A statement released by the Commodity Futures Trading Commission CFTC on July 7th has set the investment community in a flutter. The Chairman, Gary Gensler’s statement was, to be honest, pretty vague merely outlining the CFTC’s perception that regulation may be in order and setting out a timetable for consultation of July and August. Everyone is expecting the CFTC to take both short term steps such as greater reporting and visibility into trades and longer term steps which may involve trading limits. But why has the CFTC felt compelled to act and what could be the impact for metals markets?
According to the FT’s Shortview, earlier this decade academics showed that commodities were not strongly correlated with stocks and bonds, so investing in them could reduce risk without reducing returns by spreading investments across more investment groups. Ever on the look out for new sources of revenue, the investment banks (them again) then found ways to sell commodity futures to retail investors by creating exchange traded funds to hold them. According to Michael Masters, a hedge fund manager quoted in the report, over the previous five years index funds of this kind have grown 20 fold, from $13bn to $260bn, far greater than the rise in demand for oil from emerging markets like China. As these funds have become established trading vehicles they have come to be accepted as hedges against inflation to the extent that as the oil price doubled this year it dragged up expectations of inflation (and stocks with it) when in reality the danger was of deflation.
The CFTC does set position limits for agricultural products but not for energy or metals. Comments made by Mr Gensler suggest this is something he is looking to change. The danger is all classes of commodity futures could be dragged into the new regulation. As Michael Cosgrove head of North American energy operations for broker GFI Group Inc. in New York said in a Bloomberg article, Oversight of contracts that do not affect supply and demand, such as Nymex cash-settled futures and ICE cash-settled swaps, is a misguided waste of taxpayer dollars. These contracts affect supply and demand no more than the betting at a race track affects the speed of the horses.
For the physical oil and metals industry there could be unforeseen implications. Banks hedge future revenue from production projects to underwrite funding for energy and mining projects. Trading limits may constrain the banks ability to act as counter-parties in such hedging deals limiting funding. With mining companies already heavily indebted and cash flow at current reduced prices, investment could suffer.
The biggest impact will likely be for exchange traded funds and the commodity trading advisers that serve them. This is an industry with $200bn in assets under management and arguably it is the activities of this sector that is at the root cause of the disproportionate in-flows and out-flows of funds that the CFTC is looking to control.