that right now, so he will 

 17 be joining us later. So with that then, I'd like 

 18 to begin by recognizing a farmer member of the 

 19 nation, the honorable Tom Erikson. 

 20 Tom is somebody that I go back quite a 

 21 ways with, back when we both worked on the Hill. 

 22 And, Tom, thank you very much for being here 
 117 

 1 today, and we'd like to hear your comments. 

 2 MR. ERIKSON: Thank you, Commissioner 

 3 Dunn, and thank you for putting today's session 

 4 together, it's certainly timely. I'd also like to 

 5 thank the rest of the commissioner, Acting 

 6 Chairman Lukken, and Bart Chilton, and Ms. Sommers 

 7 for also attending today's meetings, I think it's 

 8 a great show of support for this part of the 

 9 community and the trading sector of agriculture. 

 10 I wanted to just take a few minutes and 

 11 talk about three items that Commissioner Dunn had 

 12 asked that we try and tee up and talk a little bit 

 13 about this morning. The first is index fund 

 14 participation in AG commodity markets, and also do 

 15 a preliminary look probably at the current 

 16 proposal that's on the table with respect to 

 17 exempting index funds. The second is spec 

 18 position limits and international competitiveness, 

 19 and whether ethanol should be treated as AG or an 

 20 energy commodity. I'll tee that up now. I know 

 21 that'll be discussed a little later. 

 22 Since the commission has published rules 
 118 

 1 on two of these matters, where appropriate, I'll 

 2 try and incorporate what I would characterize as 

 3 preliminary and very early thoughts and 

 4 observations with respect to those. 

 5 Turning to index funds and their impact 

 6 on the AG markets, the phenomenal growth that 

 7 we've seen in the open interest in AG commodities 

 8 in recent years really does reflect a lot of 

 9 investor interest in commodity markets. 

 10 The advent and maturation of commodity 

 11 index funds has given retail exposure. It's 

 12 easier to get retail exposure really to those 

 13 price movements, and also it's become simpler and 

 14 really -- because arguably less volatile because 

 15 the funds are comprised to a basket of physical 

 16 commodities that go beyond agriculture, and I 

 17 guess I'm talking about these broad based indexes 

 18 as opposed to some of the narrowly based indexes 

 19 that we're seeing emerge today. 

 20 Index fund investment has created price 

 21 risk exposure to AG commodities for a class of 

 22 market participants that is not so much driven by 
 119 

 1 cash market fundamentals as they are by the rules 

 2 of the index itself. As index funds have grown, 

 3 they've become a much larger force in our futures 

 4 markets. For example, as Dave mentioned earlier, 

 5 for time last year, open interest in the Chicago 

 6 Board of Trades futures contract soared from its 

 7 historical average of two times wheat production 

 8 to ten times the U.S. production of wheat. 

 9 The consequences of this growth, both 

 10 positive and negative, are really just now being 

 11 made more visible, I think, in the market and 

 12 within the regulatory community. Most noteworthy 

 13 concern from a negative consequences perspective 

 14 is the deal among many traditional market 

 15 participants, that the index fund positions do not 

 16 really add liquidity to the market, because they 

 17 generally are not price responsive. And this is 

 18 something that was mentioned a little bit in our 

 19 earlier discussion. 

 20 And there is some view that these index 

 21 fund positions really create a losery liquidity, 

 22 and that traditional market participants on the 
 120 

 1 commercial market side and even some of the 

 2 smaller speculators really trade around that block 

 3 of just -- in the market throughout the 

 4 contract -- the trade agreement contract without 

 5 being responsive to underlying cash market 

 6 conditions. Last year, the CFTC responded to 

 7 these changing market developments by creating a 

 8 category of index funds as a supplement to the 

 9 commitment of traders report. This additional 

 10 transparency into the agricultural markets has 

 11 proved to be useful. 

 12 Last week's proposal by the commission 

 13 to exempt index funds and others from spec limits 

 14 appears to be a further response to what the 

 15 commission I think is observing in this market. 

 16 I'd make just a few observations I guess and 

 17 preliminary thoughts. Thank you. 

 18 First, the proposed exemption appears at 

 19 first blush to be an appropriate next step as it 

 20 is applied to index funds. It would encourage 

 21 index funds to offset financial risk exposures in 

 22 a regulated market environment and provide some 
 121 

 1 information about the size of that investment 

 2 community. 

 3 The proposed exemption seems to provide 

 4 a way for the CFTC to better identify index fund 

 5 participants in the market. However, it doesn't 

 6 appear that it was -- it will necessarily simplify 

 7 the commission's job in really identifying and 

 8 reporting for purposes of the commitment of 

 9 traders report that segment of the market, as you 

 10 would still only be capturing those index funds 

 11 that self-report and make themselves available for 

 12 the exemption, so the smaller class of index fund 

 13 participants would still not be maybe readily 

 14 apparent and require the commission staff to 

 15 continue to do its due diligence to ferret those 

 16 out. And to that end, the question comes, has the 

 17 commission given any thought perhaps to expanding 

 18 on this to provide just a class of registration 

 19 and its forms, where those kinds of funds could be 

 20 self- identified and it wouldn't be as much a 

 21 ferreting work for the commission staff or really 

 22 dividing the purpose of participation? 
 122 

 1 The proposal is also limited to broad 

 2 based commodity funds that have no more than 50 

 3 percent of their assets devoted to agricultural 

 4 contracts. The conversation earlier I thought was 

 5 interesting on that point. 

 6 I think our initial thought is that we 

 7 would find that the commission's rationale has 

 8 some -- is sound and has some merit in that it 

 9 would limit the opportunities of narrowly based 

 10 fund that would be based as the commission's rule 

 11 points out on maybe just the soy complex or a 

 12 bread -- maybe a bread index or whatever it might 

 13 be, a food index, as being a surrogate to get a 

 14 way around the spec limits. 

 15 Another point would be the proposal 

 16 would for the first time obligate those trading 

 17 pursuant to the exemption to the same obligation 

 18 that commercial market participants currently 

 19 have, and that is to establish and liquidate 

 20 positions in an orderly manner. That, I think, is 

 21 probably, while it's deep in the weeds of the 

 22 proposal, I think it's probably one of the more 
 123 

 1 significant things that the commission can do, and 

 2 that I think will have some real value from a 

 3 regulatory perspective. 

 4 Finally, well, maybe not finally, but 

 5 close, the proposal would also go beyond extending 

 6 the exemption to index funds and apply -- allow 

 7 the exemption to go to pension plans and other 

 8 institutional funds directly. 

 9 This is one where I think, at least for 

 10 us, we would have some real serious reservations 

 11 about. While it's true that the dollars, as Don 

 12 talked about earlier, the dollars at the pension 

 13 plan, if put into an index fund or if entered -- 

 14 if the exposure to corn, for example, was an over- 

 15 the-counter exposure with a swap dealer, while 

 16 those dollars would get that treatment of this 

 17 exemption, we don't think that the logic really 

 18 ought to extend to those dollars being directly 

 19 invested, and the reason really is because those 

 20 fund dollars, those really are speculative 

 21 position interests, and to allow that size of a 

 22 position to go into the market as a commercial, 
 124 

 1 without any risk exposure to corn, whether it's 

 2 cash or a derivative exposure to price, would 

 3 really eliminate or do serious damage to kind of 

 4 the traditional distinctions between hedgers and 

 5 speculators. We wonder really if there might be 

 6 some analysis that might be available that would 

 7 support who would be left really in that 

 8 speculative community. It may just be those few 

 9 individuals that choose to speculate. And I'm not 

 10 sure what that would even do with the commitment 

 11 of trader report and as far as where the 

 12 concentration of participants would be. 

 13 Finally, I'll just raise a couple of 

 14 points that the group might want to discuss more 

 15 broadly later. I think we can all presume that 

 16 further easing of fund participation through this 

 17 exemption, you know, would attract increased 

 18 investments in our agricultural commodity markets, 

 19 which is not a bad thing. 

 20 You know, even today, it's not unusual 

 21 to see index funds as a category comprising, you 

 22 know, upwards of close to 60 percent of the open 
 125 

 1 interest in any contract month. Presuming we 

 2 continue to see growth in passive investments and 

 3 agricultural contracts, a couple of questions 

 4 might be worth considering; one is, can we expect 

 5 to see the further erosion of the relationship 

 6 between futures values and cash market values; and 

 7 two, what impacts are likely from even more 

 8 significant rolls during fund liquidations in 

 9 advance of the spot month. I'll turn now just 

 10 briefly to a few comments with respect to the 

 11 speculative positions limits. We're continuing to 

 12 consider carefully the proposal that's out there 

 13 and so these are very preliminary comments and 

 14 just I think observations. 

 15 I think it's fair to say that as an 

 16 industry, as a company, we're all supportive of 

 17 maintaining -- you know, allowing a greater 

 18 participation within the speculative community. 

 19 So I don't think that, you know, there's 

 20 any -- reaction on our part that would, you know, 

 21 strongly oppose at this point consideration of 

 22 higher limits in agricultural markets. I suspect, 
 126 

 1 however, some of the questions that may be raised 

 2 will be mostly directly at wheat. 

 3 And again, I think Dave, you know, 

 4 hinted at some of the issues that we face in the 

 5 wheat complex. A proposed single month limit of 

 6 11,100 contracts is the equivalent of holding 55.5 

 7 million bushels of wheat. That single speculative 

 8 position would be equal to holding nearly 16 

 9 percent of the U.S. soft red wheat production of 

 10 about 360 million bushels, and 12 percent of the 

 11 U.S. hard red spring wheat production of 450 

 12 million bushels, and nearly six percent of the 

 13 U.S. hard red winter wheat production of one 

 14 billion bushels. Those are significant numbers, 

 15 no matter how you look at it. But I know that we 

 16 all are working closely to try and find ways to 

 17 accommodate the speculative needs of speculative 

 18 community, and so I think we will be able to work 

 19 through these. But I think the numbers on wheat 

 20 in particular are fairly striking. 

 21 Ethanol, agricultural, energy, you know, 

 22 what appears I think for a lot of folks to be a 
 127 

 1 decision of small consequences really I think 

 2 fundamental to the commission and what you're 

 3 charged with doing. 

 4 I suspect personally the most logical 

 5 way of considering the question is to look at the 

 6 underlying purpose of the product traded. And 

 7 under that analysis, it would appear that the most 

 8 logical place for ethanol to trade would be as an 

 9 energy commodity. 

 10 You're not alone in looking at this. 

 11 And, in fact, the World Trade Organization, WTO, 

 12 has come out on both sides of the issue so far. 

 13 You may be aware that, for purposes of trade 

 14 rules, ethanol is traded as an agricultural 

 15 product, but biodiesel is traded as an industrial 

 16 product. And so I'm not sure if that gives you 

 17 any comfort at all, but you're not alone. And 

 18 that would conclude my remarks. Thank you. 

 19 MR. DUNN: Thank you, Tom. We'll try to 

 20 find a third side of that issue. Our next 

 21 panelist is Tom Coyle with the National Grain and 

 22 Feed Association. Tom, since my tenure on the 
 128 

 1 commission has just been an excellent source of 

 2 information, and has been a regular contributor to 

 3 our Agricultural Advisory Committee. 

 4 And back in the fall of 2005, Tom, along 

 5 with our staff in Chicago, put together a trip for 

 6 Chairman Lukken and me to go down the Illinois 

 7 River and look at some of the situations that they 

 8 had in storage and delivery points. That was 

 9 very, very memorable, Tom, and I want to thank you 

 10 for that. 

 11 MR. COYLE: Well, thank you for the 

 12 wonderful introduction, and thanks for putting 

 13 together a great agenda. 

 14 The National Grain and Feed really very 

 15 much appreciates the opportunity to participate in 

 16 today's Advisory Committee. 

 17 I'll make a few comments this morning to 

 18 provide the -- insight into the specific topics on 

 19 the agenda. But first I want to thank the 

 20 commission for the efforts regarding the -- 

 21 treasury report. At the time of the last Advisory 

 22 Committee meeting, we discussed the issue of basis 
 129 

 1 changes, the wheat basis, and wheat particularly, 

 2 and the impact that this new investment funds were 

 3 having on convergence. We expressed our view at 

 4 the time that the primary cause was this growth 

 5 and these new market participants that had 

 6 different goals and different -- to make a 

 7 decision. So the change to the -- treasury report 

 8 is something that we very much welcome, so it's 

 9 something we wanted for a while, so thank you. 

 10 The new category adds clarity and 

 11 transparency to fund activity in agricultural -- 

 12 market and allows the traditional hedgers, most of 

 13 our members, the opportunity to assess who is 

 14 participating in the market. 

 15 There is still some concern I would say 

 16 about the definition of index, the category, and 

 17 which transactions go into it, OTC transactions by 

 18 funds that are managed through sways, do they show 

 19 up as commercial or do they show up -- in which 

 20 case they wouldn't show up in the -- as an index 

 21 fund. 

 22 So that would seem to run contrary to 
 130 

 1 the spirit of the index category. 

 2 The historical data that's presented by 

 3 the CME Group and by Dave Kass, who's got all the 

 4 data, would suggest that there's been a small 

 5 growth in index participation total contracts and 

 6 share of open interest. That would seem counter 

 7 intuitive, because there seems to be more money 

 8 entering that sector. So it may very well be that 

 9 it's actually entering the market through swaps, 

 10 so it shows up as commercial. So we think that 

 11 the report is really critical, our trade is using 

 12 it, and therefore, I want to make sure that the 

 13 definition is accurate. 

 14 Regarding the proposed spec limit 

 15 increases, the National Grain and Feed has -- 

 16 we've not had a chance to meet as a risk 

 17 management committee to discuss the meeting, we'll 

 18 be meeting on January 10th. And, in fact, we have 

 19 asked for an extension in the comment period so we 

 20 can have a face-to- face meeting to discuss this 

 21 issue. 

 22 What I can tell you is that the 
 131 

 1 Association has traditionally supported the Board 

 2 of Trade, has supported the increase in spec 

 3 limits. Generally we've taken the view that the 

 4 exchanges, with appropriate CFTC oversight, are 

 5 best positioned to manage their businesses, to 

 6 enhance market efficiency, and to promote market 

 7 transparency. 

 8 However, in the situation in the market 

 9 place today, things have changed a bit. The lack 

 10 of convergence and certain contracts over the past 

 11 two to three years has led to some concerns by 

 12 NGFA members about the continued utility of 

 13 exchange traded contracts for traditional hedgers. 

 14 And there's a view at least by a 

 15 percentage of our members that increased spec 

 16 limits have contributed to the growth and open 

 17 interest by non-traditional participants, more 

 18 volatility, wider than expected basis levels, and 

 19 lack of convergence. 

 20 Some of our members will likely view 

 21 that further speculative increases will exacerbate 

 22 those problems. So we'll have our meeting in 
 132 

 1 January and we'll provide that feedback. But 

 2 again, generally we've supported it. 

 3 If I recall, at the time of analysis of 

 4 the most recent increase in spec limits, we 

 5 provided feedback that said we support the 

 6 increase in the spec limits, but we really 

 7 requested two changes, one, that there was more 

 8 transparency, to change the -- treasury report 

 9 achieve that, and second of all, that there was 

 10 diligence to assure that the convergence or the 

 11 expiration process was honored, in fact, that if 

 12 we had people with -- carrying over 600 contracts 

 13 into the delivery month, that that really would 

 14 change the foundation of our cash contracts, we 

 15 would see that as a major problem. 

 16 The Board of Trade has been diligent on 

 17 that matter, so it does not appear to have been a 

 18 problem. But it is still -- I expect that will 

 19 still be -- a response we'll come back with later. 

 20 As far as the hedge exemption proposal, the logic 

 21 behind the proposal to issue risk management 

 22 exemptions to index and pension funds seems sound. 
 133 

 1 We believe the commission is asking the 

 2 right questions. This issue has not, again, been 

 3 discussed by our committee, we'll do that in time 

 4 for comment, by January 28th. 

 5 We see the logic behind the concept, the 

 6 conceptual notion that allowing index or dealers 

 7 or pension funds that are managing a basket of 

 8 risk to assess the AG markets directly, rather 

 9 than going OTC. We view that that would bring 

 10 increased transparency to the market place. 

 11 It could lead to more accurate reporting 

 12 of index and pension fund activity, would allow 

 13 spec funds more flexibility to take the other side 

 14 of these funds long only positions, and bring more 

 15 balance to the market. 

 16 However, much like the expansion of 

 17 speculative limits, we expect that there will be 

 18 some reluctance by our members for the same 

 19 reasons that I gave regarding the limit. 

 20 This will bring more participation by 

 21 non-traditional hedgers into the market. 

 22 On a side note of caution, one of the 
 134 

 1 conditions that a fund would be required to meet 

 2 to receive a risk management exemption would be 

 3 that the fund is passably managed, and that's 

 4 good. However, I would draw the distinction 

 5 between passively managed and not traded. Direct 

 6 fund participation would be positive in one light, 

 7 it would be observable and predictable. For 

 8 example, all participants would know when funds 

 9 roll their positions forward. 

 10 However, what happens if trading on a 

 11 particular contract becomes liquid? Say 40 

 12 percent of the contract's volume is not for sale 

 13 for a two year period. We talk about the open 

 14 interest of wheat. Tom made the comment, Dave 

 15 Kass showed the information earlier. But it shows 

 16 that roughly 19 percent of the open interest in 

 17 wheat is in an index fund. 

 18 If you look at the long only side using 

 19 those same numbers, it's actually 47 percent of 

 20 the open interest. If we go back to the situation 

 21 that occurred last October, on the one hand, we 

 22 don't want -- we wouldn't want to see the 
 135 

 1 speculation in these huge volumes, but we had a 

 2 significant portion of the market that couldn't be 

 3 economic during last October. 

 4 So while they were passive, the market 

 5 went to significant inverses for no economic 

 6 reason other than there was a demand for futures 

 7 contracts. So we would prefer funds participate 

 8 -- participation not be speculative, but that it 

 9 would be economic -- I think that's a real 

 10 challenge. But it seems to me that if Goldman 

 11 Sachs, that had all these contracts that couldn't 

 12 be rolled until November, if they were able to 

 13 roll those in October, we would have had a really 

 14 better balance of the market. We're not expecting 

 15 a pension fund or an index fund to be uneconomic 

 16 just because their perspective says that they can 

 17 roll. 

 18 So the comments earlier that were made 

 19 that there will be some discretion and that 

 20 they've got some latitude, that's hard when it's 

 21 gray. But it seems that -- we want that -- once 

 22 we know they're in the market, we'd like to know 
 136 

 1 that they're acting in an economic manner. 

 2 Finally, I'll make comments later about 

 3 the agriculture ethanol in the afternoon session. 

 4 But I would like to share the highlights of a task 

 5 force that the National Grain and Feed established 

 6 to consider overall market performance. 

 7 As we heard earlier from a gentleman 

 8 from the corn growers, the Executive Committee of 

 9 the National Grain and Feed, at the request of the 

 10 Risk Management Committee and the Country -- 

 11 Committee established a task force to respond to 

 12 these wide basis levels and the apparent 

 13 disconnect between the cash market and the futures 

 14 market. This commission noticed this issue in 

 15 wheat 18 months ago. But we were beginning to see 

 16 similar versions of that in soybeans. 

 17 The task force was established to 

 18 consider market performance and develop 

 19 recommendations for the CME Group that could 

 20 enhance convergence and also to identify 

 21 educational materials we should develop for our 

 22 members to respond to these changing market 
 137 

 1 dynamics. 

