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March 3 2006

By: Tom Szabo

SILVERAXIS.com

There has been much discussion about the proposed silver ETF, the Barclays iShares Silver Trust. As usual with anything silver, there is plenty of irony, confusion and baseless speculation. Hopefully this commentary will, to some extent, help change the sorry state of affairs.

Let's first look at a few fun (boring) facts about the proposed silver ETF. Silver investors should consider keeping these points in the back of their minds.

ETF Unmasked

With all the above irrelevant stuff out of the way, let's get down to business and take a look at a few really important things about the silver ETF.

First of all, there appears to be the basic problem of only a few people understanding how an ETF works. So let's take care of that right now. Simply put, an ETF is a passive trust. It can only issue or redeem ETF shares upon a tender to or from the fund of so-called "baskets" by the ETF's market makers, who are formally referred to as Authorized Participants. The term basket originated from the basket of stocks making up a stock index, which is what ETFs originally tracked. A silver ETF basket is 50,000 shares initially representing 500,000 ounces of silver. I say initially because over time trust expenses will erode the number of ounces in each basket and therefore in each ETF share.

Not surprisingly, the market makers are required to be DTC members (the DTC is custodian for most of the U.S. stocks held in brokerage accounts), meaning they must be major brokerage operations, clearing firms or the securities arms of large banks. This means that no matter how wealthy or how large a trader you might be, unless you are a member of the DTC, you cannot trade ETF baskets, only ETF shares.

If you understand the above, you know more about an ETF than 99% of investors and 90% of so-called experts. But let's get into some more details to see if we can discover a little argentum wisdom.

The Market Makers

Initially, the silver ETF's market makers will consist of the securities arms of UBS, Barclays (which is also the sponsor of the ETF) and Citigroup. The job of the market makers, not surprisingly, will be to make a market in ETF shares so as to ensure sufficient liquidity at all times and therefore hopefully keep bid/ask spreads narrow. This is no different from the function of market makers for regular stocks.

What is different from regular stocks is that in an ETF, the market makers have an incentive to keep ETF prices closely tracking the underlying basket, whether silver, gold or a stock index. To see why, you must realize that market makers can generate arbitrage profits by delivering or taking delivery of baskets to or from the fund to the extent ETF shares are not reflective of the spot price of the basket. I'll give an example of precisely how this works in a moment, but for now let's just acknowledge that so far virtually every ETF has done a good job tracking its underlying basket.

But then again, no markets while being tracked as an ETF have faced a major crisis like the 1987 stock market crash or the 1980 blow off in precious metals. Keep this in mind when we talk about silver, since extreme volatility in silver prices can sometimes be the norm.

In fact, the potential daily trading volume of the silver ETF may eventually approach or even exceed the trading volume on the spot markets and COMEX. This would turn everything upside down and result in the spot market tracking the silver ETF instead of the other way around!

Okay, let's stop for a second to catch our breath and remember my basic point about how an ETF operates. To repeat, there is no active fund manager or management discretion in an ETF. Running an ETF is a mechanical business. It is the market makers who are in charge of fund performance, a responsibility they naturally and willingly take on most of the time in the pursuit of arbitrage trading profits.

As promised, I'll provide an example of just how things are supposed to work in the silver ETF. First, the market makers will try to purchase 1,000 ounce "good delivery" bars of silver, theoretically on London's LBMA market, but more likely from a pre-designated stockpile of silver as discussed below. In any case, the market makers will deliver successfully acquired silver to the ETF in baskets of approximately 500,000 ounces. The ETF in turn will issue 50,000 shares per basket, which the market makers will then presumably sell to ETF investors in small lots. The same process works in reverse, namely the market makers purchase ETF shares from investors, redeem them to the ETF in baskets, and take delivery of silver from the ETF.

We can use a bit of math to illustrate what makes the market makers tick. Let's assume for a moment that the silver ETF share price is being bid by investors at $110.00 while the spot price of silver is $10,00 per ounce. In such a scenario, the market makers would be very happy to deliver relatively low priced physical silver to the ETF in exchange for baskets of ETF shares, which they would then proceed to sell to investors at the higher ETF share price. Since a silver basket is 500,000 ounces, the result would be an arbitrage profit of $500,000 to the market makers for each basket they create and sell to ETF investors! The calculation of the profit is the trading price of the basket ($110.00 times 50,000 shares = $5.5 million) less the cost of the basket (500,000 ounces times $10.00 per ounce = $5 million).. Conversely, if the ETF price is being bid significantly lower than the spot price of silver, the market makers will buy relatively cheap ETF shares from investors, redeem them in baskets to the ETF, and sell the silver on the spot market for a profit.

