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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.
FORMULA FOR DETERMINING FAIR VALUE
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.
Richline is involved in the fabrication of precious metals into jewelry. The acquisition of US Precious Metals will bring them into the mill and findings portion of the precious metals industry, as well as acquiring European and Asian distribution channels.
A small deal for Berkshire, but it is a bit of fun.
I wonder if Warren will have an introductory note to Richline's next company report, "May Is Gold Month." lol.
RTTNews
Cookson Group Sells US Precious Metals Business To Richline Group
2/23/2012 4:00 AM ET
(RTTNews) - Cookson Group plc reached an agreement to sell its US Precious Metals business, an operation that forms part of its Precious Metals division, to Richline Group Inc., an unit of Berkshire Hathaway Inc.
Earlier, Cookson announced that, following the US Precious Metals business becoming loss-making, it had begun a strategic review and significant downsizing of the business. Subsequently, Richline expressed an interest in buying this business, and on 22 February 2012, Cookson and Richline inked a deal for Richline to acquire the business, subject to normal legal and regulatory closing provisions which may be completed in the 2012 second quarter.
The net cash consideration is subject to closing balance sheet adjustments but is expected to be sufficient for Cookson's exit from the business to be cash neutral, including taking into account the restructuring and other costs incurred in preparing the business for sale. The gross assets of the businesses being acquired by Richline are nearly $69.8m or 44.4 million pounds, while the net assets are about $60.2 milion.
JCK
Richline Acquires U.S. Precious Metals Business
By Rob Bates
February 23, 2012.
Richline Group will acquire the U.S. precious metals division of the Cookson Material Products Group in the second quarter of 2012.
According to a Cookson statement, the gross assets of the businesses being acquired by Richline are approximately $69.8 million, and net assets roughly $60.2 million. It said its U.S. precious metals business had become “loss-making.”
Businesses in the United Kingdom, France, Hong Kong, Japan, and China that will distribute and sell Richline product are part of the acquisition, Richline said.
Richline, owned by Warren Buffett's Berkshire Hathaway, said this deal demonstrates its commitment to the mill and findings segments of the businesses...
A Richline spokesman declined comment on a Reuters report that suggested it is about to purchase Italian jeweler UnoAErre.
Some of my friends in Japan are keeping an eye on this one for me, and I thank them for their help. I never learned to read Japanese beyond memorizing subway stations and street signs and the like, in addition to the usual polite conversational ability which has badly faded with the years.
The problem I have is finding good articles in English. The Japanese Shimbuns are also notoriously circumspect and polite, even when it comes to institutional fraud and the loss of pensioners money.
While they keep talking about 'lost money' and 'hiding losses' it looks more like embezzlement on the surface for at least part of the funds. It appears that virtually all the customer money has 'vanished.'
It will be interesting to see which European bank received the customer money once it hit Hong Kong via the Cayman Islands. It is not a good sign for customers that a European or American bank was involved. That smells more like theft than loss.
The Asahi Shimbun
AIJ moved huge sums to Cayman Islands, Hong Kong
February 25, 2012
AIJ Investment Advisors Co. transferred huge sums in corporate pension assets it manages to a fund in the Cayman Islands and then moved the money to the Hong Kong account of a major European bank, sources said.
The Securities and Exchange Surveillance Commission has not been able to trace where the money went after reaching Hong Kong.
The sources said the SESC was investigating the motive for transferring the funds overseas, including the possibility that the money may have been misappropriated.
It turns out that several of the companies and organizations that entrusted assets in pension funds to AIJ may lose up to half of what had been set aside to make pension payments.
In the worst-case scenario, some of the corporate pension funds may have to be dissolved because of the loss of the assets. In other cases, some individuals who are members of the corporate pension funds could see part of their pension benefits reduced.
The Financial Services Agency ordered AIJ on Feb. 24 to suspend business operations for one month. The company had collected about 210 billion yen ($2.6 billion) from about 120 corporate pension funds.
However, AIJ officials told investigators with the SESC that the company was now only managing an investment portfolio worth about 20 billion yen, meaning that about 90 percent of the assets deposited by the corporate pension funds are wiped out.
The FSA also instructed AIJ to explain to corporate clients what went wrong. The agency will begin an investigation from Feb. 27 of all 260 or so investment advisory companies to search for possible problems in their pension fund management practices.
Neither the FSA nor the Ministry of Health, Labor and Welfare have disclosed the names of the 120 or so corporate pension funds that placed their assets with AIJ...
AIJ officials have not divulged to the SESC how the assets were lost. The assets may have been lost due to bad investment decisions by AIJ or company officials may have diverted the money for their own use. AIJ officials apparently also made false statements to their corporate clients about the gains earned for the pension funds.
Investigators will look into where the assets flowed as well as the extent of the false statements made to determine if criminal charges should be filed against AIJ and its officials.
Bloomberg
AIJ Suspension Undermines Japan Pensions Hedge Fund Appetite
By Tomoko Yamazaki and Komaki Ito
February 26, 2012, 11:10 AM EST
Feb. 27 (Bloomberg) -- The suspension of AIJ Investment Advisors Co.’s operations amid concerns hedge funds it manages had lost pension money may undermine plans by Japan’s retirement funds to boost returns to meet demand in an aging society.
The Financial Services Agency on Feb. 24 ordered the Tokyo- based firm with 183.2 billion yen ($2.3 billion) of client money to stop business for a month as the regulator investigates “possible losses” at AIJ’s hedge funds. The FSA also will undertake a nationwide probe of 263 asset managers.
