Page 2 of 2 SPEAKING FREELY Back to basis for silver By Antal E Fekete
In an earlier article I have, somewhat flippantly, described this momentuous
paradigm-shift as "the last contango in Washington". The historic contango of
gold will give way to permanent backwardation. It will mean that gold is not
for sale at any price - not against the irredeemable dollar. Note that while
the gold price is open to government manipulation, the gold basis cannot be so
easily falsified. It reflects the truth as it is. The basis never lies.
Canary in the coal mine
According to one hypothesis, permanent backwardation in silver will precede
that in gold. Thus silver is the canary in the coal mine. But you have to have
ears to hear the canary sing. In other
words, you must be able to read the message carried by the silver basis.
If deflation and depression is in store, then the case for silver is not so
clear-cut, in view of silver’s extensive industrial applications. It is
possible that silver will be dumped by investors fearing that industrial demand
is vanishing. But again, it is also possible that the rush into gold, a regular
feature of depressions, will spill over as a rush into silver. Whatever
happens, the silver basis will provide a reliable early warning sign.
The return of contango in silver is an indication that bullion banks are
dumping silver. Continued backwardation is an indication that investors and
bullion banks are still accumulating silver. Investors and traders would do
well to learn all they can about the silver basis to be able to interpret
events correctly as they unfold, even if they never intend to trade the silver
basis.
The inordinate size of the short commitment of traders indicates that bullion
banks actively trade the silver basis. Among their customers are wealthy
investors and, possibly, governments or government agencies. CFTC investigators
insist that there is no market manipulation in silver. I am willing to take
their word at face value. Basis trading is not a market manipulation, even if
done on a large scale. It is dynamic hedging, and hedging is just what the
futures markets are for. While futures trading would not work without an
adequate speculative following, it is not primarily for the benefit of the
speculators. It is for the benefit of the hedgers. Speculators are supposed to
know this and they should stop crying "foul play!".
What is seen and what is not seen
Those who hold that there is market manipulation are victims of an optical
illusion. What appears as an oversize naked short position involving no more
than eight trading houses or bullion banks is just the visible side of basis
trading in silver. But there is another, invisible side as well. The invisible
side is hedged metal in private hoards, in the reserves of bullion banks and,
possibly, in secret government depositories.
It is well-known, for example, that the Chinese government controls large
stores of silver, remnants of the long-lasting silver standard in China. A lot
of the silver that governments and private individuals dumped in the West after
the 1873 demonetization found its way to the East, where the Chinese Mint was
still open to silver. At that time China offered the only unlimited market for
silver.
There is some controversy about the question whether silver was flowing into or
out of China between 1934 and 1949. Be that as it may, after the overthrow of
the Nationalist government the Chinese communists inherited untold amounts of
silver. If there was an outflow of silver from China before the communist
takeover, it certainly stopped after 1949.
Chinese hedges are no Texas hedges
It is a plausible assumption that the Chinese at present trade the silver basis
under a seal of secrecy. Some of the world’s largest banks are in China, and
they definitely have bullion trading desks. Unlike their opposite numbers in
Japan and the West, the Chinese banks are not brain-dead. While they also have
a large portfolio of dollar-denominated assets, they are probably fully hedged
by their holdings of silver and gold. The Chinese banks don’t have to carry the
ideological baggage of anti-gold mentality, so prevalent in the United States.
Their financial condition is incomparably superior to that of banks in the
dollar orbit.
In order to understand the silver saga it is important that we put ourselves
into the Chinese mindset. For the Chinese, silver is money, and the US dollar
is a dishonored promise. They see no reason to exchange their silver for paper,
of which they already have more than their fill. Their perspective on the
market is entirely different from that of silver investors in the West. Their
participation in the silver market is motivated by their desire to earn a
return on their holding of silver in silver.
A price explosion would frustrate their strategy. They don’t want a supply
shock in silver. On occasion they have to pacify the restless silver market
through selling, with the idea of buying the material back, preferably at a
better price. This is not naked short selling; this is dynamic hedging. No
crusade of the "insanely bullish" can reclassify it as market manipulation.