 2 We set up a task force that was really a 

 3 broad task force. We had the option of setting 

 4 one up of country -- it was really our country 

 5 elevators that are serving farmers that were 

 6 really concerned about their basis exposure. Wide 

 7 basis levels, hard time now getting money, so you 

 8 have higher futures markets, so it's hard to get 

 9 your margin money covered by your bank, and now 

 10 you've got a basis exposure that was unexpected. 

 11 It's unexpected because the landscape is changing. 

 12 It was a significant enough issue that 

 13 the Executive Committee set up this task force. 

 14 We could have set up a task force when eight 

 15 people from the country elevator committee, we 

 16 would have come up with one conclusion, right. 

 17 But instead, we set up a broad based task force. 

 18 It had representatives from the professional 

 19 trading community, it had a fund participant, 

 20 wheat miller, soybean processor, corn miller, 

 21 exporter, delivery -- farm manager. 

 22 We really had a broad base group, senior 
 138 

 1 executives or senior traders on this task force, 

 2 all hoping that over a couple months of study, 

 3 we'd come up with some silver bullet that would 

 4 really identify ways to enhance convergence. 

 5 I'd say that in that regard, we were 

 6 disappointed. We found no silver bullet. 

 7 Eighteen months or 16 months ago when we sat down 

 8 there, I made the comment that the reason for the 

 9 basis in wheat was because we had this dramatic 

 10 increase in open interest in the wheat contract, 

 11 which drove prices higher, and it was really not 

 12 driven by demand. We had big supplies, we had 

 13 high prices, and the basis had to offset that. 

 14 We can't really say that's the situation 

 15 today. Certainly, these long only funds have 

 16 increased price levels. 

 17 But we're also seeing, as Dave Lehman 

 18 mentioned earlier, that transportation costs have 

 19 really sky rocketed. Not only have they gone up 

 20 dramatically, but they've also gone -- the 

 21 volatility has gone up rather dramatically, as 

 22 well. And then you have the change in energy, 
 139 

 1 where you've got this dramatic growth in ethanol 

 2 production in this country. Alone, each of those 

 3 three factors, the investments in agriculture, 

 4 investment capital chasing agriculture, ethanol or 

 5 transportation alone be considered changes in our 

 6 industry. They're all happening at the same time. 

 7 So the fact is, we have more exposure, 

 8 there is more volatility. Over time, the markets 

 9 will get in balance. 

 10 We'd like to find something that would 

 11 make it happen right now, but that's not possible 

 12 with those kind of changes. 

 13 I heard mention earlier about storage; 

 14 storage will be built. It may be expensive, but 

 15 the fact is, with more ethanol consumption, more 

 16 -- we need the storage, right. 

 17 People act economically, so we build 

 18 storage, basis exposure will go down, because 

 19 farmers will hold grain off the market, elevator 

 20 operators are building storage, as well. 

 21 When barge freight is at, for years, at 

 22 150 or 200 percent -- were struggling to break 
 140 

 1 even. Now it's at 800. 

 2 Of course, building a barge is $550,000, 

 3 not $330,000. But over time, people start 

 4 building barges, because if you can get 300 

 5 percent or 400 percent south on barges, and then 

 6 let's say that that's $30 a ton, and you also get 

 7 $30 a ton going northbound, you start doing what's 

 8 economic, you make enough money with the 

 9 equipment, you build transportation, as you do 

 10 that, you start to slim out the volatility and the 

 11 cost of transportation. 

 12 Investment funds, they participate, as 

 13 well. They start to find creative ways, what they 

 14 call their alpha, so that they can better manage 

 15 their exposure, as well. We weren't able to find 

 16 something right now that would change the 

 17 contracts to make convergence happen overnight. 

 18 A certain number of our members would 

 19 certainly be disappointed in that. But I would 

 20 say, looking at the quality of the people on the 

 21 task force, I had no problem with the fact that, 

 22 if the people in this room couldn't come up with 
 141 

 1 some silver bullet, it wasn't there. 

 2 That said, we did make a couple of key 

 3 recommendations to the Board of Trade, and then we 

 4 identified a few points that we thought that they 

 5 should consider further. The two recommendations 

 6 that we made, one was that they increase the 

 7 storage rates from roughly four and a half cents a 

 8 month to five cents a month. That would make it 

 9 consistent, corn and beans consistent with wheat. 

 10 No reason why the two would be different. It 

 11 allows more of the basis -- maybe to be in a 

 12 futures market, where it's more transparent. 

 13 The second recommendation was to 

 14 increase the load out charges from four cents a 

 15 bushel to six cents. They were six cents a bushel 

 16 in 1999. The wheat contract has always been six 

 17 cents a bushel; make corn, beans, and wheat the 

 18 same. 

 19 What these two changes do is increase 

 20 the utility of the existing delivery system. We 

 21 think that was logical. 

 22 It's not going to solve the convergence 
 142 

 1 problem, but it's certainly in the right 

 2 direction. 

 3 We made -- we gave the Board of Trade 

 4 three other ideas; one was to consider adding some 

 5 sites that would be rail -- would have rail access 

 6 to better serve the domestic market. As Dave said 

 7 earlier, there are pros and cons of that. 

 8 Ideally in the future market, in the 

 9 delivery market you would like to have one site, 

 10 one site where it's easy to identify. You've got 

 11 domestic, you've got export, all modes of 

 12 transportation would be ideal. We don't have that 

 13 today. But if you -- every time you expand the 

 14 delivery locations, you also -- you increase the 

 15 complexity, and you get in a situation where what 

 16 you really want, you don't get. 

 17 It's like illusory access to grain. But 

 18 we did suggest that that's something that can be 

 19 considered. 

 20 Another novel concept that was thrown 

 21 out fairly aggressively by one of our members was 

 22 to change the contract. Today the owner of the 
 143 

 1 certificates -- loadout, to add the feature that 

 2 allows the delivery owner to compel loadout. 

 3 We had a tremendous amount of 

 4 discussion, and in the end, we couldn't agree to 

 5 that. It appeared that any benefit from such a 

 6 thing would have a significantly more negative 

 7 impact the other way. 

 8 If you compelled the long to loadout 

 9 when transportation costs just happened to raise 

 10 from 400 percent to 500 percent, or 800 percent, 

 11 why would a long be long future? So you've really 

 12 destroyed -- you've given a delivery owner way too 

 13 much -- you didn't balance the market because they 

 14 would have way too much an advantage. 

 15 So it wasn't something -- committee, but 

 16 the fund participant had suggested that the sugar 

 17 contract had a feature similar to that. He also 

 18 identified that there was significantly more 

 19 volatility in that kind of -- that we would see in 

 20 our grain contract, but since none of us on the 

 21 committee really understood sugar, we made the 

 22 recommendation to the Board of Trade that, you 
 144 

 1 know, they could look at that, maybe there's a 

 2 feature we're not aware of. 

 3 And the other recommendation we made for 

 4 further study was some kind of an index feature, a 

 5 new contract in addition to the current physical 

 6 delivery contract, but some index contract or an 

 7 index feature that would compliment the existing 

 8 contract and maybe reduce some of the basis 

 9 exposure or be another conduit for funds. 

 10 We didn't -- there's been lots of talk 

 11 about that, but no one really could give an idea, 

 12 what would they really want to do, so we just 

 13 passed the ball back to the Board of Trade and 

 14 said you study it. 

 15 But in any case, our compliments to the 

 16 Chicago -- the CME Group. They had a meeting this 

 17 week that David mentioned, they discussed these 

 18 issues, seemed to be fairly good support from the 

 19 group of participants on the key recommendations, 

 20 some reservations on some of the ideas for further 

 21 study, but our comments to the Board of Trade, or 

 22 the CME Group, excuse me, for actually quickly 
 145 

 1 responding to that, to get insight. So that's it, 

 2 I'll make other comments later. 

 3 MR. DUNN: Tom, this is probably going 

 4 through everybody's mind here, but is that 

 5 proprietary information that you've got or is it 

 6 something that you might be able to share your 

 7 report with the rest of the AG Advisory Committee? 

 8 MR. COYLE: We'll be happy to share our 

 9 -- the study. We did it, we surveyed the group, 

 10 some of the information we got back, some of the 

 11 thoughts, and I'll be making a presentation at the 

 12 country elevator council meeting next week in 

 13 Chicago, as well. 

 14 MR. DUNN: If you could make that 

 15 available to us, then we'll get it out to all the 

 16 AG Advisory members, because I think that you guys 

 17 are right on target, as usual. 

 18 And speaking of being on target, our 

 19 next panel member, Dan Brophy, is somebody that's 

 20 been in this business a lot longer than it looks 

 21 when you look at him. He has got a tremendous 

 22 background. Brophy Commodities is one that I'm 
 146 

 1 sure that everybody is very, very familiar with, a 

 2 member of risk committees on exchanges, and has 

 3 been on various exchanges. He brings great 

 4 credentials to this. And Dan presented to us a 

 5 great overpiece that we got in time to send out 

 6 with our package. Even though it may be a 

 7 preliminary piece on the actual comments that the 

 8 Commodity Market Council will have, it certainly 

 9 is a lot of food for thought right off the bat. 

 10 So, Dan, if you will, please go forward 

 11 with that presentation. 

 12 MR. BROPHY: Thank you very much. Thank 

 13 you for arranging this. I know everyone else has 

 14 thanked you before, but this is a very good 

 15 exercise for the industry. We all have different 

 16 constituencies we represent, and sometimes the 

 17 constituencies butt heads a bit, and this is 

 18 really a great forum for everybody to express 

 19 frank views about difficult issues. 

 20 And I'd also say that, as I said to you 

 21 privately, that the staff of the CFTC is just 

 22 terrific to work with. I try to avoid any 
 147 

 1 exposure to dealing with CFTC and forms other than 

 2 this, and thus far I've been able to, but they're 

 3 really, as you said in your opening remarks, you 

 4 have a very good staff, they know the industry, 

 5 and they know the participants. 

 6 My comments today are pretty specific, 

 7 they're seven pages long. For any of you who 

 8 haven't read them, I'd recommend them if you're 

 9 tired of taking sleeping pills. I'm not a lawyer. 

 10 So what I'm going to do is just summarize them 

 11 quickly. They're very specific, and they 

 12 represent the views of the CMC's futures 

 13 committee. With respect to index funds and 

 14 commodities markets, we now know that index 

 15 hedging, in effect, transforms a futures contract 

 16 into an investment security. I think that's 

 17 something that we all figured out sometime in '06. 

 18 Given that, the CFTC's release of the 

 19 supplemental report beginning last January was 

 20 very valuable. In that short period of time since 

 21 its release, it's become one of the industry's 

 22 most essential tools for analyzing markets. 
 148 

 1 The CMC recommends that the CFTC 

 2 incorporate the COT supplemental report into a 

 3 newly formatted COT report, discontinuing the 

 4 supplemental and making the supplemental data part 

 5 of the standard COT report data series as soon as 

 6 possible. 

 7 With regard to the new release on risk 

 8 management positions, the CMC recommends an 

 9 explicit recognition that these risk management 

 10 positions are, in fact, a new variant of bona fide 

 11 hedge, and in accord with that view, we recommend 

 12 that the commission include within the definition 

 13 of bona fide hedging a new and separate category 

 14 of financial hedgers, which would encompass the 

 15 group of participants pretty generally described 

 16 in the proposed regulations. For purposes of 

 17 reporting these positions to the market place, we 

 18 think that a financial hedger's category should 

 19 replace the index fund category and COT reports. 

 20 We also understand that index fund 

 21 positions also reside in the commercial category, 

 22 as Dave pointed out, and as Tom mentioned, as 
 149 

 1 well. This, to us, is a limitation in the current 

 2 reporting mechanism, and we recommend that, in 

 3 addition to modifying the hedge definition to 

 4 include financial hedging, the CFTC should include 

 5 index fund hedges that now reside within a 

 6 commercial category in a new financial hedger 

 7 category. 

 8 We also recommend that the CFTC initiate 

 9 a study of the recent trend toward alpha or 

 10 enhanced return trading by index funds. This is 

 11 mentioned in different terminology in your 

 12 release. 

 13 We recognize that this activity is 

 14 completely legitimate, but it is price responsive, 

 15 it is not passively managed, and it is, in our 

 16 opinion, speculative in nature, and it should be 

 17 reported in that way. 

 18 Further on COT reporting, we suggest to 

 19 the commission that you revise your threshold 

 20 measurement for reporting index trader activity. 

 21 To us, the relevant reporting objective is to 

 22 identify the magnitude of hedger open -- financial 
 150 

 1 hedger open positions relative to total open 

 2 interest. Therefore, the relevant reporting 

 3 threshold should be based on the percentage of 

 4 open interest held by financial hedgers regardless 

 5 of the number of firms. 

 6 The number of firms can be useful, but 

 7 the more important thing for a hedger in 

 8 particular in these markets is short hedger 

 9 assessing his risk is to realize the magnitude of 

 10 the long side of the open interest that is not for 

 11 sale and has, in effect, been securitized. 

 12 So this is not a solution, Tom Coyle 

 13 mentioned, there's no silver bullet. We could 

 14 discuss that, but it's certainly not a solution to 

 15 the convergence problem, but what it is, again, 

 16 along the lines of the -- our initial request that 

 17 a commitment of traders report include data on 

 18 index hedging, this is something that gives the 

 19 short hedger with this problem some sense of what 

 20 he's dealing with, the risk he's got. 

 21 With respect to confidentiality and 

 22 reporting thresholds for AG index fund 
 151 

 1 participants, we argued in August of 2006 that 

 2 there was no risk that reporting requirements on 

 3 financial hedgers would or could infringe on 

 4 proprietary information or their competitive 

 5 position. Since that meeting, market developments 

 6 have reinforced our position; anonymous electronic 

 7 trading, as has been noted here today, has taken 

 8 over the preponderance of daily volume in every 

 9 major AG futures contract in just over a year, and 

 10 it continues to gain share each month. So I think 

 11 within a couple of years, the futures side of the 

 12 AG contracts at CBOT/CME will -- it'll almost -- I 

 13 wouldn't be surprised to see 95 percent a year 

 14 from now in all the contracts. 

 15 We have one more recommendation. 

 16 Considering that there's constant innovation in 

 17 the index investing area, particularly the 

 18 invention of new index products, we recommend that 

 19 the CFTC begin reporting financial hedger open 

 20 positions in the CBOT soybean meal contract in 

 21 Minneapolis Grain Exchange spring wheat contracts 

 22 using some sort of a reasonable open interest 
 152 

 1 percentage threshold, again, not a threshold based 

 2 on the number of firms involved. 

 3 With respect to the speculative limits 

 4 and what we regard as a related issue, 

 5 international competitiveness of U.S. futures 

 6 markets, there seems to be supports in increase in 

 7 non-spot individual and all month combined spec 

 8 position limits as proposed by the commission. 

 9 Every step, including this proposal, which 

 10 encourages broader participation in our markets, 

 11 attracts more volume, more liquidity. Volume 

 12 begets liquidity, liquidity begets further volume. 

 13 Each of these factors builds beneficially on 

 14 itself, tending to reduce bid spreads and build 

 15 depth of order book in every market, and that's 

 16 exactly what all of us as users should want. 

 17 So the CMC supports any effort, 

 18 including this proposal which attracts more 

 19 participants and more order flow to our futures 

 20 markets. Consistent with long standing CMC 

 21 policy, we're asking the commission again to grant 

 22 each exchange authority to set its own speculative 
 153 

 1 limits subject to commission guidelines and 

 2 oversight. 

 3 Elimination of this regulatory 

 4 redundancy would fully implement the core 

 5 principals of the CFMA for all AG commodities, and 

 6 most importantly, the CFTC would still retain all 

 7 of its oversight powers. 

 8 We think that giving the exchanges this 

 9 flexibility poses no risk of irresponsible 

 10 decisions on their part that would harm the 

 11 trading public. And we think in no way does it 

 12 diminish or negate the COTC's authority, yet 

 13 granting this freedom to exchanges gives them one 

 14 additional perhaps small, perhaps large step, but 

 15 one additional step that they can take as they 

 16 deem appropriate to attract new order flower 

 17 enhancer to defend their competitive position 

 18 domestically, or most importantly, 

 19 internationally. We're fully aware that we're 

 20 tilting at windmills, that in the past these 

 21 commission policy has been the opposite of our 

 22 recommendation. 
 154 

 1 But we have great confidence in the very 

 2 well tested system that intertwines CFTC oversight 

 3 powers, a strong staff, as I mentioned, exchange 

 4 self-regulation, and the incentives, as has been 

 5 brought up in this forum, for exchanges to act 

 6 quickly and responsively on behalf of their 

 7 customers and market integrity. 

 8 The consequences to a public company, 

 9 just using CME as an example, with probably a $35 

 10 billion market cap, the consequences to a public 

 11 company are just absolutely devastating if they 

 12 have a head butting situation in public with the 

 13 CFTC. They're very strong incentives for the 

 14 exchanges to do things responsibly. 

 15 The CMC understands that some 

 16 agricultural producer organizations in particular, 

 17 and there may be other organizations, as well, 

 18 still believe that activities of large speculators 

 19 in futures markets pose a threat to their members. 

 20 From our perspective, this is simply not the case. 

 21 The speculative activity in futures 

 22 markets can drive -- can influence day to day 
 155 

 1 prices, but it -- I'm not an economist, but I 

 2 think any of us involved in the markets every day, 

 3 as I am, most of us in this room are, we would 

 4 recognize that this speculative activity, which by 

 5 the way, is price responsive, is powerless in the 

 6 face of larger fundamental forces related to the 

 7 factors we have mentioned. 

 8 Our markets today reflect global 

 9 economics and trends, not speculative buying 

 10 power. The prices begin to retreat tomorrow on 

 11 the AG side, speculative activity will follow that 

 12 retreat, not cause it. And I'd be glad to fill in 

 13 with some additional comments that I have based, 

 14 in part, on what Mike said earlier on that 

 15 subject. 

 16 With respect to international 

 17 competitiveness and price discovery, our general 

 18 experience on CMC is that users on a world-wide 

 19 basis trade a contract for a myriad number of 

 20 reasons ranging from hedging or other commercial 

 21 utility, its relevance as a proxy for financial or 

 22 commodity instrument, its liquidity in the depth 
 156 

 1 of its order book, reducing cost of entry and cost 

 2 of exit, its volatility, its speculative appeal, 

 3 the level of exchange fees, the level of governed 

 4 taxes and so forth. 

 5 The domicile of the contract may or may 

 6 not be a factor, whereas liquidity is a major 

 7 factor, and there's a good example of that in the 

 8 lack of used of the Matif and Life wheat 

 9 contracts, where those are a far superior hedge 

 10 for European internal wheat trading, but that 

 11 order flow tends to come, as far as I know, and I 

 12 think you gentlemen on the staff of the COTC could 

 13 probably find out, most of that order flow does 

 14 come to the U.S. 

 15 In summary, we believe that the best way 

 16 for an exchange to draw a maximum order flow from 

 17 all sources, domestic and international, is to 

 18 have systems and policies in place that encourage 

 19 low cost, high efficiency futures markets. 

 20 In all cases, the most efficient and 

 21 lowest cost markets are those with the maximum 

 22 order flow and liquidity which minimizes bid 
 157 

 1 spreads, lowers users costs incurred entering or 

 2 exiting the market. 

 3 We support exchange policies and COTC 

 4 policies that provide the most attractive trading 

 5 and execution environment, and as a general policy 

 6 matter, exchange controlled flexible position 

 7 limits would be one small, perhaps, as I said, 

 8 perhaps large step in continuing -- a continuing 

 9 process to provide the most attractive business 

 10 climate for U.S. futures exchanges. With regard 

 11 to ethanol, is it an agricultural and energy 

 12 commodity, and the related issue of egg (?) swaps. 

