30 March 2010

What is the 'Spot Price' of Gold and Silver And How Is It Set?

When you ask even a relatively experienced and sophisticated precious metals trader "what is the spot price of gold or silver?' you will generally hear a pause, and then they will come back with a price after checking their computer screen for the latest spot price from some ubiquitous and reliable provider of such quotes, or one of the lesser known, diverse providers of this information.

But when you say, "No what I was asking is 'what is the spot price, where does it come from, who sets it?'" you will most often hear that this is the last physical trade, or the current market price of physical bullion.

Well, is it?

Actually despite what you might think or what you might have heard, it is not.

The reason for this is that there is no centralized and efficient market for the sale of physical bullion in the US at anything resembling a 'spot price.' What is their number, where are their prices and trades posted? Who is buying and selling what, TODAY, with the real delivery of bullion as the primary objective?

There are several large markets for physical bullion in the world, where real buying and selling occurs, with delivery given and taken. The most famous is the London Bullion Market Association, which is an dealer association, over the counter market where the price is set twice a day as the 'London fix' but each counterparty stands on their own with no central clearing authority. From the perspective of bullion the LBMA is 'where the action is' and the Comex is a sideshow. Although there are recent revelations and suggestions that the LBMA is also slipping into a paper market with multiple claims on the same unallocated bullion, fractional reserve bullion banking as it were. Nothing new. It just gets more out of hand at certain times in history.

The reason that physical trading in bullion became so highly concentrated in London was best explained to me by one large bullion dealer. "This situation exists because of the gold confiscation in the US in 1933. When that happened, physical metal trading in the US came to a complete stop. When gold ownership was again made legal on December 31, 1974, the physical metal trading had become so developed outside of the US that it stayed there and never really returned."

But once the London Fix is over, and the day moves around the world, the New York markets open and become more dominant. Where and how is that price obtained? Where is the price discovery.

The fact of the matter is that the bullion market in the US is highly fragmented among many, many dealers in bullion. Yes they have their 'wholesale' sources, but even those sources are more fragmented than I would have imagined.

There seems to be no central market for physical gold and silver in the US, except for the largely paper futures markets. Because the fact of the matter is that the spot price of gold and silver are a type of Net Present Value (NPV) calculation based on the futures price in the nearest month, or the front month.

I had not been able to obtain the actual calculation used by any of the principle quote providers. And I am not saying that they are doing anything wrong at all. Or right for that matter, since I do not audit them or look over their shoulder. I do not know how accurate anyone's reportage might be, or how to explain the discrepancies between the futures prices and the spot prices that occur all too frequently these days. How can one without more transparent knowledge?

For those of you that are familiar with it, the spot price would be calculated from the futures in much the same way that the 'Fair Value' price is obtained for a stock index like the SP from the futures trade, essentially an NPV calculation.


F = S [1+(i-d)t/360]

Where F = Fair Value futures price

S = spot index price

i = interest rate (expressed as a money market yield)

d = dividend rate (expressed as a money market yield)

t = number of days from the current spot value date to the value date of the futures contract.

So like most net present value calculations we would have some 'cost of money' figure used to discount the time decay from the strike time of the contract to the present. There is no dividend with gold for example, but there is a lease rate, and a proper calculation should include some allowance for this.

The details are not so important, again as I say, unless you wish to start up your own quotations service, or do your own pricing as a large dealer to make sure you know what a fair price might be.

What is important is that almost all retail transactions for physical bullion in the US key off a 'spot price' that is derived from a paper market which is not based in the reality of physical supply, since the futures exchanges explicitly allow for the settlement in cash if physical bullion is not available. In fact, the vast majority of transactions are settled in cash, and are little more than derivatives bets it seems, and often hedges related to other things like another commodity or interest rates.

So that is the truth of the spot price of gold and silver in the US as best as I can determine it. I am not saying that anyone is doing anything wrong or illegal. I am saying the system is inefficient in that it suffers from the lack of a robust physical market to 'keep it honest.'

Also, almost every trader I speak with does not really understand what the spot price really is, or the implications of what price discovery looks like in a fragmented market where the pricing is set by a group of speculators that rarely deal in the actual commodity itself.

I am surprised that indeed some smart entrepreneur has not consolidated the buying and selling of physical bullion on demand into a highly transparent and efficient market which is the real price setter, rather than the commodities exchanges in which arbitrage can be easily crushed by the very rules of the exchange that allow for unlimited position size, extreme leverage, cash settlement as an easy alternative to shortage, unaudited and unallocated stores of supply, and secrecy. We even recently saw the scandal where a large Wall Street broker was selling bullion and even charging the customer annual storage fees without ever having purchased the bullion for them in the first place!

The actual prices for stocks are published on a price by transaction basis on public exchanges whereas gold and silver have no such facility. That is a key difference, and why the futures market has a significant need for tighter reins on speculation including position limits, accountability for deliverables, and limits on leverage and speculation, more so than any other market. The metals markets are thin and small compared to the forex and financial asset markets, and therefore the most vulnerable when they intermix.

