June 16, 2008

A Hidden Silver Default?

(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.)

Today I am going to write on a subject that I feel is of the utmost importance to all silver investors. It’s particularly important to those holding shares of the Barclays silver ETF, traded on the American Stock Exchange under the symbol SLV. Because this may prove to be quite controversial as well, I will attempt to be thorough in my discussion, in the hopes that my words will not be misinterpreted. Although I will try to keep it short and simple, there is much to discuss.

It is just over two years that SLV has been in existence. Trading commenced at the end of April 2006. I started writing about this Silver Trust three years ago when it was first proposed, and have written many articles since then. I have always maintained that the silver ETF was big doings for silver. In just two years the amount of silver held in SLV has grown to 195 million ounces, the largest known stockpile on the face of the earth. Throw in two new silver ETFs from London and Switzerland and total silver ETF holdings jump to more than 220 million ounces. That’s a lot of silver.

It’s no secret why the silver ETFs have proven to be so popular. For the first time in history, they enabled institutional and retirement funds and other stock-only type accounts to easily buy and hold silver. Given silver’s unique dual role, as industrial commodity and investment asset, this was no small development. It is also clear that the advent of the ETF had an important impact on the price of silver. Not as much as I had expected, but still significant. After all, the price of silver tripled after the SLV was proposed. While there were other factors, it was the introduction of SLV that exerted the most influence on the price. Prior to the SLV, silver was locked in a $4 to $5 trading range.

As a silver analyst, I have always recognized the importance of the SLV in the silver supply and demand equation. Key to that issue was the matter of whether real silver backed up the assets of the trust, as Barclays claimed. While some commentators doubted that all the silver claimed to be in the trust was really there, others suggested the silver was being leased out or was being used to suppress the price of silver. However, I always believed that the silver claimed to be on deposit was actually in the custodian’s vaults. I still do. What I will be discussing today doesn’t involve the silver claimed to be on deposit. So much time and attention has been placed on the silver already deposited (or not) in the SLV, that the most important issue has been overlooked. That involves silver not claimed to be on deposit.

(A brief side note here. I’m a (very) independent silver analyst. I write what I feel should be written about concerning silver, with little or no concern for what others may think. I’ve written more than 300 articles in the past seven years that have been underwritten by Investment Rarities, Inc., and made available at no charge to all who care to read them. Not once have I written that readers should buy silver from them, although I do hold them in the highest regard. Nor have I ever taken any potshots at the SLV, perhaps much to the chagrin of the president of IRI, Jim Cook, who rightly views the SLV as a competitor to what his firm sells. I want to thank Mr. Cook for never trying to interfere or influence my analysis on the SLV or any other issue I chose to write on.)

After Barclays decided to follow my public suggestion that they openly list all the weights, serial numbers and hallmarks of the bars on deposit, my conviction that the silver said to be on deposit was reaffirmed. I publicly congratulated Barclays for doing the right thing.

However, I did mention in past articles that I noticed delays, from time to time, in the depositing of silver into the trust for new shares that were purchased. I attributed this to the logistics of physically procuring and transporting the silver to the custodian’s vaults in London. This wasn’t the way the prospectus clearly dictated, namely, that the silver had to be deposited before any new shares were issued or, allowed to be purchased. However, I wanted to save my critiques for more important issues. You learn to pick your battles, and I chose not to harp about a short delay, of a week or two, of a few million ounces of silver being deposited into the trust.

I began to notice this pattern of delay in depositing silver into the trust about six to eight months ago. In fact, the pattern became so regular that I could tell, fairly precisely, when and how much silver would be deposited. I did this by observing the price and volume patterns in the trading of SLV shares. I shared this information with close associates, and could see they were surprised with the accuracy of the pattern.

One thing became clear - in obvious conflict with what the prospectus dictated, there were regular periods when the trust did not have all the silver it should have. In other words, SLV had the silver it said it had, but, at times, there should have been more silver than that. It was also clear to me the mechanism by which this delay could be effected. Buyers of new shares could be issued those shares without new additional silver being deposited through the short selling of shares to the buyers of the new shares.

Aside from a fascination with observing the pattern, my main take from the consistent delays in depositing silver into the SLV, was that silver was not readily available in London. As an analyst, this told me that the supply of wholesale quantities of silver was much tighter than was generally known. This coincided, of course, with a well-known tightness in retail forms of silver, especially US Silver Eagles (thanks to Izzy’s article).

So here we had evidence of delays in the delivery of both retail and wholesale silver. Many are loath to utter the word "shortage" in connection with silver. They believe that to be impossible or they think the word means no availability at any price. That definition is silly, as there will always be some quantity available at some price. A commodity shortage doesn’t mean that all the silver (or any other commodity) in the world suddenly disappears. The correct definition of a commodity shortage would revolve around delivery delays, not unavailability. In other words, a delay in delivery of both retail and wholesale forms of silver would constitute a shortage. Maybe not a severe shortage, but a shortage nevertheless. Such evidence of delivery delays, in the face of declining prices, should disturb believers in free market principles.

