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I started writing this
piece as the sub-prime crisis was unfolding. I wanted to establish the
connection between the silver basis and the budding banking crisis caused by phony
bond insurance schemes and the lack of hedging irredeemable dollar debt with
metal holdings. My original title was Putting
Clothes on the Naked Bogeyman. As writing progressed I realized that it
would take more than one article to dress up the bogeyman; hence the revised
title.
Trading hedged corn
When I tell my audience at Gold Standard University
Live that huge quantities of commodities are bought and sold every day without any reference to the price, my
words are received with an incredulous silence. It appears incredible to the
uninitiated that the price risk can be neatly side-stepped. I have to explain
to my listeners that when the professional grain trader gives an order to buy
or sell corn, he may be unaware whether the price of corn is up or down. He
doesn’t care. He is buying and selling hedged corn, and he takes his clues from the basis, not the price
of corn itself. He has replaced price risk with basis risk which he knows how
to handle as its behavior is less erratic and more predictable. Most people
don’t realize that the bulk of grain trading on the futures markets is
driven not by the price but by the basis.
In
the grain market by basis is meant the difference between the futures price
and the local cash price of the grain. Thus the basis varies from place to
place, and from one delivery month to another. Trading the basis means buying
or selling hedged grain. The merchant goes long on the basis by purchasing
hedged grain when the basis is wide, and selling it when the basis is narrow
(possibly negative). He goes short on the basis by selling hedged grain first
when the basis is narrow (possibly negative), and selling it later when the
basis is wide.
The myth of naked shorts
The silver market is similar. Large quantities of
silver are bought and sold every day without reference to the price.
Professionals trade hedged silver on clues from the silver basis. They are
not gambling on the price variation of silver: they want to earn a reliable
income on physical silver already in store. They may do this on their own
account or, more typically, on customer account. The ever growing inordinate
and concentrated naked short position in the face of a strongly rising price
is a myth.
I
defined silver basis in my earlier articles as the difference between the
nearest futures price and the cash price of silver (see references).
It
is puerile to assume that most professional traders are naked short in silver,
just as it would be sheer ignorance to suggest that most professional traders
of grain are naked short in corn. They are not. You may rest assured that
their corn is well in place in a grain elevator somewhere. If the elevator is
registered with the commodity exchange, then the hedger may post a reduced
margin on his position. But the elevator need not be registered, in which
case the hedger posts full margin. While this is not typical in the grain
trade, it is quite common in the silver trade. Rightly of wrongly, the silver
trade is surrounded with far more secrecy than the grain trade. This has to
do with the fact that silver is considered a monetary commodity by many in
the first place, and an industrial commodity only in the second. We must understand
that lots of people are accumulating silver not so much for the ride to
$1000, which may or may not happen, but in protest against low interest rates
on passbook savings and certificates of deposit. They are happy to post full
margin instead of the lower hedge margin on their short position in silver in
exchange for anonymity. Of course, the exchange knows that theirs is a hedge
position, but must treat this information as confidential. So must the
C.F.T.C.
Let’s
start by reviewing the differences between the grain and silver trade. As
most grain is sold to the ultimate consumer within the year of production,
the basis has a yearly cycle with trough just before and peak just after
harvest. By contrast, the silver basis is not cyclic. Silver is typically
accumulated year after year by investors and bullion banks. Instead of an
annual cycle following the crop year, the silver basis has a long-term
falling trend, a strong hint of a slowly developing shortage. It is
impossible to predict when shortage will hit. After every major price advance
there is profit-taking by unhedged investors, and after every major price
decline there is short covering by hedged investors and bullion banks. Net
selling through profit-taking and net buying through short covering may or
may not balance out. Accordingly, the trend towards a permanent silver
shortage is going to be uneven.
Historical sketch of the grain
trade
Farmers produce billions of bushels of grain every
year. Most of this grain is sold several times in the futures markets as part
of the basis-trading before it is consumed. An understanding of the
historical development of the futures markets may be helpful. Standardized
futures contracts began trading on commodity exchanges in the late
1800’s. Futures markets revolutionized the way cash grain was traded
and gave the grain elevators and the farmers the ability to buy and sell more
easily and profitably. Grain companies learned how to use futures contracts
more effectively to manage risks, and to maximize income from their
elevators. The big revolution was the advent of basis-trading, to replace
price-trading. This revolution is not mentioned in school curricula; not even
in university curricula. This is a pity. The story of basis trading is a
story of capitalism triumphant. It teaches how the free market can overcome
the capriciousness of nature. As more and more people learn the skills of
basis trading, profitability grows and business expands.
