Draft:Exchange-traded commodity

• Comment: Most of your sources are inappropriate. Qcne (talk) 08:25, 21 February 2024 (UTC)

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Definition

An ETC (exchange-traded commodity or currency.) is a type of exchange-traded product (ETP). It offers traders and investors exposure to liquid underlyings like commodities or currencies, including precious metals, energy resources, CO2 certificates, and cryptocurrencies.

ETCs are open-ended securities listed and traded on regulated stock exchanges. They track the price movements of their underlying constituents, serving as collateral for the units outstanding.

In contrast to ETFs (exchange-traded funds), ETCs are structured as collateralized debt securities (notes). This means they’re subject to separate regulatory treatment within the jurisdiction of the European Union. They aren’t restricted by the minimum diversification requirements of UCITS.

The underlying assets or commodities tracked by ETCs serve as collateral for the units in circulation. This allows ETCs to track the performance of individual or multiple underlying holdings. A single-asset ETC can track the price of gold, solely, while a basket ETC can track the weighted average price of several cryptocurrencies.

Unlike structured retail products (often called certificates), ETCs are listed in the ETP trading segment of European exchanges. Trading for ETCs occurs with multiple market makers supporting the quotation near the underlying. Authorised Participants (APs) can often create units by delivering the underlying and vice versa—similar to the creation and redemption of ETF units.

ETCs can act as an alternative to trading commodities in the futures market. They’re also useful instruments for investing in assets that are otherwise difficult to access for investors for various reasons, like their investor profile, legal jurisdiction, and tax incentives.

History of ETCs in Europe

Exchange-Traded Commodities (ETCs) marked a significant milestone in European investment markets. The first gold ETC was introduced by ETF Securities in 2003. This landmark launch revolutionized the way investors accessed and invested in gold, a timeless asset revered for its stability and value.

ETF Securities' gold ETC facilitated investor participation in the gold market through a novel and accessible avenue—a listed security on the prestigious London Stock Exchange.

Their innovative structure set gold ETCs apart. Backed by physical gold securely held in vaults, this innovative design eliminated the need for investors to own or store the physical metal. The product offers a seamless and regulated alternative to traditional gold investments.

By tracking the price movements, gold ETCs expose investors to the precious metal's performance without the complexities associated with handling tangible assets.

Structural set-up

• Built around a (zero-interest) certificate, offering a narrow (non-diversified) exposure to single commodities.
• Issued by an SPV, which may or may not be registered in an EU/EEA jurisdiction.
• Counts typically on average several APs/liquidity providers to facilitate secondary market liquidity.

Risk management

• The underlying certificate is non-rated.
• Investor claims may be physically backed (i.e. secured by physical quantities of a commodity held in custody with a third-party institution) or secured via a collateral pool. Latter may not be diversified, or collateral to the guarantor/sponsor’s credit rating.
• ETCs may contain leverage/inverse leverage features (up to 3–4 times NAV).

Regulatory requirements

• Disclosure requirements under EU Prospectus Regulation and MiFID II point of sale disclosures. Where offered to non-professional (retail) investors, PRIIPs disclosures rules also apply in the form of KID.

Types of ETCs

There are several types of ETCs:

1. Physically Backed ETCs: These ETCs directly hold physical commodities, like gold or silver bars, to replicate the value of the underlying asset. They aim to track the price movements of the commodity they represent.

In Europe, physically backed exchange-traded commodities (ETCs) are available for gold and silver. These ETCs hold physical quantities of the respective precious metals to back its value. They’re designed to track the performance of the underlying commodity by directly holding it in a custodial arrangement.

For instance:

• Gold ETCs: These physically backed ETCs hold physical gold bullion in secure vaults to represent the value of the gold. They aim to track the price movements of gold. There are several major products and providers of gold ETCs in Europe like the Invesco Physical Gold ETC by Invesco, the iShares Physical Gold ETC of iShares by Blackrock or the Xetra-Gold ETC launched by Deutsche Börse Commodities.
• Silver ETCs: Similarly, physically backed silver ETCs hold physical silver, typically in the form of bars, to mirror the price movements of silver. Examples are the WisdomTree Physical Silver ETC by Wisdomtree or the iShares Physical Silver ETC.

Physical backing ensures that the ETC's value correlates closely with the physical commodity's price. Investors interested in investing in commodities like gold or silver through ETCs can consider these physically backed options as they directly link the ETC's value to the underlying metal.

It's essential to conduct thorough research and consider factors like fees, liquidity, and the ETC issuer's credibility before investing.

