Do you own silver or paper?

July 12, 2018

Pat Heller


When a COMEX gold or silver futures contract matures, the party that holds the long side may choose to sell off the contract, to trade it for a contract that matures further in the future, or may demand delivery of the underlying metal.

If the holder of a maturing long contract specifies that they want delivery of the underlying metal, it used to be that there were three standard forms of settlement – 1) delivery of the actual metal out of registered COMEX inventories, 2) payment in cash, or 3) payment in the form of an equivalent number of shares in a gold or silver exchange traded fund. Although the party on the short side of the contract theoretically could specify how they wanted to settle their obligation, the long side party also had some influence on how settlements were made.

Over a century ago, another settlement option was established in U.S. grain markets – Exchange Futures for Physical (EFP). This process involves the long side party receiving a cash payment from the short side party and also a futures contract for the equivalent asset on another commodity exchange. Because this form of settlement resulted in the party on the short side settling a contract at a cost higher than the current spot price of the contract, it was considered to be only an emergency measure.

I could not pin down when the EFP option also became available for gold and silver contracts except that it appears to be for at least a couple of decades. Again, since a settlement in this manner would cause the party on the short side to pay out more than by settling in other ways, it was not often used – at least not until last fall.

Beginning last fall, a major percentage – now more than 50 percent – of all maturing COMEX gold and silver contracts where the party on the long side asks for delivery have been settled by EFP instead of physical delivery from COMEX registered inventories, or by cash, or by shares in ETFs.

In the silver market, for instance, COMEX parties on the long side of the silver futures contracts are receiving cash plus either a futures contract on the London market, the over-the-counter (OTC) market, or any privately negotiated settlement between the long and short parties.

A major disadvantage to investors is that contracts settled by EFP are no longer reported as to any eventual delivery of physical metals, or when they are delivered, or if any subsequent contract changes occur. Thus, any data on supply and demand for physical gold and silver becomes even more incomplete than it already was.

As of three months ago, a total of 770 million ounces of COMEX silver contracts were awaiting settlement by EFP in the London Bullion Market Association (LBMA), an amount that is almost 90 percent of expected 2018 newly mined silver production.

The mystery of what is exactly happening gets deeper from there. In theory, if gold and silver was being delivered from LBMA bonded warehouses (which do not have sufficient inventories to cover all liabilities for EFP contracts), these inventories would be dwindling. Yet, the gold and silver inventories of the LBMA are largely unchanged.

Obviously, some kind of non-public settlements of gold and silver contracts are happening – but in paper form rather than physical metals. Just exactly what is happening is a secret and a mystery to me.

The secrecy surrounding the surge in exactly how maturing COMEX gold and silver contracts called for delivery are being settled leads me to suspect two things – 1) that there is a huge and growing shortage of physical metal to meet these obligations, and 2) that also means that people who may think they own gold or silver when they purchase a COMEX futures contract that is settled by EFP are likely to find out that they only own a piece of paper instead.

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