Comment Text:
10-005
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Precious Metals Position Limits:
Analysis and Recommendations
Theodore Butler
Butler Research LLC
March 22, 2010
Introduction
Tremendous volatility in energy and other commodity prices during 2008 and the resultant public outcry
suspecting excessive speculation to be at the root of that volatility led to attempts to rein in future
commodity price volatility. With the swearing in of Gary Gensler as the new Chairman of the Commodity
Futures Trading Commission (CFTC) on May 26, 2009, attention was quickly focused on reviewing
whether a revamping of speculative position limits might help prevent future commodity price volatility.
On July 7, 2009, Chairman Gensler announced plans for a thorough review on the matter of position
limits, including public hearings, principally in regards to energy markets and other commodities of finite
supply.
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ent070709 b.pdf
At the center of the Commission's review of hard speculative position limits were three basic issues;
who should set position limits (the CFTC or the exchanges), at what level position limits be set, and who
should be exempt from speculative position limits for bona fide hedging purposes. On January 14, 2010,
the Commission voted to proceed with and opened for public comment a staff proposal that the agency
set hard limits in four energy markets. The proposed limits were based chiefly upon a formula consisting
of a percentage of total open interest, including a set of restrictions concerning who would be eligible
for exemptions to the proposed limits for bona fide hedging purposes. Also on January 14, the
Commission announced a public hearing on position limits in precious metals, now scheduled for March
25, 2010.10-005
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A brief word on the purpose of speculative position limits in general. As the term implies, the intent of
position limits is to limit speculative trading entities from artificially influencing the price of traded
commodities. Limits are not designed to undermine or unnecessarily restrict the important role that
speculators play in the risk-transfer process that marks the economic purpose of the futures trading.
Speculative position limits serve an important purpose; to protect the market from concentration and
manipulation. Much like the reduced speed limits in an elementary school zone are designed to save the
lives of school kids and not just inconvenience drivers, position limits are not designed to punish
speculators. The trick in both cases is to set the limits low enough to serve the intended purpose, but
not so low as to impede the price discovery process or local traffic flow.
One further point concerns the definition of who is a speculator and who is a hedger. Many assume that
all positions held in the commercial category of the CFTC's weekly Commitment of Traders Report (COT)
are bona fide hedge positions. But that is virtually impossible, as the largest traders in COMEX gold and
silver futures are US commercial banks, which trade both for clients and on a proprietary basis. Because
these banks' positions are reported as a single trading entity, legitimate hedge positions are commingled
with proprietary trading positions, thereby blurring the true nature of large concentrated positions. This
heightens concern that concentrated positions in COMEX gold and silver futures may be manipulative in
nature.
Many provisions in the Commission's proposed energy position limit initiative should effectively deal
with this problem. However, the thrust of the Commission's proposal in energy contracts is designed to
prevent concentration in those markets in the future, as there is no apparent concentration in any of
those markets currently. In the case of precious metals, particularly in COMEX silver on the short side,
the issue of concentration is of present concern. Accordingly, it behooves the Commission to take the
opportunity in the open public hearing and otherwise, to closely examine the issue of concentration in
the COMEX silver market with a degree of urgency not required currently in energy markets.
By virtue of the staff proposal at the January 14 meeting having been passed, let's assume the issue of
who should set position limits, the exchange or the Commission, has been answered. Now, the only
remaining questions are at what level position limits in precious metals should be set, and what would
constitute bona fide hedging exemptions to those limits.
The Level of Position Limits10-005
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The COMEX gold and silver futures markets are the highest volume exchange traded precious metals
derivatives markets in the world. As such, they are at the center of the position limit hearing. Previously,
I have made the public case that the level of the current exchange-dictated accountability silver limit is
out of line with either the exchange accountability level or federally-imposed hard position limit for
every other regulated commodity. On every rational basis of comparison, including world annual
production and world inventory levels, the COMEX silver accountability limit registers as an aberration
compared to all other commodities. Such comparisons are valid and adhere to the spirit of setting
position limits in a fair and consistent manner. Since the Commission has voted to proceed with an
energy proposal which includes the setting of hard position limits by a formula related to a percent of
total open interest, I'm going to do the same here. Furthermore, since the CME Group, Inc. (owner of
the COMEX and NYMEX) also proposed a formula around open interest, but also included volume and
deliverable inventory considerations, I'm also going to include volume and deliverable inventory
considerations.
