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Who's rigging the gold markets?Robert Wutscher Ever wondered about the economics of gold trading? Why is it that the commercials are always the biggest shorts? Or why it is that the commercials are always acting opposite to the speculators? Conspiracy theories aside, which may or may not be true, and which cannot be proven or disproved. To a large extent these rely on inexplicable anomalies and the attribution of “hidden motives”. Let's see if we can shed some light that at least helps clarify some of those inexplicable anomalies. Arbitrage trading must be happening in gold for prices to be in alignment in the various gold futures exchanges, contract expiry months and the physical markets, right? So let's see how this would pan out in the COT numbers. Let's first assume that most investors expect the gold price to rise, because of quantitative easing or whatever. Speculators and funds positioning themselves for such a move can be expected to load up on long paper contracts. The demand is more likely to manifest in the futures markets because of the synthetic leverage offered by the margin (by synthetic I mean that the speculator does not have to apply separately for a 75% loan and then use it to buy the 100% physical. He simply uses available cash to buy the 25% margin). In this particular case, the paper price is likely to move first, opening up a gap to the physical price that the commercial arbitrageur, most likely a bullion bank, will attempt to exploit. It does so by buying the physical and selling the paper until the gap closes (1). With no risk down! Various dynamics present themselves. If the demand is particularly intense in the futures pits, a lot more paper contracts will be in demand, and the bullion banks will be able to exploit a lot of volume, but also having to buy on the physical market until the price gap closes. Only a strong price move will be able to temporarily halt or satiate the demand in the paper market. A strong move is likely to be accompanied by extreme tightness experienced in the physical markets as the commercials scramble for available physical to hedge their positions (the arbitrage can also occur between the various gold futures exchanges around the world). This may be one of the reasons why margin requirements have recently been raised and why more may be required as paper demand outstrips the physical. Remember that the arbitrageurs only act at the margin, effecting trades for physical only when a price gap presents itself. There could therefore easily be many more paper contracts than actual physical gold backing. If gold demand is also strong for the physical, you would logically expect less paper shorts on price rises. This is because there will be less opportunities for arbitrage. The demand for physical is more likely to be lower than for paper for reasons of convenience and the lack of leverage in the physical. From this we can infer that if paper shorts are increasing significantly on a price rise, there is a lower level of non-hedge physical demand. That could be one reason why the build up of commercial shorts sometimes, and not necessarily always, precedes a fall in the gold price: the physical demand is somewhat lacking if you stripped out the demand from the arbitrageurs. Or to put it another way, the lack of cash demand for gold is allowing the commercial arbitrageurs a space in the futures market. This is not to deny that demand can also be robust in the coin market. In the coin pond, demand is likely to be strong for the little fish who are looking up to the actions of the big fish speculators in the futures ocean. This may be the reason why we sometimes read stories of coin shortages, but no 400 troy ounce bar shortages. Now let us look at what happens in the reverse scenario, when for whatever reason the speculators and funds decide to sell some of their long positions. The commercial arbitrageurs simply buy the contracts the speculators wish to offload (by covering their shorts or adding longs if they run out of contracts) and while keeping an eye on the higher physical price (2), dump their physical positions without a flinch of emotion until the price gap is again closed. For as long as the price gap stays closed, either after a rise or fall in price, they simply hold onto whatever long or short paper and physical positions didn't make the gap until it opens up again. The irony is that it may not be the commercials, but the leveraged speculators themselves who are rigging the market, by not opting for the physical directly. The implications of all this theorizing: apart from instilling some doubt as to whatever “hidden motives” one may have entertained the commercials capable of, when you see a price rise unaccompanied by a significant increase in commercial shorts, then you know that rise is for real. Notes: (1) This gap may only last a nano-second based on today's computer technologies and may therefore never be picked up on the public price feeds. (2) I have left out technical details for ease of exposition. One of them here would be that the price gap should be considered net of normal differences in price (the basis) between contract months and the physical. Physical shortages or lack of physical held by arbitrageurs for selling (net of gold leasing) in theory could distort the basis, even resulting in backwardation (where the physical price rises above that of the paper. The paper price is usually lower to account for net interest costs of the arbitrageurs positions). ### Jan 4, 2010 - Special offer for 321gold readers: Send an email to rwutscher@telkomsa.net, together with any constructive objections or any inside information from those of you who have actual practising experience related to the commercials that either validates or invalidates the above theory within seven days of this post and after that I will provide you with further analysis as well as any modifications (even if this involves a complete refutation) as a result of the responses to this post. ### Jan 1, 2010 The shadow economist, Robert Wutscher, is a retired financial due diligence specialist who has taken up the study of economics. His study has turned to the shadow side of economics: what most economists ignore, suppress or fail to account for in their models under the light of mainstream economic consensus methodology. A rich resource exists in many old economists who have passed away with insights that do not sit comfortably in today's quantitative models and with warnings/lessons of the past going unheeded. The modern consensus methodology is primarily based on quantitative methods and generally considers only economic aspects and assumptions that are amenable to quantitative analysis, even if this can only be done with abstraction of reality or of the mathematics itself. It ignores other concepts essential to human decision making, that may be too hard to quantify and that may be hidden in the shadows of the aggregates and averages that form the edifice of macroeconomics and econometrics. The shadow economist is new on the block and will generally challenge the conventionally held wisdom even that of the gold bugs. He welcomes constructive criticism. He can be reached at rwutscher@telkomsa.net 321gold Ltd |
