What are commodities and securities?

Commodities are products, such as electricity, raw materials or agricultural goods, that can be bought and sold. Some commodities, like electricity, do not have a tangible physical form but can still be traded as commodities based on their supply and demand. Commodities typically have supply limitations, and each unit is interchangeable with other units of the same commodity.

Securities, on the other hand, refer to fungible financial investment assets that can be traded. This includes stocks, bonds, funds, options and, more recently, cryptocurrencies. Securities represent ownership stakes that give holders rights to potential profits, governance votes, risk sharing and revenue tied to an underlying company or entity.

Traditionally, securities are issued by corporations and governments to raise capital. However, following the advent of Bitcoin

BTC

$69,107

and the proliferation of cryptocurrencies, many digital assets are classified as securities by regulators. The determination often hinges on the specifics of each cryptocurrency and its issuance.

Although existing laws do not comfortably fit digital assets, securities can be seen as “investment contracts” in United States law. This means that investors participate in the market with the intention of making profits solely from the efforts of a third party.

This regulatory uncertainty has led to a number of enforcement cases involving projects such as Ripple’s XRP

XRP$0.61

and Telegram’s TON tokens. As of June 2023, the U.S. Securities and Exchange Commission had labeled at least 68 cryptocurrencies as securities, including popular tokens like BNB

BNB$579

, Solana’s SOL

SOL$171

, Cardano

ADA$0.59

, Polygon’s MATIC

MATIC$0.8897

, The Sandbox

SAND$0.62

and several others.

Historical performance of commodities and securities

The distinction between commodities and securities from a regulatory perspective has evolved over many decades alongside the development of derivatives and financial markets. Several major pieces of legislation in the 20th century helped shape the oversight rules we experience today.

For instance, the Securities Act of 1933 and the Securities Exchange Act of 1934 established disclosure requirements, registration protocols and anti-fraud provisions in securities issuance and trading. These acts serve as the foundation of the SEC. Later, the Commodity Futures Trading Commission (CFTC) was created through the CFTC Act of 1974 to regulate commodity futures and options derivatives markets in the United States.

As novel assets like cryptocurrencies emerged that do not neatly fit prior classifications, regulators have expanded their interpretations of existing laws to provide oversight. Recent examples include the SEC deeming some tokens as investment contract securities (based on the Howey test) or the CFTC allowing Bitcoin futures products. Such flexibility allows the broad application of longstanding investor protection principles to modern markets.

Ongoing technological evolution means policy and agencies like the SEC must continually adapt reporting rules, exchange standards, custody requirements and other regulations to preserve market integrity as products develop. This historical foundation informs current oversight approaches for both commodities and securities.

Differences between commodities and securities

Despite some overlap in their characteristics, commodities and securities are two broad categories of tradable assets with distinct qualities. Below is a comparison of commodities and securities:

Tangibility

Commodities are raw materials or basic goods that can be bought and sold. Some commodities represent ownership of a physical product, such as a bag of grain or a barrel of crude oil. Commodity markets respond to supply and demand dynamics in the physical global market. However, not all commodities are physical, tangible assets.

Meanwhile, securities represent financial abstractions — one cannot see stocks or bonds physically. However, securities confer a bundle of rights enforced by legal contracts rather than physical attributes. Stocks, bonds and derivatives exist as ledger entries allowing the transfer of ownership claims on expected profits, dividends or asset appreciation.

Investing in a commodity future gives temporary ownership of a certain quantity of the commodity, while investing in the stock of an oil company gives an ownership stake in the company itself.

Consumption vs. revenue flows

Commodities are consumable goods that get transformed through usage in industrial or commercial processes. Gold and silver can be transformed into jewelry.

Securities, on the other hand, grant holders the right to periodic benefits like dividends, coupons, principal repayments and potential profit shares. In the cryptocurrency industry, these benefits could come in the form of capital appreciation or airdrops.

