By Patrick A. Heller – Liberty Coin Service
Commentary on Precious Metals Prepared for CoinWeek.com
In my previous column, I discussed how the COMEX Commercial traders in the silver market increased their net short position by more than 71 million ounces from January 17 through February 7. Let me explain in more depth how the COMEX operates, just what it means for the Commercial traders to establish a net short position, and how they could protect themselves from a high risk of loss when holding a large short position.
In general, the COMEX is a platform to trade physical metals without the bother of having to take or make delivery of a bulky asset. First off, a seller cannot sell a short contract unless there is another party to buy it to take an offsetting long position. Therefore, all long and short positions in the COMEX silver market should net to zero. At the extreme, the outstanding long contracts would be covered 100% by physical silver in the COMEX bonded warehouses. However, since most traders of COMEX contracts do not intend to take possession of the underlying physical commodity, there is only a fraction of physical silver in COMEX warehouses to fulfill delivery of contracts. COMEX silver contracts are for 5,000 ounces of pure silver made up of five 1,000 ounce bars.
To avoid having to deliver or take delivery of a maturing COMEX contract, most traders and investors close it out ahead of time by purchasing an offsetting contract. If the trader or investor still wants to maintain a position in the commodity, they can close out a maturing position at the same time they replace it with another contract with a maturity date further in the future. Thus, for example, someone holding a short position in a March 2012 silver contract could purchase a March 2012 long position to cancel out that liability while simultaneously selling short a March 2013 contract.
Those who have not closed out their March 2012 long or short positions by February 29 have effectively given notice that they will take (the longs) or make (the shorts) delivery of the underlying physical metal.
Those who have purchased long positions for which they take delivery have to make full payment of the contract price (if they borrowed money to make the acquisition), plus delivery, insurance, and transfer fees. Those who owe delivery on a matured contract are responsible to make delivery of the physical metal. If the metal is already stored in a COMEX warehouse, the seller can notify the buyer of the location and availability of the bars to take possession.
However, many short sellers do not own silver in COMEX warehouses to be able to make delivery. Prudent short sellers who do not have COMEX inventories to deliver to buyers will have offsetting long positions in physical silver, contracts on other exchanges, shares of exchange traded funds, or derivatives. It is also possible that short sellers do not have their positions covered by these means, which means that the seller is said to have sold a “naked short.” A naked short seller is at full risk of loss should the price of silver rise.
Sellers also have two other options for fulfilling their COMEX silver contracts. They can settle for cash in lieu of the commodity or they can settle for the equivalent number of shares in the SLV silver exchange traded fund. I believe that the buyer has the option to refuse these alternate forms of settlement.
The largest risk to the COMEX silver market is that a large number of maturing long contracts will be demanded for delivery. In March 2011, when a real supply squeeze affected the market, several people told me they were being paid more than $60 per ounce to accept a cash settlement rather than the physical metal.
There is also the risk, as happened in the MF Global Holdings bankruptcy, that customer assets had been re-hypothecated by a broker. That means that customer assets were pledged as collateral for debt of the broker. In the MF Global disaster, multiple COMEX gold and silver contracts suffered default of delivery.
It is also possible that some of the Commercial traders with large net short silver positions could take physical possession of some silver held by exchange traded funds in order to make delivery. This would leave the investors in the ETFs facing a loss of part of their investments.
It is also possible that short sellers might be unable to meet their contractual liabilities to holders of COMEX long accounts, and that even the counterparties to their derivatives contracts might not be in a position to fulfill their commitments. Should this occur, the COMEX would likely declare a force majeure event to relieve itself from any liability for the defaults.
As I think you see, owning paper silver may be convenient, but it does carry risks of loss. A better solution for most people might be purchase of physical silver bullion-priced coins and bars that they can have in their direct possession. Physical silver and gold don’t need credit ratings, because they are the asset rather than a promise of an asset.
Patrick A. Heller owns Liberty Coin Service and Premier Coins & Collectibles in Lansing, Michigan and writes Liberty’s Outlook, a monthly newsletter on rare coins and precious metals subjects. Past newsletter issues can be viewed at http://www.libertycoinservice.com. Other commentaries are available at Numismaster (http://www.numismaster.com under “News & Articles). His award-winning radio show “Things You ‘Know’ That Just Aren’t So, And Important News You Need To Know” can be heard at 8:45 AM Wednesday and Friday mornings on 1320-AM WILS in Lansing (which streams live and becomes part of the audio and text archives posted at http://www.1320wils.com.
What happens if force majeure is declared? Who loses and who wins in that scenario?
The naked short banks would fill their own positions with metals from the ETF, and the little guys that thought they owned the metal in that same ETF would lose.
Sounds a lot like the bad paper mortgage companies got the govt to buy. Will the American taxpayer have to bail out these paper pusher of phoney assets? Make the trader have physical possession before allowing them to trade.
My brain feels like it’s been through a mangle, trying to understand this short/long contract business… I think I’ll just *buy* some physical silver coins, at less than spot on ebay… aaah, that’s better !
You really need to hold your physical gold and silver in your possesion because one day soon, the COMEX will default and paper metal holders will be left holding paper.
Larry P,
EXACTLY! If we would just have the guts to ABOLISH naked paper trading in ALL commodities (i.e. speculating), then commodity pricing would reflect ACTUAL REAL supply and demand. Only producers should be allowed to write a naked short (because they make the stuff they’ll be delivering), and only people planning to take delivery should be allowed to write a naked long, because they need to make some physical product out of it, or want to sit on it for now.
Of course if we did that, gold might very well drop below $750 and silver to $10 or lower. We can’t really know.
Very informational Mr. Heller.
In a some what related issue:
Who verifies &/or certifies that ETFs such as GLD & SLV are not shell games?
How often is a INDEPENDENT audit with a meaningful INVENTORY conducted?
Semper Fi
Thanks for the excellent article, which I bookmarked for future reference on this confusing topic.
Reading between the lines, one could also take away that all of the silver in the ETF SLV has the potential to be re-hypothecated, ala MFG, and the SLV shareholders — beyond just being JPMorgan naked short-selling enablers — could be left with worthless pieces of paper when the COMEX goes into force majeure mode.
This is the one piece of the typical Heller rant with which I fully agree. Paper contracts are partially a sham. I am quite sure that at any given time, people “own” (in the monthly statement sense of the word) signficantly more silver than exists on the planet. Same thing with just about any heavily traded commodity. Options, futures, strips, straps, straddles, etc. are all “obligating” underlying assets that only exist to some percentage. If your silver that you own doesn’t make a ringing sound on a glass table, then you don’t own silver. You own an IOU for silver, which is as good as the solvency of the guy who wrote it.
Here’s the sickest part, though. The real physical silver market, whether it’s coins, bars, ingots, whathever, is DWARFED by the total market of the paper pushers. The physical metal market is the tiny little tail being wagged by the big ugly dog of the paper pushers. In a very real sense, the value of the physical silver we have is determined NOT BY US, but by the paper pushers. They can make OR BREAK the value of all of our physical metal holdings on a WHIM!