 Putting Loincloth
on The Naked Bogeyman
Antal E. Fekete
Gold Standard University Live
aefekete@hotmail.com
Jun 13, 2008
I started writing this piece
as the sub-prime crisis was unfolding. I wanted to establish
the connection between the silver basis and the budding banking
crisis caused by phony bond insurance schemes and the lack of
hedging irredeemable dollar debt with metal holdings. My original
title was Putting Clothes on the Naked Bogeyman. As writing
progressed I realized that it would take more than one article
to dress up the bogeyman; hence the revised title.
Trading hedged corn
When I tell my audience at
Gold Standard University Live that huge quantities of commodities
are bought and sold every day without any reference to the
price, my words are received with an incredulous silence.
It appears incredible to the uninitiated that the price risk
can be neatly side-stepped. I have to explain to my listeners
that when the professional grain trader gives an order to buy
or sell corn, he may be unaware whether the price of corn is
up or down. He doesn't care. He is buying and selling hedged
corn, and he takes his clues from the basis, not the price
of corn itself. He has replaced price risk with basis risk which
he knows how to handle as its behavior is less erratic and more
predictable. Most people don't realize that the bulk of grain
trading on the futures markets is driven not by the price but
by the basis.
In the grain market by basis
is meant the difference between the futures price and the local
cash price of the grain. Thus the basis varies from place to
place, and from one delivery month to another. Trading the basis
means buying or selling hedged grain. The merchant goes long
on the basis by purchasing hedged grain when the basis is wide,
and selling it when the basis is narrow (possibly negative).
He goes short on the basis by selling hedged grain first when
the basis is narrow (possibly negative), and selling it later
when the basis is wide.
The myth of naked shorts
The silver market is similar.
Large quantities of silver are bought and sold every day without
reference to the price. Professionals trade hedged silver on
clues from the silver basis. They are not gambling on the price
variation of silver: they want to earn a reliable income on physical
silver already in store. They may do this on their own account
or, more typically, on customer account. The ever growing inordinate
and concentrated naked short position in the face of a strongly
rising price is a myth.
I defined silver basis in my
earlier articles as the difference between the nearest futures
price and the cash price of silver (see references).
It is puerile to assume that
most professional traders are naked short in silver, just as
it would be sheer ignorance to suggest that most professional
traders of grain are naked short in corn. They are not. You may
rest assured that their corn is well in place in a grain elevator
somewhere. If the elevator is registered with the commodity exchange,
then the hedger may post a reduced margin on his position. But
the elevator need not be registered, in which case the hedger
posts full margin. While this is not typical in the grain trade,
it is quite common in the silver trade. Rightly of wrongly, the
silver trade is surrounded with far more secrecy than the grain
trade. This has to do with the fact that silver is considered
a monetary commodity by many in the first place, and an industrial
commodity only in the second. We must understand that lots of
people are accumulating silver not so much for the ride to $1000,
which may or may not happen, but in protest against low interest
rates on passbook savings and certificates of deposit. They are
happy to post full margin instead of the lower hedge margin on
their short position in silver in exchange for anonymity. Of
course, the exchange knows that theirs is a hedge position, but
must treat this information as confidential. So must the C.F.T.C.
Let's start by reviewing the
differences between the grain and silver trade. As most grain
is sold to the ultimate consumer within the year of production,
the basis has a yearly cycle with trough just before and peak
just after harvest. By contrast, the silver basis is not cyclic.
Silver is typically accumulated year after year by investors
and bullion banks. Instead of an annual cycle following the crop
year, the silver basis has a long-term falling trend, a strong
hint of a slowly developing shortage. It is impossible to predict
when shortage will hit. After every major price advance there
is profit-taking by unhedged investors, and after every major
price decline there is short covering by hedged investors and
bullion banks. Net selling through profit-taking and net buying
through short covering may or may not balance out. Accordingly,
the trend towards a permanent silver shortage is going to be
uneven.
Historical sketch of the grain trade
Farmers produce billions of
bushels of grain every year. Most of this grain is sold several
times in the futures markets as part of the basis-trading before
it is consumed. An understanding of the historical development
of the futures markets may be helpful. Standardized futures contracts
began trading on commodity exchanges in the late 1800's. Futures
markets revolutionized the way cash grain was traded and gave
the grain elevators and the farmers the ability to buy and sell
more easily and profitably. Grain companies learned how to use
futures contracts more effectively to manage risks, and to maximize
income from their elevators. The big revolution was the advent
of basis-trading, to replace price-trading. This revolution is
not mentioned in school curricula; not even in university curricula.
This is a pity. The story of basis trading is a story of capitalism
triumphant. It teaches how the free market can overcome the capriciousness
of nature. As more and more people learn the skills of basis
trading, profitability grows and business expands.
