It was all over the news last week, both mainstream and gold sites. Barclays was caught manipulating the gold price. They were fined £26M, and forced to pay a client who was damaged by their action. The trader who worked for Barclays, Daniel Plunkett, was also fined and banned from working in the financial sector. Here is a link to an article at the Financial Times.
This story is a big deal to the gold community.
It is commonly held that the gold price should be much higher than it is today. For example, many think the proper gold price is the money supply divided by the gold held by the US government. The monetary base is currently about $4T. The US Treasury owns about 261M ounces of gold. Simple math gives us $15,300 per ounce. If we use a broader measure of the money supply, the gold price should be even higher.
Also, there is the argument from common sense. Since 2008, the Fed has been “printing” trillions of dollars. Its balance sheet ballooned from just over $800B to just under $4.4T today. With all this fresh, new money flooding into the markets, why isn’t the gold price reacting as it should?
There are other theoretical arguments why the gold price should be skyrocketing. Instead, the fact is that it’s been dropping since 2011.
It must be that someone is pushing the gold price down. How else can we explain why the price is $1,300 and falling? They are keeping it thousands, if not tens of thousands of dollars, below the level where it ought to be.
And now, we have the Barclays scandal. It seems to offer the smoking gun, incontrovertible proof that the gold market is indeed manipulated.
Not quite.
Consider this analogy. Suppose a teenager stands accused of setting fire to several homes in his neighborhood. Despite investigations by the town police, sheriff, state police, and the FBI, they cannot find the sort of evidence that would convict him in court. Then, a breakthrough occurs. The kid is caught red-handed stealing candy at the corner store. Can the district attorney bring him to trial for multiple counts of arson now?
No. You can’t get there from here. Arrest him for petty larceny. Make him apologize to Mr. Hooper and do his 10 hours of community service, or whatever punishment is suitable, for candy theft. But as to the arson, you don’t have any more evidence than you did yesterday.
Compared to the arson of suppressing the gold price, Barclay’s client scam is the equivalent of stealing candy. They sold an options contract to a client. This contract obligated them to pay out if the PM gold fix was above $1,558.96 on June 28, 2012. On that day, right before the PM fix process began, the gold price was a few bucks over the threshold. Then it began to drop. Then it rose. Then Mr. Plunkett took steps to push the price below his threshold. He entered an order to sell some gold. After a few more gyrations, the committee agreed to set the fix below the threshold. Barclays did not have to pay its client. After the fix was set, Plunkett bought back the gold he had sold. He took a slight loss on the purchase and sale of the gold, but nothing close to the cost of paying the client. Not incidentally, Mr. Plunkett was paid a big bonus.
What Barclays did may or may not have been illegal at the time they did it. I don’t know, and I am not an expert on UK law. It was certainly interpreted as having been illegal by the UK Financial Conduct Authority.
Certainly, Barclays breached the most fundamental trust that a financial institution must establish with its clients. In a free market, why would anyone do business with a bank that deliberately acts against client’s interests? Today, we don’t have a free market. We have an enormous burden of regulations. There aren’t many choices for bullion banking services. And as we saw with Deutsche Bank resigning from the silver fix, the legal environment is getting worse. Not only are there no new entrants into this market, the existing ones are quitting.
Barclay’s ethical breach and possibly illegal act is a serious matter. However, it is like the kid caught stealing candy, providing no further evidence to convict him of arson. Barclay’s ill-considered sale of gold prior to the fix and purchase afterwards gives us no more proof that the price of gold is thousands of dollars below what it would and should be.
On that front, we are left with specific claims that do not fit the evidence. Broadly, the claims of manipulation fall into two categories. Either the cabal is selling metal out of central bank reserves, or it is selling paper such as futures contracts.
If they are selling metal, that can only apply to gold, as they don’t have any silver metal. So gold is suppressed but silver may be free. If so, how do we explain the fact that the silver price has dropped twice as much as the gold price? In 2011, an ounce of gold would buy about 31 ounces of silver. Today it will buy about 66 ounces. Clearly, whatever force is hitting gold is hitting silver harder.
