Many expert commentators believe that prices in various markets, especially at the futures exchanges, are being increasingly manipulated. The Commodities Futures Trading Commission (CFTC) has recently begun to hold hearings, ostensibly to consider imposing position limits on bank-based speculators who are falsely posing as commercial hedgers. Position limits were imposed many years ago, in order to stop speculators from gaining enough control over a market to dictate the price.
Big banks, however, have managed to use their influence to get special exemptions and exceptions in order to avoid the limits.
A primary issue involves so-called “swap dealers”, who have obtained "hedge exemptions", allowing them to masquerade as commercial hedgers when they are really issuing derivatives and speculating on commodities.
Naturally, big derivatives dealers, like Goldman Sachs (NYSE:GS) and JP Morgan Chase (NYSE:JPM), are fighting tooth and nail, warning of terrible consequences if the law is finally enforced by the previously do-nothing agency.
"We believe that eliminating or limiting swap dealer hedge exemptions not only will not address the 'swap loophole' but actually will have several negative consequences," said Donald Casturo, managing director of Goldman Sachs’ commodity division, said in prepared remarks before the Commodity Futures Trading Commission.[i]
In truth, there will be no negative consequences to anyone other than the banks, who will lose control over the market price. Position limits will simply prevent big bank based speculators from taking new positions based upon the purchase or sale of imaginary commodity stockpiles represented by paper derivatives. Indeed, none of these banks have ever performed any function other than providing liquidity to the market. This has always has been the function of speculators, and there is no justification for creating a special class of speculator who is given special favors by the government that others are denied.
The fact that big banks issue over-the-counter derivatives whose price is set to follow the alleged "market price" of various commodities does not make them dealers in those commodities. Position limits will correctly prevent banks from taking as many positions as they choose, long or short, based solely upon imaginary commodity stockpiles that are really just OTC derivatives. Some commodity prices will rise, and others will fall, as a result of the removal of these exemptions, but the price, whatever it moves to, will more accurately reflect true supply and demand in the real world market.
To utilize deep pockets to successfully manipulate markets, one must first consolidate control over the market. When you want to lower prices, it helps a lot if you can create supplies of the commodity from “thin air” by creating paper derivatives posing as a commodity investment.
When you want to raise prices, it helps a lot if you can use your deep pockets to either stop or slow the issuance of new paper commodities or buy an overwhelming number of long positions, thereby creating an artificial shortage on your own timetable.As the rest of the market panics from your overwhelming manipulation of concentrated positions, you can buy or sell at a profit.
Most exceptions and exemptions are shrouded in secrecy, deep in the bowels of the agency’s file rooms, safe from the prying eyes of the public and its elected representative, including the very Congress that empowered the agency in the first place. The information as to whom, with respect to what, and when the CFTC staffers granted various exceptions and exemptions is withheld, at times, even from CFTC Board Commissioners.
It is said that the CFTC staff initially refused to release the letter I am about to show you, to the CFTC Commissioner who requested it, until they contacted, and got permission from Goldman Sachs! Secrecy of this sort is a recipe for fraud and corruption.
As far as we know, this Goldman Sachs letter was the first secret exception, given to a big bank speculator, who wanted to be reclassified as a commercial “hedger”. It was delivered by the CFTC staff to Goldman Sachs’s “J. Aron” commodities division, back in 1991, and it allowed them to engage in buying long positions in wheat, corn and soybeans based upon the fact that they were selling derivatives.
The 1991 letter was followed by a cavalcade of other exception letters, allowing investment banks to engage in unlimited speculation in almost all markets, including food, oil, gas, gold, silver, platinum and so on. Nowadays, all the major investment banks are classified as “commercial hedgers” in one market category or another.
The genesis of the current Commodities Act is found in the Commodity Reform Act of 1922, which represented the first major Congressional attempt to rein in manipulation of grain markets. Futures dealers opposed the 1922 Act vociferously, to the point of bringing the matter to the Supreme Court. But, the high Court rejected their challenge, writing:
...The act in § 4 forbids all persons to use mails or interstate telephone, telegraphic, wireless, or other communication, in offering or accepting sales of grain for future delivery or to disseminate prices or quotations thereof, excepting the man who holds the grain he is offering for sale…and under such conditions as to reflect the general value of grain and its different grades, and which have been designated by the Secretary of Agriculture as "contract markets."…[ii]
Thus, the Supreme Court has made it clear that the true intent of all these Commodities Acts is to rein in manipulation by forcing a tight relationship between the markets and the real world’s supply and demand. That relationship has been thwarted by the fact that CFTC has been playing “footsie” with the big investment banks.
A true hedger is a dealer or producer relying on the cash market to carry on a business in a commodity. Sometimes, to “insure” the safety of his finances, one of these businesses may resort to futures market. That is when it becomes a “hedger”.
