The spotlight on commodity index funds and their impact on markets continues to burn brightly following a scathing report from Sen. Carl Levin (D-MI), chairman of the U.S. Senate Permanent Subcommittee on Investigations, and Sen. Tom Coburn (R-OK), acting ranking minority member. The report claims that commodity index traders, in the aggregate, have made such large purchases on the Chicago wheat futures market that they "have pushed up futures prices, disrupted the normal relationship between futures prices and cash prices for wheat, and caused farmers, grain elevators, grain processors, consumers and others to experience significant unwarranted costs and price risks."
The 247-page report released last Tuesday is the fifth in a series released by the subcommittee on commodity pricing since 2003. The first four focused on energy prices, including for gasoline, crude oil and natural gas (see NGI, July 2, 2007). Two have focused on how excessive speculation can distort commodity prices.
"In the last three years, speculators have spent billions of dollars on commodity indexes, and the financial firms selling those index instruments have purchased billions of dollars in commodity futures to offset their financial risks, creating price disruptions for producers and consumers," said Levin.
"In the case of wheat, we found that index traders purchased huge numbers of wheat contracts on the Chicago exchange, increased futures prices relative to cash prices, and created unwarranted costs and risks for wheat farmers, grain merchants, grain processors and consumers. It is another case of speculative money overwhelming a market, and federal regulators failing to take the steps needed to protect the market. In fact, the CFTC [Commodity Futures Trading Commission] has allowed some index traders to exceed normal trading limits for wheat." Levin added, "It is time for the CFTC to change course, rein in commodity index traders and clamp down on excessive speculation that is disrupting commodity prices."
The focus on index traders comes as the United States Natural Gas Fund (UNG) -- an index fund that has been rapidly expanding positions in front-month gas contracts -- seeks a CFTC exemption from position limits (see related story). UNG operators claim that as a passively managed commodity index fund with a "neutral" investment strategy, it has no impact on the price of natural gas.
The UNG filing at the CFTC was among the comments the agency received last week on its "concept release" on whether it should eliminate the "bona fide hedge exemption" for speculative futures market trades and install a new "limited risk management exemption from speculative position limits" that would call for increased oversight and trading limits on commodity futures and derivatives and swap dealers in the over-the-counter (OTC) market.
The CFTC offered its proposal earlier this year, getting out in front of the drive in Congress for regulatory reform. The CFTC's "concept" of a new system proposes to require OTC swap dealers to certify that none of the OTC swap positions of their noncommercial clients exceed position limits in related exchange-traded commodities. The proposal would roll back the hedge exemption that facilitated the surge in investments in recent years in the commodity futures market by institutional investors, including pension funds, hedge funds, investment banks and university endowments.
The CFTC proposal, and even stronger limits on index fund involvement in the commodities futures markets, are supported in comments from groups representing the grain, cotton and dairy industry filed in response to the proposal [74 FR 12282].
In its own investigation the Senate subcommittee examined millions of trading records from the Chicago Mercantile Exchange, Kansas City Exchange, Minneapolis Grain Exchange, the CFTC and others to track and analyze wheat prices. It uncovered "substantial and persuasive evidence" that, by purchasing so many futures contracts, commodity index traders in the aggregate pushed up futures prices; created an unprecedented, large and persistent gap between futures and cash wheat prices in the Chicago market; and impeded the two prices from converging at contract expiration. As an example, the report noted that the average wheat gap, or basis, between futures and cash prices on the expiration of futures contracts on the Chicago exchange grew from about from 13 cents per bushel in 2005 to 34 cents in 2006, to 60 cents in 2007, and to $1.53 in 2008, a tenfold increase in four years.
CFTC Chairman Gary Gensler weighed in on the report while speaking at the Managed Funds Association meeting in Chicago on Wednesday. "Chairman Levin's thorough report is a significant contribution in understanding the potential effects of index trading in the wheat market and other commodity futures markets," he said. "As the commission continues our own analysis and appropriate regulatory responses, Chairman Levin's recommendations will be given the utmost attention and careful consideration."
The report urges the CFTC to apply a standard position limit to all commodity index traders in the wheat market, which would cut out the numerous exemptions that exist in today's market. In addition, the report recommends that the CFTC analyze the impact of commodity index trading on other commodities to determine if excessive speculation is distorting prices.
