Comments 

Of 

American Cotton Shippers Association 

To 

Commodity Futures Trading Commission 

On 

Speculative Disruption In Cotton Futures Contract 

April 22, 2008 

The American Cotton Shippers Association (ACSA) submits these comments for the 

record in the Commodity Futures Trading Commission’s (CFTC) Round Table Forum 

impelled by the disruption caused in the agricultural futures contracts by excessive 

speculative interests. In particular, our comments pertain to the speculative disruption in 

the Intercontinental Exchange’s (ICE) No. 2 Cotton Contract. 

Interest of ACSA 

ACSA, founded in 1924, is composed of primary buyers, mill service agents, merchants, 

shippers, and exporters of raw cotton, who are members of four federated associations 

located in sixteen states throughout the cotton belt: 

 Atlantic Cotton Association (AL, FL, GA, NC, SC, & VA) 

 Southern Cotton Association (AR, LA, MS, MO, & TN) 

 Texas Cotton Association (OK & TX) 

 Western Cotton Shippers Association (AZ, CA, & NM) 

ACSA’s member firms handle over 80% of the U.S. cotton sold in domestic and export 

markets. In addition, our members also handle a myriad of foreign growths of cotton, 

which is forward priced based on the New York futures market. Because of their 

involvement in the purchase, storage, sale, and shipment of cotton, ACSA members, 

along with their producer and mill customers, are significant users of the ICE’s No. 2 

Futures Contract. Therefore, they are vitally interested in a return to an orderly futures 

market reflecting market fundamentals that are not grossly distorted by speculative 

interests. Accordingly, we urge the CFTC to restore orderly price discovery to allow the 

cotton contract to once again be utilized by commercial participants who physically 

handle cotton for price discovery and to effectively hedge their purchases and sales. 

Congress Authorized Futures Trading in Agricultural Commodities for Price 

Discovery & Hedging 

In 1921, the U.S. Congress authorized contract market designations in the agricultural 

commodities for the purposes of trading in futures contracts primarily for the purposes of: 

• Hedging against price risks; 

• Discovery of prices through vigorous competition; and 

• Actual pricing of commercial transactions. 
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The Congress acknowledged that while futures contracts offer an investment opportunity, 

this conduct should be subordinate in importance to the commercial uses for which the 

agricultural contract markets were created. 

In establishing the agenda for the April 22nd Roundtable Discussion, the Commission 

requested comments on Price Discovery in the Agriculture Futures Markets, including an 

overview of the market fundamentals, the role of speculators, index funds and 

commercial hedgers, the adequacy of transparency in the markets, and the adequacy of 

contract terms and conditions. In the discussion that follows we establish that the market 

fundamentals bear little relationship to the speculative activity in the ICE Number 2 

Cotton Contract. As a result, commercial hedgers have exited this market, due to the fact 

the traditional cash to futures relationship has ceased to exist. 

 

This situation is the result of a recent phenomena, the advent of index funds with an 

estimated aggregate value of $1 trillion and the participation of Over-the-Counter (OTC) 

traders, which take a myriad of forms. While bringing record liquidity to the agricultural 

contracts, these entities have turned such contracts into investment contracts, thereby 

defeating the purposes for which said agricultural contracts were created. The result has 

rendered the agricultural contracts, particularly the cotton contract, ineffective for 

hedging against price risks, the discovery of prices, and the actual pricing of commercial 

transactions. The physical markets in the agricultural commodities have been adversely 

impacted precluding cooperatives and merchants from offering price quotations to 

farmers or end users since they cannot use the contracts for hedging purposes. 

The New Speculative Activity Ignores Market Fundamentals 

Creating Severe Strain on the Cash Trade Resulting in the Lack of Price Discovery, 

the Loss of a Hedging Tool, & Higher Margin Costs 

Since January, the U.S. cotton industry and its supporting financial institutions have 

lacked confidence in the ICE Number 2 Cotton Contract as a vehicle to manage its price 

risks through hedging and to seek price discovery. 

