Exchange Traded Commodities contracts

Exchange Traded Commodities (ETCs) appear to be increasingly attractive as instruments that give investors exposure to the commodities markets. 

Although it is possible for them to be structured in a number of ways, those we have seen so far (with the exception of the precious metals contracts mentioned below) are structured in a way that combines features of contracts for differences and transferable securities. This is because the investment instruments are generally listed on exchanges as debt securities, but they have no specified maturity date and do not pay interest.  The main element of return on the investment is an amount related to the price of a commodity, or level of a commodity index or indexes. 

Some exchange-traded contracts for precious metals (for example, Gold Bullion Securities loan notes) are, however, listed as specialist debt securities. In the case of those structures that the FSA has considered, it has taken the view that they should not be regarded as contracts for differences, essentially because on redemption the holder is entitled to have the issuer of the notes sell the relevant amount of the precious metal on the market and the holder would receive whatever price was obtained. Other examples of securities that would be treated like this include 'physical ETC' securities recently issued by one firm.

Some considerations for intermediaries

Regulated firms in the market will need to ensure that they have the necessary permissions to cover those ETC structures in relation to which they wish to advise and/or transact.  In the case of the first category of ETC above, this will require permissions covering both debt securities and contracts for differences. 

In the case of the contracts for precious metals referred to above, a firm will need to ensure that its permission covers debt securities.  However, though this is the case for the precious metals securities we have currently listed (as at April 2008), we are conscious that different structures could emerge, so firms may need to research the regulatory classification in each case to ensure that they have the necessary permissions.     

Where relevant, firms will also need to have regard to the applicable conduct of business requirements for contracts for differences, particularly where the customer is a retail client.  Relevant requirements may cover the marketing, advising and selling of ETCs.  Since 1 November 2007, firms have also had to consider the effect of the introduction of the revised investment conduct of business sourcebook (COBS).  Among other changes, firms need to consider

• the degree of flexibility they have in explaining the risks of an investment to their clients (including under COBS Chapters 2 and 4), and
• the new appropriateness obligation in COBS Chapter 10, if they are carrying on business on a non-advised basis. 

In terms of the appropriateness obligation, the FSA's view is that ETCs that are contracts for differences will need to be treated as 'complex' instruments for the purposes of the appropriateness test.  Additional information available on the appropriateness test includes industry guidance developed by the MiFID Connect group of industry associations (and recognised by the FSA in August), and Q&A and 'case study' material published by the FSA itself on its website.