Page 1 of 2 If you've been around the world of commodity-based exchange-traded products for some time, you've probably noticed the phenomenon of "crowding" at some point or another. Crowding is the pushing and shoving of speculators attempting to wedge their way into the commodities markets, either to gain portfolio diversification or to stave off the effects of latent inflation. With exchange-traded funds, it's easy to see crowding's immediate effects. Long-only funds are buyers of commodity futures contracts—repeat buyers, since their positions are constantly rolled forward. But funds that buy futures can only grow to a certain size—i.e., hold a certain number of open futures positions—before they bump up against position limits, or other so-called accountability levels. Position limits are hard stops imposed by federal law on speculative holdings in corn, soybeans, wheat, oats, soybean oil, soybean meal and cotton, while accountability levels are exchange-mandated—and squishier—concentrations of nonagricultural commodities. Exchange-traded commodity funds are subject to limits because they're speculative positions undertaken solely for investment purposes. Speculators take on risks laid off by commercial entities dealing in cash market commodities; a wheat farmer, for example, might sell futures to hedge a portion of her crop against falling prices. Some Restrictions Apply Such transactions can take place without restriction up to the farmer's cash market risk as they're deemed "bona fide hedges." But an investment fund taking the other side—the purchase of Chicago wheat futures—would be limited to taking on 6,500 contracts in any one month (speculative trades in the spot delivery, however, would be further restricted to a maximum of 600 contracts). If it can't put more money into new, index-mandated futures, a large and growing fund could develop substantial tracking error—as did the PowerShares DB Agriculture Fund (NYSE Arca: DBA) prior to its restructuring in October 2009. The answer to the question of position limits—or, as we'll see, the deflection of the question—came in the form of exchange-traded notes. ETNs are zero-coupon, unsecured debt obligations whose principal values are tied to variations in the notes' benchmark indexes. Marketing ETNs doesn't require the issuer to open and maintain a commodity futures account. Instead, exposure to the futures market is obtained through swap agreements in which another financial institution offers to "pay" the commodity return in exchange for the receipt of some money market rate, such as a Libor-plus spread. This deflects the position limit issue onto the back of the swap dealer. A dealer will hedge the exposures internally in its swap book to the extent it can. An obligation to pay a commodity return to one customer, for example, can be relieved by the receipt of the commodity return from another. Any net exposure that can't be crossed on the dealer's book would likely require the dealer to hedge in the futures market. It's here where things get interesting. To date, the futures positions undertaken by swap dealers have been deemed bona fide hedges by regulators and therefore not subject to position limits. All this greatly chagrins market participants who see these positions as de facto speculative holdings. The hue and cry about swap dealers crowding the markets has been raised to such a level that regulators now want to harden position limits and to restrict the swap dealers' hedge exemptions.
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