The
grain business prospered until the 1930’s when the Great Depression
began and governments became heavily involved in grain trading. Government
programs dominated the marketplace. Storage of grain was encouraged and
construction of new elevators was subsidized. However, the market was
stagnant, to a large extent precisely because the new elevator space was
taken up by government-owned grain. This grain was just sitting there in the
elevators, until it was ultimately given away to other governments or to
charities.
In
the 1970’s governments decided to reduce their presence in the grain
market. A new era started when market forces were allowed to prevail once
more. The grain business re-learnt how to increase efficiency, manage risks,
and generate income through basis trading. Generally, the abundance of grain
kept the market stable. Under these conditions the opportunity for trading
was confined to buying and holding grain. This is known as the „carry
trade”: buying when the basis is at its highest and selling when it is
at its lowest. The basis was following a consistent pattern and as it
declined from harvest to the end of the crop-year, the grain trade was
provided with a reliable income.
It
would take a sizeable drop in production to cause any significant move in the
price and a deviation of the basis from the customary pattern. While it did
not happen very often, the market came away with the flying colors proving
the superiority of trading the basis over trading the price especially under
volatile conditions.
The
21st century brought new challenges to the grain trade. The market became
demand-driven. Increasing population and improved living standards around the
world opened up markets to more people and boosted demand for processed food
and other consumer products. There has been a tremendous growth during this
first decade of the century. In addition to the carry trade, „value
added trade” has put in an appearance and started growing. In this
environment grain does not sit around in elevators for a long period of time.
The market absorbs it and makes it into all kinds of products for human and
animal consumption. Most recently grain has started trading also for use in
energy production. All these changes contributed positively to basis trading
as it has changed the dynamics of the marketplace.
Of
course, not all grain traders are trading basis. A dwindling number still
trade price. Most of these traders are barely surviving. They will have to
learn the skills of basis trading, or perish. It is a safe bet that no new
grain elevator is being built with trading the price in mind. They are built
with trading the basis in mind. Those who are still trading price are missing
one of the great opportunities of the century by not understanding basis.
Historical sketch of the
silver trade
Second only to gold, silver is a monetary metal. This
means that above ground silver represents several years’ output of the
mines. One should not be misled by the propaganda line that this silver
„has been consumed by industrial applications”. The recovery of
scrap silver is a function of the price. As the price of silver rises, the
rate of recovery will rise with it, sometimes dramatically. In addition, an
unknown but substantial amount of silver still exists in monetary form.
Owners do not want to reveal their identity, or the size of their hoard. But
this does not mean that monetary silver has disappeared in consumption. There
is no support for the claim that silver is in short supply, or that silver
has ceased to be a monetary metal. Any apparent shortage simply means that
the carry trade holds back stocks from the market in hope of an early price
advance. At the right price it will make the metal available.
Prior
to 1873 the price of silver was stabilized through monetary legislation at
$1.29 per oz. After the Civil War the U.S. Mint was closed to silver. The
German government also closed its Mint to silver in the wake of the Prussian
victory over France about the same time. Silver was dumped in the markets in
unprecedented amounts, driving the price down to as low as 70 cents by the
end of the 19th century. Although the price spiked back to $1.29 at the end
of World War I, it did not last and during the Great Depression it hit a low
of 25 cents. We may add that upheavals in the silver market were a direct
consequence of government meddling. Ultimately people have learnt how to
neutralize the destructive influence of the government in an effort to
control money, and they borrowed a leaf from grain merchandising manuals in
trading the silver basis.
Through
all this time up to 1965 there was no silver trading on the organized
commodity exchanges for reasons of insufficient volatility. By 1965 the world
market price threatened to exceed the statutory price, as demonstrated by the
disappearance of silver coinage from circulation, and volatility perked up.
