Last week, the good folks at Miles Franklin created quite a stir by posting a blog from a supposed bullion bank insider. It seemed a rather cunning bit of disinformation so I asked my friend, Andrew Maguire, to read the piece and write up a few "clarifications".
Before we get started, it's probably best to re-visit the actual blog post from Miles Franklin. You can read it by clicking this link: https://blog.milesfranklin.com/the-cartel-and-hedgies-are-short-paper-but-long-physical-gold.
Recall that regular members of "Turd's Army" not only have the ability to observe Andy's trades in real time, they also receive his weekly commentary every Sunday. (To register, click here: https://www.coghlancapital.com/daytrades-application?ak=turd_army). Andy's commentary is an invaluable service and offers true insight into the behind-the scenes dealings of the bullion banks in London. This week, Andy included in commentary his rebuttal to "Trader David R" and he has kindly made it available to all Turdites everywhere. I hope that, by reading it, you will gain an increased understanding of the bullion bank system as well as an appreciation of the ongoing campaign by Cartel agents of disinformation to deceive and confuse you.
(Please understand that this post is not meant to discredit Miles Franklin or their services. They are a great firm that does terrific work in educating and serving the investing public. Ranting Andy did not approve of the blog post in question and it seems that his company published it in an attempt to "air all sides". I know that I have published a few things that I later regretted so I don't want anyone to hold this against them. They did not set out to intentionally deceive anyone, "Trader David R" did.)
The following section formed part of this week’s, (September 30th 2012), weekly commentary, written exclusively by Andrew Maguire, on behalf of subscribers of Metal Trades Services, available at Coghlan Capital, https://www.coghlancapital.com, and due to an overwhelming amount of our members requesting an explanation from an article posted this week on Miles Franklin blog titled “The Cartel And Hedgies Are Short Paper, But Long Physical Gold” and this trader’s biased assumption that there is no market manipulation.
The market dynamics discussed in the above commentary leads perfectly into some good member questions arising from an article posted this week on Miles Franklin blog titled The Cartel And Hedgies Are Short Paper, But Long Physical Gold
The article needs dissecting as it is accurate in just enough respects to appear credible but the author ends up both oversimplifying and misrepresenting the complex business of bullion banking. Considering the source of the information claims to be a specialist precious metals trader, there are some glaring inaccuracies which draw into question either his qualifications or his motives. Fact, the bullion banks are indeed long a good deal of physical and it is also true that bullion prices are set to rise, but the article is net very misleading. By only looking at a very small piece of a much larger overall picture, it leaves one with the impression that the bullion banks main source of income is arbitraging contango. This could not be further from the truth. Perhaps it is best to take a paragraph at a time and break down where the inaccuracies lay and what is crucially left out.
“…They buy the physical silver at the same time they sell the future (on Comex) futures trade in contango (higher price than spot physical) they get zero interest rate cash from FED so borrow the money for free, they own the vaults to store the silver…. so as the future comes to maturity they can either settle against their physical long or roll the future to collect more free contango…. This is pure arbitrage paid for by the FED. This has been going on for over 30 years and why shouldn’t they be allowed to have 25% of the Open Interest? There is no manipulation because they are short the futures and long the physical and have “ZERO” price risk, but nice profits! It’s brilliant trading and completely 100% legal and that’s why they will never be charged with manipulation because there is none going on. Sometimes it’s just that easy!...”
In answer, The bullion banks are indeed in the business of financing, buying & selling, and owning vast quantities of physical, however, what is not mentioned in the article is a critical omission, i.e. the amount of derivative leverage employed by these banks. A simple contango arbitrage does not involve collateralizing physical metal many times over. To illustrate this here is an excerpt from ‘Bullion Banking Explained’ written by the CPM Group's Jeffery Christian in 2000.
