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CFTC’s Commodity Position Limits Are a Bad Idea

By Jim Fink on April 5, 2012

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For instant diversification and low-cost investing, nothing beats an index fund, whether it be an open-ended mutual fund, ETF or ETN.  Each form of index fund has advantages and disadvantages, as I outlined in the MLP context in my article entitled Which MLP Index is Best?  

Closed-end funds (CEFs) are another form of investment fund, but they are almost always actively-managed and consequently don’t provide index exposure. As I explained in Closed-End Funds: Buy at Discounts and Sell at Premiums, CEFs often trade at prices wildly divergent from the net asset value (NAV) of their underlying holdings because there is no redemption feature that allows a CEF holder to exchange the CEF for its underlying assets. I am not a fan of CEFs because this illiquidity problem adds an unnecessary layer of complexity to the investment process that can really hurt investors who aren’t paying attention and buy CEFs at premiums to NAV.

A Volatility ETN Collapses

What you may be surprised to learn is that ETFs and ETNs are not immune from the illiquidity problem inherent to CEFs. In fact, the problem may be more severe since it is not expected to happen. Take, for example, the recent price blowup of the VelocityShares 2x VIX Short-Term ETN (NYSE: TVIX).  Leveraged ETFs and leveraged ETNs that rebalance daily are uniformly terrible long-term investments, but what happened in the case of TVIX is especially egregious. On February 21st, Credit Suisse (NYSE: CS) – the issuer of the ETN – announced that it had “temporarily suspended” issuance of new TVIX units because its risk department had determined that the company had maxed out on its ETN debt exposure. The result of the suspension was that TVIX unit holders could not redeem their units for the cash value of the underlying volatility index (AMEX: ^TVIX-IV), so the market price of TVIX started to deviate widely from its index. Take a look at the following chart comparing TVIX with its index:

ETN and Underlying Index Diverge

Source: Bloomberg

Prior to February 21st – the date of issuance suspension – the value of the index and the price of TVIX were virtually identical. Starting on February 21st, however, the price of TVIX remained stable even though the underlying index was falling. The issuance suspension had made TVIX units scarce and unable to fill market demand, which was strong because investors wanted a volatility hedge in case the stock market sold off. Actual option implied volatility was falling because stocks kept rising during the period, lessening investor fear and lowering demand – and prices – for S&P 500 index puts, the prices of which form the basis for the TVIX index.  The disparity got so bad that by March 21st TVIX was trading for $14.43 while its underlying index was valued at only $7.62 – almost a 90% premium to net asset value.

On March 22nd after the market closed at 7:42 PM Eastern Time, Credit Suisse announced that it would resume TVIX unit issuance on a “limited basis.” Suspiciously, the price of TVIX had started to collapse much earlier during the trading day at 11:10 AM Eastern Time. By the close – still before the official Credit Suisse press release — the price of TVIX units had collapsed 30% and continued to fall over the next two days, culminating in a total price decline of 60%.

In contrast, the non-leveraged iPath S&P 500 VIX Short-Term ETF (NYSE: VXX) fell only 15% over the same three-day period and the 2x leveraged ProShares Ultra VIX Short-Term Futures ETF (NYSE: UVXY) fell the expected 30% (2 x 15%). In other words, TVIX fell four times as much as VXX even though TVIX was only leveraged 2-to-1 and twice as much as the similarly-levered UVXY. Clearly, TVIX fell much more than its leveraged nature would suggest because the 90%-plus premium in TVIX mostly evaporated overnight once Credit Suisse lifted the issuance suspension and supply and demand reverted back close to normal. I say “close to normal” rather than normal because even at today’s close (Apr. 4th) TVIX is trading at a modest premium of 6% to NAV, which demonstrates that Credit Suisse’s “limited basis” issuance is not adequate:

 

February 21st

March 21st

March 26th

April 4th

TVIX ETN

$17.01

$14.43

$5.88

$7.45

TVIX Index

$16.99

$7.62

$55.6

$7.03

Premium

0.001%

89.4%

5.8%

6.0%

 

It’s safe to say that a lot of average investors got hurt trading TVIX because they didn’t understand how this complex, leveraged, derivative-based ETN worked, nor were they aware of the huge premium to NAV at which it was trading. The Securities and Exchange Commission (SEC) has opened an investigation into the TVIX price plunge, but it’s unclear whether the SEC is concerned only with the obvious leak of Credit Suisse’s decision to lift the TVIX unit issuance moratorium before the news went public, or whether it is also concerned with Credit Suisse’s unilateral decision to limit TVIX unit issuance in the first place, which caused the massive price premium to develop.

