Costata has been working on a few detailed responses to some of the comments in the last thread. But with the comments going over 600 in four days, and then Blogger swallowing about 140 of them on Thursday, I thought it would be a good idea to start a fresh open forum for Costata's replies and for all of you to continue the discussion.
Sincerely,
FOFOA
813 comments:
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Part 5/6
Market Manipulation
A lot of people were shocked by the idea that the paper silver market could be leveraged to such an extreme level. We shouldn’t have been. This process of corrupting markets has been going on for a long time. These trends tend to become more and more extreme over time rather than self-correcting. In my opinion the situation is going to get a whole lot worse before it gets better. Here’s some more background reading for anyone interested. Firstly an essay by Martin Armstrong that I have linked before. His observations about the silver market are well worth reading.
How did we get to this place? I think Martin Armstrong gave an excellent potted history of the origins and evolution of this extreme cowboy (outlaw?) culture on Wall Street in this essay. He also touches on some of the other central themes of his writing in this essay. The government damaging markets, abusing its privilege as the lawmaker and encouraging cronyism.
Here’s a link to an excellent opinion piece from a stockbroker by the name of Marcus Padley talking about the changes in culture that occurred after 1986 when the stock trading floors in London were closed and the markets became electronic. He describes a similar change in the ‘business culture’ of brokers and dealers to the one Armstrong describes among Wall Street banks.
The real beginning of this disastrous FIRE dominated US economy commenced in the 1970s and gained traction in the 1980s when the taxation system began to be modified to favour capital “profits” and penalize labour. For those readers who enjoy analysis that is a tad wonkish this paper has a lot to offer. In short it demonstrates very clearly that for the past few decades the share of productivity gains and the overall slice of the profits has been increasingly skewed toward capital and away from labour.
There was a major change in direction of US government policy and financial services industry law around 1979 and 1980 with the passing of legislation that facilitated the development of the credit card industry by beginning to remove all controls on interest rates. The US states began to dismantle their consumer protection laws in order to compete for the establishment of the call centres and back office operations of the card providers. The organized crime syndicate loan sharking operations were on borrowed time. There was a new kid on the block.
Introduction, Secret History of the Credit Card. PBS Frontline: November 23, 2004: http://www.pbs.org/wgbh/pages/frontline/shows/credit/etc/synopsis.html
http://www.pbs.org/wgbh/pages/frontline/shows/credit/more/rise.html
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This period also saw the word “deregulation” enter the political arena as vote winner.
Another significant turn for the worse occurred when US banks began to routinely on sell securitized debt instruments and offloaded the management of their loans to “servicers”. They no longer had any skin in the game. Credit quality became a non-issue for them. MERS was an all time low for these jackals. They effectively broke the land title system in the USA by corrupting the title transfer system.
The repeal of the Glass Steagall Act in America probably did more damage to the international financial system than any other single act of recklessness by any government anywhere. From that point forward Wall Street made the rules. Once again this was a gradual process. Wikipedia describes some of the crucial events in this process here.
The Banking Act of 1933 was a law that established the Federal Deposit Insurance Corporation (FDIC) in the United States and introduced banking reforms, some of which were designed to control speculation[1]. It is most commonly known as the Glass–Steagall Act, after its legislative sponsors, Carter Glass and Henry B. Steagall.
Some provisions of the Act, such as Regulation Q, which allowed the Federal Reserve to regulate interest rates in savings accounts, were repealed by the Depository Institutions Deregulation and Monetary Control Act of 1980. Provisions that prohibit a bank holding company from owning other financial companies were repealed on November 12, 1999, by the Gramm–Leach–Bliley Act.[2][3]
The proliferation and the explosive growth of derivatives outside the public exchanges completed our migration to the dark side in my humble opinion. I commented on this in my post:
It appears that the volume in the OTC markets and shadow banking “dark pools” comes at the expense of both liquidity and stability in the public exchanges. As a result the price discovery function of the public exchanges may be seriously compromised. At the same time the off-exchange trading must reference, at least to some degree, the prices "discovered" on the public exchanges. What a fricken mess! But an ideal environment for market manipulation.
