Open Lawyer's Letter to Bart Chilton, CFTC Commissioner

Re: Silver futures manipulation & the failure by CFTC staff to adequately investigate.

I am writing to you because you have established a reputation as a man who wants to clean up the futures market.

In a report, dated May 13, 2008, CFTC staff allegedly “investigated” the functioning of the silver futures market. Their conclusion was that it is functioning properly. Unfortunately, the investigation was woefully flawed. Staff failed to inquire into the most basic issues. They didn’t ask for warehouse receipts, didn’t inspect alleged warehouses, didn’t count the bars of silver, and, in fact, didn’t do any accounting at all, with respect to the alleged silver that is supposed to cover derivative dealer futures contracts.

Because the amount of silver futures, allegedly “promised” for delivery far exceeds the entire world’s supply of deliverable silver, looking into this was of critical importance. As a result of the inadequate investigation by CFTC staff, we still don’t know whether there are primary stockpiles of silver covering long futures contracts, and/or what secondary stockpiles cover the puts and calls that are, in turn, alleged to “cover” these base contracts. Instead, staff issued a report that merely speculated that, “maybe”, “somewhere”, there “might” be sufficient silver to satisfy the contracts. The critical question is where? That has not been answered at all.

One cannot legitimately say that a liability is “covered” when one does not know where the commodity to “cover” is located. If dealers know how to find more silver than is known to exist, why can’t CFTC use its existing statutory authority to demand that information? The report is one of the sloppiest pieces of work I have ever seen in all the 24 years I have practiced law. On page 8 of the CFTC report, it states, for example:

“The Commission's guidance on speculative position limits focuses primarily on the spot month because, in our experience, physical delivery futures markets, such as silver, are most susceptible to threats of manipulation during the spot month.”

Yet, if silver futures contracts are being adequately covered, as they must be, according to CFTC regulations, how can a simple demand for physical delivery “manipulate” a market in the spot month? Dealers should be able to easily deliver whatever silver is demanded. The silver should be easily deliverable from adequate stockpiles, required by law.

Let us digress, for a moment, and examine a short history of the futures market, how it should be operating, and how it actually operates. When futures markets were first conceived, Wall Street banks were not the dominant writers of futures contracts, and almost never would be in the short positions. Banks provided cash liquidity, and held a majority of long positions. Market participants who actually produce or hold large quantities of a particular commodity in the ordinary course of business, such as farmers, miners, refiners, wholesalers, etc., held the “short positions.” This allowed them to hedge against a price decrease for their goods. This provided liquidity and business stability for the producers, whose businesses in agriculture and mining were often very risky. Now, however, trading futures contracts has become a game of speculators and banks. The futures system has morphed into a legalized casino, with banks as casino operators, taking directional bets from speculators, which are sometimes other banks. All of them are gambling on the prices of commodities. That is not what the futures market was meant to be.

Commodity Futures Trading Commission (CFTC) regulations are quite clear, although they are not enforced. In theory at least, a dealer is obligated to maintain adequate cover. Unlike the London futures contracts, COMEX contracts put on a pretense to actual delivery upon request. This is part of what causes the spot market to look to the American futures markets, and not the European ones, for so-called “price discovery.” The fiction of delivery creates an illusion that participants are dealing in real silver. But, before we get more deeply into that fact, let me point out that 17 CFR 31.8

"...(a)(1) Each leverage transaction merchant must at all times maintain cover of at least 90 percent of the amount of physical commodities subject to open long leverage contracts entered into with leverage customers, and must at all times also maintain cover of at least 90 percent of the amount of physical commodities subject to open short leverage contracts entered into with leverage customers..."

So, each futures contract should represent real units of real silver. The contracts, in fact, make that promise. The problem is that, in the real world, it doesn’t work that way. The promise is false. CFTC Regulation 1.3(z), 17 CFR 1.3(z) provides that dealers are exempt from position limits. However, it does provide they are exempt from having to cover their contracts. They are granted an “exemption” because they are supposed to be “hedging” existing supplies of silver. Yet, one cannot “hedge” against something that doesn’t exist. It is obviously a lot cheaper for an entity, like a bank, which normally would hold no grains or metals, to avoid the expense of keeping cover stockpiles required by law. But, doing so corrupts the system. That is the problem.