The difference between the Chinese banks and their Japanese and Western
counterparts is that the Chinese hedge paper with metal, while the Japanese and
their American mentors hedge paper with paper. Theirs are Texas hedges (with
reference to the anecdotal rancher who hedges his herd with long live cattle
futures contracts).
Silver basis and the banking crisis
The present banking crisis necessitating unprecedented bailouts of
multinational banks and is not unrelated to silver basis trading. By now it is
clear that the cause of the crisis is the banks’ inordinate portfolio of assets
concentrated in debt denominated in the irredeemable dollar, unhedged by gold
and silver. By contrast, the Chinese banks, which also have large dollar
assets, are hedged in metal. The Chinese banks are in no need of a bailout. So
much for diagnosis. The prognosis: more bank failures in the West and in Japan;
further relative strengthening of banks in China.
It is unreasonable to expect that exchange officials and CFTC investigators
disclose the hedging activities of bullion banks, Chinese or otherwise. To
repeat, trading the silver basis is not market manipulation. The high
concentration of short positions is due to the fact that governments and
wealthy individuals wanting to earn a return on their silver holdings prefer to
take their business to a select few trading houses and bullion banks with the
necessary expertise and capital to trade the silver basis on a large scale.
This offers them the best chance to preserve anonymity.
The sluggishness of silver deliveries is explained by the long lines of
communication. It takes time to get the silver from the East for delivery in
the West. One should not read imaginary shortages into this. At present, silver
is not in short supply. If it were, silver could not drop in price as much as
$5 an ounce or 25% in a matter of days and continue trading at the lower end of
the range. Paradoxically, sluggishness of deliveries is the very proof that
there is no corner in the offing - not yet. If there were, the metal would move
from East to West in supersonic aircrafts.
The best little warehouse in Comex
I strongly disagree with the tactics of Comex (the New York Commodities
Exchange, a division of the New York Mercantile Exchange) in putting a limit on
long positions in silver and on silver deliveries, which looks like an
admission that there is a shortage. Silver in approved warehouses is there to
be delivered on demand. Let the chips fall where they may, and let’s see what
the market will do if the last bar of silver is removed from the warehouses.
A limit on deliveries does not prove shortage; it only proves that the exchange
is inefficient and does not favor transparency. In limiting delivery it
undermines its own usefulness. The exchange should oblige hedgers to keep
sufficient silver in the warehouses ready for delivery at all times, in return
for protection of their privacy. Failure to comply should be penalized with
margin call on short hedge positions, possibly higher than the value of the
underlying contract. This would enhance the credibility of the exchange more
than anything else.
As it is, the best little warehouse in Comex is for window-dressing only. For
serious business, such as you know what, you had better go to another
warehouse.
Bleeding to death in the bull ring
It is not in the interest of wealthy individuals, bullion banks, and
governments with large stockpiles of silver that the price go to $100
overnight, which could happen if secrecy were breached and anonymity blown
away. As they can derive an income from their silver holdings already, these
owners of silver prefer a controlled rise in the price. And that’s exactly what
we’ve got.
Failure to understand this may lead one to all kinds of superstitious beliefs
concerning the power of the bullion banks to manipulate the price of silver.
The panicky short covering predicted when silver was trading below $5 never
materialized during the run to $20 and higher. There has been and will be a lot
of short covering, but nothing what could be called a short squeeze. Not until
the curtain falls on the Last Contango in Washington.
As a quick back-of-the-envelope calculation shows, if the naked silver bogeyman
were real, he would have by now lost an arm and a leg after losing his shirt.
He would have bled to death in the bullfight. Let’s be generous and admit that
he does have, at the very least, well, a loin-cloth to wear in confronting the
charging bull.
References: Other papers of the author can be accessed on the website
www.professorfekete.com
Antal E Fekete has since 2001 been consulting professor at Sapientia
University, Cluj-Napoca, Romania. In 1996 Professor Fekete won the first prize
in the International Currency Essay contest sponsored by Bank Lips of
Switzerland. He also runs the Gold Standard University.
Session Four of the Gold Standard University Live will be held in Szombathely,
Hungary from July 3-6. The subject is The Bond Market and the Market Process
Determining the Rate of Interest (Monetary Economics 201). It will be followed
by a panel discussion. For more information please see www.professorfekete.com/gsul.asp.
(Copyright 2008 A E Fekete)
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