Today In Silver

This is a good test to see if my understanding of the basis is correct. So here goes …

If the lease rates are increasing that means that the basis (future price less spot price) is also increasing. In grains trading, a warehouseman would buy the basis of that grain that has the highest basis so I am assuming that this is also true for precious metals. A rising basis would encourage speculators to buy the basis of the PM whose basis is the greatest and rising. You would buy the basis by buying metal in the spot market and by simultaneously selling the metal forward. This would have the effect of increasing demand for bullion and increasing supply of paper metal, eventually causing the basis to contract.

OK I will take a stab at this.
If the lease rates went down would’nt that mean few were willing to lease silver to sell forward at these prices ??

and visa versa that when they spiked up everyone piled in to sell forward

A higher lease rate may indicate that there is no shortage of wholesale silver and that the shorts are not covering.

Higher lease (interest) rate means that the underlying commodity is less available (shortage?). If the higher rate is permanent expect the price to rise until it reaches a healthy basis. Did you mention current backwardation in one of your comments? It might be true, watch out!

Okay, I?ll take a stab too, though I?m still trying to make sense of this silver lease rate thingy.

Assuming LieBOR is ?stable? then we can expect increasing silver price volatility..?

If the carry on silver drops, then wouldn?t that mean the ceiling on the basis is coming down??

Given the drop in futures already, doesn?t that imply upward price pressure on spot??

Basis risk has increased ? signs of stress??
With eventual pressure on hedgers to sell the physical long side and cover futures shorts.

Wow, did I just say all that?
Please tell me what I said.

A rise in the “lease rate” equates to a drop in the forward offered rate (assuming LIBOR hasn’t changed). The forward offered rate IS the basis. (More specifically, a one-year forward offered rate equates to an annualized basis, for instance.) So we’ve got a silver basis (contango) that has fallen, though not yet to backwardation (excepting the compelling arguments for “retail backwardation” having already occurred).

Maybe you’re only looking for an explanation that goes this far, Tom. But to further speculate about the implications of a rise in “lease rates” here, I’ll say that since forward selling has become less profitable, we’ll have less of it (all else being equal). In other words, since the basis has gone down, we’ll see less hedging of physical stockpiles on the futures market. The shorts will cover (to some extent), causing the futures price to go up.

Mike (above), we seem to be saying similar things.

I’ll revise my comment by saying: OK, I do see a difference between the forward offered rate and the basis, but only inasmuch as we calculate them based on data from different markets (the former on the LBMA, the latter by comparing futures prices on the COMEX to spot prices - presumably on the LBMA?). By offering to sell silver for future delivery (the price of which one determines using a “forward offered rate”), doesn’t the LBMA act as something of a futures market? Not the same as the COMEX, granted.

I realized the need for this revision upon re-reading Tom’s statement that “the implied 1-year forward rate of the COMEX silver futures remains around 3% as I write this, which is not much changed from the recent past.” Right, we seem to have a divergence between the LBMA and the COMEX, as the title of the post implies. We can, so far, only safely state that we have a divergence, not a decrease in the basis, or perhaps we could term it an “unconfirmed” decrease in the basis.

Could this divergence have come about on the LBMA because of the LBMA’s function as (primarily?) a spot market? From increased spot buying on the LBMA (for current delivery relative to future delivery) leading to a decrease in the forward offered rate? (not the forward offered price, mind you, but the relative price differential expressed as a percentage rate). Could (some of) this increased spot month buying have occurred due to SLV adding 4 million ounces (whose Authorized Participants may have bought those additional ounces on the LBMA, or through dealers who then correspondingly increased their buy orders on the LBMA)?

Have I gotten closer to where you were going with this, Tom?

With the new rate today (19th), I see the LBMA has corrected the yesterday’s anomaly in the [url=http://www.lbma.org.uk/2008sifo.htm]SIFO[/url] figures. It still shows a drop in forward rates over the weekend, but not enough to turn the 1-month lease rate positive just yet. In fact, as of today, the 12-month forward rate is slightly higher than it was on Friday morning.

Had such a large drop in the forward rate really occurred, I would have suspected that the SLV purchase of four million ounces had cleaned out a large proportion of the silver stocks available on the London market. (The forward rate falls when the spot price rises relative to the future price. This would cause some stocks intended for leasing to be sold on the spot market instead). Such a situation would indicate extreme tightness on an exchange with a current monthly turnover of 120 million ounces.

