The Securitization of Commodities:Crossing A Gold (Or Silver) Line In The Sand

• Author: Elizabeth L. Ritter
• Position: Assistant General Counsel at the United States Commodity Futures Trading Commission
• Pages: 07

Elizabeth L. Ritter is Assistant General Counsel at the United States Commodity Futures Trading Commission. She is also an adjunct professor at the Washington College of Law. The author wishes to thank Michael Penick, Industry Economist, Office of the Chief Economist, Commodity Futures Trading Commission, for providing data for this article. The opinions expressed in this article are solely those of the author, and are not intended in any way to represent the views of the Commission.

Page 7

IN RECENT MONTHS, Barclays and the World Gold Council have begun trading exchange-traded funds (ETFs) based on the rise or fall in the price of gold. From a marketing perspective, the marriage of ETFs and gold was made in heaven. ETFs have been publicized as an investor¥s dream: they can be bought or sold on margin; unlike mutual funds they can be traded throughout the day; and they benefit from certain tax advantages over mutual funds.¹ And gold is, well-gold. It glitters, it¥s glamorous, it¥s global. Gold prices skyrocketed through the fall of last year to reach a high of over $450 an ounce at the end of 2004, enticing virtually everyone to play the gold market. It?s solid, reliable, and in a bear market it frequently becomes the investment of choice-as Jill Leyland, an economist at the World Gold Council states, "Bad news is good news for gold."² And commodity markets generally are hot, both onand off-exchange, enjoying record volumes in recent years.³ iShares COMEX Gold TrustÆ, sponsored by Barclays and traded on the American Stock Exchange (AMEX), and StreetTracks Gold SharesÆ, sponsored by the Gold Council and traded on the New York Stock Exchange (NYSE), both enjoyed solid successes in trading volume at inception.⁴ The StreetTracks contract has, since the beginning of the year, benefited from trading volumes averaging approximately 2 million contracts per day, even as its net asset value has declined. Other than portfolio diversification, what is the lure of such a seemingly quixotic investment?

Simply put, iShares Gold Trusts and StreetTracks Gold Shares are marketed to investors as an efficient method to access changes in the price of gold, without having to take actual possession of physical gold bullion. Rather, gold price risk is accessed through the trading of a security-a much more familiar, and therefore comfortable, investment option for many market participants. You can deal with your local securities broker, and trade the gold market just as you trade Intel or IBM stock. Sounds like a good deal, right? There is an issue, however, as to the appropriate regulatory characterization of these products: are they securities, are they commodity futures, or are they cash market transactions? This article explores those questions, and provides some legal and policy background regarding the nature of these transactions. Specifically, we review the regulatory framework for commodity futures and options transactions, note some of the differences between the commodities and securities markets, and analyze gold ETFs in light of applicable securities and commodities case law and statutes. As a result of this analysis, we reach the conclusion that the gold ETFs as described herein are most appropriately viewed neither as futures nor as securities, but rather as cash market transactions, with the resulting regulatory ramifications that flow from such a determination.

Commodity Futures and Options Regulation

IN 1974, CONGRESS PROMULGATED LEGISLATION to create the Commodity Futures Trading Commission (CFTC), an independent federal regulatory agency that oversees the trading of the commodity futures and options markets in the United States. While there once was a rather romanticized perception of the free-wheeling world of commodity futures trading, dominated by Chicago pork belly traders and Midwestern wheat and grain merchants, after the 1971 Bretton Woods decision to remove the dollar from the fixed gold standard, the word "commodity" took on a whole new meaning. Futures and options trading on underlying financial commodities soon began to develop and expand, so much so as eventually to overtake by large measure the trading volume of more "traditional" commodities, and to transform the futures and options markets into the global financial risk management markets they are today. "Gold prices skyrocketed through the fall of last year to reach a high of over $450 an ounce at the end of 2004, enticing virtually everyone to play the gold market."

The primary federal interest in regulation of this type of trading is two-fold: commodity markets are used 1) to shift or assume market risks; and 2) to discover and disseminate price information "through trading in liquid, fair and financially Page 8 secure trading facilities."⁵ Congress has long recognized a fundamental difference between these types of markets as opposed to capital formation markets, which are regulated by the Securities and Exchange Commission (SEC). (Indeed, federal regulation of the commodities markets under the Department of Agriculture was in place almost a decade prior to the 1933 enactment of federal securities regulation.)

Jurisdictional Issues Between Commodities and Securities Transactions

SINCE THE CREATION OF THE CFTC, numerous jurisdictional questions have arisen regarding precisely where the line should be drawn separating federal securities laws from federal commodities regulation.⁶ The distinction is critically important: while there are several facial similarities between the two bodies of regulation, intrinsic differences between the commodities and securities markets require application of the appropriate regulatory structure in order to carry out Congressional intent regarding fundamental issues of market integrity and customer protection.

Risk management markets are sometimes referred to as a "zero-sum game." For every dollar lost, a dollar is gained-every time I win, you lose a corresponding amount, and vice versa. This is fundamentally different from the "rising tide raises all ships" concept of the capital formation markets. Accordingly, the two types of markets require two different types of regulation. And let¥s not forget cash and forwards transactions, which generally are neither securities nor futures, and which are specifically excluded from the jurisdiction of the CEA.⁷ Each of these markets has different uses, and, while the same terminology may be utilized across markets, each is regulated by a different set of rules.

Here¥s an elementary example: the term "insider trading" means something very different in the securities world than it means in the commodities world (where it¥s actually desirable to have people with inside industry knowledge actively trading the marketplace-that¥s how prices are discovered). Consequently, application of securities insider trading laws to commodities trading is entirely inappropriate.⁸ Another example: the term "margin" in the commodities world refers to a performance bond deposited to ensure performance on a futures contract (and is usually fairly low, often 5-7% of the value of the underlying contract), while the same term in the securities world refers to collateral deposited in partial payment of the security (and is generally not less than 50% of the underlying stock). Most importantly, as noted above capital formation markets and risk management markets are utilized by market participants to perform different identified functions, and therefore require regulatory oversight programs tailored to those specific uses.

Accordingly, given the importance of determining the character of a particular product in order to evaluate under what oversight system it is appropriately regulated, we turn to this question: Are gold investment products such as shares in the trust vehicles described above properly traded as securities? Or should they be characterized under an alternative product class?

Are Gold ETFs Securities?

TO ESTABLISH A REGULATORY CHARACTERIZATION for gold ETFs, it¥s helpful to provide a brief overview of how they are structured and traded. StreetTracks Gold Shares and iShares Gold Trust shares represent fractional, undivided beneficial ownership interests in investment trusts, the sole assets of which are gold bullion. (Occasionally, the trusts hold cash as well, used in redemptions and...