Alasdair Macleod – 18 January 2011
The regulatory failure of precious metal contracts in US derivative markets will have important systemic consequences, and nowhere is the problem becoming more obvious today than in silver. Several banks have been running a substantial short position for a considerable time. This position has been permitted to continue because of weak management by both Comex as the principal dealing exchange and by poor oversight from the US Commodity Futures Trading Commission as regulator.
Between them Comex and the CFTC have ignored two fundamental truths about the market. The first truth is that the continual rolling of short or long positions is fundamentally unhealthy, and is indicative of a growing risk of trader default over time. The second is that no market participant in an open outcry system has any commitment to deal or provide liquidity, unlike a market where there are licensed market-makers who have to make two-way prices at all times. There is therefore no reason why such a long-running speculative position should be permitted even for the Commercials (the banks), and their long-term presence, for which there must be a reason, may be evidence of price manipulation.
The weakness in market control stems partly from the separation of overall market functions into management and regulation by two different bodies. The result, put simply, is there is no one in charge. If the Comex’s management had regulatory responsibility it would have been forced to stand up to the Commercials from the outset, because it would almost certainly see the continual rolling of excessively large positions as leading to potential difficulties in time. It would have a duty to investigate price manipulation, because there would be no third party regulator for a large trader to hide behind. Regulation is an integral component of this management function, and a properly constituted market authority is the most effective way to enforce the spirit of regulation as well as the letter.
However, the CTFC is the regulator and it has to satisfy not only its regulatory mandate, but the agendas of those that appoint its senior officers. This politicisation of the role, while perhaps justifiable on grounds of a concept of public accountability, actually provides a channel for the financial establishment to achieve their own undeclared objectives.
It is this suspicion that has helped convince an increasing number of observers that the regulatory system is inherently biased. Only now, after much prompting by GATA and others has the possibility of price-rigging begun to be grudgingly acknowledged. But the critics are up against powerful banks, which know how to tick boxes and so are rarely caught out on compliance and legal issues. They understand the politics of regulation and are well positioned to lobby accordingly. And they know how to play off the exchange against the regulator.
We have theorised over the inadequacies of the regulatory system and must now turn to the facts. The deficiencies of the system have led to the silver market becoming completely polarised. There is a divorce between derivatives, where there is inadequate control over large long-running positions, and the physical market, where there is now virtually no metal for delivery. It has become a dangerous reversal of functions that is now complete: paper silver is no longer priced on the back of physical metal; it is the physical that is notionally priced on the back of paper. The tail is wagging the dog to the point that the free supply of derivatives has led to the metal being driven from circulation. [i]
While the market for silver derivatives may interest only a minority, the same problem occurs for gold, which is a far more serious systemic issue. The separation of functions between market and regulator has facilitated a similar price suppression scheme, totally negating the principal function of derivative markets, which is to provide liquidity by harnessing speculative demand for the benefit of prudent hedging activities.
This simply does not happen for precious metals. The Commercials on Comex are mostly banks that also provide unallocated gold accounts, which they manage on a fractional reserve basis. Their basic risk requirement is for a hedge to offset the effect of a rise in the gold price on these unallocated accounts, so they should be holding long, and not short gold contracts. Unfortunately, the size of unallocated account business is too large to hedge on Comex anyway. Furthermore, the majority of the speculating public are and always will be net buyers when they have any interest at all, so both non-Commercial and Commercials are fundamentally buyers. For this reason the concept of an effective public derivatives market for precious metals is flawed from the outset, and must not be confused with those commodity derivatives where there is a healthy deal flow provided by product suppliers and industrial demand.
For any bank running unallocated bullion accounts on a fractional reserve basis, markets that allow the public to buy gold and silver only increase the price risk to its own position. The temptation to use these markets to manipulate prices downwards, or at least to try to stop them rising is therefore very great, and this is exactly what has happened. There is now an accumulated short position by the Commercials of about 700 tonnes of gold. To this must be added the far larger short position on the bullion banks’ unallocated accounts, and the uncovered sight accounts run by the central banks in the major dealing centres. No one knows for sure how much the total short position amounts to, but we can be certain that the Commercial shorts on Comex are by far the smallest component.
It is the inevitable unwinding of these massive short positions that will have adverse systemic consequences. The unallocated accounts, probably the largest element of the problem, can be closed out for cash under the standard LBMA account terms, probably with a multi-government bail-out. The resolution of uncovered sight accounts at the central banks will be kept a close secret. It is Comex which will probably bear the most visible manifestation of the crisis.
[i] For statistical evidence of the relationship between contract volumes, the silver price and the unavailability of bullion, see a recent article by Adrian Douglas of Market Force Analysis at https://marketforceanalysis.com/article/latest_article_011511.html.