CFTC Aftershocks

Sat, Nov 20, 2010 - 11:53pm

On March 25, fifteen individuals selected by the US Commodity Futures Trading Commission (CFTC) testified to that body on proposed position limits for the precious metals markets. One big surprise was the inclusion of Bill Murphy, Chairman of the Gold Anti-Trust Action Committee (GATA). Although his organization has been blacklisted by the mainstream American media, he was able to enter some of GATA’s eleven years of research into the public record. Although only allowed to speak for a few minutes, Murphy’s testimony covered territory ranging from the “strong dollar” policy, the lack of transparency from the Federal Reserve on gold swaps, and the CFTC’s own stalled silver market investigation.

During the question and answer period, Murphy was asked for an example of precious metal manipulation, and he mentioned whistleblower Andrew Maguire. It turns out that Maguire contacted the CFTC last year because he was tired of listening to JPMorgan Chase traders brag about their manipulative profits in silver. Maguire was able to predict the silver market moves in advance in his emails to the CFTC, but despite this impressive demonstration, he was banned from testifying. A day after this testimony, Maguire and his wife were injured by a hit-and-run driver in a remarkable “coincidence.”

Another notable presenter was Jeffrey Christian of CPM Group. While much of his testimony was muddled or contradictory, it was useful in one respect: he explained that the London Bullion Market Association (LBMA) only holds one ounce of gold for every 100 traded. He compared gold to markets in T-bills and currencies, which are intangibles, not commodities. Although Christian tried to claim that the COMEX gold shorts aren’t naked, as the bullion banks hold offsetting longs on the LBMA, he admitted these are “hedges of paper on paper.”

During subsequent public statements, Christian seemed to regret these statements. He attempted to minimize the significance of his testimony by claiming that all trading professionals were aware of the minimal metal backing of the LBMA. However, if this were true, why did CFTC commissioners ask him to expound on the inner workings of the London bullion market? Even the LBMA’s own website muddies the waters, describing unallocated accounts as the “most commonly used method of holding metal,” when the investor holds only a paper claim.

Considering Christian’s history of backing the bullion banks’ interests no matter how convoluted the logic, I’ve wondered how independent CPM Group really is. Their website claims that CPM separated from Goldman Sachs in 1986, but could CPM still be entwined with its former parent company?

In a recent Lehman Brothers investigation, Hudson Castle - a spin-off firm of former Lehman employees - was found to have only the facade of autonomy from that failed investment bank. Hudson Castle existed to shift risks off Lehman’s books as the bank’s “alter ego.” Is it possible that CPM Group is acting as a covert shield for Goldman Sachs’ commodity business, defending the bank and developing “research” that assists Goldman’s trading strategies?

Precious Metal Pretense

While I'm sure many trading professionals do know that the LBMA trades predominantly paper claims for gold, or unallocated accounts, the fallout from Christian's testimony indicates that the public is NOT aware of this fact. Even trade websites like Mineweb.com refer to the LBMA as a “physical delivery market,” implying that transactions are settled in bullion.

On the retail level, small investors are regularly confused about the differences between allocated and unallocated bullion. This is not surprising considering the misleading phrases used in descriptions of everything from pool accounts, to precious metal certificates, to ETFs. Investors are often charged “storage fees” for unallocated metal as if the bank or mint was actually holding bullion, rather than offering an unsecured claim on the assets of that institution. Panic sets in when individuals decide to take delivery of “their” metal, only to be met with long delays and multiple explanations for them. Since institutions know that only a small fraction of participants will ever ask for custody of the bullion, only a tiny amount of metal has to be kept on hand for withdrawals.

Naturally, representatives of these institutions have been busy with damage control, asserting that investors should trust the stability of the system. After all, it has lasted for decades, and is managed by regulators and auditors.

Considering the numerous financial scandals this decade, these arguments are weak. Bernie Madoff was permitted to commit his crimes for decades by US regulators. Arthur Andersen no longer exists due to its negligence during Enron audits. It seems there is a new revelation about financial corruption every week, so I don’t have much faith in the virtue of banking, either.

While contrarian financial websites have long questioned the integrity of precious metal ETFs and other dubious investments, suddenly mainstream media like CNBC have joined the chorus. Investors are increasingly becoming aware of the deceptions in the system and are taking action. Hedge funds like Greenlight Capital are switching to bullion and taking delivery. Due to the euro crisis, retail coin demand in Europe has exploded 10 fold year-over-year. Even central banks from China to Argentina are swapping their paper assets for metal.

Rise of the Dragon

Long term readers will be aware of my lack of respect for US regulatory bodies, including the CFTC. The Commission claims to want the facts on the precious metals markets, but they banned whistleblower Andrew Maguire from testifying. Ted Butler, whose research into these markets is unparalleled, was only allowed to address the CFTC in a private meeting. Instead, the regulators allow people like Christian to present, whose analysis is so nonsensical that Chairman Gary Gensler had to correct it during the hearing.

However, there seems to be a rift inside the Commission lately between the Bart Chilton faction who wants more transparency and position limits and the opposing faction – probably led by Gensler - who wants to make cosmetic changes without impacting the big banks much. I believe that the Maguire revelation forced the hand of the CFTC, and that's why this agency has decided to investigate potential manipulation of the silver market by JPMorgan Chase.

Nevertheless, a few scapegoats and some fines will not restore regulatory credibility. Unless some senior executives serve jail time, this lack of integrity will severely harm the financial sector in the US and UK.

Over the longer term, legitimate traders will look for exchanges which enforce the rules equitably, moving their business elsewhere.

I expect the big winner will be China. I believe the Chinese plan to turn the yuan into a reserve currency, and Shanghai into a major financial center by the end of 2020. China has taken steps to improve the convertibility of the yuan, completing more currency swaps with trading partners, and initiating international bond sales. They’ve started to clean up corporate governance, and levy capital punishment for white collar crimes. As investors flee corrupt Western exchanges like the LBMA and COMEX, China will become the new standard for financial honesty and transparency.

Although many analysts believe palladium is expensive at this price, a shortage trumps any other fundamental factors. Knowledgeable observers believe the Russian stockpile is nearly gone, and it’s unlikely there will be any further substantial destocking. South Africa will almost certainly have to cut electricity to the mines during the World Cup, ceasing production from the second biggest source of metal. Increased production from Canada, the US and Zimbabwe will not be able to compensate.

I don’t believe the market fully understands the implications of these facts. Once traders realize that palladium is now in a supply deficit, I predict we will see another price explosion this summer that will take out the 2008 high of $600. A strong rebound in the euro or more serious mining issues could see palladium top $700 per ounce later this year.

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