Could the US cut retail investors out of commodities?

How a Wall Street elite contrived to turn the physical commodities market into a casino, and trigger damaging “spikes” in everything from oil to foodstuffs was beautifully reported on by Matt Taibi of Rolling Stone Magazine in 2010. But the food riots last year may be spurring politicians on both sides of the Atlantic to take action. Retail investors, the “long only” bettors who have for years forced prices upward, are seen as part of the problem. So the Democrats are proposing rule changes that would force small investors in the US to divest themselves of the $50 billion they have tied up in commodity derivatives – if Obama wins the election.

Pension funds, insurance companies and other institutional investors have been making massive bets on commodity prices, as have retail investors through mutual funds and structured notes. It all started in 2006, when the IRS allowed funds to sidestep the law established in 1936 and revised in 1954, which restricted mutual funds from owning more than 10% of total assets as commodities, through 72 private letter rulings (PLRs). Exceeding that limit would have previously made mutual funds liable for corporate income tax.

One after another mutual funds requested an exception from IRS that allowed them to set up commodity investments using derivatives. To meet the guidelines for the special tax treatment, the funds set up “sham” companies in the Cayman Islands. But they are now at the mercy of an IRS which may revoke previous rulings that have allowed mutual funds and structured notes,

The mutual fund industry has built a major new asset class “on a surprisingly thin legal basis” says Reuters. If Congress confirms that the IRS acted legally – in which case every mutual fund is automatically going to be able to exceed restrictions on commodities ownership – or it is going to eliminate the mutual fund exemption, and reverse the existing PLRs.

Judging by the political mood in Washington, in which the mutual funds’ controlled foreign corporations are “corporate fictions, offshore shams, paper exercises whose sole purpose is to make an end run around the legal restrictions on commodity investments by mutual funds,” it would be foolhardy to think things are going to go the mutual funds way, especially as this would only send another wave of money into commodities markets.

Assuming Congress is determined to restrict the speculation which now dominates commodity exchanges, then the secret “Bona Fide Hedging” exemptions that Goldman Sachs and 14 others have obtained from the CFTC since 1991, and which allowed them to masquerade as physical hedgers and escape virtually all limits placed on speculators, could be the next to be addressed.