As the introductory Commodity Corner column of the magazine I found this to be a good opportunity to introduce commodities and futures.

One could argue commodities have been around since the beginning of civilization. People have produced, paid or bartered for commodities to use for either production or to consume. Some of the uses of commodities include food, energy, construction, manufacturing, and clothing.

According to the Merriam-Webster dictionary, commodities are defined as: 1) an economic good. 2) A product of mining or agriculture. 3) An article of commerce especially when delivered for shipment. 4) A mass produced un-specialized product. [i]

In today’s global markets both large and small firms will trade and hedge commodities as part of their daily business as either a producer or end-user of the commodity. For example a chocolate candy producing firm will need to purchase cocoa, sugar and of course energy to fuel their factories. If they do business in foreign countries they may need to buy and sell foreign currencies for hedging or delivery purposes. (See “Currencies in Your Future Portfolio?” of the Spring/Summer 2012 issue).

To manage their price risk, a commodity producer, such as a farmer may sell a futures contract to lock-in their selling price. An end-user, such as a coffee chain may buy a futures contract to lock-in their purchasing price. Keep in mind commodity markets tend to be mean-reverting markets as they spike or decline from an average price and then revert back towards that average price overtime. This is often due to shocks in the system such as increased demand, reduction of supply, weather concerns, disruption of distribution channels or possibly political or regional events. If a commodity becomes too expensive, the market participants’ behavioral mechanism will appear as they seek less expensive substitutes. This is known in economics as the substitution effect and one of the differences to note between commodity and equity trading.

Commodities are traded in two common locations: either the spot/cash market usually reserved for industry or sometimes known as “commercials” such as producers, distributors and end-users as the actual physical commodity is traded. Or the products trade on an exchange such as one of the futures exchanges found around the world.  The futures exchanges are often utilized by both commercials and speculators. An exchange offers commercials the opportunity for immediate offset of their commodity risk by speculators offering liquidity to take on the risk. If a commercial has a loss from hedging, it often means they profited in the underlying cash market, because they are holding the opposite direction in the cash market. One can think of the loss on the hedge as a premium on an insurance policy.

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[i] Shore, M. (2011) DePaul University 798 Managed Futures Lecture notes

Copyright ©2013 Mark Shore. Contact the author for permission for republication at info@shorecapmgmt.com Mark Shore has more than 20 years of experience in the futures markets and managed futures, publishes research, consults on alternative investments and conducts educational workshops. www.shorecapmgmt.com

Mark Shore is also an Adjunct Professor at DePaul University’s Kellstadt Graduate School of Business in Chicago where he teaches a managed futures / global macro course and an Adjunct at the New York Institute of Finance. Mark is a contributing writer to Reuters HedgeWorld.

Past performance is not necessarily indicative of future results.  There is risk of loss when investing in futures and options.  Always review a complete CTA disclosure document before investing in any Managed Futures program.  Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone.  The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.

So the big financial system overhaul bill has finally passed. It seems like legislators, lobbyists and lawyers have been working on this thing forever. In reality they have been working on it in one form or another pretty much since someone taped that two dollar bill to the revolving door at Bear Stearns.

A lot of friends who are not in the financial industry have asked me what I think of the legislation. As if I’ve read all 2,300 pages. Most of the people who just voted on the bill haven’t even read all 2,300 pages … or even one-tenth of that. But I still offer my quick take, which is that it’s a large and complicated bill designed to try to rein in a large and complicated industry, the excesses of which over the years caused large and complicated economic problems.

It is going to be years before we understand the full effect of this legislation. Some winners and losers are easy to pick out. Others will take some time. One big winner for sure is lawyers. This bill is going to create a lot of work for lawyers and compliance departments, figuring out what the bill actually says and how to implement specific provisions firm-by-firm. Some law firms may create entire departments just to figure out which pieces of this affect their clients and how.

For hedge funds, the new rules mean registration, and higher compliance costs. But administrators, prime brokers and accounting firms are already developing and deploying middle- and back-office systems designed to automate many of the compliance functions that will be required by greater regulatory oversight. In the end, the new rules will probably not be a large barrier to entry, even for an industry that could probably use a slightly bigger one. Financial regulation reform will not result in the dismantling of the hedge fund industry as we know it, nor will it likely affect returns.

Even the supposedly greater regulatory oversight to which hedge funds will be subject may in reality never materialize. Subjecting hedge funds to more regulation will only be effective insofar as the regulators can handle the added workload. In recent years there has been little to suggest the SEC is equipped to identify, understand or address the kinds of risks that forced the global financial system to its knees—including counterparty risk and leverage.

