Whether you are an industrial, agricultural, commercial or household user of water, here is a line that is very unlikely to appear on your next bill: “financial innovation management fee.” Nevertheless, like the claims to trade stocks from your phone without fees, the cost of “financial innovation” could be hidden in water bills. How could financial innovations — new financial products promising benefits for those who understand what they are and how to use them — affect those water bills?
On September 8, the U.S. Commodity Futures Trading Commission (CFTC) released the first ever U.S. financial regulator report about managing climate-related financial risk. About two weeks later, the report’s sponsor, Commissioner (now acting Chair) Rostin Behnam, welcomed, with less fanfare, a Chicago Mercantile Exchange (CME) futures contract to manage the price risk of water. The contract, made available for trade on January 1, would be cash settled only, so physical water could not be delivered to the contract buyer.
Pedro Arrojo-Agudo, the United Nations special rapporteur for the human rights to water and sanitation, said, “The news that water is to be traded on [the] Wall Street futures market shows that the value of water, as a basic human right, is under threat.” The CME, when asked about the special rapporteur’s statement, had no comment. However, Simon Puleston Jones, the former European head of the Futures Industry Association has concerns not dissimilar to those of the Mr. Arrojo-Agudo: “The one asset class that I don't want to see open to potential manipulation or upward price pressure via financial markets is the one resource that all of humanity needs for its survival . . . We need to think now about the potential direct and indirect negative consequences of treating water as an asset rather than a resource.” What could go wrong with the CME contract? Or right?
First, it is necessary to understand a few of the terms of the contract. The CME filed a Freedom of Information Action Confidential Business Treatment Request with the CFTC on November 19, 2020, the same day the CME applied to the agency for CME self-certification that the water futures contract was consistent with CME rules and CFTC modifications of those rules. CME could have requested that the CFTC approve the contract at the same time it filed for self-certification.
The 16-page application gives a detailed description of the contract and its underlying asset, the Nasdaq Veles California Water (Price) Index (NQH20). The application describes how the price index was constructed from the volume-weighted average spot rate prices of water rights transactions in four California water basins plus in the surface water market. The contract unit is 10 acre-feet (10 acres to the depth of one foot) of water times the NQH20. The contract is listed for trade in March, June, September and December “plus two nearest non-quarter serial months.” For example, if you anticipate a sharp increase in the price of water for December, you could buy now x number of contract units at lower price y and be able to “roll over” the contract in January or February 2022, if you didn’t wish to sell in December.
It appears that only the CME’s Exhibit B, “Position Limits, Position Accountability and Reportable Trade Levels” is subject to the Confidential Business Treatment Request, which the CFTC granted. There are legitimate competitive reasons for ensuring the confidentiality of contract positions held by individual investors and reported by the CME to the CFTC. However, as explained in greater detail below, the CFTC grant of confidentiality can also mask excessive speculation in contract positions the exchange believes do not have to be reported to the CFTC.
There are reasons to doubt that CME contract transactions will result in a price benchmark to help water district managers in California determine the price they charge wholesale water users, above all irrigated agribusiness. According to Mike Wade, executive director of the non-profit California Farm Water Coalition, cited by the Financial Times, “This type of water futures market is an investment tool more than a water management tool . . . There likely will be non-farm people who will try it out to see if there’s money to be made.” What kind of investors would be interested in a futures contract whose underlying asset is tiny compared, for example, to that of all No. 2 yellow corn estimated by the Chicago Board of Trade to be deliverable profitably to U.S. interior and coastal export ports?
When the Nasdaq exchange launched a water price index in January 2019, it claimed that its proprietary water pricing algorithm could “provide a benchmark for water transactions across California.” But in 2019, there were just 221 water sales transacted in California using the Nasdaq water price algorithm. How will the futurization of the Nasdaq Veles water price index in the CME contract attract more investors and who will benefit from that futurization?
What would happen if every California water manager and commercial water user (collectively “commercial hedgers”) were to buy positions in the contract to prevent having to buy water in the cash market if prices spike due, e.g., to a drought more severe and extended than predicted? There might not be enough capital invested in the contract (i.e., “liquidity” is the term of art) to enable the commercial sellers of the contract to find commercial buyers for their positions. Enter the traditional speculator, an entity with an economic interest in the contract, such as an insurance company concerned about the impact of drought on its customers, to buy the commercial hedgers’ contract positions to protect against future price spikes. The traditional speculator provides necessary liquidity to the contract to enable commercial water users to buy and sell the contract when they wish.
However, there are investors with no direct or even indirect commercial interest in water prices, who are likely to become dominant investors in water futures contracts. As Lance Coogan, the chief executive officer of Veles Water Ltd., told the Wall Street Journal, investors could buy water futures contracts to hedge against the price of assets that have no discernible correlation to water prices. Here enter the financial engineers, who package uncorrelated or very loosely correlated assets, into commodity index funds (CIFs). (For an extended analysis of CIFs, traditional speculators and price booms and busts in commodities, see a 2011 Better Markets essay.) The prices of those goods on futures markets then move together in the CIF.
The construction of a CIF is more complicated than can be explained here, but a visit to the website of the most renown CIF, the Standard & Poor’s Goldman Sachs Commodity Index (S&P® GSCI), gives you an idea of the index’s contract components, risk weighting and index trading strategy.