By early March, the open interest had reached record levels of just over 300,000 contracts 

or 30 million bales of cotton. About two thirds of this open interest was in the May and 

July contract periods, while the other third was in the December contract month. Since 

the U.S. produced only19 million bales in 2007, the commercial trade (producers, 

cooperatives, merchants, and mills) represented a much smaller portion of this volume. 

The commercials that held the physical cotton had sold futures to lock in their basis and 

carry the cotton until sold and shipped. 

This basis was determined when the producer, cooperative or merchant agreed to the 

physical sale. It is imperative that a traditional hedger be able to hedge by locking in his 

basis to reduce price risk, and that the market providing the hedge represent the 
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underlying cash market value. It is equally critical to the interest of his or her lender. 

Banks demand that a client’s position be marked-to-market on a daily basis so that they 

can value the collateral held by the bank in the trader’s account. 

Speculative trading, at a time when not one additional bale was consumed or destroyed 

by weather, drove up cotton futures prices by over 50 percent in a two-week trading 

period in late February. On March 3rd, the price in the front month (March) reached 

$1.09, when two weeks previous to that it was at 72 cents. At the same time, the physical 

price was in the low 60 cent range. On that day, in a short time frame, the commercial 

trade did not have sufficient time to adjust to this irrational event, which was unrelated to 

the physical or cash market – a market with half of last year’s 19 million bale crop still 

unsold – the highest level of U.S. stocks since 1966 - a market with a 50 percent U.S. 

and world stocks-to-use ratio given record world yields and reduced consumption due to 

poor economic conditions. 

The commercial trade was subject to an immediate, unwarranted, and severe financial 

strain – a strain never realized before in the history of the U.S. cotton industry. Credit 

lines and lender’s perceptions of client risk were tested well beyond the norm. To meet 

margin calls, banks would have had to value a clients’ physical stocks well beyond what 

the market could bear. The value of the cash commodity bore no relationship to the 

futures or option prices. No potential buyer of the physical commodity, either a textile 

mill or another merchant, would pay an amount in excess of its spot or cash market value. 

Therefore, to satisfy its lenders, the commercial trade had to close out futures at huge 

losses to generate the cash to repay its loans. Some smaller merchants, who could not 

withstand these losses, were forced to discontinue operations. Larger merchants with 

more substantial balance sheets were severely impacted as well and in some cases had to 

cease or greatly reduce the scope of their operations. At the end of the day, over $1 

billion would be posted in margin calls. 

The current futures market situation precludes any form of price discovery because of the 

potentially high margin risks. Lacking the financial ability or willingness to hedge in the 

futures market, the result is that merchants and cooperatives cannot offer farmers forward 

prices. This situation also precludes individual farmers from using the futures market. 

Lacking price discovery, the U.S. cotton farmer cannot adequately make production 

plans. The same goes for a U.S. textile mill who cannot determine what his raw fiber 

costs will be in future months. Further, this situation has severely impacted foreign 

producers, particularly in Australia and Brazil who use the ICE Contract to price forward 

contracts up to two years in advance of planting. 

The entry of large speculative funds and index funds into the agricultural futures 

contracts has clearly distorted both the futures and the physical or cash markets in 

agricultural commodities. There is such an abundance of cash in the hands of these funds 
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that their impact on the agricultural markets is overwhelming and negates the primary 

purposes for the existence of such contract markets. 

Re-examine Hedge Exemption for Index Funds Not Involved 

In Agricultural Markets 

Lacking confidence in price discovery, the U.S. cotton industry and some of the world’s 

leading producers are now at a virtual standstill.1

 The U.S. cotton trade has successfully 

utilized the cotton futures contract as the foundation for its business model for over 135 

years. Overnight, we have been stripped of a vital tool in which to conduct our business. 

We are now exposed to greater risk, which allows only the few highly financed or 

leveraged companies to function. 