Market volatility

The prices of commodities are quite volatile and react to supply-demand imbalances, geopolitical risks affecting production and sentiment shifts around inflation hedges. And unlike securities, commodities are not income-generating assets. So, investors rely solely on price appreciation for returns.

Securities, especially stocks, can experience significant volatility as well, influenced by company performance, economic conditions, investor sentiment and market dynamics. However, the factors driving securities’ volatility differ compared to commodities. The valuation of a stock or fund is linked to the business performance of the underlying company, and price swings may be due to economic developments or changes in investor sentiment.

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Liquidity

Commodities largely trade through futures on centralized exchanges or over-the-counter directly between suppliers and commercial consumers. Securities tend to enjoy more widespread exchange availability and near-continuous price discovery.

However, the liquidity of each asset class can vary widely. Some highly traded commodities, like oil and gold, can exhibit liquidity comparable to blue-chip stocks, while less-traded commodities and small-cap securities may face limitations.

In addition, commodity contracts typically have lower daily volume than blue-chip stocks, except for gold and oil futures. Their specialized nature means there are fewer aggregate market participants compared to stocks. This impacts slippage on large commodity orders.

Historically, commodities have been proven to exhibit greater price swings than securities. While commodity cycles see larger price swings over five-to-10-year periods based on scarcity or new discoveries, securities demonstrate steadier growth tied to corporate earnings. On the flip side, commodities act as crisis hedges that hold value better when stock markets crash.

Regulatory outlook

Commodities and securities are overseen by different regulators. Some commodities are tangible physical assets like agricultural goods, metals and energy that are consumable and driven by supply-and-demand dynamics. However, commodities also include non-physical assets like electricity and carbon credits that have an impact on supply and demand.

The key regulator for commodity derivatives markets in the U.S. is the Commodity Futures Trading Commission. The CFTC regulates contracts such as futures, options and swaps under authorities granted by the Commodity Exchange Act and focuses oversight on areas like price manipulation, trading platform standards and enforcing position limits.

Meanwhile, securities constitute financial assets such as stocks, bonds and funds representing ownership stakes and rights in an underlying entity. However, the distinction between commodities and securities can sometimes blur, especially with the advent of digital assets and cryptocurrencies. Some cryptocurrencies have been classified as securities by regulators, which has implications for regulatory oversight.

The SEC does this by enforcing extensive corporate financial disclosures to inform investment decisions, upholding accounting standards completeness, guarding against insider trading abuses and overseeing brokers, brokerage firms and stock exchanges, along with bodies such as the Financial Industry Regulatory Authority (FINRA).

While nuances exist, regulators like the CFTC and SEC play complementary roles by bringing long-established investor protection principles to both traditional and modern markets under their purview.

Globally, regulatory oversight of cryptocurrencies is more stringent in developed regions, like some parts of Asia, Europe and the United States. This has forced several cryptocurrency exchanges to either blacklist residents in certain regions or enforce Know Your Customer (KYC) requirements.

Position limits and reporting in commodity markets

To promote fair and orderly commodities trading, regulators enforce strict position limits and reporting requirements on market participants. Position limits cap the number of net long or short futures contracts a single trader can hold in a particular commodity. The CFTC and commodity exchanges like CME Group establish these thresholds to prevent excessive speculation and manipulation.

For example, an institution may have a position limit of holding a maximum of 20,000 corn futures contracts at once. If the firm exceeds this level, it must apply for an exemption. However, such exemptions are usually granted under specific conditions, like bona fide hedging, where the futures positions offset risks in the physical market. The process for obtaining an exemption is rigorous and requires detailed justification.

Relatedly, traders must fulfill routine reporting on their activities above a specified volume threshold, disclosing insightful data such as account identity, controlled accounts and opening or closing positions. Together, strict position limits and trade reporting offer crucial transparency that aids price discovery while curtailing the potential abuse of commodities derivatives.

By capping influencer power and mandating data access, regulators achieve the dual aims of preventing distortion and monitoring for suspicious concentrated activity. These safeguards ultimately solidify confidence in benchmark commodity prices, which impact many downstream consumer goods.

