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Commentary

The Hunt For Leveraged Players

From John Mauldin’s newsletter:

The Commodity Futures Trading Commission announced yesterday that they are looking very hard at possibly closing a regulatory loophole that allowed some extremely large commodity index funds to get around position limits. 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.

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.

So the thing is:

  • Traders and Hedge funds have limits on how much they can buy (or short).
  • Banks don’t.
  • Banks help traders who want to trade above their limits, by selling them “swaps” on the underlying future.
  • And for the trade, they create a position in the commodity markets. Technically this is a hedge against the swap, but in the market it is an open position. (there’s no squared off trade in the market)
  • This loophole can’t be plugged unless the exchange decides that swaps cannot be issued other than on the exchange, or that banks also get limits.
  • If they do this a lot of traders, banks and funds will have to get out and unwind their trades. This is certain to cause volatility in the commodity markets.

Why have trading limits at all? Because of counterparty risk and attempts to corner a market by controlling a large part of it. So this is a loophole to get around trading limits, and the problem now is not controlling a large part, but a payment crisis if the market goes opposite (downwards) to the direction of maximum interest. The payment crisis can be:

a) market goes down

b) exchange asks banks to put down more margin

c) banks ask hedge funds to pay extra margin against swap

d) hedge funds says sorry boss, no more money here

e) banks panic and sell whatever positions they had against the swaps

f) prices fall, and some banks have to pay out of their pockets

g) if positions are ultra large, some banks run out of money

Setting limits on banks may help but what if banks choose to have no positions on the exchange at all? Then the bank needn’t be afraid of exchange limits – only it’s counterparty risk increases – but heck the fees are so lucrative, it might as well be worth it (especially if they find a party on the other side of the swap). So do a swap on the long side of a commodity to one trader or fund, and on the short side to another, and bypass the exchange entirely.

This will obviously result in too much of a gamble, one hedge fund or another will go bust, the bank will be left holding the bag, and eventually some bank will go bust if the move is strong downwards. But unless regulation is set up to regulate swaps, this cannot be avoided.

Is a similar thing happening in India with P-Notes? P-Notes, like swaps, are derivative instruments (ODIs or Offshore Derivative Instruments in SEBI Parlance) that are not traded on an exchange. People abroad buy these notes from an FII, against positions set up in India.

FIIs have position limits on Indian exchanges. But what if they have gone and done more transactions on P-Notes themselves, bypassing the Indian exchanges? Like, against one block of say 1cr. worth Reliance stock, they issue and trade p-notes worth 5 crores? Eventually if the system unwinds on sharp market moves, the unwinding of the notes can result in a crisis at the FII end, and in turn in the Indian markets.

SEBI, I think, has planned to figure this out by issuing a new circular. They ask all FIIs to provide details of how much amount of P-Notes they have issued in comparison with their total assets. That will give them an idea if there is an overleveraged situation.

FIIs have been selling huge values on the exchanges. I don’t know if it’s a response to this circular (the sales were happening even before this was issued, but that doesn’t say much) This can become very interesting. Let’s see how it goes.