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

What is evident, however, is that the difference between spot and near-month futures contracts becomes negligible over the long term. Consider the full seven-year period of price manipulation in silver: Can you spot the days and times when spoofing occurred?

 

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

 

9 Futures-Based ETFs Exposed

Still, just because manipulation results in momentary price discrepancies on the order of fractions of a penny doesn't mean somebody isn't making a lot of money from it (or that the practice should be legal). But for investors concerned about price manipulation blowing up their ETFs … well, we don't think that's particularly likely.

There are a number of futures-based precious metals ETFs that would have been exposed to price manipulation during the time in which it was recorded to occur. These ETFs are listed below:

 

Futures-Based Precious Metals ETFs Exposed To Price Manipulation
Ticker Fund Issuer AUM ($M) Expense Ratio Spread
AGQ ProShares Ultra Silver ProShares 180.80 0.95% 0.12%
DBP Invesco DB Precious Metals Fund Invesco 105.47 0.78% 0.08%
DGL Invesco DB Gold Fund Invesco 99.99 0.78% 0.05%
DGP DB Gold Double Long ETN Deutsche Bank 78.25 0.75% 0.10%
DZZ DB Gold Double Short ETN Deutsche Bank 21.99 0.75% 0.16%
DBS Invesco DB Silver Fund Invesco 17.58 0.79% 0.20%
DGZ DB Gold Short ETN Deutsche Bank 10.83 0.75% 0.11%
UBG ETRACS UBS Bloomberg CMCI Gold Total Return ETN UBS 3.40 0.30% 1.66%
USV ETRACS UBS Bloomberg CMCI Silver Total Return ETN UBS 1.82 0.40% 2.49%

Sources: ETF.com, FactSet; data as of Nov. 14, 2018

 

(Other futures-based ETFs, such as the VelocityShares line and the iPath metals ETNs, were not trading during the full 2009-2015 window.)

Four of these ETFs are leveraged or inverse instruments, meaning they're meant to be held for a single day or less. Even so, these funds rebalance daily, a frequency that tends to smooth out any nanosecond long blip in the price of the futures contracts they hold.

The Invesco ETFs, meanwhile, hold futures contracts across the curve for months at a time, rolling at expiry to whichever contract on the futures curve will offer the most favorable roll yield. Momentary price blips are likely to have even less of an impact.

Finally, there are the UBS ETNs, which don't actually hold physical contracts at all, but are debt instruments that track the return of an index. These indexes rebalance monthly—which, again, smooths out momentary price discrepancies that arise.

ETF Investors Probably Didn't Notice

So, what does all this mean? Well, if you're staring closely, you can spot some bumps in the intraday trajectory of these nine futures-based ETFs—but only if you know what to look for and when to look for it.

All this said, the FBI investigation into this manipulation continues. In his plea deal, Edmonds said that he'd been coached on the practice by other traders, and that his bosses knew of his actions. As such, it's possible that more charges and information about specific instances of manipulation will be revealed.

But one has to wonder: If price manipulation were so powerful as to influence precious metals prices in a persistent way—a way that should have buy-and-hold investors headed for the exits—then why haven't all four precious metals markets performed better?

Gold and silver have been range-bound since 2013, while platinum is down almost 50% since 2013. Only palladium has performed well, rising 115% since the start of 2016 (read: "ETF Of The Week: Palladium ETF Shines").

Contact Lara Crigger at [email protected]

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