Although these delivery delays into the SLV well after the shares were purchased bothered me, I chose not to complain. (By the way, this pattern can be discerned by the uneven deposit pattern into the SLV compared to its trading volume). The main thing that bothered me was that the shares were being shorted at all.

I am going to make a very straight-forward statement. I don’t think short-selling of any kind should be allowed in the shares of the SLV, nor in the shares of the two publicly-traded gold ETFs, GLD and IAU. Of all the tens of thousands of different common stock and other traded securities that are regulated by the US Securities and Exchange Commission (SEC), these three metal ETFs are very unique and distinct from the rest. Out of tens of thousands of different securities, only SLV, GLD, and IAU call for a rigid metal backing, 10 ounces of silver behind each share of SLV, one-tenth of an ounce of gold behind each share of either GLD or IAU. Investors buy shares of these ETFs because they are assured that this specific metal backing exists. Investors buy shares knowing that the sponsors and custodians guarantee the metal to be there.

But what happens when someone buys shares in these ETFs and the seller is selling those shares short? Does the short seller deposit metal to back up the buyer’s purchase? No. The short seller just sells the shares short without depositing metal, perhaps borrowing other shares first, perhaps not. The buyer doesn’t know who he is buying from, he gets a confirmation of his purchase from his broker, pays for it and assumes, according the representations in the prospectus, that he is buying new shares issued by the sponsor who has deposited metal, or from an existing shareholder who has decided to liquidate his shares. It never occurs to the buyer that he is buying from a short seller who is not depositing metal. In essence, the short seller is circumventing what is promised in the prospectus. That party is short-circuiting and destroying the promise clearly laid out in the prospectus that real metal backs every share sold.

Here’s the disturbing question - which buyers’ shares are left without silver backing when short sellers are involved in the transaction? Just the hapless and unsuspecting buyer who was unlucky enough to happen to have his purchase short sold, or do all SLV shareholders get shaved proportionately, like a silver coin clipped in olden times? Don’t look to the prospectus for answers, because you won’t find any.

For those who were unaware of this and don’t understand how shares can be sold with no metal backing (or doubt my contention), there is hard proof. There is a short position list reported that proves short selling exists. Currently, the SLV shows a small published short position on the American Stock Exchange of around 250,000 shares, or the equivalent of 2.5 million ounces. On March 11, this reported short position hit almost 1 million shares, or nearly 10 million ounces. So, there can be no doubt that some short selling exists, which raises all sorts of disturbing questions. In my opinion, this aspect of the metal-only ETFs wasn‘t fully thought through before their introduction. Unfortunately, the problem may be worse than just this SLV short selling; maybe much worse.


Around this past April 15 I began to notice a more pronounced delay of silver deliveries into the SLV. This was for much larger amounts of silver than I previously observed. In fact, the amount of short selling in SLV shares began to look extreme.

Just a short word on short-selling. Please don’t confuse this discussion on the short selling of shares of the SLV (and GLD and IAU) with the short selling I continually discuss in COMEX silver futures. I know this can be a complicated topic, but it is important for you to understand it. In futures, there must be a short for every long. Therefore, the problem in silver futures is not the presence of shorts, but the documented concentrated nature of this short position, namely, an extremely large short position held by just a few traders. Less extreme concentrations in other commodities have always been considered manipulative by the CFTC in the past; just not now in silver (and gold), for some reason.

In securities, there is no requirement that there be a short position for every share of stock. In fact, that would be absurd. But, due to relaxations in the restrictions on short selling over the past decade by the SEC, the new phenomenon of naked short selling has exploded. Naked short selling in stocks doesn’t involve first borrowing the shares in which to sell short. The naked short seller just sells short without borrowing shares. The short seller then fails to deliver the shares to the buyer on settlement date. The punishment for what is essentially a delivery default? The SEC puts out a (long) list of stocks which have fails to deliver. That’s all it does, it makes a list. No fines, no forced buy backs, no identification of who is naked short selling, no staying after school for detention. And yes, SLV is on that list from time to time. To SLV owners, that should be disturbing.

One last kick in the teeth for SLV and silver investors. All investors who purchase SLV shares must pay in full for their shares (or borrow from their brokers at sky-high margin interest rates). Not only do the naked short sellers not have to deposit a dime for their short sales, nor deposit one ounce of real silver, they receive the full cash proceeds that the buyers put up and get to earn interest and deploy that cash until they buy back their short sales. Which may be never, as no one is pressuring them. This is a Wall Street scam and fleecing of the first order.

