12 December 2013

Delivery Day: Why a Comex Default Is Unlikely as a 'First Mover' Event

"The very hirelings of the press, whose trade it is to buoy up the spirits of the people. have uttered falsehoods so long, they have played off so many tricks, that their budget seems, at last, to be quite empty."

William Cobbett

A couple of people pointed me in the direction of this CME rulebook when I asked for some details about how there can be so many deliveries in a highly active month like December, but so little outgoing activity can be shown in the warehouse inventories.  And several more offered their own information, and I thank them for it.

Here is a link to the CME Rulebook On Deliveries

Another fellow was kind enough to send a couple of the most pertinent passages my way. They are included below. 

As you can see, a 'delivery' can be made, and most likely is most often made, by the transfer of a Warrant for the metal. The Warrants are issued and backed solely by the licensed facility, ie the specific warehouse controlled by JPM, HSBC, etc.

The Warrants have no expiration, so one might assume that they become traded around like currency, for those in the business of not actually taking physical delivery and moving their bullion out of the warehouse complex.

And I would not assume that even a licensed operator like JPM would move their house account bullion out of another operator's warehouse to save on storage costs,  because they typically are not engaging in long term holdings that would make it worthwhile. 

I don't think it becomes too hard to see how this structure, which to my knowledge is not audited, can become quite the twisted paper chase of counterparty risk and rehypothecation, given the general practices of the Banks in some many other areas.

As an aside, I do not necessarily believe that JPM's stopping the vast majority of the gold deliveries for their 'house account' is a bullish sign, not at all.   But it should at least raise some eyebrows that a 'market maker' is buying bullion so heavily for its own account.  Is this to underpin short side obligations in some other markets?   Only the bookkeepers know for sure. 

By taking these warrants and the underlying bullion for their own account, they may even be controlling its disposition of the bullion, eg. making sure it remains within the Comex licensed facility complex and is not taken out and melted into bars for use on other exchanges in Asia.   The Comex inventory is rather thin after all.

By the way, we do know that an operator is taking delivery for their house account, versus a customer, because there is a CME report that explicitly shows this.  I was surprised at this level of detail.

To sum this up, I am now even more persuaded that if there is any default or sudden deleveraging in the gold market it is unlikely that the Comex will precipitate this event. It is more likely that some incident in another market more physically based would trigger deleveraging, which would thereafter cascade throughout the paper gold market in London and New York.

Since we know rehypothecation is taking place as a customary business practice, with the only question being the extent of it, and with operators acting as their own regulators in terms of inventory, with even the exchange explicitly taking no liability for their data, I think it is very possible for an incident in the gold market to occur. 

The probability of this cannot be determined for the usual reasons, in that it is not possible to gauge the actual amount of counterparty risk because of the opaque nature of the information and the market.  It could be discovered, but that would require a third party audit.

But there is rehypothecation, and there is counterparty risk. And it appears to be a bit stretched by historical standards. And this post is certainly no defense of the Comex. If anything its connection to the broad global market for physical bullion is more tenuous than I had even thought previously, more like a shell game than a market that brings together producers and consumers. That it is a price setting mechanism for a much larger and broader physical market that plays a key role in the allocation of resources is almost unbelievable.

Some cavalierly point to 10:1 leverage as acceptable, as being customary for Banks holding around ten percent reserves (in another better day before sweeps etc., but that is no matter).

It begs the question that liquidity in the currency markets is significantly greater and more flexible than in the physical bullion market, a fact that so many modern economists often gleefully celebrate.

The Fed can expand its Balance Sheet to kingdom come, but they cannot produce a single ounce of actual gold bullion in that process. And that is why gold is such an emotional topic, so feared and derided in turn, because it resists the forces of fiat money and the human will by its mere stubborn existence.

706.E. Delivery Day
The day on which the long clearing member receives the Warrant for the metal shall be referred to as "Delivery Day." Delivery may take place on any business day beginning on the first business day of the delivery month or any subsequent business day of the delivery month, but no later than the last business day of the current delivery month

705B-5. A Warrant shall be of unlimited duration and remain valid until cancelled by the Licensed
Facility that issued it.

705B-6. Licensed Facility shall be solely responsible for insuring that no duplicate Warrants are
issued, printed or released by it.

Chapter 113
113102.E. Termination of Trading
No trades in Gold futures deliverable in the current month shall be made after the third last business day of that month. Any contracts remaining open after the last trade date must be either:
(A) Settled by delivery which shall take place on any business day beginning on the first business day of the delivery month or any subsequent business day of the delivery month, but no later than the last business day of the delivery month.
(B) Liquidated by means of a bona fide Exchange for Related Position (“EFRP”) pursuant to Rule 538. An EFRP is permitted in an expired futures contract until 12:00 p.m. on the business day following termination of trading in the expired futures contract. An EFRP which establishes a futures position for either the buyer or the seller in an expired futures contract shall not be permitted...

CME Group Rule Book Chapter 7:
703A-5. "Eligible" shall mean, with respect to any metal, that such metal is acceptable for delivery against the applicable metal futures contract for which a Warrant has not been issued.

538.B. Related Positions
The related position (cash, OTC swap, OTC option, or other OTC derivative) must involve the commodity underlying the Exchange contract, or must be a derivative, by-product, or related product of such commodity that has a reasonable degree of price correlation to the commodity underlying the Exchange contract.

It appears that an ETF can be used to settle a Comex futures contract, noting that this is a negotiated settlement and not forced upon the receiving party. There could be subsequent rule changes to this one, but it really doesn't matter much since I am fairly sure they can settle in cash if both parties agree.