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The Silver ETF - Not So Ironic After All?

By: Tom Szabo

-- Posted 23 March, 2006 | |

By: Tom Szabo


In a commentary on March 3, 2006, I argued a number of points about the proposed Barclays iShares Silver ETF, some of which were presented as being ironic or clarifications of widespread misunderstanding. Well, along came the SEC a couple days ago and approved the ETF, agreeing with the AMEX and seeming to render much of my argument as kibosh. The SEC Release approving the rule changes that will allow the silver ETF to trade on the AMEX can be found here. By the way, if you take the time to read these SEC comments, the only logical conclusion at which you will arrive is that the listing of this ETF is a foregone conclusion. The Form S-1 Registration Statement will have to be amended by Barclays and declared effective by the SEC, but these are mere formalities.


Many of the SEC comments came as no great surprise, since the issues I discussed are inherently what the SEC and the AMEX should be concerned about: the equal availability and dissemination of information to market participants and the existence, surveillance and enforcement of regulatory controls to prevent manipulation. In fact, the AMEX had already addressed in a summary fashion how it planned to mitigate many of these concerns in both the application for the rule change and the comment letter from Neal Wolkoff, Chairman and CEO of the AMEX. Still, I was a little surprised that the approval came without a lot more effort.


What was the most (at least to me) surprising, however, was the brief treatment afforded to what has been expressed as the main concern of diverse parties with conflicting interests in the silver market. I am talking about the Silver User's Association (SUA), Ted Butler and the CPM Group; each of whom made comments against the approval of the rule change on the basis of inadequate physical supplies being available to meet expected ETF demand. It has similarly been my contention that the SEC was unlikely to approve the ETF for trading unless there was identification of adequate stockpiles of silver to meet the anticipated demand, initially amounting to 130 million ounces of silver. By "initially", I mean the theoretical maximum amount of silver the ETF could accumulate over time, as its popularity grows, before having to file a follow-on registration statement.


This is an important distinction because some people (not the SUA, Ted Butler or the CPM Group despite Mr. Wolkoff's careless waiving of the stupid stick) still believe the ETF will immediately overwhelm the spot silver market with an opening bid for 130 million ounces of silver. This false belief has led to the conclusion by a few commentators that only Warren Buffett with his 130 million ounce or so hoard can come to the rescue of the silver ETF. I am not at all worried about this bit of fantasy. What does worry me, and this has not been acknowledged by the SEC or AMEX, is that the silver ETF is likely to create continuous, relentless demand for silver in the spot market which will lead to a “dog piling” effect from buyers other than the ETF in a manner similar to what happened in the Hunt episode of 1979-1980 and to a lesser extent when Buffettt made his purchase in 1997-1998.  In effect, the transparent, obvious demand for physical silver by the ETF will allow every market participant to front-run the purchase of its silver baskets.


Front running could create a dangerous demand multiplier that might backfire on the Barclays offering simply because it is an order of magnitude smaller, and therefore easier to influence, than the gold market. I realized this when it was pointed out to me that market makers may be hesitant to create new ETF shares if there is a even a slight chance of a supply squeeze in the spot market. In such a case, there is a risk of being naked short the ETF shares with no way to cover. Given the small arbitrage profit margins that an ETF market maker expects to make, the risk of a large trading loss may be unacceptable. One possible result of this could be that the ETF might cease to function as an efficient silver speculative tool at the exact moment of greatest opportunity for silver investors. But this is just speculation to be borne out by future "facts on the ground".


Wait a second, not so fast, let's examine that last couple of paragraph for a moment . . .


Aha! Here we find a bit of irony after all: market transparency resulting in a possibly bad outcome.


I would like to emphasize that this is not a call to panic or an admonishment against investing in the silver ETF, but nonetheless silver investors should be careful and aware of this surviving silver ETF irony. Shall we see if I can resuscitate any more?


But first, it's about time we get to the part where I eat crow. Boy was I wrong in thinking that the actual physical supply of silver underlying the spot market was important in the ETF approval process! Apparently the AMEX and SEC feel that the daily volume of contracts exchanged on the COMEX and the spot market are sufficient evidence of liquidity, and therefore the availability, of the physical metal.


Is it important to U.S. regulators that the spot silver market is an unregulated over-the-counter (OTC) market and that silver trading information is limited to "daily volume" courtesy of the LBMA? Doesn't appear to be. Neither the SEC nor the AMEX have shared their viewpoint on what quantity of silver might actually underlie this OTC market, the estimated percentage of trading accounted for by leasing and derivatives or the true fabrication offtake component. I would think these are important factors to consider in assessing incremental physical demand that will remove silver from the market and store it in an unavailable fashion on a possibly permanent basis.