Key securities regulations

Similar to position limits for commodities, securities markets employ volume control mechanisms, disclosure rules and trading oversight to ensure fair access and prevent manipulation.

For instance, the SEC’s Regulation SHO restricts short-selling equity securities during extreme downturns, known as circuit breakers. This prevents predatory bear raids. Relatedly, insider trading laws prohibit those with non-public corporate information from profiting from or selectively disclosing the data to influence share prices.

Another example is the SEC’s Regulation on Fair Disclosure, which enforces simultaneous public dissemination of material company events rather than allowing insiders early access. Securities issuers also must adhere to strict periodic reporting of audited financials and business developments so all investors have equal information.

Additionally, to uphold orderly trading, equities exchanges implement automatic halts on shares whose prices rise or fall past defined thresholds within a five-minute window. These “limit up, limit down” bands pause trading briefly before resuming, regulating volatility.

Through regulations like these and overseeing self-regulatory organizations that directly supervise brokerages and stock exchanges, the SEC fulfills its mission of nurturing transparent and equitable U.S. securities markets. The framework aims to facilitate access while ensuring a level playing field.

Investment in commodities vs. securities

As with all forms of investment, putting your money into either commodities or securities has pros and cons. Commodities, for instance, offer better inflationary hedges, while securities are better at steady compounding.

Advantages of investing in commodities

Inflation hedge

Commodities serve as an effective protection against inflation and dollar devaluation. Their intrinsic utility value and limited supply mean prices often rise when the dollar weakens, offering a robust hedge during hot inflation periods due to real economic demand.

Portfolio diversification

Investing in commodities such as metals, grains and energies introduces distinctive demand-supply dynamics into a portfolio. With a low correlation to stocks and bonds, commodities help offset risks during equity market shocks, providing a unique diversification benefit.

Crisis resilience

In times of sharp market selloffs, commodities often act as a defensive asset class. The physical nature of commodities provides a buffer against financial system risks, offering relative stability when compared to equity securities.

Advantages of investing in securities

Steady compounding

Diversified equity index securities offer steady compounding benefits through rising corporate earnings, dividends and share buybacks. This aspect is particularly beneficial for generating fixed income over extended periods.

Risk-return balance

While securities experience periodic drawdowns and volatility, they historically offer favorable long-term risk-adjusted returns. This balance makes them an attractive option compared to other asset classes.

Mainstream accessibility

The securities market provides easier access to licensed advisers, wealth management vehicles and low-cost passively managed products. This accessibility allows non-professional individuals to gain exposure to the market, benefiting from its liquidity.

Disadvantages of investing in commodities

Volatility

Commodity prices demonstrate high short-term volatility that may arise from unanticipated supply disruptions, geopolitical events, demand shocks and difficulty adjusting production rapidly. This increases the probability of mistimed trades.

Carry costs

Physical commodities impose additional costs of storage, insurance and transportation that erode nominal returns relative to financial securities.

Tax treatment

Commodities are taxed based on collectible capital gains rates rather than the preferable long-term stock gains rate when held over one year. This results in higher tax liabilities.

Unsuitable for passive investing

Unlike equity indexes, commodities cannot be held indefinitely because paradigm shifts like the discovery of mineral substitutes or alternatives can erode long-term value, unlike corporations, which create perpetual innovation and cash flows.

Disadvantages of investing in securities

Market risks and bubbles

Securities are susceptible to market risk, including the potential for bubbles that drive valuations to unsustainable levels, leading to painful corrections. This risk underscores the importance of market awareness and the potential for total loss in bankruptcy cases.

Bankruptcy risk

Individual and corporate investments in securities carry the risk of bankruptcy, which can result in the total loss of invested capital. This risk contrasts with the relative safety of government-backed bonds or insured deposits.

Liquidity risks

While major securities enjoy deep liquidity, smaller market cap companies may face limitations in trading volume, affecting their ability to execute timely exits and potentially leading to adverse pricing impacts.

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