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NOTE: I’ve been having some problems accessing the
SILVERAXIS blog but hopefully it should be working now and comments should be
enabled on this latest post. I’ll be providing some market observations
shortly as well. This post was made available to Metal Augmentor subscribers
on July 16, 2009 at 6:47 p.m. EDT.
Adrian Douglas, a Director of GATA, wrote a piece recently called The
Alchemist in which he pointed out
that the “Exchange of Futures for Physical” (”EFP”)
mechanism of the gold commodity market allows ETF shares such as IAU and GLD
in the definition of “Physical Products”. While this is true, we
shall see by the end of my rebuttal that it is also irrelevant to the
physical gold market. Furthermore, Mr. Douglas alleges that the regulators
are rigging the market in favor of the manipulative shorts since ETFs are
“paper” and not the same as physical gold — indeed ETFs may
not hold any bullion at all! Alas, I’ve addressed the “empty
ETF” issue many times before so I will not spend much more time on it,
but I will demonstrate in detail why it doesn’t really matter if ETFs
are really “paper” or “Physical Product” when it
comes to EFP transactions. In fact, it doesn’t really matter to market
participants what is exchanged on the physical side of an EFP, be it even
toilet paper, as long as EFPs remain only a minor component of overall
trading volume on the exchange.
Unfortunately, Mr. Douglas has done a disservice to the gold
community by not explaining how the EFP works and thus I shall try to correct
this first. Doing so, however, will take a bit of effort and so I have
dedicated the first part of this rebuttal to providing an overview of the EFP
transaction. The second part will consist of looking at Mr. Douglas’
allegations and refuting them point-by-point.
Every Exchange
of Futures for Physical (or Product) involves two parties that
wish to swap Futures and Physical positions at the same time. In all cases,
one party already has Physical exposure to a Product that it wishes to sell
and/or to convert to a price exposure via Futures. The reasons for this are
myriad and I’ll have specific examples in a moment, but first it is
important to note that the two parties in an EFP transaction will always
first come to a private
agreement off-exchange (also called ex-pit) on the number
of positions, timing, price, and form of the Product being exchanged. The
parties may use a reference price for the EFP transaction that is based on
Futures trading on the commodity exchange or they may use whatever reference
price they wish, as long as both agree. Once an agreement is reached, the
parties’ brokers are informed of the number and price of the Futures
positions being exchanged as part of the EFP and this information is then
transmitted to the exchange. Importantly, price data is NOT
transmitted as a trade, only quantity, and therefore EFP transactions are not
part of the futures market pricing mechanism.
The following illustrates how an EFP in COMEX gold basically
works. There are other ways to do an EFP, including ways to close out Futures
positions, but they are all variations of this basic transaction.
 
You’ll note in the above graphic that the Futures
position isn’t simply moved over from Trader B to Trader A, but rather
there is actually 10 new long Futures entered into the account of Trader A
and 10 new short Futures entered into the account of Trader B. Since Trader B
is already long 10 Futures, the 10 new short Futures are essentially an
offset. The net effect of the EFP transaction is to move the Physical gold
from Trader A to Trader B and the 10 long gold Futures from Trader B to
Trader A. That is essentially why it is called an exchange.
But, why use an EFP in the first place? Well, it turns out
there are several reasons why two parties would wish to engage in an EFP
instead of separate transactions involving a purchase or sale of Physical
Product and the purchase or sale of Futures contracts. The key consideration,
however, is usually transaction efficiency. Without an EFP, the sale or
purchase of Physical Product and the separate entry of a Futures order may
result in “price slippage” due to market volatility or
fluctuating trading volume in the spot and/or Futures markets. EFP
transactions are often for hundreds if not thousands of contracts and
typically there is not sufficient depth in the bids and asks to fill such a
large order at the same price.
The risk of adverse price movements can be substantial, and
given that commodity transactions often seek to take advantage of profits of
1% or less, price certainty before a transaction commences is crucial.