And subjecting the hedge fund industry to greater regulatory scrutiny, while it may help discourage the kind of outright fraud we’ve seen, it won’t totally prevent it. Nothing will. You can’t legislate morals.

As we choke down and digest this thing over the coming months and years, one thing that will stick in my craw is how financial regulatory reform is a shining example of the way the American legislative system works. What I mean by that is this is a bill that was written by lobbyists, not legislators. The whole lobbying process is distasteful to me, but I harbor no illusions about why it exists: the complexity and nuances of many aspects of the world today—finance, health care, energy policy, to name three—are beyond the ability of most elected officials to comprehend.

That’s not necessarily meant to be a knock on politicians. They are, after all, politicians; they are not bankers, doctors or energy experts. But they are also not like everyday people. Many members of Congress may not know what a gallon of milk costs at the store and are years removed from calculating how much gas to put in the car to make it to work the rest of the week while still having enough money left over to buy food, pay the rent and shop for clothes for the kids. Put simply, politicians are not equipped to understand the complexities on either end of most legislation. Enter the lobbyists. Banking lobbyists, environmental lobbyists, organized labor lobbyists, gun lobbyists, tax lobbyists, abused spouse lobbyists, renters’ rights lobbyists, auto safety lobbyists, auto industry lobbyists…. All have a story to tell, a change to suggest, a meal or trip to pay for.

I was talking the other day with an executive at a hedge fund administration firm. The conversation inevitably came around to financial regulation. He said he was in favor of financial regulation that gave investors confidence. The old way of doing business wasn’t sustainable, he said. I was dismayed, but not surprised, when he told me nobody connected to drafting financial regulatory reform had ever asked him what he thought might be needed, nor had they asked anyone he knew. Industry lobbying groups—the Managed Funds Association, in particular—had spoken on behalf of the industry.

Apparently the lobbying is only just beginning, even now that the bill is about to become law. Regulators themselves appear to be the next targets as they determine how to implement this new rule book they’ve been given.

Although the banks and others may complain about the additional costs of complying with these new rules, they’re not going to be the ones ultimately paying for it. They’ll pass those costs on to their customers and clients.

Which it could be argued is a fair thing to do. We as consumers have benefitted from the financial wizardry that led to credit default swaps and collateralized debt obligations and we should probably be responsible for paying to make sure things don’t get out of hand again.

Not that this legislation will necessarily do that. When it’s all sorted out, it probably will have some positive effects, but only if its implementation is carried out by intelligent, competent people of integrity. Like the Zen master says, “We’ll see.”

I have been keeping up as best I can with the developments surrounding negotiations in the United States and Europe with respect to government reform of the financial system. And when I say “as best I can,” I mean “barely.”

Just today we learned that reform for hedge funds in Europe is pretty much dead until the fall. In the short-term, European Union legislators seem unable to bridge the divide between how mainland Europe would like to treat hedge funds (one passport to allow distribution in all of Europe or no passport at all) and how the United Kingdom would like them treated (the broad Europe-wide passport or, failing that, country-by-country passports). The U.K., with the bulk of Europe’s hedge fund industry, understandably wants to make it easier for hedge funds to operate from there.

Here in the United States, House and Senate negotiators are still talking, trying to beat a self-imposed deadline of today (June 24) to hammer out what financial reform will look like. While there appears to be agreement on some key points including bank capital requirements and moving most derivatives trading on-exchange and routing it through centralized clearinghouses.

Unresolved, as of late in the afternoon, was the fate of Democratic Arkansas Sen. Blanche Lincoln’s proposal to force banks to get out of the swaps dealing business and the so-called Volcker Rule, which would require banks to close their proprietary trading desks. Bank lobbyists and FOBs in Congress (that’s Friends of Banks) were working to block the Lincoln proposal and weaken the Volcker Rule.

The struggle in Europe and here in the U.S. is indicative of the times in which we live. On the one hand we’ve seen massive failures in the financial system that have negatively affected smaller investors who rightly feel they are at the mercy of a system being gamed by big players. At the same time there are many who feel that government intrusion into the financial system in the ways that have been proposed would cripple the financial system, restrict innovation and weaken the economy.

The tension between the two sides is natural. On Friday we can talk about outcomes. Right now, the devil remains in the details. How those details play out in the next few hours will determine what kind of financial system we have going forward.

In case you read about U.S. Attorney Preet Bharara’s comments last week and wondered why in the world ordinary folks would look at the investment industry and figure it’s a rigged game, the answer is: because it is!

