Feb 022016
 

Since my article on the LBMA Silver Price on Friday, more market participants have come out criticising the process:

  • Afshin Nabavi, MKS: “People are going to lose all faith in the fix if this keeps going.” (link)
  • Brad Yates, Elemetal: “When Thursday’s number came in, people initially thought CME would void it, it was so far out of line with the market. When they endorsed it and it became the official print, the benchmark immediately lost credibility. We had two clients shift business away from pricing on the fix to live pricing.” (link)
  • Simon Grenfell, Natixis: “The new silver price setting mechanism appears broken. It is clearly an issue that the regulator should be looking at.” (link)
  • Grzegorz Laskowski, KGHM: “The large discrepancy between the spot price and the fix is very alarming to us especially that it happened twice in a row. I think the LBMA needs to make every effort to explain why it happened and needs to help to develop a system that would help to avoid these kind of situations in the future.” (link)
  • Unnamed bullion banker: “People are too scared to change their orders in the middle of the process so it got stuck. In the old days, banks would step in and take positions in order to balance the process. No-one dares do that anymore, as then they have to answer to compliance etc.” (link)
  • Unnamed precious metals dealer: “The system is broken. In the old days, if it was out of line, someone would have bought the fix and then sold the futures. It’s a joke — that’s all I know.” (link)

The most damming comment comes from Ross Norman as he is respected enough to be included in LBMA’s oral history project ‘Voices of the London Bullion Market’, who noted that “ten times in the last six months the silver price has been ‘fixed’ outside the trading range of the spot price for that day which is nonsensical. … A benchmark or reference price it is not. … the so called LBMA silver price does not come close to reflecting reality – and it is clearly vulnerable to manipulation – it is therefore effectively invalid.”

It seems the LBMA is certainly feeling the heat, with Ronan Manly noting this recent change to the LBMA’s website:

Ross asks why the LBMA Silver Price oversight committee (on which the LBMA sits) has “not come forward and explain what is going wrong and what they are going to do about – it is after all their job”. However I think there isn’t much they will be able to do about it because, as Ross himself notes, the real problem “is that banks are increasingly unwilling or unable to place corresponding orders where they perceive a mis-pricing because of fears of being accused of abusing a situation and facing the wrath of the regulator or their compliance departments.”

To fix the Fix, bullion bank traders (whether they are direct participants or not of the fix process) have to be able to “buy the fix and sell the futures” when the fix gets swamped by sell orders (or vice versa). The problem is that banks have a wide range of clients who hold positions with them across spot, forwards, futures, options, ETFs and so on. It is therefore highly like that one of those clients would be the loser of any such activity (and others winners) and complain (as did the client Barclays’ trader Daniel Plunkett traded against) about it. Alternatively, the regulator may decide to investigate markets from time to time.

The problem is that when a regulator comes looking at trades after the fact they could construe manipulative intent when no such thought was going through the trader’s mind – who was just arbitraging a market imbalance – and the trader finds themselves fined £95,600 and banned from trading, as Plunkett was.

If you think that traders would not be worried about such an unfair claim against them happening, or that client complaints or random regulatory investigations it would be unlikely, you haven’t been reading enough Matt Levine, who, coincidentally on the day of the silver stuff up included the two following stories in his daily article:

  • Nav Sarao, who is facing a 380-year jail sentence, “may not have had a material, or even any, impact on the bout of equity market volatility in May 2010 that later became known as the flash crash, according to a draft research report by University of California, Santa Cruz and Stanford University professors” (link)
  • Tom Hayes, who is serving 11 year jail for LIBOR rigging, saying that he was “thrilled that the brokers can tonight return to their families and their lives” while also “bewildered that he is now in a situation where he has been convicted of conspiring with nobody” (link)

Now I’m not saying these guys are scapegoats, but as a trader these stories would not make you feel comfortable that you would be given the benefit of the doubt. So would you help keep the fix in line with other markets if it risked you going to jail? No you would not, so the traders sat/sit on their hands. No matter what the LBMA, CME or Reuters say, I can’t see traders keeping the fix in line with other markets unless they got a letter from the FCA and SEC saying they will not go to jail, and the chances of that happening are zero.

