Is the SEC Disproving The Laws of Supply and Demand?

A new staff memorandum from the SEC appears aimed at disproving the law of supply and demand.

The issue is whether to permit JP Morgan Chase and Blackrock to create new exchange traded funds (ETFs) backed by physical copper. The new ETFs will track a commodity price, the price of copper, as many ETFs already do. But instead of using futures or derivatives to replicate copper exposures, the ETF can stockpile physical copper to back up its shares. So these ETFs will control large stores of physical copper for the benefit of ETF owners. JP Morgan’s prospectus states that initial offering of their ETF will result in the purchase of as much as 30 percent of the copper currently available for immediate delivery worldwide.

There are already ETFs backed with physical metals, but only for basically financial assets like gold or silver. Copper is a crucial industrial metal, and this would be the first time a fund had been allowed to stockpile such a vital commodity. It’s well known that speculation in key commodity markets using swaps and other derivatives has increased massively in recent years, and there’s plenty of evidence that such speculation can greatly affect prices. But at least in the case of such paper speculation there is still one layer of remove between market positions and physically hoarded positions. That’s not true here. Every time an investor purchased a share of this ETF, they would in effect be contributing to a market squeeze by hoarding actual physical copper.

If you think that sounds like a bad idea, well the actual copper industry strongly agrees with you.  Their comment on the proposal states these ETFs would “grossly and artificially inflate prices for an industrial commodity already in short supply”. Opposition to the proposal was also registered by Senator Carl Levin and Americans for Financial Reform.

Now the SEC staff has examined the issue, and come up with surprising finding that there is no apparent relationship between copper prices and available copper supplies. This is a finding that would revolutionize financial markets — if they believe their findings the authors could leave government employ and make large amounts of money trading against investors who still assumed that the availability of a commodity affected the price. Indeed, the finding disagrees even with the filings by JP Morgan and Blackrock themselves, which freely admit that the new investment vehicles may impact real economy copper prices. See for example this comment on page 10 of the Blackrock iShares ETF prospectus:

An increase in the demand for copper, driven by the success of the trust or of similar investment vehicles, could result in increases in the price of copper that are otherwise unrelated to other factors affecting the global copper markets.

Because there is no limit to the number of Shares that the trust can issue, a very enthusiastic reception of the Shares by the market, or the proliferation of similar investment vehicles that issue shares backed by physical copper, could result in purchases of copper for deposit into the trust or such similar investment vehicles that are large enough to result in an increase in the price of physical copper.

The methodology of the SEC staff memo is deeply flawed.  Among other things, the authors ignore evidence in their own analysis that hoarding supplies does in fact influence prices, fail to deal with basic methodological issues involving the inference from correlation to causation, and ignore key facts about the actual structure and functioning of copper markets. (If you want further detail, here is AFR’s detailed analysis of the problems with the staff memorandum).

The numerous problems with this memo illustrate how far we still have to go in convincing the SEC that commodity-related ETFs can distort commodity supplies and encouraging excessive speculation.  But the SEC can still rescue the situation by recognizing the flaws in the staff analysis, giving it the weight it deserves – none at all – and rejecting the application to trade physically backed ETFs in key commodities. This decision is critically important, not only for the copper markets, but also because the approval of these ETFs would set a precedent for the further financialization of the broader commodity markets. It would also, for the first time, essentially give legal permission for the hoarding of physical supplies by persons who may also be trading in the commodity itself. If a physically backed ETF is approved for copper, there is nothing to prevent it happening for oil and food as well. Turning down physically-based ETFs should not be a hard call for the SEC, but it’s not clear if they will do the right thing.