Futures markets serve as a hedging devise for commodity producers and processors. In a perfect world of balanced supply and demand, commodity processors would contract directly with producers for future inventory needs at negotiated prices. In the real world, there are nearly always more producers wanting to sell than processors willing to buy, or visa-versa. This gap is bridged by speculators who step in to assume market risk—as temporary buyers or sellers—in exchange for a profit opportunity. If they did not exist, speculators would need to be invented in order for futures markets to function.
But the same cannot be said about commodity index traders who, on average, hold eight times the position size of large speculators. Commodity indexers would have you believe that theirs are benign passively-managed positions, which are simply roll forward as futures contracts expire, without affecting prices. The truth, as the chart below illustrates, is that commodity index traders show the same momentum trading pattern as speculators, adding buying pressure to rising prices and selling pressure to declines. Despite the fact that commodity indexers are long-only traders, their trading shows high volatility than speculators. Any commodity price movement or volatility caused by speculators is magnified two-and-a-half-fold by commodity index traders.
Commodity Index Traders outpaced CTA’s since 2009 commodity bottom
Who are these outsized traders? And how do they circumvent position limits designed to prevent market manipulation. According to International Swaps and Derivatives Association, 70% of commodity index long futures contracts are held by just four large banks (Bank of America, JP Morgan, Goldman Sachs, and Citibank). In 1991 the futures market regulator, The Commodity Futures Trading Commission (CFTC) was convinced to grant these swap dealers trading limit exemptions previously reserved for actual commodity producers and processors who had real inventory to hedge. The four big banks use futures markets hedge commodity index swap agreements made with commodity index, pension, sovereign, and other funds who wish to add a commodity exposure to their portfolios.
Commodity index traders are the largest long player in commodities, currently holding 35% of reported long positions.
With swap dealer regulation a primary goal Frank-Dodd reforms you would think that these cozy relationships between regulators and swap dealers would be old news. But it is business as usual at the Commodity Futures Trading Commission. And this means continuing loopholes for large swap dealers. The commodity indexers have become the largest long players in future markets – at least in those reported in the CFTC’s Commitments of Traders reports. And this is not about to change as the CFTC created a new loophole for swap dealers–post Frank-Dodd–on page 170 of “the Final Rules for Position Limits for Futures and Swaps:”
“the Commission understands that swap dealers, who constitute a large percentage of those anticipated to be near or above the position limits set forth in § 151.4, generally use futures contracts to offset the residual portfolio market risk of their uncleared swaps positions. Under these final rules, market participants can net their physical delivery and cash-settled futures contracts with their swaps transactions for purposes of complying with the non-spot-month limit. In this regard, the netting of futures and swaps positions for such swap dealers would reduce their exposure to an applicable position limit.
“Taking these considerations into account, the Commission anticipates that for the majority of participants, the non-spot month levels are estimated to impose limits that are sufficiently high so as to not affect their hedging or speculative activity as these participants could either rely on a bona fide hedge exemption [pass-through from a bona fide hedger] or hold a net position that is under the limit. Thus, the Commission projects that relatively few market participants [that is, swap dealers] will have to adjust their activities to ensure that their positions are not in excess of the limits.”
These big banks use netting offsets to effectively reduce their derivative risk by more than 90%, increasing their trading capacity. This practice ignores counter-party payment risk, but if the Treasury’s bank regulators allow this practice for to meet reserve requirements, that is a separate issue. But applying this accounting stratagem to offset futures positions is Bizarro logic the defies reason—and unequivocal Congressional direction to the contrary—while granting swap dealers what amounts to unlimited futures trading capacity and gutting Frank-Dodd in the bargain. Business as usual.
The shame of this is that it is so unnecessary. In my book, “The Commitments of Traders Bible” (Wiley 2008), I list hundreds of company stocks and mutual funds whose price movements are highly correlated with various commodity markets. I point out that the S&P GSCI—the most-tracked commodity index—has a near-perfect .98 correlation to crude oil prices. There are hundreds of oil sector stocks that move in virtual tandem with crude oil prices that would substitute nicely for a futures position.
Avoiding the moral difference between investing in a producer of a strategic commodity and the buying and hoarding of same, we need to be realistic about investor demand versus market capacity. Commodity investing’s popularity continues to grow. The total open interest for major US commodity futures markets is currently about $600 billion (notional value). This is a pittance compared to equities. The five SuperMajor oil company stocks alone have a float-adjusted market capitalization of twice this amount. Stock markets are made for investors. If you want a commodity exposure, you won’t start a food riot by investing in an oil stock.
Mr. President, if you are looking for a silver bullet for gasoline (and food) prices, you will find it in your shirt pocket. Take out your pen and sign an executive order directing the CFTC to finally disgorge swap dealers of their oversized commodity positions. This may be the simplest fix of your Presidency. Will creating a level playing field in commodity markets cause a market disruption? A bit, but it will be in favor of American consumers.
While you are at it, you might insist that the CFTC complete its “Commodity Index Trader” report by including the remaining core commodity markets. While they have added a number of reports of questionable usefulness in the past five years, they have neglected this illuminating report, which was suppose to be a two-year pilot program. (It may not be coincidental that the International Swaps and Derivatives Association is on record opposing the creation of this report.)