On Friday, I published an
article: The
Arbitrageur: Silver Backwardation. I was the only one to cover the news
of the end of silver backwardation. And I gave my prediction that the price
of silver could correct sharply.
This piece presents my
analysis and theory of what happened. This will necessarily include some
educated guesses, as the big financial firms don't have a hotline by which
they share their problems and plans with me.
Let's start with what we know.
The silver cobasis began rising in August 2010, with the December 2010
cobasis becoming positive (i.e. backwardation) by November 11. Backwardation
in near-dated futures then became a regular feature. March 2011 silver became
backwardated on Jan 19, 2011 and May and December silver contracts went into
backwardation on February 17, 2011.
By the beginning of March,
something changed. May and December went out of backwardation, and silver
cobases began to fall. As we know, by then silver was in a mini-mania. Its
price went parabolic for a while and there was no stopping it, even though
the structural dynamics which had originally driven it to rise were no longer
present. A few short months afterwards, the silver price fell 27% in one week
in April.
By August, backwardation
existed only in 2013 and beyond. By November, one could see backwardation
only in 2014+. By this winter (2012), it existed only in 2015. And on
Thursday, Feb 16, backwardation was extinguished entirely.
I've written several times
about the problem of backwardation in the monetary metals. When it becomes
permanent, it will be a sign of a collapse in trust. But I think this episode
with silver is something else, and not just because silver has completely
left backwardation. Gold during this entire time has not been backwardated
(except for the brief flickers as each contract heads into expiration, which
is now part of the "new normal").
My hypothesis is that there
was a big duration mismatch problem in silver lending. Let's take a look at
how a hypothetical bank might operate in the silver market today. Contrary to
popular supposition, I do not believe that they are engaging in naked
shorting of the monetary metals in this historic period of debasement of our
paper currencies. I've written about this before (http://keithweiner.posterous.com/debunking-gold-manipulation).
What they are doing is
arbitrage. They can buy physical and sell a future to make a spread (i.e. the
basis). In the meantime, they can earn a little more by lending the metal.
The party who leased it, of course, sells it to raise cash and buys a future
to ensure that they have the metal so they can repay their loan without
exposing themselves to the price of silver. The borrower knows all costs in
advance. They must pay an interest rate on the silver, plus pay the cost of carry.
To the borrower, the cost of carry is as follows.
Borrower's cost of carry =
Future(ask) - Spot(bid)
There are all sorts of
potential borrowers, in different states of liquidity and solvency. For some
borrowers this may be a good deal, better than what they could get in other
funding markets.
Now, enter duration mismatch.
The lender could be lending
for a longer period than the future he sold. Or the borrower could be
borrowing for a shorter term than the assets he is funding. Let's look at
both cases.
If the arbitrager buys
physical, sells a future to expire in 6 months, and lends the silver for a
year, this is duration mismatch. He may do this on the presumption that only
X% of silver futures buyers will stand for delivery. But if X%+ 0.1% stand
for delivery, he's in trouble. He would have a choice:
1.
He could buy
physical silver in the open market in order to deliver it to the buyer of the
future. This would lift the offer in spot silver, and help create
backwardation. If he does this, he may as well sell another future to match
the duration of the silver lease, which would press the bid on another
future, also helping create backwardation.
2.
Second, instead of
buying physical silver, he could "roll" the future. This would
involve buying the expiring contract and selling a farther-out contract. This
would lift the offer in the expiring contract, causing the basis to fall (but
not having much impact on the bid, as liquidity is drying up and the market
makers are abandoning the expiring contract). And it would press the bid on
the farther-out contract, thus helping push it into backwardation.
But what if, instead, the
borrower was mismatched? The motivation for the lender is simple greed, a
desire for incrementally more profits than he could get legitimately.
Especially nowadays, and especially when the upside is small, I think greed
is tempered by a healthy fear of getting caught. But what is the motivation
for a borrower to mismatch? He may be trying to avoid insolvency! He may feel
he has no choice but to take this risk, or else be forced to close his
business. I think borrower duration mismatch is the more likely today.
Let's look at this scenario.
The borrower borrows silver for a 6-month term, sells the silver, and at the
same time buys a future which expires in 6 months. So far, so good. Six
months later, the borrower is in no better a position than he was before. He
still can't fund his assets, perhaps because they are Greek government bonds
which the regulators say he can hold at par but which the markets say
something rather less polite. He needs the money.
In this situation, the
borrower tells the lender "I can't return the silver right now. I am
willing to pay the penalty but I must roll the loan." Then the borrower
rolls his future, selling the expiring contract on the bid and buying a
farther-out contract at the offer. This would tend to push the expiring
contract into backwardation, and help keep the farther-out contracts out of
backwardation (ceteris paribum). We do see expiring contracts go into backwardation.
There is one other angle I
want to look at. The cobasis, especially for long-dated futures, sat at a
nearly constant level for long periods of time. Unlike the nearer months, it
does not move around as the market starts with little liquidity Sunday
afternoon (Pacific time, USA) and has maximum liquidity at the time of the
London PM fix. For months, it sat at +0.25% (annualized). Now it sits at just
a hair under 0.
The marginal offerer of the
future was willing to sell a contract for 0.25% less than he could sell
physical (cobasis = Spot(bid) - Future(offer)). Why? I think it helps to look
at it as the price he was willing to pay to fix a problem.
What kind of problem could be
fixed by selling a future cheaper than one can buy physical? To understand
this, look at it inversely. Who has sold physical and bought a future? Our
friend, the borrower, did that!
Abruptly, backwardation ended
on Thursday. Recall that this was a day when the paper currency spigot was
turned on full blast. How could paper printing affect the spreads in precious
metals?
My hypothesis is that
borrowers of silver who were stuck having to perpetually roll their silver
leases were given a more attractive source of financing.
Perhaps it is the ECB who is
widely believed to be expanding the list of assets (or should I say
"assets"), which they will accept as collateral in exchange for
dirt-cheap funding. But whoever the new sugar-daddy lender may be, I posit
that this took the pressure off the silver market by allowing the borrowers
to unwind their silver lease and futures positions and go straight to the
source of paper funding.
Granted, this is based on a
lot of conjecture. But I think it's fair to say that it's educated
conjecture. And it fits all facts known (to this author as of Feb 19, 2012).
