I wanted to write this to capture my logic here after a spirited discussion last night. I want people to understand my frustration with not being understood to a clearer degree, as the Twitter 140 or so character limit doesn’t really work for me for relaying my position in a dispute.
Above is how it started.
Essentially, I was trying to state that it was a fractional reserve exchange of sorts that is responsible for price discovery. I got into it a bit with my friend Jim. When I try and bring up points – I don’t really like that sometimes I get a bit facetious and tongue in cheek, and it’s hard to convey this over Twitter in a playful manner – but I mean no ill will. Jim has helped me get a greater understanding of the futures market, as he is a futures broker. But it doesn’t mean I can’t have an opinion on what the market is – how I see it.
My MAIN issue has nothing to do with Jim. Love the guy. My MAIN issue is that it is a fractional reserve exchange that is used for price discovery, and we sort of had words on that. I laid out my gripe on the Comex using analogies that may not have been crystal clear for people to understand – but I also did go essentially point by point with Kyle Bass’s discussion he had.
At 2:02, he calls it a “fractional reserve exchange”. Let me play this out for you with the logic…
If I am a miner, I can forward sell my silver to capture a price now and deliver it later. Likewise, if I’m a speculator, I can look at silver mines coming online, see supply is going up (or look at the major markets and see a recession which might drive the industrial demand of silver down) and with this, place a BET that silver will go down. I also don’t have a lot of issue with that – to an extent. For example, if I think silver may go up $2-3 the next few months, I am aware that for every $1 silver moves, a futures contract would move $5,000. So if there’s a big move coming, and I want to bet, I can make $10,000-$15,000. But the grand assumption here is 99% or more just want the cash. I can understand that. But WHAT IF – more want the silver? You now introduce a risk factor here not easily defended to anyone who questions the mechanism – which is ultimately what Kyle Bass relayed.
Where I have issues is that this is a small market and the “speculators” are now big money groups who can bend price in any direction at the margins to make money using High Frequency Trading (HFT). What used to be hedging and some speculation has now become an embarrassment of a market that has nothing to do with the underlying supply and demand of the physical metal. And this massive leverage now at 20:1 has falsely conveyed a narrative that there’s plenty of silver.
My belief is that the STRUCTURE of the DESIGN of the market WAS brilliant. It became perverted. At any moment, you can have a group or few smash price down by littering the market with paper – giving a false sense that more supply of underlying metal is coming to the market. One would then say, “well, there’s a buyer for every seller”. True, but you have to understand directionality of what’s happening. If I own a penny stock and throw out a sell of a million shares, it could take some time to fill and push price down drastically. Tranches would be sold off in chunks, but at a continuously lower price as I have advertised a major supply of shares hitting the market. I would have to entice buyers at increasingly lower prices to execute that trade. The same goes if I put a buy order out for a million shares – price would have to continue to increase to entice people to sell. This is what is lost in the “buyer for every seller”. It is a directional drive lower when high numbers of selling hit the market which pushes the bid down.
This is essentially what happens with the aggressive selling, taking futures prices down. At issue here is that if this was legitimate hedging, I have zero issues with this. This COULD be a reason for the 8AM beat down daily. Overnight, price slides up, and first thing in the morning – all of these mining companies based in the Eastern time zone in Toronto or the like then start selling their production forward. Possibly.
But the VOLUMES are insane. And I want to talk about this as a pricing mechanism. I want you to consider the different players here…
- Retail speculators
- HFT speculators
At main issue is that I find a massive problem with item 3 above. I believe that needs to be banished, 1000%. Done. Over. This item has perverted the market. You see something with the market – and algos are scanning headlines and with this – automated buy/sells occur. If you want to control this price, you can release news and frame it in such a way to push the algos in the direction you want them to go. This is some Dr. Evil shit at work.
I have another analogy here. Assume you are a jockey racing horses. YOU have a direct impact in what horse wins the race. To ME, this is the hedgers. However, you have a roaring crowd of 100,000 that placed bets – these are the HFT spec money. What happens then is that the more people that bet on horse 1, the odds change that shows horse 1 might win. Now, let’s assume that every single time a horse race started, that the crowd BETTING on the horse DETERMINED who would win? Assume for a moment horse 1 was just taken out back and shot due to a broken leg. The race is going, but horse 1 was just announced the winner. He didn’t even race. This is kind of what is going on here – it’s again, another extreme, but it’s showing you how price is determined. It’s not being determined on the horse and the jockey, but the 100,000 people in the stands betting. This has to change, and will change when there are no horses actually racing anymore.
Furthermore, I have another issue. The MAIN issue I have is what Kyle Bass described as a fractional reserve exchange. Meaning, in the REGISTERED category, you have about 35m oz. However, you currently have “open interest” with about 136,000 contracts. Each contract is for 5,000 oz, so we are looking at about 680m oz bought/sold. Divide 35m into 680m. Thats a 20:1 ratio.
