IATP is not among the “asset management companies and trade associations of asset management companies” managing Exchange Traded Funds (ETFs) to whom the ESMA discussion paper is directed. However, we are compelled to comment on the paper because of the damage to commercial hedging and to food and energy security that has been caused by excessive speculation in commodities, whether invested through over-the-counter index funds or through ETFs. There is a wide array of studies that demonstrate the harmful effects of index speculation on transparent price discovery and commodity prices and volatility, so we will not rebut apologists for excessive speculation here. The United Nations Food and Agriculture Organization (FAO) has identified higher and more volatile prices as a factor in the increase of food insecurity in more than three dozen FAO member states. There is a statistically compelling argument for spot month and aggregate position limit rules to help prevent excessive speculation. In responding to some of ESMA’s questions, which apply to ETFs across a range of asset classes, our focus will remain on commodity derivatives.
We agree with the view of the Financial Stability Board in its April 2011 note, cited in your discussion paper (p. 5), that the increasing incorporation of commodity derivatives into ETF investment strategies is a “disquieting development.” As FSB notes, “plain-vanilla ETFs” were designed to manage risk in the large universe of equities and not in relatively thinly capitalized markets, such as that of commodity derivatives. The G-20 financial ministers have yet to incorporate this FSB warning into their recommendations on commodity price volatility. We are aware of the transatlantic diplomatic tension regarding European Parliament directives on OTC derivatives, which has apparently resulted from U.S. Secretary of Treasury Timothy Geithner’s efforts to persuade the EU presidency to extend G-20 recommendations on OTC derivatives to ETF derivatives. However, we are grateful that ESMA has taken the initiative to request comments on ETFs, since the weight of money of commodity index products, whether traded OTC or exchange traded, will continue to induce volatility and drive bona fide hedgers from commodity markets, unless those products are tightly regulated and those regulations are enforced.
Hardly a week goes by, it seems, but that another financial firm announces another ETF “innovation” to track another commodity index in the name of portfolio diversification. While these products are targeted at institutional investors, such as pension funds and university endowments, warnings about the risks of synthetic ETFs for retail investors, such as those indicated in the discussion paper (paragraph 4) should be extended to institutional investors and their retail customers. The sudden and largely correlated fall in commodity prices in mid-May triggered by High Frequency Trading of ETFs surely caught a majority of ETF institutional investors by surprise. The ongoing lack of regulation of HFT strategies, including the HFT placing of orders with no intention of completing trades (“spoofing”), is further grounds for the restrictions on ETF trading that ESMA is contemplating. IATP regrets that we will not be able to attend ESMA’s September 27 public hearing on automated trading, but we look forward to reading the post-hearing report.