In practice, market makers will always maintain some inventory of both physical silver and ETF shares in order to avoid having to make frequent small trades on the spot market and to limit how often they need to create or redeem ETF baskets.

Houston, We Have a Problem

So what happens in the likely event that market makers can't buy enough silver to put together a basket fast enough to make arbitrage profits? The market makers will refuse to make a market in the ETF, that's what.

Such a scenario has a deadly implication for the silver ETF. Simply put, any ETF is fatally flawed if it does not have a large and liquid underlying market to allow market makers to consistently take advantage of arbitrage profits. This is the only reason the SEC needs to provide in order to deny the proposed silver ETF. This is also the reason why it is meaningless to point out that the gold ETF was approved. Gold has a large, liquid spot market supported by large stockpiles. Silver? Everybody knows that story.

Concern about stockpiles was the main reason the SEC recently met with CPM Group. Basically, the meeting appears to have been a follow-up to CPM Group's provocative but largely ignored (by silver bugs) SEC comments at the end of January 2006, which included such gems as: (1) a reiteration of CPM Group's estimate of only 75 to 100 million ounces of silver held in European vaults along with an explanation of why the larger GFMS figure is completely bogus, (2) the speculation that Warren Buffett has likely sold some of his silver, and (3) the disclosure that the ETF's proposed custodian, JPMorgan Chase, does not have enough space at its London vault to store the ETF's proposed silver holdings.

Silver's small, illiquid market and no available stockpiles should make it easy to decipher the proverbial writing on the silver ETF's wall. The only way it will be approved by the SEC is if available stockpiles amounting to at least 130 million ounces of silver can be demonstrated to exist. This will be a daunting task since even the COMEX warehouses hold in available form but a fraction of this amount of silver.

Existing Stockpiles?

What about Warren Buffett, doesn't he still have most of his silver stored in London, of all places? And what about the fact that the Buffett purchase and the number of ounces the ETF plans to hold are in the same ballpark?

There is in fact a connection between Mr. Buffett and the silver ETF, but it is not the one most people might be thinking of. The simple truth is that the silver ETF's proposed 130 million ounces was the largest amount of silver that had a chance of being justified to the SEC based on Mr. Buffett's historical precedence of accumulation without excessive disruption to the silver market. The problem, of course, is that this is 2006, not 1997, and today the stockpiles are simply no longer there. In effect, the silver ETF is a few years too late.

Of course, there is always a chance the SEC will ask Barclays to dramatically reduce the ETF's proposed silver holdings to something "more reasonable" in recognition of existing market conditions. But since an ETF requires certain economies of scale, I doubt Barclays would go for that.

Let me try to put speculation about the Buffett stockpile to rest once and for all. If, as some have wildly alleged, there is a secret deal between Barclays and Buffett, why has this not been disclosed in SEC filings as required under federal securities laws? This would be a highly material fact and not disclosing it would amount to fraud. Besides, are we to believe that Mr. Buffett, arguably the most successful value investor ever, would be looking to fully exit an investment before it has even had a chance to begin ripening? Does Mr. Buffett seem to be the type to settle for 50% gains in the midst of a raging bull market? Sure, he may have sold a modest portion of his silver hoard if the CPM Group's sources are correct, but it would be completely out of character for him to be looking for the exits at this point.

Eureka!

What if I'm wrong and Mr. Buffett, or some other owner of a large silver stockpile, is somehow secretly involved? Could we predict what impact this would have on the silver market and silver prices? Sure we could! There would, in fact, only be a marginal impact since the ETF, or more accurately the market makers, would buy most of the silver from the stockpile instead of the spot market. Indeed, judging by the plans of many ETF supporters, there might even be some net dumping of physical silver on the spot market in favor of the ETF. This of course could actually drive the spot price of silver lower!

But wait, there is more! Jason Hommel, in a recent piece, makes a startling statement about the ETF's need to accumulate 130 million ounces of silver BEFORE it can start trading. As I mentioned in the bullet point section at the beginning of this commentary, this statement appears to be patently wrong since, according to the SEC Form S-1 filed by Barclays, only 1.5 million ounces of silver are required to be accumulated by the trust before the ETF can commence trading.

While technically correct, such a conclusion would actually be wrong. As I stated above, SEC approval is likely contingent on verification of available stockpiles of silver. And if such stockpiles don't already exist, is there a reason why a few interested parties might not be crazy enough to try building them? I say "interested parties" because Barclays as sponsor of the ETF could not do anything without making public disclosures under SEC rules. Neither could the ETF itself, since it won't actually legally exist until approved by the SEC.

