In Ted Butler's Archive


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

When anyone speaks in absolute terms, they set themselves up to be absolutely right or absolutely wrong. Being right is easy to handle, but being absolutely wrong, especially in full public view, is something to be avoided. That’s why it’s good to avoid speaking in absolute terms about markets. I’m going to disregard that normally good advice and speak in absolute terms about the gold and silver markets. I’ll be talking about something truly important, something that has me very nervous.

The Problem

In simple and absolute terms, the gold and silver markets are in the most dangerous position since I’ve followed them, or more than 35 years. I have definitely not turned bearish on silver, nor am I expecting lower prices in the long term. Although I expect near term volatility to increase, I’m more bullish on silver than before, if that’s possible. Then, what’s the danger?

The danger is to the market itself, specifically to the COMEX, the world’s leading precious metals exchange. Trading on the COMEX has come to dominate the world price of gold and silver to such an extreme extent that it has become unhealthy. A large part of the danger is the concentrated short positions. They have grown to such an alarming size that they threaten normal operations and, perhaps, the very existence of the Exchange. But it’s not solely the concentrated short position, as I hope to explain.

Please keep in mind; the COMEX is part of the New York Mercantile Exchange (NYMEX), which, in turn, is the largest energy exchange in the world. This is no minor matter. Any disruption of such an important financial institution, now a publicly traded company, could have serious repercussions.

I know that this is a complicated issue. I know I have been alone in writing on this issue. I know I bring it up repeatedly. Although I focus on the silver concentrated short position, lately it appears that gold has caught the silver concentration “disease.” I am convinced it is the most important issue in gold and silver.

The paper COMEX market has been allowed to become so dominated by large traders that it is doing something that is expressly against commodity law. Because the regulators at the CFTC and the NYMEX have allowed them to do so, the largest traders in COMEX gold and silver futures now set the price, rather than “discover,” or follow, the price set by the fundamentals. It is important to grasp this concept.

Commodity law and regulation are intended to prevent the futures markets from controlling the price of world commodities. The futures market “tail” should not wag the world market “dog.” Yet that is precisely what has occurred in silver, and now gold. Large speculators in COMEX silver and gold, both on the short side as well as the long side, now set the world price of each. This is contrary to commodity law.

Over the past three weeks, the price of gold has climbed $100 per ounce and silver has climbed more than $2 per ounce. The large non-commercials on the COMEX accounted for roughly 95% of the net buying in gold and silver over this period, with the “little” guys (unreporting traders) making up a very small 5% of the total net buying.

My point is simple – large speculative buyers of paper contracts were behind the gold and silver price moves, not refiners or jewelry fabricators or industrial consumers. Nor were long-term investors who pay cash on the barrel. Therefore, paper speculators determined the price. That is against commodity law. Period.

While it is true that large paper buyers are responsible for the recent price increases, that in no way, diminishes the real crime and danger in the gold and silver markets, namely, the continued expansion of the concentrated short positions. The concentrated short sellers in COMEX gold and silver futures threaten the very existence of the Exchange.

Since it started moving up from $4 oz several years ago, it made no sense that silver should have the largest short position of any commodity in history. The only reason, and it can hardly be called legitimate, is to attempt to manipulate the price to be lower than it would have been without the giant short position. It should be clear today that whatever their motivation, the big shorts miscalculated and they are on the wrong side of the trade.

The latest COT Report, for positions held as of January 9, indicates new record extremes in all the concentrated short categories in silver and gold futures. In both the 4 or less traders category and the 8 or less traders’ category, the net short concentrated positions rose to levels never witnessed. In gold, the eight largest traders accounted for 95% of the all the COMEX commercial selling in the past three weeks (with the 4 largest making up most of that amount). Without this concentrated short selling, prices would have climbed much higher. The remarkable fact is that the natural hedgers, the gold mining companies, have been retreating from forward selling, leaving the question open as to who the heck the sellers are and what is their legitimacy?

At precisely the time the gold miners hold the lowest forward sale position in many years, the four largest traders on the COMEX hold a record net short position of 75 days of world mine production and the 8 largest traders hold a short position of more than 104 days world production. Gold’s concentrated short position, expressed in days of world mine production is the largest of any commodity other than silver.

The 4 or less traders in silver are now net short more than 282 million ounces, or more than 161 days of world mine production, another ugly new record. The 8 largest traders are net short almost 200 days of world mine production. Not only is this a record for silver, it is so far beyond a record for any commodity that I can confidently predict that no commodity will ever again have such a preposterously large short position.

