-- Posted 5 September, 2008 | | Discuss This Article - Comments:

A recent posting by Ted Butler analyzing the sudden sale of an additional 27,606 COMEX silver contracts by 2 banks as of August 5^th has created renewed interest in the possibility that COMEX silver is manipulated.  Not surprising, given a $6.00 collapse in silver concomitant with the placing of this short side bet.

Jon Nadler, Senior Analyst for Kitco Bullion recently posted an exhaustive rebuttal of the notion that precious metals market pricing is in anyway manipulated by the actions of large traders.  The full text of Mr. Nadler’s thoughts can be found here: 

http://www.kitco.com/ind/nadler/aug292008B.html

This Kitco posted analysis is a verbatim repeat of a congratulatory email sent to ‘Mish’ Shedlock of Sitka Capital from Nadler, after Shedlock made the remarkable discovery that a futures contract represents a long for every short, and therefore there can be no manipulation, no matter how concentrated a particular futures position may be.  Verbatim, that is, except for the deletion of assertions of retail silver abundance Nadler made in the email version that were apparently too ridiculous to be posted twice, even by Nadler.  Nadler’s email to Shedlock, with the portions included regarding how much retail silver is available and that was deleted from his Kitco posting can be found here: 

(http://globaleconomicanalysis.blogspot.com/2008/08/jon-nadler-senior-analyst-kitco-chimes.html )

...Mr. Nadler inadvertently and unknowingly confirms the mechanism by which these markets can be manipulated through the very process he describes as benign. 

His analysis attempts to refute all thoughts of manipulation with two arguments.  The first is the very model of intellectual sophistication and asserts that if you disagree with him and instead believe that the sale of 165,000,000 ounces of silver (25% of world silver production) on the COMEX by 2 U.S. banks had a depressive effect on the price of silver then you:

a.      Are ignorant

b.      Are stupid

c.      Flunked out of freshman economics

d.      Are on drugs

e.      Are all of the above

Since I have, at various times, met or been accused of all of the above criteria, I will stipulate that there is a possibility that he may be right on this one.  Having said that, and as sophisticated and nuanced an analysis as this represents, I am not sure that this in and of itself disproves silver manipulation, so let’s get on with the second half of his analysis that actually proves the opposite of what he thinks it does.

This second point is that there exist “Banks/Bullion Banks” that are “market makers”, who “passively” buy and sell gold and silver, apparently taking these positions out of a sense of altruistic civic “obligation” in response to other trader’s demands. In his view, the sudden appearance of a short position of 33,000 COMEX silver contracts is simply the result of these civically minded banks hedging on the COMEX an OTC position they purchased from funds “stampeding” out of the silver market.  Therefore, he goes on, the appearance of this short position on the COMEX is nothing unusual, not manipulative, and if you disagree please pick from the list above the characteristic that describes you best.

Nadler here intentionally, or out of a lack of knowledge, attributes to commodity traders the function of a market maker in a stock security.  In stocks, the underwriting banks of a public offering do make a market in the stock, buying where there are no other buyers, and then selling out of any inventory of the stock to new buyers.  However, in commodities, the concept doesn’t apply except in very thinly traded markets.  In fact, the CFTC glossary of terms, notes this about market makers in commodities:

Market Maker:  In the futures industry, this term is sometimes loosely used to refer to a floor trader or local who, in speculating for his own account, provides a market for commercial users of the market. Occasionally a futures exchange will compensate a person with exchange trading privileges to take on the obligations of a market maker to enhance liquidity in a newly listed or lightly traded futures contract. 

In other words, there are no ‘Market Makers’ in gold and silver, except those trading for the speculative benefit of their own accounts, and they are certainly under no obligation to buy a massive amount of anything they don’t think they can make money on.  After all, who does Nadler presume imposes this ‘obligation?’  Nadler is simply wrong when he tries to assign a market makers ‘obligation’ to bank trading activity that is purely speculative.  This is not “passive” trading, but for profit trading, and as long as there is nothing manipulative or illegal about such activity, more power to them.  So now let’s look at the activity Nadler describes, and consider whether it is as benign and passive as he contends.

We’ll assume for a moment that the 33,000 short contracts held by 2 banks were put on as Nadler asserts, and do not represent a government coordinated intervention in the gold and silver market to support the dollar, or a government coordinated bailout of a failing or near defaulting commercial trader, which are both possibilities, if hard to prove.  If Nadler is correct, then what happened is that these 2 banks bought 165,000,000 ounces of silver from panicking funds on the OTC, where all such transactions are private, invisible, essentially unregulated and then turned around and sold 165,000,000 ounces on the COMEX, a completely transparent market where any change in price is instantly and electronically communicated to millions of traders worldwide, regularly tripping buy or sell orders in the process.  So, you have an invisible purchase, and a visible sale of a massive amount of silver.  Based on Shedlock, Nadler and CFTC analysis, this represents a perfectly rational hedge, can’t be manipulative because as we all know, hedging is largely neutral since as Shedlock so insightfully notes, there is a long for every short in the hedge.

