We want to know from the Commodity Futures Trading Commission its total activity in this unprecedented default; the specific actions it has taken and those it expects to take.

Also there is the question as to whether the CFTC, as it was created a year ago, has the legal authority and resources to carry out its responsibilities.

We believe this is a very serious matter and one that cannot be permitted to happen again.

For that reason, we have called witnesses today who are most closely connected with these particular activities and are seeking from them testimony as to precisely what happened and why it happened.

At this point, I will insert a statement by Senator Dole. [The prepared statement of Senator Dole follows:]

STATEMENT OF HON. ROBERT DOLE, A U.S. SENATOR FROM KANSAS

Mr. Chairman, I commend you for scheduling this oversight hearing on potato futures trading. Certainly, all of us are concerned about last month's massive default by sellers of potato futures contracts. But, perhaps more important, this situation needs to be explored fully to prevent such tragedies from occurring in the future, either in potatoes or other commodities.

It is my hope that those testifying at this hearing will provide answers to the following types of of questions:

1. Why did the default occur? Were the New York Mercantile Exchange and the Commodity Futures Trading Commission aware of the developing problem before the default actually occurred?

2. Has the potato futures contract been serving any useful economic purpose or has the contract been used only for speculation?

3. What corrective action has the Commodity Futures Trading Commission taken? Has the Commission responded to the responsibility given it by Congressional mandate? I look forward to the testimony.

Senator HUDDLESTON. Our first witness will be Mr. Richard B. Levine, president of the New York Mercantile Exchange in New York.

Mr. Levine, if you will proceed.

STATEMENT OF RICHARD B. LEVINE, PRESIDENT, NEW YORK MERCANTILE EXCHANGE, NEW YORK, N.Y.

Mr. LEVINE. Mr. Chairman and members of the committee: I am grateful for the opportunity to present these comments to this subcommittee.

I am Richard B. Levine, president of the New York Mercantile Exchange. The exchange has been designated by the Commodity Futures Trading Commission as a contract market for futures trading in platinum, palladium, fresh frozen imported boneless beef, U.S. silver coins, gold, heating oil, industrial fuel oil and, of course, Maine potatoes. The exchange also conducts a spot market in silver dollars and butter.

The exchange is a 104-year-old institution, and futures trading in Maine potatoes has been carried on since 1941.

On May 25th of this year, three clearing member firms of the exchange failed to tender delivery notices involving 997 Maine potato contracts. The subsequent failure of three contract lots to meet delivery inspection standards and the failure of the delivering firm to replace them within the allowable time raised the total number of defaults to 1,000 contracts.

The exchange can well appreciate the subcommittee's concern over this default in view of the subcommittee's interest in the activities of the Commodity Futures Trading Commission.

Therefore, I am pleased to have the opportunity to increase your awareness of how the exchange is dealing with the situation, demonstrating its self-regulatory responsibilities, responding to the regulatory interests of the Commission and planning for the future with an expansion of its potato futures contract to embrace additional growing areas.

The fact of the default is simple to understand: A failure to deliver and a failure to fulfill futures contract obligations by three firms.

The issues involved, however, are complex and in the case of many factors, are still in the process of discovery by investigation and verification.

The exchange audits and investigations staff has already compiled a mass of data and evidence for presentation to our business conduct committee.

This committee will bring charges against any exchange member or member firm found to have violated exchange bylaws or rules. The exchange's adjudication committee will pass upon these charges and the board of governors will impose penalties if the charges are sustained.

The procedures for dealing with the default are no less complex than the issues. A fair market value for the undelivered potatoes has been determined by a special committee appointed for that purpose.

Our board of governors has already held hearings on the value determined by the committee and, upon request of member firms involved, has continued those hearings until June 22.

Upon their conclusion, the board will decide whether to change the fair market value determined by the committee and after its decision, the three defaulting firms will pay to the 14-member firms who did not receive delivery the difference between the contract settlement price on the last day of trading and any higher fair market value.