The only hope for the fix is if non-banks step up to act as market makers/arbitraguers, otherwise “it can only get worse” as Ross says. Bullion Vault’s article hints that some such trading did happen

“As soon as [the benchmark] was done, [futures market] was hit with arbitrage selling and traded down to 14.07 with 5,000 lots trading. Then bounced back to trade $14.30+.”

however given how far the fix was able to drop, and how the futures market dropped much less, such arbitraging was not enough (but highly profitable to whoever executed it). Possibly more non-bank traders will step into the market to take advantage of the fact that the banks are impotent.

The problem for the LBMA Silver Price as a business is that unless traders do step in, more and more clients will stop placing their orders on it, as some of Elemental’s clients have. As the two-way liquidity drains away the chance of imbalances and out of line fixings increases, which causes more to pull out and so on in a death spiral.

unable to place corresponding orders where they perceive a mis-pricing because of fears of being accused of abusing a situation and facing the wrath of the regulator or their compliance departments. … Since Mitsui the only non-bank amongst the price setters departed – (and therefore the least regulation-bound), we have only banks remaining in the benchmark setting process so it can only get worse.

If the alleged email from the CME to its clients below (as reported by Platts and called “nonsensical” by a banking source) is indicative of how this issue is being dealt with, then the future of the fix is fraught.

“The platform worked as it should, in fact perfectly. It’s as good as the orders the participants enter. If you are a client of a ‘participant’ I guess you should direct this question at them. If you want individual flexibility, become a participant.”

Jan 292016
 

Since I’m partial to a bit of alliteration in my post titles, it is just as well that the Fix had a name change because there is a word beginning with F that describes what happened midday London yesterday (and that word is Farce – go wash your mind out with soap). Anyway, “storm of stupidity” is probably a better fit because it looks like a combination of price insensitive sellers using what now appears to be a closed-end fund.

Before we get underway, I want to address the manipulation argument. This was predictably raised by those looking for a simple explanation, seeing the price action as another Plunkett-style trade. I think that is unlikely in this case, as any trader attempting that post-Plunkett would certainly not be wanting to draw attention to themselves and only be looking for a few cents. Once you saw the price dropping dramatically and the fix process struggling to clear, you wouldn’t keep pressing on to leave a nice trail in what you know is a fix that is going to be investigated due to its extraordinary nature.

My first “stupid” is the people who put sell-at-market orders on. These people are most likely mining companies, particularly those for whom silver is a by-product. As I discussed here last year, they think it is safer to trade on a benchmark – safer in that if they traded the spot market and didn’t achieve the benchmark price they would get in more trouble for that then the times they achieved a better price.

I asked our senior dealer whether this fix farce would prompt such sellers to stop using the fix and let their brokers “work” their position in the spot market old-school style. He said no – generally they weren’t aware of the intra-day price movements and just took the benchmark as given. I suspect however that such a view is based on the assumption by the sellers that an industry benchmark is liquid and will represent the market price. Clearly this was not the case yesterday.

This leads us on to our second “stupid” – regulators/compliance. Adrian Ash reports that:

“Dealers blamed Thursday’s action on rules – decided by the compliance departments of banks and brokerages, and aimed at meeting the new regulatory regime – which block traders participating in the benchmark auction from “arbitrage” in other silver markets at the same time.”

A classic case of unintended consequences where regulators come up with simplistic solutions and end up throwing the baby out with the bathwater. How is a benchmark meant to represent the market if it can’t be connected back to that market? This means the LBMA Silver Price is sort of a closed-end fund without an ETF-style market making arbitrage mechanism to keep its price in line with reality.

It does raise the question of whether the CME/Reuters or the brokers have some duty of disclosure to tell their clients that because of the inability of brokers to arbitrage the LBMA Silver Price, the price they get may be at a discount or premium to the rest of the market. With the undoubtedly millions of ounces sold on the fix at an 80 cent loss, someone may try to sue someone.

