Gold dropped to new lows of $1,130 per ounce last week. This is surprising
because it doesn’t square with the fundamentals. China and India continue to
exert strong demand on gold, and interest in bullion coins remains high.
I explained in my October article in The Casey Report that the
Comex futures market structure allows a few big banks to supply gold to keep
its price contained. I call the gold futures market the “paper gold” market
because very little gold actually changes hands. $360 billion of paper gold
is traded per month, but only $279 million of physical gold is delivered.
That’s a 1,000-to-1 ratio:
Market
Statistics for the 100-oz Gold Futures Contract on Comex
|
|
Value ($M)
|
Monthly volume (Paper Trade)
|
$360,000
|
Open Interest All Contracts
|
$45,600
|
Warehouse-Registered Gold (oz)
|
$1,140
|
Physical Delivery per Month
|
$279
|
House Account Net Delivery, monthly
|
$41
|
We know that huge orders for paper gold can move the price by $20 in a
second. These orders often exceed the CME stated limit of 6,000 contracts.
Here’s a close view from October 31, when the sale of 2,365 contracts caused
the gold price to plummet and forced the exchange to close for 20 seconds:
Many argue that the net long-term effect of such orders is neutral,
because every position taken must be removed before expiration. But that’s
actually not true. The big players can hold hundreds of contracts into
expiration and deliver the gold instead of unwinding the trade. Net, big
banks can drive down the price by delivering relatively small amounts of
gold.
A few large banks dominate the delivery process. I grouped the seven
biggest players below to show that all the other sources are very small.
Those seven banks have the opportunity to manage the gold price:
After gold’s big drop in October, I analyzed the October delivery numbers.
The concentration was even more severe than I expected:
This chart shows that an amazing 98.5% of the gold
delivered to the Comex in October came from just three banks: Barclays; Bank
of Nova Scotia; and HSBC. They delivered this gold from their in-house
trading accounts.
The concentration was even worse on the other side of the trade—the side
taking delivery. Barclays took 98% of all deliveries for customers. It could
be all one customer, but it’s more likely that several customers used
Barclays to clear their trades. Either way, notice that Barclays delivered
455 of those contracts from its house account to its own customers.
The opportunity for distorting the price of gold in an environment with so
few players is obvious. Barclays knows 98% of the buyers and is supplying 35%
of the gold. That’s highly concentrated, to say the least. And the amounts of
gold we’re talking about are small—a bank could tip the supply by 10% by
adding just 100 contracts. That amounts to only 10,000 ounces, which is worth
a little over $11 million—a rounding error to any of these banks. These
numbers are trivial.
Note that the big banks were delivering gold from their house accounts,
meaning they were selling their own gold outright. In other words, they were
not acting neutrally. These banks accounted for all but 19 of the contracts
sold. That’s a position of complete dominance. Actually, it’s beyond
dominance. These banks are the market.
My point is that this market is much too easily rigged , and that the
warnings about manipulation are valid. At some point, too many customers will
demand physical delivery and there will be a big crash. Long contracts will
be liquidated with cash payouts because there won’t be enough gold to
deliver. I saw a few squeezes in my 20 years trading futures, including gold.
In my opinion, the futures market is not safe.
The tougher question is: for how long will big banks’ dominance continue
to pressure gold down? Unfortunately, I don’t know the answer. Vigilant
regulators would help, but “futures market regulators” is almost an oxymoron.
The actions of the CFTC and the Comex, not to mention how MF Global was
handled, suggest that there has been little pressure on regulators to fix
this obvious problem.
This quote from a recent Financial Times article does give some
reason for optimism, however:
UBS is expected to strike a settlement over alleged trader misbehaviour at
its precious metals desks with at least one authority as part of a group deal
over forex with multiple regulators this week, two people close to the
situation said. … The head of UBS’s gold desk in Zurich, André Flotron, has
been on leave since January for reasons unspecified by the lender….
The FCA fined Barclays £26m in May after an options trader was found to
have manipulated the London gold fix.
Germany’s financial regulator BaFin has launched a formal investigation
into the gold market and is probing Deutsche Bank, one of the former members
of a tarnished gold fix panel that will soon be replaced by an electronic
fixing.
The latter two banks are involved with the Comex.
Eventually, the physical gold market could overwhelm the smaller but more
closely watched US futures delivery market. Traders are already moving to
other markets like Shanghai, which could accelerate that process. You might
recall that I wrote about JP Morgan (JPM) exiting the commodities business,
which I thought might help bring some normalcy back to the gold futures
markets. Unfortunately, other banks moved right in to pick up JPM’s slack.
Banks can’t suppress gold forever. They need physical gold bullion to
continue the scheme, and there’s just not as much gold around as there used
to be. Some big sources, like the Fed’s stash and the London Bullion Market,
are not available. The GLD inventory is declining.
If a big player like a central bank started to use the Comex to expand its
gold holdings, it could overwhelm the Comex’s relatively small inventories.
Warehouse stocks registered for delivery on the Comex exchange have declined
to only 870,000 ounces (8,700 contracts). Almost that much can be demanded in
one month: 6,281 contracts were delivered in August.
The big banks aren’t stupid. They will see these problems coming and can
probably induce some holders to add to the supplies, so I’m not predicting a
crisis from too many speculators taking delivery. But a short squeeze could
definitely lead to huge price spikes. It could even lead to a collapse in the
confidence in the futures system, which would drive gold much higher.
Signs of high physical demand from China, India, and small investors
buying coins from the mint indicate that gold prices should be rising. The
GOFO rate (London Gold Forward Offered rate) went negative, indicating
tightness in the gold market. Concerns about China’s central bank wanting to
de-dollarize its holdings should be adding to the interest in gold.
In other words, it doesn’t add up. I fully expect currency debasement to
drive gold higher, and I continue to own gold. I’m very confident that the
fundamentals will drive gold much higher in the long term. But for now, I
don’t know when big banks will lose their ability to manage the futures
market.