While it is simple to prove that both short selling and naked short selling in the SLV exists, it is not easy to quantify the amount. I’m convinced much of the naked short selling is done on an unreported basis. My best current guess of the amount of cumulative short selling in SLV shares since April 15, is between 2.5 to 5 million shares. This represents an amount of silver of between 25 to 50 million ounces. Let me be clear. I believe that buyers have paid for and hold shares in SLV for more than 25 to 50 million ounces of silver than are deposited in the trust. Can I prove this? No. Do I make this statement loosely and without careful consideration? No. Could the amount of naked short sales of SLV be less than my estimate? Yes. Could the amount of naked short sales be more than my estimate? Yes.

In the interest of full disclosure, I did try to take the high road in this matter. Several weeks ago, I notified Barclays Global Investors (BGI), of my specific concerns and asked them to resolve the issue privately. Since I have seen no effort on their part to do so, nor to refute my contentions, I decided to go public with this. In addition, a colleague of mine, Carl Loeb, also wrote to Barclays, which resulted in an exchange that either confirmed or did not deny the information I am describing today.

So what does this all mean to the silver market and, especially, to SLV investors? For the silver market, nothing could be more bullish or more disturbing. If I am correct, one or more Authorized Participants (APs), perhaps even Barclays, are the most likely candidates to be the big naked shorts in SLV. And it is hard to imagine that such naked short sellers of SLV are not one and the same as the big concentrated COMEX shorts.

What makes this so bullish for silver is that there is only one good reason for anyone to naked short sell SLV shares - because the available silver needed to be purchased and put into the custodian’s vault doesn’t exist. Rather than go out and aggressively bid up the price of world silver, it is infinitely easier just to sell shares of SLV short. No one would be the wiser and it keeps the price nice and orderly. But this also confirms that real silver may be unavailable in wholesale quantities. In other words, this would be proof of a wholesale shortage of silver to go along with a retail shortage.

What is disturbing, if my numbers are as correct, is that the same fraud and manipulation of the concentrated shorting in COMEX silver futures, has now spread to the SLV. And, if so, probably by the very same entities. Think about it - why would anyone willing to be short hundreds of millions of ounces of COMEX silver futures, hesitate to sell tens of millions of ounces more in SLV to keep the scam going? In for a penny, in for a pound. In fact, the pressure that has been put on the concentrated COMEX shorts may have forced the manipulators to sell the SLV short, in order to keep the COMEX short position from growing.

But what is most disturbing of all is that, aside from the manipulation connection, the short selling in SLV shares represents something that was only expected to be realized in the future in COMEX silver - a delivery default. If there is the equivalent of 25 to 50 millions of silver sold short in SLV (maybe less, but maybe more), that is equal of 5000 to 10,000 COMEX contracts. If buyers stood for the delivery of 5000 to 10,000 contracts of COMEX silver, and the sellers failed to deliver within the required contract period of time, everyone would know that was a major default and it would result in the most serious (bullish) impact possible for the price of silver and the exchange.

I ask you to use your common sense. If buyers bought and paid for 25 to 50 million ounces of silver in the SLV, as I claim, and the sellers did not deposit the silver as required, but instead just sold shares short, is that not a clear default? Is that not the same as 10,000 contracts defaulting on the COMEX? Just because no one knew it happened, until it was explained to them, does that make it less of a default?

Finally, even if my calculation of how much naked shorting of SLV shares is wide of the mark, I have laid out a scenario that could happen easily and that, to my knowledge, has never been publicly aired. Short selling (and naked short selling) of these shares does exist and those shares do not have silver behind them. At the very least, this should all be nipped in the bud by Barclays and the SEC and any short selling of SLV shares of any type should be strictly forbidden. Keep the short sellers confined to the COMEX and derivatives cesspool. All silver (and gold) investors should be concerned because the unique nature of these ETFs, with their direct connection and convertibility into metal, renders them as potential tools of fraud, manipulation and default.

What should SLV investors do about this? I think a few things. First, don’t rush to sell your SLV shares in disgust and walk away from the silver market. That would be like cutting your nose to spite your face. Silver is close to exploding in price, in my opinion, and to sell out just before that happens would be foolish and cause you to rue the day you did so. But neither should you sit passively with your SLV shares and pretend this short selling is unimportant.

If you can, make the switch to real silver, either in your own possession or in bona fide professional storage. A switch means a simultaneous transfer of one asset to another. Make the arrangements to buy real silver before you sell your SLV shares. Don’t get cute and try to time the market. And for the umpteenth time, professional storage (of 1000 oz bars) involves getting the serial numbers, weights, hallmarks of all bars certified to be specifically owned by you, having the ability of taking actual delivery of these same bars at your demand and storing your silver apart and distinct from the dealer you bought it from. Please don’t ask me about this or that program, just make sure it conforms to these rules.