Since the March 25 public hearing concerns precious metals, I'm going to confine my comments to just
gold and silver position limits. First, I will address the current accountability level in each and what CFTC
hard position limits should be, based upon a fair and consistent formula. Then I will address what form
bona fide hedging exemptions to hard limits should take. I will do this by comparing the current
accountability levels in gold and silver with the objective of proving that the position level in silver needs
to radically altered relative to gold.
Presently, the COMEX maintains the same accountability level of 6,000 contracts in both gold and silver.
The size of one COM EX gold contract is 100 troy ounces, while the size of the COM EX silver contract is
5,000 troy ounces. This means that the current accountability level in gold is equal to 600,000 ounces
(6,000 contracts x 100 oz contract size), while silver's accountability limit is the equivalent of 30,000,000
ounces (6,000 contracts x 5,000 ounces). At current prices (approximately $1100 in gold and $17 in
silver); a gold contract equals a dollar amount of $110,000, while a silver contract has a notional dollar
value of $85,000, roughly comparable amounts. That's where the similarities stop.
Using data from the most recent COT report, for positions held as of March 16, the total open interest of
COMEX gold futures was 496,481 contracts, giving that market a total notional value of almost $55
billion. COMEX silver futures on that date had a total open interest of 114,192 contracts, giving silver a
total notional value of less than $10 billion. In terms of total open interest, the COMEX gold futures
market is 4.35 times as large as the silver market. If the CME Group is advancing the idea that position
limits be determined by a formula based upon open interest, then how could two markets with radically
different open interests have the exact same position accountability level? In terms of total notional
value (open interest x contract dollar value) COMEX gold is more than 5.5 times larger than COMEX10-005
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silver. Why isn't gold's accountability limit proportionately larger than silver's or silver's limit
proportionately lower?
Using the key principle of the CFTC's (and the CME's) energy formula proposal, namely, that position
limits be set as a percentage of total open interest, any hard position limit in precious metals would
require silver's position limit to be less than a quarter of whatever the position limit is in gold. It does
not matter what percentage rate is used, as long as the same rate is used. But it doesn't stop with an
open interest comparison. In terms of volume, the average daily trading volume in COMEX gold runs 4 to
5 times the volume in COMEX silver. Once again, the fact that each market has the same position limit is
absurd.
Lastly, the hard position limit for the spot delivery month does somewhat reflect that silver requires a
lower limit than gold's limit. The exchange does limit speculators to 3000 contracts in gold in the spot
month and 1500 in silver. But even though silver's spot limit is 50% of gold's spot limit, that doesn't go
far enough. Spot month position limits are largely a reflection of the level of potential deliverable
supply, or inventory in exchange-approved warehouses. As of Friday, March 19, 2010, there were
10,022,064 ounces of gold in COMEX-approved warehouses, or the equivalent of 100,221 contracts. The
total amount of silver in COMEX-approved warehouses on that date was 116,621,449 ounces, or the
equivalent of 23,324 contracts. Therefore, there is 4.3 times more contract equivalent gold in COMEX-
approved warehouses than there is silver. If the proper spot delivery month position limit for COMEX
gold is 3000 contracts, then silver's spot month limit should be less than 750 contracts, not 1500.
I agree, in principle, with the objective nature of the CFTC's (and CME's) open interest formula in the
energy proposal, although I do think the core percentage rate of 2.5% was too high. In my opinion, the
core rate should have been in the 1.5% to 2% range, but it is not worth quibbling about. One thing that
does bother me, however, is that the actual energy formula from both the CFTC and he CME Group calls
for the position limit be calculated by taking 10% of the first 25,000 contracts of open interest, and then
2.5% of open interest above that. This calculation is not so critical in the energy markets where open
interest can exceed one million contracts. But in a market with an open interest much lower (like silver),
such a provision would necessarily distort the actual resultant position limit. In a smaller market the 10%
of the first 25,000 contracts of open interest would be correctly viewed as a gimmick designed to evade
the principle of a fair and consistent approach across all commodities of finite supply. The Commission
would be making a serious error if it adopted a formula which included 10% of the first 25,000 contracts
of open interest in silver.10-005
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The conclusion is simple - gold and silver are sufficiently similar so as to require their position limits be
fairly and consistently applied. COMEX gold is four to five times larger than COMEX silver in terms of
open interest, volume, deliverable supplies and total notional value amounts. There is no conceivable
reason why they should have the same 6,000 contract position limit, except for manipulative purposes.
