Opinion by Rich Strait

Today ETFs provide the smaller retail investor an ever-growing variety of products that offers indirect access to the futures markets via these securitized instruments. Transactions are done simply through the investor's retail securities account, bypassing the requirement of maintaining a regulated futures account with an FCM.

However, this comes at a relatively high cost to the investor. Fees, tax treatment and inefficient futures hedging practices hat may cause price correlation slippage between the ETF price and that of the underlying commodity must all be considered.

Despite these pricing realities, the meteoric growth of ETFs has dramatically altered market fundamentals. ETF investors are mostly holding long positions, so large pools of non-working underlying inventories of allocated physical commodities or exchange futures (or a combination) are created. This buying and holding drives prices artificially higher while increasing margin requirements on the underlying futures contracts.

The results can have the effect of deleveraging proprietary and systematic market makers who provide the needed liquidity for the commercial hedger. Accordingly, there is significant potential for dramatic liquidity events and resultant price distortion perpetrated by the sudden liquidation of ETF sector positions.

Now this situation is complicated further by shortsighted attempts by the CFTC to impose more regulations on the futures markets, while ignoring a vastly larger global marketplace over which they have no jurisdiction. I believe this will only serve to diminish market liquidity, transparency and importance of the very markets they can and do regulate.

Negative Impact on Futures IBs, CTAs and FCMs

Naturally there is a negative impact on IBs, CTAs and prop trader. Their activities may be further diminished via the proposals on mandatory position limits. When coupled with the increased cost of holding positions, the investor community will be forced to offshore and OTC markets to meet their needs. With very few exceptions, clearing of ETFs underlying futures are transacted through a handful of large FCM-Prime Brokers, and bypass the smaller, independent FCMs who generally service independent market markers.

Conclusion

It seems to me the ETFs are perceived as the low upfront cost alternative to maintaining a futures account. These products, however, are attracting clients that often have little knowledge or understanding of the underlying products, and the potential risks that come along with trading them.

The pricing of commodities has been going only one way of late – and that is up. It only make us veteran traders wonder what will happen when these ETF positions start to liquidate.

Rich Strait is President of Strait, LLC, located in Miami, FL.
Contact him at rich@straitllc.com