In Ted Butler's Archive

The Game Changer?

(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.)

Every once in a great while, something big comes along to upset the status quo. Sometimes the change is long overdue and welcome. I think we may soon witness such a game-changer in silver.

As I briefly referenced last week, the new chairman of the CFTC, Gary Gensler, issued a statement on July 7, that I felt was very important.
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Upon further reflection and subsequent additional statements from Commissioner Bart Chilton, I am convinced that great change may be on the way. Click Here to read

The statement from Chairman Gensler is clear; he is deeply concerned about and is soliciting your input on the matter of speculative position limits. In a moment, I will suggest how you can participate in the coming great change.

The issue of legitimate speculative position limits is one about which I have petitioned the CFTC and the COMEX for more than 20 years. In fact, I consider it a signature issue and one in which there has been much public dialogue between myself and the CFTC. (Here are some samples from 2002 , Click HereClick Here ) Simply put, speculative position limits are designed to prevent large futures traders from unduly influencing the price of a commodity, either on the long or short side. It goes to the heart of the silver manipulation. I have always maintained that if legitimate speculative position limits were in place and enforced in COMEX silver, then manipulation would not be possible. This is the clear intent of commodity law. Knowing this, I pressed the CFTC on this issue relentlessly. Unfortunately, the CFTC and the COMEX were equally consistent and they dismissed my arguments for more than 20 years.

Now the CFTC has done a complete about face. The new stance by the CFTC to review the entire issue of position limits is nothing less than ground shaking in nature. I know that many are skeptical about the Commission’s real intent, but this 180-degree turn by them holds profound implications for the price of silver. It is also my opinion that Chairman Gensler and Commissioner Chilton should be applauded for the steps they have taken. Since they will face much criticism and discouragement from changing the status quo, they must be supported in this endeavor at every turn. I intend to support them and I ask the same of you.

There are two aspects to speculative position limits. One is the proper level of the actual position limit in each commodity in contract terms. What is the maximum number of contracts a single trading entity is allowed to hold, long or short, in every commodity? The second aspect is what exemptions from the maximum number of contracts should be granted to trading entities with bona fide hedging requirements larger than the stated position limit. There has to be a legitimate economic reason, under commodity law, in the granting of these hedging exemptions. A desire to manipulate prices is not a legitimate economic reason.

The Proper Level of Position Limits

How does a regulator go about deciding what the proper level of speculative positions should be in each commodity? Setting limits too low would restrict market liquidity, and any unreasonable restriction should be avoided. Setting limits too high could allow futures traders too much price influence, which is against the very purpose of having limits in the first place. Obviously, a regulator would look at as many factors of an objective nature as possible in coming up with the proper level of limits.

The economic purpose of futures trading is for price discovery and to enable legitimate hedging. So the first place a regulator would look is to the level of actual production and consumption in the real world. Since futures trading is not supposed to set the price of a commodity, but follow the supply/demand developments of the actual commodity, speculative position limits must be set low enough as to not disturb real world commerce. Therefore, the most important factor a regulator would consider is the world production and consumption of each commodity. He would then apply a logical and consistent formula that would treat each commodity objectively. A regulator wouldn’t arbitrarily assign radically inconsistent position limits relative to actual production and consumption.

For the most part, the regulators have done a good job and have set the level of speculative position limits in a consistent method on almost all traded commodities. Quite frankly, I don’t see a problem with the level of position limits in most commodities. In fact, there is only one commodity where the level of the position limit is radically out of line with all other commodities. You guessed it – COMEX silver. (For simplicity sake, I am considering the accountability limits set by the NYMEX/COMEX to be the equivalent to the CFTC-set position limits on agricultural commodities)

Most commodities generally have a position limit which runs less than one percent of world annual production. This is even true with the accountability limits set on the NYMEX/COMEX in gold, copper and crude oil. But not in silver. As the following graphs indicate (courtesy of Carl Loeb), silver is way out of line with all other commodities, even gold, when it comes to the level of position limits relative to world production. Silver has an accountability limit of 4.5% of annual world production (30 million oz vs. 672 million oz). Gold has a limit of 0.8% (600,000 oz vs. 75 million oz), while crude oil has a limit of 0.07% of annual world production (20 million barrels vs. 30 billion barrels). Therefore, silver’s accountability limit ranges from being 5.6 times larger than gold to being 64 times larger than crude oil, as a percent of world production.

Here’s a very simple question – why is silver’s limit so out of line with every other commodity? The answer is also simple – there is no good reason and it should be reduced to a level consistent with all other commodities, including gold.

Some might say that you can’t compare silver to commodities like grains, or even crude oil or copper, because as a precious metal, there are large stocks of existing above ground inventories. This observation would obviously apply to gold as well, which also has large above ground inventories. But when you make an apples to apples comparison of the accountability limits in silver and gold relative to their respective above ground bullion inventories, a shocking picture emerges. Using one billion ounces as silver bullion inventories and two billion ounces as gold’s bullion inventories (silver conservatively high, gold conservatively low) relative to the 30 million oz silver position limit and gold’s 600,000 oz limit, silver has a position limit equal to 3.0% of world inventories. Gold’s limit comes in at 0.03%. In other words, silver has a position limit, relative to above ground bullion inventories, 100 times greater than gold’s limit. Once again, I ask why does silver have such a large position limit? Once again, there is no legitimate answer. Silver’s limit must be lowered.

In the matter of the proper level of speculative position limits, only silver needs to be radically reduced relative to all other commodities. If silver had an equivalent limit relative to world production as gold’s limit (0.8%), the proper limit in silver would be 1000 contracts (5 million ounces), not the current 6000 limit (30 million oz). If silver had an equivalent limit relative to above ground inventories as gold, the new silver limit would be only 60 contracts (300,000 oz). That’s too low, but 6000 is too high. What should the proper limit be in silver? In my opinion, somewhere between 1000 and 1500 contracts (5 to 7.5 million ounces).