I’m going to repeat a few quotes, below and in part B, from that Spiegel interview I linked to in my post. The interview where Ekkehard Schulz, the CEO of ThyssenKrupp, was discussing two of the commodity metal markets – nickel and iron ore. I thought his observations were illuminating and acute.
If you haven’t already seen it I want to bring this comment to your attention from Bron Suchecki of the Perth Mint. He is talking about the bullion banks and compares them to spiders inside a sensitive web of market intel. He also shares a link to a paper from Ben Davies of Hinde Capital.
This is why I call silver a ‘trade’. The price could go anywhere if market manipulators are in control. It could become just like the nickel market that Ekkehard Schulz described where “the price per ton fluctuates between €10,000 and €50,000”.
Part B - Artificial Markets
Part B - 1/6
We are now going to attempt to deepen our insights into manipulated markets by using a part-factual and part-theoretical thought experiment to turn a real, solely physical market into an artificial construct. Before we do that we will look at how this physical market was rendered partially artificial by a double cross and inside information. A foretaste of what could have lain ahead if the “financial innovators” had gained control of this market.
The point of this exercise is to compare the features of our artificial market construct to the “real” markets we have to live with today. If this artificial market closely resembles actual markets then I think we have to consider the question of whether these markets are real or they are, in fact, just imitations of real markets. As the saying goes if it walks like a duck, quacks like a duck and looks like a duck, it’s a duck.
Commodity Markets
Ekkehard Schulz pointed to the wild swings in the price of nickel as an indicator of a market that has been distorted “by disconnecting prices from the real economy and the natural resources from real consumption”. If you go looking for other examples of markets that are disconnected from reality you will find plenty of examples. Here’s a few suggestions if you want to do some research. Take a look at the copper market where you will find a major international bank/trader setting up an ETF so institutional “investors” can gain exposure to that market.
Look into Carl Icahn’s efforts to monopolize water rights in the southern United States. Ekkehard Schulz also pinpointed the iron ore market as a target for JP Morgan. And let’s not forget the biggy, the grandaddy of all attempts to create an artificial market, carbon emissions trading. (Yes, I know some of you have a planet to save. The comments are open, so fire away.)
FOFOA shared a quote from a treatise by John Locke (1632-1704) where he discusses property and distinguishes socially harmful hoarding from that which is socially harmless.
”And indeed it was a foolish thing, as well as dishonest, to hoard up more than he could make use of. If he gave away a part to any body else, so that it perished not uselessly in his possession, these he also made use of. And if he also bartered away plums, that would have rotted in a week, for nuts that would last good for his eating a whole year, he did no injury; he wasted not the common stock; destroyed no part of the portion of goods that belonged to others, so long as nothing perished uselessly in his hands.
Again, if he would give his nuts for a piece of metal, pleased with its colour; or exchange his sheep for shells, or wool for a sparkling pebble or a diamond, and keep those by him all his life he invaded not the right of others, he might heap up as much of these durable things as he pleased; the exceeding of the bounds of his just property not lying in the largeness of his possession, but the perishing of any thing uselessly in it.”
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Part 2/6
I am going to try to demonstrate that this issue of artificial markets and hoarding of commodities isn't some esoteric argument or moral dilemma. It raises practical issues that we have to consider out of necessity. I also want to try to show that being in the right metal isn't merely a debate about investment potential.
In part B we are only going to delve deeper into one more example of financial “innovation” in markets before we try a little DIY artificial market construction. Let’s take a look at the concept of “naked shorting”. A topic close to the hearts of many silver analysts which I looked at in my corner post. A quick explanation for the uninitiated.
Assume that you and I both hold stock in a company that has 100 million shares on issue. I think it is worth $1.10 per share and you think it is only worth 0.95 cents. As they say it’s a difference of opinion that makes markets and horse races. I’m a buyer around $1.00 and you may well be a seller at that level. Now a third party thinks this company if only worth 0.90 cents. So they put on a covered short. They go to an institution that holds a big slice of the stock of this company and they borrow some shares for a fee. They sell those shares on the market at, say, $1.00 hoping that the price will fall to 0.90 cents and they can scalp a profit when they buy back the stock to return to the lender.