 13 The CMC believes that ethanol is an energy 

 14 commodity. We recommend that the commission take 

 15 this view in its consideration of the issue. On a 

 16 broader basis, we recommend that, where it's 

 17 possible within the existing regulatory structure, 

 18 the CFTC harmonize regulations for egg swaps with 

 19 those for swaps on non-egg commodities. 

 20 There are very complex legal and 

 21 regulatory issues. We leave those to be argued by 

 22 the staff of the COTC and the capable staffs of 
 158 

 1 the exchanges, who have true expertise. We do not 

 2 have that expertise on our committee. 

 3 However, what we decided to do was go to 

 4 the broader issue, and the broader issue here is 

 5 that there's an obvious commercial reality in 

 6 play. Participants in the cash ethanol trade want 

 7 their transactions cleared and guaranteed by the 

 8 central counter party, in this case, CME 

 9 Clearinghouse, it could be Ice or anybody else in 

 10 another case. 

 11 CMC believes that regulations should 

 12 promote, not obstruct, legitimate commercial 

 13 activity. I would say 13,000 contract open 

 14 interest in the ethanol swaps, what does that 

 15 represent, Dave, 400 million gallons, or is my 

 16 math -- 

 17 MR. KASS: (off mike) 

 18 MR. BROPHY: So 400 million gallons, 

 19 that's legitimate commercial activity. The 

 20 participants in an OTC trade in any AG commodity 

 21 or other commodity want clearing services from any 

 22 U.S. exchange or an independent clearing entity. 
 159 

 1 The commission should have the regulatory latitude 

 2 to accommodate that demand. 

 3 Legally important, but outmoded in 

 4 economically artificial distinction should not 

 5 impede development or delivery of services and 

 6 products that the market wants. There's an old 

 7 fear of bucket shops and I wanted to address that 

 8 with respect to these OTC instruments. 

 9 A clearinghouse cannot settle an 

 10 instrument without evaluation price that is 

 11 determined in a transparent environment and 

 12 available to the clearing entity in both counter 

 13 parties. So the nature of the clearing and 

 14 settlement process effectively excludes what I 

 15 would call the bucket shop risk. And at the same 

 16 time, it provides a credit guarantee, which is 

 17 clearly of increasing value to OTC participants. 

 18 While we respect the responsibility and 

 19 the burden that the COTC carries in interpreting 

 20 and enforcing the law, the debate in this case 

 21 illustrates a central risk factor in the 

 22 international competitiveness of U.S. exchanges. 
 160 

 1 Product innovation and the needs of today's market 

 2 users outpace the law and regulation. And I 

 3 think, as an aside, the CFTC really has been very 

 4 good in the past in keeping up with all of this. 

 5 I think the last place that COTC wants 

 6 to find itself is in the situation the SCC is in, 

 7 where it's under great pressure because regulation 

 8 that is too onerous has caused some degree of 

 9 migration of capital formations overseas, causing 

 10 loss of that business here in the U.S. We don't 

 11 want to see that with the U.S. futures industry. 

 12 As a single organization, CMC, we 

 13 realize that our voice has a very limited 

 14 influence, but we do have a responsibility to say 

 15 what we think to the commission, especially in 

 16 this kind of a forum where we're invited to be 

 17 candid. 

 18 We would like to persuade the commission 

 19 to unite the commodities industries and the 

 20 futures exchange community to ask for reforms that 

 21 meet market needs and keep U.S. Exchanges healthy 

 22 and competitive. 
 161 

 1 With respect to changes in law, there's 

 2 any notion that the risks in certain of these 

 3 enumerated commodities can be seen as controllable 

 4 or that any participant or group of participants 

 5 in these markets can somehow be protected or 

 6 shielded from existing risks by the commission or 

 7 any other governmental entity is just outmoded. 

 8 The risks are embedded in the climate of today's 

 9 commodities markets, they reflect economics, not 

 10 manipulation or speculative access. 

 11 No participant in any sector, including 

 12 the agricultural sector, can avoid or ignore the 

 13 inherent risks. 

 14 The fact is that the AG community needs 

 15 access to these products to manage those risks, 

 16 and law and regulation, which impede that access, 

 17 do not do a public service. 

 18 The commodities industry, the U.S. 

 19 futures exchange, and the CFTC need to work 

 20 together, not to navigate the maze of existing 

 21 law, which as I pointed out is unsuited in some 

 22 cases to today's business environment, but rather 
 162 

 1 to find ways to accommodate the demand for better 

 2 risk instruments. 

 3 These include customized OTC products 

 4 like swaps, clearing services, and central counter 

 5 party guarantees to participants in OTC 

 6 transactions. Part of this effort might involve 

 7 more commercially oriented regulation, which I see 

 8 is part of your packet, and part may literally ask 

 9 -- involve asking for improvements in existing 

 10 law. With these realities in mind, the CMC has 

 11 the following recommendations; as the first step, 

 12 the commission should approve the CME Group and 

 13 Ice U.S. petitions involving grain and soft 

 14 commodity swaps. Secondly, wherever possible, the 

 15 commission should support in its future regulatory 

 16 interpretations the harmonious treatment of AG and 

 17 non-AG swaps. 

 18 Third, wherever possible, the commission 

 19 should support in its future regulatory 

 20 interpretations those industry and exchange 

 21 product initiatives which bring into a cleared 

 22 environment OTC AG products that are now unclear. 
 163 

 1 Fourth, the commission should research 

 2 by its surveys its direct contacts and other steps 

 3 the needs of the OTC market place for new products 

 4 and clearing services. Number five, based on that 

 5 research, which we suggested here, the further 

 6 consultation in the commodities trading community, 

 7 the commission should request changes in law to 

 8 accommodate the product innovation that is 

 9 demanded by industry and expanding in pasens (?) 

 10 and scope daily. 

 11 The CMC would be glad to lend its 

 12 resources to any effort in this area. And I'm 

 13 pleased to answer any questions or fill in some 

 14 more. Thank you. 

 15 MR. DUNN: Thank you very much, Dan. It 

 16 was a very thoughtful piece that the CMC put 

 17 together, and again, I commend you on your speed 

 18 of doing that. Let's open it up now for the 

 19 Advisory Committee; are there any questions or 

 20 comments based upon the panel? 

 21 MR. GOULD: Mr. Chairman, I'm 

 22 Administrator of -- Agency and I'd just like to 
 164 

 1 mention that during the break, we passed out a 

 2 handout about livestock products available through 

 3 the risk management agency. It's just a matter of 

 4 information. Those products are available. 

 5 The -- Agricultural Risk Production Act 

 6 provided some substantive changes in the way the 

 7 Risk Management Agency does business, and through 

 8 the direction of the Federal -- Corporation Board, 

 9 and part of that now is livestock products that 

 10 have come forward for -- for swine, cattle, and 

 11 sheep, so I just wanted the committee to be aware 

 12 of those products that are on board and available 

 13 through the insurance companies that the 

 14 corporation does business with. 

 15 MR. DUNN: Thank you, Eldon, we 

 16 appreciate it very much, and we'll make sure that 

 17 those members of the Advisory Committee that 

 18 aren't here get a copy of this, as well. 

 19 MR. GOULD: Thank you. 

 20 MR. DUNN: Dan, a couple of times you 

 21 talked about, in your paper, that the CFTC should 

 22 do some research or some survey, and it's 
 165 

 1 something that our Acting Chairman would like to 

 2 do, I'm sure, but we often find ourselves without 

 3 the fiscal resources to be able to do some of 

 4 that, and that is one thing that the Advisory 

 5 Committee, I think everyone should keep in mind 

 6 especially as we look at these various things. 

 7 Every time we're asked to do something 

 8 new or something different, there is a cost to it, 

 9 and we do have very limited, human and fiscal 

 10 resources. 

 11 You also talk about some changes in the 

 12 law, and I'm wondering, have you suggested to 

 13 Congress, since they're in the process now of 

 14 thinking about -- or going through our 

 15 reauthorization, of making some of these changes 

 16 in the current legislation? 

 17 MR. BROPHY: We've not discussed that as 

 18 an organization. We're -- as you know, we're 

 19 seeking a new president, so our resources have 

 20 been somewhat limited lately, but this will be a 

 21 subject of our activity. I think I can say that 

 22 on behalf of the organization safely, and that 
 166 

 1 subject actually did come up specifically, very 

 2 briefly, in the last committee meeting that led to 

 3 this presentation. 

 4 MR. DUNN: Any of my fellow 

 5 commissioners have any questions? 

 6 MR. LUKKEN: This is a very basic 

 7 question, but because the commitment of traders 

 8 report came out of a regulatory need and 

 9 eventually evolved into a market transparency 

 10 issue that a lot of us use, it used to be 

 11 categorized by speculators versus non-speculators. 

 12 Then it turned to commercial versus 

 13 non-commercials. We're now talking passive and 

 14 active, long term, short term. Does the group 

 15 have a consensus on how we should divide this up? 

 16 Both for our regulatory and market 

 17 needs. What's the best way to categorize some of 

 18 these things? So that we can, as a regulator, use 

 19 it to prevent manipulation and fraud and other 

 20 things that we look for. But then for a market, 

 21 then we could turn around and provide that to you 

 22 in some meaningful way. 
 167 

 1 Because some of the things being 

 2 suggested as far as index traders (off mike) -- 

 3 It's a very basic question, but I don't know if 

 4 anybody has views on that. 

 5 MR. FENTON: I guess I'll make a 

 6 comment. We traditionally had this speculator and 

 7 the non-speculator or the non-speculator in 

 8 commercial/non-commercial, but it would seem that 

 9 we would want to add categories that show 

 10 speculative interests in the market and then 

 11 hedging interest in the market. What we're 

 12 looking for is to make sure that there's a 

 13 distinction between commercial, meaning grain 

 14 hedging, and now, as Dan suggested, financial 

 15 hedging, which is fine. They're both hedging. 

 16 But it's -- there's different timeframes of 

 17 decision, so that would be a useful distinction. 

 18 MR. LEHMAN: Just maybe make another 

 19 observation. I think prior to the evolution of 

 20 this index fund community and the swap community 

 21 where you have this new financial risk exposure, 

 22 it was very clean. You've got speculative 
 168 

 1 interest and commercial interest, and all of that 

 2 interest that's in that index fund category today 

 3 would fall on the side of speculative. Because of 

 4 a demand for higher limits and being able to trade 

 5 above the speculative limitations, you've got a 

 6 new creation or a new -- a new participant that's 

 7 emerged that needs, I guess, further refinement in 

 8 the report from the market perspective, because 

 9 those are participants that trade much -- much 

 10 differently. So, I think, you know, part of it -- 

 11 it's not easy; it's a struggle -- I'm glad it's 

 12 you guys -- because the markets are going to 

 13 continue to evolve, and, as you see these new 

 14 demands, it will be a trick in finding that 

 15 balance, I think, as to what information is useful 

 16 from a regulatory perspective and then what 

 17 information also is going to prove of value to 

 18 those folks who are in the market trading these 

 19 underlying cash market risks. 

 20 MR. COYLE: Dan, I know you're a Chicago 

 21 person. I'm a Chicago person. I'm certainly -- 

 22 to better understand some of the things in your 
 169 

 1 seven pages, I think maybe either with you or with 

 2 your futurist committee I'd be happy to -- because 

 3 some of it sounds like you might -- may not have a 

 4 good understanding of what we're doing now, and 

 5 others I know are a new approach, to kind of sort 

 6 out all that and how we do what we do and things 

 7 like that. I'd be happy to sit down with either 

 8 you or your committee or however you want to do 

 9 that, or anybody else up to a point. I mean, 

 10 there's only so many of me. So -- but we -- we'll 

 11 certainly want to explore that maybe offline 

 12 rather than do that here. 

 13 MR. FENTON: I'd just like to make a 

 14 comment and then ask a question. When we were 

 15 thinking through how we would revise the 

 16 commitments and we ended up producing a 

 17 supplementary report, we thought that -- you know, 

 18 what people were telling us was this new type of 

 19 trader who was not reacting to the fundamentals in 

 20 the market, not a merchant or not otherwise 

 21 trading, you know, in a way that reflects activity 

 22 in the underlying cash market, okay? Fine. They 
 170 

 1 were also not price responsive in the way a 

 2 traditional speculator would be whether it's based 

 3 on fundamental analysis or technical analysis. 

 4 They're not that type of trader. So, they're a 

 5 third a type that is a financial hedge or risk 

 6 diversifier, and so what we think we've done is 

 7 created three pretty clean categories that have 

 8 those three trading focuses. So, I guess my 

 9 question then is why is that not doing the trick? 

 10 MR. BROPHY: I actually have a question 

 11 for you. In what sense is the replication of 

 12 commodities price through an index that we all 

 13 recognize as non-price responsive -- in what sense 

 14 is that speculative? So, that's -- I think that's 

 15 the best way of saying we're suggesting you just 

 16 create a new category, because if there's alpha- 

 17 enhanced return trading around that, that is a 

 18 difficult question and I'm glad that I'm not in 

 19 your shoes to figure out how to deal with that and 

 20 account for that, but as I've worked on these 

 21 issues and we kicked things around, we keep coming 

 22 back to it. In what sense is this activity 
 171 

 1 speculative? To us, it's not. It's hedging. 

 2 It's a different kind of hedging. 

 3 MR. FENTON: So -- well, first I'll 

 4 mention one of the reasons we continued to produce 

 5 the reports we've produced in the past and then 

 6 supplemented it was because we've heard in the 

 7 past that people have been using this data over 

 8 many years in their analyses -- used the long data 

 9 stream and so they wanted to continue, so -- but 

 10 what we think the supplemental report does is it 

 11 does break out the index trading separately from 

 12 speculators, so it -- to the extent that in the 

 13 traditional report they're being classified as 

 14 non-commercials. They're -- in the supplemental 

 15 report they're being moved into the index trader 

 16 category, and to the extent that they're swap 

 17 dealers doing index trading they're being taken 

 18 out of the commercial category and being put into 

 19 the index category. So, I think you could view 

 20 the index category -- and there's a little bit of 

 21 kind of slippage because especially swap traders 

 22 may be doing some other things besides index 
 172 

 1 trading that we are not able to break out, but we 

 2 think it's a pretty good breakout of the financial 

 3 hedgers that you're looking for. 

 4 MR. COYLE: But again we can -- I can 

 5 maybe sit down with you or your committee and we 

 6 can talk about exactly how we put this together 

 7 without -- obviously without giving away anything 

 8 but more the process of how we do these things. 

 9 MR. BROPHY: We don't want you going to 

 10 jail. The only -- I'm not sure I have anything to 

 11 add to this other than to say once again that 

 12 these flows, these investment flows that have 

 13 created such -- to an extent they have created 

 14 volatility in our markets, you can say that these 

 15 investment flows have created it all, but you can 

 16 also look at whether an economic development -- 

 17 around the world and probably do some sort of 

 18 correlation studies with those influences as even 

 19 bigger contributors to it voluntarily. But the 

 20 fact is the volatility or the investment flows are 

 21 here to stay. 

 22 My brother's estate settled last March, 
 173 

 1 and I was sitting in with a banker from Northern 

 2 Trust, the most conservative bank I know, and 

 3 their recommendation for my sister-in-law's 

 4 long-term portfolio was 2 percent representation 

 5 in commodities, and I said to the guy if you had 

 6 recommended this three years ago would you have 

 7 your job? And he said no, that he's recommended 

 8 it on behalf of the most conservative bank in the 

 9 world probably. So, these things are not going 

 10 away. 

 11 Last week I think it was, the Chinese 

 12 government announced that they'd be selling 2 

 13 million tons of corn from their domestic stocks to 

 14 calm their domestic markets. Well, what does that 

 15 tell you? China won't be exporting corn. What 

 16 does that tell you? Their economy is growing 

 17 every day at a pace three times ours, and they 

 18 have a population four times ours. It says that 

 19 China will be importing corn soon. So, these -- 

 20 those are fundamental factors but those kinds of 

 21 things also excite the investment community that 

 22 wants participation. So, I think what we really 
 174 

 1 are coming down to is a conflict that hits the 

 2 traditional hedging community with its reliance on 

 3 a physical delivery contract to bring about a 

 4 convergent string of delivery period with 

 5 investment flows that are many multiples the size 

 6 of the crops that have to be hedged by the short 

 7 hedger -- the farmer all the way to the elevator 

 8 -- and until we find a new contract design, which 

 9 Dave Gleeman (?) alluded to, you're going to be 

 10 wrestling with these problems and we're going to 

 11 be wrestling with these problems, too. So, I 

 12 think part of the issue is the old physical 

 13 contract design. I'm saying that as a private 

 14 citizen, not as a CMC member. 

 15 MR. LEHMAN: Question for clarification. 

 16 When you're looking at extending the exemption to 

 17 pension plan money and other institutional 

 18 investment fund money, clearly those dollars going 

 19 into the market are speculative dollars. There is 

 20 no cash or financial price risk exposure to the 

 21 underlying ag commodity. For purposes of 

 22 reporting commitment of trader information, where 
 175 

 1 will those pension fund dollars be put? Would 

 2 they be commercial? Would they be index fund? 

 3 Would they be speculative? 

 4 MR. FENTON: Well, we are already facing 

 5 that situation. There are those kinds of traders 

 6 in the market. They're not -- they're subject to 

 7 position limits as it is. They're -- in the 

 8 traditional report they're being classified as 

 9 non-commercial. In the supplemental report 

 10 they're being moved into the commodity index 

 11 trader category. 

 12 MR. LEHMAN: So, today, if Calpers has a 

 13 position directly in corn -- 

 14 MR. FENTON: If it's part of a 

 15 broad-based index trading program, they're 

 16 classified as commodity index traders? 

 17 MR. LEHMAN: Okay. 

 18 MR. LUKKEN: Can I add something? This 

 19 is something we've heard a lot from pension funds. 

 20 I remember a Dutch pension fund coming in to talk 

 21 to us about this. If they were hitting -- as a 

 22 non-commercial, hitting their caps and wanted, as 
 176 

 1 a big fund, to get broad exposure to commodities, 

 2 what they were doing was going through a big Wall 

 3 Street firm. The firm was getting its hedge 

 4 exemption and putting it into the market. So, we 

 5 weren't seeing necessarily the right pricing 

 6 structures going into the marketplace. And I 

 7 wonder if we don't get them into this category, if 

 8 we don't allow more front door entrance, that 

 9 we're not just going to see a back door that's 

 10 more opaque. And that's the sort of tension we 

 11 have to sort of play here. And I don't know what 

 12 the right answer is, but certainly it's worthy of 

 13 discussion. 

 14 MR. DUNN: All right, I'm not hearing 

 15 any more folks, I'm anxious to hear Leroy. 

 16 MR. WATSON: Yeah, I'm Leroy Watson with 

 17 the National Grange. I'd like to ask Dan a little 

 18 bit to maybe clarify a little more of his 

 19 discussion about the classification of ethanol as 

 20 an energy product rather than an agricultural 

 21 product and then make a couple of comments to help 

 22 you form your response. 
 177 

 1 First of all, I think it's obvious that 

 2 clearly the price signals coming from an ethanol 

 3 market are going to have far more of an impact on 

 4 sort of the on-the-ground production decisions 

 5 that are made related to people who are actually 

 6 participating in agricultural operations as 

 7 opposed to whether or not somebody in the, you 

 8 know, the energy industry, somebody who drills for 

 9 oil or natural gas or digs coal is going to poke a 

 10 hole in the ground and look for additional fossil 

 11 hydrocarbons related to price signals that have 

 12 been developed from, you know, the ethanol 

 13 markets. I mean, I just don't see anybody looking 

 14 at an ethanol market and saying now's the time to 

 15 drill for more oil. So, clearly I think the 

 16 impact that we can predict, at least for the 

 17 foreseeable future, is going to be overwhelmingly 

 18 upon the production decisions related to 

 19 agriculture and not related to energy. 

