Rush into commodities worries British financial regulator


FSA Warns Banks and Funds
Over Commodities Gold Rush

By Patrick Hosking
The Times, London
Tuesday, March 27, 2007

Investment banks and fund managers are in danger of relying on inexperienced personnel as they rush to build up commodities operations, the City's lead regulator said yesterday.

In a strongly worded report, the Financial Services Authority said that it was concerned about the lack of expertise in commodities and believed that some firms were "overstretched." It was imperative that City firms manage this risk effectively, the FSA said, as they set up new trading desks and investment units to cater for booming demand.

Increased price volatility had raised the cost of trading and the risk of firms failing, the FSA said, referring to the collapse of Amaranth Advisors, the US hedge fund that lost $6 billion when it was wrong-footed by natural gas prices last year. The FSA also cited Ospraie, the American hedge fund manager, which had to close one of its funds after heavy losses betting on falling metal prices.

In a modern-day gold rush, City firms have been aggressively expanding their commodities capabilities as investors begin to embrace the notion of raw materials -- and associated derivative instruments -- as a separate asset class.

Charles Prince, Citigroup's chief executive, recently said that he wanted to build the bank's commodities division faster than in the past. UBS and JPMorgan are among many banks to have been recruiting aggressively.

FSA officials said that they had heard repeatedly voiced concerns about staffing levels and quality at firms: "We heard the same concerns so often that we have to conclude that some firms must be overstretched. If inexperienced traders don't fully understand the nature of the commodities markets they operate in, this could harm the interests of both the individual firm and the markets as a whole."

The FSA said that its warning also applied to commodities exchanges that had to ensure that their compliance functions were properly resourced. Commodities and commodity derivatives are mostly traded on the London International Financial Futures and Options Exchange, the London Metal Exchange, and the ICE Futures market.

The FSA said that it regarded these three institutions to be "frontline regulators" of their own markets. It sounded a warning note about increasing volatility in commodity prices. Many analysts, it said, believed that the market was not responding to fundamentals in the way it used to.

In the past five years institutional investors have diverted growing sums into commodities, attracted by the yields and the diversification properties. Energy and many raw material prices have soared, with booming demand from China and India cited as explanation, producing strong returns for many commodity investors.

Hector Sants, the FSA managing director (wholesale business), said: "The risks we have identified should not come as a surprise to those active in the market but serve to focus attention on the areas we consider to be of most impact and importance."

-- The face value of commodity derivatives contracts has almost quintupled to $6.39 trillion (£3,250 billion) in two years.

-- Of $18.6 trillion of pension fund assets, $80 billion is invested in commodities.

-- The FSA predicts that this figure could rise to $930 billion if consultants' advice is followed.

-- The pension funds of BT and J Sainsbury are investing in commodities.

-- Investment banks have developed a string of new tradeable instruments to track the prices of plastics, emissions allowances, coal, ethanol, freight contracts, and other measurable variables, such as longevity and rainfall.

-- Hedge funds have invested between $40 billion and $100 billion in commodities, according to the FSA.

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