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The other broad allegation is that the cabal is selling futures naked. I have written extensively about this in the past. In essence, there are two major ways this view contradicts the data. First, the sale of a large number of futures will push down the price of a futures contract. Indeed, that is the whole point. If the price of a contract is pushed down, that will cause the condition known as backwardation. Backwardation is when real metal is more expensive than a futures contract. It’s what one would expect, given the allegation that real metal is scarce and getting scarcer, while there is an abundance of bogus paper flooding the market.
I have published data at a time when the manipulators are alleged to have sold 500 tons of gold paper naked. There is nary a blip in the spread between spot and future.
Second, once the futures position is created what happens next? As each futures contract approaches expiration, those who have a position must choose. If you are long—i.e. you bought a future—you can choose to take delivery. You simply need the cash in your account to buy the metal at the contract price. If the contract price is $1,300 then you need $130,000 because each contract is 100 ounces.
If you are short—i.e. you sold a future—then to make delivery you need the metal. The whole premise of the manipulation theory is that they don’t have the metal, that they are “naked” short. In this case, the banks cannot make delivery. They must “roll” their contract position forward. To roll, they must buy the expiring contract and sell the next one out. As I write this, the June gold contract is being rolled right now. Those who want to maintain their positions can move to August, October, or farther.
If banks had massive short positions, they would have to buy large numbers of June contracts. This would push up the price of the June contract. The contract would move further into contango, which is when a future contract is above spot.
What if the banks were merely arbitragers? What if they are buying spot metal and selling futures to earn a small spread? In this case, they have no urgency to close their contracts. They can deliver metal, or they are happy to roll their arbitrate positions if the market pays them an additional profit to do so.
The urgency would be felt by the naked longs, those speculating on the gold price, but who don’t have $130,000 per contract lying around in their accounts. These speculators would have to sell June contracts. This, of course, would cause the opposite change to the price of the June contract. It would fall. This would cause the contract to move into backwardation.
When physicists debate two theories of how the universe works, they always try to think of how to design an experiment to see which theory is right and which is wrong. They love building larger particle colliders and larger telescopes because then they can peer through the lens and say “Ahah! It’s bending to the left!” That means Dr. Smith is wrong and Professor Jones is right.
When market analysts debate two theories, we should take the same approach. The behavior of the expiring contract is our experiment. If the spread between futures and spot bends up—i.e. deeper into contango—it’s because there is buying of the expiring contract with urgency. This means the banks are naked short. If it bends down—into backwardation—there must be selling of the contract with urgency. That means the banks are hedged, and the only urgency is the speculators.
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Think about the design of this experiment for a minute. Go through the cases until they make sense. For example, verify there is no other party who would be buying up an expiring future with urgency.
Let’s look at the basis for some contracts. Recall, the basis is basically the spread between the future price and the spot price (future – spot). This oversimplifies it slightly, but we are just interested in seeing the pattern.
Here is a chart showing the basis for contracts in 2012 through 2014, as each heads into expiration. The bottom axis is labeled with the number of trading days prior to the first of the month named in the contract (e.g. for the June contract, 1 means May 31).
Chart of numerous gold bases heading into expiry
There are a certainly a few irregularities in the data set, but they are not important to our experiment. There are some different shapes and sizes here. These contracts do not show parallel lines. However, they all show a falling trend.
The bottom line is that the typical pattern is to bend down, into backwardation.
The sellers of expiring contracts are the ones with the urgency. That is, they are naked longs, without the cash to take delivery.
Now, here is the chart of the two most recent gold contracts, April and June 2014.
Chart of Apr and Jun 2014 gold bases heading into expiry
April shows different behavior. It has a noticeable rising pattern until a few days before the end. There is a good case to be made that a short seller or several short sellers were closing or rolling their positions in February and March of this year. June shows a decline, though more moderate than prior months.
In the weekly Monetary Metals Supply and Demand Report, I have been reporting for some time that the gold price is a bit below its neutral price. The picture of April and June basis behavior is one more piece of evidence to support that.
To clarify, I do not think that the gold price is thousands of dollars below where it should be. I think the gap is about a hundred bucks, in other words a short-term trading phenomenon, not a long-term conspiracy.