An EFP can avoid price slippage since it may be transacted outside the
regular trading session. More importantly, the EFP “price” itself
is quoted in terms of “basis”, being the difference between the
Futures price and the spot price for the Physical Product. In effect, you
know what you are getting with an EFP transaction ahead of placing the order.
Another way to think about it is that an EFP is essentially a spread order
but instead of the legs consisting of two different Futures, one leg is a
Futures and the other leg is a transaction for Physical Product in the cash
market.
Perhaps the best way to answer the “why” question
is to provide an example of a possible EFP transaction in the gold market.
We’ll refer to the above illustration but replace the abstraction with
a situation that could actually occur in the real world. Indeed, this
particular type of transaction does apparently occur in crude oil trading,
which is the only description of an EFP transaction from a credible source
that I was able to find online. Most of the following example has been
adapted directly from the document Exchange Futures for Physical (EFPs) for ICE
WTI Crude Futures. This document has
additional EFP nuances that I will not mention here and so the serious
student of the commodity markets may want to study it as well.
Trader A: The trading arm of
a metal refining company, which has just finished a production run of 1,000
ounces of COMEX-approved gold bars refined from concentrates that were
purchased from mining companies. Note that Trader A is long 1,000 ounces of
gold once the concentrates have been refined to bullion. [I could complicate
this example by having Trader A hedge the long Physical position, but let's
not go there in this simple example.] Let’s just say that Trader A naturally
wishes to sell the recently-refined 1,000 ounces of gold since he is in the
refining business, not the gold hoarding business. Trader A has a policy,
however, of selling in installments throughout the year with the majority of
gold sales being made in months with favorable seasonals for gold prices.
July and August are not favorable seasonally but September and October are.
Moreover, Trader A wishes to receive the proceeds from selling the 1,000
ounces of gold soon so that he can finance the purchase of additional
concentrates from mining companies.
Trader B: A gold fabricator
needs 1,000 ounces of gold by late September in order to manufacture 50,000
linear feet of 18K gold chain to supply her jewelry manufacturing clients in
time for the holidays. Trader B, like Trader A, expects the price of gold to
rise between now and the end of September, and she therefore wishes to
“lock in” the gold price. She has provisionally done so by going
long 10 contracts of October 2009 COMEX gold Futures, but she will not be
able to use such Futures contracts for her supply of Physical gold since it
would be too late to take delivery on the October 2009 Futures. Trader B
would like to have the gold available sooner than later so that there is no
need to scramble for supply at the last moment. Late July would be an ideal
timeframe to switch from long gold Futures to long Physical gold.
Note that both participants are long in a market where they
expect the price to rise. Trader A, however, has not secured a buyer for his
gold whereas Trader B wants to be able to secure supply of the quality and
delivery timing she needs.
It turns out that Trader A and Trader B have done business
together before. And so they agree to exchange their respective positions in
order to meet their respective needs — the seller (Trader A) wants to
remain long the market as he thinks the price is going up. The buyer (Trader
B) wants to secure a price and the quality and delivery timing she needs.
So how exactly does the Exchange of Futures for Physical work?
Sometime in late July of 2009, Trader A agrees to sell to Trader B 1,000
ounces of gold for cash at the London afternoon fixing price for that
day’s trading (let’s say it is $940/ounce). By agreement between
the parties, the 1,000 ounces of gold will be delivered to Trader B within 3
days and Trader A will be paid $940,000. Concurrently, Trader B agrees to
sell to Trader A ten (1o) October 2009 COMEX gold Futures contracts at the
settlement price for that day’s trading*. Once an agreement has been reached,
the two parties inform their respective brokers of the terms of the EFP. The
brokers then contact each other and register with the Exchange that the EFP
has been agreed and the price. After the EFP transaction is registered with
the exchange and cleared, Trader B is able to use her freed-up margin equity
as well as accumulated Futures profits from her account as partial payment
for the Physical gold.