This leads us on to the question of what were the bullion banks doing during the fix? In a situation where the banks can’t arbitrage during the process and there is a persistent buy/sell imbalance, then they have to take on price risk that when the price fixes, they are not going to be able to layoff the “market making” position they took on into the spot or futures markets at a profit.

The fact that the price spiralled down implies that the volume being sold was large, large enough that the banks were not confident that when the price fixed that they would be able to lay their positions off in the “free/open” market without moving the price down. It does beg the question of where were other market players to take advantage of such a divergence? I think the answer is that such trading is a tricky business as you can’t be sure that your order into the fix will balance the market and you will get set at that price – it is not a simple arbitrage where you know you can execute at two different prices, it is a much more dynamic process. Managing that risk is a skill set that, surprise, is probably only located within the LBMA market making banks. But they have their arbitrage hand tied behind their back (thank you regulators).

I think it is also important to note that the setting of the price of the auction rounds is automated. There is the capability “in exceptional circumstances” for the CME to “overrule the automated new price of the next auction round in cases when more significant or finer changes are required”. It would be interesting to know if the CME just let the algorithm run wild or intervened, although I note that Reuters, in addressing IOSCO Principles for Financial Benchmarks, say “No expert judgement will be levied – auction-based methodology”. Yes, brave new world, no meatbags required.

A contributor to this situation, by giving regulators intellectual “cover”, are those academics who failed to understand what market making is and the different roles of brokers and principals. In precious metals we had various academic papers that observed an interaction between the fixes and the spot and futures markets and presented it as if they had found evidence of manipulation when they had merely discovered arbitrage. In FX market this manifested as outrage about foreign exchange “rate-rigging” (eg here).

The problem for the CME/Reuters/LBMA is that if the sell-at-market sellers wake up and can’t be reassured that the silver fix has a mechanism to keep it in line with the rest of the silver market, then they will abandon it and the fix will die. But I can’t see how the fix administrators are going to be able to roll back regulatory/compliance requirements for “no arbitrage”. Maybe others will step in to perform that arbitrage. But then why can they “rip faces off” but not the banks saddled with being conduits for fix orders? Maybe regulators will want to regulate these 2nd tier arbitrageurs so there are only “real” buyers and sellers? And the 3rd tier? I wouldn’t be confident that regulators wouldn’t go down that absurd rabbit hole rather than admit they were wrong.

You’ll note I’ve used the word “fix” rather than “LBMA Silver Price” in this article. Its resistance to what seems to me to be a superficial cleaning up of the old fix – look at this new fix Mr regulators, its electronic, uses algorithms and we’ve stopped using the word “fix” and we’ve even made the price “easier to see. The traders wanted to have bigger fonts, so we did that” (yes, I kid you not). All the while, however, it was structurally deficient in the face of large buy/sell volume imbalances.

For institutional and other big money investors, this fix farce will just make them think that the silver market’s liquidity is a joke.

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I wonder if CME is still “proud” of this new fix system? Well at least the bigger fonts will make it easier for people to see how much money they are losing.

 Comments Off on LBMA Silver “Price”: A Perfect Storm of Stupidity
May 082015
 

Last week I did a post on the London gold Auctions, noting at the end “the number of days where the volume offered for sale does not change, or changes very little, through each round”. I’d like to explore that in more detail in this post. As and example of what I was talking about, see the chart below.

London Auction 30th March

The red and green lines show the volume of ounces offered to buy (bid) or sell (ask) as each round progressed (note: the auction finishes if the volume bid and ask is within 20,000oz, hence the red and green lines don’t come together at the final successful round). The purple line shows the price set by the Chair of the auction for each round.

On this day you can see that amount offered for sale pretty much remained the same as the price dropped. This is counter to theoretical laws of supply and demand – as the price drops, you would expect quantity supplied to reduce. In the case of the buyers, we see what is expected – quantity demanded increasing.

