CFTC Commodity ETF Restrictions: Not Tall Enough to Regulate

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Includes: DBA, DBC, UNG, USO
by: Craig Pirrong

Historically, the CFTC has not been an overly intrusive regulator. It has not attempted to push its jurisdiction to its limits, and in most areas it compares favorably to other federal regulatory agencies. Under pressure from Congress, and exploiting the opportunities presented by the financial crisis, however, the CFTC is becoming much more aggressive and ambitious.

The most recent cases in point: its actions to clamp down on index funds, and now exchange traded funds (ETFs). Last week, the agency revoked position limit exemptions for two ETFs offered by Deutsche Bank. Seeing the threat from restrictions on the ability of ETFs to hold positions, several sellers of the funds, such as Barclays and the UNG fund, have announced that they will not issue new shares, even though these shares are selling at a premium.

Just what is the theoretical or empirical basis for these restrictions on commodity ETFs? Beats me. It is possible that these funds affect prices when they roll from an expiring contract into the next one, but there is a self-correcting mechanism that would mitigate these effects: the funds demand for liquidity is known, both in its approximate magnitude and certainly its timing. This permits the flow of additional capital into the market during roll periods to mitigate the price impacts. Moreover, to the extent that ETFs affect prices during the roll, they tend to move prices against them. That is, their price impact raises their cost and reduces their performance. Since the funds have to compete with other investment vehicles for funds, if these costs become too large and thus impair performance sufficiently, the flow of money to the funds will decline.

But I don’t think it’s the roll issue that exercises certain CFTC commissioners. I think that they really believe that these ETFs distort prices. The basis for that belief escapes me. The Commission surely has produced no reliable evidence of such an effect, nor have I seen any reputable academic studies documenting such an effect. Moreover, although many of these funds are “long only,” leading some to claim that they inflate prices, there are also funds that profit when prices go down, meaning that there is no necessary structural bias towards purchases.

Before interfering with the ability of investors to allocate capital across alternative vehicles, a government regulator should have a very strong logical and empirical basis to conclude that free choices are inefficient, and are distorting prices. It should identify a market failure, and provide empirical evidence that this market failure is resulting in a material distortion in prices and resource allocations. Moreover, it should analyze rigorously the effect of its actions: How will investors respond to the regulation? If the flow of funds is distorting market X, will limiting the flow into X just divert monies into markets A, B, and C, distorting those prices? Or, will investors respond to constraints on the size of a given fund by splitting investments across multiple funds, thereby sacrificing management scale economies and inflating costs?

The CFTC has done none of these things. None. It just justifies them with vacuities such as:

Cutting out individual investors isn’t the goal, said Bart Chilton, a CFTC commissioner, in an email. “The Commission has never said ‘You aren’t tall enough to ride,’ ” Mr. Chilton said. “I don’t want to limit liquidity, but above all else, I want to ensure that prices for consumers are fair and that there is no manipulation — intentional or otherwise.”

The CFTC seems hell-bent on segmenting commodity and financial markets, apparently viewing the commodity markets as some kind of ghetto, or insufficiently responsive to normal economic forces to be largely self-regulating. This is bad finance. The goal of public policy should be to encourage the integration of financial markets to ensure the efficient allocation of risk across investors and market participants, and the consistent pricing of risk across these markets.

Chilton’s statement is shocking for another reason. Consider the last sentence: “I want to ensure that . . . there is no manipulation — intentional or otherwise.” Now, note that as a CFTC commissioner, Chilton may have to rule on manipulation cases. Therefore, although it would be nice if he knew economics, it is imperative that he at least know the law. But Bart Chilton apparently does not, or is in the habit of speaking so carelessly as to give the impression that he does not. In fact, under existing case law, including CFTC decisions, to find someone guilty of manipulation under the Commodity Exchange Act, four conditions must be met. One of these conditions is that the accused have a specific intent to cause an artificial price. (See especially the Commission’s decision in the in re Indiana Farm Bureau case.)

In other words, “unintentional manipulation” is a legal oxymoron, at least so far as the CEA is concerned.

So, here we have one of the commissioners with responsibility for enforcing Federal anti-manipulation laws who apparently does not know the law.

Rather than speaking carefully, and expressing views that are consistent with the laws and precedents that he is charged to enforce, Chilton appears to be the poster child for the arch comment of a Texas cotton trader testifying before the Senate in 1928: The word ‘manipulation’ . . . in its use is so broad as to include any operation of the cotton market that does not suit the gentleman who is speaking at the moment.”

ETFs apparently do not suit Bart Chilton. God knows why. But to justify his dislike of them, he throws around the very, very heavily freighted word “manipulation” in a way that is inconsistent with its meaning under the laws that he is responsible for enforcing. That is very disturbing. Very. If you use that word, you better have a high degree of confidence that you have the law, the economics, and the facts on your side. On that score, Chilton strikes out. Ignorance of the economics is, alas, pretty common. Ignorance of the law is inexcusable.

Yesterday I wrote about the German financial regulator Bafin seeing no evil in what the data strongly suggest was one of the largest manipulations in history. Today I write about a US regulator who sees manipulations where there is no evidence that they exist.

Keep this in mind when anybody – a Congressman, a regulator, or a talking head – tries to convince you that more regulation is the key to reducing the prevalence of misconduct in financial markets, and ensuring that these markets work more efficiently. Regulators can make both Type I and Type II errors: false positives (Chilton) and false negatives (Bafin). I would suggest that the rates for both type of error is extremely high, especially when policies are predicated on as little logic and evidence as the crackdown on commodity ETFs. I would further suggest that the costs of these errors are very high, and importantly, those that make the errors do not incur the costs–which would tend to explain why they make so many of them.

The CFTC is getting vast new powers, and asking for even more (cf. Chairman Gensler’s letter to the Congressional Agriculture committees regarding the Administration’s draft OTC regulation bill). It does not inspire confidence that at least one of the commissioners who will exercise these powers does not even know one of the very fundamental tenets of the law governing the powers he already has.