Naked shorts have carried this practice to a new level. They effectively issue their own stock in a company. They literally create it out of thin air. The famous investor Jim Rogers defended this practice on an episode of The Keiser Report from the 14.15 mark here. His argument seemed to hinge on the fact that the naked shorts would still be forced to cover anyway if their bets went against them. I’m going to speculate on a possible method that could be used by a naked short to have their cake and eat yours too.
When you have a brokerage account any stocks you hold are attributed to your account by the broker. But who is recorded as the actual owner of those stocks on the share register of the companies you hold shares in. According to this analyst it may be the nominee of a subsidiary of the Depository Trust and Clearing Company (DTCC). Who does the DTCC record as the owner of the stock purchased through a broker?
If it is the broker on one interpretation of the law this could make you nothing more than unsecured creditor of your broker dealer. If you have a margin loan with the broker and conduct all of your transactions and trading through that account. The broker-dealer can see all of your positions and front run your trades, borrow those stocks and so on. Once you factor in co-located servers into this picture it might put quite a different perspective on Jim Roger’s defense of the naked shorts. What if you are “lending” the stock that is being used to short a stock in your portfolio?
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Part 3/6
Back to our naked short. He offers to sell perhaps 10 million (of our?) shares of that company stock. You and I are startled by this. Wow! Did we get our valuations of that company’s shares outrageously wrong. Owners of 10 per cent of that company appear to want to dump the stock. If we panic and dump “our” stock too it might crash the price and allow the naked short to buy back in at a huge profit. What if our broker-dealer also issued a downgrade for that stock at the same time? Revisit the brokerage account system described above. If we dumped that stock did we simply cover our broker-dealer’s “naked” short with a guaranteed profit for them?
Now we come to our second and final deeper investigation of a market that is naturally and realistically physical in character. You will have to take my word for the facts of this tale because I don’t want to make poor Jonathan’s head explode by asking him to read too much more background material. We will take this physical market, turn it into an abstraction of reality and render it artificial in order to speculate on the impact of this process.
Let’s head off to the Tsukiji Fish Markets in Tokyo. The largest physical market for tuna in the world where the Bluefin Tuna is traded. I’m only going to provide two links. Here is a video of this fish market in operation and this is an overview of this amazing creature. These fish are the Formula 1 racers of the ocean.
To begin our story - It emerged a few years ago that the Japanese fishing fleets were harvesting multiples of their quota of the Southern Bluefin Tuna from Australian waters. As you can probably imagine that put a huge hole in local fishery management plans. These plans were designed and implemented to make the resource extraction of this fishery sustainable. There were further revelations to come.
We then found out that one of the large Japanese trading companies was stockpiling frozen tuna. Literally the whole fish you saw in that video of the Tokyo Fish Market. Why would they put capital into such a venture with no prospect for an immediate return? Of course, it’s a better choice than gold because you can actually eat tuna. But it is still a potential supply overhang with relatively large overheads in keeping those fish frozen and in marketable condition. These traders had created a kind of tuna “ETF” except no shares traded on an exchange. It was a true “dark pool” with no way to know precisely who owns those fish. So why were they hoarding these fish?
Perhaps this was their plan. Knowing these fish were being over-extracted and the catch was being under-reported it follows that the price of tuna was artificially low. That’s the logic of supply and demand. When it became known that the quota was being exceeded the tuna fishermen might be forced to slash their take of the wild stock. With a much lower supply the hoarders could confidently expect those stored fish to be revalued upward.
If over-extracting this fishery depleted the wild stock to a sufficient degree the fishery itself might suffer a collapse in the population of these fish rendering continued extraction uneconomic. The trader controlling the tuna hoard could have made a killing. They might even obtain a corner on the tuna market in Japan and then drip feed those hoarded fish into the market to maximize prices.
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But why would a government and its regulators turn a blind eye to this type of market manipulation and betrayal of an agreement with a major trading partner? It could easily be justified if you understand how concerned Japan is about food security. (The same is true of energy security.) These are islands with a relatively large population to feed and limited land for agriculture and stressed fisheries. The hoarder could probably get away with placing his hand over his heart and claiming his actions were designed to increase Japan’s food security.
