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This is a partial reprise of a post from
two years ago. The question has again arisen about the discrepancy between
the spot price of gold and silver, and the prices shown on the front month of
the futures market.
When you ask even an experienced trader, or even an economist who may have
received a Nobel prize, 'What is the spot price, where does it come from, who
sets it?' you will often hear that this is the last physical trade, or the
current market price of physical bullion for delivery.
Here is a fairly typical explanation one might get from an 'industry expert.'
"That is why the New York Spot
Price is different from the London Gold Fix price. The spot price changes on a regular basis, just as stock prices do, and reflects
the bid and ask prices quoted by wholesale dealers for spot delivery."
Well, does it?
Actually despite what you might think or what you might have heard, it does
not.
There is no centralized and efficient national market in the US for the sale
of physical bullion at anything resembling a 'spot price.' What is their
telephone number, where are their prices and trades of actual transactions
posted? Who collects and is privy to that knowledge, and how are they
regulated? Who is buying and selling TODAY, with real delivery of bullion as
the primary objective?
There are a few large wholesale markets for physical bullion in the world,
where real buying and selling can occur, with delivery given and taken. The
most famous is the London Bullion Market Association, which is a dealer
association, an over the counter market where the price is set twice a day
and called the 'London fix,' but each counterparty
stands on their own with no central clearing authority.
As an aside, there are credible claims and factual evidence that the LBMA has
slipped into a paper market with multiple claims on the same unallocated
bullion with daily trade volume in multiples of available supply, a fractional reserve bullion banking as it were. Some say
the leverage is 100:1.
The reason that physical trading in bullion became so highly concentrated in
London was best explained to me by a large bullion dealer. "This
situation exists because of the gold confiscation in the US in 1933. When
that happened, physical metal trading in the US came to a complete stop. When
gold ownership was again made legal on December 31, 1974, the physical metal
trading had become so developed outside of the US that it stayed there and
never really returned."
But once the London Fix is over, and the trading day moves with the sun, the
New York markets open and become the dominant price setting mechanism. Where
and how is that price obtained? Where is the price discovery?
I will not delve into it here, but there is credible evidence that shows that
the price changes for gold in the NY trading window are heavily skewed to
price decreases as compared to the other periods of the day, beyond any
reasonable statistical expectation. It is so obvious as to be almost
notorious amongst seasoned traders. That alone should raise alarms with the
regulators. No honest market has such obvious anomalies unless there is
something terribly wrong in its structure.
The bullion market in the US is highly fragmented among many dealers who do
not set the prices amongst themselves as in London. Yes they have their
'wholesale' sources, but even those sources are more fragmented than one
might imagine.
The fact of the matter is that the spot price of gold and silver is nothing
more than a type of Net Present Value (NPV) calculation based on the
futures price in the nearest active month, or the front month.
I have not been able to obtain the specific formula used by any of the
principle quote providers such as Kitco for example.
And I am not saying that they are doing anything wrong at all. Or right for
that matter.
The spot price is calculated from the futures in much the same way that the
'Fair Value' price is derived for a stock index like the SP from the futures
trade, which is essentially an NPV calculation.
FORMULA FOR DETERMINING FAIR VALUE
F = S [1+(i-d)t/360]
Where F = Fair Value futures price
S = spot index price
i = interest rate (expressed as a money market
yield)
d = dividend rate (expressed as a money market yield)
t = number of days from the current spot value date to the value date of the
futures contract.
So like most net present value calculations we would have some 'cost of
money' figure used to discount the time decay from the strike time of the
contract to the present. There is no dividend with gold, but there is a
forwards rate and a least rate, and a proper calculation should include some
allowance for this opportunity cost.
Given that the 'cost of money' or short term interest is roughly zero, the time
premium of the futures over spot is likely to be negligible. But since the
methods of calucating spot are not public, I cannot
speak to this now.
What is important to remember is that the spot price follows the futures
front month by some calcuation. And rather than a
physical market setting the price in fact almost all retail transactions
for physical bullion in the US key off a 'spot price' that is derived from a
paper market which is not based in the currently available physical supply.
Further, the futures exchanges explicitly allow for the settlement in cash if
physical bullion is not available. In fact, the vast majority of transactions
are settled in cash, and are little more than derivatives bets,
and trading hedges related to other things like another commodity or interest
rates.
