SEC Gives JP Morgan and Other Big Banks License to Manipulate Commodities

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.

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  1. diane

    Looks like they’ve put years of planning into the controlling and warehousing of commodoties, while the regulators in charge stuffed their pockets:

    06/16/11 (bolding mine):

    GS, JPM and Glencore now control virtually the entire inventory bottlenecking pathways: “In recent years, major investment banks like Goldman and J.P. Morgan and commodities houses like Glencore have been snapping up warehouses around the world, turning the industry from a disperse grouping of independent operators into another arm of Wall Street. The LME has licensed about 600 warehouses around the world. The transformation has raised questions about whether the investment banks, which also have big commodity-trading arms, are able to use their position as owners of warehouses to manipulate prices to their advantage.”And since the outcome of this anti-competitive delayed tolling collusion ends up having quite an inflationary impact on end prices, the respective administrations are more than happy to turn a blind eye to this market dominant behavior which buffers the impact of deflation on input costs. We may have seen the end of the OPEC cartel. Alas, it has been replaced with a far more vicious one – this one having Goldman Sachs and JP Morgan as its two key members.



  2. Conscience of a Conservative

    Investors are looking to diversiy. Stock and bond markets don’t offer attractive returns and there is the inflation risk and fear of u.s. currency depreciation so this makes sense. If the fund were to merely hold the physical commodity I would not be overly concerned. I’d like to see more details perhaps the prospectus. My suspcion is that the fund won’t be holding the physical metal in entiretly and that the fund could wind up being a giant ETN where investors take on counter-party risk.

    1. Yves Smith Post author

      Please read the underlying article. It was very clear that the fund will hold the actual commodity and that the opposition was based on how much of the LME the JPM fund alone would control.

      Look, GLD now is the fifth biggest holder in the world of gold. Investors prefer holders of the actual commodity. And as a retail investor, I would never never buy an ETN, I regard them as considerably inferior to ETFs (I’d elaborate except I need to turn in).

      If you are worried about currency depreciation, buy a basket of foreign currencies, or unhedged foreign bonds (T Rowe Price has a fund which has done a very good job of country/bond selection) or precious metals. You don’t need to distort markets for actual commodities to find a decent hedge.

    2. from Mexico

      Conscience of a Conservative says:

      Investors are looking to diversiy. Stock and bond markets don’t offer attractive returns and there is the inflation risk and fear of u.s. currency depreciation so this makes sense.

      So the money-at-interest rentiers have pushed the blowing of debt/asset bubbles to the breaking point, so now they’re turning their attention to monopoly capitalism?

      Makes sense to me.

      1. skippy

        It would be more – honest – to invest with some drug lord than the exchanges – banks… these days.

      2. TC

        Makes sense to me, too. It’s either consolidate via manufactured asset grabs or succumb one way (deflation) or another (hyperinflation) to circumstance debt/asset bubbles otherwise preordain.

  3. BondsOfSteel

    Actually, I think this is a good thing. If this copper store will be like the SPDR GLD ETF, what JPM is actually doing is setting up a secondary market in copper. This secondary market can even out any spikes in the primary market by delivering stored copper if the price/demand rises too high, or storing if the price/demand is too low. Long term, this is a good thing.

    The problem is with the short term. With treasures yeilding almost nothing, there is a lot of cash with few places to go. It’s possiable that short term, we can see this cash go into physical stores of commodities, negating some Fed action by driving commodity inflation.

  4. Jamie Elswick

    So my investment strategy of hoarding US Nickels – the only currently minted circulating coin whose metal value (75% copper, 25% nickel) exceeds its face value (at least as of this writing, currently worth $0.0515693) – is looking pretty smart! And if the price of copper falls for whatever reason – I can always just spend them!

    Sure beats leaving it in a bank where it can earn 0.000025% interest…

  5. Lune

    This may be a stupid question, but I’m curious how current regulations *prevent* JPM or anyone else from doing this right now? For example, if a bunch of my friends and I wished to rent a warehouse, then buy copper from the LME and stuff it in our warehouse instead of using it, who could stop me? This is what investment banks did with oil (remember those stories of tankers filled with oil parked offshore?) and ETFs currently do with gold.

    Is there actually a regulatory distinction made between end-users and speculators that prohibits speculators from taking physical delivery of copper (or ag products) at the expiration of a futures contract?

    I’m not defending the SEC, but I wonder if the real story here is not SEC perfidy but rather that JPM found a regulatory loophole that allows their fund to be regulated through the SEC rather than the CFTC and be bound by a completely different set of rules than traditional commodity funds.

    1. Roger Fox

      You and your friends could probably do that and be legal. The problems start when a regulated entity (a bank) wants to do it and market it like an ETF/security – now the whole range of regulations comes into play.

      Copper is a commodity that industry actually uses to make things; until now it has never been a ‘money substitute’. Gold has never had any significant share of its supply used for industrial purposes; it’s never been anything other than a ‘money substitute’. All gold is effectively ‘warehoused’, all the time.

      If this ETF demands that copper be withdrawn from circulation for industrial use and be placed ‘indefinitely’ into warehouses (as is done with some gold funds) – how does this not squeeze the supply available for industry?

      This thing has ‘boom/bust’ written all over it IMO. Banks that play it right will make big money, and those that don’t will get bailed-out, again.

    2. ominousMIDI

      I was also wondering why this was a call for the SEC to make (as opposed to CFTC). SEC would have jurisdiction over the setup and trading of the fund, but it seems like CFTC would still have to sign off on the underlying copper trades (not to imply they’re better @ their job and would actually block the thing, either).

      Sorry if it’s a dumb question, but I’m kind of new to the whole “in-depth tracking of corporate corruption” thing. Is there something specific about this fund designed to skirt CFTC scrutiny? What am I missing here?

  6. Bagehot by-the-Bay

    JP Morgan has a comparable share of the silver market (>30%), and has the power to put the price of silver just about anywhere it wants. Running a copper EFT will give JPM a whole new set of tools for gaming yet another market. For just one example, its traders will be able to short its own EFT with impunity; in a pinch, as the entity running the EFT, JPM can cover these shorts by making a paper ownership transfer of metal and creating new shares.

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