View or download a PDF of the letter here.

Chairman Rostin Behnam
Commissioner Dawn DeBerry Stump,
Commodity Futures Trading Commission

Dear Chairman Behnam and Commissioner Stump:

Pursuant to Section 5c(c)(5)(C)(ii) of the Commodity Exchange Act (“CEA”), codified at 7 U.S.C. 7a-2(c)(5)(C)(ii) (2020), and Commission Regulation § 40.11(a)(1)-(2), please take the following letter as a request for the Commission to immediately suspend the exchange of self-certified Nasdaq Veles California Water Index Futures contracts (hereinafter “Water Index Futures”) and hold a hearing on the matter.

Ultimately, we urge the Commissioners to issue an order barring the buying and selling of these futures contracts because:

1) They are not consistent with the CEA definition of “commodity[;]”

2) They relate to the trading of water entitlements not authorized under California law;

3) Their trading is susceptible to manipulation and thus contrary to the Commission’s Core Standard 3, including because of the thin and opaque underlying market involving any water entitlement trades that do occur in California; and

4) They are contrary to the public interest, including because allowing them reads the CEA in a way that undermines public trust obligations, and could drive up prices for water, the impacts of which would most acutely be felt by those who are worse off, particularly small farmers.

Introduction and Background on Water Index Futures

In December 2020, in anticipation of major drought, the Chicago Mercantile Exchange (“CME”) announced it had certified Water Index Futures as the world’s first water futures contracts, allowing investors to purchase and sell them based on the NQH2O Index that purportedly tracks the spot-rate price of water entitlements in California.

Pursuant to the Commodity Futures Modernization Act, Water Index Futures were self-certified by the Chicago Mercantile Exchange (“CME”), without the Commission’s review, approval, and ultimate determination that they meet the requirements of the CEA and Commission regulations.

At first blush, Water Index Futures appear similar to other futures contracts over which the Commission has jurisdiction. The NQH2O Index is a benchmark for the cash price for the exchange of water allocations in California and is updated weekly. Each contract is for 10 acre-feet of water, up to a maximum of two years, and is only cash settled. If, at the time of the expiration of the contract, the index value is higher than the agreed-upon price set forth on the contract, then the long-position hedgers and speculators get paid the difference from the short-position hedgers and speculators. If the index price is below the contract price, those parties holding the short positions get paid the difference from the long-position parties.

But the underlying “commodity” at issue with Water Index Futures is unlike any other that the Commission has allowed as a basis for a futures contract. Not only is water necessary and essential for life, it is a common public resource managed by the state for the public welfare and without substitution. Because of its unique nature, financial instruments that could affect water’s availability and affordability need special care and review.

Further, as argued below, California “water entitlements” are not a CEA “commodity” at all. Even if the NQH2O Index was considered a commodity, it would be an exempt commodity that in many instances is based on an interest that is not a lawfully traded fungible interest under California law. Further, the futures product is susceptible to manipulation and contrary to the public interest because of the serious detrimental impact that excess speculation in water futures contracts based on the price benchmark for water may have for all who depend on the underlying, fundamental resource for drinking, hygiene, and sanitation.

As some observers have pointed out, an inherent weakness of the Commission’s self-certification process is that it “allows exchanges—who have a financial incentive to list new products, regardless of how risky they may be—to quickly list complex commodity derivatives with no public or market input, and minimal regulatory review.” Given the nature and importance of the underlying supposed “commodity” involved in Water Index Futures, however, we urge the Commission to not let any such weaknesses be the basis for the continued availability of this product for trade. Instead, the Commission should formally review Water Index Futures, and determine that they are inconsistent with Core Principle 3 in the public interest.