 20 The second aspect I'd like you to 

 21 comment on related to your (off mike) that in your 

 22 presentation you talk about the fact that a lot of 
 178 

 1 producers still carry forward a certain degree of 

 2 apprehension about the speculative aspects of 

 3 people acting in the futures markets while -- and 

 4 I think it's also clear that, you know, certain 

 5 subgroups of traders within, you know, futures and 

 6 commodity markets have different cultures, and 

 7 clearly the energy culture has been far more 

 8 laissez faire, and if we look at, you know, 

 9 instances like Enron or the Ameraf (?) hedge fund, 

 10 those are exactly the types of people that 

 11 producers that I represent don't want 

 12 participating in an agricultural product, so -- 

 13 and I don't, you know, have a broader discussion 

 14 of why energy tends to attract a small amount of 

 15 those malfeasant participants. I'm sure they're 

 16 there in all aspects of commodity trading at some 

 17 point or another. But if you're trying to assure 

 18 us that these aspects are under control or at 

 19 least not a major factor, then why do we want to 

 20 move to energy markets where we have so many 

 21 recent examples of where they haven't been under 

 22 control? 
 179 

 1 MR. BROPHY: You may have to steer me 

 2 back to make sure I'm answering your question 

 3 directly. 

 4 With respect to ethanol being ag or 

 5 energy, I personally had to go through my own 

 6 thought process to justify my support for the 

 7 CMC's view of things, and one of the thoughts I 

 8 came up with -- I think someone else mentioned 

 9 that had a better example earlier today -- but if 

 10 there were a market for corn-based plastic, would 

 11 that be considered an ag commodity or a plastic 

 12 commodity? And I think in the case of ethanol, 

 13 there was a -- wasn't there a bankruptcy this week 

 14 or last week of a plant in Nebraska? And I'm sure 

 15 that had to do with margins, and the margin issue 

 16 didn't have anything to do with corn; it had to do 

 17 with ethanol. So, I'm not sure that's answering 

 18 your question, but at the moment that's the best I 

 19 can think of. 

 20 With respect to markets being under 

 21 control -- I think that was the phrase you used -- 

 22 I tried to emphasize in my comments that there is 
 180 

 1 no controlling these markets. They are so much 

 2 bigger than U.S. production capacity. They're so 

 3 much bigger than U.S. export loading capacity, 

 4 which has triggered some of the transportation 

 5 issues that Tom Coyle mentioned and Dave Lehman 

 6 has mentioned. They would be this big regardless 

 7 because of development around the world and the 

 8 fact that the U.S. produces so much of these key 

 9 commodities and has such an efficient pricing 

 10 mechanism through the futures markets, liquid cash 

 11 markets for domestic users and exporters and 

 12 importers. So, it's not a matter of anything 

 13 being under control that you or I can exert 

 14 through legislative means or through policy means 

 15 or through articles or ads in newspapers. It's -- 

 16 the markets are just too big. And in his 

 17 presentation, Mike mentioned a possible 

 18 manipulation where somebody puts a bunch of buying 

 19 orders in and people tailgate those and get 

 20 themselves long anticipating the big buying orders 

 21 moving up in price and then whoever it is that did 

 22 that all of a sudden cancels the orders and puts 
 181 

 1 in big sells. Well, my experience in -- that had 

 2 something quite similar to that happen in soy 

 3 beans, and I don't know exactly why, about three 

 4 months ago perhaps, but my experience is that 

 5 these markets are so big if you think you can 

 6 manipulate them, you're going to lose your shirt. 

 7 The order flow coming into our markets, 

 8 our little bitty ag markets, is so immense you 

 9 can't imagine it, and it is worldwide and it's 

 10 going to keep growing, and that's order flow from 

 11 speculative players who are price responsive and 

 12 order flow from index players who are not. My 

 13 sister- in-law is not going to sell her commodity 

 14 portfolio anytime soon. So, I mention -- I hope I 

 15 somewhat answered your question. 

 16 MR. DUNN: (off mike), you get the last 

 17 question or comment. 

 18 SPEAKER: Mr. Chairman, this may not be 

 19 a question or a comment, but in the context of 

 20 ethanol as an agricultural commodity or a food 

 21 commodity versus a field commodity, I'd like to 

 22 share this thought as a member of the advisory 
 182 

 1 committee -- is the fact that as a function of 

 2 government decisions, the ban on MTB -- the 

 3 mandate that we currently have in place, the 

 4 pending legislation to mandate 15 billion gallons 

 5 of corn-based ethanol, the tariff on imports, the 

 6 51 cent blenders credit -- I might make the point 

 7 that it is neither; it is more of thinking in 

 8 terms of a government contract. It is a commodity 

 9 that may not be responsive to marketplace supply 

 10 and demand derivatives either in energy or 

 11 relative to agriculture. It may -- it -- and 

 12 that's one of the problems we have with it is the 

 13 fact that it isn't really market driven today, and 

 14 if we go to this 15 billion gallon mandate, I 

 15 don't think it will be market driven at all, and 

 16 that is a particular concern in the value of price 

 17 per gallon of ethanol and also as it relates to 

 18 corn. 

 19 MR. DUNN: Okay, and with that, that 

 20 will close out this morning session. 

 21 

 22 
 183 

 1 A F T E R N O O N S E S S I O N 

 2 (1:53 p.m.) 

 3 MR. DUNN: This afternoon I think we 

 4 have just a group that is going to be very much 

 5 equal to the morning session. We're going to 

 6 start off with the role of agriculture in 

 7 over-the-counter markets, and this is something 

 8 that many of the folks this morning alluded to. 

 9 I'd like to get started here with a summary of the 

 10 legal landscape, and we're going to bring back Don 

 11 Heitman to give us that overview. 

 12 So, Don, if you will. 

 13 MR. HEITMAN: The issue I'd really like 

 14 to talk about is -- what the heck is an 

 15 agricultural commodity for purposes of the 

 16 Commodity Exchange Act and why is status as an 

 17 agricultural commodity so important? And it ties 

 18 into the Commodity Futures Modernization Act, 

 19 because the CFMA established a tiered system 

 20 whereby the degree of regulation depends on the 

 21 commodities traded, the participants, and the 

 22 method of trading. So, intermediated training 
 184 

 1 versus principal to principal -- if you're a 

 2 retail customer trading through an FCM, you're 

 3 more likely to need protection than Goldman Sachs 

 4 trading for its own account 

 5 principal-to-principal, because they've got 

 6 lawyers to look out for them. If you're on a 

 7 trading facility versus doing bilateral trading; 

 8 if you're a retail customer versus a financial 

 9 institution -- 

 10 And in this tiered regulatory system, 

 11 commodities that are more susceptible to 

 12 manipulation -- for example, physical commodities, 

 13 such as the agricultural commodities -- are subject 

 14 to greater regulatory oversight than financial 

 15 commodities, because financial commodities are 

 16 recognized as being less susceptible to 

 17 manipulation. And so whether or not a given 

 18 commodity constitutes an agricultural commodity can 

 19 determine where and how it may be traded. 

 20 There are three types of commodities 

 21 recognized in the Commodity Exchange Act, and 

 22 somebody was asking me at lunch about defining 
 185 

 1 things and how to categorize things. Well, there 

 2 is absolutely no question in the Commodity 

 3 Exchange Act. Everything falls into one of these 

 4 three categories. Unfortunately, Congress only 

 5 really told us what one of the categories is, 

 6 because the first category is an "excluded 

 7 commodity," which is basically an interest rate, 

 8 an exchange rate, a security, or a macroeconomic 

 9 index, and there is in Section 1(a)(13) of the Act 

 10 a huge, long definition of what an excluded 

 11 commodity is. That's the only definition. The 

 12 other two categories are an "exempt commodity" -- 

 13 and all the Act says is well, anything that's not 

 14 excluded or agricultural falls into exempt. Then 

 15 there's the third definition -- well, the third 

 16 term is "agricultural commodity," but it's not 

 17 defined. Congress in its infinite wisdom did not 

 18 deign to tell us what an agricultural commodity 

 19 is, and so all we know is -- well, we know some 

 20 things about it. We know that obviously the 

 21 enumerated commodities listed in the Commodity 

 22 Exchange Act, which include all the basic 
 186 

 1 agricultural commodities that are subject to 

 2 speculative position limits, and in addition 

 3 livestock, livestock products, and some other 

 4 things -- those obviously have to be recognized as 

 5 agricultural commodities. 

 6 But the concept is clearly broader than 

 7 just the enumerated commodities, because the House 

 8 Report on HR 4541, which is a predecessor bill to 

 9 the CFMA and is pretty much the closest thing we 

 10 have to a legislative history -- that report says 

 11 the committee intends agricultural commodity to 

 12 include all agricultural commodities whether or 

 13 not specifically enumerated in the Act -- but they 

 14 still don't say what that means. 

 15 The question then becomes why is how we 

 16 apply the term "agricultural commodity" important? 

 17 And it's significant in the context of several of 

 18 the Act provisions. For example, Section 2(g), 

 19 which is known as the swaps exclusion, excludes 

 20 certain swap transactions from all provisions -- 

 21 and it isn't really all provisions, it's "all 

 22 other" provisions -- of the Act. But that 
 187 

 1 exclusion applies only to a transaction in a 

 2 commodity other than an agricultural commodity. 

 3 So, if it's an ag commodity, it's not eligible for 

 4 the 2(g) swaps exclusion. 

 5 And I would like to also point out that 

 6 before the meeting this morning, Greg Mocek, our 

 7 Director of Enforcement, pointed out to me that, 

 8 in fact, 2(g) doesn't completely get you off the 

 9 hook -- for example, from the manipulation 

 10 provision. Oh, and he just walked in. I'd like 

 11 Greg to listen as I read a sentence from the 

 12 preamble to the Part 35 rules. The Act provisions 

 13 "concerning manipulation or attempted manipulation 

 14 of the market price of any commodity in interstate 

 15 commerce would continue to apply to persons 

 16 engaging in the swap agreements but not to the 

 17 agreements themselves." So, swap agreements are 

 18 excluded under 2(g), but if you're using the swap 

 19 agreement in an attempt to manipulate the market, 

 20 Greg Mocek can still come and jump up and grab 

 21 you. So, in any event, one significant provision 

 22 in applying the ag commodity definition is Section 
 188 

 1 2(g), because ags are not eligible for the 2(g) 

 2 exclusion. 

 3 The other two main provisions are 

 4 Section 2(h)(1), which exempts certain bilateral 

 5 transactions in exempt commodities for most 

 6 provisions of the Act. The easiest way to 

 7 describe a 2(h)(1) market in a shorthand way is 

 8 that's a one-to-many market. Enron online was a 

 9 2(h)(1) market. 

 10 A 2(h)(3) market exempts certain 

 11 transactions in exempt commodities on an 

 12 electronic trading facility or "exempt commercial 

 13 market," a many-to-many market, from most Act 

 14 provisions. And ICE, the Intercontinental 

 15 Exchange, is the best example of a 2(h(3) market. 

 16 And in both of these 2(h) examples, 

 17 agricultural commodities may not be traded on an 

 18 exempt market, because an exempt commodity is by 

 19 definition, not an agricultural commodity. So, 

 20 whether or not you can trade agricultural 

 21 commodities under these particular provisions -- 

 22 whether or not something is an agricultural 
 189 

 1 commodity -- is important, because it determines 

 2 how the commodity is treated under those 

 3 provisions. 

 4 There is one other important regulatory 

 5 provision when it comes to ag commodities, and 

 6 that's the swaps exemption, which is in Part 35. 

 7 Part 35 was a predecessor of the CEMA. Before the 

 8 CFMA, it was the Commission's attempt to deal with 

 9 some of these issues of how do we regulate swaps. 

 10 By its terms, Part 35 applies to all 

 11 swaps. But with respect to everything else, when 

 12 they passed the CFMA, Section 2(g), the swaps 

 13 exclusion, superseded Part 35 with respect to 

 14 everything but agricultural commodities. However, 

 15 Part 35 is still on the books, so as a practical 

 16 matter Part 35 applies only to agricultural swaps. 

 17 The conditions are very similar for agricultural 

 18 swaps under Part 35. Part 35 is very similar to 

 19 Section 2(g), with one exception. 

 20 If you look at the terms and conditions 

 21 applicable to agricultural swaps under Part 35, 

 22 number one, they may be entered into solely 
 190 

 1 between eligible swap participants, which 

 2 basically is institutional and other sophisticated 

 3 investors. And that's equivalent, in Section 

 4 2(g), the eligible contract participants. 

 5 Number two, the swap is not part of a 

 6 fungible class of agreements that are standardized 

 7 as to their material economic terms, and that's 

 8 roughly equivalent to individual negotiation. 

 9 That's Section 2(g)(2). 

 10 Number three, the swap is not entered 

 11 into and traded on or through a multilateral 

 12 transaction execution facility, which is roughly 

 13 equivalent to 2(g)(3), not executed on a trading 

 14 facility. So, up to this point, whether under 

 15 Part 35 or Section 2(g), the conditions are pretty 

 16 much the same. But the fourth condition of Part 

 17 35 is that the creditworthiness of any party to 

 18 the swap would be a material consideration in 

 19 entering into the swap. In other words, the swap 

 20 is not cleared, because if it was being cleared, 

 21 you wouldn't care about the creditworthiness of 

 22 the opposite party because the clearing house is 
 191 

 1 interposed between the two of you. 

 2 So, the one significant difference 

 3 between 2(g) and Part 35 is that under Part 35 the 

 4 swaps cannot be cleared. Therefore, if ethanol is 

 5 an industrial commodity, a non-agricultural 

 6 commodity, an ethanol swap could be traded under 

 7 Section 2(g) and it could be cleared on an 

 8 exchange. You could bring an OTC transaction it 

 9 to an exchange and get it cleared through an 

 10 exchange clearing house. But if ethanol is an 

 11 agricultural commodity, then an ethanol swap could 

 12 not be cleared absent an exemption or some special 

 13 relief from the CFTC. And that's the primary 

 14 difference. 

 15 Now let's look at issues affected by the 

 16 question, "what is an agricultural commodity?" 

 17 And I actually jumped the gun on my next slide. 

 18 If ethanol is agricultural, it can only be traded 

 19 under Part 35 and can't be cleared. If it's not, 

 20 you could do ethanol swaps and get them cleared. 

 21 And if ethanol is not an agricultural commodity it 

 22 could also be traded on an exempt commercial 
 192 

 1 market pursuant to Section 2(h)(3). 

 2 What are some additional questions -- 

 3 and then this is in the context of issues that 

 4 have been raised with DMO. Are coffee, sugar, and 

 5 cocoa agricultural commodities? And intuitively 

 6 one would think "yes," but there has not been a 

 7 formal determination by the Commission to that 

 8 effect. 

 9 Are pulp and paper agricultural 

 10 commodities? Well, in fact, the Commission has 

 11 sort of said that pulp and paper are not 

 12 agricultural commodities. But we only said it 

 13 indirectly, because a couple of years ago we got 

 14 an application from someone to start an exempt 

 15 commercial market in pulp and paper. So, then the 

 16 question became can they do this -- can they start 

 17 a 2(h)(3) market in pulp and paper? Because if 

 18 pulp and paper is agricultural, it can't be traded 

 19 on an exempt commercial market. And there was a 

 20 big internal debate on how you should treat pulp 

 21 and paper, whether it's agricultural or not, and 

 22 there was a certain amount of -- I wouldn't say 
 193 

 1 squabbling, but a certain amount of heated 

 2 discussions within the staff about how pulp and 

 3 paper should be treated, and Chairman Newsome 

 4 finally just said, "issue the letter." And so we 

 5 did. But the letter just says you're recognized 

 6 as an exempt commercial market. The fact that we 

 7 issued the letter means that we think that pulp 

 8 and paper are not agricultural commodities, but 

 9 there is nowhere any rationale stated. 

 10 And another question -- are corn basis 

 11 swaps agricultural commodities? And are OTC 

 12 contracts for things such as beef cuts or non-fat 

 13 dry milk -- OTC contracts that would then be 

 14 submitted to an exchange for clearing -- are these 

 15 contracts for agricultural commodities? Aside 

 16 from the pulp and paper question, we haven't 

 17 really made a determination about any of those 

 18 things. In each case, the status of a commodity 

 19 as an agricultural commodity or not determines 

 20 whether and how these things can be traded. As 

 21 with ethanol, if any of these things on the last 

 22 slide -- if any of those are agricultural 
 194 

 1 commodities -- then swaps involving them could 

 2 only be traded under the restrictions of Part 35. 

 3 Among other things, that means they couldn't be 

 4 cleared. If they're not agricultural commodities, 

 5 they could be cleared, they could be traded under 

 6 the 2(g) swaps exclusion, and they could be traded 

 7 on exempt commercial market. 

 8 So, clearly then, it's important to be 

 9 able to draw a line between agricultural and non- 

 10 agricultural commodities, and one way you could do 

 11 it is by source. Is it grown or cultivated? Is 

 12 it or was it alive? You could do it by use or 

 13 function. Is it used for human food or animal 

 14 food? You could do it by correlation with other 

 15 commodities. Does the market for the commodity 

 16 behave like an agricultural market or a 

 17 non-agricultural market? If you apply that to 

 18 ethanol, does ethanol trade more like corn, or 

 19 does it trade more like an energy commodity? Or 

 20 you could do it by degree of processing. How much 

 21 can a commodity be changed and still retain its 

 22 status as an agricultural commodity? And the best 
 195 

 1 example -- somebody this morning was talking about 

 2 plastic products that are made from corn, and this 

 3 slide use the same analogy for soybeans. 

 4 Soybeans, soybean oil, and soybean meal are all 

 5 enumerated agricultural commodities, but where do 

 6 you stop? Soybeans clearly are an agricultural 

 7 commodity, but provide the building blocks for 

 8 everything from candles to crayons, fabrics to 

 9 flooring, shampoos to solvents. Should any of 

 10 these products be considered agricultural 

 11 commodities? 

 12 When we were debating this internally in 

 13 the pulp and paper context, my question to some of 

 14 the people that wanted to adopt a broader 

 15 definition was, "wait a minute, the Washington 

 16 Post is made out of paper pulp and it's printed 

 17 with soybean ink. Is the Washington Post an 

 18 agricultural commodity?" So, that's the kind of 

 19 issues that we're trying to deal with. 

 20 What are some of the options for 

 21 addressing the issue? Well, the Commission could 

 22 propose a comprehensive definition of 
 196 

 1 "agricultural commodity." In fact, I've got a 

 2 draft of one up in my office. However, it's a 

 3 very hard thing to get a handle on, because there 

 4 are so many different gradations along the line. 

 5 Where do you draw the line between one thing and 

 6 another? In any event, the first option would be 

 7 to try to propose a definition. I hope that, if 

 8 it happens, it will be after I retire and somebody 

 9 else can write it. 

 10 Secondly, we could grant exemptions to 

 11 allow clearing of agricultural swaps on a 

 12 case-by-case basis in response to industry 

 13 petitions involving individual products. We could 

 14 do the same thing -- grant exemptions to allow 

 15 clearing -- on a class-by-class basis. So, for 

 16 example, we could grant a blanket exemption 

 17 allowing the clearing of livestock product swaps 

 18 so that swaps involving various types of beef cuts 

 19 are all entitled to an exemption as agricultural 

 20 commodities and you wouldn't need a separate 

 21 petition for each product. Or, finally, you could 

 22 grant a blanket exemption and just make ag swaps 
 197 

 1 subject to the same restrictions as 

 2 non-agricultural swaps. Just say, "all right, the 

 3 2(g) exclusion applies to all swaps, agricultural 

 4 and non-agricultural," and then you have mooted 

 5 the question of what's an agricultural commodity 

 6 at least in the swaps context. 