A 2006 report in the series found that billions of dollars in commodity index trading on the crude oil market had increased futures prices in 2006, and were responsible for an estimated $20 out of the then $70 cost for a barrel of oil. The 2007 report showed how hedge fund Amaranth made huge trades on the natural gas market, pushed up futures prices and increased natural gas prices for consumers. In July the subcommittee will hold a hearing on excessive speculation in the wheat market.
CME Group, which runs the Chicago Mercantile Exchange and the New York Mercantile Exchange, said Wednesday that while it appreciates the government's efforts to "ensure effective regulation" of commodity futures markets, it disagrees with the findings and recommendations in the report, which is based on "anecdotal information" versus "sound empirical and economic" analysis.
"The subcommittee report is contradicted by four separate studies conducted by the Commodity Futures Trading Commission (CFTC), the Government Accountability Office (GAO), Informa Economics Inc. (Informa) and CME Group -- all of which concluded that there is no causality between market participation of index funds and noncommercial traders and wheat price levels or cash market convergence at expiration," CME Group said. "The CFTC, the GAO, Informa and CME Group all used in-depth market data to analyze how changes in the positions of index funds and other market participants are related to price changes, as well as the price differential between wheat cash and futures prices. Each study concluded that fundamental supply and demand factors related to crop failures, strong economic growth in many importing nations, acreage switching caused by demand for biofuels, and currency volatility have all been responsible for recent periods of increased volatility and price swings in commodity markets."
In its comments on the CFTC proposal CME said limiting swap transactions would restrict their function as market-makers. "Swap dealers are legitimate hedgers that should continue to be allowed to qualify for an exemption from speculative position limits pursuant to the existing bona fide hedging definition," CME said in its comments on the CFTC's proposal.
ICE Futures U.S. Inc. said in its filing it believes the bona fide hedge exemption should be expanded to accommodate swap dealers, or the CFTC should create a risk management exemption geared to swap dealers' needs, rather than those of their clients. "Swap dealers play an important liquidity role and need an exemption that allows them to hedge their swap books at any point in time." ICE Futures provides a dedicated contract market for trading in agricultural, equity index and currency contracts.
The American Feed Industry Association (AFIA) sees the unfettered entrance into the futures market of institutional investors as providing unrealistic commodity price levels relative to true commodity demand. The effect is increased when prices go up as investors pile into the market and bid the prices higher. "Index speculators do not normally sell, but rather buy and hold their index positions, thereby producing an artificial economic increase in demand, and, in turn, commodity market pricing."
In some agricultural crops the futures trading on a daily basis almost meets the entire U.S. crop volume, AFIA said. "As a result, the physical commodity customer today is unable to attain convergence between its hedge position and the cash market. The physical purchaser is forced to borrow significant funds to cover margin calls and/or sell commodities, usually at an inopportune time, to cover these distorted hedge costs. Thus hedging as a risk management tool is no longer effective for its intended users."
As of May 26, approximately $125.6 billion was invested in index funds, including $84 billion tracking the Goldman Sachs commodity index fund (GSCI), $41.7 billion following the Dow Jones AIG fund and $15.2 billion tracking all others. Investments in the GSCI index included 66.9% in energy, 19.4% in grain and livestock, and 9.8% in metals, according to AFIA's submission.
At the peak of the grain markets, index funds owned more than 450,000 contracts or 2.25 billion bushels of corn, which represents 17% of the U.S. crop. "With GSCI index investments consisting of approximately 63% of index fund capital, this would translate to one investment strategy owning approximately 1.41 billion bushels -- or 10% of the U.S. crop." A normal speculative position limit would be 22,000 contracts or 110 million bushels..."This is staggering: 1.41 billion versus 110 million, controlled by one strategy," AFIA said.
While these investors may be hedging their portfolios, they are not hedging the commodities in which they are investing.
The damage was done in 2000, AFIA said, when Congress codified earlier CFTC regulatory action granting Wall Street banks an exemption from speculative position limits for hedging OTC swap and index transactions. Funds from the institutional investors now flow through these banks.
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