An SEC action that appears likely to do considerable harm to companies and individuals in the US and abroad appears to have gone completely unnoticed, save for an important piece in The New Republic by Linda Khan.
Heretofore, as Kahn describes, the main participants in physical commodities markets ex precious metals have been end users. While there have been reports of metals hoarding in China, it’s not easy for most investors to do since they are bulky. (Oil is a special case, since producers can speculate simply by “inventorying” oil by keeping it in the ground; above ground storage is limited and not as “efficacious” in the words of oil investor Dan Dicker, as one might think. The picture is oil is further complicated by the fact that the prices for OPEC oil are based on an average of futures prices, not spot prices, which producers found were subject to manipulation).
The SEC has paved the way for investors to take a direct stake in commodities, rather than through commodities futures. The agency gave the green light to JP Morgan to launch a fund whose shares would be backed by warehoused copper. The implications are not pretty. Per Khan:
In practical terms, the SEC handed traders at J.P. Morgan control over 20 to 30 percent of the copper available for immediate delivery from the London Metals Exchange — the commercial market where companies that use copper go to procure last-minute supplies.
The investors purchasing shares in J.P. Morgan’s fund won’t be buying copper to use, but to store. The intricacies of the fund are complex, but its underlying rationale is straightforward: the more shares investors buy, the more copper is taken off the market. And the more copper that is taken off the market, theoretically the more valuable the copper and the shares become.
Moreover, it’s a no-brainer that this JP Morgan “innovation” will lead to the creation of copycat fund in other markets, most troublingly those for agricultural products.
The SEC asserts that its own study showed that changes in inventory levels at the LME did not have a price impact. That’s just barmy. The question regarding the LME would be to define what a normal level of inventory would be (a certain level is necessary to handle routine transactions); amounts in excess of this buffer level would be seen by economists as proof that prices were above the true market clearing price unless you had a good explanation as to why not. Not surprisingly, experts pooh-poohed the SEC analysis:
….companies that use copper strongly oppose the new fund, and argue that allowing investors to hoard the metal will lead to supply shortages, create substantial price volatility, and distort the market. “The implications of this practice would be grave for our companies, our industry, and, indeed, for the U.S. economy,” a group of copper users wrote to the SEC in August…
Public interest groups and academics also criticized the methodology the SEC used to justify its decision. John Parsons, a financial economist and lecturer at MIT, said the SEC failed to consider how the copper market actually works. “Just as the SEC staff did in the Madoff case, it carefully asks the wrong questions and thereby comes to easy answers,” he wrote.
The SEC is undermining provisions in Dodd Frank calling for the CFTC to rein in undue speculation in critical commodities. Readers may recall that commodities prices moved up in a coordinated manner in 2008. It looked like a speculative bubble, and was, since prices collapsed in the second half of the year (we were pretty sure that oil was a bubble, and called it and even traded it well; there was similar behavior in other commodities, but bad harvests and ethanol subsidies made the price rises arguably influenced by fundamentals in the grains complex). Seasoned regulators are aghast:
“Allowing investors to speculate in the futures market created horrific price volatility,” said Michael Greenberger, a law professor at the University of Maryland and former director at the CFTC. “Here, you’re allowing investors to intervene with physical supplies. We’ll see a double whammy.”
Like it or not, the SEC has created a real world experiment. BlackRock has petitioned the agency to launch its own copper fund, one that would be twice as large as JPM’s and will get an answer by February 22. Given that its proposal is identical to JPM’s, it is well nigh certain to be waved through. If the nay sayers are correct, that hoarding by investors will drive prices up, we should see the impact (although the mere announcement of the JPM approval, particularly in light of the pending BlackRock application, may have led speculators to bid up prices in anticipation of the funds’ launch. That too should be measurable). But if the next few months proves the SEC analysis to be wrong, you can bet the agency won’t admit its error and halt the creation of more funds. If these concerns are borne out, we can only hope that real economy players put pressure on Congress to shut this toxic innovation down.