This inside knowledge of a crucial piece of market intel gave this trading company the ability to game the market. It damaged the physical market’s capacity to discover prices accurately. It made the market artificial. Think back to my corner post. The information the bullion banks possess about the physical gold and silver markets is light years ahead of this Japanese trading company hoarding tuna. The international banks are replicating this systemic advantage in an ever increasing number of commodity markets too.
Back to our tuna story. There was a huge innovation in Australia’s tuna fishing industry in the last couple of decades. (And more innovations from Japan.) The Aussie tuna fisherman figured out how to raise these tuna in pens in the ocean off Southern Australia. They also ‘lucked out’ in the feeding regime. They invented a pelletized feed that they could raise the tuna on. Sadly they couldn’t breed them in a fish farm. They had to capture fish from the wild population and rear them to marketable size. It takes around 4 kilograms of pilchards from South America to produce 1 kilogram of ‘Australian’ tuna. (These fish are high order predators and carnivores.) The price differential between a kilo of tuna in Tokyo and the pilchards and other inputs made ocean pen rearing a wildly profitable exercise.
Now I am going to play with the chronology a bit as part of another small thought experiment. Let’s assume that Wall Street and London stepped into this market. The Tokyo Fish Market is closed and the trading becomes electronic. With some generous allowances from the market regulators we could see 100:1 leverage in this electronic tuna market. Now we have 99 paper fish traded for every single real fish. How could you make an obviously physical market like this one completely artificial? Easy. We did the same thing with gold despite the fact that gold’s value derives from its weight, purity and other physical qualities just like a tuna.
Let’s look at some of the implications of this new paper tuna market. For starters the bankers and traders are now intermediating this market. It is no longer merely a physical market where the resource extractor-producers and the consumers are dealing more or less directly with one another. Sure there were brokers involved before but the interests of the operators are aligned with their respective clients and customers. As you can see from the earlier breeches of trust on quotas it’s hard enough to regulate a physical market. Now we no longer have to deal solely with price signals in physical tuna we have a paper tuna market generating its own price signals.
There is another key feature of this market that is analogous to the silver market. The restaurant owners and food service providers have similar constraints to the industrial silver users. They have bookings for tables and customers who will expect their sushi and sashimi on time. Is the demand relatively “inelastic” like our industrial silver users? Could a physical corner exploit the fact the demand for tuna is “time sensitive”? In my opinion the answer is crystal clear. Yes to both questions. Do you recall my rigged market dictum? “Those who can be screwed, will be screwed.”
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Remember that tuna “ETF” created by the Japanese trading company. Boy oh boy have the banksters got a deal for them. Perhaps that trading company would be prepared to act like the “swing producer”. Operating in a similar way to my speculation about SLV’s function for a silver market manipulator. They could release or buy up tuna in the physical market to exacerbate cyclical trends in order to increase the insiders’ paper trading profits. What if there was also and OTC derivative market developing in tandem to this paper tuna market? Now there are three sets of price signals in this market. The physical market, the paper tuna public exchange and finally a totally opaque OTC market that only a small number of the market participants have any intel about.
What are these new “signals” from the market telling the South American pilchard fishermen? Perhaps the huge increase in the trading volume would tell them that there was an explosion in demand for tuna. You see neo-classical economics assumes that supply is infinite. Demand creates supply in their lexicon. We might see enormous investment in the pilchard fishing industry. Of course it could all be malinvestment if it was based on price, demand and supply signals that were false (artificial).
What would it do to the resource extractor-producers in Australia? Suddenly planning, entrepreneurial decision making and economic calculation would become much harder, perhaps even impossible. It takes time to rear fish. Would all of the profits be arbitraged away from the extractor-producers in paper trading before they could get their fish to market? Remember that interview with Ekkehard Schulz where he mentioned that 30 times the physical volume of nickel was being traded. Of that range of “ €10,000 and €50,000” per tonne of nickel how much of that high of the higher Euro pricing is ending up in the pockets of the nickel miners and refiners?