 7 And that's the last slide, so that's 

 8 kind of the issue that we're wrestling with, and I 

 9 guess, I'll leave it to the chairman. 

 10 MR. DUNN: Thank you, Don, and we 

 11 appreciate your outlining it, and I think you very 

 12 succinctly put up what's facing the Commission 

 13 here. We have two entities that are looking at 

 14 agricultural swaps and are very interested in 

 15 them, and let's get their perspective on them. 

 16 Let's start again with Dave Lehman. 

 17 Thank you for coming back, Dave, and give the 

 18 perspective from the CME group. 

 19 MR. LEHMAN: Thanks, Don, and some of my 

 20 slides -- and my first one actually sort of covers 

 21 some of the ground that Don just covered. Sorry 

 22 about that. 
 198 

 1 Our understanding is that to clear OTC 

 2 agricultural swaps, we need approval from the 

 3 Commission from two of the provisions of the Part 

 4 35 swaps rules, and that's subsection (b) and 

 5 section (c), and those are listed here that the 

 6 swap is not a fungible agreement with standardized 

 7 terms, and I'm not -- I guess I'm a little unclear 

 8 if that's really necessary after hearing Don's 

 9 comment that as long as they're privately 

 10 negotiated it would be considered to not be 

 11 fungible -- 

 12 MR. HEITMAN: Well, I was trying to just 

 13 simplify things a little bit for the purpose of 

 14 the presentation, but it would have to actually be 

 15 both. 

 16 MR. LEHMAN: -- because what we do 

 17 today, we do clear swaps today in ethanol, and 

 18 that will -- I'll get to that in a minute, but 

 19 they are standardized in their terms. They are 

 20 privately negotiated in terms of the buyer and 

 21 seller enter into the agreement's off (?) 

 22 exchange, and then they're entered into our 
 199 

 1 front-end clearing system by a futures commission 

 2 merchant representing one of the counterparties, 

 3 and that goes to the credit worthiness 

 4 consideration requirement, so there -- we need an 

 5 exemption from both of those. The ag swaps that 

 6 we propose to offer for clearing would meet the 

 7 other two provisions of 35.2(a) in that the 

 8 counterparties would be eligible swap participants 

 9 and (d) that the swap is not entered into or 

 10 traded on multilateral execution facility. As I 

 11 said, we do not intend to offer these for trading 

 12 on our -- either our electronic or open-option 

 13 platforms. 

 14 The benefits that we believe exchange 

 15 clearing, centralized clearing can provide to the 

 16 over-the-counter markers -- it's -- there -- we 

 17 really see this as a bridge between regulated, 

 18 exchange-traded markets and unregulated 

 19 over-the-counter markets, that by bringing these 

 20 into the clearing house we're able to increase 

 21 transparency into this market by publicly 

 22 reporting activity. We do report for our ethanol 
 200 

 1 swaps volume cleared every day and open interest 

 2 in those products, as well as a settlement price, 

 3 which is not the transaction price for the swap 

 4 but a price that we've valued. Our clearing house 

 5 values that transaction at -- for purposes of 

 6 margining and for doing the pay/collect. 

 7 So -- and that leaves the second 

 8 benefit. We provide a valuation of service to the 

 9 industry and a daily pay/collect cash flow between 

 10 counterparties through the clearinghouse. It also 

 11 enhances the ability to do market surveillance and 

 12 -- like bringing these over-the-counter 

 13 transactions into the exchange clearinghouse 

 14 you're better able to see what's going on in the 

 15 over-the-counter market in relation to a futures 

 16 market, and obviously those two markets work 

 17 together and the transactions in those markets 

 18 certainly are influenced by one another. Our 

 19 ethanol calendar swap product is settled every day 

 20 to the settlement price for the ethanol futures 

 21 contract for the corresponding futures contract. 

 22 Additional benefits -- these 
 201 

 1 transactions now have become transactions backed 

 2 by the capital and guarantee of the clearinghouse 

 3 of the exchange. CME Group's clearinghouse has a 

 4 $4 billion financial safeguard package in place, 

 5 and there's enhanced financial integrity through 

 6 the elimination of counterparty risk. 

 7 So, what we've -- we're doing again is 

 8 talking to our customers. As I said, we launched 

 9 an ethanol swap complex -- in December of last 

 10 year we launched two calendar swap products -- a 

 11 forward month and a previous month swap. The 

 12 market has migrated to the forward month swap. 

 13 Since December we've cleared over 45,000 contracts 

 14 in ethanol forward month swaps. We have open 

 15 interest at 12,000 contracts, which is about 400 

 16 million gallons of ethanol, so that's about 5 

 17 percent of the current ethanol production 

 18 capacity, and that was as of November 30th. 

 19 In addition, in October of this year -- 

 20 October 15th -- we launched an option on the 

 21 ethanol calendar swap. Again, it's traded off 

 22 exchange, traded directly between counterparties 
 202 

 1 and then entered into our clearing house for 

 2 clearing, and we've already reached 4,000 in open 

 3 interest in that option just in about six weeks of 

 4 trading. In addition, we launched basis swaps for 

 5 New York Harbor, Gulf Coast, Los Angeles in 

 6 October as well. 

 7 This chart shows the activity in the 

 8 forward month swap. This is how it comes in, and 

 9 it -- the bars-- the little bars are daily 

 10 transaction volume. We actually -- it's cut off 

 11 at the top of the chart -- we did 3600 contracts 

 12 as the record in terms of daily volume of 

 13 contracts cleared. I'll note that this contract 

 14 is half the size of the underlying ethanol futures 

 15 contract, so this is a 14,500-gallon contract as 

 16 opposed to a 29,000-gallon futures contract. The 

 17 blue line -- the light blue line is open interest, 

 18 and these are the number of contracts that have 

 19 been entered into clearing and have not yet 

 20 expired. Most of the contracts that the swap 

 21 contractors cash settled, it's settled to an 

 22 average -- a monthly average -- of futures prices 
 203 

 1 for the corresponding future, so these contracts 

 2 tend to be held to expiration and then cash 

 3 settled. 

 4 The additional products that we've 

 5 received requests from customers for, an 

 6 unsolicited in most cases. Don referred to them 

 7 -- dairy swaps -- requests for swaps on different 

 8 classes of milk, whey, dried whey, calendar swaps 

 9 and options, butter, lactose -- a whole range of 

 10 products. Beef products, as well, beef cutouts, 

 11 primal beef cuts, subprimal cuts, etc. In 

 12 addition, feed ratios. So, there's a pretty broad 

 13 level of interest out there in a number of 

 14 different products. 

 15 So, we talked about the regulatory 

 16 benefits. The benefits to the market that we 

 17 think make these attractive instruments and are 

 18 creating a demand is that it does enhance price 

 19 risk management. A basis swap can be used to 

 20 manage the risk between a specific location, the 

 21 cash price at that location, and the futures 

 22 price, and, as we've talked this morning, the 
 204 

 1 basis risk is increasing. We think this is a tool 

 2 that can augment our existing futures contracts 

 3 and provide a more complete risk management 

 4 solution. The increased transportation cost and 

 5 higher flat price levels are factors in why the 

 6 basis is more volatile. Improved capital 

 7 efficiency, again through daily market-to- market 

 8 margin process. The counterparties no longer have 

 9 risk with one another. 

 10 MR. LEHMAN: We mentioned the eligible 

 11 slot participant or eligible contract participant 

 12 can participate in these markets. I think if you 

 13 meet the $10 million net worth requirement, then 

 14 you're free to operate in the over-the-counter 

 15 slot markets without regulation. So, what we 

 16 think bringing these into the clearinghouse does 

 17 is it does help the smaller sized entity compete 

 18 because they don't have the balance sheet to 

 19 compete in the end in the market. 

 20 And, again, it may also provide 

 21 services, clearinghouse services for products that 

 22 are too small to support a futures contract. 
 205 

 1 I've listed the contract specs. I think 

 2 these are in your packets for one of our 

 3 corn-basis swaps. Again, this looks a lot like 

 4 the corn contract. It's 5,000 bushels, same 

 5 months, same price basis. They will expire prior 

 6 to the delivery month for the corresponding 

 7 futures contract, so there's no effect on the 

 8 convergence process or the delivery process. 

 9 The final settlement price would be a 

 10 five-day average of the difference between the 

 11 cash price at the location in the region that we 

 12 selected and the corresponding futures contract. 

 13 So we think that five- day averaging period in 

 14 terms of the settlement process ensures that that 

 15 will be a valid representative settlement price. 

 16 So, that's it in terms of our swap 

 17 presentation. What we would prefer as CME Group 

 18 is Don's final suggestion, that the Commission 

 19 uses exemptive authority to remove the 

 20 differentiation between agricultural swaps and 

 21 swaps on non-agricultural commodities, and that 

 22 would be the best solution in our view. 
 206 

 1 We, obviously, have a petition in draft 

 2 form that we submitted for receiving the authority 

 3 to clear corn basis swaps, and that's a pretty 

 4 laborious effort on our part as well as on the 

 5 Commission staff's part if we have to do that for 

 6 every product that we want to clear. 

 7 So, I look forward to the discussion. 

 8 MR. DUNN: Thank you very much. I 

 9 appreciate your presentation here. 

 10 Our next panelist is from ICE. ICE 

 11 Futures also has a petition in to the Commission 

 12 to look at certain agricultural swaps. We're 

 13 fortunate to have Tom Farley who is the 

 14 President/CEO of ICE Futures U.S. with us. 

 15 Tom remarked to me before the session. 

 16 He said, it's remarkable how candid you folks are 

 17 here. So he says he's going to change his 

 18 presentation a little bit because of that. 

 19 So, Tom, if you will, please. 

 20 MR. FARLEY: Commissioner Dunn 

 21 recommended that I not give too much of my 

 22 business plan away because Dave Lehman will be 
 207 

 1 taking notes over there on behalf of the CME. 

 2 Thank you very much, Commissioner Dunn, 

 3 for inviting Audrey Hirschfield, SVP and General 

 4 Counsel, and me to be here with you today. 

 5 Thank you also, Chairman Lukken and 

 6 Commissioner Sommers and Chilton. 

 7 In D.C., somewhere along the line, I 

 8 picked up the perception of being summoned to the 

 9 regulator or Congress to sit at one of these 

 10 tables with one of these microphones is a bad 

 11 thing. So, I came in today a little bit nervous. 

 12 I don't know if it was the Oliver North hearings 

 13 from 20 years ago, but this has been a great day 

 14 and I won't need Brendan Sullivan (?). 

 15 The presentations have been fantastic. 

 16 I want to, in particular, to acknowledge Don who, 

 17 just in the most succinct fashion I've ever heard, 

 18 explained all of the swaps regulatory environment. 

 19 By way of introduction, ICE Futures 

 20 U.S., formerly NYBOT, we changed the name about 

 21 halfway through this year. We have five main food 

 22 and fiber products: Coffee, cocoa, sugar, cotton 
 208 

 1 and orange juice. 

 2 Our customers have asked us to begin 

 3 clearing OTC swaps in our world sugar, coffee and 

 4 cocoa products. Then we, in turn, have asked the 

 5 Commission for the necessary exemptive orders to 

 6 facilitate this new business, this new line of 

 7 business for us. 

 8 World sugar, cocoa and coffee, these are 

 9 all commodities that are largely produced outside 

 10 of the United States and are listed for trading on 

 11 foreign markets such as the Light (?) in the U.K. 

 12 as well as foreign markets in South America such 

 13 as the BM&F and the Far East. 

 14 We're starting on day one with just 

 15 basic cash-settled swaps instruments, not basis 

 16 swaps as Dave just described. However, over time, 

 17 we would expect to add, to have new requests to 

 18 the Commission or, if you did an exemption, we 

 19 would expect to bring new products to market that 

 20 might include basis locations, swaps contracts 

 21 such as Dave described for corn or contracts based 

 22 on different qualities of the underlying 
 209 

 1 cash-settled but cash-settled based on different 

 2 qualities of the underlying physical. 

 3 We have not, as of yet, asked the 

 4 Commission for exemptive orders with respect to 

 5 the so-called enumerated ags that trade on our 

 6 exchange, cotton and OJ, the more domestic ags 

 7 with price supports, et cetera, although we've not 

 8 ruled that out either. 

 9 So, that's just a bit of background on 

 10 our exchange and the reason that Commissioner Dunn 

 11 invited us here today. 

 12 The OTC markets in sugar, coffee and 

 13 cocoa are alive and well. If there's one message 

 14 I'd like everyone to take away, it's that, that 

 15 they are already active markets. We're not 

 16 inventing new product here. In fact, we estimate 

 17 that the annual markets for sugar, coffee and 

 18 cocoa are between $8 billion $16 billion in terms 

 19 of notional value on an annual basis. 

 20 Every day throughout the world, market 

 21 participants engage in these swaps transactions, 

 22 typically cash-settled swaps transactions that, by 
 210 

 1 and large, settle based on the settlement prices 

 2 of our physically delivered contracts on the old 

 3 NYBOT and now ICE Futures US. 

 4 The reasons why market participants use 

 5 swaps and a lot of this may just be 101 for this 

 6 audience, but I'll move through it quickly. The 

 7 reason that people would trade swaps and not 

 8 futures are several. One is that swaps are more 

 9 customizable. Futures are kind of the ultimate in 

 10 standardized financial products. Swaps are much 

 11 more customizable. 

 12 Two, trading cash-settled instruments 

 13 eliminates what I call the oops factor, and that's 

 14 somebody who simply wants to hedge price risk. 

 15 They're not set up to take delivery or make 

 16 delivery of physical. 

 17 They go on vacation; they forget to exit 

 18 or roll their position; and now they have to go 

 19 charter a tanker to go pick up a thousand tons of 

 20 sugar in a port in Brazil. 

 21 A third reason why swaps are beneficial 

 22 or, at a minimum, a perceived reason is that you 
 211 

 1 can negotiate counterparty to counterparty and, if 

 2 you have a particularly large order, you can fill 

 3 it with one counterparty. People view that as an 

 4 advantage of swaps. It reduces their 

 5 administrative costs. 

 6 The bottom line here is that swaps have 

 7 real, tangible benefits. The market is active, 

 8 and the market is here to stay. Our goal as an 

 9 exchange is to improve the use of swaps and do 

 10 what we can to bring what we do best to the swaps 

 11 industry, and I'd like to talk about that just for 

 12 a minute or two. 

 13 You may have noted that my $8 billion to 

 14 $16 billion of the size of the OTC markets is 

 15 quite a large range. It's borderline absurd that 

 16 as a president of a futures exchange, I'm quoting 

 17 the market in terms of 100 percent. 

 18 I noted with interest earlier that David 

 19 and Mike were having a discussion about the OTC 

 20 markets, and Mike and David can agree, two 

 21 experts, I'd note, on agricultural markets. They 

 22 can agree it's a large market. David can say it's 
 212 

 1 six to one off-exchange to on-exchange for all 

 2 futures and can't really give an estimate of what 

 3 it is for ags, nor can I, nor can Mike. 

 4 I also can't tell you, moving to 

 5 something else I can't tell you. I can't tell you 

 6 what the open interest is in, say, sugar swaps, 

 7 and I can't give you an estimate of the inherent 

 8 credit risk that's embedded in these OTC swaps 

 9 markets. I can't tell you a lot, and this is a 

 10 classic case of a lack of transparency in these 

 11 markets. 

 12 I can tell you, however, that having 

 13 better and more transparent answers to those 

 14 questions is good for all of us, and it's good for 

 15 all of our constituents in this room. This is why 

 16 our customers are asking us to start clearing 

 17 swaps, and that's why we've come to the Commission 

 18 and asked the Commission to give us and our 

 19 customers the legal certainty that we need to be 

 20 in this business. 

 21 Stated broadly, there are two areas 

 22 where we think we can augment the swaps markets. 
 213 

 1 The first is lack of transparency that I just 

 2 spoke about. A lack of transparency gives rise 

 3 to, well, it gives rise to, at a minimum, 

 4 information asymmetry where a very small number, 

 5 typically larger participants, have the majority 

 6 of the information in the marketplace. 

 7 The second issue that we think we can 

 8 improve or augment is we can just add the central 

 9 counterparty model. I'll explain that in two 

 10 sentences because it's been covered several times 

 11 already today. By providing a central 

 12 counterparty model much like our friends and 

 13 competitors at the CME, we would allow smaller but 

 14 credit-worthy market participants to participate 

 15 in the market, and we would reduce some of the 

 16 systemic risk that exists in the market because of 

 17 this daisy chain of credit risk that results from 

 18 this interconnected spiderweb of bilateral 

 19 contracts between direct counterparties. 

 20 Our model for clearing OTC swaps, I have 

 21 to say is identical to what David described. I 

 22 think one of us is breaking into the other's 
 214 

 1 email. If you just slapped our logo on his 

 2 presentation and substituted the products, it's 

 3 nearly the same thing. 

 4 Our model will squarely address the 

 5 problems of transparency and credit intermediation 

 6 or credit amelioration in the OTC markets. With 

 7 regard to transparency, much like the CME, we'll 

 8 report open interest on a daily basis, volume on a 

 9 daily basis, the settlement prices that are used 

 10 to value these contracts. Again, these contracts 

 11 are already traded today, so this is just 

 12 additive. An exchange such as ICE Futures US will 

 13 be able to publish this information. 

 14 On the credit piece, our central 

 15 counterparty model will enable more market 

 16 participants to benefit from OTC swaps, as I 

 17 mentioned a moment ago, and it will reduce 

 18 systemic risk through the mutualization of risk. 

 19 I just want to point out that in this regard, this 

 20 is directly in line with what was contemplated and 

 21 expressly endorsed by the President's Working 

 22 Group on Financial Markets as well as by the 
 215 

 1 Commodity Futures Modernization Act of 2000. 

 2 Mechanics for clearing an OTC swap are 

 3 straightforward, and it's going to sound familiar 

 4 because it's very much like what David just 

 5 described in the CME. Market participants will 

 6 negotiate the terms of a sugar swap or a cocoa 

 7 swap or a coffee swap away from the exchange, and 

 8 they will agree to enter into that transaction and 

 9 then send that transaction to our exchange for 

 10 clearing. 

 11 They'll submit this transaction to the 

 12 exchange and substitute it for what we call a 

 13 cash-settled cleared only future. I think a more 

 14 common sense way of saying that is they're going 

 15 to substitute to us and we are going to give them 

 16 a look-alike swap or, simply put, they're just 

 17 going to pass their swap to us and we're going to 

 18 clear it. 

 19 We're then going to report open interest 

 20 and buying information, as I mentioned. The swap, 

 21 much like a standard futures contract, will result 

 22 in initial margin for both parties and then 
 216 

 1 variation margin for one of the parties depending 

 2 on which direction the value of the swap goes. 

 3 Finally, the swap will be fungible only 

 4 with other identical swaps. It won't be fungible 

 5 with, obviously, delivered futures. That's it for 

 6 the mechanics. 

 7 Finally, the merits, I don't think 

 8 anyone argues the merits of providing a central 

 9 counterparty model into the OTC swaps market. 

 10 They're obvious to us. They're obvious to our 

 11 customers. As I mentioned, these markets are here 

 12 to stay, and we think it's time in the 

 13 agricultural world that exchanges bring what they 

 14 do best, which is shining a bright light of 

 15 transparency, reducing systemic credit risk to 

 16 these markets. 

 17 Much like Dave, we've requested that the 

 18 Commission use its exemptive powers to enable us 

 19 to transact in these original three contracts 

 20 which we've requested. We, too, think that if you 

 21 do the work and you get comfortable, if we do the 

 22 work and we get comfortable, that it would make 
 217 

 1 sense to have more of a blanket approach, although 

 2 we'd leave that up to you to decide. 