The grain business prospered
until the 1930's when the Great Depression began and governments
became heavily involved in grain trading. Government programs
dominated the marketplace. Storage of grain was encouraged and
construction of new elevators was subsidized. However, the market
was stagnant, to a large extent precisely because the new elevator
space was taken up by government-owned grain. This grain was
just sitting there in the elevators, until it was ultimately
given away to other governments or to charities.
In the 1970's governments decided
to reduce their presence in the grain market. A new era started
when market forces were allowed to prevail once more. The grain
business re-learnt how to increase efficiency, manage risks,
and generate income through basis trading. Generally, the abundance
of grain kept the market stable. Under these conditions the opportunity
for trading was confined to buying and holding grain. This is
known as the "carry trade": buying when the basis is
at its highest and selling when it is at its lowest. The basis
was following a consistent pattern and as it declined from harvest
to the end of the crop-year, the grain trade was provided with
a reliable income.
It would take a sizeable drop
in production to cause any significant move in the price and
a deviation of the basis from the customary pattern. While it
did not happen very often, the market came away with the flying
colors proving the superiority of trading the basis over trading
the price especially under volatile conditions.
The 21st century brought new
challenges to the grain trade. The market became demand-driven.
Increasing population and improved living standards around the
world opened up markets to more people and boosted demand for
processed food and other consumer products. There has been a
tremendous growth during this first decade of the century. In
addition to the carry trade, "value added trade" has
put in an appearance and started growing. In this environment
grain does not sit around in elevators for a long period of time.
The market absorbs it and makes it into all kinds of products
for human and animal consumption. Most recently grain has started
trading also for use in energy production. All these changes
contributed positively to basis trading as it has changed the
dynamics of the marketplace.
Of course, not all grain traders
are trading basis. A dwindling number still trade price. Most
of these traders are barely surviving. They will have to learn
the skills of basis trading, or perish. It is a safe bet that
no new grain elevator is being built with trading the price in
mind. They are built with trading the basis in mind. Those who
are still trading price are missing one of the great opportunities
of the century by not understanding basis.
Historical sketch of the silver trade
Second only to gold, silver
is a monetary metal. This means that above ground silver represents
several years' output of the mines. One should not be misled
by the propaganda line that this silver "has been consumed
by industrial applications". The recovery of scrap silver
is a function of the price. As the price of silver rises, the
rate of recovery will rise with it, sometimes dramatically. In
addition, an unknown but substantial amount of silver still exists
in monetary form. Owners do not want to reveal their identity,
or the size of their hoard. But this does not mean that monetary
silver has disappeared in consumption. There is no support for
the claim that silver is in short supply, or that silver has
ceased to be a monetary metal. Any apparent shortage simply means
that the carry trade holds back stocks from the market in hope
of an early price advance. At the right price it will make the
metal available.
Prior to 1873 the price of
silver was stabilized through monetary legislation at $1.29 per
oz. After the Civil War the U.S. Mint was closed to silver. The
German government also closed its Mint to silver in the wake
of the Prussian victory over France about the same time. Silver
was dumped in the markets in unprecedented amounts, driving the
price down to as low as 70 cents by the end of the 19th century.
Although the price spiked back to $1.29 at the end of World War
I, it did not last and during the Great Depression it hit a low
of 25 cents. We may add that upheavals in the silver market were
a direct consequence of government meddling. Ultimately people
have learnt how to neutralize the destructive influence of the
government in an effort to control money, and they borrowed a
leaf from grain merchandising manuals in trading the silver basis.
Through all this time up to
1965 there was no silver trading on the organized commodity exchanges
for reasons of insufficient volatility. By 1965 the world market
price threatened to exceed the statutory price, as demonstrated
by the disappearance of silver coinage from circulation, and
volatility perked up. Silver trading on the organized commodity
exchanges started. However, secrecy continued to surround the
silver trade as one monetary crises followed another at more
or less regular intervals. There was a conception that silver
could also be confiscated as gold was in 1933. In the event,
the ban on gold ownership and trading was lifted in the U.S.
at the end of 1975, allowing gold futures trading to start and
giving a boost to silver futures trading already in progress.
