Thoughtful Disagreement with Ted Butler

Too Big to Fail?

Dear Mr. Butler, in your article of 2 October, entitled Thoughtful Disagreement, you say:

“Someone will come up with the thoughtful disagreement that makes the body of my premise invalid or the price of silver will validate the premise by exploding.”

Back in the late 90s this was actually a fairly well-timed case, as silver eventually rose from a low of around $4 in 2000/2001 to a high of almost $50 in 2011, but we neither bought into the “shortage” story (note: one of the reasons why gold and silver are monetary metals is precisely that their above-ground stock is so large that shortages are extremely unlikely to ever develop), nor the idea that nefarious forces kept prices from rising. This is not to say that nefarious forces as such don’t exist, only that they probably have better (and more profitable) things to do. Also, since silver was the best-performing commodity from 2000-2011, they would have to be considered pretty inept.

“Here are the issues. Silver (and gold) prices are set by paper dealings on the COMEX by a few large speculators (banks and managed money traders), to the exclusion of input from real producers and consumers, making the price discovery process and the resultant price artificial. For the past nearly ten years, CFTC data have indicated that JPMorgan has been the dominant paper silver short seller, along with a few other large banks and as a result of that dominance and control none have ever taken a loss when adding short positions. In addition, for the past six and a half years, JPMorgan has accumulated a massive amount of actual silver (650 million oz) at rock-bottom and self-created depressed prices, all while never taking a loss while shorting silver on the COMEX.”

Silver was in a very strong bull market from 2001 to 2011;  the correction since the peak, even though it was quite sizable could well turn out to be part of a longer term bull market. Nothing argues against this idea from a technical perspective. Note the interesting way in which monthly MACD has developed in this context.

Silver Monthly, 1998 - 2018

- Click to enlarge

• the price of silver is set exclusively in the futures market (throughout my article, I will refer to silver but what I say is equally applicable to gold also)
• JP Morgan and the banks are speculators
• the largest speculator has never taken a loss
• JP Morgan has accumulated a large amount of metal, as opposed to paper.

Let me first address #3. The others are all integral and I will respond to them at length below.

When I was about 12, I spent every waking moment teaching myself to program computers. I had this brilliant idea, or so I thought, for how to beat the casino at roulette.

Bet $1 on red. If you win, take the profit off the table and bet $1 again. If you lose, bet $2. If you win, you’re even and go back to a $1 bet. If you lose, double again to $4 and so on. The magic is due to the fact that a string of losses becomes more and more improbable the longer it gets.

So I wrote a little program to test this scheme. After hundreds or thousands of iterations, you would lose your entire stake. I checked everything; there was no bug in the code. So what caused the losses?

Roulette has a 0 and a 00. These numbers are neither red, nor black. The probability of winning a bet on red (or black) is less than 50%, but the payout is only 1 to 1. It doesn’t matter how big a stake you bring to the table (though larger takes longer). Betting on roulette will wipe you out eventually.

You might be wondering, what does this have to do with JP Morgan being so big that it need never take losses in silver? The principle is the same. If the bank was net short from Nov 2008 (when you said they became “the new Mr. Big on the short side of silver” after their takeover of Bear Stearns) through April 2011, then it was on the wrong side of a market that moved from $8.30 to $49.80. There is no protection for the big, the medium, or the small. Betting wrong brings losses to anyone.

If the argument is that JP Morgan is so big, that it could just short more silver then I have two responses First, please read the above roulette story. Second, the price of silver did go up more than $40. Whatever hypothetical power the bank is supposed to possess, it did not in fact stop the price from rising almost six-fold.

If the argument is that JP Morgan did take a loss, but doesn’t have to report it, then let me just note that a bank that big has many people who know its silver position: traders, accountants, internal and external auditors, directors, regulators, etc. Over a period of years, this must add up to hundreds of people who would be risking their careers and liberty to commit fraud by signing off on financial statements showing a profit in such case of loss.

JP Morgan CEO Jamie Dimon. His grin tells us his bank isn’t mired in giant losses on silver positions. - Click to enlarge

The bank’s financial statements say the same. The biggest trading loss the company reported in recent years occurred when one of its traders, Bruno Iksil, who became known as the “London whale” took way too large positions in otc credit derivatives and ended up as the “speared whale of London” – mainly because his positions grew so big, he basically was the market. The loss amounted to around $2 billion, which was embarrassing for JPM, but far from threatening its existence. It never reported any significant losses in silver.

