Financial Markets and Institutions:
Issues Involving the Use of the Futures Markets to Invest in Commodity Indexes
GAO-09-285R: Published: Jan 30, 2009. Publicly Released: Feb 5, 2009.
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Until mid-2008, prices for a broad range of physical commodities, from crude oil to crops such as wheat, had increased dramatically for several years--raising concerns and leading to a debate over the possible causes. Some market participants and observers have attributed the price increases to fundamental economic factors related to supply and demand. Others have suggested that the price increases resulted from speculation in the futures contracts by hedge funds and investors in commodity indexes. Like stock indexes, commodity indexes track the composite price of a basket of long futures positions in physical commodities. The indexes' investment strategy is passive, remaining the same regardless of whether prices are falling, rising, or flat. Two commonly referenced commodity indexes are the Standard & Poor's Goldman Sachs Commodity Index (S&P GSCI) and Dow Jones-American International Group Commodity Index (DJ-AIGCI), which are based on a broad range of physical commodities, including energy products, agricultural products, and metals. Since around the mid-2000s, pension plans, endowments, and other institutional investors increasingly have used investments in commodity indexes to obtain exposure to commodity prices as an asset class, typically to diversify their portfolios or hedge inflation risk. To prevent excessive speculation that could cause unwarranted changes in futures prices, the Commodity Futures Trading Commission (CFTC) and futures exchanges place limits on the size of futures positions--the number of contracts--that a trader may hold. In agreement with your office, this report addresses (1) whether the federal law governing futures trading prohibits investors from using the futures markets to gain an exposure to commodity indexes, (2) whether the federal law governing pension plans prohibits them from investing in commodities through the futures markets, (3) how margins have affected the ability of investors to obtain exposures to commodity indexes, and (4)how position limits have affected the ability of investors to obtain exposures to commodity indexes.
Although the use of the futures markets by institutional investors to gain long-term exposure to commodities represents a new type of speculation, the Commodity Exchange Act (CEA)--the law governing futures trading--does not prohibit this activity. Futures markets historically have been used by commercial firms to manage price risk and speculators to profit from price movements. In a regulatory response to some funds that sought approval to conduct investing in commodity indexes, CFTC staff noted that the use of the futures markets by funds to provide their investors with a commodity-index exposure represented a legitimate and potentially useful investment strategy. Under the federal law governing private pension plans--the Employee Retirement Income Security Act (ERISA)--such plans may invest in commodity indexes using futures contracts or other derivatives but must determine that such investments are, among other things, prudent. Although ERISA does not prohibit pension plans from investing in futures, it sets certain minimum standards for pension plans sponsored by private employers. A 1996 opinion issued by the Department of Labor recognized that derivatives might be a useful tool for managing a variety of risks and broadening investment alternatives in a plan's portfolio. But the opinion also noted that investments in certain derivatives might require a higher degree of sophistication and understanding on the part of plan fiduciaries than other investments. Commodity index investors generally have not been directly subject to futures margins (or performance bonds), because they primarily have used OTC swaps, not futures contracts, to obtain their exposure. Instead, the swap dealers that provide commodity index exposures to investors through swaps are subject to futures margins if they use exchange-traded futures to hedge their risk exposure from these swaps. Moreover, such dealers may have entered into other OTC transactions that offset their index exposures and, as a result, may not use futures to hedge their index exposures in full. Futures exchanges, not CFTC, generally set margins, which are based on the price volatility of the underlying commodity of a futures contract and typically are small relative to a contract's market value. Both the buyer and seller of a futures contract post margin, which serves to ensure that they can meet their contractual obligations; moreover, futures margin is not an extension of credit. If margin requirements on index-related futures were increased, two of the largest swap dealers told us that the cost of providing investors with commodity index exposures using OTC swaps would increase and might lead investors to use alternatives to OTC swaps, such as commodity index funds. They also said that once institutional investors have decided to allocate a portion of their portfolios to commodities, they will choose the most efficient way to do so. According to the market participants we spoke with, imposing higher margins on index-related futures positions also could raise challenges. For example, swap dealers use futures to hedge their net exposure--the residual risk remaining after a dealer internally nets OTC swaps with offsetting exposures--and may not be able to untangle and identify the futures positions that are attributable specifically to commodity index swaps. Similarly, index investors largely have not been restricted by contract position limits that are used to prevent excessive speculation in the futures markets. Such investors primarily have obtained their index exposures through OTC swaps that are not subject to futures speculative position limits.