You can see this trend seems to be diminishing over time.
My problem here is this. IF this was all hedging, I would have no real issues because the silver would be coming into the COMEX to service those contracts. Think about it. If the TOTAL mine supply each year is 800m oz, and ALL silver comes in through here (it doesn’t), you are looking at about 66m oz per month getting added. If the total in inventory was 35m and 66m was sold, but 66m coming in, the registered of 35m is not an issue. This would perhaps be a 2:1 ratio which would not stress the market too much.
But once again, this is perverse. You have 680m oz sold (and bought) on paper contracts. A futures guy might be like, “they bought and sold contracts, not silver”. This is about the definition of a derivative. And again, I’d contend that price discovery should NOT be based on a derivative of the product. Let’s assume, for 1 minute, that all 680m oz of paper contracts decided they all wanted the silver. This is a risk. It may be highly improbable that 100% take delivery. IF so, you would have 1 oz for every 20 sold. The buyers, in this case, had agreed to buy silver with this contract and when they went to take it, there were 20 of them for each oz of silver. In other industries, this is called “fraud”.
The response I get with this concern it, “it will never happen”. “It’s not reality”.
I provided an extreme example as a thought experiment to introduce the concept of risk. It falls on deaf ears. What you find is that the registered is 5.1% of what was actually agreed upon for sale. It is POSSIBLE that 1-4% come to take delivery, and more stocks hit the vaults to replenish. This has been seen in the monthly draw downs for 18 months. But it is ALSO possible that 6-7% of them suddenly need the silver. Perhaps behind the scenes, the wholesalers suddenly strike out trying to buy on the OTC and start raiding the COMEX. What many think is this would be a single month 8% take delivery to wipe out the COMEX, but in reality, it looks more like a slow drain where it’s 1-2% each month and they are taking the metal off of the registered. It’s a “drip, drip” raid as opposed to waking up to see 60m oz leave the COMEX overnight. Consider that if these stocks get down to 17m in the next 1-2 months, we are then looking at a 40:1 ratio. It is heading there, and my bet is that some smart bastard with a few billion sees this and does something about it.
This is what that might look like with the draw downs over time.
The above is the LBMA stocks – that red line is essentially since “silver Squeeze” started with 180,000 of our closest friends buying anything and everything not bailed down at the same time that solar/green/EV demand continues with ferocity AS silver price is somehow sold into dirt. Why? Because price is being determined by the bettors and not the jockeys.
You might say – “Nate, the LBMA is not the COMEX”. Touche.
But a year ago I started tracking high numbers of “EFPs” with the COMEX numbers. I honestly don’t know what the hell this is, and it has been described as “settling the contract with LBMA bars outside of the COMEX”. What this might mean could be one of a few things – perhaps SLV or one of the ETFs buy silver from the COMEX and then take delivery within the LBMA warehouse where they are. This could account for massive volumes. It also could be European entities that could get metal from LBMA quicker than if they got it from the US.
Either way – I tracked serious, serious volumes of COMEX contracts being settled there, and not taking from the COMEX warehouse.
If you look at the Sep EFP, this was roughly 125m oz settled OUTSIDE of the COMEX. Meaning, perhaps there was 35m oz in the COMEX registered and they SOLD 125m to be settled – the sellers of these contracts appeared to be able to settle it off the COMEX with their physical stores in the LBMA, so to that extent, the “registered” in the COMEX did not matter to settle that volume. In many cases with this – the owner of the registered simply changes hands. So “taking delivery” does not mean “leave the vault”. So in that respect, I get where the futures guys are coming from.
But what if the free float in the LBMA is dwindling down? Look at that chart above with the blue line. I think there’s like 20 ETFs based out of the LBMA, with the SLV and the Aberdeen silver ETF as the biggest ones.
Ronan Manly at BullionStar had done an article quite some time ago about how the free float in the LBMA was getting razor tight. Which then would perhaps lead one to believe that the EFPs might be going lower and the drain in the COMEX would accelerate.
What you have seen over the last 18 months since Silver Squeeze started was the REGISTERED go from 150m to 35m oz. That’s a 77% drawn down in registered. However, with price dropping – you could also see oz moving from registered to eligible.
One can then claim, “look at the pile in eligible. There’s 267m oz there for over 300m oz in the vault!!”. Ronan the Destroyer strikes again – this time talking about how the COMEX people had been assuming a 50% haircut for the eligible to be probably available to move into the registered. That’s 133m oz in reserve of the 35m oz. However, they came to realize the 50% haircut may be very conservative, with a lot of these oz as “long term holds” and would not be for sale. Assume you are Toyota and might need 2m oz per year. Maybe you have a JIT pile of 300,000 oz you buy from OTC and have delivered around the world monthly. However, your broker tells you that they are having a tough time sourcing – so you then start tapping your 2m pile. This pile was never for sale, at any price. But it is counted as eligible.
