CFTC Position Limits And ETFs

September 26, 2011

A wave of new position limits on commodities futures contracts is forthcoming, and ETF investors need to take note.

For those of you who own commodity ETFs, the looming regulation from the Commodity Futures Trading Commission could have a dramatic impact not only on the nature of your portfolios, but the risks associated with it.

Two separate news items in the past week shed light on talk that’s been making the rounds in financial markets for months; namely, that the CFTC is getting serious about cracking down on commodities speculation.

The first piece, run by the Baltimore Sun, depicts CFTC officials increasingly frustrated by a lack of support at the top of the organization for hard-line commodities futures contracts positions limits.

The second, run by the Economist in mid-September, claims that position-limits regulations are in fact on the way and the scope is likely to be far-reaching. The article said that as many as 28 commodities could be saddled with limits that preclude individual investors or funds from controlling more than 25 percent of deliverable U.S. supply for these commodities.

Notable commodities to be covered include gold, corn and oil. The main caveat is that should a company be engaging in “bona fide” hedging for commercial purposes, the limits won’t apply. Of course this is of little consolation to the litany of long-only commodities funds.

The question every investor should be asking right now is, how this will impact portfolios?

The answer, from a returns perspective, is likely minimal. Take the case of the United States Natural Gas Fund (NYSEArca: UNG), which in 2010 bumped up against existing CFTC position limits.

Instead of halting creations and redemptions or closing the fund, John Hyland, manager of the fund, began using total-return swaps, an over-the-counter derivative product used by many other noncommodity-focused funds. The good news for investors is these contracts offer the same exposure to natural gas futures as do the exchange-traded futures contracts.

The bad news is that derivatives like total-return swaps open investors up to new risks. Below is a snapshot, courtesy of the fund’s website, of the OTC positions held by UNG. As you can see, the use of these total return swaps has opened up investors in UNG to counterparty risk.

Moody's Credit Rating Number of
Value $
Exposure $
Held $
Net of
Collateral $ *
A2 1 256,803,836 (22,738,262) 75,757,094 (22,738,262)
Aa2 1 106,167,330 (7,968,182) 22,199,236 (7,968,361)
Aa3 2 472,439,919 (3,895,182) 88,679,930 88,679,039
Total 4 835,465,085 (34,601,805) 186,636,260 (34,602,311)

The most obvious takeaway from this table is the lack of transparency regarding who the specific counterparties are.

From a business perspective, this makes sense. UNG’s managers don’t want to disclose the identity of their counterparty so as to prevent competitors from undercutting them. But it also means that investors are beholden to potentially flawed credit ratings from Moody’s or Standard & Poor’s.

What’s more worrisome is the fact that should one of the counterparties go bust, it could set off a chain reaction that wouldn’t result in a substantial loss of capital to investors, but a loss of leverage.

Because each swap is collateralized in an escrow account by the counterparty, the investor’s assets are protected—but only to a degree.

If a counterparty were to announce bankruptcy, the fund would miss out on returns the fund would have realized that day, as the counterparty wouldn’t be able to pay that day’s returns. Although the fund manager would receive all of the collateral from the escrow account, he or she would need to secure another swap agreement, something that could take a couple of days.

For investors, that means they’re essentially under-levered. In other words, the fund doesn’t have complete exposure to the futures curve as it’s spelled out in its prospectus.

The UNG illustration, while imperfect, is a great example of what investors in commodities ETFs need to be aware of moving forward.

It’s one thing to understand a complex commodities fund that owns different parts of the futures curve for a specific commodity, but it’s an entirely different thing to quantify the daily counterparty risk of a portfolio.

Unfortunately for investors, this is something they’re going to have to contend with as the CFTC closes in on its Dodd-Frank mandate to limit speculation in commodities.


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