Are Precious Metals ETFs Broken?

November 15, 2018

Last week, conspiracy theorists had their worst fears confirmed when former JPMorgan Chase trader John Edmonds admitted to personally manipulating the precious metals markets for about seven years, at the direction and guidance of his supervisors.

Between 2009 and 2015, says Edmonds, he and other traders at the company had conspired to manipulate the prices of various precious metals futures contracts trading on the NYMEX and COMEX, including gold, silver, platinum and palladium futures, all to swing prices to their benefit.

To do this, Edmonds and his co-workers engaged in "spoofing," or placing a bogus trading order only to cancel it just before execution, thus giving the appearance of greater supply or demand for a given contract. These fake trades lure additional buy-and-sell orders, which in turn pushes prices in a direction favorable to the manipulator.

This isn't the first time traders have been caught spoofing precious metals contracts. This raises the question: If price manipulation has been going on for so long, can you really trust your precious metals ETFs?

The short answer is: Yes.

Difference Between Spot & Futures

For starters, the vast majority of metals ETFs are physically backed—meaning they hold bullion in a vault somewhere, instead of futures contracts. As such, their share prices are determined first and foremost by moves in the underlying bullion.

That's not to say the process by which bullion prices are decided is particularly transparent. Precious metals prices are set twice daily in what's known as the "London fix" (except for silver, whose price is set once daily). These fix levels, established behind closed doors by five market-making banks, determine a worldwide "starting price" for gold, silver, platinum and palladium.

After the fix is in, then the spot price begins to vary. If you buy or sell precious metals on the open market, then spot is the price at which you transact.

Precious metals futures contracts, however, establish some trading price for a certain amount of precious metal to be bought or sold in the future (hence the name). For gold trading on the COMEX, the amount is 100 troy ounces of 0.995% minimum fine gold; for silver, it's 5,000 troy ounces; and so on.

The price cited for a futures contract, then, is whatever you'd expect to pay or receive when the contract expires. As a result, near-term futures contracts often cleave closely to spot bullion prices, while contracts with further-out expiration dates can deviate.

Easier To Manipulate Futures Prices

The precious metals bullion and futures markets aren't the same, though the two of course are related, and dedicated precious metals traders often hold positions in both. However, price discovery is fundamentally different in the two markets: Bullion prices are set by large market participants twice a day, while futures contracts are priced on an ongoing basis through individual transactions.

That point is key, because it means bad actors will find it significantly easier to manipulate futures prices than spot.

For a trader to manipulate the price of bullion, they'd have to convince all five market-making banks to change their fix—which isn't likely to happen (though some argue the market makers themselves are tweaking the fix to their own benefit, which is a separate conspiracy theory altogether).

To manipulate a futures price, however, all a trader needs to do is engage in some shady trading, such as the practice of "spoofing" described above.

Manipulation Depends On HFT

The sentencing document outlines one particular example of spoofing that occurred; on Oct. 12, 2012, at 1:08:48.831 p.m., Edmonds transmitted a sell order to the CME server for approximately 402 silver futures contracts.

Edmonds planned to—and did—cancel the order before it executed, but not before several other market participants reacted by putting in their own sell trades, including at least one trader who sold a single futures contract at 1:08:48.837 p.m. Central Time for the price of $33.585. All this manipulation was done so Edmonds could purchase six futures contracts at a below-market price.

As you can see from the above time stamps, the speed at which this manipulation takes place is on the order of nanoseconds; it's only made possible through computerized, high-frequency trading. The discrepancies that arise are small, and the time frames over which they persist are miniscule, such that regular buy-and-hold investors may not ever notice they exist.

Below, we've plotted the difference between the spot price of silver and the near-month silver COMEX futures price on Oct. 12, 2012. Spot silver closed that day at $33.515/oz, while silver futures closed at $33.669/oz. Was the discrepancy due to manipulation, or due to normal buying and selling pressures? It's really impossible to tell.


Source: Bloomberg; data as of Nov. 14, 2018

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