If this value is unchanged from the committee's figure of $10.66 per hundredweight, or $5,330 per contract, present holders of long positions will receive $980 per contract.

The exchange clearinghouse committee will also hold hearings to determine whether any additional payments should be made to any individual contract holders who can prove special damages not compensated by the ordinary settlement.

This opportunity to receive fair compensation, by the way, is specifically provided under the default provisions of the contract.

The clearinghouse committee has already held lengthy hearings on prospective penalties to be assessed against the defaulting firms by reason of the default.

These hearings will be continued on June 25, June 29, and June 30. also upon request of the firms involved.

The committee's recommended penalties will be the subject of additional hearings before the board of governors which will make the final determination.

The exchange is thus affording due process to all parties. Needless to say, the procedures and the issues have been the recent pre

occupation of almost as many attorneys as there are actual customers involved.

The public, the exchange community, the Commission and this subcommittee await the resolution to this situation while due process is served.

And served it will be, in an effort to afford fairness and equity and opportunity or mitigating comment by exchange members or member firms facing penalties for their actions.

Once served, however, due process will result in appropriate and responsible exchange action. The exchange is fully aware that its credibility and self-regulatory responsibility will be demonstrated by the manner of its disposition of the matter.

At the same time, the exchange is accountable to the Commission which, as you know, is pursuing its own investigation. I can testify that this investigation is being conducted intensively. However, inasmuch as the Commission's investigation and the exchange's activities are pending, I am sure the subcommittee will agree that this is neither the time nor the forum for the discussion of the complex details involved in this matter.

Moreover, the exchange would seriously compromise its efforts and procedures to deal effectively with the default, the penalties resulting from it, and the disciplinary proceedings resulting from exchange rule violations if more than a general overview of the situation were provided here.

Nevertheless, subject to these constraints, at the conclusion of my statement, I shall try to be as responsive to questions as the circumstances permit.

On May 27, 2 days following the default, the Commission urged the exchange to limit trading to liquidation only in the Maine potato contract for next May's delivery.

The exchange complied on the following day, requesting and receiving authority to limit trading to liquidation only in this delivery month.

The Commission has requested that the exchange submit for its approval a revised contract which would increase the supply available for delivery.

Under our revised contract, the exchange believes it has the basis to persuade the Commission that a May delivery option is feasible. A large number of varietal types of potatoes will be deliverable from virtually all Eastern potato-growing areas. Delivery will be required by truck rather than rail, although rail delivery will be possible, pursuant to action by the board of governors, should delivery exclusively by truck be impractical at any time.

The broader geographical potato-producing areas covered by the contract will create a more useful hedging vehicle. Comments of potato industry representatives to date indicate a high probability of success for the new contract.

Finally, while the subcommittee's interest in this default is understandable, its members and staff should keep in mind the capability with which Congress endowed the Commission to deal with events even so unlikely and unpleasant as this.

The Commission's power to regulate futures trading is more than adequate. In fact, it is awesome.

I have no doubt the Commission views this situation as a test of its own capability, jus as the New York Mercantile Exchange is being tested as a responsible public institution.

I am confident that both the exchange and the Commission will emerge the stronger for this test.

I ask that you share this confidence and defer both formal inquiry and judgment until the record of performance has been established. The board and administration of the exchange are totally immersed in this task, and have no doubt of its importance. The Commission, as well, has made the exchange keenly aware that its own views and actions are based on the same understanding.

Senator HUDDLESTON. Thank you very much, Mr. Levine.

I appreciate the specific and detailed explanation of what the exchange has proposed and is attempting to do after the fact of the default.

It seems to me that an important part of this inquiry is what the actions of the exchange were, when concerns were expressed that default might occur.

Certainly, questions were raised about the deliverability of the short contracts. They were raised by members of the Commodity Futures Trading Commission staff; your staff was aware and had some

concern.

