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THE DEATH OF HEDGING

Perhaps the greatest contributors to America's long-term economic success and consistently improving standard of living have been a strong reliance on the free markets and the rule of law. The United States has a rich tradition in fostering unfettered competition and in upholding a fair and impartial system of justice.

One of the premier U.S. systems of free markets is the commodities futures market, which is a marvel and the envy of the international business world. With few exceptions, the US dominates futures trading in most major commodities. This futures system is rooted in law and application which dates back well over a hundred years. The importance and benefit of the US futures system to all members of society can not be understated. Anything that threatens the integrity of this free market system must be dealt with immediately, as public trust in the system must be preserved at almost any cost. While some may view these markets as mere gambling, it is the transfer of already existing risk from the commercial hedger to the speculator that legitimizes the entire futures existence. Without hedging, futures wouldn't exist.

Specifically created to safeguard these commodity markets, there exists a distinct federal agency, the Commodity Futures Trading Commission (CFTC), whose chief responsibility is to prevent manipulation and fraud. It is the unquestioned final arbiter in the futures world.

Unfortunately, the CFTC appears to be unable to come close to fulfilling its prime mandate, preventing manipulation. To be sure, the agency has been effective in feathering its own nest once a manipulation has been uncovered by someone else or some market event, by piling on fines after the fact. But, there is no recent history of manipulation uncovered by the CFTC. While parties guilty of manipulation and fraud should certainly be punished, my point is that the determinant for judging the effectiveness of the CFTC, compared to its mandate, should be how well it does at rooting out and exposing fraud, rather than how much money it extorts from the guilty once a manipulation is terminated and the damage has been done. The CFTC should be able to uncover a manipulation in progress, at least once in a while. Especially when it comes delivered gift-wrapped in a presentation that is well documented and explained in clear and concise language.

Let me first explain to the CFTC (the intended recipient of this piece) as clearly as possible, what the gold and silver leasing manipulation is all about, and how it violates the very body of law that this agency is governed by. In fact, the violations to commodity law and common sense in the gold and silver leasing manipulation are so egregious, that the CFTC should have seen the tell tale signs eons ago and acted accordingly, thus saving innocent people years of needless suffering.

For the past 15 years, gold and silver have been leased from central banks and then sold on the open market by the recipients of the metal - bullion banks, mining companies, users and speculators. It is a pure short sale as the metal is sold by the recipient of the lease and must be paid back someday to the lending central bank. It is the interest rate on the lease that is all that matters to the lending central bank, as a result, metal is dumped on the market irrespective of price. The resultant physical short sale position has been growing for 15 years (as there has never been a year of net repayments), and can't possibly be paid back according to the most basic laws governing the world of physical properties. It is this uneconomic selling of metal that is flooding the market and depressing prices, in spite of the existence of a well known physical deficit in both gold and silver. The laws of supply and demand have been upended in the gold and silver markets, yet the CFTC pretends to notice not. One would think that this description of central bank leasing of gold and silver would be enough to get the CFTC rolling. But let me get a lot more specific and lay out for them just what laws and principles are being broken and offer up the name of a specific violator - the Barrick Gold Corporation.

I contend that Barrick Gold has violated the most basic principles of commodity law and in turn, has contributed mightily to the manipulation in gold and silver. The principle violation revolves around an obvious and intentional evasion of the rules and laws of the CFTC. Specifically, by utilizing the leasing/forward sale mechanism, Barrick has been able to short sell many times what the legal limit would be on a US futures exchange, according to the clear intent of commodity law. Barrick's annual gold production is roughly 3.5 million ounces, or approximately 5% of total annual world production. As of March 31, 1999, the company held a reported physical short sale position of 12.5 million ounces, or approximately 18% of world annual production. This is gold borrowed from central banks (additionally, Barrick is short millions of paper ounces of gold and silver equivalents, as well as a sizable physical short silver position). The 3.5 million-ounce annual gold production is equal to 35,000 contracts on the COMEX; the world's leading precious metals futures exchange, or what would be the equivalent of 17% of total open interest. The 12.5 million-ounce physical gold short position of Barrick is the equivalent of 125,000 contracts on the COMEX, or an astounding 60% of total open interest. That's right, Barrick holds a short position that is the equivalent of 60% of the total position of the world's largest gold futures market - and it's been over 70%! (And to think they called the manipulative Sumitomo copper trader "Mr. 5%" for his reported share of the copper market - does that mean Peter Munk, Barrick CEO, should go by "Mr. 60%"?)

