Commodities traders are wrestling with two questions stemming from President Obama's announcement Thursday that he would push for legislation to limit activities, including proprietary trading, of the nation's largest banks. The questions are: No. 1, Can the president get it through Congress? and No. 2, What would be the impact on the commodities market?
Spurred by last year's financial market meltdown, Congress already is about halfway through the process of enacting somewhat less stringent new restrictions on financial markets. The House has agreed on a bill and several Senate committees are expected to send a combined Senate version to the floor early in the current session. The entire process, however, is a long way from over.
There undoubtedly will be revisions and a merging of the House and Senate bills. It's much too early to count votes, but the president's announcement apparently made an impression on investors as financial stocks led a 213-point drop in the Dow Jones average Thursday, followed by a 216 point slide Friday.
As for the impact on commodities markets and prices, if firms like Goldman Sachs and JP Morgan Chase dropped out, well, it depends. Several analysts NGI contacted indicated their companies thought the question too hot to handle right now. Others were striving for neutrality.
"If you have the view that speculative money flow does not influence prices, then it shouldn't have any effect at all. If you think that money flow might temporarily take prices outside the range of fundamental value, then you probably think that it could have an effect," said Kyle Cooper, an analyst for IAF Advisors in Houston. "Now whether that's going to be for higher prices or lower prices, that's anybody's guess.
"At times large trading houses probably provide some liquidity and can dampen volatility in the market," Cooper said, "but if they help sponsor a large macro fund that's coming in to buy commodities across the board, and the size of that transaction actually overwhelms the physical size of the natural hedgers, then they create volatility."
Cooper said that without the large banking interests there might not be enough liquidity in the market, particularly in the back months, to support activity by physical hedgers. "When a large producer comes in to execute a large hedge then the volatility actually is going to be increased because as a producer locks in his forward price, there will not be liquidity to keep the market balanced; that will actually increase volatility."
Tom Lord, president of Volatility Managers LLC in Colorado Springs, CO, sees a runaway speculators' market, and he's not sure if it can be contained.
"The futures exchanges have intentionally made it easy to roll large positions. What that means is as long as you've got a lot of money and you're willing to bet a lot, which is pure capitalism, you have the ability to influence the market price. You can't get caught short in a rising physical market as long as you're willing to sell into it. That fundamentally means that the consumer is now in essence in a price market, not a commodity market, not a physical market. And the more volatility you get, the more risk they have associated with what is in essence an input, not a core business product," Lord said.
Lord noted that as proprietary traders of equities the banks have historically been the liquidity providers. That is a fundamentally different issue than their role in commodities.
"In the commodities space they are the liquidity providers, especially in the sense of long-dated [trades]. The reality is...what percentage of your market really needs 20-year trades. So what you've got is an illiquid market and you need somebody to provide a price at least," Lord said.
"I don't know how you do the regulation. Even if you get the banks out, you can't get hedge funds out. What do you do, say, 'Sorry, if you aren't a physical player, you can't trade?'"
Lord agrees with the president that the compensation structures are a large part of the problem. "Compensation structures in many of the companies, especially a lot of your hedge funds, are designed to drive people to high leverage. What happens if you blow up? Everybody says the bankers screwed up in the banking crisis. My response is, what do you mean?" As an example, say a broker made $300 million over five years. "The bank blows up. [he] walks away, and the shareholders get screwed. I'm sorry, what was the problem with this trade from [his] point of view? He succeeded.
"The question is how do we create a structure where risk and reward are held by the individuals and/or organizations doing it, not just corporately but personally? As long as I can walk away...I wreck your Ferrari, but I don't own it. Who cares?"
Lord said the "problem of the ability to accrete massive amount of risks in organizations that are fundamental to our economic structure is a systemic problem that needs a solution. I'm just not sure our political process can achieve one. I don't think there is a silver bullet. I see this as an attempt to open the discussion...How do I get those incredibly high risk-accreting activities out of the same place where I've got entities that are very critical to the economic process? I don't think it happens."
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