However I would also have expected to see a similar change in rates on other exchanges, as arbitrageurs took advantage of the difference, but that clearly didn’t happen. The reason is apparently that it didn’t happen on the LBMA either

I am not going to make a stab at the “correct answer” and here’s why:

Way back at the dawn of the computer age the term GIGO was born. Garbage In, Garbage Out. I have found it a useful idea to keep in mind, especially today when we are in an information war among all the other wars going on (war on poverty, drugs, health, illiteracy, terrorism, … governments love to declare war on any subject at the drop of a hat). So I’m going to add information to the list.

Now back to GIGO. The formula for the lease rate differential is simple. But, is the data true? Here is a copy of an exchange I had with another fellow regarding Libor (though I do think Liebor is a more accurate description).

http://tinyurl.com/62ssvf

Changes to Libor Rejected
By Laurence Norman
Word Count: 510

LONDON — After nearly two months of deliberations, the British Bankers’ Association rejected many of the proposals aimed at addressing concerns about the accuracy of its benchmark interest rate, known as the London interbank offered rate, or Libor.

The BBA said it had decided against establishing an added dollar Libor rate to better capture the U.S. market, and would make no changes to the definition of Libor, which is supposed to reflect the short-term rates at which banks lend to one another.

The association also left in limbo a plan to expand the panels of banks that report their borrowing …

So the system remains the same and the reliability remains in question. Actually, the reliability is confirmed as fiction and that is an additional point that leads me to believe the system is under such stress that it can’t handle the truth.

Back to this comment. Basically I don’t think the Libor is being accurately stated as information voluntarily reported by banksters is an oxymoron. As financial stress increases, no bank is going to voluntarily increase their stress level by reporting the truth. So this group’s credibility (for me) remains suspect.

Thank you, Tom. I have a comment on part of your last summary sentence: “Since LBMA is a physical exchange all the time whereas COMEX is a physical exchange only when certain conditions exist (ie., it is a delivery month and there is significant spot month futures volume and open interest)….”

from http://www.lbma.org.uk/london/clearing :
“The London bullion market relies on a daily clearing system of paper transfers.

Members offering clearing services utilise the unallocated gold and silver accounts they maintain between each other for the settlement of mutual trades as well as third party transfers. These transfers are conducted on behalf of clients and other members of the London bullion market in settlement of their own loco London bullion activities.

This system avoids the security risks and costs that would be involved in the physical movement of bullion.”

The LBMA seems to have changed their website fairly recently, as several weeks ago, I remember reading something similar, but that mentioned the possibility of physical delivery in some (more rare) cases. Now, however, they seem to admit to little or no physical delivery at all. And do we trust them to actually have all the gold and silver in these unallocated accounts that they represent having? This aspect relates to issues brought up in an article linked to by someone else in a recent comment on another entry in this blog:

http://tinyurl.com/5queq9

Forgive the author for thinking that gold and silver trade on the LME (instead of the LBMA), and he seems to reach potentially viable conclusions (in my opinion), although they deserve further investigation and verification, of course. He mentions the same negative lease rates that you’ve mentioned, Tom, terming them “subsidies” for borrowing paper (promises for) metal which can be used to back up or create further derivatives (such as COMEX short positions). Perhaps this sort of analysis can bridge the gap between analysis of verifiable data and more “wild” conspiratorial speculations. As in, the COMEX commercial shorts aren’t “naked” in the eyes of the CFTC, but perhaps the paper claims that back their positions are themselves “naked,” but on the LBMA? Comments, Tom? Thanks again.

Also, in a related issue, with regard to this quote from Ted Butler (found at http://news.silverseek.com/TedButler/1193161018.php ) about the oft-mentioned out-of-court settlement between Morgan Stanley and disgruntled metal-storage customers: “Morgan Stanley?s actions were not in any way unique in this practice. In fact, in the court documents summarizing the proposed settlement, one of Morgan Stanley?s defenses was that they were not doing anything unusual by charging storage on metal that didn?t exist, as this is a widespread industry practice.” My question: has anyone else seen these “court documents summarizing the proposed settlement”? Because I haven’t looked all that hard, but I’ve only seen sources that said something to the effect of “The company did not admit to any wrongdoing, but stated that the settlement was made to avoid the costs of protracted litigation.” (from http://tinyurl.com/5ewhuc ) Did they admit to it, and further implicate their competitors in the industry, or did they deny any wrongdoing? We need to be careful with our claims - I’ve parroted this story to others myself, recently, but now I’m realizing that I haven’t actually seen enough evidence yet.