• Currency and Cryptocurrency ETCs: In Europe, physically backed exchange-traded commodities (ETCs) aren’t limited to just commodities. There are various types of ETCs available, including those tracking currencies and cryptocurrencies (the latter in Europe, often referred to as Exchange Traded Cryptocurrencies).

These ETCs can come in various structures—physically backed (holding the actual currencies or cryptocurrencies), synthetically backed (using derivatives or other financial instruments), or a combination of both. They offer investors an opportunity to diversify their portfolios or speculate on the price movements of currencies or cryptocurrencies through regulated exchange-traded markets.

Investment firm Wisdomtree launched a number of currency ETCs, like WisdomTree Short EUR Long GBP.

Fintech company Bitpanda launched cryptocurrency ETCs like the Bitpanda Bitcoin ETC. In 2020, ETC Group listed the first ETC fully collateralized by Bitcoin, BTCE on the Frankfurt Stock Exchange in Europe.

In 2021, Europe surpassed Canada to hold the world's largest and most traded physical single asset cryptocurrency ETC.

FBTC by Fidelity Investments is another example of cryptocurrency ETCs that track the price of cryptocurrencies.

1. Synthetic ETCs: Instead of holding the physical commodity, synthetic ETCs use derivatives or other financial instruments to mimic the price movements of the underlying asset. They don’t possess the actual commodity but derive their value from the performance of futures contracts, swaps, or other financial agreements. XBTProvider by CoinShares became the first synthetic cryptocurrency ETC provider in the world in 2015 when it launched Bitcoin Tracker One on the Nasdaq Stockholm Exchange.
2. Leveraged/Inverse ETCs: These ETCs use financial derivatives to amplify (leveraged) or inverse (inverse/short) the returns of the underlying commodity. They aim to provide multiples (or opposites) of the daily performance of the commodity index they track.
3. Broad/Basket ETCs: Some ETCs track a basket of commodities, offering diversified exposure across multiple commodities in a single investment. These can include energy, metals, agriculture, or other commodities.

The Wisdom Tree Physical Crypto Market ETC (Ticker: BLOC/WBLC) is one illustration of a basket product that follows the price of multiple digital assets that are part of its underlying holdings. Another example is the ETC Group MSCI Digital Assets Select 20’s DA20 Crypto Basket ETC which is benchmarked to the MSCI Global Digital Assets Select Top 20 Capped Index.

Structure of exchange-traded commodities (ETCs)

Exchange Traded Commodities offer investors a route to gain exposure to the commodities market. This is done through securities traded on stock exchanges, similar to the way shares are traded.

Distinct from Exchange Traded Funds (ETFs), which may cover a broad spectrum of assets, ETCs are dedicated solely to commodities. Their appeal lies in providing a direct investment avenue into commodities. Skip the complexities of futures markets or physical ownership.

A key characteristic of physical ETCs under consideration is their nature of being fully collateralized. They don’t rely on derivatives and futures contracts to track commodity prices.

This means that for each ETC share issued, there is a corresponding amount of the physical commodity held in storage. Such a structure significantly reduces the risk associated with derivatives. The value of these ETCs is directly tied to the actual commodities they represent, be it metals, energy resources, or agricultural products.

This collateralization provides a layer of security and stability, as the risk of counterparty default is minimized. It aligns the ETC's performance closely with the underlying commodity prices. Furthermore, the physical backing of these ETCs demands rigorous regulatory compliance and transparency. These measures ensure that the commodities' storage, auditing, and reporting meet high standards.

Fully collateralized ETCs are a preferred choice for investors seeking a tangible connection to the commodity markets. The structure combines the liquidity and accessibility of stock market trading with the foundational assurance of physical commodity backing.

Creation and redemption process

The creation of an ETC involves a detailed process where APs, large financial institutions, play a pivotal role. APs provide the initial assets, either physical commodities or cash, which are then pooled together to form the basis of the ETC. In return, APs receive shares of the ETC, which they can sell to investors on the open market.

Redemption is the reverse process. When investors decide to exit their positions in an ETC, they sell their shares back to the market. APs can collect these shares and opt to redeem them with the ETC issuer.

During redemption, APs receive either the underlying commodity or a cash equivalent, depending on the structure of the ETC. The redemption process is crucial as it ensures the liquidity of ETCs. It also helps maintain a balance between the ETC shares and the underlying commodities they represent.

Market making and pricing mechanism

Market making in the context of ETCs involves maintaining liquidity and ensuring a stable market for these securities. Market makers, often large financial institutions or specialized trading firms, commit to buying and selling ETC shares, facilitating trades for investors. They profit from the spread—the difference between the buying and selling price.

The pricing of ETCs is influenced by various factors—including the underlying commodity prices, supply and demand dynamics in the ETC market—and broader economic indicators.

