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Within the last few weeks, ETF Securities, one of the principal sponsors of exchange-traded funds, has been admitted as a non-member account holder in LMEsword, the warrant depositary system.
The news started me thinking about ETFs, and what might be their implications for market participants.
First, we have to have a bit of history: a long time ago, before the advent of paper money, societies needed some way of creating a store of value that could be used as a means of paying for goods and services traded. Lots of things were tried, and eventually precious metals proved to be the most reliable.
Just as an aside, before fixing on gold, the Chinese experimented for a period with copper – the original copper cash, discs with holes in, suspended on a long piece of cord. They were destroyed as a means of exchange because the ease with which they could be counterfeited or debased created a raging devaluation and therefore inflation.
Closer to home, when Henry VIII needed money to pay for his French war, he deliberately debased the silver coinage of the time, with the same result – devaluation and inflation.
Paper money was introduced to obviate the need to transport huge weights of gold or silver coins. It is important to realise that by and large, modern coinage has more in common with paper money than it does with precious metal coins – in other words, it’s a representation of value, rather than an absolute store of it in its own right.
The concept of a monetary store of value gives me a basis for being able to understand the logic of precious metal ETFs. If gold is effectively an alternative currency, and if the concept of mining them, refining them and then burying them again in vaults because they are perceived to have an intrinsic value is accepted, then the idea of the ETF seems a logical extension of that perceived value, and creates a relatively easily tradable form of the metal.
Where I have a problem, though – and I am perfectly prepared for readers to explain to me what I am missing – is with ETFs in industrial metals. At the very basic level, copper, for example, has a value because it can be used to conduct electricity, or convey liquids and so on.
Without that usage, however, I struggle to see its value. It’s quite pretty, but it’s not rare enough to be secure as a store of value – as the Chinese found when they tried it in absolute value coinage. That being the case, the value of the metal in an ETF must be piggy-backing on the price that metal can achieve in the market, at any given time, as an industrial, consumable commodity.
That’s OK , as far as it goes, but it seems to me to create its own problem. If the value can only be generated by the need for industrial consumption, then surely taking a chunk of normal production away from potential consumption and storing it, effectively saying it cannot be consumed, will be self-defeating.
Surely what will happen is that initially the price of the commodity will be pushed up, as enthusiasm for the new product tempts investors, but then in the long-term, the existence of the ETF stockpile will depress the price, as buyers will be aware of the existence of extra tonnage, outside the ambit of the normal supply/demand chain of the market.
Effectively what the producer who sells his metal into an ETF is doing is to oversee the creation of what is to all intents and purposes another mine, but a mine without the normal insecurities of the mining industry.
Isn’t it better to sell consumable industrial commodities to consumers, and if supply outstrips demand, then reduce supply, rather than pile it up as a hostage to fortune in the future?
Back to LMEsword and my bafflement increases. Does an ETF provider joining suggest that LME warrants may become the asset-backing industrial metal ETFs?
And if it does, then surely that would have very serious implications for the meaningfulness of reported LME stock numbers, and possibly for the LME’s position as market of last resort.
If stocks were not available to withdraw because they formed the backing of a fund, wouldn’t that change the nature of the market?
Again, let me stress that I am very happy to be corrected on this issue; I confess I don’t get the logic behind it, but I am willing to be convinced that it all makes good market sense.
If you want to, please contact me on lordcopper@metalbulletin.com, or on Twitter with your comments. I will ensure the magazine gives them space.
Oh, and precious metals, industrial metals, oil? Whether or not we agree ETFs make sense here is one thing, but not terminal. What happens when somebody decides to create an ETF in agriculturals, and starts taking foodstuffs out of the supply chain? Or, perish the thought, water? There’s a social aspect to this stuff, as well.