Without the additional details, I find it just a little dangerous to agree with the SEC that the LBMA (a large component of the OTC market) reporting a range of "monthly average daily volume figures" for 2004 of "a high of 143.4 million to a low of 75.5.million troy ounces per day" means that the "overall worldwide volume of silver trading" suggests "the significant size of the overall market". Compare this "volume" to end-user industrial demand, which amounts to roughly 850 million ounces per year, along with the most conservative estimates of available silver supplies (generally assumed to be no more than 500 million ounces of silver in "good delivery" bar form), and you can clearly see that the trading volume in Internet stocks at their heyday was a joke compared to current silver "clearing" volumes on the OTC market as measured by published LBMA figures. And we haven't even taken into account the significant decline in LBMA volume since the height of the gold/silver carry trade in the late 1990's.


On the other hand, I should give some credit to the AMEX for stating that with respect to the COMEX (and TOCOM, its Tokyo equivalent) "only a small percentage of the future market turnover ever comes to physical delivery of silver represented by the contracts traded".


In any case, taking this discussion much further would be purely an academic exercise. At this point, we (you, me, the SEC, AMEX, SUA, Ted Butler, CPM Group, etc.) are merely making guesses of varying merit. Meanwhile, we will only find out who was actually right about the silver ETF as the drama unfolds in the months and years ahead.


Unfortunately, the eating of crow is not yet over for me. In no particular order follows some important observations which qualify my previous comments and possibly cast doubt on my (self-anointed) expertise in the matter of silver ETFs.


A Little Ditty About Authorized Participants and Market Makers


I previously referred to the Authorized Participants who redeem and create ETF baskets as "market makers". This is actually a simplification. The Authorized Participants can act as market making arbitrageurs for their own accounts, but they can also carry out a clearing function for the more active and numerous specialists that are registered by the exchange on which the ETF trades, in this case the AMEX. And either the specialists or the Authorized Participants themselves may also have clients on whose behalf trading is being conducted and so each may operate both in a market making capacity for its own account and as introducing brokers for others. As a result, there are unlikely to be such imbalances between buying and selling that mispricing is the norm, requiring constant market intervention. I apologize if my careless prior description implied that.


In fact, the extent to which market making will be responsible for establishing prices in lieu of active buying and selling by investors cannot be known ahead of time, but it is instructive that trading in the gold ETFs have allegedly resulted in little in the way of market making activity, especially the redemption and creation of baskets. This may be partially due to the process of exchanging ETF baskets which involves steps and complications that most trading firms simply do not wish to get involved with on a regular basis. And to the extent that market making activity results in the holding of long ETF positions, there are ways to deal with the unwanted exposure which I will leave to the reader's imagination for now. Suffice it to say that regular buying and selling between ETF investors appears to be responsible for the vast majority of gold ETF trading.


Another matter I would like to clarify is the expected bid/ask spreads on ETF shares and between the ETF and the spot market. For purposes of illustrating how arbitrage opportunity can close the gap, I am guilty of using an exaggerated example implying a possible difference of $1 per ounce between the ETF and the spot silver market. In reality, such an extreme scenario is not likely to take place and would be very short-lived. Most of the time we should see variations in a similar range experienced by the gold ETFs, or perhaps a little more accounting for liquidity and other factors. According to Adam Hamilton, such variance between ETF and spot gold prices on an end-of-day basis have been bound by 2% plus or minus even during periods of high volatility. This translates to 20 cents in the case of $10 silver. If this were to ever balloon to $1, there would be some real trouble in the silver market.


Can You Say Access to Information?


My warning about unequal access to information by the average ETF investor as compared to "market makers" also needs qualification. The SEC and AMEX have gone to great lengths to make sure basic information such as the spot price of silver, the NAV and fractional silver equivalent (to reflect the decreasing amount of silver as trust expenses are paid) of the ETF share will be readily available at all times. In fact, two of the possible reasons for halting the trading of ETF shares involve the unavailability of spot silver prices or the fractional silver equivalent of each share on at least (no more than) a 15 second delayed basis during market hours.


Of course, the flip side of this is the remote possibility that trading might be temporarily halted if such information is not available for whatever reason. Moreover, Murphy's Law guarantees this would happen at the worst possible time for ETF investors. The more adventurous silver bug might even dream up scenarios under which an indefinite trading halt might take place.


But casting doomsday scenarios aside for a moment, there is still a possibility that inexperienced investors will not pay attention to the NAV or fractional silver equivalent and end up paying too much or selling for too little. Nothing worthwhile in life is easy. Caveat emptor.


To Manipulate or Not To Manipulate . . . Is There a Question?


For those readers still with me, a big round of self-congratulation should be in order. The remainder of this piece might be the most esoteric part, but I view it as possibly the most important in light of the rampant conspiracy theories that abound in the precious metal arena. Unfortunately for those expecting me to abandon reason and opt against a close shave administered by Occam's razor, I need to admit that my previous statements about the silver and gold ETFs might have been just a bit fantastic.