Perhaps one of the market makers or their affiliates could take on the daunting task of accumulating a silver stockpile. But what would be the incentive for taking on such a dangerous task? No, the only way I could see there being a concerted accumulation of silver on behalf of the ETF is if some crazy billionaire or rogue financial institution got involved. Heck, who knows, it's happened before!

In any case, Mr. Hommel has opened the door to a very interesting possibility with fundamental and earth-shattering implications for the price of silver. For if it is true that silver might be accumulated on behalf of the ETF, the price of silver would certainly be headed for much higher ground. Interestingly though, once the ETF did start trading, the silver price would likely settle down, if not fall, for the same reasons it might do so in the case of existing stockpiles.

We should note that some pre-ETF accumulation appears to have occurred when the gold ETF was launched in 2004 and the same thing happened, namely, the price of gold rose before the launch of the ETF and temporarily fell afterwards.

The Real Irony

What I have said so far isn't really the ironic thing about the silver ETF. For that, we need to look at the market makers a little more carefully. As stated above, the market makers are the securities arms of major banks and other financial institutions. They are responsible for the creation and redemption of silver baskets consisting of 50,000 ETF shares that initially represent 500,000 ounces of silver.

So what? Well, these market makers are sophisticated trading organizations with corporate divisions that run precious metal derivative books, metal leasing operations and/or bullion trading desks, that's what! Moreover, they are the sworn enemies of the Gold Anti-Trust Action Committee (GATA).

The importance of understanding the role of market makes can be illustrated by studying the experience of the gold ETF during its first full year of operations.

Fortunately for us, Adam Hamilton of www.zealllc.com recently analyzed the performance of the gold ETF. In his piece, Mr. Hamilton showed that the ETF's holdings have remained stable and even increased during 2005 despite gold corrections and periods of weak investor sentiment. We should thank Mr. Hamilton for this important observation even though his speculation about why this was happening contains some glossing over of ETF operating realities.

According to Mr. Hamilton, the gold ETF has not been forced to sell much gold on the open market during periods of low demand for ETF shares simply because the selling pressure and buying interest in ETF shares have been proportional to the spot gold market. That is to say, gold ETF investors were supposedly reacting to gold market gyrations in a similar manner as physical gold investors were reacting to them. Thus, Mr. Hamilton hypothesizes that the ETF was able to maintain a price equilibrium between its shares and the spot price of gold without having to sell much, if any, of its gold holdings.

Well, I'm going to be nitpicky with Mr. Hamilton, whose reasoning usually approaches 100% infallibility. But before I do that, let me state that his overall point was to show how tightly the gold ETF had tracked the spot price of gold since its launch in 2004. He did not intent to explain the inner workings of an ETF. Regardless, the devil is in the details as cliche lovers like to say.

First, as I explained above, all ETFs are passive funds, including the gold and silver ETF. The manager of the gold ETF does not make investment decisions such as when to sell gold on the open market, as Mr. Hamilton simplistically claims. True, the manager can temporarily halt creation of additional baskets under certain circumstances and therefore has ultimate control over the issuance of new ETF shares. But what's more important is that the ETF cannot trade in its own shares (it holds no cash), redeem baskets, control redemptions or otherwise transact in ETF shares or silver. Instead, these are actions entrusted to the market makers. Why I belabor this point at Mr. Hamilton's expense will become obvious a few paragraphs from now.

Second, I find it highly unlikely that gold ETF investors have been able to single-handedly maintain, over such a prolonged period of time, the discipline necessary for the ETF to so closely track the spot price of gold. I draw on the historic example of the sizable NAV premiums and discounts at Central Fund of Canada in support of these doubts.

In contrast to Mr. Hamilton, I posit that the only practical mechanism the ETF has for keeping the ETF price close to the spot price of gold at all times is the pursuit of arbitrage profits by the market makers.

So what can we conclude about the fact that the gold ETF's holdings have remained stable or even increased during gold corrections and periods of weak gold sentiment? Just one thing: the market makers must have obviously intervened.

Actually, I come up with two possible intervention scenarios:

At first glance, I thought the first scenario is the more likely of the two, given the propensity of gold stocks, which the gold ETF sort of is, to be more volatile than gold itself. But if this were indeed true, the ETF price should rise and drop faster then the underlying price of gold. In fact, Mr. Hamilton's charts seem to show the exact opposite. ETF share prices seem to lag, admittedly by a tiny amount, the spot price of gold during both rallies and corrections.