“….In the second quarter 1998, one of our mining clients had a forward sale on its books which was coming due at an unattractive price. This was a silver trade, with a forward sale locked in at $5.00 coming due when silver was trading at $6.00 per ounce. In fairness to the producer, its bank had forced it to sell forward, forcing it to use forwards instead of more efficient options positions, as part of the terms of a revolving credit facility the bank had extended the producer. On our advice the producer rolled the position forward, and sold that month’s silver output at the higher $6 spot price. The chief financial officer of the mining company asked us why the bank, which had a $1 per ounce profit on the position, would allow them to roll the position forward. The explanation is that having a silver position on its books at $6 per ounce provides the bank silver assets that it can collateralize many times over, which is worth a lot more to a bank than $1 per ounce in one-time profits…”.
Subsequently, Jeffery Christian, testifying as an ‘industry expert’ at the March 2010 CFTC metals trading hearing, was on record admitting leverages of 100/1 as ‘normal business’. There are some circumstances in Bullion banking when it may be acceptable to collateralize more than once but clearly it can be seen that Bullion banks employ very large leverage. The same is true with the so called contango arbitrage and we see evidence of this when looking at the OCC report, where up until recently, JPMorgan and HSBC owned over 98% of all precious metals derivatives. Notably, these do not include Comex futures.
The moment a bullion bank or trader employs leverage, i.e. selling more futures contracts against fully allocated unencumbered physical in inventory, it is no longer a simple contango arbitrage, as profitability of this trade relies on the price not raising above the level the futures contracts were sold naked short. The protection of these naked short bets is achieved by accumulating and then controlling a sufficient % of position concentration vs. Open interest. By taking advantage of the current lack of transparency between the OTC markets and the Comex, the bullion banks and other commercials, out of view of the regulators, are able to build the necessary very large concentrations of short positions and to be able to control rises in price on the Comex. Once open interest reaches sufficient levels, to a point where enough weaker hands are able to be collusively harvested, they act as a cartel and ring the register on these positions and cover. This is the sole reason this so called ‘contango’ trade has been very profitable and only ‘without risk’ because of the control these commercials have established by operating in the primarily ‘non-delivery’ paper futures markets.
As far as contango is concerned, there is in reality no contango to arbitrage. A true calculation for contango has to account for ‘real’ carry costs. Even if a bullion banks financing is near to zero, there has to be a time cost to carry, store and insure metal to maturity. This currently puts all precious metals into backwardation by anyone’s calculations. There have also been many times the metals have been in backwardation over the 30 years he alludes to. In this case, it would make more sense to sell physical and buy the equivalent futures contracts. A good recent, (no calculations necessary), illustration of this is better seen in the smaller silver market, where the bullion banks ‘footprints’ are easier to discern. As we had been noting in several Metals Trades commentaries in the weeks before the SIU2 rollover to December, silver spot bid was higher than futures ask. This condition prevailed because no bullion bank or trader was willing to take on the counterparty risk on what was a blatantly obvious ‘in your face’ arbitrage opportunity.
This beggars the question, if I had any unencumbered physical metal in inventory, why wouldn’t I, when presented with this opportunity, simply sell it in any size I wish and buy the cheaper futures contract, thereby immediately pocketing a ‘risk free’ profit in the knowledge I would be repaid my physical when the contract expired in a matter of a few short weeks, that is, if I was assured there was adequate unencumbered physical inventories to repay me? If you ever needed a window into just how encumbered /leveraged /rehypothecated Comex physical inventories are, the data speaks for itself and the reasons for not capitalizing upon this obvious arbitrage was not helped by the distrust created after the MFG and PFG collapses where the CME dodged their responsibility, leaving fully capitalized investors, hanging out to dry.
To make the statement that this contango arbitrage has been a simple easy risk free game for 30 years is simply ludicrous. Even if backwardation was not a factor, to suggest bullion banks charge nothing for carry costs because they own the vault is nonsense, as any bullion bank trader working out his month end commissions will attest to. Barclays announced this week that they are opening their own vault in London to store gold and other precious metals due to demand from their clients, they are doing this because storage is a very profitable part of a bullion banks business. That the source claims precious metal vaulting costs are free to the trading bank is the key element of this ‘contango’ trade being profitable. I have been trading precious metals for longer than the 30 years he identifies and can attest to the fact this is complete misinformation and brings the sources provenance and/or motives into question.
Then the next paragraph…..
