26 February 2012

What Is the 'Spot Price' of Gold and Silver?

This is a partial reprise of a post from two years ago. The question has again arisen about the discrepancy between the spot price of gold and silver, and the prices shown on the front month of the futures market.

When you ask even an experienced trader, or even an economist who may have received a Nobel prize, 'What is the spot price, where does it come from, who sets it?' you will often hear that this is the last physical trade, or the current market price of physical bullion for delivery. 

Here is a fairly typical explanation one might get from an 'industry expert.'
"That is why the New York Spot Price is different from the London Gold Fix price. The spot price changes on a regular basis, just as stock prices do, and reflects the bid and ask prices quoted by wholesale dealers for spot delivery."

Well, does it?

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

There is no centralized and efficient national market in the US for the sale of physical bullion at anything resembling a 'spot price.' What is their telephone number, where are their prices and trades of actual transactions posted?   Who collects and is privy to that knowledge, and how are they regulated?  Who is buying and selling TODAY, with real delivery of bullion as the primary objective?

There are a few large wholesale markets for physical bullion in the world, where real buying and selling can occur, with delivery given and taken. The most famous is the London Bullion Market Association, which is a dealer association, an over the counter market where the price is set twice a day and called the 'London fix,' but each counterparty stands on their own with no central clearing authority.

As an aside, there are credible claims and factual evidence that the LBMA has slipped into a paper market with multiple claims on the same unallocated bullion with daily trade volume in multiples of available supply, a fractional reserve bullion banking as it were. Some say the leverage is 100:1.

The reason that physical trading in bullion became so highly concentrated in London was best explained to me by a 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 trading day moves with the sun, the New York markets open and become the dominant price setting mechanism. Where and how is that price obtained? Where is the price discovery?

I will not delve into it here, but there is credible evidence that shows that the price changes for gold in the NY trading window are heavily skewed to price decreases as compared to the other periods of the day, beyond any reasonable statistical expectation.  It is so obvious as to be almost notorious amongst seasoned traders.  That alone should raise alarms with the regulators.  No honest market has such obvious anomalies unless there is something terribly wrong in its structure.

The bullion market in the US is highly fragmented among many dealers who do not set the prices amongst themselves as in London. Yes they have their 'wholesale' sources, but even those sources are more fragmented than one might imagine.

The fact of the matter is that the spot price of gold and silver is nothing more than a type of Net Present Value (NPV) calculation based on the futures price in the nearest active month, or the front month.

I have not been able to obtain the specific formula used by any of the principal quote providers such as Kitco for example. And I am not saying that they are doing anything wrong at all. Or right for that matter.

The spot price is calculated from the futures in much the same way that the 'Fair Value' price is derived for a stock index like the SP from the futures trade, which is 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, but there is a forwards rate and a least rate, and a proper calculation should include some allowance for this opportunity cost.

Given that the 'cost of money' or short term interest is roughly zero, the time premium of the futures over spot is likely to be negligible.   But since the methods of calucating spot are not public, I cannot speak to this now.

What is important to remember is that the spot price follows the futures front month by some calcuation. And rather than a physical market setting the price in fact 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 currently available physical supply.

Further, 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, and trading hedges related to other things like another commodity or interest rates.

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.'

It does seem a bit ironic by the way, that the most popular provider of spot price information for gold and silver is currently operating under charges of fraud in a scheme involving a conspiracy to defraud their government in Canada. And yet the consumer must take their price quotes on faith, since there is no apparent disclosure of how their price quotes are obtained. Perhaps their case has been resolved, and I am not aware of it. But the irony remains.

The spot price of gold and silver is therefore subject to manipulation. So it is incumbent on the regulators like the CFTC to be mindful of any price fixing activity in the metals futures, particularly in the 'front month' which directly influences the going rate for many if not most of the retail bullion transactions in the States.

I am surprised that 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 virtually unlimited position size, extreme leverage, cash settlement as an easy alternative to shortage, 'naked shorting,' unaudited and unallocated stores of supply, and above all, the veil of 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. Not to mention a situation in which a large futures broker was able to steal the gold and silver on deposit from their customers with little recourse and limited remedy against one of the bullion banks who may have received the goods as it were.

Since the futures market sets the national price for retail transactions that have nothing to do with the futures market per se, there a significant need for tighter reins on short term speculation including position limits, accountability for deliverable supply, and limits on leverage and speculation.

The metals markets are thin and small compared to the forex and financial asset markets, and therefore the most vulnerable.

The futures market will be efficient and honest the more it takes on the rigors of the physical market.

What about the usual argument that the self-regulating proponents trot out that if the metals pricing is inefficient, it will create artificial shortages, and physical buying will break that scheme down over time?

Participants in the futures are not able to seriously address a significant market mispricing because the prices set in the paper markets are not conducive to efficient arbitrage of inefficiencies. The rules of the exchange sets limits on the delivery of physical bullion, favoring cash settlement and the positions of insiders and those who make markets in paper shorts that may be in multiples of physical supply. The CFTC has shown a remarkable inability and some might say unwillingness to address this in the silver market for example, which is a scandal.

Not even a motivated buyer with deep enough pockets 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. More likely they would be labeled as trying to 'corner' the market and punished severely.

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.

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 than what exists in the US today, except perhaps to set up something more like an opaque and self directing monopoly such as the Federal Reserve and its Banks have in their ability to create money virtually out of nothing.

The retail buyers and producers are largely at the mercy of those who control the paper markets, and these are a relatively few bullion banks and hedge funds. And this says nothing about the involvement of the central banks in influencing the price, which they sometimes admit that they do.

Reform is generally slow to come when a powerful status quo benefits from such a financial arrangement and price fixing such as this. Economic theory indicates that underinvestment and shortage will result, and if the artificial pricing is sustained over time, that shortage and systemic underdevelopment could lead to a severe market break and even a default.

We saw something similar to this when Enron was actively fixing the national energy markets in the US.  What will happen in the metals markets will be at least an order of magnitude more disruptive.

I think that a default is becoming more likely every day that the regulators refuse to act in the interests of promoting honest price discovery and fairness, which is their very reason for being.

And when the bullion banks cry for exchange intervention and government relief, keep in mind that their problems are the result of no acts of God or anything other than a protracted abuse of the market and the public for the personal benefit of a few at the expense of many.