According to commodity law and the clear intent of that law, Barrick Gold would never have been able to amass a 125,000 contract short gold futures position on the COMEX. Even the brain-dead CFTC would have caught that. After all, the CFTC is guided by position limit laws dating back 60 years (source - www.cftc.gov) that forbid a commercial entity from hedging more than one year's production. The reasoning behind that law is that it is impossible to forecast, with accuracy, beyond one year, and more importantly, if a commercial entity hedged more than one year's production, it would have an undue influence on the market. In other words, if a producer sold (hedged) more than one year's production, the framers of commodity law knew it would artificially depress prices. Clearly, this is what Barrick has done. But it is much, much worse than that might appear.

What Barrick has done, aided and abetted by the CFTC, is literally destroy the very nature of hedging - the very soul and justification for the entire futures concept. Not only has Barrick violated the original law's clear intent of not selling more than one year's production, it has additionally violated the intent of law by positioning it's short sales outside the apparent reach of commodity regulation. By choosing the leasing/forward sale mechanism, rather than a futures contract, Barrick has escaped, temporarily, CFTC oversight.

It would be bad enough if Barrick had somehow been able to sell 12.5 million ounces of paper gold on a licensed futures exchange, but the fact that they have sold short 12.5 million ounces of real, physical gold (borrowed from central banks), makes it much worse. While the framers of commodity law knew that excessive paper sales would depress prices of any commodity (hence the laws concerning position limits), they never imagined that someday someone would be stupid or manipulative enough to sell short excessive physical commodities. If excessive paper short sales can depress a market, how could a reasonable person deny that excessive physical short sales wouldn't have an even more pronounced effect? In a nutshell, the physical selling of leased metal has been screwing up the free market. That's the problem with this whole leasing/forward sale concept - it is so inherently bankrupt, that it just flies under everyone's radar. For the umpteenth time, you can't lease an item, consume or sell it, and pretend it can be returned in a deficit - that's fraud.

Barrick has additionally destroyed the concept of hedging by adopting a policy of never, ever covering a physical short sale. Look at their annual statement or web page (www.barrick.com), and you will see this clearly. Their short position has never been reduced, and they state clearly that they intend to increase it. This is not hedging; this is mindless manipulative short selling. Real hedges are established and liquidated according to the price of the underlying commodity. Legitimate hedging looks to lock in a favorable price and then close out the hedge when the price is close to cost of production. Barrick isn't hedging; it is short selling massive quantities of physical gold for a much different reason - to be able to speculate with the proceeds of their giant gold short position, some $4 billion. (And while this speculative activity accounts for the bulk of their total earnings, you have to wonder how they are doing on that speculation lately, now that interest rates have turned up or how they will do in the future).

The most remarkable aspect to this whole line of thought is the lack of response to my allegations by both Barrick and the CFTC. Let's face it, I'm accusing Barrick of some pretty serious and quite specific violations, and the CFTC of outrageous dereliction of duty. If I were way off, they'd be all over me. Yet they both do their best to ignore it, hoping it will just go away. While Barrick can be excused for its silence (it has already said too much in its public reports), that the CFTC has yet to issue one statement or one word about the leasing of precious metals and its effect on the market is mind-boggling. The practice that has influenced (negatively) gold and silver the most during the past 15 years has drawn no comment from the chief commodity watchdog. That should explain to you how the recent copper manipulation could have existed for so many years under the close supervision of the CFTC. This dog won't hunt.

Because this agency can't or won't do its job, I think it is time to give them a little help. I think it is time to force the CFTC to address this issue. It is too important to be ignored. Please understand me, I'm not saying that the CFTC has to agree with any or all of my contentions. They just should go on record as saying something, silence is no longer an option. Too many regular people see that something is wrong in gold and silver. Hell, they can even say it's not in their jurisdiction (but that would be hard after piling on afterwards in the copper manipulation) - just tell us whose job it is. There appear to be as many as 500 million ounces of gold and over a billion ounces of silver sold short in the leasing scheme, by a wide variety of financial institutions, mining companies, users and hedge funds. Leasing is the prime determinant for the price of gold and silver. It is time for the CFTC to state what impact leasing has on the market. If there's something wrong, fix it. It's OK for them to dismiss my allegations about leasing in general or Barrick Gold in particular, but not without saying why.

To that end, if you agree that my contentions at least merit a response, I respectfully request that you let the CFTC know, either directly, or through an appropriate political representative, that you would like the issues above addressed (see the above URL for mailing and e-mail addresses). Please feel free to include this article. We are witnessing the destruction of a vital free market system, but there is something we can do about it. Although it appears they must be dragged, kicking and screaming, to the scene of a massive manipulation and fraud, we can force the CFTC to do its job.

Ted Butler

June 27, 1999