* The 10 Futures contracts aren’t exactly being
transferred from Trader B to Trader A. Rather, what is happening is that
Trader A is credited 10 new long Futures contracts against 10 new short
Futures contracts for Trader B. The Futures contracts in Trader B’s
account are then offset so that she ends up with a neutral position. The net
effect is that Trader B’s long Futures position is exchanged for
Physical Product consisting of gold bullion.
Because both participants believe the gold price is going to
increase, the EFP has suited both their needs, enabling security of supply
for Trader B without commitment to a price on behalf of Trader A.
Before we go on, it is important to reiterate that typically
the biggest benefit to EFP participants is that the transaction is able to
bypass the exchange or more specifically the trading pit (or its electronic
equivalent). Being able to make large trades at a certain price, especially
outside of regular market hours, can be advantageous for market makers,
hedgers, price scalpers and scalliwags of various stripes. EFPs therefore
encourage the use of Futures by parties that would otherwise not consider
them and probably for that reason many exchanges allow them. At the same
time, however, EFPs also deprive the market of trading volume. It is
primarily for this latter reason that regulators have placed rules and limits
on how EFP trades can be made.
Still, the advantages of EFP transactions can be such that
historically many trades were not “bona fide”, meaning there was
no physical leg to the transaction at all. No doubt a certain percentage of
EFP transactions in every market, including COMEX gold, are nothing more than
a sham seeking to take advantage of ex-pit
transfers of positions between two parties, which would not be otherwise
possible save for EFPs.
If Mr. Douglas is worried about the use of ETFs in Exchange of
Futures for Physical transactions, I wonder how he would feel if he found out
that many EFPs are backed by nothing at all, not even paper? Fortunately, the
main damage that results from such transactions is that the exchange is
deprived of minor amounts of trading volume. Yet if left unchecked, the price
discovery process could eventually be impacted by runaway sham EFP trading.
The ultimate progression of this would be a subversion of the exchange as
various entities would set up their own “trading circles” and
report their trades as EFPs.
Now that many of you hopefully have a rudimentary
understanding of how EFPs work and why they are used (and abused),
let’s now examine why somebody would wish to exchange ETF shares for
Futures. In terms of how such a transaction would look, we can actually just
substitute ETF shares for the 1,000 ounces of gold in the above graphic. But
let’s consider a slightly different format to explain a new scenario
using our Trader A and Trader B.
Trader A: Arbitrage trader
who buys the ETF when the shares are trading at par or discount and sells
when the shares are trading at premium. Those familiar with Metal
Augmentor’s ETF Basis charts will know that fluctuations between
discount, par and premium do exist. Since Trader A is an arbitrageur, he
hedges the accumulated long ETF position in GLD using short gold Futures.
Trader B: Authorized
Participant of the ETF who officially accumulates or distributes shares based
on premium or discount to spot prices. The Authorized Participant can deliver
Physical metal to the ETF in order to create new shares, or remove Physical
metal from the ETF after redeeming existing shares.
In effect, Trader A is a subcontractor of Trader B,
accumulating ETF shares until there is a sufficient quantity for Trader B to
bother with. An additional incentive for Trader A other than getting a cut of
the total arbitrage profits is that Trader B may actually fund a portion of
the cash to buy the ETF shares. In other words, a portion of the $920,000
cash shown in the illustration above may have been advanced by Trader B to
Trader A in the form of a low-interest loan so that Trader A will have the
funds to start accumulating ETF shares.
The above examples are two of literally dozens that can be
used to transact EFPs on a bona fide basis. My examples actually have a valid
business purpose but it is entirely possible and permissible to also use EFPs
for purely speculative purposes. All the exchange cares about is that the
physical component of the transaction is real and not a sham and of course
also that position limits and other exchange rules are not circumvented by
the EFP.
Based on the foregoing, it should be easy to see how Adrian
Douglas’ concerns about the EFP mechanism are misplaced if not entirely
unfounded. Nevertheless, I will address his points in Part Two of this
rebuttal, to be available in a few days.
Tom Szabo
Silveraxis.com
Also
by Tom
Szabo
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