After thinking about this for a bit, I came to the conclusion that things are as they should be. After all, the ETF is a tracking mechanism for gold, that is, the ETF shares are supposed to follow the lead of the spot price of gold. Thus, there is an expected delay as spot prices work their way into the price of ETF shares.

This in turn apparently gives market makers the opportunity during corrections to deliver gold to the ETF and sell shares to ETF investors at relatively higher prices, The reverse is true during rallies, which might account for the sometimes tepid growth in gold holdings during rising gold prices. Stated another way, the market makers are always taking profits away from ETF investors, all in the name of keeping the ETF tightly tracking the spot price of gold.

While you digest that, let me make another important point. Mr. Hamilton's charts seem to be constructed using daily closing prices, which would tend to smooth out any intraday volatilities and differences between the ETF and spot gold. I would really like to find out if intraday prices track as closely as closing prices. After all, market makers might be tempted to engage in end of session window dressing in order to make things look better to investors than they actually are.

Let's now move on to the second scenario, the one in which the market makers might in fact have been acquiring (or shorting) ETF shares for their own account during opportune times such as near the bottoms of corrections or the tops of rallies (right before a turnaround?). If in fact the market makers are doing this without redeeming ETF shares, which Mr. Hamilton's analysis seems to show they are doing, what could possibly be their motive? The answer is the same regardless of how sensational the accusations might be (secretly accumulating ETF shares during an engineered selloff, for a later raid or just temporary price manipulation? trading on behalf of a hedge fund? attempting to cover naked short positions held by bullion bank affiliates? part of proprietary gold trading strategy?); ETF investors are being taken advantage of without their knowledge.

As if this weren't enough, the situation is even more conflicted in the case of the silver ETF, for which Barclays is not only the sponsor with administrative power over the trust, but it is also one of the original three market makers.

I'll mention one more thing before making a sprint for the finish line of this silver ETF analysis that seems to have turned into a gold ETF analysis. ETF investors are at risk of forgetting the fact that each ETF share will represent less and less underlying asset over time due to the accumulation of trust expenses. The silver ETF specifically, with its minimum 0.5% annual fund expense, will incrementally represent less and less per share than the 10 ounces of silver that it started with. As a result, calculating the ratio of silver ounces to ETF shares will become not only more and more complicated, but also increasingly important. It is possible that some investors will ignore this aspect of the silver ETF altogether, especially when engaged in panic buying or selling.

The jury is still out on the effect of trust expenses on gold ETF prices, although it does appear that over time the ETF price has been infinitesimally underperforming spot gold, as it should. On the other hand, this trend could reverse and ETF shares might be overbid compared to spot prices, especially when investors get too excited and fail to properly take trust expenses into account. Regardless, the real issue is that ETF market makers will know exactly what the fair value of each ETF share should be at any moment, giving them a trading advantage over unsophisticated investors.

It never ceases to amaze me what a strange market silver is! I can't think of another instance where the little guy is so eager to hand the castle keys over to the very people they blame for all their ills: the commercials, COT, bullion banks, short sellers. etc.

For those not inclined to believe conspiracy theories, it should still be enough to realize that ETF market makers (1) are insiders with their own self-interests including separate precious metals operations in the paper and physical markets, (2) will use superior market knowledge to create arbitrage trading opportunities at the expense of retail ETF investors, (3) will be responsible for management of ETF bid/ask spreads, (4) will control the ETF's demand for metal on the spot market through their monopoly over the issuance and redemption of ETF shares, and (5) will have perfect knowledge at all times about the operation of the ETF including the amount of silver underlying each share.

To boot, tax complications and the erosion in fund assets due to trust expenses actually might make the silver ETF more difficult to figure out than owning physical bullion. Yet the usually skeptical silver crowd has bought the touting of the silver ETF as all advantage, no downside, hook, line and sinker.

Conclusion

If silver didn't have such a small spot market and little in the way of available stockpiles, perhaps the benefit of an ETF--its liquidity and the fact that it can be traded like a stock--might outweigh the very serious but difficult to see toll on investors arising from the market makers' inherently unfair advantage. Indeed, the wild popularity of ETFs in general seems to indicate that investors don't think ETFs can cause them any problems whatsoever. To which I answer, let's see just how well each ETF will fare in its eventual test by fire: market conditions so disruptive that even the market makers are helpless.