However, at this point one begins to wonder if a hedge of this size – 33,000 contracts in silver and 86,000 contracts in gold – that has one leg in a visible market and one leg in an invisible OTC market is quite as benign as Shedlock/Nadler/Szabo/CFTC et al insist it is.  We have been told for years that the fact that the COMEX silver market structure sports a larger commercial net short position than any other significant market is of no manipulative import because it represents a hedged position, long someplace else.  The someplace else, according to Nadler, is the OTC market.  If he is correct on this, then this type of ‘hedge’ is precisely the sort of position needed to manipulate the market while flying below the radar of a somnolent CFTC and some of the more modest intellects in the analytic world.   I think the inherent potential for a COMEX/OTC spread for mischief can be demonstrated by considering the following possible sequence of events, which would be perfectly consistent with Nadler’s views on what happened during the latter part of July and the first two weeks of August, the published data, as well as the trading opportunities open to the banks holding the reported positions:

1.      Hedge funds begin selling silver and gold on the OTC market, and the 2 banks that show up on the Bank Participation Report begin buying.

2.      As the banks buy OTC they sell COMEX, and by August 5^th they are long 165,000,000 ounces of silver on the OTC and short 165,000,000 ounces COMEX. 

3.      The selling on the COMEX of such a massive amount of silver and gold contracts trips stop losses, further depressing the price of silver and gold, ultimately hitting a 40% decline in silver from recent highs.

4.      The banks at this point have a large profit on the short COMEX position and a large loss on the OTC long position.

5.      The banks now begin covering the short position on the COMEX.  Not huge amounts that would cause the price to spike, but enough to have it rise over the next couple of weeks, if not dramatically. 

6.      Since no one is ‘obligating’ them to do so, they don’t bother to sell any of their large under water OTC long position to match the liquidation of their COMEX short position.  After all, with a retail shortage of silver and increasingly gold, long positions would seem to be pretty good bets.

7.      Periodically, the banks throw a few large sell orders out to slow or reverse building rallies.  The thinly traded overnight markets work well for this because it doesn’t take a lot of volume to have an immediate effect on price.  Kind of a 2 steps forward, 1 step back approach.

8.      Over the course of a few weeks, the banks cover some percentage of the COMEX short position, making money.  Based on price action since mid July and the Bank Participation Report cutoff date, the banks would have a minimum basis for their 27,606 new short COMEX silver position of $17.65 and their 79,000 new short COMEX gold position of $925.00. 

9.      Now, let’s assume that over the next week or two, the price goes up a bit and more COMEX short covering occurs.  At some point, and barring another successful whap down of the price on the COMEX, whatever profitable short covering is possible on the COMEX would have occurred.

So, how much profit might the banks have made on this trade so far?  Well, the COT reports from July 15 (peak price) to August 26 give us a clue.  During that period, the gross commercial short position in silver was reduced by 20,000 contracts and in gold by 109,000 short contracts.  Based on the Bank Participation Report dated August 5^th that showed 2 banks holding 25% of total open interest in silver and 3 banks holding 21% of total open interest in gold, I don’t think it unreasonable to assume the banks participated in this short covering proportionally.  If so, as of Friday, August 29, the banks would have realized a minimum of $100,000,000 in silver and $228,000,000 in gold, with a lot of daylight still left between the spot price and their short basis, so the fun isn’t over yet. 

The banks are in a position, whenever they wish, to spike the PM price upwards by the simple mechanism of buying back additional portions of their remaining COMEX short position with the happy result that after having made money on their short leg, their long leg on the OTC becomes profitable.  At some point they stop buying back on the COMEX, but at whatever point they stop, they have made money on a good chunk of the COMEX short, their OTC excess long is also now solidly profitable, and any remaining COMEX/OTC spread isn’t doing them any harm.  And the wonderful thing about this money machine is that it is a RENEWABLE RESOURCE!  As long as you can rely on the CFTC, Jon Nadler et al to keep telling people it’s all ok and there is a nickel left in the pockets of COMEX silver investors you can KEEP DOING IT!  This manipulation does not involve beginning to short silver at $7.00 and hanging on with your teeth through a relentless price increase.  It only involves the ability to put on gargantuan COMEX short positions from the safety of the Commercial category of traders without regulatory interference so that you can reap profits in induced sell-offs both on the short and long side of a hedge in 2 different markets – one that sets the price (COMEX) and one that reflects it (OTC).  And we owe it all to Jon Nadler to explain to us the mechanics of this clever manipulation.

What a wonderful world. 

- C. Loeb

Independent silver investor