#2 Oil (heating oil) futures began trading on NYMEX in 1982, and West Texas Intermediate Crude in 1983. From the first day, ANY speculator willing to plunk down the margin requirement could buy (or sell) these products.
There was and still is a position limit on the number of contracts that any single speculator can hold or control. In the case of WTI Crude today, that number is 20,000. Only legitimate hedgers can exceed this number and they must be recognised by the exchange AND the CFTC as legitimate hedgers before exceeding the position limit.
The problem occurred in the Commodity Futures Modernization Act of 2000. A portion of this (frankly idiotic) bill redefined the term 'hedger' to include operators of what are usually called 'index funds'.
The specific problem with index funds is that they can be -- and are, frequently -- created out of thin air. Suppose the Harvard University Endowment (to name one infamous example) decide they wish to invest in commodities. Tough luck; this activity happens to be thoroughly prohibited by law.
But, Harvard then talks to (say) Goldman Sachs, and Goldman says, "No problem, gents. We'll just create a commodities index fund for you.", and so they do, and pretty soon (figure about 4-5 weeks) Harvard is in the commodities biz. From the long side only -- it is also illegal for trusts, endowments, and other parties bound by the Supreme Court's 1840 "Prudent Man doctrine" to take short positions in ANY market. This is ludicrous, of course, but nevertheless quite true.
Please note that endowments and trusts ARE allowed by law to deal in indicies. However, the intent of the Regress was quite clear: when the law allowing this was passed, the only indicies of any importance were the usual suspects, S&P500, DJIA, NASDAQ 100, Tokyo's Nikkei, FTSE and DAX -- all of them securities indicies of long standing. The Regress could not envision the notion of "commodity indicies" aside from the venerable CRB index (which still trades, but not much).
Now, back to our example. So far, the markets haven't been affected at all by Harvard's actions; this is a private transaction between two entities. But now, Goldman, having sold X number of index fund units to Harvard, must get rid of its own risk, specifically that it is pretty considerably short in whichever commodities make up the index. How does one get rid of short-side risk? Easy. They buy futures contracts in the commodities that comprise the index.
If there were only one such "index fund" created in this fashion, there would be no problem and no story. The hammer comes now: if Harvard plays, MANY other similar institutions will also. And pension funds. And charitable trusts. And so the markets see, over a couple of years' time, a huge influx in long-side capital...and prices rise apace. Why is this?
Because the futures markets -- almost every one of them, and certainly every physical futures mkt such as corn or crude -- are VERY small in absolute dollar terms. There is so much capital sloshing around the world that, the minute capital-rich institutions decide to play, even indirectly as in our Harvard-Goldman example here, there are simply not enough 'natural' short players (typically those who hedge their production of a good against price risk) to accommodate all the would-be long "index fund" players.
The point of all this, if it accidentally has escaped you so far, is that Goldman and the investment banks are now allowed to purchase UNLIMITED numbers of futures contracts in any market that they've incorporated into an "index fund". Thus, prices in the affected markets -- which is most of the physical futures mkts by now -- tend to rise fairly sharply and over extended periods of time.
This is entirely a contrivance of goobermint, and politicians' desire for hefty payoffs from investment banks. It could be halted in its tracks by repealing a couple of provisions of the CMA of 2000...but don't hold your breath.
Hope this little explanation is of some use to you, and FReegards!
Thanks for taking the time to reply and clarify my post.
I’d appreciate any comments.
It seemed that the markets were working well for years then along came Phil Gramm and Clinton. Except for 1987 and LTC we’ve had financial and commodity markets that were fairly orderly and worked well for decades. Investors had trust and that benefited the markets and greater good.
Then we threw away what worked and we ended up with too big to fail entities and a commodities market gone wild. Now we have a system that many investors really don’t trust. The fast money people believe that instability, volatility and profits mean more than overall confidence. Wild axxed speculation may provide profits but it can lead to bubbles and much worse.
The financial markets with all that money sloshing around are not much different from the drug markets in Mexico and Columbia where the money taints and touches everything including government. When that happens nothing is ever done for the greater good, nor is the outcome going to be positive for most.