The only real question is that should gold's position limit be raised, or should silver's limit be lowered. I
have publicly argued that silver's position limit should be lowered and still believe strongly in that. Even
if the Commission adopted the exact same formula it used in its energy proposal, the resultant position
limit in silver would drop substantially from the current 6,000 contract accountability limit, although not
to the 1500 contract level that I advocate. However, a case could be made for raising gold's position
limit instead, and I would like to comment on that.
If the Commission strictly adopted the same formula in COMEX gold that it proposed in energy (2.5% of
total open interest after 10% of the first 25.000 contracts) gold would have a position limit of 14,275
contracts at current open interest levels. (Silver's limit would be under 4800 contracts). Is it reasonable
that gold's position limit be raised from 6,000 to 14,275 contracts (and silver's limit lowered to 4800) in
order to redress the obvious disparity in their respective position limits? I don't think so.
Some common sense must be applied in deciding on the proper level of position limits. The proposed
maximum position limits for crude oil, for instance, would amount to no more than a day's world
production or some fraction of that. A position limit in COMEX gold of 14,275 contracts would be the
equivalent of 1,427,500 ounces, or almost seven times daily world gold mine production. In silver, the
current 30 million ounce accountability limit is 16 times larger than daily world silver mine production. It
is important to remember that the economic justification for futures trading is to allow hedgers to
transfer risk to speculators, so speculative positions must be viewed relative to legitimate hedging.
Gold mining companies are the natural hedgers on the sell side (aside from jewelry manufacturers, I'm
not sure who are the natural gold hedgers on the buy side). No more than 25 mining companies in the
world produce 600,000 ounces annually (the current accountability limit). Any gold or silver miner, as a
natural producer, could easily get a bona fide hedge exemption with no great difficulty. Currently, the
miners are holding their lowest short hedge position in the forwards market in 20 years, so this is moot,
as the mining community is not interested in hedging for the most part. The other class of potential
bona fide hedger would be a holder of gold or silver inventory at risk in a price decline. Similar to a large
miner, such a large inventory holder should be able to get a bona fide hedge exemption regardless of
the speculative position limit. Of course, regulatory care must be taken so that such a large "hedge"
seller is not unduly influencing the market, intentionally or otherwise.10-005
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It is not necessary, nor advisable to increase the gold position limit from the current 6,000 contract
accountability limit in order to adjust the extreme relative imbalance between gold and silver
accountability limits. It is necessary to radically reduce silver's position limit from the current 6000
contract accountability limit to 1500 contracts on an all-months-combined basis and 750 contracts in the
spot month. Although it shouldn't be necessary to point this out, these limits must apply to both long
and short holders.
Exemptions from Position Limits
Next is the remaining important consideration before the Commission; the allowance of exemptions
from hard speculative position limits for bona fide hedge positions. In fact, this is the most important
issue, as COT concentration data indicate several traders in COMEX gold futures hold both net long and
short positions well in excess of the current 6000 contracts. In silver, there are several traders holding
short positions above the current 6000 contract accountability limit, and no more than one long trader
holding such a position. Further, separate Bank Participation Report data, since August 2008, indicate it
is primarily one or two US banks holding the largest net short positions in both COMEX gold and silver
futures.
The concentration data from the CFTC is so extreme in COMEX silver futures that it set off a formal
investigation by the Commission's Enforcement Division in September 2008, which is still ongoing. This
current investigation follows extensive silver reviews in 2002, 2004 and 2008, by the Commission's
Division of Market Oversight (DMO). All these silver reviews can be traced to public allegations by me
that there was a downward price manipulation underway in the silver market. All the allegations of
silver manipulation and subsequent DMO reviews involved the same issues currently being considered
in the March 25 public hearing, namely, concentration, position limits and bona fide hedge exemptions.