“If the funds actually suffered losses, this could potentially have a massive impact on pension plans that actually invested with them,” said Taro Ogai, who oversees consulting for pension fund investments at Towers Watson in Tokyo. “Pensions already face difficulties. At a time when they are trying to boost returns and cut risks, investing in hedge funds may become difficult for them.”
The inquiry is a setback for Japan’s pension industry that has been looking to diversify away from bonds and equities into alternatives investments, including hedge funds, to maintain steady returns and fund retiree benefits in a country with the world’s fastest-growing aging society and two decades of slumping markets...
Regulators have been investigating AIJ, which invests in futures and options of equities and bonds, since the end of January, and discovered that the company has been unable to explain to investors the current state of the way their money is being managed, according to the FSA...
AIJ’s funds have been traced from Japan to the Cayman Islands, followed by a trust bank in Bermuda and ultimately to “a major European Bank” in Hong Kong, the Asahi newspaper said Feb. 25, citing an investigation by Japan’s Securities and Exchange Surveillance Commission. AIJ kept money-flow records up to the unidentified bank in Hong Kong and no further records have been found, the newspaper said...
AIJ may have lost most of the 200 billion yen it manages for companies’ pension plans, the Nikkei newspaper reported Feb. 24, citing unidentified securities investigators...
Japan’s financial regulator is also planning to investigate trust banks that handle pension money as well as corporate pensions, the Nikkei newspaper reported over the weekend. The regulator penalized at least 35 financial institutions last year including Citigroup Inc. and UBS AG for breaching securities rules, according to its website...
AIJ, led by Kazuhiko Asakawa, was established in April 1989, and had 120 clients including pension plans with 183.2 billion yen in assets as of the end of 2010, according to a statement from the FSA. It has 12 employees. Phone calls to AIJ’s main office were answered by an automatic recording which didn’t allow messages to be recorded. Asakawa was a former employee at Nomura Holdings Inc., according to a person familiar with his employment. Keiko Sugai, a Tokyo-based spokeswoman at Nomura, declined to comment...
AIJ’s fund was ranked top among pension funds in 2008, said Fujio Nakatsuka, a spokesman at Rating & Investment Information Inc. in Tokyo. He said the rankings were based on responses from pensions and not what R&I had recommended to investors...
Reuters
AIJ Investment routed pension money to Cayman Islands
Fri Feb 24, 2012 1:11pm EST
Feb 25 (Reuters) - AIJ Investment Advisors Co is believed to have channeled about 200 billion yen ($2.48 billion) of corporate pension assets in custody into private investment trusts in the Cayman Islands, making it difficult to track the missing funds, the Nikkei said.
Japan's financial regulator on Friday temporarily shut AIJ on suspicion it may have hidden losses in the $2.6 billion pension funds it managed.
The Securities and Exchange Surveillance Commission (SESC) suspects that the Tokyo-based investment advisory firm may have used the tax haven to hide information on its investments. AIJ registered three investment trusts there, the Nikkei said.
Pending the results of the SESC's investigation, the Financial Services Agency plans to rescind AIJ's registration, the business daily said.
About 90 percent of the corporate pension assets managed by AIJ have disappeared, the daily said.
AIJ, after signing discretionary investment agreements with the corporate pension funds that worked with it, had the money put into the Cayman Islands investment trusts, the daily said.
AIJ is believed to have instructed that the money, once put into the investment trusts, be managed via a British-affiliated bank in Bermuda...
This is more Madoff than Corzine, but the song of unforeseen counterparty risk remains the same.
The Japanese regulators have decided to take a closer look to see how many more of the 299 asset management firms have funding problems like this.
Don't it always seem to go that you don't know what you've got 'til its gone?
Wall Street Journal Japan
Missing Funds at AIJ: Watchdogging Japan
By Kana Inagaki and Phred Dvorak
February 24, 2012, 1:53 PM JST
The revelation that billions of dollars may have gone missing from client funds managed by a little-known Tokyo asset management firm highlights a sobering fact about Japanese financial regulation: It’s pretty spotty.
Japan’s financial watchdog Friday said investigators were looking into the alleged disappearance of “most of” the 183 billion yen, or about $2.3 billion, in pension-fund assets managed by AIJ Investment Advisors Co. Details are sketchy: regulators haven’t said exactly how much is supposedly lost, how many clients AIJ had, nor even whether they suspect foul play.
But we do know that if AIJ was doing anything wrong, the chances of its being caught out by Japan’s regulators were pretty slim.
Investment managers like AIJ are required to submit business reports to regulators once a year, Japan’s Financial Services Agency says. If those regulators suspect problems, they can carry out hearings. And some companies actually conduct voluntary audits of their own businesses. (AIJ was not one of them.)
A firm involved in dubious activity would need to be fairly unlucky to find itself caught in the net of one of the Securities and Exchange Surveillance Commission’s annual audits. The regulator conducted inspections of 15 investment managers in the year ended March 2011. Since there were 299 such firms in total, the chances of getting audited were about one in 20.
The FSA says it’s now going to do an audit of all 263 firms that have similar investment-management mandates to AIJ’s.
According to Japan’s Nikkei daily, AIJ may have misled clients for years, claiming they had cumulative returns as high as 240%.
It all makes for a fairly bleak spell for Japanese financial regulators. After all, the discovery of pension funds missing at AIJ comes only months after camera-maker Olympus Corp. admitted to it successfully hid more than $1.5 billion in losses for 13 years.
“To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly.”
John Kenneth Galbraith, The Great Crash of 1929
