JP Morgan Gets a Big Holiday Gift From the SEC

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In 1996, the world learned a Japanese firm had cornered the copper market. The company, Sumitomo, was fined $125 million for squeezing copper supplies and artificially inflating prices--at that point the largest penalty ever levied by a U.S. government agency. The Commodities Futures Trading Commission called the scheme “one of the most serious worldwide manipulations” of a commodity in decades. Last Monday, the Securities and Exchange Commission posted a decision that could effectively lead to a repeat of the Sumitomo corner, with one key difference: hoarding copper will now be legal.

Until now, the main people buying physical copper have been the people who use it, like manufacturers that produce basic industrial goods such as pipes and electrical wires. Speculators have been limited to trading in futures, which are forms of bets that link only indirectly with physical supply of copper. Two weeks ago, however, the SEC blessed a controversial fund designed by J.P. Morgan Chase that, for the first time, will let investors buy shares backed by physical, warehoused copper, to use as a form of investment.  

The change may seem arcane. But long-time participants in the copper market say the effects will be immediate: Manufacturers looking to make productive use of copper will find themselves competing with speculators backed by some of the richest banks and funds in the world, raising prices for many consumer products. The long-term result may be even more disturbing: The SEC's ruling all but invites bankers to increase speculation in other, even more essential goods, like grain and oil.

In practical terms, the SEC handed traders at J.P. Morgan control over 20 to 30 percent of the copper available for immediate delivery from the London Metals Exchange -- the commercial market where companies that use copper go to procure last-minute supplies.

The investors purchasing shares in J.P. Morgan's fund won't be buying copper to use, but to store. The intricacies of the fund are complex, but its underlying rationale is straightforward: the more shares investors buy, the more copper is taken off the market. And the more copper that is taken off the market, theoretically the more valuable the copper and the shares become. The Sumitomo trader who cornered the market in the ’90s relied on the same essential strategy to artificially inflate worldwide copper prices.

The SEC says that its own internal analysis shows that levels of copper inventory at the London Metals Exchange don’t affect its price, and that copper users will still have ample sources from which to buy. But companies that use copper strongly oppose the new fund, and argue that allowing investors to hoard the metal will lead to supply shortages, create substantial price volatility, and distort the market. "The implications of this practice would be grave for our companies, our industry, and, indeed, for the U.S. economy," a group of copper users wrote to the SEC in August.

"It effectively creates a corner on the market," said Marcus Stanley, policy director at Americans for Financial Reform, an advocacy group that lobbies for greater accountability and fairness in the financial sector. "It means a manufacturer won't be able to procure copper because the copper will be tied up in somebody's retirement fund. That's not what commodity markets were intended for."

Public interest groups and academics also criticized the methodology the SEC used to justify its decision. John Parsons, a financial economist and lecturer at MIT, said the SEC failed to consider how the copper market actually works. "Just as the SEC staff did in the Madoff case, it carefully asks the wrong questions and thereby comes to easy answers," he wrote.

Allowing financial interests to interfere with industrial activity is disruptive enough. More troubling is that the SEC's decision collapses the distinction between precious metals traditionally used for investment, like gold and silver, and metals and other goods that we consume in large quantities, like copper and corn. It signals to bankers that all goods are fair game for financial play, no matter how vital to our economy or our well-being.

"There's no reason why banks won't try this with grain and oil next," said Michael Masters, a hedge-fund manager based in New York. "As long as they can, why not? Right now, there's free rein. It will only stop when regulators decide that allowing essential things to be hoarded for investment is misguided investment--and dangerous for the public."

The SEC's move comes two years after Congress took steps to limit speculation in the futures market. Major producers and buyers of goods like wheat and oil have traditionally used futures contracts to hedge risk and stabilize prices. In the past decade, though, traders began to sell financial instruments that enabled investors to buy and sell futures contracts as a form of investment. Investors flooded these markets with hundreds of billions of dollars, increasing the volume of speculation in the futures markets by 1,900 percent between 2003 and 2008.

Although the link between the futures markets and real physical supply is indirect, the results of this speculation were disastrous for producers and consumers. The price of wheat rose by more than 120 percent between 2005 and 2008, pushing 250 million additional people worldwide into poverty. Oil prices spiked to a historic peak at $145/barrel in 2008. In response, Congress included in the Dodd-Frank Act a mandate for CFTC regulators to curb excessive speculation in our markets for essential goods. 

In a sense, futures contracts provided bankers with a backdoor way to speculate with essential goods. The SEC's recent decision effectively opens the front door for financial interests to capture even more direct control over the supply of these goods. Thanks to the SEC, traders and investors will be able to directly manipulate actual stocks of copper rather than simply bet on future supplies.

"Allowing investors to speculate in the futures market created horrific price volatility,” said Michael Greenberger, a law professor at the University of Maryland and former director at the CFTC. “Here, you're allowing investors to intervene with physical supplies. We'll see a double whammy."

The SEC and J.P. Morgan declined to comment.

One of the oddest features of the decision is the SEC’s assumption of the authority to make it. Regulation of commodity markets usually falls to the CFTC. But since J.P. Morgan bankers designed their shares to be publicly traded, they managed to win approval from the SEC, even though their financial product will materially impact the physical market and could hurt actual users of copper and, ultimately, the public. (According to one observer, a CFTC official acknowledged the fund could harm the copper market but said the agency lacks the formal authority and the manpower to intervene.)

Some observers say the SEC’s decision accords with the agency’s primary mandate, which is to protect investors from unfair trade, not the interest of manufacturers or the public. But critics of the decision say the SEC has strayed outside its traditional territory. "The SEC does not have the expertise or the experience to make a sound decision on how this new investment vehicle will affect market fundamentals," Greenberger said.

However haphazard its authority, the SEC's decision has significant ramifications.

A squeeze in the copper market could play out in months. By February 22, the agency will rule on an identical fund proposed by BlackRock that would enable that investment management firm to remove twice as much copper as J.P. Morgan, and tighten supplies that much further. If approved -- as is widely expected -- the agency will send an even clearer message to banks and investors, inviting them to turn America’s markets for essential goods into their personal financial playgrounds.

Lina Khan is a policy analyst for the Markets, Enterprise, and Resiliency Initiative at the New America Foundation.

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