It’s time for more ETF oversight

June 5, 2012, 10:28 PM UTC

FORTUNE — The price of copper is a global bellwether, signaling industrial health wherever it trades. When China was in its steroid-induced growth phase, copper was Mr. Universe. Then China coughed and copper caught the mother of all pneumonias. Seeing opportunity in volatility and global range, JPMorgan Chase (JPM) plans to launch an ETF backed by physical copper.

Southwire, one of the largest copper consumers in the U.S., and metals trader Red Kite have filed a complaint with the SEC, claiming the fund will “inflate prices and squeeze supply by removing as much as a third of the London Metal Exchange’s copper stocks.” They say the effect on the markets will be comparable to the Sumimoto scandal when metals trader Yasuo Hamanaka (a/k/a “Mr. Copper”) sucked up 5% of the world’s physical copper and maintained artificially high price levels, enabling Sumimoto Bank to sell its positions profitably while also charging high commissions on customer copper trades.

The complaint says the proposed ETF will “grossly and artificially inflate prices” and “wreak havoc on the US and global economy.” Regulatory filings indicate the ETF could hold as much as 61,000 metric tons of physical copper.

This may not remain an SEC case – the CFTC may want to oversee copper too, if only as an excuse to ask for a budget increase. Depending on how the Commission rules, and on the language they use, this could point to a formal government determination that speculation causes price volatility. One thing is certain: ETF demand is not normal economic demand and, contrary to the marketing materials and the definition accepted by the regulators, ETF trading often creates artificial imbalances in the underlying instruments.

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ETF units are created or liquidated to meet orders, making traders completely price-insensitive. A large order to buy a copper ETF causes a trader to dash out onto the floor and buy all the physical copper he can. Can this disrupt the markets? A Sumimoto trader’s control of just 5% of the world’s copper was enough to disrupt pricing in the marketplace for ten years. The complaint calculates the new ETF could stockpile as much as 30% of the copper held on the London Metals Exchange. This would cause the ETF to buy copper within the U.S. – a net importer – disrupting the flow of supply.

Coincidentally, the Wall Street Journal recently noted an earnings release from mining equipment maker Joy Global (JOY), predicting higher prices for copper because “a substantial portion of the current inventory has been pledged as collateral for financing in China.” It appears much of the world’s copper is “off-market in Chinese warehouses as part of complex financing deals among local traders and banks.”

Other sinister players lurk in the ETF markets. There was the recent $800 million ETF trade as an unidentified institution redeemed 20 million shares of SPDR Barclays Capital High Yield Bond ETF.  Rather than cash out of the instrument, according to ETF Trends, the investor took the bonds, a “customized in-kind redemption” where the investor bypassed the open market, protecting against liquidity bottlenecks and the ever-present threat of smaller traders looking to pick off small profits while working the large execution. Said one Barclays analyst, “the maneuver adds to the already strong evidence that cash market liquidity remains challenged, as less traditional avenues for accessing cash liquidity have become more attractive.”  ETFs, the new Third Market.

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We can think of multiple ways in which this trade could have been used to manipulate the markets. The institution placing the ETF order could have used the trade to mark up prices in its own holdings, to create liquidity for its own illiquid positions, or simply to skim small profits on a short sale.

With the potential for a drain of 30% of the LME’s copper for the proposed ETF – plus China’s unknown holdings – copper has become money, a physical good held as inaccessible collateral for bits of paper that people accept in trade. Is America worried that China controls too much of our Treasury debt? How about too much of the world’s natural resources? How about too much of the world’s arable land, with massive farming ventures already established in Brazil and across Africa? Will we push back against global economic encroachment, or will we continue the fire sale as America sells itself off piece by piece?

The political fallout from this case is worth watching. A joint SEC-CFTC decision against the ETF would change the entire ETF industry – obviously a hot potato. The ETF market has over a thousand vehicles with well over a trillion dollars in assets, and issued by the biggest names in finance, including Citigroup (C), PIMCO, UBS (UBS), JP Morgan, Morgan Stanley (MS), and Goldman Sachs (GS). An adverse SEC decision would call into question the regulatory justification for marketing these funds and could be a first step towards an official government position that speculation, not supply and demand, drives price volatility in the commodity markets. One would not expect a lowly government agency to challenge such a powerful sector.

In an election year, is President Obama willing to bet he can eat Wall Street’s cake and still have it?