Unregulated speculation has severely limited our role of making a market for our 

producer and mill customers. In the future, how can producers maximize their price at the 

 

1 In normal times of abundant supply, futures will trade at full carry from the first to the second futures 

month. “Full carry” in this context is for the certificated stock – cotton eligible for delivery on the futures 

contract as distinguished from regular cotton inventory. The difference between the two is the weight and 

overage penalties that accrue on certificated stock as it remains under certification for extended time 

periods. For cotton under certification between four and twelve months, these penalties amount to 3.5 lbs 

of weight per bale per month. So if, for example, a trader were to take delivery of this cotton in May and retender the bales on July futures, he would invoice each bale in July at seven pounds less than he paid for it 

in May. This seven pounds amounts to just over $5 per bale at current prices (7 lbs @ .73 equals 5.11). This 

needs to be added to the cost of carry on regular inventory. Regular carry amounts to about $5.50 per bale 

per month in a Memphis warehouse (Memphis is where the bulk of the current cert stock is stored). To 

summarize, the cost of carrying cert stock for two months from May to July amounts to about $16.10 per 

bale ($5.11 penalty + two months carry @ $5.50). This amounts to 322 points at 500 pounds per bale. 

Between May 1 and July 1 there will be 600,000 bales of certificated stock with an age of four months or 

older. This is roughly 60 percent of the 1 million bales in the cert stock. This means the weighted cost of 

carrying the entire cert stock from May to July is 290 points (600,000 bales @322 and 400,000 bales @ 

243). In theory, then, 290 points is the maximum spread that May should trade under July, since that is 

sufficient discount to ensure a risk-less transaction, buying May and selling July. “Risk-less,” that is, 

except for the cash flow risk of owning over one million bales hedged with short July futures for two 

months! In the event the cotton market should repeat its recent performance and spike say thirty cents per 

pound, the owner of the cert stock would need to come up with an additional $150 million to meet margin 

calls before he could liquidate his seemingly “risk-free” trade. Few if any members of the cotton trade are 

in position to take this cash flow risk. This is proven by the 360-point spread at which May/July was 

trading at last week. 

The additional 70 points over the cost of carrying the position for two months reflects the trade’s current 

unwillingness (or inability) to take this cash flow risk. In normal times, merchants would trip over each 

other to lock in such a margin, yet the market has traded at this level. In fact, far from rushing to lock in 

this margin, merchants continue to add additional bales to the cert stock, presumably to get the cotton off 

the balance sheet along with the accompanying short futures. This implies extraordinary levels of risk 

aversion, and a failure of the market to provide accurate price discovery. 
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farm gate or textile mills minimize their costs at the receiving dock lacking a futures 

market that provides accurate price discovery? 

We simply cannot function in a market with unrestrained volatility unrelated to supplydemand conditions or weather events. The ICE Number 2 Contract is no longer a rational 

market for price discovery and hedging – its use to the commercial trade has been 

minimized. It is now an investment vehicle for huge speculative funds that have created 

havoc in the market unimpeded by fundamentals or regulation. It is a market overrun by 

cash precluding convergence of cash and futures prices, hedging, and forward contracting 

– a market lacking an economic purpose – a market not contemplated by the Congress 

when it authorized futures trading of agricultural commodities. 

While speculative interests are vital to the functioning of a futures contract, a balance 

must be struck. In that regard, the CFTC is urged to take the necessary and immediate 

action to bring this about and restore the commercial trade’s confidence in the futures 

market. Therefore, we recommend that an index fund with a hedge exemption should 

restrict its position in a commodity to the dollar allocation or the percentage of 

funds allocated to that commodity as defined in its prospectus and recorded with the 

CFTC. Further, any variation should be subject to speculative position limits, and 

that such funds should report their cash positions on a weekly basis. 

