The CFTC Is Needlessly Breaking Good Products 21 comments
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August 20, 2009
IF AIN’T BROKE, DON’T FIX IT
DBC (PowerShares DB Commodity Tracking Fund) and DBA (PowerShares DB Agricultural Fund) are in the news as the CFTC (Commodity Futures Trading Corporation) has revoked the position limit exemption for these funds. They have also intimidated the issuers of UNG (United States Natural Gas Fund) into not issuing more shares to meet demand, essentially breaking the issue as an effective product and needlessly costing investors a fortune. In the case of UNG, this is part of a government effort to squash speculation in energy markets, always a politically correct or populist thing to do.
In 2006, Deutsche Bank (DB) creatively brought to market DBC and DBA and later partnered these with PowerShares in a marketing arrangement.
The lead product, DBC, is a wonderful creation. The primary benefit to investors was and is to give them exposure to commodity markets which are uncorrelated to conventional markets. This reduces overall portfolio risk, as most studies have demonstrated. Further, benefits included allowing investors market involvement without having to invest in expensive and often illiquid commodity pools, or exposure to potential high leverage.
To get these products launched, DB requested and was granted an exemption from the CFTC to exceed position limits since the fund would theoretically grow. Position limits exist to prevent individuals and other entities from “cornering” the market and/or creating undue volatility. Obviously, these aren’t problems for an index-based product like DBC since these issues don’t motivate them. The basic problem now is with grain markets where position limits are much tighter than other commodity sectors. DBC has exceeded these limits and will have to pare down some positions to comply with the commission’s edicts.
Investors use products like DBC to achieve their goals, and stay with them because they have confidence in their reliability.
By this action the CFTC has disrupted a market and product that was doing its job, perhaps undermining investor confidence in the product’s reliability. DBC will still work as a product going forward because DB is a resourceful organization, but psychology may suggest that these products have been needlessly damaged. Should that happen, it would be a shame!
So why pull the exemption now?
The image above may seem a little over the top and perhaps it is but let’s look at some facts.
From Wikipedia below is an abbreviated description of Gary Gensler, the new agent of change from the Obama Administration:
“After receiving a BS and an MBA from the Wharton School of the University of Pennsylvania, Gary Gensler spent 18 years at Goldman Sachs, making partner when he was 30, becoming head of the company’s fixed income and currency trading operations in Tokyo by the mid-’90s, and eventually the company’s co-head of finance.[3]
As the Treasury Department’s undersecretary for domestic finance in the last two years of the Clinton administration, Gensler found himself in the position of overseeing policies in the areas of U.S. financial markets, debt management, financial services, and community development. Gensler advocated the passage of the Commodity Futures Modernization Act of 2000, which exempted credit default swaps and other derivatives from regulation.
In March 2009, Senator Bernie Sanders (I-VT) attempted to block his nomination to head the Commodity Futures Trading Commission. A statement from Sanders’ office said that Gensler “had worked with Sen. Phil Gramm and Alan Greenspan to exempt credit default swaps from regulation, which led to the collapse of AIG and has resulted in the largest taxpayer bailout in US history.” He also accused Gensler of working to deregulate electronic energy trading, which led to the downfall of Enron and supporting the Gramm-Leach-Biley Act, which allowed American banks to become “too big to fail.”[5]
Gensler is the co-author of a book (with Greg Baer), The Great Mutual Fund Trap. The thrust of the book is that active trading and investing is an inefficient strategy for individual investors, and that individuals should stick with index and exchange traded funds.
After proposing to enact limits on the speculative trading of oil, many sources, including the New York Times, have compared Mr. Gensler to Wesley Mouch (the character from Atlas Shrugged who was both portrayed as an incompetent lobbyist but eventually the country’s economic dictator.)”
Is Gensler on the puppet strings of Goldman Sachs (GS)? Well, once in the brotherhood, always in the brotherhood is probably enough said. But it goes deeper - much deeper. In the above excerpt from Wikipedia, note the section regarding swaps and Commissar Gensler’s involvement with them. These are big in commodity market day to day trading. They dwarf anything DBC can or will do. And, intraday, these swaps exceed position limits routinely if regulators can figure them out. This doesn’t even include what happens daily in OTC markets.
Who are the big players in this game? Goldman Sachs probably tops the list. Is Commissar Gensler going to check out Goldman Sachs' trading activity?
I spoke with an industry friend today who discussed the current CFTC action in the following manner:
“Suppose it’s illegal to chew gum in a mall. Authorities stop the person from doing it. However, at the same time there isn’t any rule from smoking crystal meth at the mall so it continues unabated. Such is the current situation with the CFTC’s action where the low hanging fruit is easy pickings for regulators but the swap market remains unscathed.”
DBC and DBA are not broken.
But positive psychology among the investment community is vital to maintain any product’s success. Once a product is tarred with the brush that “something’s wrong”, it’s hard to undo. This has been going on with leveraged products over the past few months whether they're from ProShares, Direxion, Rydex, Van Eck and now commodity products via PowerShares DB. They’re easy pickings for regulators but in doing so they’re doing great harm to the investment community and particularly individual investors who should be free to utilize products that protect them and provide opportunities heretofore unavailable.
My qualifications to address this subject are being a former Commodity Trading Advisor, Commodity Pool Operator, Introducing Broker and NFA Arbitrator (the Maytag repairman of arbitrators).
The CFTC should reverse course and Commissar Gensler should cut his strings to Capo dei capi*, or at the very least delve deeply into the swap market where Da Boyz play every day.
* Capo dei capi: The leader of all leaders or boss of bosses. The most powerful Mafia boss to whom all others defer.
Disclaimer: Among other issues the ETF Digest maintains positions in: DBC.
