Implementation of the Dodd-Frank Act
Farmer-owned cooperatives use over-the-counter (OTC) derivatives (commodity swaps) to hedge the commercial risk of their own operations and to provide customized risk management tools to farmers and ranchers. Increasingly, producers are depending on their cooperatives to provide them with tools to manage price risk and lock in margins as volatility in commodity markets has increased in recent years.
NCFC encourages Congress to take an active oversight role as the Commodity Futures Trading Commission (CFTC) develops regulations implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). It is imperative that regulations maintain the ability for farmer-owned cooperatives and their producer-owners to effectively manage their commercial risk in the future.
As regulations to implement the Dodd-Frank Act are put in place, NCFC is working to ensure that the CFTC takes into account the unique nature of cooperatives and their continued ability to provide risk management products and services to their members. Farmer cooperatives must not be subjected to the same level of regulation as the Wall Street financial institutions that the Dodd-Frank Act is intended to cover. While NCFC’s focus primarily has been on who will be regulated as a “swap dealer,” excluding forward contracts from the definition of a swap, the end user exception to mandatory clearing of swaps, position limits, and other issues that would affect farmer co-ops have cropped up during the process, including the potentially burdensome recording and recordkeeping requirements for futures and hedging transactions.
NCFC is supportive of legislative initiatives in the 2017 reauthorization of CFTC, including: clarifying the definition of a bona fide hedge; codifying a CFTC provision to allow for margin funds to be transferred to a customer’s futures commission merchant (FCM) within one full business day of market close; and, reducing recordkeeping requirements in the cash commodity markets. Those provisions are included in the House-passed H.R. 238, the Commodity End User Relief Act. It is unclear as to whether the Senate will take up CFTC legislation in 2017.
As processors and marketers of commodities and suppliers of farm inputs, cooperatives are commercial end-users of commodity swaps. Cooperatives use swaps to effectively minimize risks associated with price movements in commodities such as grain, dairy products, livestock, energy and fertilizer. In addition, swaps give cooperatives the ability to offer customized tools to producers, helping to better manage risk and returns and provide more predictable profitability.
In order to provide risk mitigation services, cooperatives must have affordable access to the OTC market with other commercial counterparties, allowing the cooperative to “aggregate” the risk of offering forward contracts and swaps to farmers.
Farmer and Cooperatives’ Use of Swaps to Hedge Commodity Price Risks
Outlined below are several examples of how cooperatives in different sectors of U.S. agriculture participate in the swaps market and provide valuable risk management services to their farmer members. Many of the examples only trade one to five contracts at a time, and thus are not set up to be centrally cleared. NCFC is working to ensure that regulatory requirements on these types of transactions do not become cost prohibitive under the Dodd-Frank Act, thereby enabling the continued use of these increasingly important risk management tools for farmers and cooperatives.
- Dairy: Co-ops provide customized hedging solutions to dairy farmers, allowing them to lock in positive margins. To guarantee those margins, farmers buy financial futures on corn and soybean meal, while selling Class III milk futures. However, many farms are not large enough to utilize Chicago Mercantile Exchange (CME) contracts. Due to their size and scale, co-ops have the ability to facilitate hedging for farmers through the use of swaps. For other milk producers, co-ops help to greatly reduce cash flow risk with swaps as the farmer is not subjected to daily mark-to-market (margin) requirements put forth by the exchanges. This encourages risk management strategy implementation and helps ensure future profitability.
- Grain: Local co-op elevators will offer farmers a minimum price for future delivery of a specific volume of grain and may also give the farmer the right to the average market price over the time period if it is better than the guaranteed price. The local elevator will then offset that risk by entering into a swap with a cooperative in a regional or federated system. The larger cooperative will then aggregate its exposure to the swaps with local elevators and enter into an offsetting swap with a dealer or other commercial counterparty.
- Livestock: Co-ops assist livestock producers by offering customized contracts at non-exchange traded weights while also reducing producers’ financial exposure to margin calls. Because exchange contracts are traded in 40,000-50,000 pound sizes, producers can better match the corresponding number of head they have to the swaps offered by the co-op (20,000-25,000 pounds). These contracts are based off the CME for live cattle, lean hogs and feeder cattle. The co-op offsets its risk of those contracts with producers by entering into a corresponding swap with a predetermined counterparty (through a broker).
- Fertilizer: Large inventories of fertilizer are necessary to provide farmers with timely service as fertilizer is produced year round and there are only seasonal applications. However, fertilizer producers and distributors do not have access to exchange-traded fertilizer contracts. A growing OTC market for fertilizer products helps co-ops hedge away inventory and price risk during volatile times, such as those experienced in 2008.
- Fuel: Customized solutions are developed by the co-op to assist individual farmers with their fuel hedging needs as individual farmers do not have the fuel demands necessary to consume a standard 42,000 gallon monthly NYMEX contract. A co-op can offer swaps to farmers in 1,000-gallon increments, depending on their specific needs, or forward contracts where the risk of offering those contracts are offset with a swap counterparty.
- Small Producers: A co-op can aggregate its members’ small volume swaps or forward contracts and transfer that risk to a swap partner. A swap dealer or other commercial counterparty would otherwise not have the interest in servicing such small entities.