For example, let’s say a gold mining company sees that the price of gold is $950 per ounce. Maybe, it can produce gold in an old section of its mine at low cost. But, it wants to take advantage of the price increase, so it decides to spend money to open up a new vein of gold deeper underground. The cost per ounce for extracting the extra gold will be $900 per ounce. The miner hopes for a $50 per ounce profit. If gold drops to $800 per ounce, it will lose $100.
So, to protect itself, the miner opens a short position on COMEX at $950. If the price of gold drops to $800, the miner makes $150 in profit on the short position, which offsets the $100 per ounce loss it has sustained on its position in physical gold.
Thus, it ends up with the expected $50 per ounce profit that it bargained for, less the commissions, no matter what happens to the price. That fact allows the miner to make the investment decision. The only cost to the mining company is the cost of the commission to buy the futures contracts. That is a fixed sum that can be calculated into the cost of doing business. The speculators, who bought long, provided liquidity and took the risk that the gold price would fall.
In this case, they lost money. But, in another case, if the price had risen to $1,050, the speculators would have earned a profit, and the mining company would still have earned its planned profit of $50 per ounce.
A bank makes its money, not by buying or selling the commodity, but, rather, by trading on the futures market. There is no real compelling need to hedge because they don't have inventories of the commodity. The Goldman Sachs’ letter represented a first step, in a series of grave errors, that converted futures markets into casinos. A cavalcade of similar letters eventually allowed bank speculators to control entire markets, even though they possessed little or none of the commodity being traded, are not engaged in any legitimate commodity related business, and earn their living by trading back and forth on the futures exchanges.
The bottom line is that CFTC has erroneously allowed hedging against hedges. Translated, they have allowed hedges against speculation, not production. This has become a toxic poison which corrupted the futures markets from their intended purpose.
“Hedging against a hedge” is the ultimate manipulative activity, because it allows the creator of speculative instruments (derivatives) to create unlimited quantities of an imaginary commodity stockpile, taking real supply and demand out of the equation.
More frightening is the fact that, when a firm hedges against a derivative, they will be leveraged on both sides of the transaction, while not being in possession of the real commodity. No rational bank, or other person, can consistently earn a profit, on such risk, especially where a futures contract is subject to a possible delivery demands, unless they are able to manipulate the market up and down.
In spite of all the chatter from CFTC about “reform”, their current concern seems limited to helping derivatives dealers to head off serious limits on speculative activity imposed directly by Congress. Were Congress to enact such limits, derivatives dealers, like Goldman Sachs, would find it impossible to use CFTC staffers to circumvent position limits.
The current hearings are fixated on upside price manipulation of the type that caused oil to soar beyond the fundamentals, back in the first half of 2008. Downside manipulation, of the type that is regularly practiced in the gold and silver markets is being generally ignored, in spite of Commissioner Bart Chilton’s valiant effort to put that subject on the agenda.
Countering the hope that we may have in Bart Chilton is the fact that the new CFTC Chairman is Gary Gensler, who is yet another Goldman Sachs man in government. His firm is a primary beneficiary of the present system. They were the first to metamorphose from speculators into fake “hedgers”.
We have watched other Goldmanites in action, such as former Treasury Secretary Henry Paulson, and their actions have not been of benefit to the system or the nation. Gensler, himself, is beginning to show his true colors, having come out in favor of some exemptions.
"While I believe that we should maintain exemptions for bona fide hedgers, I am concerned that granting exemptions for financial risk management can defeat the effectiveness of position limits," said CFTC Chairman Gensler.[iii]
Gensler has moved in and out of government, at various times, going back and forth from and to his firm, Goldman Sachs, in a revolving door. While Gensler worked for the Clinton administration, he designed the so-called “Commodity Futures Modernization Act” (CFMA), which passed into law in 2000. The Act contributed greatly to the severity of the current financial crisis. It allowed credit default swaps to remain unregulated.
Ultimately, the source of all the mischief on futures exchanges is CFTC. Just as drug dealers have a very hard time in cities filled with honest cops, market manipulator would not be able to function if CFTC enforced the commodities trading acts. Many of CFTC staffers, however, just like Chairman Gary Gensler, will eventually go back to, or start employment with the companies they are supposed to be regulating.
The exemption/exception letters are one part of the many dirty secrets of a useless agency, safely hidden in file rooms. Such letters are the product of incompetence and corruption, both of which breed well in the darkness. If Congress passes legislation opening up all of CFTC files to public inspection, light will enter the darkness and kill them off these breeding grounds.
In addition to opening up the hidden CFTC files, Congress must eliminate CFTC’s exclusive jurisdiction over commodities, and give concurrent jurisdiction to the states. When it does so, most of the current problems with the futures market casinos will abruptly end.
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Disclosure: No positions in Goldman Sachs
[ii] Chicago Board of Trade v. Olsen, 262 U.S. 1 (1923)