And that is the faulty logic. Just because it is a registered bar that is ELIGIBLE for sale, does NOT mean it IS for sale.
So if the LBMA stocks have dropped like a rock the last year with EFPs, and the ETFs have sold off a lot of their metals as people sold out of silver, AND the COMEX registered has dwindled to 35m oz…..
How the hell would you plan to service the 680m oz sold?
The idea here is that a lot of people “rollover” each month. But Kyle Bass destroyed the narrative with the carrying costs – if you know you would be holding the metal for a few years AND the market was getting extremely tight, that 1% that takes delivery monthly could be 5%? And, IF there’s a draw down of significance in the LBMA AND the COMEX, how is this supply being backfilled? You think dropping the price of silver by 50% over the last year entices more production? If so, you need to go back to econ 101. In fact, all of these miners are squeezed to bankruptcy – between rising fuel prices and inflation – not only did you cut the price of the product they are producing, but you then put their nuts in a vice and cranked it up because it’s causing production to slow.
You can see a 5m or so per month draw down in registered monthly. I don’t have the numbers on the LBMA chart above, but it appears to be about a 20-25m per month draw down there – with little free float.
So if you are a strong believer in the COMEX futures, it’s plain to observe the below.
- As supplies are massively dwindling in the COMEX “for sale” pile, price is dropping 50%
- As supplies in the reserve LBMA “EFP” pile, price is dropping 50%
- As massive demand for solar and EVs is continuing mercilessly, price is dropping 50%
- As mine supply will be less this year – I believe Steve St. Angelo predicted something like 800-820m, DOWN from last year – price is decreasing 50%
So my main issue is this. By any and all economic measures, the underlying commodity supplies are drastically falling while demand is cleaning out house and putting a higher premium on 1,000 oz bars. To me – it is evidence that the pricing mechanism of silver is broken, and many cannot see the forest for the trees that this divergence is coming to a head, and somewhat soon.
Is the COMEX going to “break”? No. Not really. But what can be reasonably forecasted is a form of Palladium, Lithium, or Nickel-like moment where the short squeeze hits and things go vertical until someone changes the rules to tamp things down.
My contention, as it is others, is we are seeing the mechanism start to break between paper price and physical availability of the underlying commodity. This “derivative” price setting mechanism DOES eventually iron itself out with price – UNLESS you have no physical to base it upon. So in the SHORT term you COULD see a violent price move up, with the THOUGHT that items in eligible and the LBMA can supply the higher demand as higher prices are seen and meet the demand.
But we are now stretched at a 20:1 ratio of the silver that was sold (and bought) and the available items in registered. At $19, you may have a hard time sourcing this continued onslaught of physical removal of silver. This would indicate price has to move up.
One can look at the Lithium market for this. Lithium is one of the most plentiful elements on earth – yet price rose extraordinarily high recently. Why? Mine supply has not kept up with physical demand.
I don’t have a ton of data on that, but you get the idea.
I understand the concepts of the futures market, probably better than the average guy, but far less than the futures gurus. That being said, it seems there’s an insistence that this market will always function 100% awesomely and there is nothing to look at. I find it disturbing that HFT is able to move the market at the margins in any direction to profit from this, and find it even more disturbing that a “fractional reserve exchange” is able to direct price on an underlying commodity in deep distress.
I have found Jeffrey Christian entertaining to listen to, but his constant insistence of “silver falling from the rafters” sounds more like a grift than reality. While I DO agree there are perhaps 60B oz mined, a great deal of this is in products and lost. Recycling has helped with about 150m-200m oz per year, but with higher demand coming in and falling mine supplies hitting the market – you can clearly see a larger yearly deficit hitting us which is drawing down 1,000 oz bars in the largest vaults.
I would also contend this form of pricing mechanism seems to work, except when the leverage gets to these extremes. It’s a stress on the underlying commodity to do so. When there were 900m oz sold and 150m in registered last year with 390m in the COMEX vault and significant LBMA float – you could see that a 6:1 paper silver to physical silver ratio is WORKABLE – especially with LBMA float to assist. However, when it is stressed in this case at 20:1 with no real LBMA float – you can actually SEE the squeeze about to hit.
Got nickel? We are in the makings of this giant glacier about to hit a small pond.
If you cannot see this impact coming from a mile away with simple math, I don’t know what to tell you.
October 26, 2022 at 2:35 pm
Good stuff Nate.
I suggest that position limits on Comex would curb some of the spec and HFT issues, but not enough to cause true price discovery.
However, the banks would just spread the positions out in customer accounts as JPM has been seen to do.
October 27, 2022 at 1:20 pm
Another great article Nate. The cost of mining and refining, along with supply and demand dynamics will soon push silver prices up significantly. In the end its a matter of Mathematics.