In any case, there are more immediate problems with the silver ETF that have no apparent resolution. The SEC's likely position will be that the spot silver market is so small and illiquid that an ETF will have a disruptive influence. Sure a miracle might still happen such as Buffett making his stockpile available or some crazy billionaire attempting to build a stockpile from scratch.

Alas, miracles are for suckers, and so I urge the silver community to go back to the drawing board. Let's find another way to provide investors with an ETF-like vehicle that is easy to trade, but is not an ETF. Until then, we'll have to settle for Central Fund of Canada, Silver Wheaton or Silver Standard Resources as the closest thing to directly owning silver in our stock accounts.

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DISCLOSURE: At the time of publication of this commentary, I did not own Central Fund of Canada, Silver Wheaton or Silver Standard Resources.

Commentary Synopsis

The proposed Barclays silver ETF, like all other ETFs, will be actively manipulated in order to keep share prices tightly tracking the spot market. But because the silver ETF has the potential to overwhelm the spot market, which is relatively small and devoid of available stockpiles, the SEC is unlikely to approve it as currently drafted.

In order to understand what I mean by "actively manipulated", you need a basic understanding of an ETF's operations. It's actually quite simple. All you need to know is that an ETF is a passively managed fund. What this means is that the ETF must rely on "authorized" market makers to create or redeem ETF shares. Meanwhile, the role of the ETF manager is limited to diligently carrying out the market makers' instructions and keeping accurate records. Thus it is the market makers who are the real brains of the ETF, charged as they are with keeping control of the ETF share price by managing the void between supply and demand. Like I said, an ETF is actively manipulated.

Why does this matter, you ask? Only because the market makers consist of the who's who of GATA defendants! And even if you don't believe in conspiracy theories (I don't), it should still bother you that the ETFs provide the big commercial players yet another tool to trade (i.e., short, hedge, scalp, flip-flop and speculate) paper gold and silver against the real thing. Ironically, support for the silver ETF comes this time from the very same people--the small retail investors--who will end up getting screwed.

The above arguments must be weighed against the obvious benefit of investors being able to trade bullion in a stock account. The SEC sure has a Hamletesque quandary on its hands!

For me, I guess the question comes down to whether or not the size of the ETF is sufficiently large [correction: should say "innocuous"] compared to the underlying spot market it is trying to track. In the case of silver, I argue that it is not, and furthermore, that there are not enough available stockpiles of silver to meet anticipated demand from the ETF. In any case, the SEC is likely to require identification and verification of available stockpiles before moving forward.

Whether or not there might be sufficient available stockpiles, such as Buffett's hoard purchased in 1997, is pure speculation.

And what if the stockpiles are actually there? Or what about an even wilder proposition, that Buffett is willing to make his stockpile available to the ETF? In such a scenario, I wouldn't expect silver prices to substantially rise as a result of ETF demand for physical silver, since the silver would be purchased out of the available stockpiles and not the spot market. Some have speculated that this is the reason silver hasn't rallied more in anticipation of the ETF's approval. My take is that uncertainty about the ETF's approval remains extremely high.

On the other hand, it is a relatively straightforward postulation that if available stockpiles did not exist, somebody could try to build inventory over a period of many months or more likely years, at which point the SEC would have little choice but to approve the ETF. Under this scenario, there would be significant and consistent silver demand on the spot market and silver prices would be expected to march substantially higher.

At the end of the day, all of this is just speculation and frustratingly adds to the enigma that continues to envelop the silver market. Before we can take any intelligent silver ETF discussion much further, we'll have to see how the ETF is progressing and silver prices are doing over the next several months.

Commentary Online References

The following references are good places to start researching the silver ETF. This list will be expanded over time.

iShares Silver Trust Amend No. 2 to Form S-1 | sec.gov

The Silver ETF: What's the Deal? | Feb 23 2006 | Jason Hommel

Where are my goldgrams and silver stored? | goldmoney.com

SUA Voices ETF Opposition to SEC | Feb 16 2006 | Jon A. Nones

SUA Letter to SEC | Feb 13 2006 | SUA

World Silver Survey 2005 - The Highlights (PDF) | GFMS

Approaching Hubbert's Peak of Silver? | Feb 20 2006 | Jon A. Nones

SEC Memorandum Re: CPM Group Meeting on Jan 31 2006 | Jan 31 2006 | sec.gov

Silver Inventories Note to SEC | Jan 30 2006 | CPM Group

The Mystery of the Silver ETF | Mar 2 2006 | Donald Dross

Comments on AMEX Rulemaking, iShares Silver Trust | sec.gov

Gold ETF Impact | Feb 10 2006 | Adam Hamilton