Whatever the proper limit the regulators decide in silver, it should be consistent with all other commodities. The current sentiment is that position limits are generally too high and should be lowered. I don’t necessarily agree with that. But I would make the point that if the regulators do decide to lower speculative position limits across the board, then silver should be lowered below the 1000 to 1500 level I recommended. It’s all about consistency and fairness.

Exemptions to Speculative Position Limits

This second aspect to the position limit debate is more complicated and involves many commodities, including silver. While speculative position limits are an important component of commodity law, another integral part of that law grants exceptions or exemptions to those limits for bona fide hedging transactions. Remember, the economic purpose behind futures trading is to allow real world producers and consumers a market to transfer unwanted price risk to those speculators willing to assume that risk. Speculators are vital in enabling producers and consumers to have the ability to hedge price risks, but the economic legitimacy behind futures trading is not to provide a venue for gambling or for traders to dominate the pricing of world commodities. Therefore, it is appropriate for there to be limits on the amount of contracts that speculators may hold.

But that doesn’t mean that hedgers have a green light to trade in any amount they desire either. Even though commodity law allows hedgers to hold contracts in excess of applicable position limits, the amount they can hold is limited by demonstrated commercial needs. Here, commodity law is quite specific, generally allowing a producer or consumer to hold contracts in an equivalent amount no greater than 12 months production or consumption, or the amount of inventory at price risk. So even bona fide hedgers have some type of limit, although it may be greater than regular speculative position limits. The framers of commodity law intended for neither speculators nor commercial hedgers to unduly influence prices through excessively large long or short positions.

If commodity law is so clear and specific when it comes to position limits and exemptions to those limits, then why all the recent attention on position limits? The answer is because all sorts of exemptions, never intended under the original Commodity Exchange Act, have come into being. A consensus emerged over the past decade or so that allowed all sorts of traders, who were not real producers and consumers, to be granted exemptions to speculative position limits. All this was done under the belief that less regulation was better and that the exemptions would increase liquidity. Among the traders granted exemptions were index fund traders on the long side, and commercial and investment banks on the short side. Now serious questions are being raised as to the wisdom of granting those exemptions to non-producers and consumers of the real commodities. And for good reason.

Evidence has emerged that indicates that the index traders hold too large and dominant a long position in many markets and that their exemptions to position limits should be rescinded. Just because they represent large investment funds looking to invest in commodities, they are not true hedgers in the meaning of commodity law. So says the Senate Permanent Subcommittee on Investigations in wheat and other markets. This issue is what Chairman Gensler and the Commission are wrestling with.

On the short side, large commercial banks have amassed shockingly large positions under the guise of these being a hedge to other derivatives positions. But just like the index funds are not true consumers of the commodities they are long, the banks are not true producers of what they are short. Nor do they hold actual inventories. These banks sold a bill of goods to the regulators pretending they were truly hedging, when in fact they were just speculating across a variety of markets.

Nowhere has this bank shorting become more egregious than in silver (and gold). In the most recent Bank Participation Report, for positions held as of July 7, one or two US banks held a short position equal to almost 24% of the total world annual silver mine production. (160 million oz vs. 672 million oz). If a couple of banks held 24% of the world’s crude oil annual production, that would be equal to more than 7 million crude oil futures contracts, truly a preposterous amount. The amount held in silver is also preposterous.

This position held by one or two US banks is more than 32% of all COMEX silver contracts. (Three or fewer US banks held more than 31% of all COMEX gold futures contracts). The Senate report on wheat was concerned that a position held by 25 to 30 index traders for more than 35% of the market was a controlling position. If that’s the case, then what the heck is a position held by one or two US banks of more than 32% of the market? The answer is not just a controlling position, but a manipulative one as well.

The reality is that the level of accountability limits in silver is too large, by a factor of five or more compared to any other commodity (including gold). Even though the current limit needs to be reduced drastically from 6,000 contracts to between 1000 and 1500 contracts, the big shorts now hold a lot more than 6000 contracts each. One or two US banks hold a minimum of more than two and half times the obscene 6000 contract limit. If silver position limits were reduced to 1500 contracts, the big banks would be holding more than ten times that limit. That’s insane.

I am convinced that the CFTC now fully appreciates the position limit and manipulation problem in silver. Fix the position limit problem in silver and the manipulation is over. Let me repeat that. If the CFTC sets position limits in COMEX silver at 1000 to 1500 contracts for both longs and shorts and discontinues the phony hedging exemptions currently granted to the big US banks and other shorts, the silver manipulation is history. I think this is in the cards. I think this is what Chairman Gensler and Commissioner Chilton intend. But it won’t happen if the big shorts get their way. If they are allowed to continue to hold their manipulative short positions, then we must wait for the physical shortage to break the manipulation.

For more than 20 years, the CFTC has turned a blind eye and a deaf ear to the problem of legitimate position limits in silver. Apparently, that has changed. The new Chairman appears to be interested in the public’s opinion on this issue. It’s time for you to speak up. It’s time to be specific. The issue is position limits, not the budget deficit, not the dollar, not his previous employment at Goldman Sachs. He is doing what he should be doing and as such, deserves to be treated with respect. Ask him and the other commissioners to reduce the position limits in silver to between 1000 to 1500 contracts, or please explain why that limit is not appropriate. Ask him to do away with the phony exemptions granted to a few big shorts or make transparent the reason why they are short. Make it short, sweet and specific – lower the silver limits to equal all other commodities and disallow phony exemptions. Send this article if you want. This could be a game changer. Don’t delay.

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