Still bursting with ideas

The commodity wizards that generated a slew of new products in the past year must be feeling just a touch restless these days. Although banks continue to gear up for growth, specialists who conjure the latest indices and other products to feed commodities-hungry clients have been idling of late. The threat of new, stricter regulations has cast a winter chill on innovation, with bankers mulling adaptation to a new landscape.

"New products have been very busy this past year, but more recently we've put the brakes on because a lot of clients are sitting on the sidelines, not clear about what is happening to all these products because of pending regulations, says Francisco Blanch, head of global commodity research at Banc of America Securities-Merrill Lynch.

Mr Blanch says his group has more than 400 products and a total of 450 indices, and has launched about 10 of these indices this year. Other banks have responded to the threat of regulation by unwinding some products. The Commodity Futures Trading Commission (CFTC) wants to curtail index speculation, introduce position limits for speculators, more disclosure of positions and possible higher-margin requirements.

Such concerns have raised the cost of accessing commodities. Recently, the price for a typical swap on the S&P GSCI index that usually trades from 15 basis points (bps) to 18bps a year has gone up to between 25bps and 30bps. Investors use the GSCI, the world's largest commodity index, as a benchmark for their strategies. The index has about $60bn in assets under management.

Others are withholding liquidity. "Some market participants are having a hard time expanding their product base, so they come to us for liquidity, says one senior commodities banker. "But we've been reluctant to take positions from certain players because we don't know what our limits will be." Those looking for extra liquidity have tended to be large commodity funds that have several billion dollars in pension funds and other investor money and which keep all of their positions in the futures market. "If the CFTC decides it can only keep $1bn in futures, it is either going to have to give money back to investors or set it off with swaps," says the banker.

"It is asking us for liquidity in swaps, but we could also get hit with limits, so we don't want to give away our liquidity right now," he adds.

Uncertainties aside, ambitions still run high. Rob Jones, co-head of global commodities at Bank of America, says: "If there's demand for a specific product in the market, we expect that demand to be met one way or another."

Hundreds of new products have already been launched in the past year. For instance, banks have been trying to help clients cope with concentration risks which could be problematic under the CFTC. There's also demand for products that tackle contango, or negative carry, a bane of this year's market. Contango is when future contracts trade at higher prices than the spot month, meaning funds pay more when they trade out of their current contracts and into the next month. Still others are finding ways to help investors access less liquid markets.

Credit Suisse's Kamal Naqvi: clients 'very clear' about what they want in terms of new products

The contango problem

"Contango has been an increasing drag on the asset class. Our clients have been very clear about wanting new product methods," says Kamal Naqvi, head of global commodity investor sales at Credit Suisse. He says the bank has launched a number of products that can deal with this issue. The bank has also devised other tools to help clients avoid concentration on the front end of the curve. "We launched an alternative benchmark to alleviate concentration in the market," says Mr Naqvi. He adds that the index is a beta product that gives clients generic exposure to the asset class, but which is far less concentrated in futures positioning, rolling conventions and in underlying commodities exchanges.

Citigroup and Barclays have also been at work on the problem. Citi's Ravi Ramachandran, head of commodity indices and new commodity investor products, says the bank has developed a new product called 'Cubes'. "We are responding to client requests to move away from the front-end investments, which are susceptible to negative roll yields in contango markets, and can be exposed to higher volatilities than those seen further along the curve," he says. Cubes aims to identify points on the futures curve which have the greatest potential for roll yield and invests in those points of the curve. Clients can also choose which commodities they want to access and create custom indices using the Cubes approach.

Martin Woodhams, head of commodity structuring at Barclays Capital, says his group has also tackled such issues. "Our strategy is a pure beta, where we've had $1.5bn assets under management (AUM) flow within less than a year. It is a roll yield strategy to enhance the performance investors can get versus the negative returns they've gotten in the front end of the curve for the past 12 months. It has been enormously successful."

Still others, such as market incumbent Morgan Stanley, prefer to focus on specialised solutions and to steer away from exchange traded funds (ETFs, see table overleaf). "We're seeing more retail interest in ETFs, but this isn't always the optimal way to invest due to potential rolling costs," says Boris Shrayer, global head of commodities marketing at Morgan Stanley.

He says investors may believe they are getting a long position in the commodity, but the cost of rolling monthly futures is almost irrelevant to what the commodity and the contract costs. For example, he notes, the US National Gas Fund has lost 59.3% year-to-date while natural gas prices have only lost 17.8%. "There are much smarter ways to own gas than own it on the front end of the curve - for instance, buying deferred call options, as volatility is quite low," says Mr Shrayer.

Martin Woodhams, head of commodity structuring at Barclays Capital

Looking for liquidity

Banks have also been eager to access pockets of liquidity that, until recently, were overlooked. Bank of America has produced a suite of speciality indices that provide clients with exposure to sub-indices of major indices such as Goldman Sachs and Dow Jones - those constructed with subcomponents.

"We're creating products in areas that have traditionally not been that liquid. There are new classes of metals - for example iron and steel. The market is looking more at these types of products to create more liquidity for different energy products," says David Goodman, Bank of America's other co-head of global commodities. He says investors want to reduce their basis risk but still want exposure to commodities."

Banks are also offering strategies that harness their physical and futures capabilities and which are helping them land deals. In one such instance, Barclays Capital secured an important mandate earlier this year when EDS came back with a second offer for British Energy. Barclays helped construct a lower cash offer by creating a commodity-linked medium-term note structure that gave a pay-off or upside return on the underlying assets of British Energy's power stations.

"We only got to be in that position because we have a dominant position in power and because of our ability to structure and distribute power paper. It was a nice combination of all our skills on the physical side, which we applied to get the transactions done," says Barclays' Mr Woodhams. Last year, Barclays launched the US Power Index, the first investable index to track the national price of electricity across all actively traded regional markets in the US.

Looking beyond the US

Still others are looking at looming regulation and what to do if position limits impair US liquidity. The S&P GSCI has been working on a potential solution for this problem - an alternative non-US benchmark that would exclude prices from the US.

"Given recent regulatory concerns, we've had a lot of interest from clients fearful about being restricted from investing in the US," says Michael McGlone, senior director of commodity indices at Standard & Poor's. He says the index is "very close" to being launched.

Given the global nature of commodities, he expects the correlation of the index to be very high to the GSCI. He says the index will include all commodities that are liquid and can be traded outside the US. One of the main issues has been finding contracts that are liquid in this respect - a real concern, given the virtual lock-up the US has had on global liquidity. S&P GSCI is also contemplating other changes. "If there are potential restrictions on specific commodities, for example, WTI [West Texas Intermediate] crude oil that makes the S&P GSCI less investable because it has a large weighting in WTI, we might need to include an investment weighting factor where, for instance, it would reflect certain restrictions and reduce the hypothetical WTI crude weight in the index," says Mr McGlone.

Banks say investors are willing to look outside the US if that is what it takes to keep liquidity moving. "We have more clients interested in knowing what their options are, so they'll wait and see," says one executive. "If the US imposes restrictions on commodities, there will be many who will look to shift."

For his part, Mr McGlone expresses confidence that the thirst for liquidity will win out. "Is the game over?" he asks. "No - people will find other ways if they are restricted on their ability to freely trade in investments. Human nature will prevail."

Exchange Traded Funds in numbers