IATP strongly critiqued in May the CFTC rationales for excluding Commodity Index Traders (CITs), such as Goldman Sachs, from the position limits (limits on the share of a contract a given investor can hold) that were applied to the contracts held by traditional speculators to prevent market manipulation, excessive speculation and market disruption. (pp. 7-8) Most CIFs are invested in the expectation of price increases in the price indexed contracts. CITs have far more capital to invest than commercial users of commodity derivatives because many of the CIF clients are pension funds, endowments and other huge capital pools with long-term interests in CIF price increases. Price movements of the contracts bundled into the CIF formula could be uncorrelated with supply, demand and other fundamental factors because of the preponderant CIF weight of capital in a contract.
What does any of this financial innovation have to do with water bills, water sales and water futures contracts? The CME water futures contract is too new and unproven to become a component of a CIF — yet. A reasonable surmise about the future of U.S. water pricing may be found in a January 3 New York Times article about a financial conglomerate, MassMutual, whose Greenstone subsidiary of another subsidiary bought and sold Colorado River water rights, leading to at least one diversion of physical water from irrigating Colorado fields to providing water for an Arizona housing development.
“Wall Street Eyes Billions in the Colorado’s Water” is so beautifully written, researched and photographically illustrated that you forget, for a moment, about the subject at hand. Surely, one might think, the article’s headline is alarmist hyperbole, designed to attract readers. A 2020 academic study in Water states, “the value of [California water] sales soared up to nearly $800 million in 2015, dropping precipitously to $300 million in 2018 after the drought subsided.” (p. 6) But the billions that Wall Street is eyeing are not from sales based on physical water transfer contracts, but sales of financial contracts derived from the price index that tabulates those sales.
The Times’ Ben Ryder Howe cites Matthew Diserio, the president and co-founder of the hedge fund Water Asset Management. According to Diserio, the U.S. water business is “the biggest emerging market on earth” and “a trillion-dollar market opportunity.” How could hundreds of millions, even billions of dollars of physical water sales, be financially engineered into a trillion-dollar market?
At least three factors could supercharge the U.S. water futures market. First, if the CME water futures contract and/or a competing contract, e.g., from the Intercontinental Exchange (ICE) in Atlanta, is bundled into a CIF with several other commodity futures contracts, then pension funds, endowments and other large pools of capital could fuel trading without effective exchange position accountability controls. Failed position accountability could cause market disruptions with negative consequences both for the water futures contract positions and any water manager or commercial water user relying on the water futures price as a benchmark from which to negotiate cash water purchases and sales. The most recent CME position accountability failure concerned the West Texas Intermediate (WTI) crude oil contract, one-quarter of which was held by U.S. Oil Fund, an exchange traded CIF. Following the second WTI crude contract price collapse in April 2020 (the first collapse drove WTI prices below zero for the first time ever), the CME imposed a lower maximum number of positions that the speculative fund could hold. How the WTI price collapses affected prices and trading volume in other contracts’ price correlated with the WTI contract is not something traders will willingly disclose.
Second, the water futures price would lead or follow price trends in the other CIF component contracts. For example, carbon dioxide emissions offset futures contracts (CME launched one on March 1) could be bundled with water futures, biodiversity offset futures and other contracts of even less plausible price correlation. This CIF could be marketed as a so-called “Nature Based Solutions” (NBS) fund. If the price of a component contract decreased, e.g., because of the discovery of massive emissions offset fraud, a price collapse in an emissions offset futures contract could take the price of a well-functioning water futures contract down with it. Shares in a NBS fund could be exchange traded, exposing retail investors, as well as institutional investors, to greater component contract price volatility, which defeats the CIF’s declared purpose of spreading the price volatility risks over several contracts. Even if bundled with a well understood and widely traded commodity — say, petroleum —price volatility in the CIF dominant commodity could disrupt rational pricing in the other contracts, including water.
Third, and probably the fastest accelerant to a trillion dollars of U.S. water futures transactions is automated trading — computer to computer without human intervention except in the design and deployment of the trading algorithms. In IATP’s view, automated trading of commodity derivatives contracts (futures, options and Over the Counter swaps) remains almost entirely self-regulated by the exchanges. If automated trading exacerbates contract or market structure flaws, and price volatility drives out commercial hedgers in water futures, the exchange can throw price limit up or down “circuit breakers.” But by then, the damage will have been done to those without the super-computer technology access and capital reserves against loss to jump back into trading to recoup losses.
The CME followed the CFTC procedure for self-certification of the contract. The staff duly reviewed the contract and allowed its self-certification. The bigger question is why the CFTC Commissioners didn’t hold a public roundtable, as they did with Bitcoin, to decide if water is a commodity that should serve as the underlying asset for a futures contract. At a 2018 meeting of the Market Risk Advisory Committee (MRAC), then Commissioner Behnam asked whether there had been enough public dialogue about Bitcoin prior to its self-certification. Then he stated, “We will ultimately be accountable for the products listed within our jurisdiction. We own this space, and we should own it responsibly. I want to do everything in my power to support and promote innovation; however, the Commission must exercise our duties such that when we look back on the record, it shows that we took the necessary steps to fulfill our mission in a careful and deliberative manner.” It is not too late for the commissioners or the CFTC Energy and Environmental Markets Advisory Committee to deliberate in public roundtables whether water is a commodity that will benefit from financial innovation or whether it is a natural resource whose affordability and accessibility could be further damaged by financial innovation.
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