The futures market will be efficient and honest the more it takes on itself the rigors of a physical market. Even Alan Greenspan alluded to this, that the dollar reserve currency standard 'would work' as long as the Fed had the discipline to manage it as if it had the rigor of an external standard like gold. Well, you can toss that vain assumption about the self restraints of human nature out the window. Do you really think that bonus hungry traders are more virtuous and selflessly devoted to the public good than the economists at the Fed? Please.

And I have not spent any time discussing it, but when one has a price that is derived from even a publicly available albeit flawed price like the front month futures, without transparency in the derivation and updating the opportunity to skin pennies all day long is there as a temptation, since there is no official or easily calculable method to check its accuracy.

I contacted a few big dealers hoping to get intimations that there was some sort of a private wholesaler network, in which two or three regional distributors set prices based on available supply. There is a 'dealer market' in which prices in lots of twenty five bars of London ready gold is quoted, but that seems to be part of the parallel market in physical bullion centered around the LBMA that is divergent from the continuous paper price and the 'spot price.'

There is always a wholesale cost and a retail price with a markup. That is not an issue. What seems to be the problem is that when a few players can crush price with paper positions, this tends to remove the discpline of arbitrage of market mispricing from the picture. This is the only part of the efficient markets hypothesis that ever made any sense. If there is a price discrepancy, market players will move in to fill it. This is the case against manipulation.

Except they cannot really address any serious market mispricing because the price is set in the paper markets which are not amenable to efficient arbitrage. Unlimited leverage through derivatives, and the willingness of central banks to sell into the gold market to manage price spikes, again as Chairman Greenspan admitted, takes care of that. Not even a motivated buyer with deep enough pockets like China would take on this market openly because all they would do is buy against themselves, and drive a default which would be cash settled by force.

You might ask at this point, why would anyone ever wish to engage themselves in this market, besides those who must obtain supply for industrial or cosmetic uses? Few do actually, except to buy physical bullion at the retail level, and hold it as protection against the devaluation of currency and the monetization of the debt.

There are always professional speculators, but they tend to go with the momentum for the reasons outlined above. Its an easy trade. I sometimes play the arb myself, or at least maintain an awareness of it. You can't fight the Fed in the short term, and the financial engineers and statists hate anything that threatens to rival or even limit their power. But that does not mean that one might not insure themselves against the eventual failure of the new masters of the universe to control the large forces and unintended consequences of world markets. What I find so disappointing is that Greenspan knew all this. and wrote eloquently about it, before he sold himself to those who he had spent the bloom of his intellect opposing. I was never interested in this subject until I started reading his various biographies to understand his thinking better in the late 1990's, and then went on to read his early works on the state and freedom. If he had been a more noble figure his fall might have been a tragedy. As it is, it just seems to be another dishonorable failure of stewardship and conscience.

This is what you have. Whether it works well or not is another matter and it seems a personal opinion heavily biased on where you sit at the playing table. But from a purely economic perspective if I were going to set up a mechanism to allow price fixing and fraud to occur, I could do little better, except perhaps to set up something more like an opaque monopoly such as the Federal Reserve with the ability to create supply out of nothing. The investors and producers are largely at the mercy of those who control the paper markets And this says nothing about the involvement of the central banks in influencing the price, which they admit that they do, if only obliquely.

Sure one can say. If you don't like the price you can keep taking delivery, except that you can't. The price is set on the Comex, which delivers paper dollars at will, and has a history of changing its rules at the drop of a hat to rescue trapped suppliers and speculative shorts. This is the sort of odd market that resolves itself in executive actions precipitated by breakdowns and default.

There is nothing here that could not be greatly improved by position limits and much greater transparency and accountability for counterparty risk. CFTC Commissioner Bart Chilton has shown himself to be remarkably insightful and courageous in promoted these changes to the US futures markets in the metals. Far from an efficient and vigorous market, as Adrian Douglas said at the CFTC hearing the US is merely a "sidehow" to the London market when it is open for trading at least with respect to actual product. But as amenable as this paper based market is to the 'easy skim' one might imagine there is a status quo that would fight any reform vociferously.

To use a poker analogy, I don't mind a 'no limits' game as long as it is table stakes where you put your 'stash' on the table for all to see, which again this is not, and the pot is split if you are raised beyond your bankroll, which this is also not. I would not imagine that a no limits game in which the big players are also often the dealers, and can see the cards that other cannot because of their seating, is the best sort of a mechanism with which to conduct price discovery for the average person in the market, who only wishes to play a few hands on a limited budget, or a small producer who wishes to bring their product to market.

As someone who approaches it as an amateur economist, and has been looking at its dynamics for the past few years, I may be missing something, but this seems less like an efficient market mechanism for price discovery and capital allocation, and more like a carney game.