Can you tell me specifically what that concern was early in April. Mr. LEVINE. The exchange is always concerned, Mr. Chairman, with the development of large customer positions. Late in March, the exchange first asked for customer positions from its clearing member firms.

The exchange was aware of the existence of the short positions and went back to the clearing member firms involved on numerous occasions to indicate the exchange's concern that the member firms assure themselves of their customers' capability of performance, and that, in turn, the exchange would look to its clearing member firms for demonstration of responsible performance under exchange rules. Senator HUDDLESTON. Did you have an actual meeting with the traders to advise them of their responsibility to avoid creating a disorderly market?

Mr. LEVINE. Mr. Chairman, the exchange recognizes and deals with its clearing members. It does not effectively know their customers. The exchange can know who the customers are but it does not deal with them nor can it regulate them; it does not deal with nor can it regulate the customers' market activities. It can regulate the activities of the member firms carrying those customers' accounts.

Mr. Chairman, the record should show that at no time was there ever a worry that there would be a default. There was a concern about the available supply of potatoes which was determined to exist in adequate supply for the shorts to continue in satisfaction. There was never a suspicion that there could have been a default.

Senator HUDDLESTON. Well, of course, the deliverable supply is the thing that would lead to a default. It certainly ought to be a red flag that you should have expressed a good deal of concern about and investigation into it.

As a matter of fact, on several occasions, the acting regional CFTC Administrator discussed with officials of your exchange the possibility of substantially increasing the margin requirements for large

74-822-762

traders who were not liquidating their positions and this was not done.

Was there any specific reason why it was not done?

Mr. LEVINE. Senator, the exchange made a determination prior to the end of trading—and I might add that all of this is part of the exchange's responsibility to make its report to the Commission.

Without getting into a great deal of detail, let me assure you that the exchange did determine that prior to the end of trading in the May contract, a sufficient supply of potatoes existed relative to the expected quantity to be delivered many fold.

The liquidation pattern of the market was not inconsistent with prior history.

The option that the clearing members on the short side of the market and their customers have to get out of the market should not be overlooked. Should these customers and the clearing members have determined that the risk of nondeliverability was so great, they had the option of not delivering the potatoes.

They chose to obligate themselves to deliver.

That obligation, the exchange looked to these member firms to perform. The exchange has normal additional margin requirements on the first of each delivery month and these were fulfilled. We were aware of the substantial financial sufficiency that the customers had demonstrated to the clearing member firms carrying their accounts. Senator HUDDLESTON. Well, are you saying that the number of open contracts on May 7-1.911 I believe-was not uncommon, not unusual, that being the last day of trading?

Mr. LEVINE. That was very unusual, Mr. Chairman. What was not unusual was the decline in the commitment pattern during the 10 days prior to the last day.

Now, at the beginning of the last day of trading, the commitment was 3.422 contracts. That figure was 16 percent less than the average commitment at the beginning of the last trading day during the prior 10 years.

Second, historically, on the average over the past 10 years, 93 percent of the exchange's commitment is liquidated on the last day. That would have indicated to the exchange, had the exchange been concerned with a default, had the Commission been concerned with a default, had anyone been concerned with a default, that the likelihood existed for no more than 250 contracts to remain open after trading on the last trading day.

The 1,911 cars that remained open came as a shock to everybody concerned. The pattern of liquidation prior to the last trading day was more than normal.

Senator HUDDLESTON. So the pattern was not unusual except as you say, it was even better maybe under normal circumstances but by the end of trading that day you had 997 default contracts? Mr. LEVINE. No, sir; between the end of trading on

Senator HUDDLESTON. May 25?

Mr. LEVINE. That is right; on May 25 there were 997 contracts in default.

Senator HUDDLESTON. Well, if this were so normal and the exchange had such little concern about it, why do you suppose that representatives of the Commission were in such constant and persistent contact with the exchange, requesting that they, No. 1, en