To date we have had 63 London Auctions, so what has been the average behaviour over this time? First, each auction has had different quantities offered, so we convert the chart above into an index, setting the mid-point of the final bid and ask volumes to 100. That way all volumes can be compared with each other. This results in the chart below.

30th March Index

Then we can graph all the bid volumes and all the ask volumes, eliminating Auctions where there was only 1 or 2 rounds as that doesn’t show much information on how buyers and seller reacted to price. The chart below graphs all the ask/selling volumes with the big fat red line being my “average” behaviour (excuse the x-axis, 12 is the last round, 11 the 2nd last etc).

Auction Ask

You can see with the clustering of the lines that most of the 45 auctions showed very little reduction in the volume offered for sale, say a reduction of only 10-20% in general. Contrast that to the buyers, below.

Auction Bid

Here we see a lot more movement, with the buyers on average starting off a lot lower in the bid volumes (between 30-50% below) compared to what the sellers do.

Of the 45 London Gold Auctions of 3 or more rounds, 38 have seen reductions in the 1st round price to the final round price. Of those 38, the average starting volume offered by sellers as an index to the final mid-point volume was 114.2, a move down of 14.2. For the buyers, the average was 52.5 a move up of 47.5.

So it seems that on the majority of days the sellers are generally price insensitive, putting in “sell at market” type orders. My guess is that it is mostly mining companies doing this selling, as for many of their managers it is safer to just sell on a public benchmark than try and “trade” your production in the spot market – if you do better than the London Auction you probably don’t get as much praise to offset the angst you get from your boss when you achieved a price below the London Auction.

You’ll note the big jump in volume from the 2nd last round (average of about 30% under the final mid-point volume) to the last successful round (where it is about 10% off the final volume). It is as if the canny buyers have observed this “sell at market” behaviour and are holding out as long as possible with the volume they offer to try and get the price down (or maybe I’m just reading too much in here).

If any of you are investors in gold mining companies (commiserations) you may want to ask them if they sell at market on the London Auctions. If the answer is yes, you may then want to ask them if they know who the sucker is at the London Auction.

Apr 282015
 

The new London Gold Price, which replaced the London Fix, has seen fifty price “settings” (“fix” is understandably on the nose these days) since it launched on 20th March this year. As part of the change, the administrator of the setting publishes details of each round, which you can view here.

This detail was not previously available to the public and represents a move towards transparency. In the past, all that was revealed was the price achieved but the retail investor did not have access to the volume traded, number of participants, how many rounds it took (for information on how the process works, see here).

This data is a valuable insight into the buying and selling dynamics in the London professional market, particularly since many professionals claim the London Gold Price provides a point of deep liquidity for the gold market. While it is early days, I am sure that analysts will look to mine this data, as some do with futures markets data, for clues on whether bull or bears have the upper hand. For example:

  • How many rounds were required to set a price?
  • How big was the gap between buying and selling volume on the first round?
  • How did buying and selling volume change in response to each round?
  • Did buyers increase volume to match sellers, or vice versa, or did they both move?
  • Was the price change from the first round to the final price related to any of the above?
  • Do any of the above predict future prices or volatility?

It is too early to read too much into the data as 50 price settings is not enough statistically but so far:

  • 20% only take one round to set a price with the majority taking between 4 to 6 rounds, averaging 3 minutes in total.
  • The longest setting took 12 rounds and close to 10 minutes.
  • Average volume is 89,233oz, or around 3 tonnes ($100m).
  • So far all the fixes have been below 6 tonnes, except for one afternoon of the 27th of March, when 608,117oz or 19 tonnes were traded ($727m worth).

For me so far the most interesting observation is the number of days where the volume offered for sale does not change, or changes very little, through each round. On those days the buyers can only be induced to increase the volume they will bid by the Chair dropping the price.

Who could be these price insensitive sellers, these “price takers” turning up each day? My guess is that it is mining companies, as we know many sell their production on the London Gold Price benchmark. Maybe they need to get a bit smarter and stop putting in “sell at market” type orders? It doesn’t look like it is doing them, or us, any good.