Secrecy prevailed and manuals
on how to trade basis in the gold and silver markets were never
made public. Those anxious to learn basis trading of the monetary
metals had to buy the manuals for basis trading in grains, and
work it out for silver and gold on their own. This is not as
easy as as it sounds, because of pitfalls due to the fact that
trading monetary metals differs from trading grains in almost
every respect. Having said that, there is no question that basis
trading in gold and silver is a wide-spread practice preferred
by the most conservative investors, and even the more venturesome
cannot do without at least a rudimentary understanding of the
underlying principles. We have mentioned above that trading the
basis for grain instead of trading the price was a triumph of
capitalism. Man has learned how to overcome the capriciousness
of nature. The same also happened in the silver market: trading
the silver basis increasingly replaced the trading of the silver
price. The difference is that here it was not the capriciousness
of nature but the capriciousness of governments that has been
overcome. Governments want you to believe that they can create
and destroy value at will by monetizing debt while demonetizing
silver and gold. In effect they cannot do either in a durable
way. Government magic goes only so far as gullibility of the
people.
Gold Standard University Live
is a world leader in offering regular panel discussions and primers
on basis trading of the monetary metals. There are plans to run
workshops as well on basis trading. The next session is scheduled
from July 3 through 6 at the Martineum Academy in Szombathely,
Hungary, to be followed by a session in Canberra, Australia in
November (see Announcement at the end of this article).
The Last Contango in Washington
Volatility in the gold and
silver markets is like a dormant volcano. Unannounced, it erupts
periodically with increasing ferocity. As it does, trading the
gold and silver price is becoming ever more treacherous. There
can be no doubt that the answer is basis trading, that is, buying
and selling hedged gold and silver. It is only a matter of time
before a trading house or bullion bank will offer this service.
The significance of the silver
and gold basis can be found in the role they play as an early
warning system. Under normal circumstances backwardation in gold
and silver is an aberration. Monetary metals must be sufficiently
plentiful in order to serve as such. This translates into contango.
But at the time of monetary disturbances, like the one triggered
by the sub-prime mortgage crisis, the monetary metals tend to
go into hiding. As they do, the cash price goes to a premium
against futures prices, and the basis goes negative, indicating
the extent of scarcity. If hyperinflation is in store, gold will
go into permanent backwardation, foreshadowed by a steep decline
in the basis.
In an earlier article I have,
somewhat flippantly, described this momentuous paradigm-shift
as "the last contango in Washington" (with a bow to
the movie The last tango in Paris.) 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 indicate that bullion banks actively
trade the silver basis. Among their customers are wealthy investors
and, possibly, governments or government agencies. C.F.T.C. 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 wily Chinese presently 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 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 C.F.T.C. investigators disclose the
hedging activities of bullion banks, Chinese or otherwise. I
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.
Presently silver is not in short supply. If it were, silver could
not drop in price as much as $5 an ounce or 25 percent 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 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. 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
By the same author:
It's Not a Dollar Crisis: It's a Gold
Crisis, June 5, 2008
The Saga of the Naked Bogeyman, November 2007
Exploding the Myth of the Silver Shortage, September, 2007
The Last Contango in Washington, June, 2006
The Rise and Fall of the
Gold Basis, June, 2006
Monetary versus Non-Monetary
Commodities, May, 2006
Ultracrepidarian Musings, May, 2006
Bull in Bear's Skin? May, 2006
What Gold and Silver Analysts
Overlook, May 1, 2004
These and other papers of the
author can be accessed on the website www.professorfekete.com.
GOLD STANDARD UNIVERSITY
LIVE
Session Four is to take place
in Szombathely, Hungary (at Martineum Academy where the first
two sessions were held). The subject of the 13-lecture course
is The Bond Market and the Market Process Determining the
Rate of Interest (Monetary Economics 201). It will be followed
by a panel discussion on the topic: The Silver Basis and the
Present Banking Crisis: Phony Bond Insurance Schemes and the
Lack of Hedging Irredeemable Dollar Debt with Monetary Metals.
The date is: July 3-6. For
more information please see www.professorfekete.com/gsul.asp
or contact GSUL@t-online.hu.
Registration can be made by e-mail upon payment of the pre-registration
fee. The remainder of the registration fee is due 3 weeks prior
to the session. Space is limited; first come, first served.
Preliminary announcement: Gold
Standard University Live is planning to have its Session Five
in Canberra, Australia, in November, 2008. This Session will
include a Primer on the gold and silver basis, prerequisite for
a Workshop on the basis offered at Session Six (planned to take
place in the Spring, 2009).
June 12, 2008
Professor
Emeritus
Memorial University of Newfoundland
email: aefekete@hotmail.com
  Professor Antal E. Fekete was born and educated
in Hungary. He immigrated to Canada in 1956. In addition to teaching
in Canada, he worked in the Washington DC office of Congressman
W. E. Dannemeyer for five years on monetary and fiscal reform
till 1990. He taught as visiting professor of economics at the
Francisco Marroquin University in Guatemala City in 1996. Since
2001 he has 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 Ltd. of Switzerland. He also runs the Gold Standard
University.
Copyright ©2005-2010 by A. E. Fekete<
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