Photo credit: Yuri Gripas

Speculation vs. Arbitrage

The answer why JP Morgan has never taken a loss, and the other three issues also, is simply: the banks are not speculators, but arbitragers. Allow me to give a brief outline of my theory of the market, and by the end it will be clear why I say they are arbitragers.

First, let me start with some simple facts that should not be controversial. People buy and sell metal in the spot market, and they buy and sell paper in the futures market. These are separate markets. And they have different prices. For example, as I write this in the late afternoon on 3 October, these are the prices:

Proving a Theory

This brings us to an interesting point. In physics, when there are two competing theories, scientists look for a case where each predicts the opposite result. Then they perform an experiment and observe the result. For example, Aristotle believed that two rocks of different weights must fall at different speeds. He said that the heavier one should fall faster, in proportion to its greater mass.

Galileo believed that they will fall at the same speed. So he took two rocks, one heavier than the other, and carefully dropped them from the Leaning Tower of Pisa. They hit the ground at the same time. Galieo’s theory was proven right, and Aristotle wrong. Later, astronaut David Scott did an experiment in the vacuum on the moon’s surface, and showed that a feather and a hammer fall at the same speed.

Galileo vs. Aristotle. - Click to enlarge

Galileo had the better ideas about physics, particularly with respect to bodies in motion and the forces affecting them. In modern-day gender studies it was found that although gravity mistreats all objects equally, it still has to be classified as a misogynist tool of oppression invented by the patriarchy (just look at these bearded fellows!) and should therefore be banned. Still, Galileo was right.

Futures contracts generally live for 18 months. They come into existence 18 months before they expire. As they approach expiration, there is a deadline called First Notice Day. On or before this day, traders with long positions, who do not have the cash to take delivery, must sell their contracts. If they want to keep their bet going, they can buy another farther-dated contract. Traders who are short, who do not have metal to deliver, must buy their contracts. If they want to keep their bet, they can sell another contract.

If the big banks are making a bet on a falling price, then they do not have the metal to deliver and therefore must buy the expiring contract with urgency. Recall from earlier, the price of a silver futures contract is not the same price as the price of silver. Indeed, the price of the Dec silver contract is not the same as the March, the May, or the July 2018 contracts. If there is urgent buying, in size, it will drive up the price of the expiring contract.

However, if the banks are arbitragers who have bought physical metal, then they have already locked in their profit. In this case, they are happy to deliver the metal if it comes to it. On the other side of the trade, who are the buyers of all these contracts? Have they got the cash to stand for delivery?

Most traders who use futures do so because the market offers leverage. To buy 10,000 ounces of silver metal you need $166,000. To buy two silver contracts, you need only a fraction of that (depending on margin requirements, which change from time to time). The urgent selling of these long speculators would cause the price of the expiring contract to fall.

If there is an equal balance, and both shorts and longs are naked, then we would expect mixed results. Sometimes, we should see an expiring contract fall, and other times we should expect to see it rise.

Our experiment should look to see what happens to the price of each contract as it nears expiry. There is one last wrinkle. We cannot look at the raw price. The signal we seek may be small relative to the price of silver. We want to look at the difference between the expiring futures contract and the reference price of spot: Future – Spot. This happens to be the basis!

We just need to look at the data, to determine which theory is true:

1. If each basis skyrockets as the contract heads into expiry, then short speculators dominate the market. This is because short speculators must buy the futures contract, as they cannot make delivery.
2. If each basis falls into the abyss, then it must be long speculators who predominate. This is because they must sell, not having the dollars to pay to take delivery of the silver.

Here is a chart showing one silver contract by itself, to clearly illustrate what the basis looks like over the life of a futures contract.

Silver Basis, Jul 2017

The silver basis over the life of the July 2017 futures contract - Click to enlarge

Monetary Metals has calculated a precise value for the basis of every contract going back to 1996. Using this data, we have put together a chart of all 109 silver contracts since March 1996. To make it easier to see, we have aligned all of them by contract age in terms of number of days until expiry on the X axis of the chart. The Y axis shows rise or fall in basis over the life of the contract up to around First Notice Day. This chart makes it possible to visualize the behavior of all contracts.

And here is the chart with all contracts overlapping on it, to show the overwhelming evidence in support of the bank-arbitrager theory that puts the bank-speculator theory to bed.

Silver Basis

Basis of all silver futures contracts since 1996, aligned - Click to enlarge