We also submit that the role of the unregulated swaps market is contributing to this 

situation since there is no limit to or transparency in their trading activity. It is our 

recommendation that the CFTC monitor and oversee all swaps and OTC activity by 

requiring the reporting of all swap and OTC contracts by market participants, and 

that it determine the aggregation of positions from all sources, including the 

exchanges, ETFs, swaps, OTC, and all other trading entities. Further, that all nontraditional hedge accounts, those not involved in the commercial enterprise of 

physically trading bales of cotton, be reported as a separate individual category. 

Cotton Margin Requirements Are Arbitrary & Onerous 

The role of margin requirements should insure the efficient operation of a contract market 

by maintaining a balance of accounts between the longs and shorts and when necessary 

by requiring additional margin calls to effect orderly settlement in volatile markets. Most 

importantly, margin requirements should be fair, consistent, and facilitate the efficient 

functioning of a contract market. That is not the case with cotton margin requirements. 

The margin requirement in the ICE Number 2 Cotton Contract is arbitrary, capricious, 

and unreasonable. The cotton contract does not margin futures to the close of the futures 

contract month, but establishes margins at the synthetic level determined by the close of 

the options contract in that month. While the futures month may be locked at the limit 

there are no limits on the option’s contract, therefore, in that situation the option is likely 

to close at a level well above the futures close. This onerous requirement limits the ability 

of the commercial trade to obtain the requisite financing to use the contract market, 
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thereby precluding the use of the contract market for price discovery and hedging. 

While the margins are established by the contract markets and do not require approval of 

the Commission, the Commission does have emergency authority under Section 12a(9) of 

the Commodity Exchange Act2

 “to direct the contract market whenever it has reason to 

believe that an emergency exists, to take such action as, in the Commission’s judgment, 

is necessary to maintain or restore orderly trading in ... any contract market.” The current 

situation is such an emergency pursuant to the statutory definition as it constitutes a 

“major market disturbance which prevents the market from accurately reflecting the 

forces of supply and demand for such commodity.”3

 In this case cotton. Such an 

emergency exists, and we urge the Commission to use it emergency authority to, inter 

alia, require that the ICE and its clearing members adhere to the practice of 

margining futures to futures settlements and options to option settlements and that 

only those involved in the physical handling of the agricultural commodity (cotton) 

be eligible for hedge margin levels. 

 

 We urge the Commission to promptly adopt our recommendations. These appropriate and 

minimal measures should help bring transparency to the cotton contract, limit excessive 

and disruptive speculation unrelated to market fundamentals, restore price discovery, and 

encourage the commercial trade to utilize the contract as a hedging mechanism thereby 

allowing producers and textile mills to once again have access to forward contracts as 

risk management tools. 

 In taking this necessary action we respectfully suggest that the Commission be firm in its 

resolve and that it ignore those who would justify this irrational imbalance in the U.S. 

agricultural contract markets on the grounds that the necessary oversight, reporting, and 

regulation of the index funds and swaps operators would drive this business offshore. 

That is a competition issue that should be resolved in the international marketplace. It is 

not the role of the Commission to guarantee the exchanges record trading volumes, but to 

assure that the agricultural contracts provide price discovery and hedging. The CFTC’s 

role is to protect those that Congress intended it to protect - the commercial users of the 

agricultural contract markets. 

By taking action to restore the integrity of the agricultural contract markets the 

Commission will be fulfilling the legislative intent that its role as an independent 

regulatory agency is to prevent “excessive speculation ... to the detriment of the producer 

or the consumer and the persons handling commodities and the products and byproducts 

thereof in interstate commerce rendering regulation imperative for the protection of such 

commerce and the national public interest therein.”4

 

 

2

 7 USC 12a(9) 

3

 Id. 

4

 7 USC 5 
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ACSA supported the establishment of the CFTC as an independent regulatory agency in 

1974. It continues to support the Commission as such and urges it to fulfill its statutory 

duty and resolve the current crisis in the agricultural contract markets. The Commission’s 

failure to assume that duty would call into question its role as an independent regulatory 

agency.