Silver trading on the organized commodity exchanges started. However, secrecy
continued to surround the silver trade as one monetary crises followed
another at more or less regular intervals. There was a conception that silver
could also be confiscated as gold was in 1933. In the event, the
ban on gold ownership and trading was lifted in the U.S. at the end of 1975,
allowing gold futures trading to start and giving a boost to silver futures
trading already in progress.
Secrecy
prevailed and manuals on how to trade basis in the gold and silver markets
were never made public. Those anxious to learn basis trading of the monetary
metals had to buy the manuals for basis trading in grains, and work it out
for silver and gold on their own. This is not as easy as as it sounds,
because of pitfalls due to the fact that trading monetary metals differs from
trading grains in almost every respect. Having said that, there is no
question that basis trading in gold and silver is a wide-spread practice
preferred by the most conservative investors, and even the more venturesome
cannot do without at least a rudimentary understanding of the underlying
principles. We have mentioned above that trading the basis for grain instead
of trading the price was a triumph of capitalism. Man has learned how to
overcome the capriciousness of nature. The same also happened in the silver
market: trading the silver basis increasingly replaced the trading of the
silver price. The difference is that here it was not the capriciousness of
nature but the capriciousness of governments that has been overcome.
Governments want you to believe that they can create and destroy value at
will by monetizing debt while demonetizing silver and gold. In effect they
cannot do either in a durable way. Government magic goes only so far as
gullibility of the people.
Gold
Standard University Live is a world leader in offering regular panel
discussions and primers on basis trading of the monetary metals. There are
plans to run workshops as well on basis trading. The next session is
scheduled from July 3 through 6 at the Martineum Academy in Szombathely,
Hungary, to be followed by a session in Canberra, Australia in November (see
Announcement at the end of this article).
The Last Contango in
Washington
Volatility in the gold and silver markets is like a
dormant volcano. Unannounced, it erupts periodically with increasing
ferocity. As it does, trading the gold and silver price is becoming ever more
treacherous. There can be no doubt that the answer is basis trading, that is,
buying and selling hedged gold and silver. It is only a matter of time before
a trading house or bullion bank will offer this service.
The
significance of the silver and gold basis can be found in the role they play
as an early warning system. Under normal circumstances backwardation in gold
and silver is an aberration. Monetary metals must be sufficiently plentiful
in order to serve as such. This translates into contango. But at the time of
monetary disturbances, like the one triggered by the sub-prime mortgage
crisis, the monetary metals tend to go into hiding. As they do, the cash
price goes to a premium against futures prices, and the basis goes negative,
indicating the extent of scarcity. If hyperinflation is in store, gold will
go into permanent backwardation, foreshadowed by a steep decline in the
basis.
In
an earlier article I have, somewhat flippantly, described this momentuous
paradigm-shift as „the last contango
in Washington” (with a bow to the movie The last tango in Paris.) The historic contango of gold will give
way to permanent backwardation. It will mean that gold is not for sale at any
price ― not against the irredeemable dollar. Note that while the gold
price is open to government manipulation, the gold basis cannot be so easily
falsified. It reflects the truth as it is. The basis never lies.
Canary in the coal mine
According to one hypothesis, permanent backwardation in
silver will precede that in gold. Thus silver is the „canary in the
coal mine”. But you have to have ears to hear the canary sing. In other
words, you must be able to read the message carried by the silver basis. If deflation
and depression is in store, then the case for silver is not so clear-cut, in
view of silver’s extensive industrial applications. It is possible that
silver will be dumped by investors fearing that industrial demand is
vanishing. But again, it is also possible that the rush into gold, a regular
feature of depressions, will spill over as a rush into silver. Whatever
happens, the silver basis will provide a reliable early warning sign. The
return of contango in silver is an indication that bullion banks are dumping
silver. Continued backwardation is an indication that investors and bullion
banks are still accumulating silver. Investors and traders would do well to
learn all they can about the silver basis to be able to interpret events
correctly as they unfold, even if they never intend to trade the silver
basis.
The
inordinate size of the short commitment of traders indicate that bullion
banks actively trade the silver basis. Among their customers are wealthy
investors and, possibly, governments or government agencies. C.F.T.C.
investigators insist that there is no market manipulation in silver. I am
willing to take their word at face value. Basis trading is not a market
manipulation, even if done on a large scale. It is dynamic hedging, and
hedging is just what the futures markets are for. While futures trading would
not work without an adequate speculative following, it is not primarily for the benefit of the
speculators. It is for the benefit of the hedgers. Speculators are supposed
to know this and they should stop crying „foul play!”
