thanks, keep posting on these commodity rule changes coming around 4/22/08...
am trying to get my hands around this issue...
FWIW, Butler seems to think gold and silver will not be impacted much...
news.silverseek.com
Now, on to the index fund discussion. As I have previously written, index funds operate very differently from the tech funds. The tech funds buy and sell on price signals, mostly various moving averages. They buy on the way up and sell on the way down. This makes the tech funds a perfect food supply for the commercials, who know how to maneuver the tech funds in and out of the markets. The index funds, in contrast, do not trade on price signals but are long term buy and holders who trade infrequently, mostly to roll over their futures positions from one contract month to another as delivery draws near. In addition, the tech funds are different from the index funds in that the tech funds operate on a leveraged or margin basis, whereas the index funds generally have the full cash value of the contracts they own to back all their holdings.
While the tech funds exist to earn short-term speculative returns, the index funds are attempting to generate long-term returns by replicating the performance of various well-known commodity indices. Because the investors behind the index funds are big, blue chip institutional investors, like pension funds, the amount of money collectively involved has grown to a staggering sum, on the order of $200 billion.
This vast sum of money has resulted in the index funds holding truly massive amounts of contracts in many commodities, almost exclusively on the buy, or long side. Because the number of futures contracts and the percentage of the market they represent in many commodities, many have come to question the impact these index funds are having on the price of commodities, most of which have recorded record price highs in recent times.
Have the index funds, due to their sheer size, unduly influenced commodity prices? What downward pressure could be expected if the index funds exited these markets by selling their massive long positions? This was the gist of the Barron’s article. Further, the article suggested the regulators forced the index funds to sell because they exerted too much upward pressure on price, negatively impacting inflation rates for everyone.
Most importantly, how much, if at all, would such an unwinding of index fund futures positions impact the price of commodities, especially silver (and gold)? Up until now, I have tried to frame the issue as objectively as possible. What follows is my opinion concerning silver. For the record, I have little, if any, interest in whether agricultural commodity prices (where most of the index fund debate is centered) go up or down. I am, however, concerned about the regulatory issues involved, although probably not in ways you might guess.
When the index funds got involved in the commodity futures markets several years ago, they were welcomed with open arms by the exchanges. The exchanges, mostly represented by commercial short sellers, thought they had been presented with a source of big money that they could milk. After all, the index funds were prohibited from taking actual delivery by the funds own business plan. When contracts on the index funds came due for delivery, the funds would automatically and religiously roll the contracts over to more deferred contracts.
This set up was manna from heaven for the exchange insider commercial shorts, who never had to worry about a short delivery squeeze from the index funds. The shorts, as the market makers, could dictate how much the index funds had to pay up to roll their contracts over, many times per year. It was the closest thing to a money machine for the shorts as could possibly be imagined - big long positions that couldn’t demand delivery, but had to be rolled over at whatever spread differences the shorts would demand. And the shorts royally raked it in for years.
So what’s the problem? And why are there calls to force the index funds to be forced to sell? The problem is that the shorts, through pure greed, created a Frankenstein. As the index funds’ long positions grew larger, that necessarily required equally large short positions, as there must be a short for every long, and vice-versa. The shorts were happy to accommodate the index funds by shorting more contracts, until conditions in the real market demanded higher prices. Crop failures around the world and demand from China and elsewhere resulted in shrinking inventories and critically tight supply/demand circumstances.
To those who are looking to blame commodity price escalation squarely on the index funds’ doorstep, please think again. Very recently, for example, it has become obvious just how serious a tight supply/demand situation has become in rice, with shortages and export bans being announced. In fact, there is genuine concern of food riots and civil unrest in many urban areas of the developing world, as rice constitutes an important staple in billions of people’s diets. Rice prices have doubled over the past year, for many of the same reasons that have caused other grains and commodities to increase in price. But there is virtually no participation by the index funds in rice futures, so it’s silly to suggest that the funds are responsible for all price increase evils.
With such real supply/demand realities, prices naturally moved higher and the shorts realized, only then, that they had an enormous risk exposure. It wasn’t that the index funds bought more as prices rose, they basically just held the large positions they always held. But because their positions were so large to begin with, it put the shorts in a very bad situation. And since the index funds don’t sell, but buy and hold, the shorts couldn’t buy back their short positions.
Even if prices come down sharply, like they have recently, the index funds still hold. With the full cash value of each contract backing the index funds holdings, they can’t be forced out by margin calls. The tech funds do sell, allowing the commercials to buy back short positions, but not so with the index funds. The commercial shorts can’t buy back the bulk of their short positions unless they can force the index funds to sell. Hence, they are pressuring the CFTC to change the rules and force the index funds to sell.
As I wrote, I don’t have a dog in this fight, but it does gall me to see the commercial shorts angling to change the rules again because they miscalculated. I do think it was a mistake that the regulators didn’t anticipate this problem, but what’s new? In the CFTC’s case, none of the current Commissioners were in office when the index funds first entered the markets, so they bear no personal blame. For continuing to allow the silver manipulation to exist, they deserve plenty of blame. For the index fund problem, I don’t think so.
While I don’t quite comprehend why pension funds and other big institutional investors should have a massive presence in commodity futures contracts in the first place, they appeared to have followed all the rules and it’s inherently unfair to force them out of positions they were legally allowed and encouraged to enter, just because they put the commercial shorts in an uncomfortable position.
One thing I do like about the index funds’ participation is that it finally challenged the decades-long strangle hold the big commercial shorts had on all the markets, that resulted in ultra-low prices. In a very real sense, the index funds were the farmers and commodity producers best friend. Those farmers and producers will surely suffer if the index funds are forced to sell. Perhaps the CFTC will strike a King Solomon-type decision by putting a moratorium on new index fund buying, but not force them to dump existing positions. In any event, it’s not my problem, except for a point I will make shortly.
What does this mean for silver? Not much. Maybe there might be some short-term psychological influence if the index funds are forced to dump unrelated agricultural futures contracts and that results in a general commodity sell-off. But the key point is that there no index fund position in COMEX silver (or gold) futures, thereby making it impossible for there to be index fund forced selling of futures contracts. This can be verified by the small commercial gross long position in any COT report, especially when adjusted for commercial spread positions, which while unreported, certainly exist. (Index fund long positions are recorded in the commercial long category by the CFTC).
Further, silver and gold are, effectively, the only commodities in the index funds’ portfolios that have actively traded physically backed ETFs. Since the index funds don’t deal in margin anyway, they would much prefer to deal in stock-like ETFs than in futures. If they could, the index funds would buy physically backed ETFs on wheat or corn or cotton or crude oil, if such ETFs existed. But they don’t, except for silver and gold. It is my understanding that the index funds make up a high percentage of the total silver and gold ETF holdings.
So even if there ever were forced index fund futures contract liquidation (not a prediction), since there are no futures contract holdings by the index funds in silver or gold, there can’t be futures contract silver and gold liquidation. And there is not the slightest suggestion that there would be any forced liquidation in the gold or silver ETFs, which are under the jurisdiction of the SEC, and quite apart from the current discussion on index fund futures contract positions. The silver ETF, if you remember, was approved by the SEC prior to its inception. |
