The Arbitrageur: The Decline and Fall of Silver Backwardation
On Friday, I published an article: The Arbitrageur: Silver Backwardation. I was the only one to cover the news of the end of silver backwardation. And I gave my prediction that the price of silver could correct sharply.
This piece presents my analysis and theory of what happened. This will necessarily include some educated guesses, as the big financial firms don't have a hotline by which they share their problems and plans with me.
Let's start with what we know. The silver cobasis began rising in August 2010, with the December 2010 cobasis becoming positive (i.e. backwardation) by November 11. Backwardation in near-dated futures then became a regular feature. March 2011 silver became backwardated on Jan 19, 2011 and May and December silver contracts went into backwardation on February 17, 2011.
By the beginning of March, something changed. May and December went out of backwardation, and silver cobases began to fall. As we know, by then silver was in a mini-mania. Its price went parabolic for a while and there was no stopping it, even though the structural dynamics which had originally driven it to rise were no longer present. A few short months afterwards, the silver price fell 27% in one week in April.
By August, backwardation existed only in 2013 and beyond. By November, one could see backwardation only in 2014+. By this winter (2012), it existed only in 2015. And on Thursday, Feb 16, backwardation was extinguished entirely.
I've written several times about the problem of backwardation in the monetary metals. When it becomes permanent, it will be a sign of a collapse in trust. But I think this episode with silver is something else, and not just because silver has completely left backwardation. Gold during this entire time has not been backwardated (except for the brief flickers as each contract heads into expiration, which is now part of the "new normal").
My hypothesis is that there was a big duration mismatch problem in silver lending. Let's take a look at how a hypothetical bank might operate in the silver market today. Contrary to popular supposition, I do not believe that they are engaging in naked shorting of the monetary metals in this historic period of debasement of our paper currencies. I've written about this before (http://keithweiner.posterous.com/debunking-gold-manipulation).
What they are doing is arbitrage. They can buy physical and sell a future to make a spread (i.e. the basis). In the meantime, they can earn a little more by lending the metal. The party who leased it, of course, sells it to raise cash and buys a future to ensure that they have the metal so they can repay their loan without exposing themselves to the price of silver. The borrower knows all costs in advance. They must pay an interest rate on the silver, plus pay the cost of carry. To the borrower, the cost of carry is as follows.
Borrower's cost of carry = Future(ask) - Spot(bid)
There are all sorts of potential borrowers, in different states of liquidity and solvency. For some borrowers this may be a good deal, better than what they could get in other funding markets.
Now, enter duration mismatch.
The lender could be lending for a longer period than the future he sold. Or the borrower could be borrowing for a shorter term than the assets he is funding. Let's look at both cases.
If the arbitrager buys physical, sells a future to expire in 6 months, and lends the silver for a year, this is duration mismatch. He may do this on the presumption that only X% of silver futures buyers will stand for delivery. But if X%+ 0.1% stand for delivery, he's in trouble. He would have a choice:
He could buy physical silver in the open market in order to deliver it to the buyer of the future. This would lift the offer in spot silver, and help create backwardation. If he does this, he may as well sell another future to match the duration of the silver lease, which would press the bid on another future, also helping create backwardation.
Second, instead of buying physical silver, he could "roll" the future. This would involve buying the expiring contract and selling a farther-out contract. This would lift the offer in the expiring contract, causing the basis to fall (but not having much impact on the bid, as liquidity is drying up and the market makers are abandoning the expiring contract). And it would press the bid on the farther-out contract, thus helping push it into backwardation.
But what if, instead, the borrower was mismatched? The motivation for the lender is simple greed, a desire for incrementally more profits than he could get legitimately. Especially nowadays, and especially when the upside is small, I think greed is tempered by a healthy fear of getting caught. But what is the motivation for a borrower to mismatch? He may be trying to avoid insolvency! He may feel he has no choice but to take this risk, or else be forced to close his business. I think borrower duration mismatch is the more likely today.
Let's look at this scenario. The borrower borrows silver for a 6-month term, sells the silver, and at the same time buys a future which expires in 6 months. So far, so good. Six months later, the borrower is in no better a position than he was before. He still can't fund his assets, perhaps because they are Greek government bonds which the regulators say he can hold at par but which the markets say something rather less polite. He needs the money.
In this situation, the borrower tells the lender "I can't return the silver right now. I am willing to pay the penalty but I must roll the loan." Then the borrower rolls his future, selling the expiring contract on the bid and buying a farther-out contract at the offer. This would tend to push the expiring contract into backwardation, and help keep the farther-out contracts out of backwardation (ceteris paribum). We do see expiring contracts go into backwardation.
There is one other angle I want to look at. The cobasis, especially for long-dated futures, sat at a nearly constant level for long periods of time. Unlike the nearer months, it does not move around as the market starts with little liquidity Sunday afternoon (Pacific time, USA) and has maximum liquidity at the time of the London PM fix. For months, it sat at +0.25% (annualized). Now it sits at just a hair under 0.
The marginal offerer of the future was willing to sell a contract for 0.25% less than he could sell physical (cobasis = Spot(bid) - Future(offer)). Why? I think it helps to look at it as the price he was willing to pay to fix a problem.
What kind of problem could be fixed by selling a future cheaper than one can buy physical? To understand this, look at it inversely. Who has sold physical and bought a future? Our friend, the borrower, did that!
Abruptly, backwardation ended on Thursday. Recall that this was a day when the paper currency spigot was turned on full blast. How could paper printing affect the spreads in precious metals?
My hypothesis is that borrowers of silver who were stuck having to perpetually roll their silver leases were given a more attractive source of financing.
Perhaps it is the ECB who is widely believed to be expanding the list of assets (or should I say "assets"), which they will accept as collateral in exchange for dirt-cheap funding. But whoever the new sugar-daddy lender may be, I posit that this took the pressure off the silver market by allowing the borrowers to unwind their silver lease and futures positions and go straight to the source of paper funding.
Granted, this is based on a lot of conjecture. But I think it's fair to say that it's educated conjecture. And it fits all facts known (to this author as of Feb 19, 2012).