 3 Thank you. 

 4 MR. DUNN: Thank you very much, Tom. 

 5 Now is the point where we open the discussion up 

 6 for the rest of the Advisory Committee to ask 

 7 questions or make comments. 

 8 MR. WESTON: I'm Ryan Weston with the 

 9 American Sugar Alliance. Thank you very much. I 

 10 really appreciate your all going through this 

 11 meeting. I work with almost all of you that are 

 12 commissioners, and I know you're a very thoughtful 

 13 bunch and take these issues very seriously. 

 14 I'd like to say I know that the 

 15 legislation left you in a little bit of a 

 16 conundrum. The enumerated commodities was the 

 17 best definition at the time for ag products. I 

 18 believe onions is in there if you look closely. 

 19 It was something we knew it was always going to be 

 20 an issue that the Commission would have to deal 

 21 with down the line. It's kind of the history. 

 22 You've done that, and you've come up with very 
 218 

 1 good rules and regulations. 

 2 The sugar industry, we basically polled 

 3 everyone and asked what was needed, with ethanol 

 4 in particular. When we were looking at the 

 5 designated contract markets, swap markets, we had 

 6 to look through many things. One of those being 

 7 how subject to manipulation is it, how big are 

 8 these markets. 

 9 The energy markets, energy swaps were 

 10 very developed back in 2000 when the legislation 

 11 was passed. As we look at the ethanol market 

 12 today, it's pretty large. It is treated as an 

 13 energy market, I think, by everyone out in the 

 14 business world. Because of that, we basically 

 15 decided, as the sugar growers and the sugar 

 16 industry, we would also consider that it should be 

 17 traded as an energy product and treated as an 

 18 energy product. 

 19 It's very tricky. We've watched the 

 20 correlation between corn prices and ethanol, and 

 21 corn prices are very high. Ethanol has gone down. 

 22 At one point in time, they were both very high. 
 219 

 1 People have tried to see if oil and ethanol are 

 2 directly linked. There is a correlation. They 

 3 are very tricky. 

 4 I know it's an early industry. It's 

 5 new, but it is, as we look at it, the future of 

 6 it, it probably is only going to get bigger. If 

 7 this Energy Bill ever gets passed the House and 

 8 the Senate, every mandate is bigger. I suppose if 

 9 the Energy Bill passes, the ethanol industry will 

 10 grow accordingly and, even if it doesn't pass, 

 11 it's still going to be quite large. Five billion 

 12 gallons is not small. 

 13 So, I know it will be difficult. I know 

 14 that we leave lots of tough questions up to the 

 15 Commission and your staff to work through and 

 16 decide. We do want to, I guess, be cautious that 

 17 we do anything that would strangle the industry 

 18 early on. 

 19 It's something where it's obviously very 

 20 important to corn right now. We think if 

 21 cellulosic takes off, it may be more important to 

 22 us. If the prices stay as high as they are with 
 220 

 1 other commodities, it may get to the point in 

 2 time, where we are a sugar first or sugar 

 3 consumption currently, but we want to make sure 

 4 the options are open in the future for all 

 5 markets, depending on how the industry grows. 

 6 So I appreciate it. I know it's tough, 

 7 but we do think it's a very large market. 

 8 I will say that the reason the ags were 

 9 enumerated and laid out was we spent a lot of time 

 10 back when I was on the Hill, when many of you were 

 11 in other jobs and some others here were working 

 12 very hard on the other side of the Hill for me, we 

 13 had all of the ag groups come in. 

 14 Most people felt safest at that time. 

 15 We knew how things were working. Everyone was 

 16 very confident in how the agency was dealing with 

 17 everything. So we left those enumerated in the 

 18 most highly regulated markets. 

 19 I think most of us in ongoing ag 

 20 products, we're still happy with that. We think 

 21 you've done a good job, but we know that things do 

 22 change. It's hard to believe it's been eight 
 221 

 1 years since that was passed. We were just joking 

 2 around that Chicago has changed a great deal. The 

 3 e-market has changed, and the underlying ag 

 4 markets themselves have changed a great deal 

 5 since. 

 6 So, we appreciate it. Thank you. 

 7 GREG: Thank you, Commissioner Dunn. 

 8 I'd like to make several broad and rambling 

 9 comments, if I could. 

 10 I'm Greg Dudan (?) with the 

 11 International Swaps and Derivatives Association. 

 12 First of all, with respect to the 

 13 continued discussions about transparency that have 

 14 come up throughout this dialogue, transparency is 

 15 a good thing. It comes up in the context of the 

 16 commitments of traders' reports. It was referred 

 17 by Tom with respect to the benefits of clearing. 

 18 I think it's important to recall what is 

 19 known as Goodhart's Law. Charles Goodhart was the 

 20 Finance Minister for Prime Minister Thatcher, and 

 21 he noted that there is often times an inverse 

 22 relationship between the ability of government to 
 222 

 1 obtain information and the value of that 

 2 information as an indicator of price. That's 

 3 because there's always a certain pool of market 

 4 participants that will trade transparency for 

 5 liquidity. They will not enter the market if 

 6 their activities are overly transparent, and 

 7 therefore you will, by exposing the line on that 

 8 market segment, it immediately loses its 

 9 informational value. So I think that's relevant 

 10 to the commitments of traders. 

 11 Chairman Lukken had said, how do we 

 12 break down these categories and how do we obtain 

 13 some level of granularity to provide a more 

 14 complete picture? On one level, of course, that 

 15 is exactly the right question to be asked, but on 

 16 another level you need to be very cautious 

 17 because, to the extent you're exposing people's 

 18 trading strategies, then these folks will be 

 19 reluctant to engage in these markets. 

 20 With respect to the ICE and CME 

 21 proposals, we think that it's a good idea to allow 

 22 these contracts to be cleared. Certainly a lot of 
 223 

 1 our members have collateral arrangements which 

 2 work just fine, and they are excellent credit risk 

 3 mitigation strategies. Nevertheless, there's 

 4 clearly demand, and so it wouldn't make sense, 

 5 from our perspective, to exclude the opportunity 

 6 to market participants to clear these types of 

 7 contracts. So, clearing is probably good to 

 8 revisit in Part 35 with respect to risk 

 9 mitigation. 

 10 Lastly, with respect to the definition 

 11 agricultural commodities, I would simply recall 

 12 the words of Justice Potter Stewart with respect 

 13 to whether or not a particular movie the Supreme 

 14 Court was reviewing was pornographic and obscene. 

 15 He said, well, you know there is no real 

 16 definition, but I know it when I see it. 

 17 So I would leave that with you as a 

 18 guide for a definition. 

 19 MR. DUNN: Any other comments or 

 20 questions? Any of the commissioners? 

 21 Well, if not, let me thank -- oh, I'm 

 22 sorry, Neil. 
 224 

 1 MR. GILLEN: Larry and I were over here 

 2 fooling around and making charts, looking at a 

 3 product from its form at harvest. It's 

 4 interesting, listening to Don. You can take 

 5 cotton which goes through a gin. From the gin, it 

 6 goes to the seed. From the seed, it goes to the 

 7 oil. From the oil, it goes to biodiesel which is 

 8 not agriculture, but it's a byproduct of a 

 9 byproduct of a byproduct, and corn is sort of 

 10 different. 

 11 The simple thing in my mind is one of 

 12 the options, your last options, was just do a 

 13 blank exemption for swaps. I mean you're just 

 14 never going to figure out for an ag, for ag swaps, 

 15 what it is based upon byproduct. You can just go 

 16 on and on and on. 

 17 Larry made another comment, Don, to 

 18 solve your riddle with the Washington Post. Is it 

 19 a paper product and seed? What is it? Larry 

 20 said, it's manure. 

 21 (Laughter) 

 22 MR. DUNN: I think some other people had 
 225 

 1 that thought as well. Any other questions or 

 2 comments? Well, if not, let me thank the 

 3 participants here, especially Dave and Tom for 

 4 coming in and providing transparency to this 

 5 Commission and to this particular issue because 

 6 often times we get requests for things and other 

 7 folks aren't aware of it. The opportunity to 

 8 bring this out and have the entire Ag Committee 

 9 listen to it and be able to comment on it is 

 10 certainly helpful for the Commission. So, thank 

 11 you all. 

 12 Now, if we can get ready and quickly 

 13 move into our final panel here today, this is 

 14 something that I think every commissioner I've 

 15 talked to has said they're anxious to hear about. 

 16 It's the global carbon market and what is taking 

 17 place there. 

 18 We're delighted to have Will Ferretti 

 19 today, who is with the Chicago Climate Exchange. 

 20 Dr. Ferretti has a long involvement in the climate 

 21 change arena. He has firsthand experience, 

 22 especially working in this new climate exchange 
 226 

 1 that we have here. 

 2 So, welcome, Will. We've also got two 

 3 experts here, whom I consider experts because 

 4 they're the people on the ground that are really 

 5 looking at this as a new market for farmers and 

 6 ranchers: Dave Miller who is from my home state 

 7 of Iowa, representing the Iowa Farm Bureau, and 

 8 Doug Sombke from South Dakota. 

 9 Thank you both for being here today to 

 10 talk about how farmers and ranchers look at this 

 11 issue. 

 12 So, I'd like to start, Will, with you 

 13 giving us an overview. 

 14 MR. FERRETTI: Thanks, Commissioner 

 15 Dunn, Chairman Lukken and Commissioner Sommers. 

 16 Thank you all for allowing us the opportunity to 

 17 speak to you. 

 18 I also bring greetings from our 

 19 Chairman, Dr. Richard Sandor who asked me to 

 20 express his regret that he couldn't be here to 

 21 join you today. He was called out of the country 

 22 unexpectedly at the beginning of the week and is 
 227 

 1 going to be gone for another two weeks. So I'll 

 2 do my best to fill in for him. 

 3 What I'd like to do is start, as you 

 4 suggested, by giving you kind of a broad overview 

 5 of carbon emissions trading and what we're doing 

 6 at the Chicago Climate Exchange but spend the bulk 

 7 of my remarks on what we see as the opportunity 

 8 for agriculture as a benefit of addressing this 

 9 global threat of climate change and global 

 10 warming. 

 11 Very quickly, about the Chicago Climate 

 12 Exchange, we are an exempt commercial market. We 

 13 operate an emissions reduction and trading program 

 14 for a suite of greenhouse gases. There's a family 

 15 of greenhouse gases recognized internationally, 

 16 six gases. We trade them and run a program to 

 17 address the reduction of those emissions. 

 18 We are a self-regulated rules-based 

 19 exchange. Regulatory services are provided to the 

 20 exchange by the financial industry regulatory 

 21 authority or formally NASD. 

 22 Our membership now, we started with 14 
 228 

 1 entities when we launched the exchange and the 

 2 program in 2003. We're now over 375 members. It 

 3 includes corporate and so-called naturals that you 

 4 might expect to be participating in this kind of 

 5 initiative. Twenty percent of the major utilities 

 6 in the United States, companies like American 

 7 Electric Power and NRG and Alleghany Energy, are 

 8 involved. 

 9 Seventeen percent of the Dow Jones 

 10 Industrials are participating members of the 

 11 exchange: DuPont, Intel, IBM and United 

 12 Technologies. Companies from the Fortune 100s 

 13 like Ford and Bank of America, Safeway grocery 

 14 chain, Motorola, International Paper are all 

 15 participating as are entities that you wouldn't 

 16 necessarily think might be involved here. Cities 

 17 like the City of Chicago, state governments like 

 18 Illinois and New Mexico have joined as have 

 19 universities are all participating in this. 

 20 When these entities join the exchange, 

 21 what they're doing is committing to reduce their 

 22 greenhouse gas emissions by 6 percent by the year 
 229 

 1 2010, and that's measured against a baseline of 

 2 the year 2000. So, each year, we put them on what 

 3 is essentially an emissions diet. They have a 

 4 target, emissions target to meet each year. If 

 5 they beat that target, they've earned allowances 

 6 that they can then trade on the exchange. If they 

 7 fall short of that target, they're obliged by the 

 8 rules of the exchange then to purchase allowances 

 9 to meet their compliance requirements. So, that's 

 10 one pool of allowances, carbon reduction 

 11 allowances that come into the exchange. 

 12 Anther pool that comes in comes from 

 13 projects that specifically try to either mitigate 

 14 or sequester carbon in specific projects, and we 

 15 refer to these as offset projects. The largest 

 16 part of that pool of offsets that's traded on CCX 

 17 right now is coming from U.S. Farms and forests. 

 18 So that brings me to what we see as the 

 19 opportunity for agriculture in this kind of 

 20 program. 

 21 The Intergovernmental Panel on Climate 

 22 Change and other have identified a whole range of 
 230 

 1 actions that can be taken right now by farmers and 

 2 foresters that can generate significant wins 

 3 against the effects of climate change and, in so 

 4 doing, provide new income streams for U.S. 

 5 agriculture. 

 6 CCX offsets projects are providing 

 7 farmers with the capability to meet this 

 8 particular opportunity. On our exchange today, 

 9 farmers are earning income from such practices as 

 10 continuous no-till, sustainable rangeland 

 11 management, forestation projects, forestry 

 12 projects and methane capture. 

 13 Looking at our no-till program alone, 

 14 nearly 10 million acres of no-till and grassland 

 15 projects have already been enrolled in CCX. 

 16 Thousands of farmers have or are in the process of 

 17 receiving payment for their carbon sequestration 

 18 services that they're providing. This is an 

 19 exchange kind of a business model on farms where 

 20 you have this supplemental source of income now 

 21 coming from the provision of an environmental 

 22 service in addition to the ag service that they 
 231 

 1 are already providing. Total payments to date, 

 2 just again on our no-till program, fall somewhere 

 3 on the order of fifteen to twenty million dollars. 

 4 If we look at the potential, in our 

 5 view, we see carbon as being the largest commodity 

 6 market in the world. Just to give you a point of 

 7 reference, the annual value of the current 

 8 Kyoto-mandated carbon crop -- it's a term that we 

 9 often refer to -- in Europe right now equals the 

 10 value of the U.S. corn plus U.S. wheat plus U.S. 

 11 soybean crop, equal value. The carbon traded in 

 12 Europe right now under the mandated Kyoto program 

 13 is equal in value to the corn, soybean and wheat 

 14 crops here in the United States. 

 15 It's been estimated that U.S. cropland 

 16 has the potential to sequester somewhere on the 

 17 order of 120 to 270 million metric tons of carbon 

 18 per year. As an exchange, we can't comment or 

 19 project where carbon prices are going. Right now, 

 20 they're trading less. Since we launched in 2003, 

 21 they've fluctuated between $1.50 roughly and just 

 22 short of $5. In Europe, under that mandated 
 232 

 1 program, carbon is trading at 25 euros or 

 2 thereabouts, roughly $30 U.S. So there's quite a 

 3 spread there between a voluntary program in the 

 4 United States and where a mandatory program is 

 5 going. 

 6 Some folks have estimated where future 

 7 prices in the United States might be. When you 

 8 take that capacity of American farmland to 

 9 sequester soil and attach those estimated values 

 10 of where carbon prices might go, it's been 

 11 calculated that farms' incomes could be enhanced 

 12 on the order of four to six billion dollars per 

 13 year as a consequence of providing that carbon 

 14 sequestration service. 

 15 To give you another perspective on what 

 16 that volume or that capacity of sequestration 

 17 means, agriculture could provide up to 25 percent 

 18 of the carbon reduction now being called for in 

 19 legislation that's being contemplated on the Hill. 

 20 There was a bill reported out of committee last 

 21 night in the Senate, the so-called 

 22 Lieberman-Warner bill, that would establish a 
 233 

 1 mandated carbon reduction regime in the United 

 2 States. Agriculture has a significant role to 

 3 play in that respect. 

 4 In closing, from our perspective, the 

 5 future looks bright with regards to agriculture 

 6 and its ability to address the challenge of 

 7 climate change. We're currently in the process of 

 8 expanding the territory for our no-till and 

 9 grasslands program. 

 10 Our offsets committee just recently 

 11 approved a sustainably managed rangeland program, 

 12 and we've go the first set of offset credits being 

 13 registered under that particular protocol. 

 14 We're undertaking R&D for reduced 

 15 nitrogen, emission payments and payments are now 

 16 moving forward under that program as is our R&D 

 17 for water quality and quantity payments are 

 18 underway. 

 19 So, with that, I again thank you for the 

 20 opportunity to present today. I'll be happy to 

 21 answer any questions following my colleagues on 

 22 the panel. 
 234 

 1 MR. DUNN: Thank you, Will. Let's turn 

 2 to Iowa. In Iowa, the Iowa Farm Bureau Federation 

 3 has really stepped out in a lead role, working 

 4 with farmers there. Dave, could you tell us how 

 5 it's operating in the state? 

 6 MR. MILLER: Thank you, Commissioner. 

 7 My name is Dave Miller, Chief Science Officer with 

 8 Aggregate Climate Credits. I'm also Director of 

 9 Research for the Iowa Farm Bureau Federation. So 

 10 I kinda wear two hats. 

 11 In fact, let me pass up to the 

 12 commissioners a copy of the comments and some 

 13 literature with regards to the carbon activities 

 14 that we have. 

 15 Aggregate Climate Credits was created to 

 16 deliver carbon credit aggregation services to 

 17 American farmers, ranchers and private forest 

 18 owners. Aggregate expanded the Iowa Farm Bureau 

 19 Federation carbon credit aggregation program which 

 20 began in 2003. We were, in fact, the first 

 21 agricultural aggregator that was registered with 

 22 the Chicago Climate Exchange. 
 235 

 1 With more than 1.3 million acres 

 2 aggregated from American farmers, ranchers and 

 3 forest owners in 25 states, we believe we are one 

 4 of the leading supplies of carbon credit 

 5 aggregation services to agriculture. Again, the 

 6 company is a wholly owned subsidiary of the Iowa 

 7 Farm Bureau Federation. 

 8 In a nutshell, aggregate is the country 

 9 elevator of carbon credits. That's kinda how we 

 10 position ourselves. Aggregate combines carbon 

 11 credits from agricultural offset projects 

 12 initiated by American farmers, ranchers and the 

 13 private forestry owners, creating pools of credits 

 14 verified by a third party and offered for sale 

 15 through the Bureau or the Chicago Climate 

 16 Exchange. 

 17 As Will indicated, a number of companies 

 18 but particularly electric power generators, 

 19 manufacturing companies, state and local 

 20 governments, are among the purchasers of those 

 21 credits. For more information, you can visit the 

 22 Chicago Climate Exchange web site for more detail 
 236 

 1 with regard to that. 

 2 The contract that we use as an 

 3 aggregator with our producers has two primary 

 4 elements. The first part of the contract 

 5 authorizes Aggregate to include the potential 

 6 offset project in one of our pools and to register 

 7 the carbon credits under the protocols and rules 

 8 of the Climate Exchange. 

 9 The second part of our contract 

 10 addresses the transfer of carbon credits to 

 11 Aggregate and sets forth the terms and conditions 

 12 for sales of such credits. It can best be 

 13 described as a delayed price contract with 

 14 specific terms for physical delivery or title 

 15 transfer, however you choose to look at that. 

 16 In compliance with the rules of the 

 17 Exchange, 20 percent of each year's credits are 

 18 held in a reserve account until the end of the 

 19 contract period. Once that contract period is 

 20 completed, the reserve credits are released and 

 21 eligible for sale. Those reserve credits act as 

 22 kind of a self-insurance against weather events 
 237 

 1 that can impact the compliance rate of credits. 

