For those not familiar with the concept of limits, it basically works like this. No trader or fund is allowed to own more than a specific amount of a commodity traded on the futures exchange. This limit varies from commodity to commodity and exchange to exchange. The point is to keep one group from manipulating the price of a commodity, as the Hunts did with silver in the early 80s.

The loophole is one where large investment banks can sell a “swap” for a specific commodity like corn and then hedge their position in the futures markets. There is no limit on the amount of the commodity that can be hedged. So, a fund can accumulate sizeable positions far in excess of what they could do directly by working with an investment bank. In essence, the swap is a derivative issued by a bank which acts just like a futures trade, but it is with the bank as guarantor and not an exchange. Swaps are not regulated as such. And up until now, the banks were seen as legitimate hedgers so there were no limits on what they could buy in the futures markets.

This works for very large commodity index funds which try to mirror a particular commodity index and need to be able to buy very large positions in excess of the normal limits (and there are scores of them), and for the banks that make the commissions and profits on the swaps. Remember, the fund gets a management fee, so growing the size of the fund grows their fees.

These indexes typically have about 26 commodities, with the largest allocation to oil, but almost anything that is traded has some small portion of the allocation. As I noted last week, there are some who believe this is working to drive up the price of commodities beyond the simply supply and demand principles. Whether or not you believe this to be the case, the CFTC is looking at the loophole.

The key word in the announcement yesterday was the word “classification.” Right now the banks are classified as hedgers and as such have no limits. But they are not really hedging the actual physical commodity as a farmer or General Mills might do, but the hedge is their financial position.

If the CFTC decides to look through them to the funds, and they did use the word transparency in their announcement, they could decide to change the classification of the banks from hedgers to speculators. While I do no think that might make a difference in the long run, in the short run it could make commodities volatile in the extreme, and exert downward pressure up and down the price curve, depending on how they would decide to unwind the commodity index funds.

For what its worth, I advised my daughter to get out of the commodity fund she was in for the time being. When the regulators are in the room, anything could happen. And they are getting intense pressure from Congress to change the rules. My bet is that the train has left the station and it is but a matter of time until position limits are put in place for commodity funds, including commodity ETFs. Is that a good thing? I think not, but that matters not one whit. The hand writing is on he wall.

Does this mean I am not a long term commodity bull? No, I remain bullish on a host of commodities over the long term from a supply and demand perspective. It is just that you might want to consider whether to stand aside for a time while the congressional elephant is stampeding around the room. Maybe it is a non-event and someone figures out a way to unwind the positions slowly and over time. Maybe the grandfather the current funds at the size they are today. Who knows? As I said, when the regulators are under pressure to do something, I want to know what the new rules will be before I play in the game.

Source: Swapping out Commodities 

Dull Chinese gold futures’ trading has come as a bit of a disappointment. On day one the Shanghai contract surged to a premium of nearly $100 over the international spot gold price. It almost touched $1,000, a new record high at that point. The Chinese seem to prefer the real thing to paper – but watch this space!

The Exchange went to a lot of trouble to avoid the tricky issues regarding futures trading in China that would have brought censure from the authorities. It did its best to deter private punters. The size of the contract was upped from the originally planned 300 grams to 1,000 grams – a hefty 32.15 ounces. They may have been overcautious in this; the measures were too effective.

The Chinese regulators are now relenting. A notice has just been published in the China Banking Regulatory Commission website loosening controls on futures trading. From now the nation’s commercial banks (and hence their millions of customers) will be allowed access to gold futures on the domestic market. More details are promised soon.

This is also seen as a move to help the Chinese banks improve their profitability and compete against overseas banks. The Chinese Central Bank has obviously noticed the profits generated from futures by banks abroad. Non-interest income can account for up to 80% of bank revenues, while Chinese banks make much of their money from the margins between interest rates on deposits and loans.

Commercial banks now interested

China’s commercial banks are huge. As a story in the official state news agency, Xinhua, says, they can certainly provide more liquidity and stability to Shanghai’s gold futures. It quotes an expert at Beijing Technology and Business University, Hu Yuyue, as saying it was “great news for the gold futures market, which is not operating that well.”

Meanwhile, physical gold trading is booming. The Shanghai Gold Exchange has two major new international members – Standard Chartered and HSBC. Even without them, business has been brisk on the back of local punters.

Shen Xiangrong, chairman of Shanghai Gold Exchange, expects the number of individual investors to triple this year. Last year around 94,000 investors traded. In 2008 more commercial banks are launching individual gold trading services. The Exchange is hoping they will now also promote its derivatives contracts.

Continues below

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Further proof that the Chinese prefer to have their gold in hand can be seen in jewellery sales. Chinese love of gold jewellery surpassed the US as the world’s second-biggest retail gold market, after India, last year. Total consumer demand on the Chinese mainland, Hong Kong and Taiwan reached 363.3 tons, 23.5% up on a the previous year, according to the World Gold Council. Demand grew even in the fourth quarter – up 20% – while gold demand elsewhere dropped.

Nor are the Chinese slouches when it comes to production. Chinese miners are expected to increase their output by over 10% in 2008, reaching 300 tonnes. That would see the country overtake South Africa as the world’s largest gold producer.

Some say it was the largest producer in 2007. Dispute arose because of a clash in the experts’ statistics. Gold Fields Mineral Services put production at 276 tonnes, China Goldfields Association counted 270 tonnes.

Mining companies were the first target…

Mining companies were the main target of Shanghai’s futures contracts. The aim was to provide the facility for the gold miners to hedge production. The first deal showed the way – it was between China National Gold Group and Jiangxi Copper.

China Daily quoted the explanation of the rational given by Jiangxi vice president, Wang Chiwei. Time taken to for his company to refine gold from copper concentrates was four months, yet the fee was only $5 an ounce. Even a small gold price movement would wipe it out.

Yet locking out the punters has reduced the depth and scale of the gold futures market. The exchange has not been able to keep up with booming gold production at home and soaring world gold prices.

….now it is the $1.8 trillion savers’ market

At the same time, the commercial banks have wanted to market gold-linked products into the booming retail banking market. The Chinese are famous savers – over a quarter of Chinese hold bank accounts, and they typically put aside 25% of their income. Last year that came to $1.8 trillion!

Competition to manage that money is fierce. Sophisticated international banks offer services that enable them to pick off the wealthiest individuals (the number of Chinese with investable assets of $100,000 or more now exceeds 4.5 million households). Domestic banks are telling their regulator, as gold’s new high price levels win the headlines, that gold products will do very nicely, thank you!

Shanghai is really going for it in 2008. The hundreds of local gold miners, refiners and fabricators are begging for more volume, and the investment market is there to oblige. The exchange has approved 65 new companies as futures members.

Trading gold futures in China may have started off modestly, but so did it in the US in the 1970s and Japan in the 1980s. Now China seems all set to build up force! Another driver for gold to hit $1,500!

Keep buying!

Erin and Isabel

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