What if this scenario had actually occurred and the paper fish market had come into being? Could something occur in the physical market that would blow up the paper trade? As it happens some things did occur that could have spoiled a paper fish market (if it had existed). Firstly Japanese scientists discovered how to breed these fish in captivity.
Secondly it turns out that these fish aren’t merely Formula 1 racers they are also among the long distance rally champs of the ocean as well. You see scientists discovered that the Northern and Southern Blue Fin Tuna weren’t completely separate populations as previously thought. They actually cross the oceans to interbreed. If the paper markets were threatening the physical tuna industry you could be assured that there would have been coordinated intervention by the USA, Australia and Japan to save it. It is simply too important to risk.
So what would happen after this paper tuna market collapsed and all the leveraged paper players are busted? Well people still gotta eat, fish gotta swim, don’t they? The market would return to being a physical only market or people would go hungry and profits would be foregone.
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A Paper Metal Market Collapse
There have been many scenarios rehearsed at this blog over the years in which the paper gold market collapses. They all basically come down to one catalyst – no physical gold. It might be unavailable because governments of the major gold producing countries simply take all of the local supply. In countries with corrupt governments there might be a variation on this theme with the same effect on the market. A foreign government might mine their gold, retain it in their reserves and just pay off the “Generals” for the privilege.
The gold ETFs could be drained completely and all unallocated pooled accounts could demand to be transferred to allocated holdings. As FOA pointed out here:
FOA (2/28/2000; 10:18:13MT - usagold.com msg#8)
First walk
"The Euro float is still too small (NB. written in 2000) to receive a massive dumping of unneeded dollars. Indeed, the more the US tries to discredit the Euro,,,, the greater the risk of a "Washington Agreement #2" where the BIS / ECB uses unneeded reserve dollars to BYPASS the paper markets and massively buy "real PHYSICAL gold". In fact, all they have to do is enter the market in a minor way and the entire paper gold arena will go up in flames."
This scenario of FOA’s applies equally to the gold ETFs. China alone could buy every single share many times over and seek to redeem all of the baskets. There is no shortage of US dollars around the world to accomplish this feat. Obviously it would blow the market to smithereens if they tried but that is not the point. The means are there, if the will is there, to do it.
So what would it take to collapse the paper silver market? The answer to this question is less clear. You could ask the same question about any of the industrial commodity metal markets. Basically there are three or four possibilities. An undersupply that cannot be resolved by a higher price. An oversupply that overwhelms the capacity of markets to absorb it. Widespread insolvency of the market participants could shut down the exchange, at least until other traders stepped in to take their places. Lastly, governments could intervene in the market to ensure that the industrial and military users of silver were assured of supply. I didn’t mention a genuine shortage of silver for a reason – I don’t think that is likely. An artificial shortage? Sure that could happen. In my opinion it is probably inevitable.
Price Discovery
So what is the likely outcome of a collapse in the paper gold and/or the paper silver market? In my opinion it’s very simple. The outcome would be price discovery based on physical metal transactions. If there is an official international market that price would be discovered on a global basis. If not it would be a local physical market.
This physical price discovery process would then reveal if the paper price had valued the metal accurately. It would reveal for all to see if the paper price had undervalued or overvalued the physical metal. So, would the prices of these metals move in the same direction? We will revisit this question in the next installment of this series Two Theories About Gold and Silver
costata,
1. Shelby Moore III writing here recently about silver. A few snippets:
"You see there is no way silver can be money, because there simply isn't enough of it in bullion form to handle the $trillions in economic activity."
You often hear this as an argument against gold. All of the existing gold in bullion form is worth less than 5000bn US$. This is insufficient as a basis of the financial system. Well, all of you know an answer to this puzzle.
2. I also have an objection to the idea that silver has industrial uses and therefore (1) it should not be used as money; and (2) it will not be used as money.
How about the following thought experiment. Assume that for a period of 20 years from 1980 to 2000, gold costs 20 US$/oz whereas silver costs 500 US$/oz. What would have happened? There would be hundreds of industrial applications of gold, but only very few of silver. The reason ist quite obvious. Gold is the second best conductor, and it is cheap and readily available. So it is used in virtually all processes. Silver is simply too precious and too rare.
