FUTURES
AND FORWARD CONTRACTS
Many
commodities trade via forward or futures contracts. A forward contract
is is an agreement between two parties to buy or sell an asset at a specified
point of time in the future. A futures contract is a
standardized contract to buy or sell a specified commodity of
standardized quality at a certain date in the future, at a market determined
price (the futures
price).
REGULATION
AND COUNTER-PARTY RISK
Both
futures and forward contracts introduce counter-party risk which depends on the financial ability
of the counter-party to perform and may result in a failure to deliver.
The calculated counter-party risk of futures contracts are assumed to
be lower than forward contracts because they are traded on commodity
exchanges. This is because generally governments must provide a common
insurance or regulatory standard, such as the Commodity Futures Trading
Commission (CFTC), and some release of liability, or at least a backing of
the insurers, before a commodity market can begin trading.
COMMODITY
MARKET SIZE
As a
result of this increased confidence the size of futures contracts has grown
tremendously. The major commodities exchanges in the United States were
the COMEX and NYMEX which merged under the New York Mercantile Exchange and
Commodity Exchange, Inc. (NYMEX) name on 3 August 1994.
The notional
value outstanding of OTC commodity derivatives contracts increased 27% in
2007 to $9.0 trillion. OTC trading accounts for the majority of trading in
gold and silver. Overall, precious metals accounted for 8% of OTC commodities
derivatives trading in 2007, down from their 55% share a decade earlier as
trading in energy derivatives rose.
BACKWARDATION
Because
of the large aboveground stockpiles of the monetary metals threfore gold and
silver should never enter backwardation. Backwardation would be
evidence of the market’s increased apprehension of counter-party risk
and the increased probability of a failure to deliver. The brief gold backwardation or the recent black swan of nine weeks of silver
backwardation in the London Bullion Market Association (LBMA) forward
markets revealed the extreme fragility of the worldwide financial and
monetary system.
Mr.
Avery Goodman, a securities attorney and a member of the roster of neutral
arbitrators of the National Futures Association (NFA) and the Financial
Industry Regulatory Authority (FINRA), has also written extensively about
whether the COMEX will default
on gold and silver, how the NYSE ran out of gold bars,
the evidence that the ECB bailed
out Deutsche Bank preventing a failure to deliver of gold on the COMEX
and a follow up article on the ECB’s saving of
the COMEX from a gold default.
Then
there are other commentators like Jason Hommel, the creator of the satirical silver CFTC appreciation
medallion above, who alleges regulatory culpability. Still others
like the Gold Anti-Trust
Action Committee (GATA) who has met with CFTC officials bring
considerable intellectual firepower to the allegation of a central bank gold
price suppression scheme where Mr. Robert Landis, a Harvard trained
attorney, asserts “Any rational person who continues to dispute the
existence of the rig after exposure to the evidence is either in denial or is
complicit.”
TOOLS
OF SPECULATION
Due to
the size of the derivative contracts traded on the commodity exchanges and
the counter-party risk the contracts are impregnated with therefore
a bankruptcy of either the counter-party, the exchange or both could
happen. Due to the increased liquidity of these exchanges many of those
buying or selling the contracts for speculative purposes neither want
possession of the underlying commodity nor possess the underlying commodity
and have the ability to physically deliver.
While
there are some some legitimate measures such as oil or gold companies that
sell forward their production, and the number of gold companies has
increasingly withered, in many cases when you buy these gold derivatives you
are buying from a speculator who is shorting gold and that gold speculator
does not actually own any physical gold.
MECHANICS
OF AN EXCHANGE BANKRUPTCY
Let us
assume for the sake of argument that gold prices go ballistic and you decide
you want your gold by taking delivery on the contract. What if gold
prices go up dramatically in one day such as a thousand dollars an ounce.
Is it possible? Of course. Is it probable? Not
really.
But that
means the person who shorted gold is in a very precarious position
and could have possibly lost everything or more. Perhaps they had
a stop but the market is fast and gaps and as a result they cannot get out of
their position. What would happen?
Let us
assume this speculator had ten thousand dollars in their commodities account
and they were short a gold contract. Suddenly, perhaps overnight, the
Chinese press the issue because the International
Monetary Fund failed to deliver on their gold sales and needed a line of
credit, gold prices rapidly jumped and this speculator lost a hundred
thousand dollars overnight. Now the brokerage firm has to attempt to
collect on this ninety thousand dollar margin call in the form of an
unsecured debt. What if they cannot collect and what if there are
hundreds or thousands of speculators in similar situations?
With
this failure to deliver and violation of margin requirements what if the
exchange, because they do not have adequate capital or liquidity, cannot get
the currency to settle the contracts? Then the exchange goes broke
unless there is a government bail out but what good would that fiat currency
do in purchasing the physical gold or silver bullion?
COUNTER-PARTY
RISK MATERIALIZING
This
is what happened with the American Insurance Group. The reason AIG went
bankrupt is because they were the other side of many speculative contracts.
When the flock of black swans they had insured against descended AIG
could not perform because they did not have the cash. The government
bailed them out at the cost of hundreds of billions if not trillions of
dollars.
This
means if you buy silver or gold on the COMEX
via futures contracts, there is a huge move up, the COMEX goes bankrupt and
the government does not bail them out then you are not going to be able to
cash out your epic gains from the casino. Like the auto maker’s
bond holders you will not realize and enjoy the profits you thought you
would.
This
is precisely what happened with people who were short a bunch of oranges and
other interesting things via hedges with Lehman Brothers and even though they
‘made’ millions of dollars on their positions they lost
everything. Why? Because Lehman Brothers went under and did
not perform on the contracts. This
is counter-party risk.
CONCLUSION
At all
time and in all circumstances gold and silver remain money. For the
conservative investor the reason to own them is as insurance for when
everything else fails. These issues of counter-party risk are important
when considering how to buy gold or silver
through third parties. There are third-parties, like GoldMoney, that not subject
to counter-party risk because of the way ownership is titled and the ability
to demand physical delivery at any time.
As I
explain in my book The Great Credit
Contraction capital is burrowing down the pyramid into safer and more
liquid assets. The safest and most liquid of them all are gold and
silver. Why? Because the world reserve currency the FRN$ is
merely an illusion that can become worthless while gold and silver are money
and will always buy something.
Consequently,
the conservative investor will determine what their gold standard is considering there are 140 ounces
of paper gold for every ounce of physical gold. Then they will take
appropriate actions, such as buying gold in a
vending machine, to remove the layers of risk between them and their
purchasing power in an effort to preserve and safeguard their capital.
Trace Mayer
RuntoGold.com
Trace Mayer,
J.D., holds a degree in Accounting from Brigham Young University, a law
degree from California Western School of Law and studies the Austrian school
of economics. He works as an entrepreneur, investor, journalist and monetary
scientist. He is a strong advocate of the freedom of speech, a member of the
Society of Professional Journalists and the San Diego County Bar Association.
He has appeared on ABC, NBC, BNN, many radio shows and presented at many
investment conferences throughout the world.
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