We just spotted Intercontinental Exchange CEO Jeffrey Sprecher’s view on ETFs in the commodity space:
Changes to Exchange Traded Commodity Funds May be Required
A recent phenomenon has been the emergence and growth of Exchange Traded Funds (“ETFs”) that invest in commodity futures. While such ETFs may represent a convenient mechanism for investors to access commodity futures markets, these funds regulated by the Securities and Exchange Commission with investor protection in mind, may not contemplate the ability of the CFTC, or CFTC regulated exchanges and trading platforms, to order down the size of an ETF’s position.
Redemption mechanisms within the ETFs must facilitate the fund manager’s ability to redeem and retire its units or shares, so as to allow the size of the fund to be reduced. Without such mechanisms, commodity positions may simply be shifted between exchange traded and OTC venues, as ETF fund managers have little ability to stem the funds inflow from new investors. CFTC and SEC regulation and oversight should be coordinated with respect to commodity ETFs.
Essentially, Sprecher thinks ETFs should be exempt from position limits because otherwise they will be forced into the dark world of unregulated “off exchange” trading. Of course, encouraging funds to keep their business on exchange would make an awful sense for the likes of ICE, which has attracted significant order-flow from funds like the UNG and USO.
Sprecher’s questioning, meanwhile, also revealed that he believes index funds have a dampening effect on prices if anything. Of course, the issue with ETFs like the USO and UNG was never about them driving prices higher. It was always about the effect their rolls had on time spreads, and contango in particular.
ICE, meanwhile, has made significant strides into penetrating the OTC market in the last year by offering clearing services and the capability to match bilateral bespoke OTC orders over its specifically developed OTC platform.
Accordingly, should it be surprising that Sprecher — with ICE so perfectly positioned for attracting OTC business — is a big fan of disincentivising trade via the opaque non-centrally cleared OTC markets? As he testified:
Aggregate position limits should be set by the CFTC in a transparent fashion and updated regularly. Position limits should be set according to market size to prevent manipulation and delivery disruptions, not to influence commodity price levels. In determining position limits or accountability levels, the CFTC should consider the entire size of the energy market in question — both exchange and OTC. While the feasibility or necessity of OTC position limits is not the subject of this hearing, it is clear that the Commission has the authority to collect data on the OTC markets. Failing to accurately assess market size in setting position limits, accountability levels and appropriate exemptions will likely result in artificially low limits, creating barriers to a well-functioning, centrally cleared and regulated derivatives market and keeping positions in the opaque OTC markets.
Let us also consider the other major significant development in commodity markets the last few years: the rise of electronic trading. ICE was among the key innovators in this area.
In a world where technology and algorithms can give you an immediate advantage there’s a huge incentive in electronic-izing OTC order flow. Bring it on exchange and the algos can work their magic for those who can afford the software development costs. Although the speed advantage isn’t quite as advantageous here, the information can be processed into analytical tools.
OTC bilateral trade is traditionally conducted via brokers or directly by phone, email or Yahoo messenger. Platts, the OTC price-discovery agency, assesses the market by encouraging traders to submit to them deals, bids and offers during a specific half-hour time frame known as ‘the window’. Only these numbers are then considered for the compilation of the daily Platts benchmark — used by the market for the pricing of swaps and other contracts. The incentive to comply exists in the fact that market participants want to contribute towards the makings of a fair benchmark. If you don’t participate, the benchmark risks being hugely off-market.
But there has always been scope for manipulation. By trading at completely different prices before the window versus those during, some say large players can move the benchmark to their advantage, meaning it is no longer indicative of the market. Platts takes such allegations very seriously, however, and insists its methodology is very proficient at guarding against manipulation.
Nevertheless, when Platts and ICE announced they had joined forces to begin conducting the window in certain contracts electronically over ICE screens, the market responded favourably. On ICE screens, increased transparency comes in the fact that market participants have more prices openly to compare, while Platts simply has more prices to consider. Platts, meanwhile, describes its relationship with ICE thus:
The new online-based assessment window will be just for the price assessment process by Platts and will be independent from ICE, Platts said.
And while that’s all very lovely, the point here is that the OTC market still risks becoming a two-tier system: one market conducted electronically for the purpose of the window — which contributes to the formation of benchmark prices zapped through blackboxes at a moment’s notice — and the other, conducted as usual off-exchange, outside of the window and out of sight of the regulators.
Those who have an understanding and influence over both, meanwhile, clearly have most to gain. And it’s understandable too why they might want to keep the ‘uninformed money’ in one specific section only.
Related links:
Presenting, the ‘physical loophole’ – FT Alphaville
GLG goes physical – FT Alphaville
Evil commodities speculators in the dock - FT Alphaville
Electronic trading and commodity prices – FT Alphaville