Regulators could ruin ETF game

Experienced parents are familiar with the situation. There is a happy silence and an absence of small children from the immediate area. One parent looks at the other and says: “Go see what they’re doing and tell them to stop it.”

In the same way, the US regulators and other authorities seem to be threatening the happy playtime of commodity-linked exchange traded products, which till very recently had been busily putting together new vehicles to offer investors exposure to oil, natural gas, agricultural commodities and the like.

The Commodity Futures Trading Commission has gone to find out what exactly commodity investors are up to.

“In the CFTC’s eyes, ETFs fall under the heading of a speculator, which it defines as a market player who invests in commodities for financial reasons and does not take physical delivery of the commodities underlying a futures contract,” according to commentary from John Keogh, managing director of Susquehanna International Securities, an ETF market maker. ETPs are products similar to exchange traded funds in the way they trade and settle, but they do not have a mutual fund
structure.

Global assets in commodity ETPs and ETFs have soared from $6bn (£3.7bn, €4.2bn) in December 2005 to $95bn in August 2009, according to figures from Barclays Global Investors. The majority of this is in the US, which boasts $65bn in the products, compared to Europe which has just $25bn.

The CFTC, which regulates both commodity futures and the ETPs that use such futures in the US, has imposed stringent limits on the positions they can take, leading to the effective closure to new capital of a number of
products.

In Europe, where commodity ETFs and ETPs have also been building assets at an astounding rate, industry participants are gazing nervously across the pond.

“It’s business as usual here, but we’re watching it [developments in the US] closely,” says Hector McNeil, chief executive of ETF Securities, which manages $13bn in exchange traded commodities.

The iShares S&P GSCI Commodity Index Trust; the iPath Dow Jones-AIG Natural Gas ETN and the United States Natural Gas Fund have all announced they will not issue any new shares, while one exchange traded note, the Powershares DB Crude Oil Double Long ETN, is to be withdrawn entirely.

Interested commentators are quick to point out there are significant differences between the European and US markets. Most importantly, according to Jan Altmann of 4assetmanagement, a Frankfurt-based ETF consultancy, the European products are largely swap-based.

“The risk and all the processes are outsourced to an investment bank, or multiple investment banks,” says Mr Altmann. Even a swap-based ETF, however, implies the underlying futures must be bought at some point, but both Mr Altmann and Mr McNeil say there are mitigating factors that make the swap-based structure more robust. “With swaps you can net off exposures so only the net ends up on the futures exchange,” says Mr McNeil, whose company runs both long and short ETPs. “You aggregate, which lessens the demand for actual futures.”

In theory, the counterparty to the swap does not absolutely need to buy the underlying futures, since it could decide it would find the income stream needed to meet the swap obligation in some other way.

However, in practice most investment banks will hedge their exposure through the futures market.

Even with netting shorts against longs, this can lead to large positions in the futures market.

Until recently, US ETFs had letters of exemption from the CFTC allowing them to exceed the standard limits for financial investors, but a number of these have been withdrawn recently amid concern the ETFs are distorting futures markets.

This followed a July report from a US Senate committee on the impact of “excessive speculation” on futures markets, particularly in wheat. The committee concluded the presence of ETP investors had distorted the market and recommended the CFTC reinstate the limits.

Although the withdrawal of exemptions on position limits has led to a number of affected ETFs declaring they will not issue any more shares, that was not the only development for US commodity ETPs.

As the US Natural Gas fund found recently, Nymex, the exchange on which the futures are traded, has started to pay more attention to breaches of its “accountability limits”. These are not binding limits in regulatory terms, but the exchange can use them to prevent positions becoming disruptively large. “There’s a lot of fear” regulators will make the US too tightly governed for commodity investors, says Mr McNeil, “but they’re not daft. They don’t want that to happen.”