Unlike direct commodity investments, ETCs are also affected by the credit risk of the issuer. Additionally, the costs associated with managing the ETC, like storage costs for physical commodities, also factor into the pricing.

The interaction between the creation/redemption mechanism and market-making activities ensures that ETC prices generally stay aligned with the underlying commodity prices. Discrepancies can occur, particularly in times of market stress or when dealing with less liquid commodities.

Performance

ETCs offer a relatively straightforward method to invest in commodities or currencies. But they aren’t devoid of risks. Their market performance can also be influenced by several factors as listed below.

• Market demand and supply: Just like any traded asset, the performance of an ETC can be influenced by the demand and supply dynamics in the market. A surge in demand for a particular commodity or currency could lead to an increase in the price of ETCs tracking that particular asset.
• Global economic trends: Commodities, and by extension ETCs, can be sensitive to global economic trends. For example, during economic downturns, precious metals like gold often see increased demand, positively impacting ETCs tracking such metals.
• Regulatory and geopolitical factors: Changes in regulatory stances or geopolitical events can influence the commodities or currencies market. For instance, stringent regulations on cryptocurrency trading might impact the performance of ETCs tracking digital assets.
• Operational efficiency: The efficiency with which the ETC tracks its underlying asset can also play a role. Mismanagement or inefficiencies can result in tracking errors, causing the ETC to deviate from the asset's actual performance.
• Cost structure: ETCs come with associated management fees and other costs. A higher fee structure might slightly dampen the returns for investors when compared to the raw performance of the underlying asset.

Expense ratio

The expense ratio is a critical metric for potential investors when evaluating the cost-effectiveness of an ETC or any other investment fund. It represents an annual fee, expressed as a percentage of average assets under management, that investors pay to the fund manager.

Components of the expense ratio

• Administrative costs: These costs cover the day-to-day operations of the ETC. This could include administrative personnel salaries, office space, and other related overhead expenses.
• Custody and compliance costs: These are the expenses associated with safekeeping the assets, regulatory filings, and ensuring the ETC remains compliant with legal and financial standards.
• Marketing and distribution: Some ETCs may factor in the costs for marketing and distribution, especially if they have aggressive growth targets or are looking to expand their investor base.

How returns are affected

The expense ratio might appear small, even the slightest percentage difference can have a significant impact on an investor's long-term returns. For instance, an ETC with a difference of 0.5% can have a sizable impact on net returns over a decade, especially when compounded.

Net Asset Value (NAV)

The Net Asset Value (NAV) represents the per-share price or value of an investment fund, including ETCs. It's calculated by taking the total value of the fund's assets, subtracting the total value of its liabilities, and then dividing the result by the number of shares outstanding.

The NAV is typically calculated at the end of each trading day based on the closing market prices of a fund's holdings. For funds that aren't traded on exchanges, the NAV often determines the buying or selling price.

In the case of exchange-traded products like ETCs, the market price can vary from the NAV due to a range of market factors.

Additionally, the trend in the NAV, whether growing or declining, can offer insights into the fund’s assets performance. It's essential to note that other factors, like capital movements, can also influence its value.

ETCs vs ETFs vs ETNs

ETCs (Exchange Traded Commodities), ETFs (Exchange Traded Funds), and ETNs (Exchange Traded Notes) are popular investment vehicles that trade on stock exchanges.They each cater to different investment needs and have distinct structural differences

Investment focus:

• ETCs: Primarily designed to offer investors exposure to a single commodity, be it precious metals, energy resources, or even cryptocurrencies.
• ETFs: Provide a more diversified investment avenue. They can represent a basket of stocks, bonds, or other securities, allowing investors to invest across a sector, market, or even globally.
• ETNs: More senior, unsecured debt instruments. These notes refer to borrowed funds that the issuer must first pay off if they go out of business. They exist as credit notes most often issued by banks.

Structural differences:

• ETNs: They are structured as debt securities, specifically as notes. These notes are essentially debt instruments that are underwritten by a bank on behalf of the ETN issuer. ETNs hold no collateral and are either leveraged or unleveraged, the former being more volatile.
• ETFs: These are structured more like traditional mutual funds, representing a stake in an underlying portfolio of securities. They are not backed by a physical commodity as collateral but by the assets in the portfolio itself.
• ETCs: These financial instruments represent a physical commodity like oil or gold. ETCs are considered much safer since they require a direct investment.

Regulatory and tax implications:

• Due to their different structures, ETCs, ETNs, and ETFs may have varied regulatory treatments, especially in jurisdictions like the European Union. Investors should also be aware of potential differences in tax implications based on their jurisdictions and the nature of their investments.