Let us take a moment to examine the facts. The specifications of COMEX silver futures contracts can be found on the NYMEX website[i], and they are crystal clear. In summary, one contract requires eventual delivery of exactly 5,000 troy ounces of silver. One metric ton equals 32,150.746 troy ounces. Total COMEX warehouse stockpiles are 133,755,900 troy ounces, or approximately 4160.27 metric tons of silver. Total reserves held by SLV (iShares silver ETF) are 192,569,101 troy ounces or 5,989.57 metric ton. [ii] According to the prospectus of iShares Silver Trust, however, no metal may be swapped, loaned or otherwise committed to 3rd parties. The other known major source of hoarded silver bullion is in the vaults of dealers, mostly in Europe. They need this metal to meet their own obligations because a lot of them buy and sell the metal physically. All known European dealer silver amounts only to a total of another 300,000,000 troy ounces at most. China and India may have very large hoards of silver, but mostly in the form of jewelry and coins, owned by individuals, who would not willingly pledge or part with it. Americans also have silver necklaces, coins, and silverware sets, but how many have contracts with COMEX dealers to deliver family silver for meltdown, upon demand? How about the government stockpile? Not a chance. All remaining U.S. government silver was turned over to the U.S. Mint for coinage, years ago. It is rationing silver eagle coins.

Let's look at the notional amount of silver futures. This information can be found at the Commodity Futures Trading Commission website.[iii] As of May 13, 2008, COMEX derivatives dealers wrote a total of 122,802 long contracts for future delivery of silver. As of May 20, 2008, these numbers increased to a total of 125,838 long contracts. On May 15, 2007, in contrast, 108,698 contracts were written. There were a number of months, in 2007, during which up to 189,000 contracts were written. All of these contracts are supposed to be 90% covered by stockpiles of physical metal, or derivatives like puts and calls that, in turn, are covered by physical stockpiles. None of these numbers, incidentally, include the options contracts, themselves. If we included the options, they which would exponentially multiple the total notional claim on the world’s silver supply, and, also, the liability for what silver metal must be delivered.

Each COMEX silver contract promises 5,000 troy ounces. So, COMEX derivatives dealers promised to deliver 614,010,000 troy ounces of silver on May 20, 2008. This appears, on the face of things, at least, to be impossible. COMEX stockpiles amount to only 133,755,900 troy ounces. That is enough to cover about 26,600 contracts. To cover the remaining contracts, dealers would have to find unknown warehouses filled with the white metal. If these warehouses exist, why haven’t they been identified by the CFTC? Instead, CFTC states in its report that “unknown” hoards of silver may exist, but doesn’t bother to tell us where. Logic tells us that derivatives dealers could not beg, borrow or steal 90% of their silver delivery promises, because they would have to come up with 552.61 million troy ounces, and that is logically impossible. As previously stated, during certain months in 2007, the number of contracts was 50% higher than now. I probably don’t need to point out that, in such a month, derivatives dealers would require 150% as much silver as we have already discussed in order to fulfill their contractual promises.

Silver is a precious world resource that we are quickly running out of, as a result of price suppression caused by the creation of fake quantities by the COMEX futures market. The 2008 U.S. Geological Survey states that the world's total proven reserve of silver is only 270,000 tons. That means 15.57 years left on earth at current mining rates. The consumption level, of course, is rising fast, so the number of years will end up being much shorter than that. Maximum exploitable silver is only 570,000 tons (32.87 years), and this is only exploitable if the price for base metals, from which the silver is extracted, rises high enough. After mining reserves are exhausted, only recycled and hoarded metal will be left. The Survey further notes that most future silver mine production will be the byproduct of base metal production. Thus, only a vast increase in the price of silver, into hundreds of dollars per ounce, may stimulate production beyond the listed reserves. Absent this, we have just shy of about 16 years worth of minable silver left in the ground. Unlike oil reserves, which continually seem to increase, year by year, the total silver reserves have not materially changed in at least the last 10 years.

Total 2008 mine production is projected to be 557.4 million ounces, up 4.1% or 23.7 million ounces from last year, according to the definitive CPM Group's Silver Yearbook 2008.[iv] Total silver fabrication demand is projected to rise modestly by 2.2% to 740.2 million ounces in 2008.[v] Demand for silver use in jewelry and silverware is projected to rise 4.6% to a total of 273.5 million ounces in 2008.[vi] Silver use for electronics and batteries is forecast to rise to 125.8 million in 2008, up 5.3% from current levels.[vii] Silver used for mirrors, brazing alloys, anti-bacterial medication, solders, biocides, and superconductors and other similar applications is expected to rise around 3% to 167.7 million ounces in 2008.[viii] Investors are forecast to be net buyers of 74.9 million ounces of silver this year.[ix] No significant sales of silver from government inventories are anticipated this year.[x] With nano-silver based catalytic converters for diesel engines on the way, a legally mandated substitution of copper in use for wood preservatives by the EU and the USA to happen within 5 years, silver-zinc batteries (with 40% greater energy storage compared to lithium-ion technology) now being marketed for mass market electronics use, silver based nano-conductive RFID ink production exploding, and a number of other new industrial silver uses on the way, the demand is likely to increase by several thousand metric tons per year, from 2008 onward. The known sources of supply are wholly inadequate to meet this demand.