I am not saying that anyone is doing anything wrong or illegal. I am saying
the system is inefficient in that it suffers from the lack of a robust
physical market to 'keep it honest.'
It does seem a bit ironic by the way, that the most popular provider of spot
price information for gold and silver is currently operating under charges of
fraud in a scheme involving a conspiracy to defraud their government in
Canada. And yet the consumer must take their price quotes on faith, since
there is no apparent disclosure of how their price quotes are obtained.
Perhaps their case has been resolved, and I am not aware of it. But the irony
remains.
The spot price of gold and silver is therefore subject to manipulation. So it
is incumbent on the regulators like the CFTC to be mindful of any price
fixing activity in the metals futures, particularly in the 'front month'
which directly influences the going rate for many if not most of the retail
bullion transactions in the States.
I am surprised that some smart entrepreneur has not consolidated the buying
and selling of physical bullion on demand into a highly transparent and
efficient market which is the real price setter, rather than the commodities
exchanges in which arbitrage can be easily crushed by the very rules of the
exchange that allow for virtually unlimited position size, extreme leverage,
cash settlement as an easy alternative to shortage, 'naked shorting,'
unaudited and unallocated stores of supply, and above all, the veil of
secrecy.
We even recently saw the scandal where a large Wall Street broker was selling
bullion and even charging the customer annual storage fees without ever
having purchased the bullion for them in the first place. Not to mention a
situation in which a large futures broker was able to steal the gold and
silver on deposit from their customers with little recourse and limited
remedy against one of the bullion banks who may have received the goods as it
were.
Since the futures market sets the national price for retail transactions that
have nothing to do with the futures market per se, there a significant need
for tighter reins on short term speculation including position limits,
accountability for deliverable supply, and limits on leverage and speculation.
The metals markets are thin and small compared to the forex
and financial asset markets, and therefore the most vulnerable.
The futures market will be efficient and honest the more it takes on the
rigors of the physical market.
What about the usual argument that the self-regulating proponents trot out
that if the metals pricing is inefficient, it will create artificial
shortages, and physical buying will break that scheme down over time?
Participants in the futures are not able to seriously address a significant
market mispricing because the prices set in the paper markets are not
conducive to efficient arbitrage of inefficiencies. The rules of the exchange
sets limits on the delivery of physical bullion, favoring cash settlement and
the positions of insiders and those who make markets in paper shorts that may
be in multiples of physical supply. The CFTC has shown a remarkable inability
and some might say unwillingness to address this in the silver market for
example, which is a scandal.
Not even a motivated buyer with deep enough pockets would take on this market
openly because all they would do is buy against themselves, and drive a
default which would be cash settled by force. More likely they would be
labeled as trying to 'corner' the market and punished severely.
You might ask at this point, why would anyone ever wish to engage themselves
in this market, besides those who must obtain supply for industrial or
cosmetic uses? Few do actually, except to buy physical bullion at the retail
level.
From a purely economic perspective if I were going to set up a mechanism to
allow price fixing and fraud to occur, I could do little better than what
exists in the US today, except perhaps to set up something more like an
opaque and self directing monopoly such as the
Federal Reserve and its Banks have in their ability to create money virtually
out of nothing.
The retail buyers and producers are largely at the mercy of those who control
the paper markets, and these are a relatively few bullion banks and hedge
funds. And this says nothing about the involvement of the central banks in
influencing the price, which they sometimes admit that they do.
Reform is generally slow to come when a powerful status quo benefits from
such a financial arrangement and price fixing such as this. Economic theory
indicates that underinvestment and shortage will result, and if the
artificial pricing is sustained over time, that shortage and systemic
underdevelopment could lead to a severe market break and even a default.
We saw something similar to this when Enron was actively fixing the national
energy markets in the US. What will happen in the metals markets will be at
least an order of magnitude more disruptive.
I think that a default is becoming more likely every day that the regulators
refuse to act in the interests of promoting honest price discovery and
fairness, which is their very reason for being.
And when the bullion banks cry for exchange intervention and government
relief, keep in mind that their problems are the result of no acts of God or
anything other than a protracted abuse of the market and the public for the
personal benefit of a few at the expense of many.
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