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By Brad Zigler

If you've been around the world of commodity-based exchange-traded products for some time, you've probably noticed the phenomenon of "crowding" at some point or another. Crowding is the pushing and shoving of speculators attempting to wedge their way into the commodities markets, either to gain portfolio diversification or to stave off the effects of latent inflation.

With exchange-traded funds, it's easy to see crowding's immediate effects.

Long-only funds are buyers of commodity futures contracts — repeat buyers, since their positions are constantly rolled forward. But funds that buy futures can only grow to a certain size — i.e., hold a certain number of open futures positions — before they bump up against position limits, or other so-called accountability levels.

Position limits are hard stops imposed by federal law on speculative holdings in corn, soybeans, wheat, oats, soybean oil, soybean meal and cotton, while accountability levels are exchange-mandated — and squishier — concentrations of nonagricultural commodities.

Exchange-traded commodity funds are subject to limits because they're speculative positions undertaken solely for investment purposes. Speculators take on risks laid off by commercial entities dealing in cash market commodities; a wheat farmer, for example, might sell futures to hedge a portion of her crop against falling prices.

Some Restrictions Apply

Such transactions can take place without restriction up to the farmer's cash market risk as they're deemed "bona fide hedges." But an investment fund taking the other side — the purchase of Chicago wheat futures — would be limited to taking on 6,500 contracts in any one month (speculative trades in the spot delivery, however, would be further restricted to a maximum of 600 contracts).

If it can't put more money into new, index-mandated futures, a large and growing fund could develop substantial tracking error — as did the PowerShares DB Agriculture Fund (NYSEARCA:DBA) prior to its restructuring in October 2009.

The answer to the question of position limits — or, as we'll see, the deflection of the question — came in the form of exchange-traded notes. ETNs are zero-coupon, unsecured debt obligations whose principal values are tied to variations in the notes' benchmark indexes. Marketing ETNs doesn't require the issuer to open and maintain a commodity futures account. Instead, exposure to the futures market is obtained through swap agreements in which another financial institution offers to "pay" the commodity return in exchange for the receipt of some money market rate, such as a Libor-plus spread.

This deflects the position limit issue onto the back of the swap dealer. A dealer will hedge the exposures internally in its swap book to the extent it can. An obligation to pay a commodity return to one customer, for example, can be relieved by the receipt of the commodity return from another. Any net exposure that can't be crossed on the dealer's book would likely require the dealer to hedge in the futures market.

It's here where things get interesting. To date, the futures positions undertaken by swap dealers have been deemed bona fide hedges by regulators and therefore not subject to position limits. All this greatly chagrins market participants who see these positions as de facto speculative holdings.

The hue and cry about swap dealers crowding the markets has been raised to such a level that regulators now want to harden position limits and to restrict the swap dealers' hedge exemptions.

The uncertainty of the regulatory environment — or rather, the increasing likelihood that the environment will become unfriendly to swap dealers — has prompted one ETN issuer to file for a series of callable notes.

Barclays Bank plc plans to launch 22 notes that mirror its existing iPath commodity lineup in every way save for a call feature and a reduced investor fee.

The call feature gives Barclays the right, starting one year after issuance, to redeem the notes at their then-current indicative value. Presumably, Barclays reserves this right in recognition of the potential for tracking error to go, er, off the tracks, should hedging be compromised by restrictions on swap dealer exemptions or tighter position limits.

Reserving the right to liquidate the obligation reduces the issuer's risk exposure, but increases the risk for investors. After the call protection lapses, these notes could be called away at virtually any time, while investors are given no additional compensation — i.e., a premium — for their pains.

However, the new notes will be offered with an investor fee of 70 basis points (0.70 percent), 5 basis points cheaper than extant iPath notes. Over time, this should provide some compensation to investors in the form of a discount to the value of the noncallable iPath notes. At the outset, while the call protection's in place, the market will likely determine the discount through arbitrage.

Trading in the noncallable notes was slated to commence June 9, but has been indefinitely delayed by the issuer.

The table below lists the new issues side by side with their noncallable counterparts:

Callable

Note Ticker

Underlying

Index

Noncallable

Note Ticker

DJPC

Dow Jones-UBS Commodity Index

DJP

JJAC

Dow Jones-UBS Agriculture Subindex

JJA

JJUC

Dow Jones-UBS Aluminum Subindex

JJU

NIBC

Dow Jones-UBS Cocoa Subindex

NIB

CAFE

Dow Jones-UBS Coffee Subindex

JO

JJCC

Dow Jones-UBS Copper Subindex

JJC

BALC

Dow Jones-UBS Cotton Subindex

BAL

JJEC

Dow Jones-UBS Energy Subindex

JJE

JJGC

Dow Jones-UBS Grains Subindex

JJG

JJMC

Dow Jones-UBS Industrial Metals Subindex

JJM

LDC

Dow Jones-UBS Lead Subindex

LD

COWC

Dow Jones-UBS Livestock Subindex

COW

GAZC

Dow Jones-UBS Natural Gas Subindex

GAZ

JJNC

Dow Jones-UBS Nickel Subindex

JJN

PLAC

Dow Jones-UBS Platinum Subindex

PGM

JJPC

Dow Jones-UBS Precious Metals Subindex

JJP

JJSC

Dow Jones-UBS Softs Subindex

JJS

SGAR

Dow Jones-UBS Sugar Subindex

SSG

JJTC

Dow Jones-UBS Tin Subindex

JJT

GSPC

S&P/GSCI

GSP

OILC

S&P/GSCI Oil

OIL

CARB

Global Carbon

GRN

Disclosure: No positions

Source: Callable iPath Notes Chart a New Course