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On
Friday, I published an article: http://dailycapitalist.com/2012/02/17/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).
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