The CFTC should avoid a two-tier system, and a new lesson for ETF investors.
A recent flurry of activity in commodity ETFs has led to a matching flurry of articles on our side, laden with details about fund assets, position limits, and index rules for rolling futures contracts. The nitty-gritty is vital for investors in these complicated funds who want to make sure their investments are safe, but it also makes it too easy to lose sight of the big picture: what first motivated regulators to step into the market, what the shape of regulations are to come, and what all this means for individual investors who want some commodity exposure. We on the ETF research team would like to take a step back and address what we've seen from the Commodity Futures Trading Commission deliberations thus far, what we applaud and what concerns us, and finally the major lesson that ETF investors need to know when investing in markets like commodities.
Bradley Kay is Director of the European ETF Research team.
Should the CFTC Really Worry About ETFs?
Regulators began to investigate potential manipulation in the commodities futures market back in mid-2007 after the 2006 turmoil in the natural gas markets caused by the risky bets and collapse of Amaranth Advisors hedge fund. Political concerns grew again in 2008 as oil prices soared past $140 per barrel, pulling gasoline prices up with them. Early concerns about market manipulation centered on hedge funds, proprietary trading by banks and other leveraged, flexible investors with opaque portfolios.
In 2009, Congress became interested in commodity ETFs through an investigation of elevated wheat futures prices in 2008. The final report of the Senate Permanent Subcommittee on Investigations, entitled "Excessive Speculation in the Wheat Market," found that indexed investments in the Chicago Board of Trade wheat futures produced sustained high futures prices that even failed to converge to the spot cash prices on occasion. This strikes us as unlikely, because commodity futures index investments never hold the futures to expiration in order to avoid holding any physical commodities. The investors holding agricultural futures to expiry must have been capable of accepting physical delivery, which means that some market force other than forced buying by long-only commodity indexes must have kept futures prices elevated over cash prices in the final days before expiration.
Furthermore, we find it hard to believe that commodity futures index investing threatens major producers, consumers, or hedgers who make up much of the market. These indexes have completely transparent holdings and tend to concentrate in one or two futures contracts, which means that any distortion they produce in the market should be fairly easily quantified. To the extent that arbitrageurs level out the distortion in futures prices across the various contracts, commodity producers actually benefit from locking in their future sales at higher prices due to index buying pressure. The buying pressure from commodity index investments may push up prices for commodity consumers, but markets where consumers demand more certain supplies have historically tended to trade in contango anyway.
The tumultuous markets of the past couple years, with numerous macroeconomic and supply shocks affecting prices, hardly provided good conditions for examining the effects of commodity index buyers in isolation. Although the CFTC certainly has a valid interest in limiting the size of secretive "smart money" positions such as those held by hedge funds and bank trading desks, the plodding and predictable money of indexed investments does not present the same threat of market manipulation. We believe the evidence of persistent distortions caused by commodity indexers' long positions should be stronger before regulators clamp down on one of the very few vehicles that individuals can use to enter these diversifying asset classes.
No Two-Tier System!
With a lack of clear public communication from the CFTC, most investors face uncertainty about the eventual size and shape of position limits we will face. Early deliberations by the CFTC suggested that it might consider an exemption for brokers to hold large commodity futures positions so long as they are held for clients such as pension funds and foundations. Because large brokers and commodity traders often represent a number of high-net-worth clients or institutions as well as their own proprietary trading, this "look-through" exemption would better match the size of allowable commodity futures positions with the number of investors behind them. However, early indications suggest that the CFTC will not extend the same courtesy to individual investors getting their exposure through an ETF that it will to institutions buying their commodity futures directly through a major broker.
Should the look-through exemption end up in the final regulations, the CFTC would support a two-tier system in which brokers can treat institutional funds as separate accounts but individual funds in an ETF face onerous restrictions on total position size. This would discriminate against the individual investor with little gain; institutional long-only investments account for a very large piece of the commodity futures market, and present the same risk of market distortion as ETFs. If the CFTC feels that financial investment in commodity futures by outside investors requires substantial regulation, it should not matter whether those outside investors are individuals or institutions.