TED BUTLER COMMENTARY

February 5, 2008

The Real Lesson Of SocGen

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

As you are undoubtedly aware, a new world record has been set in the markets, as a low-level trader from the giant French bank, Societe Generale, caused a $7 billion+ loss through speculation in European stock index futures. The loss has generated countless articles and various opinions ranging from the fate of the bank, to the regulatory failures exposed and the impact on the markets. But I think all may have missed the real lesson.

Please allow me to cut to the chase and point out, not only what the real problem involved, but also the solution to preventing such occurrences in the future. I think it was Albert Einstein who said you must try to explain important matters as simply as possible, but not too simply.

I know it sounds too simple, but the problem in the SocGen episode was that too large of a position was held by a single trader. But it wasn't the large size of the position alone that was the problem, it was the fact that it was held by a single trader on a very leveraged basis. In other words, the position was too concentrated and too little margin backed the position. A large market position held by many diverse entities shouldn't be a problem. A large leveraged position in one or few hands usually is a problem. It too often results in manipulation or disorderly markets, sometimes both. This is the central theme in my relentless attack on the concentrated short position in COMEX silver (and gold). It is too large and held by too few entities with too little backing.

It is not as if the regulators are unaware of the problems of concentration, as this issue lies at the heart of securities and market regulation and law everywhere. The problem lies in the failure of regulators in better preventing concentrated positions in the first place, or in not acting quickly or forcibly enough against concentration until it's too late. Remarkably, a simple and fair solution that deals with concentration before it develops does exist.

This new loss eclipses the previous record of more than $6 billion, set almost 16 months ago, by a single trader from the hedge fund, Amaranth Advisors. The Amaranth loss, in turn preceded big losses by a single trader from Barings Bank and separate big losses and manipulation in copper, also involved single traders operating on extreme leverage. I did write about the Amaranth fiasco, at the time, and tried to make the clear connection to concentration. http://www.investmentrarities.com/09-26-06.html  I did not, however, offer a simple solution to deal with the problem, because, quite honestly, I had not yet discovered it. But I have since then.

The solution lies in preemptively and selectively imposing much stricter margin requirements where they matter most, namely, on the big concentrated positions. Hike the margins, not on everyone, but only on the positions most likely to cause market problems. The big problems caused in the markets are always caused by concentrated leveraged positions. That's where the attention should be focussed.

Since my interest is in silver, I have previously provided specific recommendations for what the margin requirements should be for the big concentrated traders in COMEX silver futures, shorts and longs alike. For those traders holding more than 150 contracts, but less than 1000 contracts, the margins should be half the full value of a contract. For traders holding more than 1000 contracts, the margin should be the full value of the contracts. Shorts could substitute bona fide warehouse receipts in lieu of good funds, provided it was for delivery purposes in the current delivery month. Some have written to me suggesting a scale-in time period, so as not to disrupt the market unnecessarily. Fine, anything to insure fairness and integrity to the market. (Stakeholders in the CME Group, Inc., which is proposing to acquire the NYMEX, might look to resolve this issue before the transaction is finalized).

To be sure, as the most recent Commitment of Traders Report (COT) indicates, we are still deep into the danger zone in COMEX silver (and gold). The most recent report shows that the concentrated net short position in silver futures has hit new extremes, with the four largest traders short 57,846 contracts, or more than 289 million ounces. The eight largest traders are net short 71,575 contracts, or almost 358 million ounces. The four largest traders are now net short more than 165 days of world mine production, with the eight largest traders net short more than 204 days mine production. Never before has any commodity had such a large (and dangerous) concentrated short position.

Additionally, never has the relative concentration between the 4 largest short traders been more lopsided when compared to the concentration of the largest 4 long traders. The latest COT, for positions held as of Jan 29, shows a concentrated silver short position more than 4 times as large as the long concentration, something not witnessed, to my knowledge in any market ever, not just silver. In almost all major markets, the relative size of the concentrated long and short positions are closely comparable. Common sense should tell you that there is something very strange that silver is so outside these normal parameters.