This is what I meant by destoying the silver market. You make it artificially cheap so that hundreds of new industrial applications come up, and therby you try to turn the silver market into that of an industrial commodity. In some sense, they also tried this with gold. Take a look at how GFMS always stresses the use of gold in jewelry. With gold, it was a bit half-hearted though. Still, the MSM always talk about mine supply and jewelry demand for gold, but never about money stock, at least not outside the ETFs.
3. On short-selling. If you want to make sure that your broker does not lend your shares, you can keep them in a cash account as opposed to a margin account. Then your shares are 'segregated' funds. Your broker would commit a fraud if they lent them to a hedge fund. If you suspect that this type of fraud is common, your only way out would be to take possession of the printed share certificates and to lock them up in a safe place yourself. I don't think this sort of fraud is too common. I have tried to borrow shares in specific companies, and often it is very difficult to find someone who lends them and even if it works, the shares may be suddenly recalled. From this expecience, I guess that this type of fraud is not too common because why woulnd't they do it given that I am willing to pay for this service.
Naked shorting of shares is possible only within the settlement period (which is 3 business days in the US), and only between brokers. The shares that are sold short naked are not actual shares (for which you are sent annual reports and for which you receive dividends and have a voting right), but rather they are a sort of derivative that promises delievery of actual shares. It makes sense only for other brokers to purchase them. So whenever you as an individual purchase shares in a cash account and the trade settles after 3 days, you can be sure that you have honest shares. If you purchase shares and they fail to settle after 3 days, you would have a legal issue with your broker. At least up to now, I am not aware of any systematic problems. By the way, in Europe ex UK, share transactions settle on the same day, and so all this is a non-issue in Europe.
Finally, the Zero-Hedge article that you link describes the clearing agent for share transactions. In Europe, for example, all stock trades have long been cleared by a small number of central clearing agents. No share certificates are moved. Are you saying you suspect that stock clearing is fraudulent? This sounds like canned food in the basement to me.
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4. So what would it take to collapse the paper silver market?
You gave the answer in the paragraph above:
China alone could buy every single share many times over and seek to redeem all of the baskets. There is no shortage of US dollars around the world to accomplish this feat. Obviously it would blow the market to smithereens if they tried but that is not the point. The means are there, if the will is there, to do it.
Victor
VTC,
Re: Shelby
Obviously I don't subscribe to the view that there is a physical limitation. I agree with the Maloney "atoms" video. I copied and linked those comments from Shelby because they show how far he has come from his strident claims for silver over gold even a year or two ago.
Re: DTCC
I see your points. I find it significant that it is not clear who has title to the shares. The brokerage account says that the account holder does but that is an account sitting on the broker-dealer's computer. If the shares are registered in the broker-dealer's name with the DTCC nominee then it creates opportunity for shenanigans. I'm not claiming this is common practice.
The signal feature of many of the "financial innovations" I have been highlighting is that the potential exists for abuse in these systems when they were at one time, or could now be, structured in a way that prevents the opportunity for abuse. It looks intentional to me.
You also wrote:
"If you want to make sure that your broker does not lend your shares, you can keep them in a cash account as opposed to a margin account. Then your shares are 'segregated' funds. Your broker would commit a fraud if they lent them to a hedge fund." (My emphasis)
Fraud doesn't seem to bother these folks in London and on Wall Street. It appears that none of these people needs to have any fear of law enforcement agencies. They walk away from every infraction with a wrist slap and a small fine relative to their profits.
Costata,
This series highlight the best description of paper markets and modern banking practice I have seen.
The scary thing is that it affects all aspects of our everyday life!
Side note: Lately, renewed questions about growing your own potatoes emerge. Our fruits and vegetables consistently undervalued, through government subsidies. The lesson is that there are several ways to distort a market.
How can governments keep the metal markets in check, under conditions of failing paper markets?
Gabriel,
Thank you.
"How can governments keep the metal markets in check, under conditions of failing paper markets?"
IMO it's difficult to see how they can prevent it.
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