What is seen and what is not
seen
Those who hold that there is market manipulation are
victims of an optical illusion. What appears as an oversize naked short
position involving no more than eight trading houses or bullion banks, is
just the visible side of basis trading in silver. But there is another,
invisible side as well. The invisible side is hedged metal in private hoards,
in the reserves of bullion banks and, possibly, in secret government
depositories.
It
is well-known, for example, that the Chinese government controls large stores
of silver, remnants of the long-lasting silver standard in China. A lot of
the silver that governments and private individuals dumped in the West after
the 1873 demonetization found its way to the East, where the Chinese Mint was
still open to silver. At that time China offered the only unlimited market
for silver. There is some controversy about the question whether silver was
flowing into or out of China between 1934 and 1949. Be that as it may, after
the overthrow of the Nationalist government the Chinese Communists inherited
untold amounts of silver. If there was an outflow of silver from China before
the Communist takeover, it certainly stopped after 1949.
Chinese hedges are no Texas
hedges
It is a plausible assumption that the wily Chinese
presently trade the silver basis under a seal of secrecy. Some of the
world’s largest banks are in China, and they definitely have bullion
trading desks. Unlike their opposite numbers in Japan and the West the
Chinese banks are not brain-dead. While they also have a large portfolio of
dollar-denominated assets, they are probably fully hedged by their holdings
of silver and gold. The Chinese banks don’t have to carry the ideological
baggage of anti-gold mentality, so prevalent in the United States. Their
financial condition is incomparably superior to that of banks in the dollar
orbit.
In
order to understand the silver saga it is important that we put ourselves
into the Chinese mindset. For the Chinese silver is money, and the US dollar
is a dishonored promise. They see no reason to exchange their silver for
paper, of which they already have more than their fill. Their perspective on
the market is entirely different from that of silver investors in the West.
Their participation in the silver market is motivated by their desire to earn
a return on their holding of silver in
silver. A price explosion would frustrate their strategy. They
don’t want a supply shock in silver. On occasion they have to pacify
the restless silver market through selling, with the idea of buying the
material back, preferably at a better price. This is not naked short selling;
this is dynamic hedging. No crusade of the „insanely bullish” can
reclassify it as market manipulation.
The
difference between the Chinese banks and their Japanese and Western
counterparts is that the Chinese hedge paper
with metal, while the Japanese and
their American mentors hedge paper with
paper. Theirs are Texas hedges (with reference to the anecdotal rancher
who hedges his herd with long live
cattle futures contracts).
Silver basis and the banking
crisis
The present banking crisis necessitating unprecedented
bailouts of multinational banks is not unrelated to silver basis trading. By
now it is clear that the cause of the
crisis is the banks’ inordinate portfolio of assets concentrated in
debt denominated in the irredeemable dollar, unhedged by gold and silver.
By contrast the Chinese banks, which also have large dollar assets, are
hedged in metal. The Chinese banks are in no need of a bailout. So much for
diagnosis. The prognosis: more bank failures in the West and in Japan;
further relative strengthening of banks in China.
It
is unreasonable to expect that exchange officials and C.F.T.C. investigators
disclose the hedging activities of bullion banks, Chinese or otherwise. I
repeat, trading the silver basis is not
market manipulation. The high concentration of short positions is due to the
fact that governments and wealthy individuals wanting to earn a return on
their silver holdings prefer to take their business to a select few trading
houses and bullion banks with the necessary expertise and capital to trade
the silver basis on a large scale. This offers them the best chance to
preserve anonymity. The sluggishness of silver deliveries is explained by the
long lines of communication. It takes time to get the silver from the East
for delivery in the West. One should not read imaginary shortages into this.
Presently silver is not in short supply. If it were, silver could not drop in
price as much as $5 an ounce or 25 percent in a matter of days, and continue
trading at the lower end of the range. Paradoxically, sluggishness of
deliveries is the very proof that there is no corner in the offing ―
not yet. If there were, the metal would move from East to West in supersonic
aircrafts.