The comments are only the author’s view of market activity and aren’t recommendations to buy or sell any security. More detailed information, including actionable alerts, are available to subscribers at www.etfdigest.com.
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"Govern a great nation as you would cook a small fish. Do not overdo it." Lao Tzu
The hinge of your article says, "Obviously, these aren’t problems for an index-based product like DBC since these issues don’t motivate them."
Well, we laymen never expected GS to HFT and banks to be promoting default swaps worth nothing before crash so why not have the perception that DBC may help speculate a higher price in food commodities?
Can't tell the players without a program;
www.brucewiseman.net/i...
Bruce is a genius
This is not how commodities trading is, it is not easy, and its high risk. Thats how it is, and how it should be. I think people are beginning to understand this, investing in ETFs for commodities is not natural IMO.
It seems to me that your criticism of the CFTCs revocation of the private letter exemptions of the two index ETFs in conjunction with your depiction of Gensler as a GS puppet is disengenous and contradictory. Genslers apparent course to further extend the attack on position limit exemptions would affect GS very negatively.
Since you have omitted any facts which would show Gensler is not a puppet, here are some more recent quotes from him for the reader to consider objectively. I would suggest that none of these quotes would have been received enthusiastically at GS:
'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"
"I don't see a Goldman Sachs swap desk or J.P. Morgan swap desk as a passive mechanic"
"I believe that institutions that deal in derivatives must be explicitly regulated. In addition, regulations should cover any other firms engaged in derivatives whose activities in these markets can create large exposures to counterparties."
"Specifically, all derivative dealers should be subject to capital requirements, margining requirements, business conduct rules and reporting and recordkeeping requirements."
"For OTC derivatives that come under CFTC jurisdiction, these standards should require adherence to position limits when they perform or affect a significant price discovery function with respect to regulated markets."
"Market transparency should be further enhanced by requiring that aggregated information on positions and trades be made available to the public."
"All derivatives that can be moved into central clearing should be required to be cleared through regulated central clearing houses and brought onto regulated exchanges or regulated transparent electronic trading systems."
"Position limits must be applied consistently across all markets, across all trading platforms, and exemptions to them must be limited and well defined."
And on July 28 2009, testifying at the first of three CFTC hearings on the position limits matter, Senator Bernie Sanders, who had questioned CFTC Chairman Gensler’s commitment to regulate aggressively as the Senate considered Gensler’s nomination, began by conceding that Gensler’s actions since taking the CFTC’s helm have been impressive.
anticipated new futures-market restrictions that have been distorting the ETF's performance. Co-manager John Hyland said today the fund entered a $500M swap contract, following a $250M deal struck in July.
Hmmm.... I wonder if Goldman Sachs was on the other side of that?
You are correct about the position limits on commodities. They serve a purpose, to prevent cornering a market. However the DBA or UNG index does not give the buyer a right to take delivery of a commodity. Therefore it is immaterial how many shares are outstanding. If at some point there are too many shares outstanding then the index won't track and investors will vote with their feet to dump them.
Summary, Overregulation will harm some of these products.
On Aug 22 11:46 AM iknow1 wrote:
> As a commodity trader I have tried the DBA and UNG ETF's and while
> thay do perform, the transaction costs associated with rebalancing
> tend to subtract from the percieved performance advantages. Because
> of their structure they probably do not need additional regulation.
> The popularity of the UNG ETF should be a message that it should
> be allowed to expand the shares available to the financial community.
>
>
> You are correct about the position limits on commodities. They serve
> a purpose, to prevent cornering a market. However the DBA or UNG
> index does not give the buyer a right to take delivery of a commodity.
> Therefore it is immaterial how many shares are outstanding. If at
> some point there are too many shares outstanding then the index won't
> track and investors will vote with their feet to dump them.
>
> Summary, Overregulation will harm some of these products.
I can't rely entirely on CPI-based hedges since the government has been gaming them for the past couple of decades. How could the CPI possibly have completely missed a massive housing bubble if it wasn't gamed?
The government needs to be regulating the use of leverage in buying these funds and other commodity vehicles. Buying a share of an ETF with cash is not speculation. Buying $30 worth for $1 using borrowed money is speculation. However, the government is allowing the books of the speculators to be gamed by waiving mark to market rules and providing government funding to them as well. Instead they are punishing small investors.
We have to become aware of HOW corporate structures are infiltrated by the political in such a way as to make it appear that the corporate structures are "using" the government. Actually, the reverse is occurring.
We are well on the road to the New Totalitarianism, which while it will appear to be beneficial to commerce and finance initially, will shortly have all the aspects of socialism.
Apologies for this "political" digression, but the financial world in the U.S. is being altered for some time to come by political rather than commercial or private transaction forces.
R. Richard Schweitzer
I agree with your contention that the CFTC is cracking down on "chewing gum" while allowing "crystal meth," but I strongly disagree that retail-oriented commodity funds such as UNG and DBC are good products. They are good products from the retail perspective--they allow access to commodities and therefore diversification as commodity prices are historically uncorrelated to other asset classes. (This perspective has also been that of the pension and investment consultants who have pushed the 10% commodities position over the last decade.) Commodity traders I have spoken to have a different perspective. Large funds of this type severely distort futures markets for a simple reason: asset allocation of ETFs is usually driven by regulatory and structural reasons, rarely in accordance with daily supply and demand fundamentals. I invite you to consider the effect the USO has had on oil prices as an example.
Respectfully,
RCS
Having said that, I agree w/ iknow1, who pointed out that transaction costs and re-balancing issues are a structural flaw of these funds.
On Aug 23 11:11 AM David Fry wrote:
> Great point on "delivery" issue.