 2 The typical soil, forestry or rangeland 

 3 contract requires compliance with the terms of the 

 4 contract for a multiyear period which is usually a 

 5 minimum of five years. Participants who fail to 

 6 maintain compliance can be subject to recovery of 

 7 credits that were previously issued, although 

 8 credit recovery of forest and rangeland projects 

 9 is limited to the amount in the reserve if that 

 10 non-compliance is to do weather or other natural 

 11 disasters beyond the control of the project owner. 

 12 Activities under the direct control of 

 13 the owner are fully recoverable, i.e., if you cut 

 14 the forest down, if you plow the land, if you do 

 15 something to reduce the carbon-holding capacity of 

 16 a rangeland by a direct management activity, those 

 17 activities would be fully recoverable under the 

 18 terms of the contracts. 

 19 The carbon market continues to expand 

 20 from the original 20 or so founding members. The 

 21 Climate Exchange has grown to more than 380 

 22 members. Agriculture's role has also grown since 
 238 

 1 the initiation of the Exchange. There now are a 

 2 number of aggregators providing services to 

 3 farmers, ranchers and foresters across the 

 4 country. 

 5 The total number of offsets registered 

 6 on the Exchange is now greater 18 million. 

 7 Agriculture has provided nearly half of those 

 8 offsets, and there's a graph that illustrates the 

 9 breakdown. Ag soils make up about 42 percent of 

 10 that; forestry, about 2 percent; ag methane, 

 11 another 2 percent; fuel-switching, about 4 

 12 percent. We're a bit involved with registering 

 13 projects from ag soils, rangeland, forestry, 

 14 fuel-switching and ag methane destruction. So, 

 15 we're getting a broad bank of experience on how 

 16 this market develops. 

 17 Simply having a greenhouse gas emission 

 18 reduction does not necessarily mean that someone 

 19 will be granted a carbon credit. An individual 

 20 with an emission reduction must go through the 

 21 following steps to turn a qualified emission 

 22 reduction into a carbon financial instrument: The 
 239 

 1 project must undergo an eligibility assessment. 

 2 It has to be in compliance with the protocol. It 

 3 needs to undergo monitoring, verification 

 4 reporting and registration on an appropriate 

 5 exchange or in an appropriate registry. 

 6 After completing all these steps, the 

 7 project may be registered on the CCX and be issued 

 8 carbon financial instruments. These instruments 

 9 then become the vehicle for trading on the 

 10 exchange. As a CCX-registered aggregator, we take 

 11 projects and amenities that are too small to deal 

 12 directly with the Exchange through this process. 

 13 The market for carbon credits trades 

 14 daily. The carbon financial instruments are 

 15 registered by the year in which the emission 

 16 reduction takes place. This is called the vintage 

 17 of the credit. Earlier vintage credits can be 

 18 delivered against sales for later vintage credits. 

 19 Bids and offers are placed on the electronic 

 20 exchange platform, and again there's a graph that 

 21 shows the prices for those credits over the past 

 22 four years for the 2006 vintage. 
 240 

 1 The very first trade on the Exchange 

 2 occurred at $1.00 per ton. The market has been as 

 3 low as and I think the ultimate low was 85 cents 

 4 per ton for carbon early in the history of the 

 5 Exchange. The high was just near $5 for at least 

 6 one vintage. In the last 18 months, the price has 

 7 trended downward. Today's market traded between 

 8 $2.10 and $2.25. So it's a market that trades 

 9 8:30 to 2:00 on a daily basis. 

 10 The carbon market responds to supply and 

 11 demand pressures similar to other commodity 

 12 markets. In this case, the demand is the need 

 13 that members of the Exchange have for excess 

 14 allowances of other members or for offsets. The 

 15 supply side is determined by the amount of excess 

 16 emission reductions by Exchange members and 

 17 offsets provided by qualified projects and 

 18 Exchange-registered aggregators. In recent 

 19 months, daily trading volume on the Exchange has 

 20 been increasing. 

 21 In conclusion, it's my opinion that this 

 22 voluntary carbon market is actually functioning 
 241 

 1 quite well. I believe that a voluntary market 

 2 will continue to grow as federal and state 

 3 legislators debate the merits of various emission 

 4 reduction programs and develop the mechanisms by 

 5 which those emission reductions will be traded. 

 6 I've included -- I think it's also in 

 7 materials that Will brought -- some of the maps of 

 8 the credit rates that are determined by zone. The 

 9 top map is our soil offset map with the red area 

 10 being six- tenths per credit or six-tenths of a 

 11 ton per acre per year. Across the U.S., we range 

 12 from that six-tenths of a ton down to two-tenths 

 13 of a ton. The drier areas of the country that 

 14 produce less biomass per acre would be at the 

 15 lower end of the rates. 

 16 The middle map is the rate for grassland 

 17 offsets, ranging from one ton per acre down to 

 18 four-tenths of a ton, and then the third map is 

 19 the breakdown for the rangeland credits. 

 20 Again, I appreciate the opportunity to 

 21 be here and would again be happy to answer any 

 22 questions that would come in. 
 242 

 1 MR. DUNN: Thank you, Dave, and we would 

 2 like to reproduce this and make sure that all of 

 3 the members on the Ag Advisory Committee get a 

 4 copy. 

 5 MR. MILLER: Yes, I can get you more 

 6 copies of that. 

 7 MR. DUNN: Thank you. Dave has told me 

 8 that he has to catch a plane this afternoon. 

 9 So if he jumps off or runs out, it's not 

 10 because we're giving him a hard question or 

 11 anything. He just has to get going. 

 12 MR. MILLER: Our annual meeting starts 

 13 tomorrow morning, and I really do need to be back. 

 14 I've got a 4:50 flight. 

 15 MR. DUNN: Doug has also been very, very 

 16 active in this with the South Dakota Farmers 

 17 Union. 

 18 Doug, could you tell us what are your 

 19 experiences? 

 20 MR. SOMBKE: I need a little technical 

 21 assistance here. As Larry pointed out earlier, 

 22 farmers have a thing about having, feeling, 
 243 

 1 touching and seeing. So I'm going to show you the 

 2 presentation that we show our urban friends about 

 3 the carbon project. 

 4 Thank you. This is going to touch on a 

 5 lot of what Dave has talked about and what Will 

 6 just talked about. It's going to be something 

 7 you're actually gong to be able to see and touch. 

 8 He's working on it. There we go. 

 9 MR. DUNN: We have great staff. 

 10 MR. SOMBKE: The carbon credit program 

 11 is something that the Farmers Union has been 

 12 involved in through North Dakota Farmers Union. 

 13 They're the aggregator for South Dakota and the 

 14 National Farmers Union Organization. 

 15 This slide indicates if you go back to 

 16 your school days in science class, it shows how 

 17 carbon is cycled throughout the environment. 

 18 As you can see by the blue bars, it 

 19 pretty much exchanges itself, nature does, but the 

 20 red bars indicate man's intervention, the land 

 21 changing use. Of course, that offsets. But if 

 22 you look over at the fossil fuel side, the 6.3 
 244 

 1 billion tons of it that we are already into the 

 2 atmosphere in that recovery. 

 3 Carbon sequestration, a few gentlemen 

 4 already talked about the prevention and reduction 

 5 of it. This is just another slide that we use to 

 6 present to our potential participants. Also, the 

 7 removal of the carbon from the atmosphere is 

 8 another form of carbon sequestration. 

 9 Our soil organic matter is going to be 

 10 one of two things, either storage of CO2 in the 

 11 atmosphere such as plowing and/or sinking the 

 12 carbon. Don Recowski, the Soil Scientist at North 

 13 Central Soil Conservation Research Laboratory in 

 14 Morris, Minnesota, we consider a guru of carbon, 

 15 and he sees this as throwing money away. 

 16 What are the values of soil organic matter? These 

 17 are just a list of a few things. Of course, it 

 18 improves the soil structure, decreases erosion, 

 19 decreases moisture loss, increases infiltration, 

 20 increases soil water- holding capacity and 

 21 increases ability to take up nutrients while 

 22 decreasing the energy requirement for agricultural 
 245 

 1 operations. 

 2 What is a carbon credit? Certain kinds 

 3 of manufacturing store extra carbon in the soil. 

 4 This stored extra carbon has a value called a 

 5 carbon credit. These credits can be sold through 

 6 the Chicago Climate Exchange, a stock market type 

 7 trading house that brings buyers and sellers. 

 8 This has all been covered, so I'm going through it 

 9 quite rapidly. They are also responsible for 

 10 rules, compliance and regulations of the buying 

 11 and selling of credits. 

 12 Who buys these credits? As Will 

 13 demonstrated earlier, it started out with 14 

 14 companies, and now it's up to 375. Companies such 

 15 as Travelocity, for instance, buy them. When you 

 16 buy your airline ticket, you can actually purchase 

 17 the credits to offset the credits that the plane 

 18 will be using. 

 19 Again, North Dakota Farmers Union is 

 20 approved by the CCX as an aggregator. This allows 

 21 them to contract with producers for a five-year 

 22 contract. They group these contracts in blocks of 
 246 

 1 carbon credits. They sell the credits on the CCX, 

 2 and then they pay the producers for carbon storage 

 3 on their acres. 

 4 This carbon credit program is the 

 5 no-till, cropland to grasses and the rangeland. 

 6 The no-till total acres across the United States 

 7 that the National Farmers Union has signed up is 

 8 2.5 million acres. We've paid out over $2.7 

 9 million so far. Depending upon the prices, as 

 10 Dave stated, it fluctuates, but the price should 

 11 hold. In an average range, we should be looking 

 12 at over $5 million paid out to producers. 

 13 This is just an example of the way we 

 14 used to till. A number of our urban see this. 

 15 What they don't understand is they've never seen 

 16 what farming is actually like and how it's 

 17 changed. 

 18 This is no-till today, no-till planted 

 19 corn to corn stubble. Here is a little closer 

 20 look. As you can see, the stubble is quite thick. 

 21 This is corn planted to wheat stubble. 

 22 This is beans to corn stubble. Now, I guess I 
 247 

 1 should have pointed out also, if you look real 

 2 closely, you can also see in this no-till picture 

 3 there's actually some corn stubble there too from 

 4 the previous year of the wheat stubble. 

 5 No-till guidelines, as Will pointed out 

 6 a little bit more scientifically than I will, the 

 7 general rule of thumb is direct seed with no more 

 8 than 30 percent surface area disturbance. Strip 

 9 till is a lot more than 30 percent soil 

 10 disturbance. 

 11 In no-till crop practices, crops must be 

 12 grown annually. Soybeans must be seeded no more 

 13 than 50 percent of the available acres. 

 14 The fallow is permitted either 

 15 chemically or mechanically, but you can use 

 16 chemicals on your crops. 

 17 If you move a certain amount, there is a 

 18 rule. Well, I'm not exactly clear on what the 

 19 rule is: There is a how much straw can you move 

 20 or how much stocks you can move. Some guys bail 

 21 and chop, those acres are not qualified. 

 22 No-till planters and drills, these are 
 248 

 1 the ones that are accepted and hydrous 

 2 applicators, manure knife applicators and 

 3 represent of course the Phoenix harrow. 

 4 Implements not acceptable, the no bore 

 5 plow, tandem disk, chisel plow, field cultivator, 

 6 row cultivator and any smoothing or leveling 

 7 implement, harrowing or generally have too much 

 8 disturbance. Again, it's that 30 percent rule. 

 9 Of the hay land, cropland, planted to 

 10 grass or alfalfa is eligible. You must use 

 11 no-till practices when seeding and hay - and 

 12 seeding it to a crop. 

 13 The no-till program. You agree to 

 14 continuing no-till and row crop through five 

 15 years. The Conservation Reserve Program is 

 16 another program which is continued crop plant is 

 17 grass. You must not seed it before 1999. Agree 

 18 to keep it grass or forest through the contract. 

 19 Here's that map that Dave was talking about with 

 20 the different zones of soil types. 

 21 As you can see South Dakota, where I'm 

 22 from that eastern part of the country, of our 
 249 

 1 state, there's 23 counties on that side. We 

 2 signed up over 220,000 acres on that side just in 

 3 the first year. The orange, yellow, I'm sorry. I 

 4 am color blind, so it's a little bit hard for me 

 5 to distinguish this. That's more of a range land 

 6 side, as you get across the Missouri River. We're 

 7 seeing a lot of interest in the grazing portion of 

 8 the CCX. 

 9 We had a group of ranchers down by the 

 10 Gregory Area which is in the middle, central part 

 11 of the state and we signed up over 100,000 acres 

 12 just in the couple of counties and look for it to 

 13 grow. 

 14 The enhanced range land of vegetation 

 15 program is the one that they signed up for. As 

 16 you can see it's only available in Central and 

 17 Western USA. It requires a grazing plan. It 

 18 involved graze land practices that include light 

 19 and moderate stock rates and rotational grazing 

 20 and seasonal use. The income potential for 

 21 producers is ideal. 

 22 Dave pointed out it ranges upon the 
 250 

 1 price and which programs you enrolled in, of 

 2 course, makes a difference and where in the 

 3 country you farm. 

 4 Price of a carbon credits when sold is 

 5 another example. This is just an example of where 

 6 the range has been as we marketed our carbon 

 7 credits. Cropland using no-till practices, and 

 8 cropland seeding grass, and then the range land 

 9 again is just a recap of the programs that are 

 10 available. 

 11 And the forestry offset pool, such as 

 12 shelterbelts. It's something that's just being 

 13 opened up and I guess when I came here, I wasn't, 

 14 I really didn't know what this program was going 

 15 to amount to so maybe you can answer questions to 

 16 that. 

 17 The methane gas anaerobic digester, 

 18 that's a good project. What we're finding out as 

 19 we talk to people with the digesters is that they 

 20 are being approached by the companies putting them 

 21 in to sign over those credits as cost reduction to 

 22 the project. So those are pretty well captured 
 251 

 1 already. 

 2 And you have, of course, restoration or 

 3 creation of wetlands is a pending project. And 

 4 this is the website that we want people to go to. 

 5 The North Dakota Farmers Union Organization has a 

 6 direct link to the project. 

 7 I will say that we are finding more and 

 8 more interest on West River. Again, it comes down 

 9 to the trust factor. Many farmers, as Larry 

 10 pointed out, would rather deal in things they can 

 11 handle, see touch and feel. They don't quite 

 12 grasp the concept that they have something stored 

 13 in the soil, or can store in the soil that is 

 14 valuable to the whole world. 

 15 MR. DUNN: Thank you Doug. We'll open 

 16 it up now to the Advisory Committee for any 

 17 questions or comments. 

 18 MR. COYLE: I'm curious. You showed 

 19 quite a range of prices and different practice. 

 20 I'm just curious can you give a ballpark of how 

 21 many dollars per acre a farmer can generate by 

 22 using these practices? 
 252 

 1 MR. MILLER: Yeah, it again is a 

 2 function of the rate which is (off mike). You 

 3 know that up front, what you don't know is the 

 4 price. And different aggregators operate slightly 

 5 different in terms of how they do that credit 

 6 pricing. We operate, I'll call it a (off mike) 

 7 basis. Think of it as putting all of the credits 

 8 into a great big bin, selling off that bin, and 

 9 everybody gets their pro rata share of the average 

 10 price of the bin. Because the market's not (off 

 11 mike) for me to sell Doug's credits ahead of your 

 12 credits. Because we have pricing packs just on a 

 13 daily basis. 

 14 So we are using average pricing so we 

 15 think it's a fair (off mike) priority pricing. 

 16 (off mike) it ends up being between about 50, 

 17 depending (off mike) it could be as low as about 

 18 50 cents an acre or (off mike) grasslands. This 

 19 year we had some grasslands that could be up in 

 20 that $4 an acre. 

 21 On forestry, forestry can be (off mike) 

 22 a function of species, location and age of the 
 253 

 1 trees. And (off mike) is 15 years old would be 

 2 almost eight credits per acre per year. In a $4 

 3 market that could be $30 an acre or more. So it 

 4 ranges quite a bit. Hard woods (off mike) is 

 5 probably nine-tenths of a ton per acre per year. 

 6 So it really makes a difference as what the 

 7 specifics of the project are. 

 8 MR. DUNN: Larry. 

 9 MR. MITCHELL: I've got a question for 

 10 all three of you. Actually two questions and if 

 11 you can't answer them that's okay. It's just 

 12 something we need to get on the table. And we 

 13 mentioned Lieberman- Warner. 

 14 What does that offer more? In another 

 15 words, when we go to a mandated cap trade system 

 16 versus what we have now, that more critical 

 17 notice. One of the big issues surrounding that is 

 18 what some would call a safety valve. It's a cap 

 19 on the price of carbon. 

 20 Now, NRECA has already said they've got 

 21 to have it or it's the end of the world. I just 

 22 talked to the Fertilizer Institute and they 

 254 

 1 basically said if they don't have this safety 

 2 valve, if they don't have this cap on the price of 

 3 carbon in that legislation, we'll basically close 
 4 the remaining nitrogen plants in the country and 

 5 we'll be importing all of our nitrogen fertilizer. 

 6 I'm not choosing sides on this. Since I 

 7 have all three of you here in the room, I thought 

 8 I would ask, how does this impact this very young 

 9 sector of commodity trading and what farmers can 

 10 see in the future? 

 11 MR. FERRETTI: To the question of safety 

 12 valves and particularly putting limits on prices, 

 13 from our perspective we see potential danger in 

 14 doing so because you put a cap on a price, you 

 15 essentially have this situation where prices are 

 16 just going to migrate to that point and the 

 17 question is, what does that price then represent? 

 18 Does it really represent the true 

 19 marginal cost of the mitigation activity? 

 20 So there are some potential, there's 

 21 potential for market distortion as a consequence 

 22 of having that kind of a safety valve cap on 

 255 

 1 price. We don't have one within CCX. We've got 

 2 other mechanisms that attempt to address risk 

 3 associated with, for example a company's growth in 

 4 emissions. And we think those kinds of rules are 

 5 equitable, but allow the price to find itself 

 6 through the marketplace dynamics. 
 7 As to what more Lieberman-Warner does, 

 8 it effectively broadens the level of marketplace 

 9 participation than we have right now. 

 10 I mean, we have 380 members. It's not 

 11 inconsequential group. That group represents 16 

 12 percent of total large stationary sources of 

 13 greenhouse gases in the United States right now. 

 14 But you would expect that that bill is going to 

 15 bring in a whole lot more players. 

 16 One of the concerns that we do have 

 17 about the bill, it is with respect to how it's 

 18 dealing with agriculture. And we think most of 

 19 the bills that have been talked about on the Hill 

 20 right now don't fully recognize the potential that 

 21 agriculture can play in helping to move towards 

 22 these reduction targets that are being set out 

 256 

 1 there. And so that's an area that we and others 

 2 of our colleagues in the agricultural community 

 3 are attempting to advise members on the Hill about 

 4 what those implications are. 

 5 MR. SOMBKE: I agree with Will when you 

 6 put a cap on something, that's never good. 

 7 Farmers have stepped up this voluntarily. 

 8 I think that shows a lot. For one 

 9 thing, you know, they are already doing the 

 10 practice so why shouldn't they capitalize from it. 
 11 And secondly, you know, this is our world and I 

 12 think they realize the importance of sustaining 

 13 life here on this earth. At the same time, the 

 14 Climate Security Act, I think needs to be 

 15 addressed and I think it needs to be addressed to 

 16 that it rewards these participants, not penalizes 

 17 them. 

 18 MR. MILLER: I guess what I would add to 

 19 that is that both Will and Doug have said there 

 20 are issues that do exist within the Climate Act 

 21 that's being considered and they are issues 

 22 relative to some of the terms, you know, 

 257 

 1 additionality, permanence, some of those types of 

 2 factors. And agriculture is a little different 

 3 than a smokestack in those regards. You know, 

 4 people ask, can you guarantee that a ton of carbon 

 5 sequestered in a field today will never in it's 

 6 life be released? 

