Streetwise Professor

November 21, 2012

An Alfred E. Newman Take on JPM’s Physical CU ETF

Filed under: Commodities,Derivatives,Economics,Politics,Regulation — The Professor @ 4:01 pm

John Parsons and Antonio Mello at Betting the Business rightly slam the SEC’s evaluation of JP Morgan’s application to create a physical copper ETF. They are spot on that the SEC’s Division of Risk, Strategy, and Financial Innovation’s analysis was superficial, and quite frankly, silly.  Who knew that there was no connection between copper prices and inventories?

That said, I think that Parsons & Mello are far too generous in their praise for the comment letter submitted by the Americans for Financial Reform (an advocacy organization with strong ties to organized labor).  That letter posits some very speculative feedback loops: prices go up, people get excited about copper, they buy more of the ETF shares, driving up the price, and on and on.  If that mechanism exists, wouldn’t it exist even without the ETF?  And I’m dubious about the strength of that mechanism if it exists, and in fact doubt its very existence.

The only real concern is that the physical ETF somehow constrains the response of inventories to supply and demand shocks.  Inventories should rise when there are surprise negative demand shocks or positive supply shocks, and should fall with surprise positive demand shocks or negative supply shocks.  Speculative storage adjusts inventory in response to changes in fundamental conditions, and the forward curve is determined simultaneously.

If the ETF somehow impeded inventory adjustments, there would be a problem.  Here it should be noted that there is an asymmetry.  It is hard to see how that the ETF could in any way constrain increases in inventories.  If demand declines, for instance,  there is nothing to preclude traditional speculative storers from adding to inventories.

Things are conceivably different when inventories should decline.  One can at least consider the possibility that holders of the ETF would lock up inventory.

There is a redemption mechanism that limits this possibility.   “Authorized participants” (basically broker-dealers) can redeem ETF shares and receive physical copper in return: these firms would likely be ones that act as speculative storers in the absence of the ETF.  Thus, an ETF share is effectively a perfect substitute for copper warrants, and its creation does not obviously alter the market mechanism in a fundamental way.

I guess one could tell a story that goes something like this.  Irrational investors (not participants in the physical markets) hold onto ETF shares even if some of those shares should be redeemed and inventories released onto the market.  As a result, prices become too high.  Due to the excessively high prices, the Authorized Participants don’t buy and redeem the ETFs, cancel the warehouse receipts and load out copper when it should be loaded out.

For this price distortion to occur, the quantity held by the stubborn, irrational ETF investors must represent a binding constraint: they must end up holding the entire inventory.  Thus, a necessary condition-but not a sufficient one-for the ETF to distort inventory holdings (and hence prices) is that the ETF holds 100 percent of inventories.  (Note: things are a little more complicated because LME warehouses are located around the world, but the JPM ETF’s copper holdings will be limited to its Henry Bath warehouses.  It is conceivable that some inventory should be taken out of Bath warehouses, but isn’t due to the stubbornly irrational ETF holders.  So ETF holdings=100 percent of Bath inventories could be a symptom of a distortion, even if there are inventories in other LME regular warehouses.  However, to the extent that inventories in other locations are close substitutes for Bath inventories, the potential for a distortion is limited.   That’s one reason to have multiple delivery locations.)

Moreover, stubborn ETF holders who distort prices present a great short selling opportunity.  That also tends to limit the potential for a price distortion, particularly a large, enduring one.

My take on the JPM phyz ETF is therefore Alfred E. Newman-esque.  What?  Me worry?  One can imagine circumstances where it causes a problem, but the symptoms of this are clear: the ETF owns all the copper.  If those symptoms don’t arise, there’s no problem.  If they do-an unlikely event, IMO-take a look at it then, and figure out what to do in that event.

In other words: don’t borrow trouble.  Deal with trouble when-and if-it arises.

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