How Big Traders Can Extract Excessive Profits

There’s an old saying in poker: if you are playing the game and you don’t know who the mark is, that means it’s you. Given that investment banks like to recruit successful poker and blackjack players as traders, one has to imagine that the ability to play a chump is a useful skill in both arenas.

Except in the world of big-time finance, knowing you are the mark isn’t necessarily any help if you still have to participate.

We raise this issue because there is a propensity among many journalists, economists, and policy wonks to romanticize markets, to see the results of free market operation (if such a thing could really exist outside a laboratory, as we discuss here) as virtuous. In fact, the article below discusses a market practice called “date rape,” which is as upstanding as its label makes it sound. And it isn’t just humiliating, but costly on a scale you might find surprising.

John Dizard, a writer for the Financial Times (and a casual acquaintance), illustrates below how fortune favors not necessarily the brave, but the powerful in his article, “Goldman and its magic commodities box“. Dizard discusses how Goldman plays the commodities market, using its role as the largest manager of commodities index funds (Goldman designed and maintains the most popular index, the Goldman Sachs Commodities Index, or GSCI, the biggest commodities index, which it has successfully leveraged into becoming the largest manager of GSCI-based index funds), market maker, and principal trader (see this post on the questionable role of indexes).

Dizard calculates the collective losses to investors (organizations like pension funds, endowments, and insurers) on the monthly roll of the GSCI (required because the index uses futures contract that expire every month) at 150 basis points on $100 billion of funds, or $1.5 billion. And who is on the other side of these trades? Dizard believes Goldman is at the top of the list:

Two weeks ago, I unfairly profiled the Chicago speculator community. “Profiling”, in the sense of accusing or convicting a suspect based on race or general appearances, is wrong, even in the case of such a rich and privileged group as the “locals”, or speculators in the commodities pits.

I was describing the practice known as index roll congestion, or “date rape”. This involves profiting from the requirement that public investors’ positions in commodities indices be “rolled over” from one contract month to another over a known five-day period. The price of the old month’s contract is depressed and the price of the new month’s contract is inflated. This can be a huge source of profit for those ready to take advantage of the naive public.

In the column, I was correct to point out that index roll congestion costs people who use indices such as the Goldman Sachs Commodity Index something in the order of 150 basis points of return a year. Given that formula-managed commodities index funds have $100bn in assets, of which GSCI-linked funds account for $60bn, a lot of money is being lost by the public to someone.

My mistake was to look at a line-up of the participants in trading on the floors of the exchanges and point out the suspects who wear gold chains, mink coats and alligator shoes, instead of the clean-cut, polo-shirted, Harvard graduate working for the famous public company….

The economic function of the locals, or speculators, in the view of public policy, is to provide liquidity for hedgers who want to offset the risk of a future requirement to buy or sell a commodity. For a price, the speculator commits his capital to taking the risk the hedger is unwilling to assume. Hedgers are supposed to be nice people who act for consumers; speculators are supposed to be non-nice people who wear pinky rings, buy magnums of champagne in nightclubs, run the exchanges and bet against the public.

I had thought that the mountain of index fund money, with its fixed, known periods of buying and selling, would be a source of profit principally for the speculators.

Actually, the problem is that there probably isn’t enough speculative capital relative to the huge weight of the index funds. And, one might add, firms that manage the index funds. Firms such as Goldman Sachs.

Locals besieged me with e-mails insisting on their innocence and said that Goldman was likely to be the principal beneficiary from the index roll. I finally did get a response from the firm. First, Goldman pointed out that it was not the only seller of funds – or notes or swaps – linked to the GSCI. (It is, however, the largest user of GSCI-linked product). The firm said it was obligated only to deliver the closing price on the reference days for each commodity contract in the index.

That means Goldman knows the size and position of the target it must hit and can, as its people say, “manage our corresponding position”. That means that it has to deliver a price at the end of the roll period. If it can cover that obligation at a better price, it will, and pocket the difference.

While Goldman won’t disclose just how good a business this is, it agrees the business is consistently profitable. Given that Goldman knows how many contracts it has to buy and sell on certain dates, that in many pits the GSCI is the biggest single factor in the market and that it has many trading hours to cover its positions at advantageous moments, its profitability is not surprising.

The GSCI has not been as profitable for all the investors who use it to get commodities exposure. Last year it lost about 15 per cent on a total return basis. Goldman itself had a record year. The customers’ yachts weren’t just small, they were under water.

There is no failure to disclose here since Goldman lays out the GSCI’s terms and conditions on its website and in customer contracts. The real failure is with the institutional investing community that still does not understand how commodity markets work.

Goldman’s people and its shareholders aren’t the only winners in the game with institutional commodity investors. As one local said: “Grain companies [and other physical dealers] are winners too because they own storage and are short hedgers.”

Also commodities funds that give some freedom to their managers to roll their positions on dates other than when the index rolls take place can earn a significantly better return.

But that requires the investor to concede some discretion to the manager. And too many want a magic, automatic box that prints money. Sadly, that doesn’t exist. Unless, that is, you own an investment bank that has an ingenious marketing department.

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