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TED BUTLER'S ARCHIVES

September 26, 2006

 Concentration  

The big market news for the week was the sudden and shocking blowup of the large hedge fund, Amaranth Advisors. In little more than a week or two, the fund reportedly lost $6 billion, or 65% of its capital, making it the largest derivatives loser in history, principally as a result of bad natural gas spread trades. (Previous big derivatives losers, like Barrick Gold, must have welcomed being surpassed.)  

Much has been written about Amaranth, as is fitting considering the magnitude of the loss, but I’d like to add a few thoughts that I haven’t seen mentioned. These thoughts are in keeping with my central theme over the past few months – the danger of concentrated market positions.  

First off, it would be proper to provide a working definition of just what constitutes a concentrated market position. Simply stated, it is a position held by one, or by a few entities related in some way, that is large relative to the rest of the market. In practical terms, we are talking about very big positions, both in absolute and relative terms. A concentrated position always represents a big chunk of the market.  

This was the hallmark of Amaranth’s natural gas position; it was an extremely concentrated position. It was so large and made up such a big chunk of the market, that when it was liquidated, it wasn’t even truly liquidated – it had to be assumed by other entities in arranged transactions. This is confirmed by published reports and a study of the concentration data in the Commitment of Traders Report.  

I guess you know you have a concentrated position when you have to dispose of it differently from the way you acquired it (through normal market transactions), and it costs you $6 billion in the process. It would be easy to say that the trader responsible for this debacle should be horsewhipped for not having a proper exit strategy, but that adds little to our knowledge base.  

What can we learn from Amaranth? Primarily, we should learn, once again, that concentration leads to bad things. No general good comes from concentrated market positions. Concentration goes hand in hand with manipulation. (Here’s a prediction  - the CFTC will charge Amaranth, sooner or later, with attempted manipulation.) Concentration is always present in delivery defaults. Disorderly and disruptive pricing is always caused by concentration in some form.  

This is why regulators monitor, or claim to monitor, concentration. It does not matter if the concentrated position is long, short or spread; concentration is behind every market problem. This is the first thing that regulators learn, or should learn.  

My concern is that the evidence strongly suggests that the regulators don’t seem capable of grasping the basics of concentration. In a very real sense, the CFTC and the NYMEX/COMEX (a Self-Regulatory Organization) have misjudged the concentration issue at every turn. They certainly missed it in natural gas and Amaranth, in spite of truly alarming levels of concentration in natural gas spreads, where the largest spread traders controlled dominant percentages (almost 35%) of the entire market, equal to hundreds of thousands of contracts. (I hope no one was surprised that the natural gas concentration problem involved the NYMEX.)  

How is it possible that the CFTC and the NYMEX blew it, once again, when it came to spotting a problem in natural gas? After all, the concentration data compiled and published by them indicated a big problem well in advance. I have come to a conclusion – neither the CFTC nor the NYMEX is capable of dealing with concentration. The people responsible for detecting concentration or manipulation need to be replaced immediately.  

Nowhere is the evidence of a concentration problem more evident than in silver. While the overall COT structure of the market in silver (and gold) rarely looked better, and provides a spectacular buy point, the concentration by the largest traders has grown to absurd levels. In the most recent COT report, as of September 19, the 4 largest traders are now net short 34,809 futures contracts, or more than 174 million ounces. Incredibly, these four large traders now control 97% of the total commercial net short position, the highest in memory and a substantially higher concentration than when I started complaining to the CFTC and the NYMEX almost 4 months ago.  

In other words, if these 4 traders’ positions didn’t exist, there would be, effectively, no dealer short position on the COMEX. It is, quite literally, these four traders against many thousands of long participants. The true test of a manipulation has always been – what would the price be if the concentrated position did not exist? Why won’t the CFTC or the NYMEX answer that question?  

Just so no one thinks that the big 4 can’t have an even more concentrated position, the sad fact is that they already do have one. Commencing with this week’s report, the CTFC is now also reporting on the silver contract traded on the Chicago Board of Trade (CBOT). While this market is only 10% of the size of the COMEX in terms of total open interest, the concentration by the big 4 and 8 short traders is actually much greater in percentage terms than it is on the COMEX.  

I would bet that the largest short traders on the CBOT are exactly, or largely, the same as on the COMEX. If I am correct, it is clear that the big shorts from the COMEX are extending and continuing their manipulation on the CBOT. I have notified the CBOT of this data.  

Finally, I want to thank everyone who took the time to contact the SEC, asking them to delay the NYMEX’s IPO until they openly respond to the allegations of concentration and manipulation. Unlike the CFTC, the SEC has responded promptly, indicating they take the matter seriously. I find this very encouraging. I am sorry I have been unable to respond to copies of your notes to the SEC and the replies you have received from them, but I appreciate them deeply. Likewise, all the e-mail I’ve received recently.  

At this point, I would give the SEC (and the CBOT) the benefit of doubt. They are not up to their necks in denying the silver manipulation for 20 years, as are the CFTC and the NYMEX/COMEX. They do not have a vested conflict of interest in maintaining the silver manipulation. I believe these people are honorable and are interested in doing the right thing.  But they are unlikely to act if not prodded by the public. I admit it is a long shot to try and get the SEC involved, considering the power and stature of the parties who prefer the status quo. But it is a no-risk long shot that can yield tremendous results.  If you agree and haven’t done so yet, please let them know your feelings. It can’t hurt, and just might help tremendously. See last week’s article for the contact info.