On December 27, The Wall Street Journal carried a front page article titled, “Price of Silver Soaring.” It is written by Carolyn Cui, who quoted me in another front page article on gold back in September, and Robert Guy Matthews.
The information contained in the article included many tidbits that have appeared in previous columns I have written, so I could say that the Journal may be starting to catch up to me.
I found that the article did not fully detail what has been happening in the silver market in 2010. From the information in the Journal article, a reader might come to the conclusion that silver had a nice price jump in 2010, but that there is a surplus of supply going into the future which may preclude further price increases in 2011 and beyond. The article notes that there was a significant increase in silver investment demand in 2010 without digging into the reasons why this is so.
To provide further information to help people get a better understanding of the silver market, I wrote this week’s column for Numismaster.com to augment the Journal article. Numismaster published this column on the afternoon of December 28 under the title “Nifty: Silver Will Be at $50.”
In the Numismaster column, I listed ten reasons why investment demand for silver has been so strong this year, and why it should be at least as strong in the future. It has a lot to do with the physical short positions in the London Bullion Market Association and COMEX commodity markets. The shortages are becoming ever more difficult to cover with paper contracts, so that the entire market may default and implode in the next year or so.
Since I finished that column, I realized that it led to a further question: Why would any bank or brokerage put itself in the position of having such a large short position in the physical silver (and gold) market? A completely exposed short position would be risky and not protective of shareholder interests, which is why I would not expect them to engage in such a practice.
The fast answer to that question is that the physical market is only a small fraction of gold and silver trading activity. Many major traders, especially in the US and Europe, want to trade precious metals but don’t want the inconvenience of having to handle physical metals. The London and COMEX markets developed to accommodate such activity.
In theory, the London market trades contracts for delivery of the physical metal at contract maturity. Therefore, the London vaults should hold 100% of the metal needed to fulfill all the contracts. However, most traders simply want to hold the position for a time and plan to buy an offsetting short or long contract to close out the position before maturity. In such an instance, no physical metal would need to be delivered. The same activity occurs on the COMEX, though this exchange explicitly does not represent that its vaults contain more than a small fraction of inventory to cover all open positions.
It would be possible for a bank to have a significant short position in the silver market which could be balanced, or hedged, by a corresponding long position in paper contracts. For the past few years, it has also been possible to own shares of gold or silver exchange traded funds (ETFs) to accomplish this same result.
It would also be possible for a bank to trade derivatives or purchase insurance to protect their exposure to a large short position.
Unfortunately, information on paper positions is not reported by either the institutions holding the positions or by the exchanges on which such positions are traded. Information on derivative positions is an even bigger secret.
Derivative positions are only as valuable as the ability of the counterparties on the other side of these contracts to fulfill their obligations should the original party default on their obligations. The size of the derivatives markets for gold and silver is so huge that it dwarfs the physical markets.
There is a problem with this secrecy, lack of transparency, and the lack of disclosure of the financial strength of the counterparties. These leave a lot of room for trouble and deception.
As I have said before, the price of gold can be thought of as a report card on the US dollar, the US government, and the US economy. This gives the US government a huge incentive to suppress the price of gold. By making it appear that the US dollar, government, and economy are all in better shape than they really are, the government pays a lower interest rate on Treasury debt. If the US government were to engage in suppressing gold prices, it would necessarily have to also manipulate silver prices downward, as these two metals generally move in the same direction.
One of the major methods of suppressing gold and silver prices would be to make it appear that there is much more metal on the market than is being generated by the mines, by recycling, and by acknowledged government sales. If a government does not simply sneak some of its own gold reserves out on to the market to sell surreptitiously, it can arrange for a major bank to borrow gold or silver and sell it on the physical market.
As long as governments and central banks don’t have to accurately disclose the amount of reserves they actually have on hand, all kinds of financial chicanery are possible. In years past, the International Monetary Fund (IMF) actually required double counting of gold reserves! If a central bank leased some of its gold, it was still required to report the gold that was no longer in their vaults as if it was still there. At the same time, the other central bank that might possess the leased gold was also required to report it as being part of its own reserves. The IMF still allows this double counting of reserves, but a few years ago it dropped the requirement to do so.
Another tactic to make it appear that there is more physical metal on the markets than is really there is to sell or lease the same metal to multiple buyers who agree to leave the metal in unallocated storage in vaults. The mega bank JPMorgan Chase has a huge short position in the silver market while at the same time serving as the first tier custodian of physical silver for the SLV exchange traded fund. Although having such positions represents a conflict of interest to the bank, apparently it is within rules set down by regulators. However, there are several questions as to whether the physical silver held by JPMorgan Chase may be subject to multiple ownership claims from the ETF and other parties.
There are many more means by which gold and silver prices could be suppressed, such as by changing laws, regulations, and exchange margin requirements.
If it turns out that some of the physical silver does have multiple ownership claims, that could result in the counterparties to derivative contracts being unable to fulfill their potential obligations. It the counterparties are at risk of default, that would put the banks who have hedged their physical short positions with these derivatives at risk of default. You could see a cascade where the default by one party led to another default, and on and on.
The several hundred percent rise of gold and silver prices over the past decade leads me to think that the paper contracts are at a much greater risk of default than publicly perceived. After all, if there really was so much physical gold and silver available to back ownership claims, prices today would probably be 80% lower than they are.
In the process of trying to use lower gold and silver prices to minimize current financial calamities, the US government may have pushed its trading partners and allies into ever more risky positions. This is the reason why the Chinese government and many other central banks are now adding to their gold reserves and major buyers of gold and silver are buying physical rather than paper forms—and taking delivery.
Should the paper markets for gold and silver start to unravel, they could do so quickly. Prices could soar so much that there literally would not be time for people to react and protect themselves. I predict that gold and silver prices in 2011 will rise by a greater percentage than they have in 2010. The actual result could be several times higher than that. Even if a major price explosion does not occur in 2011, I would expect it to occur in 2012 or soon thereafter.
This is the information, along with that of the December 28 Numismaster article, that I wish The Wall Street Journal article had included in its December 27 front page article.
Patrick A. Heller owns Liberty Coin Service in Lansing, Michigan and writes “Liberty’s Outlook,” a monthly newsletter covering rare coins and precious metals. Past issues can be found online at http://www.libertycoinservice.com/ Pat Heller is also the gold market commentator for Numismatic News. Past columns online at http://numismaster.com/ under “News & Articles”. His bimonthly columns on collectibles can also be read at http://www.lansingbusinessmonthly.com under “Articles” and “Department Columns.”His radio show “Things You ‘Know’ That Just Aren’t So, And Important News You Need To Know” can be heard at 8:45 AM Wednesday mornings on 1320-AM WILS in Lansing (which streams live and becomes part of the audio and text archives posted at http://www.1320wils.com.