It is the combination of aggressive (and yes, manipulative) buying by large COMEX speculators and the reckless concentrated short position that puts the Exchange potentially in harms way. The big shorts are so exposed that they could now be desperate. In the last three weeks, the eight largest short traders in gold and silver have racked up market losses (and margin calls) of more than $3 billion. This, in addition to hundreds of millions they were out prior to that. These new losses are far beyond any that they have ever experienced. And because of the record large short positions they hold, their exposure to new losses has never been greater. This should be alarming to market observers (and regulators).

The extreme concentrated short position in gold and silver is the prime reason to be alert to an attempt for a vicious and engineered sell-off by the shorts. It also will be the reason for a market melt up, if the shorts lose control. There is nothing good one can say about the concentrated short position. It smells to high heaven and this is why I write about it so frequently. It is obvious that neither the regulators at the CFTC nor the Exchange have lifted a finger to rectify this dangerous situation, in spite of repeated public petitions.

Due to the uniqueness surrounding the silver concentrated short position, and how much it represents in terms of real world metal, it wouldn’t take an extreme market move to disrupt the Exchange. A $20 up day in gold and a 50-cent up move in silver (which has been experienced recently) generates an additional $630 million daily loss and resultant margin call to the 8 largest shorts in gold and silver. Two such days and you double the loss to more than $1.2 billion. It is likely that the 8 large shorts are close to the same in each market.

If one or more of the concentrated shorts run out of liquidity, due to growing losses, and they are unable to fund daily margin calls, the Exchange would be impacted. Because the shorts are held in such concentrated hands, the losses and margin calls are automatically concentrated. Therefore, if one or two (or more) of the big shorts get into trouble, the Exchange and the markets get into trouble. This is the problem.

If a big short can’t meet continued margin calls, the burden falls, eventually, to all the other clearing (guaranteeing) members. There is a guarantee fund maintained by the NYMEX, and a separate default insurance policy to meet a clearing member default, but the two combined only total about $250 million in protection. Because the size of the concentrated short position is so large, in a default, those funds could be exhausted quickly. Then it comes down to demands on other clearing members.

Thus, in a case where one of the big concentrated shorts gets into trouble and can’t meet margin calls, other clearing members (and, effectively, public shareholders of NYMEX stock), not involved in gold or silver (like energy houses) will be required to pony up massive amounts of money to clean up the mess. If that’s fair, the explanation is lost on me.

Let me be clear, if the shorts lose control, the price will explode. If the shorts are able to rig another sell-off and are able to cover many of their short positions on tech fund liquidation, it will set up a great buy point. But it will still be how this short position plays out that is the main factor in the market currently. From a free market perspective, that’s nuts.

The Solution

My solution involves nothing more complicated than selectively increasing margin requirements. This is something the Exchange does on a regular basis, and is understood by all to augment the strength and integrity of the Exchange. But my solution involves targeting the margin increases to where they will really do some good.

The problem in COMEX silver and gold is because of the largest traders, not the small traders. Therefore, that’s where the focus of the solution should be. Smaller traders haven’t had anything to do with the manipulation or in creating the potential margin default. So, they should not be subjected to higher margins to safeguard the market.

I would use the Exchange’s and the CFTC’s own definition of large and small traders to determine the margin increases. The definition of a large reporting trader is anyone holding 150 or more contracts of silver and 200 contracts of gold. For all traders holding fewer contracts than those levels, no special margin increases.

For those traders holding more than the reporting limits, and up to 1000 contracts each of silver and gold, I suggest increasing margin requirements to one-half the full cash value of a contract. Any such margin increase should apply to both the longs and the shorts.

For those very few traders holding more than 1000 contracts in gold or silver, the margin should be the full value of the contract. This would probably involve less than 25 silver traders and 100 gold traders. The only exception would be for shorts depositing warehouse receipts to be delivered in the current delivery month.

Why am I proposing this steep increase in margins for the very few largest traders? To protect the market from default and to discourage unnecessary speculation or manipulation by either giant shorts or longs. Such full contract margins would restrict the very largest traders from trading in massive quantities of paper contracts and nullify their heavy resultant influence on prices.

Not only does every exchange use margin increases when they deem it appropriate, the NYMEX, in particular, has resorted to even more extreme measures in the past. In 2000, they increased the margin in palladium to almost double the contracts full value. When the NYMEX instituted the extreme margin change in palladium, it was intended to punish the longs and protect Exchange insider shorts. My proposal is to strengthen the integrity of the market and does not discriminate against either the longs or the shorts.

I am suggesting my margin proposal be enacted before a default is apparent. Extreme margin increases and trading restrictions will, by precedent, most likely be enacted by the regulators after the problem becomes apparent. I know governments and regulators are reactive, rather than proactive, but they need to do something now.

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