The Case for Position Limits: What is the 'Spot Price' of Gold and Silver And How Is It Set?

Posted by Jesse at 11:50 AM
30 March 2010

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 know, 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?

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 LBMA in London, where the price is set twice a day as the 'London fix.' 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 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 is because of the gold confiscation in 1933. When that happened, physical metal trading in the US came to a complete stop. When gold ownership was again made legal in 1975, the physical metal trading had become so developed outside of the US that it stayed there."

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 though sources are more fragmented than I would have imagined.

There seems to be no central clearing for physical gold and silver in the US, except for the 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 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 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 explains 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.

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 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.

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.

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.

But I am saying that almost every trader I speak with does not really understand this 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 the rule, unaudited and unallocated stores of supply, and secrecy.

The actual prices for stocks are published on a price by transaction basis on public exchanges where as gold and silver have no such counterpart. 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 most others, and therefore the most vulnerable.

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 price 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, then tend to remove arbitrage from the picture. This is the only part of the efficient markets hypothesis that 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 fill it because the price is set in the paper markets which are not amenable to efficient arbitrage because of almost unlimited leverage through derivatives.

This is what you have. Whether it works well or not is another matter. But as an economist if I were going to set up a mechanism to allow price fixing and fraud, I could do little better, except perhaps to set up something more like the Federal Reserve. 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 fixed by position limits and much greater transparency and accountability. 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.

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.


Posted by Jesse at 11:50 AM

http://jessescrossroadscafe.blogspot.com/2010/03/what-is-spot-price-of-gold-and-silver.html

Dan