 7 The answer is no. I can't give you that 

 8 100 percent guarantee of permanence. But the 

 9 reality is that I can probably give you a 95 to 97 

 10 percent probability that it will never be 

 11 released, but I can't give you 100. 

 12 And so there's way in terms of -- the 

 13 science would say that the actual sequestration in 
 14 Iowa soils is about three-quarters of a ton per 

 15 acre per year, that the credit rate is six-tenths. 

 16 So we've discounted that. And those type of 

 17 approaches can deal with a lot of the issues that 

 18 get raised. Relative to the caps - price caps to 

 19 me. There's no record in history of them being 

 20 very effective. That's probably my response to 

 21 that. I think it's a failed mechanism that's been 

 22 proven to fail over years and years of experience 
 258 

 1 in markets. 

 2 That doesn't mean there aren't some 

 3 needs for some safety valves. Agricultural is 

 4 highly energy dependent. We understand some of 

 5 these linkages, but price caps probably aren't the 

 6 way to go. 

 7 MR. DUNN: Don. 

 8 MR. HEITMAN: I'm just curious and maybe 

 9 this is a dumb question, but if carbon credits are 

 10 trading for two or three dollars here and $16 in 

 11 Europe, why can't somebody figure out some way to 

 12 arbitrage? 

 13 MR. FERRETTI: They are. The 

 14 participation in CCX is quite broad in terms of 

 15 who, the members. We've got the naturals that 

 16 have described the corporates. We've got the farm 

 17 community involved in terms of off-set providers. 

 18 Another segment of the membership, what we call 

 19 liquidity providers and these are commodities 

 20 trading firms and hedge funds who in fact are 

 21 looking at the price differential between a 

 22 mandated program in Europe and the voluntary here 
 259 

 1 in the United States and are providing, not only 

 2 liquidity in the market, but are in there buying 

 3 on a speculative assumption. 

 4 MR. MILLER: In part it depends on for 

 5 what purpose you're buying the credits. If you're 

 6 buying credits to position a product as a carbon 

 7 neutral product, having off-set its manufacturing 

 8 processes to carbon. (off mike). And credits 

 9 from medical sources are adequate for that. 

 10 Compliance for the Kyoto requirements in Europe, 

 11 the U.S. credits are not recognized, so you have a 

 12 credit that's not arbitrageable into that market 

 13 for the compliance purpose. So it really depends 

 14 on what purpose the company might have behind 

 15 those credits. 

 16 MR. SOMBKE: What Dave just pointed out, 

 17 the Kyoto Agreement. The protocol. To my 

 18 recollection there's only two industrial countries 

 19 that haven't recognized it and that's the United 

 20 States and Australia. 

 21 SPEAKER: Australia recognized it. 

 22 MR. SOMBKE: Did they? So we're the 
 260 

 1 last ones now. 

 2 MR. COYLE: Thank you Mr. Dunn. Will, I 

 3 talked a little bit this morning about the 

 4 differences that you've talked about, the dollars 

 5 and it's actually $2 to $30 right now, not 2 to 

 6 60. So that's 15 to 1 difference and the primary 

 7 reason is the mandatory cap and trade system. 

 8 But I'm curious about the difference 

 9 between the program that we have and the program 

 10 in the EU. For example, could you explain the 

 11 differences do they include agricultural land or 

 12 not? And are there any other significant 

 13 differences? 

 14 MR. FERRETTI: Dave may be able to help 

 15 me on this one, too. But my understanding is that 

 16 right now the European program does not include 

 17 agriculture. In fact, at one point we were 

 18 talking to some European farmers about listing on 

 19 CCX. I don't know if we ever, I don't think we 

 20 ever got that far. Dave sits on our Off-sets 

 21 Committee and so he deals with our off-sets 

 22 protocol as well as applications for approvals to 
 261 

 1 register off-sets on the Exchange. 

 2 Other differences that may be addressed 

 3 and understand too, that what Europe is in right 

 4 now is a pilot phase. Their pilot program ends 

 5 this year and then they go into the so-called 

 6 Kyoto Phase next year running from '08 to 2012 and 

 7 things are likely to change during that timeframe. 

 8 Right now during the pilot phase they only address 

 9 one greenhouse gas, CO2. CCX addresses all six 

 10 greenhouse gases, the entire family of gases. 

 11 The regulated community, if you will, 

 12 the sectors included in the European program is 

 13 rather narrowly defined to heavy industry, 

 14 utilities, heavy manufacturing. Ours is 

 15 multi-sectored, broad-based including as I've 

 16 described earlier everybody from, you know, farm 

 17 and forest to cities, universities, and light 

 18 industrial as well as heavy industrial. So those 

 19 are the immediate differences between -- 

 20 MR. COYLE: So would you say that, I 

 21 mean, depending upon you know, what Congress does 

 22 and whether or not it gets signed into law, et 
 262 

 1 cetera. Take that aside. But our models so far, 

 2 do you think they hold more potential for a 

 3 greater amount of good in the marketplace and for 

 4 the world. I mean, given that we have ag, given 

 5 that we have a broader base of folks covered. 

 6 MR. FERRETTI: We like to think so. And 

 7 we also believe that we've avoided some of the 

 8 pitfalls that the European program experienced, in 

 9 terms of the initial allocation of allowances and 

 10 the subsequent impact on pricing that that had. 

 11 You know, they had a significant decline in prices 

 12 that some people immediately jumped on and were 

 13 saying ah, this is evidence that this kind of 

 14 program doesn't work. 

 15 It's a failure. The reality was that it 

 16 was a design flaw. I think we've taken a lot of 

 17 that into account. 

 18 We were quite happy with the comment 

 19 made by Senator Bingaman last year at a summit 

 20 that he and Senator Domenici had hosted on the 

 21 Hill where they were inviting input from a whole 

 22 variety of parties about what the architecture of 
 263 

 1 a U.S. climate mandate might look like and when my 

 2 colleague Mike Walsh finished making our 

 3 presentation the Senator said, it looks like 

 4 you've done all of the work why don't we just make 

 5 CCX the national standard. It was a hard 

 6 opportunity not to say no. 

 7 So we think we've got a lot of 

 8 experience that will contribute to the design of a 

 9 well assembled program in the United States. 

 10 MR. COYLE: My last question for you 

 11 Will. So is there something that you think that 

 12 we can be doing? And there may not be. Maybe we 

 13 are doing everything perfectly. But is there 

 14 something that you think we could be doing here, 

 15 the Commissioner, the staff could be doing, to 

 16 sort of anticipate what might happen? I mean, 

 17 other than looking at the law or looking at 

 18 potential law, so that when we get this. 

 19 I mean, if you've got a better mousetrap 

 20 and we may be getting a new law in the future, how 

 21 do we avoid having you wait for us, other than use 

 22 to do the appropriate due diligence, which of 
 264 

 1 course we will do. Is there anything you can 

 2 suggest? 

 3 MR. FERRETTI: You know, I will be happy 

 4 to consult with my colleagues back in Chicago. I 

 5 think the kind of open dialogues that we've had 

 6 with the Commission over the tenure of our 

 7 existence, I think, you know, bodes well in terms 

 8 of how we, you know, how the Commission can stay 

 9 on top of this issue and how we can provide advice 

 10 and input to the role that you need to be playing 

 11 ultimately in this particular marketplace. And 

 12 so, we will continue to be of service and 

 13 available to you. 

 14 MR. COYLE: I beg your indulgence, real 

 15 quick. I want to ask Doug and Dave one quick 

 16 question. 

 17 So I know it's difficult when you guys 

 18 are doing this program, or North Dakota is doing 

 19 this program, but you know, you are parts of 

 20 national organizations too, which have 

 21 overreaching policy. Have you all, your national 

 22 organizations written in favor of the cap and 
 265 

 1 trade legislation in the Senate? 

 2 MR. MILLER: At the moment American Farm 

 3 Bureau has not taken any position on the mandatory 

 4 cap and trade, they do have stated policy and have 

 5 had it for several years. They strongly support 

 6 the development of the voluntary market, but they 

 7 have no position on the mandatory at this point. 

 8 The American Farm Bureau policy session will be 

 9 coming up in January and it could be something 

 10 that may be addressed at that point in time. 

 11 MR. COYLE: And are you just in Iowa 

 12 Dave, or are you other states too? 

 13 MR. MILLER: We started just in Iowa and 

 14 as we moved into other states it became easier to 

 15 spin this out as a wholly-owned subsidiary. I 

 16 don't have to explain why is Iowa Farm being from 

 17 Mississippi. We're an aggregate, it has become a 

 18 vehicle for national implementation and we have 

 19 contracts in 25 states. 

 20 MR. COYLE: Doug. 

 21 MR. SOMBKE: I guess, I'd almost say 

 22 ditto. You know, we use North Dakota Farmers 
 266 

 1 Union because to set up another aggregator it 

 2 takes a lot of assets. And if South Dakota was 

 3 going to do it, we couldn't do it. We don't have 

 4 that capability, so therefore we go through 

 5 national through North Dakota. 

 6 MR. COYLE: And what about the support 

 7 of the Lieberman- Warner proposal? 

 8 MR. SOMBKE: We look forward to working 

 9 with them, but as far as the cap, no. 

 10 MR. COYLE: Have you guys written a 

 11 letter, has national written a letter? 

 12 MR. SOMBKE: Yes. Yes, we've written a 

 13 letter in support of working with them, yes. 

 14 MR. COYLE: Thanks for your patience for 

 15 my questions. Thanks. 

 16 MR. DUNN: Excuse me. While I go back, 

 17 because there might be something I missed here. 

 18 For the land use practice, who certified it? Is 

 19 it a self certification or the producer? Is it 

 20 the aggregator or do you have an outside entity 

 21 like Soil Conservation Service? 

 22 MR. MILLER: I can address that. It is 
 267 

 1 a third party certification or verification by 

 2 third party, or self verification by a producer. 

 3 We operate it really to a large degree, similar to 

 4 how USDA operates the government program. In that 

 5 a farmer goes in and certifies his activities and 

 6 then they spot check. 

 7 We ask our participants to certify every 

 8 year their compliance status with us, and then 

 9 there is a third party exchange approved verifier, 

 10 but it's a third party verifier that spot checks 

 11 10 percent of our contracts every year. Our 

 12 compliance history is right between 98.8 to 99.7 

 13 percent compliance. So a very solid compliance 

 14 record in terms of what that third party verifier 

 15 is finding in terms of compliance. 

 16 MR. SOMBKE: That's a very good 

 17 question. And I'm sorry I didn't talk about that 

 18 because we do talk about that in the presentation 

 19 we present to the producers. Producers are the 

 20 only ones that can receive the payments. The 

 21 landowner cannot. It's because of the sign up at 

 22 the FSA office such as Dave alluded to, you need 
 268 

 1 to present your 578 form which only the producer 

 2 can produce. 

 3 MR. DUNN: A final question here from 

 4 me. Has there been any impact then on the primary 

 5 product that that producer may be involved in? Be 

 6 it corn crop or livestock? 

 7 MR. SOMBKE: Not to my knowledge. The 

 8 way we present this to people is, you're doing 

 9 this already. Don't change your practice just 

 10 because you're going to gain another buck or two 

 11 an acre. That's not the whole point here. The 

 12 point is to get paid for what you're sequestering 

 13 now. Now, does that mean they won't change in the 

 14 future? 

 15 I'm not going to say that, because if 

 16 the price would get up to what the Europeans are 

 17 getting, I think you're going to see a lot of 

 18 changes. 

 19 And plus, you know, the fuel cost is 

 20 getting more expensive and guys are going to start 

 21 doing a lot more no-till. 

 22 MR. MILLER: I would probably position 
 269 

 1 slightly differently, in that we are rewarding 

 2 early adopters as opposed to paying for what we're 

 3 just doing because it's not business as usual. 

 4 Continuous no-till is not the norm. The record 

 5 would indicate that about 62 million out of 350 

 6 million acres a year are no-till, but probably a 

 7 small fraction of those are continuously no-tilled 

 8 every year. And then we take it a step farther 

 9 and require a five-year continuous no-till 

 10 contract with recovery if you fail for all five 

 11 years, if you fail to honor that in any one of the 

 12 five years. That's not business a usual. It's a 

 13 fairly strict --t that we're putting into that 

 14 contract relative to compliance requirements. 

 15 So while - they may be comfortable with 

 16 the practice and in fact we position it, I 

 17 probably don't want a brand no-tiller committing 

 18 to five years of something he's never done before. 

 19 I want them to have some experience with the 

 20 practice before they commit to a long term fee 

 21 that affects their whole livelihood. And so yes, 

 22 we want them to have some experience with it, but 
 270 

 1 this is not business as usual. It is 

 2 substantially beyond that. 

 3 For a lot of people, what we are finding 

 4 is the conversion to continuous no-till has - 

 5 there are some issues that arise with that. 

 6 Some producers find some production 

 7 issues that arise with that, but they tend to work 

 8 through those and over time the reductions in 

 9 energy consumption, the enhancements to soil 

 10 structure, enhancements to tilth, and a number of 

 11 other things in about three to five years give 

 12 them positive payback to what they are doing. 

 13 And so we are seeing, particularly as 

 14 energy prices go higher, more interest in no-till 

 15 type of practices and adopting the types of 

 16 practices for which credits can be granted. And 

 17 it back to just because I sowed the soybean field 

 18 doesn't mean I'm going to get a carbon credit. It 

 19 goes way beyond that in order to qualify through 

 20 the protocols. 

 21 MR. FERRETTI: Yeah, I will just echo 

 22 Dave's point. Our purpose here is drive change 
 271 

 1 and to drive farmers to undertake practices that 

 2 are going to generate important environmental 

 3 service. One more anecdotal evidence in that 

 4 respect has been offered by one our members. 

 5 You may be aware that Senator Richard 

 6 Lugar registered his farm in Indiana to 

 7 participate in the program and he has a so-called 

 8 back forty that's been unproductive for any other 

 9 kind of use that he planted in hardwood trees and 

 10 he's earning carbon credits from the sequestration 

 11 service being provided by those trees. And he has 

 12 become a rather vocal advocate among his colleague 

 13 farmer sin Indiana about, here's a productive way 

 14 to use an otherwise unproductive piece of land on 

 15 the farm. So again, the idea here is to drive 

 16 change and behavior and practice. 

 17 MR. DUNN: Chairman Lukken and I have 

 18 had an opportunity to hear the Senator on this. 

 19 Bob, question or comment? 

 20 MR. CASHDOLLAR: Bob Cashdollar, Farmers 

 21 Organization. Are hardwood trees and no-till soy 

 22 beans equal in carbon sequestration and, what about 
 272 

 1 crop rotations and all of those other farm 

 2 management practices. How is that dealt with? 

 3 MR. SOMBKE: As Dave said, forestry 

 4 depends on the type of trees, the age of the trees 

 5 and so forth. The no-till is all the same. 

 6 The no-till acres are all the same. It 

 7 doesn't matter if you plant corn, soy beans, 

 8 wheat. It doesn't matter. 

 9 MR. CASHDOLLAR: What about 

 10 vegetable-type crops? Are the involved? 

 11 MR. SOMBKE: No. No. There was a 

 12 difference. They did have alfalfa included in the 

 13 grass before. Now it's no longer, now it's a 

 14 no-till. 

 15 MR. FERRETTI: I've brought some packets 

 16 with me that describe -- they have fact sheets, 

 17 one-pagers that describe the credit rates for each 

 18 of the programs that we have been talking about 

 19 here. So you can get an idea of how many tons per 

 20 acre in the case of the soil program and so on, 

 21 for our different type of off-set programs. 

 22 MR. CASHDOLLAR: And the farmer certifies 
 273 

 1 each year or just for what's on their contract? 

 2 MR. SOMBKE: No, he signs up for the 

 3 contract for five years but he certifies every 

 4 year through his FSC 578 forms. 

 5 MR. CASHDOLLAR: I'm a real baby at this 

 6 stuff. I mean, a lot of this is really new to me. 

 7 But what I learned last week is that in India, 

 8 Europeans are coming in and buying carbon credits 

 9 in the OTC market often at really low prices. And 

 10 so the commodity exchange in CDEX wants to create a 

 11 market much like you guys have, I guess. So the 

 12 question I have is for all of the countries who 

 13 have signed up under the Kyoto Protocol, is that 

 14 one single market? I mean all over the globe, any 

 15 country that signed up? So that's a single market 

 16 and these carbon credits can be bought and sold 

 17 across all of those borders? 

 18 MR. FERRETTI: The Kyoto Protocol allows 

 19 for, has a mechanism called the Clean Development 

 20 Mechanism. And what the CDM does is that it 

 21 enables a so-called Annex One country, which is 

 22 essentially are the developed countries, the 
 274 

 1 industrialized countries of the world. 

 2 To use as part of their compliance under 

 3 the Kyoto Reduction Cap, a certain percentage of 

 4 compliance can be achieved through the access off 

 5 CMS credits, Clean Development Mechanism credits. 

 6 And the credits come from projects in non-Annex 

 7 One countries. So countries like India and China 

 8 that are undertaking fuel-switching projects or 

 9 HFC destruction, or renewable energy projects can 

 10 earn CDM credits that can them be purchased and 

 11 used, delivered for compliance in the European 

 12 program. Yes. 

 13 We recently just conducted an auction, 

 14 by the way, for Tata Motors in India who had a 

 15 whole portfolio of CDM credits from projects that 

 16 it had invested in, renewable energy projects and 

 17 had tried to sell those in the over-the-counter 

 18 market and was not happy with the kinds of prices 

 19 that they were being offered and so we conducted 

 20 an auction on their behalf and were able to get 

 21 them higher than over-the-counter prices. 

 22 MR. DUNN: Any other questions or 
 275 

 1 comments from the Committee? Anyone? 

 2 Mr. Chairman, any comments that you 

 3 have? 

 4 MR. LUKKEN: No, but I just want to 

 5 express my appreciation for everybody coming in 

 6 today. This is a fascinating topic and something 

 7 we're trying to closely follow as these markets 

 8 develop. I know it's also something that we're 

 9 considering in the current re-authorization. 

 10 There is some mention of carbon trading and what 

 11 category of regulation it falls in similar to our 

 12 discussion of ethanol, whether it's Ag's or 

 13 Energy's. So that's the thing I think we're going 

 14 to keep a close eye on, but definitely this was 

 15 useful today to understand better how the 

 16 agriculture markets are using this and how it can 

 17 be beneficial to the end user. So thanks 

 18 everybody for coming in today. 

 19 MR. DUNN: Well, I would like to thank 

 20 this panel. I would like to thank all the 

 21 participants. This has just been a tremendous 

 22 day. It seems to have gone a lot longer than it 
 276 

 1 should have and I apologize for that, for not 

 2 keeping better tabs on the time. But it went 

 3 very, very fast for me because I learned a lot and 

 4 this was tremendous. I'd like to thank the staff 

 5 here at CFTC for putting this on, everyone from 

 6 our technical people to the folks that helped you 

 7 in and out and got your badges on you and all of 

 8 that. And my staff in particular, Eric Juzenas 

 9 who is my chief of staff, Jason Gizzarelli who is 

 10 my legal assistant, and Nicole McNair. The three 

 11 of them have really, really worked hard on putting 

 12 this together and that hard work has developed 

 13 into this, what I think was a really, really good 

 14 Agricultural Advisory Committee. 

 15 Thank you all for being participants 

 16 here. 

 17 (Whereupon, at 3:43 p.m., the 

 18 PROCEEDINGS were adjourned.) 

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