Montreal, Canada

Leave it to big government to regulate and, sometimes, over-regulate financial markets. The net result implies more trading curbs for commodity exchange-traded-funds (ETFs) as regulators aim to reduce speculators in the commodity pits.

The super-spike in many commodities in 2007 and 2008 drew the attention of global regulators who mostly blame speculators for driving prices through the roof. Crude oil, for example, topped north of $147 a barrel in July 2008 before crashing under the weight of the credit crisis. The same was true for the grains complex where more than two dozen riots erupted in many countries as prices for basic food staples went ballistic.

Following the CFTC’s (Commodity Futures Trading Commission) lead last year, the Europeans are considering imposing new legislation on commodity trading derivatives and position limits on many raw materials starting in 2011. The move is being driven by French president, Nicolas Sarkozy, who assumes the presidency of the G-20 economies next year.

In 2009, the CFTC imposed new position limits on energy ETFs and some agriculture ETFs. The net result was that several ETFs like UNG and DBA, for example, saw their mandates diluted by forced position limits.

DBA, which was essentially a grains-focused and sugar ETF, is now a mish-mash of many commodities, including live cattle and lean hogs.

UNG, the United States Natural Gas Fund, was also forced to reduce its exposure to U.S. traded natural gas futures and, instead, now diversifies its gas contracts in London.

London has the most to lose if the French and the rest of the European Union (EU) have their way.

France is likely to promote a total overhaul of commodities regulatory reform. And that’s bad news for the United Kingdom where the French want to shut the “London Loophole.” London is home to Europe’s biggest commodities exchanges and though the British invite some level of regulatory reform, it isn’t clear how far the French are willing to dilute their trading platform through new position limits.

There’s probably some truth behind government moves to restrict essential commodity speculation. Things like grains and oil have drawn record investment flows over the last eight years as commodities went through the roof. But like most efforts, government regulation tends to overshoot and usually causes harm to the business and free-market model. I’m pretty sure the same will happen in Europe.

One thing is for sure, however. New bull markets in any raw material will draw regulators thereby making it more difficult for investors to diversify in commodities – a hard asset class that belongs in every portfolio – especially ahead of the Great Reflation later this decade.