In every DMO review, it was found that no silver manipulation was in place. Yet, the issue, obviously,
won't go away. In addition, numerous public and private complaints to the Commission's Inspector
General concerning the methodology behind the DMO's reviews have been lodged and ignored.
The current formal silver investigation by the Enforcement Division is now 18 months old. This
investigation is believed to have been set off by analyses of the August 2008 Bank Participation Report.
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http://news.silverseek.com/Ted Butler/1220376924.php
The data in that and other Bank Participation Reports revealed that an unusually large net short position
was held by one or two US banks in both silver and gold for the first time. In silver, the net short position10-005
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held by one or two US banks, has amounted to as much as 30% of world annual mine production and as
much as 40% of the entire COMEX open interest (net of spreads) at times. So compelling was the factual
evidence that it resulted in a formal silver investigation. In reality, no one requested a formal silver
investigation, involving valuable resources and taxpayer funds. Instead, the simple question was asked,
"how can such a large concentrated position, held by one or two entities, not be manipulative?" A year
and a half later, we still await the answer.
The facts revealed in the Commission's own statistics go to the heart of the exemption issue. Whether
the silver hard speculative position limit is set at 6000 contracts or reset to a more equitable 1500
contracts, either limit will be rendered ineffective if hedge exemptions are granted in the manner
currently permitted by the exchange. All that it will mean is by how many multiples the big silver shorts
exceed the limit. Any exemption that allows for one or two entities to hold a 30% to 40% share of any
market is permitting an end-run around the purpose of position limits and the spirit of commodity law.
As indicated in the introduction, the Commission's energy proposal, if applied in precious metals, should
remedy the obvious current circumstance of allowing big US banks to masquerade as hedgers when they
are clearly speculating on a proprietary trading basis. In silver, hedge exemptions should be limited to
those who produce or consume the actual metal, or hold real metal inventory known to be at price risk.
While the Commission is to be commended for holding a public hearing on the matter of position limits
in precious metals, if there is a problem that needs to be resolved, that problem is centered on COMEX
silver. In reality, it nearly boils down to this being a silver-specific issue. Simply stated, the COMEX has
abrogated its responsibility to impose legitimate position limits in silver and has further compounded
the problem by refusing to rein in an obvious concentration on the short side of the market. The CFTC
has sanctioned the COMEX's dereliction of its regulatory responsibilities, but now seems receptive to
openly reviewing the issue. This is a welcome and long-overdue change. Allow me to respectfully remind
the Commission that it is important for a regulator, in addition to enforcing the law, to convince your
natural constituents, the American people, that you are doing so. Public perception of fairness and a
level playing field is nearly as important as fairness in fact.
Summary and Recommendations
Many have raised the fear that if the Commission were to adopt reasonable and legitimate speculative
position limits in COMEX silver and began limiting exemptions to truly bona fide hedgers, that there
would be an exodus from the COMEX to unregulated trading venues. I believe this fear is unfounded. On
the contrary, I believe such actions will actually enhance market liquidity, transparency and integrity by
attracting new traders. Yes, it is possible that some large trading entities may abandon the COMEX if the10-005
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playing field were made level. Good riddance to them. Honest traders prefer honest markets. Let those
traders who seek unfair advantage seek it elsewhere. The Commission's responsibility in that case is to
make sure that they don't return to our regulated markets through the back door.
Please remember that very few COMEX gold and silver trading entities would actually be impacted in
the event the Commission was to enact hard position limits. According to the concentration data in the
current COT Report, if the Commission adopted the current 6000 contract accountability limit as a hard
position limit in both gold and silver and threw out all hedge exemptions, only 5 or 6 gold traders on the
long side and maybe 12 traders on the short side would be affected. In silver, maybe
1 trader on the
long side and 5 on the short side would be affected. And this is with removing all current hedge
exemptions, admittedly a strong measure. In the event the COMEX silver position limit were set at 1500
contracts (a reduction of 75%), a total of 10 long traders and 10 short traders would be impacted.
It is important to keep in perspective the small number of traders who would be impacted by the
enactment of hard position limits and a genuine crackdown on illegitimate hedge exemptions, especially
compared to the many thousands of traders in total. It is difficult for me to understand the rationale of
those who would argue that a small number of traders be allowed to dominate a market via
concentration. What about the remaining 99% of all other traders? It must be remembered that trading
futures on our regulated markets is a privilege, not an automatic right. If someone wants to buy more
silver or gold than may be permitted by futures position limits, there are plenty of alternative venues in
which they can buy.