“….Let’s go and visit their vaults and you can see all the physical silver there… Lease rates are at full carry +. There is no shortage what so ever and the banks are charging 40 bp for storage because they cannot find any more space to put it all, you can take all the physical you want! The JPM manipulation is not a manipulation, but a way of trading that has been going on for years. JPM is short futures (due to contango) and long physical. People need to understand that metals are just a derivative of the interest rate market and once people do, they will get a better understanding why the market moves the way it does….”
In the above paragraph, this ‘trader’ makes the assertion that there is so much physical owned by the banks that there is no more room to store it and further that you can ‘take all the physical you want’. This information is patently false, as anyone seeking silver in size will verify. I and my clients are very close to the physical market and know this is not the case. We, Sprott and many others have been subject to very large delays in receiving size allocations. As Metals Trades members know, we were recently involved with the conversion of a 10 million oz. spot index purchase we made when silver dipped into the 26’s in May. When we sought allocation, it ended up taking over 6 weeks to obtain the full order.
We needed this silver to be delivered to a Swiss vault, but were initially refused allocation unless we had it delivered within the LBMA system, namely to UBS in Switzerland. The client however, specifically wanted the silver stored outside the LBMA system in private vaulting facilities because they wanted to be assured they held unencumbered numbered bars in their name with no counterparty risk attached. The fact that this silver was to exit the LBMA system was of no concern as it was ultimately to be re assayed into smaller bars destined for Asian consumption and would not be reentering the LBMA system again. Having Brinks simply pick up the paid for physical in London was refused. Considering that over 5000 tonnes of so called ‘physical silver’ is cleared between LBMA banks in London every day, this should not have posed a problem, however, these transactions although counted as ‘physical’ in reality consist of unallocated metal which the bulk of, when cleared, is simply netted on the books amongst the clearers every day with very little physical actually changing hands. Taking delivery of 312 tonnes shouldn’t have even caused a ripple, except for the fact it was ‘real numbered bars’ that were sought. If leveraged 100/1, (the lower side of Jeff Christians 400/1 silver summit estimations), this would have amounted to netting out 31,200 tonnes of unallocated silver, or a year’s mine output!
This was just 1 example of many we experienced; there are many other validations of delays in receiving allocation of wholesale bars in size. To those seeking neutral third party validations, this from market manipulation skeptic Dennis Gartman, written earlier in September…
… “We have asked questions and we too are finding out that deliverable stocks of silver are tight and growing tighter and this is especially true regarding “large” sums of silver. We shall have to do a bit more inquiry into this “problem,” but one gets the sense that should things become tighter still we may see silver futures actually move into backwardation. This has our interest, and likely it shall grow even more interesting in the days and weeks ahead. Even GATA from time to time may be right. “…
Then we get to the final 2 paragraphs…
“They are clear as day on the “Notes to consolidated financial statements” under “physical commodities.” You can see the assets. If someone actually believes that their statement is being forged, then there is nothing that I am going to say that will convince someone like that. These guys made a fortune in silver last year and it wasn’t because they were short. I know the guy who did these trades and saw the house in the Hamptons he just bought. He also had a huge flag made which has gold and silver bars on it. If you ever go to the Hamptons and you see the flag, you know who lives there!”
And finishes with ..
“I explained to you what HSBC and JPM do on the silver. They get $ from the FED for free. They own all the storage vaults, so they do not have to pay the fees for storage. They then own the physical silver in their vaults and sell the futures contracts (which are in contango) at a much higher price than OTC price so then hold the both till delivery. Since there is no cost for $ and no cost for storage, they made a fortune on earning the contango of the silver and gold market. It’s a brilliant strategy, which has made them a fortune. If you sat with me for a day I could show you how this market really works”.
Here he names HSBC and JPMorgan, the 2 banks that up until this year also held the book on over 98% of all precious metals derivatives, JPMorgan still holding the lions share. (Citi bank has now replaced HSBC). There is no need for a bullion bank to ‘forge financial statements’ when the bank can list their highly diluted and rehypothecated unallocated assets under the heading ‘physical commodities’. There are, however, no allocated audited bar numbers to back up these ‘assets’.
I hope this provides some clarity to the questions arising from this very misinformed article.