The following is an open letter sent to the Commodity Futures Trading Commission (CFTC), in response to their request for questions from the public to be considered for use during the April 22, 2008 agriculture roundtable. This roundtable was called due to convergence issues between futures and the spot price in the cash grain markets.
To whom it may concern,
First, we would like to commend the Commodity Futures Trading Commission (CFTC) for facilitating the April 22, 2008 roundtable discussion on the agricultural markets.
We are long time participants and registrant in the futures industry. One of the things we proudly point out to interested investors is the fact that we operate in a highly regulated market and are members of the National Futures Association (NFA).
Overall, the CFTC and the NFA have done an excellent job as regulators. While no one likes an audit, the principles-based structure has served the industry well, and there are clear guidelines as to how to operate. Admittedly there are grey areas too, and prior guidance such as the "fully-funded subset methodology for calculating rate of returns" was problematic. But setting aside specific concerns, the CFTC and the NFA, on the whole, deserve recognition for their accomplishments.
Recently, however, there have been financial innovations involving the commodity markets which for various reasons have developed outside the direct oversight of the CFTC. This has been disconcerting because we believe such developments have served to undermine the integrity and authority of the CFTC to oversee the commodity markets.
Below is a list of questions that we would like to raise to the CFTC as we believe they relate directly to the matter at hand:
1) Our research reveals that commodity-linked ETFs are materially different from futures contracts. Most significantly, they do not serve an economic purpose in providing a means for bona fide hedgers to hedge. Specifically, shorting a commodity-linked ETF does not result in the ETF reducing its underlying commodity exposure, therefore its bias to the long-side is systemic. If such instruments undermine the economic purpose of the futures market, why have they been allowed to be marketed by the securities industry?
2) Acknowledging that securities are specifically excluded from the jurisdiction of the Commodity Exchange Act (CEA), but also noting recent rules imposed on the innovation of the single stock futures hybrid, why is it that Series 7 securities representatives can now sell commodity-linked products without a Series 3 license and without registration as associated persons? Is this not a violation of the CEA and CFTC regulations?
3) "Why are commodity-linked exchange traded funds (ETFs) allowed to be registered as exempt commodity pool operators despite the fact that these institutions market their securitized commodity-linked vehicles to the retail public?" Similarly, how can it be that so many hedge funds have now exploited loopholes in the CEA as to participate directly in the commodity markets vis-a-vis over-the-counter (OTC) derivatives without having to become registrants? It seem clear now that "exemptions" under the Commodity Futures Modernization Act of 2000 have served to undermine the authority of the CFTC, and put the industry as well as the economy at risk.
4) Why are securities firms allowed to market commodity-related securities products without the same constraints which are imposed on futures industry registrants? For example, many promoters of commodity-linked index funds and ETFs state as fact the theory of the 'roll return' or 'roll yield,' when in fact such structural risk premium is hotly debated by academics and practitioners, and is based on past performance. In other words, it is a hypothetical concept, but securities professionals have been allowed to market this idea without providing required hypothetical disclosure which would be required by futures professionals.
5) Why are securities professionals allowed to hold themselves out as commodity professionals? The debasing of this core rule has led to confusion in the public's mind and threatens the futures industry profession, thereby undermining the CFTC's authority as granted by the CEA.
Thank you for accepting the above questions to be considered for use during the roundtable. We believe the concerns they raise are directly related to the matter at hand.
We plan on submitting a written statement for the official record by May 7th, but would like to use this opportunity to make the following observations prior to the roundtable discussion.
We believe that the "securitization of commodities," a difficult topic in itself to analyze given the proliferation of different types of securitized commodity instruments, has led to an undermining of the prime economic purpose of the commodity futures market.
The primary benefit provided by these markets is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge. Hedging is indispensable to our financial system. Securitized commodity products are not structured to serve that purpose however. Rather, this innovation has allowed money flows to distort price discovery, while at the same time undermine the all-important hedging utility. Further, they are sold as investments, when in fact these products are speculative.
A major point of confusion which has led to exploitation by promoters of securitized commodity products, as well as the OTC derivatives market as represented by the ISDA, is the Commitment of Traders (COT) reports. We urge the CFTC to take action as recommended by the majority of commentators to the 2006 "Comprehensive Review of the Commitments of Traders Reporting Program." This recommendation was that the Commission continue to publish the COT reports, and that such reports be revised to include additional categories of data, such as positions held by swap dealers, so that a clearer understanding of which participants are benefiting from price moves can be monitored. This is of national economic concern, which in turn has international dimension and implications, as noted by the United States Senate Permanent Subcommittee on Investigations.
Finally, I would like to state that the career of commodity futures speculation is an honorable trade if practiced honorably. I fear, however, that our industry has been overrun by the securities industry, which does not have the same priorities.
Very truly yours,