And since it is my learned view that only a few conspiracy theories hold up under even the lightest of scrutiny and that massive manipulation, conspiracy or fraud will always be exposed before successful completion, I now find it necessary, lest I succumb to hypocrisy, to further explain the crux of my arguments about the silver ETF. I am talking, of course, about the opportunity for malfeasance.


As many of you know, the U.S. equity markets are actually run by so-called self-regulatory organizations (SROs) such as the NYSE, NASDAQ and AMEX. The SROs maintain listing, regulatory, operating and other rules in order to communicate, monitor and enforce the Exchange Act of 1934 as well as the SRO's own mandates with regard to publicly traded securities.


There are a few primary tools that the AMEX and SEC will ideally use to try to detect and prevent abuses and manipulative practices with respect to the silver ETF. I shall try to explain the major ones without relying on distortional simplification.


The first, AMEX Rule 1203A, prohibits market making activities in the underlying instrument (including spot silver and COMEX futures) by an exchange specialist. Such market making can be still be carried out by an affiliate, however, as long as the specialist has obtained AMEX approval of its procedures meant to restrict the flow of information between the specialist and the affiliate (the proverbial Chinese Wall). While this process in itself has problems, it is important to note that this rule does not prohibit the specialist from concurrent trading in the underlying commodity whether on the spot market or futures exchange.


In this regard, Rule 1203A will not prevent isolated manipulative activities involving the ETF and the underlying market. For that, the AMEX proposes that its "surveillance sharing agreements" with the NYMEX and other regulatory organization will enable it to identify abusive practices, namely any suspect trading on the COMEX, CBOT or OTC market resulting in unusual profits taken in ETF shares and vice versa.


The other important AMEX Rule is 1204A, which is quite powerful as long as exchange members are in full compliance. This rule requires the specialist to provide the AMEX with a list of all accounts, including client accounts, over which it has trading discretion with respect to ETF shares and the commodity markets, including futures accounts used to trade on the COMEX or CBOT. A non-AMEX affiliate which is only a member of a commodity market would again be monitored through "surveillance sharing agreements".


This all sounds pretty good, but we must keep in mind that SRO Rules and the Exchange Act have not prevented the several hundred serious cases of rule violations and fraud in the last few years. It seems like hardly a month goes by without a story popping up in the press about the latest enforcement action involving jail sentences and penalties reaching into the hundreds of millions of dollars.


It turns out that the silver ETF itself is no more inherently subject to manipulation or abusive activities than the other ETFs. But the existence of a relative small underlying market and the modest size of the ETF itself (130 million shares at $10 silver is a $1.3 billion market cap) present opportunities for abuse not readily available with respect to many other ETFs, or at least less available as it may be the case with GLD (currently at $6 billion market cap). My point is simply that it does not take an unlimited amount of capital to abusively influence silver prices, which of course was why a pair of billionaire brothers by the name of Hunt made a run at cornering silver in the 1970's. Where opportunity knocks, enterprising responses often appear, and sometimes the result is bad enterprise.


On balance, however, I find that I probably need to be more realistic. The original case I laid out may have made things seem like the silver ETF would operate in a Wild West of predatory market making that would deprive the average silver investor of a decent chance at a fair fight. In fact, standard (gun fighting) rules do exist as I tried to explain above and I'm sure they will be enthusiastically enforced by the SEC and AMEX when rule breakers are caught. The radical element might argue with the waffle-like quality of this statement especially since the sheriff of the AMEX is none other than Ted Butler arch-enemy Neal Wolkoff, former COO of the NYMEX which Mr. Butler claims is the snake pit of silver manipulation. But other than partially explaining Mr. Butler's own hostility toward the ETF, I personally have dismissed such implications a while back.


On the other hand, I will agree with Mr. Butler on at least one thing: the "Commodity-Based Trust Shares" rules approved last year for the gold ETFs and just approved for the silver ETF, along with the standard rules that apply to all AMEX listings, may not be adequate for the purpose of keeping the law and order and protecting the citizenry of the small financial outpost known as the silver ETF.


And so I triumphantly reassert the ironic nature of this new beast: words such as "free market", "public interest", "capitalism", "transparency" (see above), "efficiency" and "liquidity" that have been thrown around to urge ETF approval by the SEC may in fact be the very concepts that will permit an abusive advantage for the big bully over the little guy. We only hope that Mr. Butler and Mr. Wolkoff can put past differences aside long enough to keep the Trojan horse out of town. And so with this last inept butchering of mixed metaphors, I rest my case against the silver ETF.


As for imminent silver ETF investors, good luck, be ready, be careful and be prosperous! (Heck, I might yet be seduced into your ranks by the utter simplicity of ETF trading)

-- Posted 23 March, 2006 | |

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