Thanks for the post regarding the Morgan Stanley settlement Tom. I had asked you a rather mangled email question earlier on that. Very interesting.

I?m not a lawyer but I am wondering, if that was an agreement settling the case for a sum of money to the claimants, is it appropriate for us to take defendant claims on such a document as factual? Is the ?undisputed evidence? referred to on this document really undisputed? If perhaps undisputed, was it relevant and conclusive?

The document also stated that the defendants believed ?that if the case were not settled, they would be entitled to summary judgment dismissing all claims.?

Yearight. Then why settle rather than eliminate any doubt regarding the integrity of Morgan Stanley?s bullion investment service? I realize that there are many factors to consider in deciding to defend a suit but certainly one important business factor would have been the perceived integrity of Morgan Stanley. Perhaps it?s asking too much of a Wall Street Investment bank to worry much about integrity.

From what I?ve seen so far I don?t know what to believe - still suspicious.

Regarding the ?relevance? of this area of silver investment, I do think we need to seriously consider this and all ?investment? silver demand in our analysis simply because of the secular shift (to come) of silver from commodity back to primarily a monetary metal. Your guestimate of the maximum number of ounces involved with these types of investment programs (a couple hundred million max) is no small sum.

For all of our benefit, I’ll excerpt these quotes….

Ted Butler said: “In fact, in the court documents summarizing the proposed settlement, one of Morgan Stanley?s defenses was that they were not doing anything unusual by charging storage on metal that didn?t exist, as this is a widespread industry practice.” (found at http://news.silverseek.com/TedButler/1193161018.php )

The court document that you linked to, Tom (thanks), says: “It should be noted that never in the Class Period has there been any default by defendants or their depositories, and no members of the Class have sustained any financial losses thereby.” and “The undisputed evidence shows that all of the precious metals held on behalf of Defendants? customers are present and accounted for, purchased pursuant to each and every customer order.” and “Further, the allegations in the Action center around the industry practices which Defendants claim they followed.” and “These [storage] fees were not inconsistent with the fees charged by other brokerage firms.”

I see very little relationship between what Butler said and what the court document says. His article admits “there is no admission of any wrongdoing,” and yet because they mention “industry practices,” he tries to incriminate the entire industry on a charge based on no evidence but his own contention, storing “metal that doesn’t exist.” Yes, Tom, I agree that Butler seems to have egregiously distorted the facts in this instance and has lost a ton of credibility in my eyes. (I’m a slight bit embarrassed at the credibility I lent him in the first place.) Never again will I be parroting his version of these facts.

I see the point that just because the company settled the case, it doesn’t necessarily mean that they would’ve lost a lawsuit. But, yes, I agree, Mike, it puts their integrity up for question if they don’t fight to clear their name. I don’t know how much it costs these days to see through to the protracted end this type of case and all the potential appeals, but at some point (fairly early on, before you end up committing much more to it), it might make sense to nip it in the bud and settle. However, if you win, can’t you ask for (and get) legal expenses paid for by the other side? So I’m still a bit agnostic on the merits of Morgan Stanley’s legal strategy in this case, but I certainly wouldn’t trust them, or any other mainstream bank or brokerage, with my silver. (After all, where did fractional reserve lending originate from, but just such unallocated vaulting practices? Such temptation!)

And this leads us to the other issue we (or especially I) seem to be making progress on understanding here in this series of comments….

Today (or yesterday by the time I’m posting here, by a lot), in helping a friend (”holding his hand”) to buy some 100-ounce silver bars, a local dealer (perhaps the premier dealer in Seattle, at least of gold - and at least in his own mind!) chatted us up and said that he (following what seems like an industry “best practice”) immediately offsets all of his retail transactions with wholesale orders (”confirms,” as he termed them) to one of his clearinghouses (a buy order to restock after he sells to a retail customer, and vice versa). (Note that he also said that he hedges his inventory for price risk, so this example would assume that he would both have to offset his pre-existing sell order - entered at a “forward offered price,” I presume - with a buy order, as well as enter another buy order to also replace his inventory.)