Arthur Samberg and whatever is left of his old firm, Pequot Capital Management, agreed to pay $28 million to settle charges that he and the firm received insider information that they used to trade shares of Microsoft Corp. In the typical weaselly manner of these settlements, Pequot and Samberg did not admit or deny the allegations, and the SEC still managed to take credit for the settlement.

This is the same SEC, mind you, that dismissed one of its own attorneys, Gary Aguirre, as he attempted to pursue allegations against Pequot. If anybody on either side had the stones to stand up and admit their behavior, the real news here appears to be that Pequot and Samberg paid off the SEC, which succeeded in collecting $28 million (but no admission of guilt, mind you) in spite of itself.

Many people I know would look at this and laugh. It’s certainly not an example of regulation. What it is an example of is how closely aligned the interests of investment managers and regulators are. After four years, everyone wanted this to go away, and $28 million was enough to accomplish that.

Laws and regulation are required because people cannot be trusted to act decently. The kinds of things Samberg and Pequot were accused of are subject to regulation and disciplinary measures. He was caught and disciplined. But does a $28 million fine really constitute a disciplinary measure? To me that’s a lot of money, but Samberg can write that off as a cost of doing business.

Most ordinary people I know would look at what Samberg was accused of—extorting a prospective employee for personal gain—and see it as another example of the everyday goings-on on Wall Street, a place where the privileged take advantage of information and power pathways not available to the rest of us to make money for themselves and other wealthy, powerful people.

Is that populist enough for you? Who will defend the kind of behavior Samberg was accused of as they attack the creeping reach of the government? As we consider candidates for the upcoming election, where exactly is the boundary between love for Milton Friedman and regulatory loathing and the notion that a level playing field should be just that?

So I’m sitting at my desk, absent-mindedly glancing now and then at CNBC’s “Street Signs” broadcast, when the Greek police decided for some reason to move the line of people protesting austerity measures that had formed outside the Greek parliament building back a hundred yards or so. As that video played at about 2:40 p.m. ET, equity markets entered a nose dive.

At one point I was on the phone reading off the changes in the Dow Jones Industrial Average as they were shown on CNBC. In a roughly three-minute span, the Dow went from being down about 700 points to being down close to 1,000 points – 998 and change, actually. Proctor & Gamble went from trading at around $62 per share to about $48 per share, a drop of about 22%. Apple Inc. dropped from the mid-$200 per share range to below $200, also a drop of about 22%. Accenture plc was trading at about $40 before dropping to 1 cent.

Just before 3 p.m. ET, equity markets—those individual stocks and others that dropped precipitously included—appeared to quickly rebound. This led CNBC’s Jim Cramer to declare that there had been a computer glitch or software problem of some sort. By the time Maria Bartiromo and the Closing Bell show started, there was speculation that someone had made giant trading error.

It seemed to me to be clear as the market dropped like a stone before our eyes that computers were at work in some way. It reminded me of the Black Monday crash of October 19, 1987, when computerized trading programs designed to mitigate portfolio losses actually exacerbated them, causing the Dow to drop 508 points, or—wait for it—about 22%.

Meanwhile the euro tested fresh lows against the dollar, oil prices fell below $77 per barrel, gold blew through $1,200 an ounce, 2-year Treasuries got to 60 basis points and 10-year Treasuries reached about 3.25%. The CBOE’s VIX, which measures the implied volatility of the Standard & Poor’s 500 stock index, shot up from about 26 to more than 38 in about 90 minutes. Its previous 52-week high was 34.57.

After the pre-3 p.m. panic, equity markets recovered, if not stabilized. The Dow wandered between down 300 points and down 500 points for the rest of the trading day, suggesting a one of those clown punching bags with the sand in the bottom seeking to find its straight up-and-down position after taking a strong right.

About an hour after the bottom fell out, reports began appearing that a human-caused trading error at a “major firm” caused the massive sell-off, likely tripping algorithmic, high-frequency trading systems and causing them to sell automatically. Last year it was estimated that algo trading firm accounted for close to three-quarters of U.S. equity trading volume.

Is this right? I mean, what kind of system is this when a “fat-finger trade” can set off worldwide market panic and cause the broader U.S. equity markets to plunge close to 10 percent in a matter of minutes?

Regardless of what kind of error it was—human or programmatic—questions need to be raised about whether the system we have allowed to evolve is safe. Or useful.

Here is the City has a copy of the letter John Paulson sent to investors. In it, he answers questions, from Paulson’s perspective, about the SEC’s civil fraud lawsuit filed against Goldman Sachs.