For those who can’t switch out of SLV, hold your shares, but press Barclays and the SEC to the wall on this issue. I believe this can be fixed if you force them to fix it and demand no short selling of any kind, due to the unique nature of these securities and the clear representations in the prospectus. You succeeded when you asked Barclays to list the serial numbers and you will succeed on this issue. That even such a thing could happen is an outrage and if Barclays drags their feet on this issue, you should give them holy hell. Even if you can switch, please inquire yourself and give Barclays a chance to comment on all this - isharesetfs@barclaysglobal.com

Further, here’s a suggestion for large investors in SLV, those holding quantities in basket increments (50,000 shares or 500,000 ounces). Switch your shares to direct ownership of silver, by making a few phone calls and having your broker or AP, convert your shares to allocated silver held in your name. It will be cheaper for you to pay storage directly than pay Barclays management fees, it will be safer, and it will immunize you from these naked short selling games. The funny thing is that your silver will not even have to be physically moved, it’s just a matter of changing the ownership paperwork. Just have your BS-detection meter handy to measure the idiotic excuses you will be given when you initially propose this to your representatives.

Lastly, I’d like to review some of my past thoughts on the SLV, beginning when it was first proposed. I was wrong when I doubted that the silver ETF would come at all, but I was right that it would have a good impact on price if it came. I was right that the SEC would never approved another ETF that involved the physical buying of the commodity involved. Perhaps my biggest mistake was in stating that 130 million ounces of silver could not be purchased at anywhere near the current price, then around $7. I even questioned what the people at Barclays were smoking to suggest that 130 million ounces could be bought without fireworks. While it’s true that a tripling in price (at the highs) does meet the definition of "nowhere near current prices," I admit that I expected much more price-wise. And since there are now 195 million ounces in the SLV, maybe it wasn’t Barclays who was smoking something. Maybe it was me. Then again, maybe not.

This is not intended as a way for me to weasel out of a past misstatement, as that is sure to occur, as I try to write unique and provocative stuff about silver nearly every week. When you are quick on the draw, and try to stay current and out in front, you sometimes miss the mark. It’s an occupational hazard. The trick is not to hurt anyone, even if you miss the bulls-eye. While it would appear that I was way off in my lambasting of Barclays about them securing 130 million ounces easily, I’d like to review my contention again, strictly for analytical purposes, in light of what I now know versus what I couldn’t have known then.

I had assumed back in 2005, that there were not 130 million ounces of available silver in the world to be bought near $7 an ounce. Of course, I knew that more than that amount of silver existed, as I always quote a billion ounces of silver bullion equivalent to be in existence. But there is a difference between what exists and what is available for sale. I thought it was impossible to buy 130 million ounces in the single to low double digit price range. With the benefit of hindsight, I now see where I was wrong. And where I was right.

I never imagined that Warren Buffett would willingly sell his silver (said to amount to 130 million ounces, coincidently) so cheaply. Of course he didn’t exactly sell his silver willingly, he was more snookered out of it due to him speculating and miscalculating on short-term price fluctuations. But the net effect of him losing his silver was that it ended up in the SLV.

Therefore, of the 195 million ounces in the SLV, as many as 130 million ounces may be from Buffett, leaving only 65 million as having been bought elsewhere. Am I doing this just to save face about a bad prior prediction? Absolutely not.

I am making these calculations to analyze what might be the real significance of the short selling in SLV shares. Had we all know that Barclays had somehow secured Buffett’s silver prior to the launch of the SLV, instead of calculating how much silver could be bought and at what price effect, starting from a zero base, we would have all made our calculations starting from a base of 130 million ounces. In other words, with the benefit of hindsight, removing the one-time snookering of Buffett, the actual amount of silver bought in two years by SLV was 65 million ounces, not 195 million. Taken Buffett out, the price of silver tripled because only 65 million ounces were actually purchased on the open market. That suggests a market tight beyond description.

I believe this is important because if my calculations are accurate, we may be in the eye of a world-wide silver shortage. That’s what the real motivation may be behind the shorting of SLV shares. The big shorts on the COMEX are now shorting the shares of SLV because they have no choice - there may be no silver available. If true, this is beyond profound for the price. If you are holding as much silver as you can hold, you are correctly positioned, in my opinion. If not, you are missing out on a remarkable opportunity.

A quick personal note. One of the unexpected benefits of being involved in silver, has been the opportunity to come to know some delightful people, because of a shared interest in silver. I had the occasion to visit (with my wife) such a friend recently, who has had a rough patch, health-wise. Here’s a wish and a prayer for a speedy recovery to my special friend Larry O and best regards to his lovely bride Judy.