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A Bad Joke?

By: Theodore Butler

-- Posted 1 April, 2009 | | Discuss This Article - Comments: Source:

Iím mindful of what day this is, and I assure you this is not about some April Foolís Day joke gone bad. But I do hope you will treat the recent announcement from the CME Group concerning the introduction of two new contracts on COMEX gold and silver as being as funny as a heart attack.

The CME recently announced that it will begin trading of new E-Mini futures contracts on gold and silver on April 19. The new contracts will be cover 33.2 oz (one kilo) of gold and 1000 oz of silver. They will replace the current lightly-traded E-Mini contracts covering 50 oz of gold and 2500 oz of silver.

Curiously, the official news release left out the most significant contract specification of these new trading vehicles; the actual delivery mechanism. I donít know if this was intentional or just an oversight. The good news is that the actual delivery mechanism was explained in subsequent news stories. The bad news is that there is no actual delivery mechanism. These new contracts will be cash, or financially-settled. There will be no real metal delivery option clause for either buyer or seller. On the termination date of each futures contract, all contracts will be closed out at a single price and each contract holder (long or short) will be credited or debited based upon his original purchase or sale price.

Let me be as clear as I can - because these new contracts do not contain actual metal delivery clauses, they are, in my opinion, fraudulent contracts. The CME should be ashamed of itself for introducing them, and the CFTC disgraces itself (again) for not preventing their introduction. I know those are strong words, so letís see if I can back them up.

While there are many examples of successful cash-settled options and futures contracts (S&P and OEX futures and options, for example), the idea of a futures contract on physical commodities being cash-settled is absurd. The concept is particularly absurd in physical commodities, like gold and silver, where physical delivery is customary and normal and easy. Thatís because it is precisely the ability to make or take actual delivery in a physical futures contract that gives that contract its legitimacy. Take away the physical delivery option and you introduce the likelihood of artificial pricing. About the last thing the gold and silver markets need right now, smack dab in the middle of a CFTC investigation, is more doubt on the functioning of the derivatives markets.

It is no surprise that the existing E-Mini gold and silver futures contracts, also cash-settled, have been such a dismal failure for the exchange and are being replaced. While the low level of volume and open interest is downright embarrassing for the exchange, after more than two years of trading, the outcome was expected and justified.

In an interview with Jim Cook, in December 2006, the following conversation regarding the then-new cash-settled contracts took place;

Cook: You were also telling me about a new type of contract the NYMEX/COMEX had introduced.

Butler: Yes, and for the life of me, I canít understand why there has been no public debate on this.

Cook: Why?

Butler: The NYMEX/COMEX and the London Metals Exchange have introduced a number of new mini-contracts on precious and base metals. The distinguishing feature of these electronic traded contracts is that they are financially, or cash settled, instead of by physical delivery. Whoever thought this up should be horsewhipped.

Cook: Why do you take issue with these contracts?

Butler: The thought that a physical commodity could be traded without having the possibility of taking physical delivery is preposterous. A naked short seller would love these contracts because there is no obligation to deliver the physical commodity. But buyers would be crazy to deal in such a monstrosity.

Cook: Why is that?

Butler: Any physical commodity contract that doesnít allow for physical delivery is not a legitimate contract. It is the physical delivery option that gives the contract its legitimacy. The originators of these cash settled contracts are either foolish or have intentionally devised a contract that favors naked short sellers.

Cook: Do you think theyíll gain popularity?

Butler: They certainly shouldnít.

Will the new versions of the old failed cash-settled gold and silver contracts succeed? I donít know. But I still know they shouldnít. This reconfiguration in contract size amounts to no more than putting lipstick on a pig. Itís still a pig.

Donít get me wrong. These new no-delivery contracts are great if you want to go short. Better still, they are great if you want to manipulate the market to the downside. They are a short sellersí dream in that you can sell whatever amount you care to without ever having to deliver an ounce of real metal. But whatís so good for the shorts is bad for the longs. So much so, that any investor who buys these contracts should have his head examined.

Even though my background is in futures and I believe in the importance of a legitimate futures market, both for speculative and bona fide hedging purposes, the majority of investors are not suited for futures trading. But some are. I donít think any silver investor should consider these new cash-settled metals contracts, unless as a substitute for some Nintendo-like trading game.

The important point is that the introduction of these no-delivery vehicles should make you run to physical silver. If the silver market is as manipulated as I contend, the manipulators would love nothing better than to get off the hook for having to deliver actual metal in the coming shortage. A no-delivery contract would accomplish that. Donít fall for their bait - stick to physical silver.

-- Posted 1 April, 2009 | | Discuss This Article - Comments:

This article is brought to you in part by Investment Rarities Inc.

Last Three Articles by Theodore Butler

Warnings Ignored
4 September, 2009

The Voice Of The People
25 August, 2009

Walking the Walk
20 August, 2009

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