If the SEC is just interested in the information leak, I will be disappointed. ETN issuers like Credit Suisse should not be allowed to simply stop the redemption process at will. When a structured security is offered to the public, the issuer has an obligation to maintain liquid and orderly markets in that security. If an issuer reaches some internal limit of company risk assumption, the issuer should either have to liquidate the security at net asset value or waive internal limits and continue to offer both unit issuances and redemptions.

CFTC’s Commodity Position Limits Could Be the Cause of More ETF And ETN Price Collapses

To be fair, Credit Suisse is not the only irresponsible transgressor. Deutsche Bank (NYSE: DB) has also suspended ETN unit issuances on more than one occasion, as has Barclays (NYSE: BCS) and The United States Commodities Funds.  In these other cases, however, the reason for the issuance suspension was not internal risk limits, but regulatory uncertainty surrounding the Commodity Futures Trading Commission’s (CFTC) position limit rules affecting 28 different commodities. The CFTC was required to issue such rules pursuant to the 2010 Dodd-Frank financial reform law and approved final position limits in October 2011 by a razor-thin 3-2 vote along partisan lines with the two Republican commissioners voting against.

The CFTC didn’t have much choice because the Dodd-Frank law had directed the CFTC to impose position limits in an effort to curb price-raising speculation.  However, the CFTC had quite a bit of discretion over the details of the position limits and the Republican commissioners thought the limits were too strict. 

I agree with the Republicans. There is no evidence that speculation causes commodity prices to rise – after all, speculation can be in favor of a commodity price decline just as easily as a price hike. An academic study on the role of speculation in commodity markets concluded:

Our findings provide evidence that speculative trading in futures markets is not destabilizing. In particular, speculative trading activity reduces volatility levels. We find that speculation activity is not causing any price movement, but it has some impact on risk: it reduces risk.

The role of speculation activity in financial markets is very important because it allows hedgers to find counterparties to hedge their positions and, in general, it allows markets to perform their institutional role. Therefore, speculators, in general, and hedge funds, in particular, should not be seen as sinful agents. In fact, we find that speculative trading activity has beneficial effect on markets.

The position-limit rules can’t go into effect until after the CFTC has defined what a “swap” is and the CFTC expects to issue such a swap definition in April. The D.C. Circuit Court of Appeals has refused to issue a preliminary injunction stopping the commodity position limits from going into effect, but a court decision is expected soon on whether to hear the case.

I hope the court not only hears the case but strikes down the position limits because they interfere with the free market and increase volatility by making it impossible for issuers of ETNs and ETFs to meet demand for unit issuances in the commodity securities they manage.

Bottom line: if the CFTC’s position limits are allowed to go into effect, we will see many more market crashes like recently occurred with TVIX. And the next time investors get hurt by an ETN or ETF premium collapsing, the blame will rest squarely with President Obama and his Democratic allies in the U.S. Congress.

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  1. avatar
    David Reply April 7, 2012 at 11:42 AM EST

    CFTC needs to institute position limits! Currently, JP Morgan and some of their Commercial friends hold HUGE (25% of market) short positions on silver. Both Silver and Gold are manipulated to the downside. All you have to do is look at the huge drops in silver for no market reason. The weekly COP reports show huge high frequency trading driving prices down. CFTC has been investigating silver manipulation (HAHA) for three years. As with most Government agencies, they are in bed with those that they regulate. Silver and gold are small markets. CFTC is considering a 4500 option contract for silver. The public wants a 1500 contract limit. Last year JP Morgan had about 47,000 contracts SHORT on silver. That’s about 50% of one years production of silver. The Hunt brothers bought about 25% of a years production by comparison. That’s a naked short and a manipulation to the downside by any definition. Maybe other commodity markets are big enough to avoid manipulation, although I doubt it. With big banks getting free money from the FED, nothing is sacred.

    High Frequency Trading should be BANNED! It is an overt manipulation tool for the big banks and trading companies. HFT is used to manipulate market prices of equities and profit from it. JQ Public doesn’t have a chance of investing in the market profitably.