Unintended consequences, that is.
ETFs have been a big deal for several years now, including commodity ETFs. Heretofore, the big commodity ETFs have been in energy, but now several firms have metals ETFs in the offing.
Most traditional ETFs have bought futures contracts. So the US Oil Fund, for instance, buys NYMEX light crude futures. As the contracts it holds near expiry, it rolls forward into deferred contracts, buying the deferred and selling the nearby.
But the new metals ETFs will invest in, and hold stocks of, physical metal rather than derivatives. FT Alphaville, quoting from a JP Morgan prospectus for its new copper ETF, has the details:
Firstly, being physically backed and not futures-based — the trust will escape all regulatory restrictions governing the size and scope of its speculative commodity positions (since there’s no exchange presence). No USO or UNG implosion danger here.
As the documentation states:
The Trust will take delivery of Physical Copper in the form of LME Copper Cathodes. Because the Trust will not trade in copper futures contracts on any futures exchange, the Trust will not be regulated by the CFTC under the Commodity Exchange Act as a “commodity pool,” and will not be operated by a CFTC-regulated commodity pool operator. Investors in the Trust will not receive the regulatory protections afforded to investors in regulated commodity pools, nor may the COMEX or any futures exchange enforce its rules with respect to the Trust’s activities. In addition, investors in the Trust will not benefit from the protections afforded to investors in copper futures contracts on regulated futures exchanges.
Note, too, that as a result it is likely that the ETF will not be subject to position limits. And I think this is a big part of the reason for going physical.
The construction of the fund to avoid regulation is clear as day. The effects are not likely to be good. The advantage of using derivatives (futures or swaps) to construct ETFs is that it makes it possible to achieve an arbitrarily large exposure to the price risk of the underlying (oil, or copper, or whatever) without ever handling the physical. That is, derivatives allow the unbundling of the price risk and the holding of the physical product. This lowers transactions costs, and crucially permits investors to achieve portfolio and risk objectives without being constrained by the size of the physical market.
In contrast, physical ETFs cannot exploit this unbundling. But apparently, the benefits of avoiding position limits and other regulatory costs are sufficiently great to justify the loss of efficiencies associated with this unbundling. (If the bundled risk-physical solution were better than the unbundled one, you would have seen physical ETFs when the regulatory constraint wasn’t a real threat.)
There is a perverse irony here. The whole rationale (supposedly) for position limits is that speculation somehow distorts physical markets. There is precious little evidence, outside of a few extreme examples (e.g., the Hunts) that this is a real problem. But by driving those that want exposure to metals prices, either for speculative reasons, or for portfolio balancing reasons, regulations are making it more likely that speculation will distort prices and the physical markets.
I’m not saying this will happen, or will be chronic. Only that distortions are more likely in the bundled world than the unbundled one in which ETFs trade in derivatives rather than the physical. ETFs that roll aren’t in the physical market, rolling out of expiring positions before they can go physical. This limits, and likely eliminates, their effect on prompt prices and consumption, production, and storage decisions.
In contrast, ETFs that hold the physical are by definition in the physical market, and there can be a conflict between the risk and profit objectives of physical ETF holders and the efficient allocation of physical supplies; those desiring exposure to metal price risk might hold onto stocks when it would be optimal to consume them instead. Conversely, in an unbundled world, traders can maintain exposure to the price risk without having any influence on the use of the metal.
I can also imagine some manipulation strategies that exploit the physical ETF. For instance, somebody could obtain a big physical position via the ETF, and use that to create or enhance market power in the derivatives market. That is, the ETF can be a way of “locking up” metal that would otherwise be available for delivery, thereby enhancing market power in the derivatives market.
I said this was a perverse irony. It’s actually more perverse than ironic. A policy intended to reduce (probably chimerical) distortions in the physical market actually increases the likelihood that such distortions will occur. That’s the kind of havoc that Sorcerers’ Apprentices wreak. Get used to a lot of that going around.