When he arranges to sell on the wholesale level, and actually ends up shipping the metal (such as, potentially, after purchasing from a retail customer and ending up with more inventory than he needs, above and beyond what would simply abrogate the need to order that item on the wholesale level, and actually leaving him with more inventory than he wants to carry), he said that the clearinghouse generally has him ship the items directly to another dealer (whatever dealer happened to take the other side of his order) rather than the clearinghouse itself. (Note that, in the case of offsetting a pre-existing sell order with a buy order, I presume that the clearinghouse would direct the counterparty to his offsetting buy order - a new seller - to deliver the silver to the original buyer so that he doesn’t have to bother with it.) I didn’t ask him the names of these clearinghouses, but it occurred to me that perhaps they are fulfilling a function quite similar to that of the LBMA (including, perhaps, the periodic price “fixings”).

Furthermore, he told me that some of his customers have money on account with him, so that they can call him up at any time to place an order with him, taking advantage of favorable short-term price movements, locking in a price (but only while his clearinghouse market is open, so that he can properly offset his transactions to limit his price and inventory risk) so that they can later pick up the metals at their leisure. During the time between the confirmation of the purchase of the metals by his customer and their pickup (which could, theoretically, happen significantly later - although he might charge for storage eventually!), this dealer effectively stores metal on an unallocated basis. After all, he has vaults! (Smaller than what I tend to imagine “vaults” looking like when I think of these “warehouses,” and not underground, but very practically sized and situated near the transfer point and final customer, all the same.) And when a customer with money on accout confirms an order with him, he has transferred ownership of the metal, but no physical shipping has (yet) occurred (although it will at some point sooner or later, for each and every sale, whether hand-delivered or parceled and shipped, except when his customer buys from him and then decides to sell the metal back without ever taking delivery) and I don’t imagine he tells his customer the specific identifying numbers on the item (if the item even has them, and if he even knows them in the case of items that he has yet to receive). Again, this function seems to closely resemble the members (”warehouses” or “vaults”) of the LBMA in terms of providing unallocated storage of precious metals for customers and facilitating trade of them which doesn’t always require physical shipping. This dealer’s trading partners on the clearinghouses, it seems, would have the same characteristics.

So here I’ll get around to my main point(s)/questions (congratulations and thanks for reading so far). This coin dealer also told us that he and his fellow dealers (at least those that use his same clearinghouses) have to trust each other to follow through with their commitments to ship metal to each other, and to do it on a timely basis, and that if anyone defaults on their commitments, such default could potentially cascade and snowball through the entire industry (and that he “worries” about such a thing happening - indeed, I submit, we could be coming close to such an occurrence). Furthermore, he proceeded to reassure us about his solvency and reliability and his 46-year track record (in contrast to many of his former competitors, whose sometimes-public demise he has witnessed over the years, taking some of their customers money in the process). I related how the owner of the other coin shop we had just previously visited told us that he was “losing $600″ selling us $500 face of 90% (which was the maximum amount he would sell us, even though he had more on hand) because he didn’t hedge his inventories for price swings (he said the “little guy” can’t do it because of the 5000 oz. contract size). The owner we were talking to called other coin shop owners like this one “fools” and warned against depositing money with them (while you wait to receive items on order), implying that just these sort of operators could spark or contribute to an industry-wide default.

Point 1: To the extent that dealers do not honor their commitments to ship paid-for metal to their retail customers or wholesale counterparties (whether due to insolvency, incompetence, malice, the default of their own counterparties, or some combination of those), they are selling unallocated AND non-existent metal.

Point 2: Currently, with the low price and such a high quantity demanded, as long as they THINK they can fulfill these orders and replace their inventories for a lower price than they’re selling them for (presumably because someone else told them they could get replacement metals to them soon enough, at such a price), these dealers have a large incentive to fill lots of orders (if only to avoid disappointing customers, but also to keep or grab more market share - after all, we’re all here on the internet telling each other who’s still fulfilling orders).

Question: Do we trust that each of the many links in the chain will be willing AND ABLE to fulfill their commitments to ship the silver they’ve promised?