Of course, the problem of position limits can be made to appear to vanish if the limits are set
unreasonably high. But just like a 70 MPH speed limit in a school zone will prevent drivers from being
inconvenienced, it will also defeat the true purpose of protecting children. The Commission's main
responsibilities revolve around preventing fraud, abuse and manipulation in our regulated markets.
Legitimate speculative position limits are the mechanism to meeting the agency's mandate.
Specifically, I would recommend that the current COMEX gold accountability limit of 6000 contracts be
converted to a hard position limit of the same amount. There is not that great a mismatch between the
concentrated long position (around 100,000 contracts) and the concentrated short position (around
180,000 contracts) of the 4 largest gold traders in each category. Because of this, the Commission should
be able to have these positions unwound down to position limit levels in an orderly price manner. In
addition, the general hedge exemption guidelines of the Commission's recently approved energy
proposal should be applied to precious metals as well.10-005
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In silver, there is a mismatch between the concentrated long and short positions of the 4 largest traders.
The current long concentrated position of the 4 largest traders is around 15,000 contracts, while the
concentrated short position of the 4 largest traders is close to 50,000 contracts (250 million ounces or
53% of the entire COMEX open interest net of spreads). Because of this mismatch, greater care must be
taken by the Commission to defuse the short position with as little of disorderly pricing reaction as
possible. A phased in reduction over time may be considered.
With the goal of resolving the unprecedented concentration on the short side of silver with a minimum
of disruption, let me offer one final suggestion that I believe was first raised by Michael Masters during
the energy hearings. Mr. Masters suggested, in addition to a hard position limit for individual trading
entities, an additional position limit by category of traders be considered. His suggestion was, as I
understand it, targeted at index funds, or as some refer to them, the "Massive Passives.," or long-only
funds that make up a big percentage of several futures markets. Since the index funds' participation is
low in COMEX silver and gold futures (they buy the exchange traded funds, or ETFs, instead), it wouldn't
be necessary to further restrict these funds. However, another category of trader is present in COM EX
gold and silver and this category of trader does appear to greatly impact prices at times. Those traders
who rely on moving averages and strict mechanical pricing signals can have a collective impact on the
market that overwhelms the price discovery function at times.
These technical traders (or technical funds as they are largely known) are not related on a cross-
ownership basis nor do they have any financial connection of which I am aware. They are independent
trading entities and are subject to speculative position limits. However, because they are largely driven
by the same mechanical price signals, they generally buy and sell at the same time. In effect, while they
operate independently, their price impact on the market is the same as if they were one single trading
entity. As such, an over-arching and separate position limit might be considered as a way to blunt the
impact of any Commission order that the large silver short concentrated position be dismantled. The
idea would be to reduce the concentrated short position with as minimum of disruption as possible, not
compound the disruption with massive technical fund buying at the same time.
In conclusion, the matters to be considered by the Commission, namely, position limits, concentration
and hedge exemptions are the most important issues of all. I have consistently alleged that a
manipulation exists in COMEX silver because of these issues. A manipulation cannot exist without the
presence of a concentrated position. CFTC data indicate that a large concentrated position exists in
COMEX silver on the short side. The clearest proof of a manipulation lies in the question of what would
the price be if the concentrated position didn't exist or was removed? The Commission found, 30 years
ago, that the Hunt Brothers manipulated the silver market due to a concentrated position. The Hunts'
buying of their concentrated long position first caused the price to soar; and the dismantling of the
Hunts' concentrated long position caused the silver market to crash. Today's concentrated short10-005
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position, believed by me to be held by JPMorgan, is much larger and exists at a time when there are
billions of ounces less silver bullion in world inventories than 30 years ago. The establishment of this
large concentrated short position has depressed the price, and when it is dismantled it will cause the
price to soar.
Many hundreds of complaints have come to the Commission about the silver manipulation. For the
integrity of the markets and of the agency itself, now is the time to respond to those complaints in a fair
and open manner and enact legitimate silver position limits with reasonable hedge exemptions.