The best little warehouse in
Comex
I strongly disagree with the tactics of Comex in
putting a limit on long positions in silver and on silver deliveries, which
looks like an admission that there is a shortage. Silver in approved
warehouses is there to be delivered on demand. Let the chips fall where they
may, and let’s see what the market will do if the last bar of silver is
removed from the warehouses. Limit on deliveries does not prove shortage; it
only proves that the exchange is inefficient and does not favor transparency.
In limiting delivery it undermines its own usefulness. The exchange should
oblige hedgers to keep sufficient silver in the warehouses ready for delivery
at all times, in return for protection of their privacy. Failure to comply
should be penalized with margin call on short hedge positions, possibly
higher than the value of the underlying contract. This would enhance the
credibility of the exchange more than anything else. As it is, the best
little warehouse in Comex is for window-dressing only. For serious business,
such as you know what, you had better go to another warehouse.
Bleeding to death in the bull
ring
It is not in the interest of wealthy individuals,
bullion banks, and governments with large stockpiles of silver that the price
go to $100 overnight, which could happen if secrecy were breached and
anonymity blown away. As they can derive an income from their silver holdings
already, these owners of silver prefer a controlled rise in the price. And
that’s exactly what we’ve got.
Failure
to understand this may lead one to all kinds of superstitious beliefs
concerning the power of the bullion banks to manipulate the price of silver.
The panicky short covering predicted when silver was trading below $5 never
materialized during the run to $20 and higher. There has been and will be a
lot of short covering, but nothing what could be called a short squeeze. Not
until the curtain falls on the Last Contango in Washington.
As
a quick back-of-the-envelope calculation shows, if the naked silver bogeyman
were real, he would have by now lost an arm and a leg after losing his shirt.
He would have bled to death in the bullfight. Let’s be generous and
admit that he does have, at the very least, well, a loin-cloth to wear in
confronting the charging bull.
References
By the same author:
It’s Not a Dollar
Crisis: It’s a Gold Crisis, June 5, 2008
The Saga of the Naked Bogeyman, November 2007
Exploding the Myth of the
Silver Shortage, September, 2007
The Last Contango in
Washington, June, 2006
The Rise and Fall of the Gold
Basis, June, 2006
Monetary versus Non-Monetary Commodities, May, 2006
Ultracrepidarian Musings, May, 2006
Bull in Bear’s Skin? May, 2006
What Gold and Silver Analysts
Overlook, May 1, 2004
These and other papers of the author can be accessed on the website
www.professorfekete.com
GOLD STANDARD
UNIVERSITY LIVE
Session Three has just
concluded in Dallas, Texas. The subject of the 13-lecture
course was Adam Smith's Real Bills Doctrine and Its Relevance Today.
(Monetary Economics 102). The titles of the follow-up conferences were: 1. The
Economics of Gold Mining and 2. Gold Profits in Troubled Times:
Putting the Basis to Good Use. Course material will soon be available in
print and in DVD format to all interested parties.
Session Four is planned to
take place in Szombathely, Hungary (at the Martineum Academy where the first two sessions
were held). The subject of the 13-lecture course is The Bond Market and
the Market Process Determining the Rate of Interest (Monetary Economics
201). Tentative date: June 27-30. For more information please contact GSUL@t-online.hu.
Further announcements will be made at the website www.professorfekete.com.
Antal E. Fekete
Professor,
Intermountain Institute of Science and Applied Mathematics, Missoula, MT 59806, U.S.A.
Gold Standard University
aefekete@hotmail.com
Professor Antal E. Fekete
was born and educated in Hungary.
He immigrated to Canada
in 1956. In
addition to teaching in Canada,
he worked in the Washington
DC office of Congressman W. E. Dannemeyer for five years on monetary and fiscal reform
till 1990. He taught as visiting professor of economics at the Francisco Marroquin University
in Guatemala City
in 1996. Since 2001 he has been consulting professor at Sapientia University,
Cluj-Napoca, Romania. In 1996 Professor Fekete won the first prize in the International Currency
Essay contest sponsored by Bank Lips Ltd. of Switzerland. He also runs the Gold Standard University.
DISCLAIMER AND CONFLICTS
DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY.
THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING
THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL
ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND
SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT
IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS
TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A
STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT,
IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.
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