Thank you for your kind introduction. It is a pleasure to be here today to address your association.
The past several years have seen tremendous growth in the U.S. derivatives industry. Silver, as you are aware, has not been left out of this bull market. The financial press has linked the recent run-up in silver prices, in part, to an exchange-traded fund (ETF) backed by silver, which was recently approved by the Securities and Exchange Commission (SEC) and began trading earlier this year on the American Stock Exchange. I am aware that the Silver Users Association has expressed concerns with regard to this new instrument, specifically, that it could lead to the removal of large amounts of silver from the open market and a subsequent loss of jobs on the manufacturing side.
What I would like to do today is discuss some of the regulatory questions raised by the trading of this new product, as well as talk about Commission efforts to bring greater transparency to the market and the developing trends that we are keeping an eye on.
As I have mentioned, the U.S. derivatives industry is enjoying a period of tremendous growth. Trading volume has quadrupled over the past ten years and each year brings another volume record. With this new growth come innovative products and complex strategies that ensure these markets will continue to prosper. For instance, the Chicago Board of Trade (CBOT) recently announced that its fully electronic precious metals complex set an all-time high as trading volume exceeded 100,000 contracts. But with this expanding market, growing pains are often unavoidable. It is our responsibility as regulators to stay abreast of developing trends.
Securitization of Commodities/Silver ETF
One such developing trend that I would like to touch on, in a more general sense, is the securitization of commodities. The securitization of commodities is without doubt increasing in both number and kind. Gold and silver ETFs are leading the way with strong initial success and prices not experienced over the last twenty years. Additionally, the SEC approved a Euro ETF late in 2005 and more recently approved the DB Commodity Index Tracking Fund in January and an oil ETF in March. With new interest in commodities trading and the benefits of the securities marketing network, this trend is something that we will have to pay close attention to, as we can expect the securitization of commodities to continue.
As I am sure you are all aware, the Commodity Futures Trading Commission (CFTC) is charged with regulating futures contracts, options (except for those on securities), and options on futures, while the SEC oversees the trading of securities and options on securities. As new and innovative products are developed, the jurisdictional lines between the two agencies sometimes become blurred. For example, we now have security futures products, which are jointly regulated by the CFTC and the SEC. It is also possible to trade hybrid products that have features of both securities and futures that are regulated by the SEC alone, such as gold or silver-linked bonds. With regard to the silver ETF, as regulators we must ask ourselves the important questions, “How are these products properly characterized?” and “What is the appropriate regulatory scheme for these instruments?”
One school of thought, as discussed in a recent article by Elizabeth Ritter who happens to be a Deputy General Counsel at the CFTC, is that such ETFs are neither securities nor futures. Because these funds are not actively managed, Ms. Ritter argues that they fail the test developed by the Supreme Court in SEC v. W.J. Howey Co., for determining what constitutes an investment contract for purposes of the Securities Exchange Act.
Under Howey, the test is whether the contract or scheme involves (1) an investment of money, (2) in a common enterprise, (3) with profits derived solely from the efforts of the promoter or other third parties. Ms. Ritter argues that the ETFs meet the first two prongs of the test but fail to meet the third prong, because the value of the funds appears to be completely dependent on the rise or fall in the price of the underlying commodity rather than from the efforts of others. Given this, Ms. Ritter makes the case that such ETFs are more appropriately classified as cash market transactions.
I believe Ms. Ritter raises important questions regarding the proper designation of these new products and that they should be more carefully considered.
Other questions raised by the classification of the silver ETF as a security include the implications for futures or options trading of these and like products. It is not unreasonable to expect that designated contract markets may, at some point in the future, determine that they wish to trade futures or options products that are similar in kind to silver ETFs. Classification of these new products as securities would necessarily raise jurisdictional questions.
The Commission’s manipulation authority is another area of concern I have regarding silver ETFs. Under section 6(c) of the Commodity Exchange Act (CEA), the Commission is charged with manipulation authority regarding the price of “any commodity, in interstate commerce, or for future delivery.” If silver ETFs are properly categorized as cash transactions, the trading of these products on national securities exchanges may affect the CFTC’s surveillance responsibilities under the CEA. For this reason, I believe it would be appropriate to engage the SEC regarding information sharing and/or surveillance programs to ensure that the Commission is able to carry out its statutory responsibilities.