Paulson reiterates that his firm neither structured nor marketed the ABACUS deal. Paulson only suggested securities that ACA could include in the portfolio; the final decision was up to ACA. Even though Paulson has not been charged in the case by the SEC, because the agency contends it was Goldman that misrepresented Paulson’s role in the ABACUS deal to prospective investors, the Paulson investor letter reads as a defense of the firm.

As I pointed out yesterday, Paulson makes some good points, the most persuasive of which, to me at least, is the fact that Paulson had been openly shorting RMBS for some time, believing strongly that the housing market was poised to tank. There were plenty of people willing to take the other side of that trade, in other words bet that the housing boom fueled by the cheap-oil orgy of the past 60 years would continue indefinitely.

Paulson was right; everyone on the other side of ABACUS and similar deals was wrong. I still don’t think the bursting of the housing bubble and the subsequent credit crisis was a zero-sum game from an investing standpoint, but Paulson’s windfall goes a long way toward evening out the “winner” side of the ledger.

In these tough economic times, it’s nice to know some people are still making enough to get by. For those of you curious about which hedge fund managers made Forbes magazine’s annual list of billionaires, but not curious enough to comb through the whole list yourself, FINalternatives has done the legwork.

Here’s the list:

35. George Soros, $14 billion
45. John Paulson, $12 billion
59. Carl Icahn, $10.5 billion
80. James Simons, $8.5 billion
113. Steve Cohen, $6.4 billion
171. Stephen Schwarzman, $4.7 billion
212. John Arnold, $4 billion
(tie) Ray Dalio, $4 billion
(tie) Daniel Ziff, $4 billion
(tie) Dirk Ziff, $4 billion
(tie) Robert Ziff, $4 billion
258. Bruce Kovner, $3.5 billion
(tie) David Tepper, $3.5 billion
287. Daniel Och, $3.3 billion
297. Paul Tudor Jones II, $3.2 billion
316. Edward S. Lampert, $3 billion
354. Stanley Druckenmiller, $2.8 billion
374. Leon Black, $2.5 billion
(tie) David Shaw, $2.5 billion
437. Julian Robertson, $2.2 billion
488. Philip Falcone, $2 billion
536. David Bonderman, $1.9 billion
536. Alan Howard, $1.8 billion
556. Wilbur Ross, $1.8 billion
582. Israel Englander, $1.7 billion
655. Louis Bacon, $1.5 billion
(tie) James Dinan, $1.5 billion
(tie) Stephen Mandel, $1.5 billion
721. Marc Lasry, $1.4 billion
773. Glenn Dubin, $1.3 billion
880. Michael Hintze, $1.1 billion
(tie). T. Boone Pickens, $1.1 billion
(tie) Henry Swieca, $1.1 billion

Clearly, the guys at the bottom need to start working harder. And what’s with the family collusion among the Ziffs? If I was Dan Och, I’d be wondering…. Actually, if I was Dan Och I’d be floating on a blow-up raft in a warm cove on my own private island. Dubin & Swieca - SUNY Stonybrook guys make good.

Four and a half minutes … who’d have thunk it could be boiled down to that? I particularly enjoy the stick figures and dramatic drum music. You’ll also notice that this 4:28 video is only part of the story about the economic meltdown. There’s a part two, if you can manage to sit through another 9:13.

The point here isn’t to suggest that this is a good history of the economic collapse, it’s more to show you what happens when you write the history of the world using YouTube.

News item: “Nowotny added that speculation driven by hedge funds played a role in the slump of Greek and other peripheral euro zone debt, and that there should be efforts to curb those actions”.

News item: “European Union plans for regulating the hedge fund industry still carry “significant risks,” warned Britain’s Financial Services Authority, even though many of the stricter rules have been toned down”.

At first glance, it’s tempting to look at these two stories, each seemingly opposing the other, and say, “It’s no wonder government can’t get anything done, here or in Europe.” That was my first reaction. (more…)

December, and thus year-end, hedge fund returns are rolling in and the results are upbeat across the board. According to the Hennessee Group, hedge funds in 2009 had their best performance year in a decade. The Hennessee Hedge Fund Index was up 24.6% last year, essentially erasing last year’s dismal 19.83% loss. It was the best year for hedge funds since 1999, when funds tracked by the Hennessee index earned 30.77%.

Only short-biased managers lost money in 2009, which isn’t surprising given the fact that the Standard & Poor’s 500 stock index earned 24.7%. We’ll leave aside, for now, the obvious—and for fans of alpha, worrisome—similarity between the Hennessee index’s return and the S&P 500. (more…)