Point 3: Whether through these U.S. wholesale clearinghouses or the LBMA itself, we know that a lot of promises are being made about the presence of silver (and gold), but as soon as counterparties start getting defaulted on, thereby losing money (because their hedges and offsets ended up failing at their purposes, for instance), and eventually becoming insolvent, they then become unable to fulfill their own promises to other counterparties, even if they want to. This gold dealer basically feared as much. A cascading default could happen just this way, anytime, in just such a circumstance as we’re currently experiencing.

Point 4: Back to the example of this dealer and how he offsets his transactions. Let’s say that he starts with one 100-ounce bar in inventory that he has already hedged with a sell order at a forward offered price for some date in the future. If that date approaches and the inventory hasn’t sold, he offsets the sell order (now a near-term or spot order) with a spot buy order (from some other dealer on the clearinghouse) and effectively earns the lease rate (the forward offered rate subtracted from the interest income he would’ve received had he lent out the funds tied up in the inventory). He can repeat this process as often as necessary until the bar sells.

When the bar does sell, he enters a spot buy order to offset the pre-existing forward sale (since he no longer has the silver to cover it, and doesn’t want to be on the hook for any price rises in it) and enters into another spot buy order to replace the inventory he just moved. These COMMERCIAL orders on the clearinghouse (or futures exchange) hedge silver in the inventory of dealers, and could largely explain the large commercial positions (more shorts than longs due to the large amounts of inventory sitting in dealer vaults or in transit between them, but some net longs among them temporarily as dealers need to replace inventory they’ve sold (which would explain Ted Butler’s “raptors” and the rotation of a pool of large commercial traders among those in the top 8 or 4 net shorts, as their levels of inventory needing hedging or replacement fluctuates).

Point 5: More importantly, notice that the sale to a retail customer of one 100-ounce bar led to the entering of two immediate buy orders in the clearinghouse (and the reverse would also be true for a purchase from a final customer). Referred to back in business school as “whiplash effect,” this magnification of perceived demand (or supply) would repeat based on however many levels the supply chain contained, exacerbating price moves both to the upside and the downside.

Point 6: At some point, this crescendo of buy orders (in the former example) or sell orders (in the latter example) due to inventory whiplash effect in the supply chain (and to other factors such as speculator panic buying / panic capitulation) gets overdone and starts to reverse. In the meantime, I find it plausible that corresponding open interest buy/sell orders could accumulate (in the various venues, futures, LBMA, wholesale clearinghouse, wholesale OTC, retail OTC, retail unallocated, ETFs, mutual funds, etc.) to a total GREATER THAN ALL OF THE ABOVE-GROUND SILVER IN THE WORLD. In the former example (at the end of a run-up in prices), the overhang in buy orders at overly high prices can eventually be satisfied by new silver production. In the latter example (at the end of a crash in prices), so few sellers of existing stockpiles not already in the supply chain appear at such low prices that a good number of parties default on their delivery commitments. (Only if all of the silver in the world changes hands, and more, can the market avoid such a widespread default, given that level of open interest across all venues.) In other words, in this latter example, we would’ve had widespread NAKED SHORTING.

In summary (and it has gotten extremely late, so please tell me if you think I’ve gone off the deep end), Ted Butler has perhaps distorted a lot of facts and perhaps has exaggerated the case, but it seems to me, if I haven’t (inadvertently) distorted the facts and if I’ve reasoned correctly here, we could (even now) be experiencing what he alleges in terms of overall market dynamics. Maybe not manipulation by conspiracy, but at least accidental/incidental manipulation resembling the sort of boom/bust cycles built into fractional reserve lending systems of tangibly backed currency (or systems that end up evolving into them). And in a sense, don’t we still have that now, but on a sort of “floating exchange rate”?

Correction: in the first paragraph of Point 4, the dealer in the example effectively PAYS the lease rate, he doesn’t EARN it. He misses out on the interest he could’ve received had he not tied up funds in inventory, yet that opportunity cost gets (usually only partly) offset by earning the forward offer rate. Or conceptualized similarly, he pays interest on the money he borrowed to finance his inventory (working capital), and that expense gets somewhat made up for by having been able to hedge his inventory with a forward offer price higher than the spot price.