With regard to the silver ETF, I would like to point out that an SEC designation as a security isn’t always the final word. On more than one occasion, SEC designation has been questioned and courts have upheld the challenge. In one 1982 case, CBOT v. SEC, the CBOT brought an action challenging the SEC’s approval of options on Ginnie Mae mortgage-backed pass-through certificates for trading on the Chicago Board Options Exchange. The Seventh Circuit Court of Appeals held that the CFTC had exclusive jurisdiction over the Ginnie Mae options and the SEC order was set aside. In a similar 1989 case, Chicago Mercantile Exchange v. SEC, the Seventh Circuit determined that the SEC had inappropriately approved as a security a financial instrument called an index participation.
I have met on more than one occasion with Commissioners at the SEC and raised the idea of establishing a CFTC/SEC inter-agency working group. As our markets continue to grow and converge, I feel strongly that establishing solid inter-agency working relationships based on the new marketplace realities will provide a forum for regulators to stay ahead, but also without getting in the way. The jurisdictional questions raised by this new product are tailor-made for this kind of necessary effort.
Commitment of Traders Report/impact of index funds
In your February 13, 2006 comment letter to the SEC, you point out that, since the silver supply is limited, it is subject to more speculative behavior and volatility.
One action that the Commission is undertaking that might be of some interest is a thorough review of our Commitment of Traders (COT) report. It is the Commission’s desire to maintain an information system that is consistent with marketplace realities and continues to provide the public with accurate and useful information regarding futures and option markets.
Over the years, the entry of non-traditional hedgers into the marketplace and changes made in the reporting system for large traders have altered the composition of the COT reports. One significant change took place in 1982, when the positions of large traders changed from being characterized as either speculative or hedging to being characterized as commercial or non-commercial. As markets and trading practices have evolved non-traditional hedgers, such as swap dealers, have been included in the commercial category when, for example, their positions are entered into to offset risks related to their swaps or similar over-the-counter activity. Persons relying on the COT reports for information or signals concerning the trading behavior of market participants may be drawing misleading conclusions from the COT report if they assume that the commercial and non-commercial classifications of today are analogous to the hedging and speculative categories of the pre-1982 reports.
Related to this, Bloomberg recently reported that global copper consumers are pressing for discussions with the London Metals Exchange (LME) over record prices for that commodity. End-user groups want to look at how the LME functions in terms of hedging and price discovery. According to Thierry Centner, International Wrought Copper Council chairman, “about 85% of total turnover on the LME may be derived from funds rather than normal industry business.”
Therefore, acknowledging changes in the markets and trading patterns and desiring to bring greater transparency to the markets, while being careful not to disclose proprietary trading information, the Commission will shortly be seeking public comment to determine whether it should adopt any changes to the way data is presented in the COT reports. I encourage you to take a close look at the upcoming Federal Register release and submit comments. This should serve as another opportunity for you to continue to raise concerns about recent developments in your market.
Other developing trends of interest
One last trend developing over recent months that could have a profound effect on our derivatives markets, and more specifically the physical commodity markets, is the nationalization movement of certain natural resource industries, which gained global attention with the high profile nationalization of the Venezuelan oil and gas sectors. Venezuela’s President Hugo Chavez is not alone in this course of action. There is talk in Tanzania of reviewing foreign mining contracts, and Mongolia’s parliament is also looking at raising taxes on foreign miners. Closer to home, Bolivian President Evo Morales nationalized his country’s oil and gas resources, which has led to concerns that this effort could spread to its mineral sector. Then, just last week, Bolivia’s foreign minister vowed to proceed with plans to nationalize that country’s timber and silver industries. Also, in the closely watched presidential election in Peru, metal investors must be paying special attention to comments made by populist candidate Ollanta Humala. Being one of the world’s largest suppliers of silver, moves to nationalize Peru’s mineral sector would undoubtedly have a significant impact on the silver market. We will continue to monitor these developments with great interest.
I thank you for the opportunity to be with you today. I would be happy to entertain a few questions.
 “The Securitization of Commodities: Crossing a Gold (or Silver) Line in the Sand.” Business Law Brief, Fall 2005.
 “Copper Consumers Seek More Talks with LME Over Rally.” Bloomberg; Janet Ong; 5/18/06.
Last Updated: April 18, 2007