Curb your energy

Proposals to regulate energy derivatives in the US could affect ETFs trading directly in the futures market, pushing some providers to use swaps. Helen Fowler reports

When the US Commodity Futures Trading Commission (CFTC) announced last month proposals to curtail positions in the energy markets, many people in the ETF community breathed a sigh of relief. 

“These proposals are much better than the worst fears in the ETF world a few months ago that they would be driven from the commodities market,” said Kenneth Raisler, former general counsel at the CFTC and lawyer at New York-based firm Sullivan & Cromwell, which advises a number of ETF providers. 

The CFTC currently sets position limits in some agricultural commodities, and has done so for many years, but this is the first time it has tackled energy. It is no coincidence that ETF products have enjoyed great success in this area in recent months. 

The ETF commodities market more than doubled in size in 2009, growing by 132% last year, according to BlackRock data. Assets held in ETFs of this type rose by $12.6bn during 2009 to reach $22.2bn. That rise puts them amongst the fastest growing product types in the ETF universe. Fourteen new ETFs invested in commodities were also launched last year. 

“The CFTC has been discussing further regulation of commodity derivatives for over six months,” said Michael John Lytle, director of marketing at Source. “They are concerned about whether the impact of heavy investment is helping or hindering the market.”

The proposed regulations would cover contracts on four commodities: Henry Hub natural gas, light, sweet crude oil, New York Harbor No 2 heating oil and New York Harbor gasoline blendstock. The CFTC’s proposals give market participants three months to comment on them before they go to a vote by the full commission. 

However, experts are already assessing the potential impact of the proposals should they eventually become law. “The proposals do have an effect on the ETF community,” said Raisler. “By imposing these limits there is a chance they will restrict the ability of some larger ETFs to trade directly in the futures market, as the size of their positions will exceed the limits being proposed.” 

Limited impact

Under the current proposals, the limits look relatively generous and likely to affect only the very largest ETFs in energy commodities. Raisler said: “The CFTC said that if the limits proposed were put in place today for crude oil on West Texas Intermediate (WTI), they would represent 66,000 contracts for an individual ETF trading in an individual month.” 

That limit of 66,000 contracts translates into around $5bn in exposure, based on mid-January oil prices. “Not many ETFs will be affected,” said Raisler. The United States Oil Fund, an exchange traded security tracking light, sweet crude oil, and the United States Natural Gas Fund might be among those impacted by the proposals, he added. 

If the proposals eventually become law, then even for those larger ETFs that run up against the limits, there is a fall-back option. “The good news is, unless Congress passes limiting legislation, there will be the ability to trade indirectly on the futures market through swaps with swap dealers,” said Raisler. 

Carrying out transactions in the swap market would be more expensive, though it is hard to estimate by how much. The swap market also has the disadvantage that it is unregulated and takes place over the counter (OTC), without the security of central clearing. 

One effect of the proposals, if they become law, is that they will “force some of the larger ETFs to enter the swap market,” predicted Raisler. 

Swap dealers themselves are capped on the size of their positions. “Swap dealers may not have headroom to carry the size of position ETF firms want and they may have to turn away ETF dealers,” said Raisler. 

If position limits become an issue for swap dealers, ETF issuers might be forced to use a range of different swap providers. 

It is not difficult to see why the CFTC is taking a closer interest in energy investment. At one point last year, the United States Oil Fund, which currently has assets of $2.2bn, represented around a fifth of total trading volume on the US Nymex Exchange for oil futures contracts. The Oil Fund invests in light, sweet crude oil, one of the commodities listed in January’s CFTC proposals. The CFTC is worried that such a dominant position could distort market pricing. 

Other concerns

It is not just the dominance of ETFs that concerns regulators. Other investors track ETF trades, timing their speculation in commodities ahead of ETF purchases they know will happen. “This issue reflects the downside of ETF transparency,” said Richard Keary, principal at Global ETF Advisors in New York. “This has happened a lot in oil ETFs. Any investor or hedge fund knew exactly what was in that fund and that the fund would have to go into the market and buy next month’s oil futures.”

As a result, hedge funds speculated in the futures market by trading just before they knew ETFs would be required to do so. The impact was enough to distort futures prices and ETFs were often left with no choice but to buy oil at inflated prices. 

“The whole notion behind position limits is to create a situation where no single firm or group of firms can distort the numbers,” said Keary. 

ETFs have come to dominate the prices of other commodities besides energy. Platinum and palladium stocks reached one-year highs at the beginning of January as investors bought ahead of the recent launch of ETFs invested in the metals. Investors bought in the correct expectation that bullion-buying by the new ETFs would drive up prices. 

Last August the CFTC repealed exemptions on position limits in wheat and corn, in response to fears ETFs were unduly influencing the prices of certain commodities. Position limits have been in place on agricultural products for some time, but up until last year it was almost automatic procedure for the CFTC to allow funds to waive the limits. 

“Until recently the CFTC automatically gave extensions on how much people can write,” said one leading participant in the ETF market. “Last year, everybody phoned up and said ‘I want to go over the official limits’. The CFTC stopped granting automatic extensions and made everybody prove to them the exemption was for real physical hedging as opposed to financial speculation.”

Market observers suggest ETFs may have become victims of their own success, so popular are the largest products based on energy futures. ETFs are responsible for making ownership of energy sector commodities more accessible in recent years. They offer retail and institutional investors the possibility of owning oil without facing the cost of storage and transport. 

Although ETFs may find they can migrate successfully to the swap market, if they cannot achieve the necessary exposure in the futures market, there is growing speculation that the swaps market, too, is in line for tighter regulation. 

Two US financial market regulators are drafting legislation to implement a crack-down on OTC derivatives, which include swaps. The move is part of an attempt to prevent a repetition of the financial crisis by the Obama administration. 

Source’s Lytle said the ETF world might be receptive to proposals to standardise the swaps market. “The US has talked about centralised clearing of derivatives for a while and it is not considered a problem. In fact, having a centralised clearing operation where you substantiate the terms of an OTC contract could make the market more efficient.” 

It is not yet known what the proposed swap regulations might entail, but speculation suggests they could lead to more conservative capital, reporting and margin requirements for major participants. “The move would not necessarily be to bring swaps onto exchanges, but towards centralised clearing. That would require a lot of standardisation,” said Bradley Kay, analyst at Morningstar. 

CFTC chairman Gary Gensler has said the agency is keen to get industry feedback on the possibility of position limits for precious metals, after announcing the need to look at other commodities, which are of ‘finite supply’. If the response to proposed limits on energy positions is anything to go by, the ETF industry will be following proceedings with interest.