But, let’s focus on 2008. This year, adding up the numbers, new mining supply will be 557,400,000 troy ounces, or 17,337.08 metric tons. In contrast, demand is 1,382,100,000 troy ounces, or 42,988.12 metric tons. That would mean a deficit of 824,700,000 troy ounces or 25,651.04 metric tons. However, part of this deficit can and will be met by recycled silver. According to the Fortis 2008 Silver Book (which I view as somewhat less accurate than CPM), recycling of used silver form former use in photographic, coin, jewelry and other uses, will amount to 13,558 metric tons. That still leaves a net deficit of -12,093.04 metric tons, in 2008. The Fortis people, based on all their numbers, somehow calculate a surplus in virtually every year since 2000, including 2008. That, of course, is logically impossible, because if there were a surplus, the price would not have gone up by about 4 xs during that time period. So, by using the numbers from CPM, combined with those of Fortis, we probably get a more accurate idea of the true situation. Given the deficit, or at least the fact that there is unlikely to be any surplus, where will COMEX based derivatives dealers get silver to back up their pledges of future delivery?

In short, COMEX futures contracts are little more than fake silver supplies, that allow derivatives dealers to operate a “casino”, and have the net effect of suppressing market prices. Aside from the inherent problem of creating fictitious stockpiles, the risk that these fake supplies are being used to consciously control the price of the real metal is also very real. By writing a few thousand extra contracts, just before maturity, dealers could act in unison to spook investors, at opportune times, quickly bringing down prices, and insuring that the “house” never loses the card game. This is because the spot market looks to the allegedly “physically delivered” New York futures market for price discovery. Beyond that, short run manipulation like this, can have very serious long term effects. At minimum, it can add a large measure of volatility to prices. This can cause conservative investors to shy away from investing in the metal, and that depresses the price in the long term, increases demand, and quickly depletes world supply of a very critical industrial metal. That is exactly what is happening.

Since 90% of the contracts cannot be delivered, CFTC should stop simply looking the other way, and require COMEX dealers to admit that their futures contracts are cash-settled paper instruments. That would go a long way to resolving the problem. The COMEX casino would shrink down to a market size similar to the London Futures Exchange. Now, however, because that has not been done, COMEX dominates the spot price. Because of its huge size, and an illusion of physical delivery, it has persuasive authority. Cash-settled paper, with no pretext about delivery, would have little or no persuasive authority, and that is the way it should be, because, in truth, that is all that the COMEX contracts really are.

Given the hard facts, the probability that COMEX derivatives dealers are in widespread violation is very high. For example, in November 2007, a class action was settled against Morgan Stanley for millions of dollars in damages. The complaint stated that Morgan Stanley, one of the biggest and most respected investment banks in the world, had committed fraud by charging customers for buying silver that it never bothered to buy.[xi] Yet, CFTC staff has completely ignored this issue.

In light of these facts, I hope that you will spearhead a drive by the Commissioners to require staff to reopen this investigation, and complete it in a proper manner. They must inquire into, and obtaining detailed information about the sources of alleged stockpile “cover” for COMEX silver futures contracts.

If you have any questions, concerns or thoughts you would like to discuss, please do not hesitate to call or write.

[i] See, http://www.cftc.gov/files/submissions/rules/approvals/2003/rul20030211.pdf

[ii] See, http://www.ishares.com/product_info/fund/overview/SLV.htm

[iii] See, http://www.cftc.gov/marketreports/commitmentsoftraders/index.htm

[iv] As republished in http://www.mineweb.co.za/mineweb/view/mineweb/en/page32?oid=51978&sn=Detail

[v] Id.

[vi] Id.

[vii] Id.

[viii] Id.

[ix] Id.

[x] Id.

[xi] http://www.reuters.com/article/bankingfinancial-SP/idUSN1225115120070612

Attorney & Counselor at Law