Part 1: Silver's Price Manipulation, The Why, The How, The When

There is widespread belief that the silver market is manipulated. But why would an entity want to manipulate the price of silver or gold? The reason is to provide credibility to a currency and/or to make a profit. In this article, which is the first of two pieces, I will cover silver manipulation as a means of currency control. In the second part, I will look at silver’s manipulation for profit. Silver is manipulated but the manipulation is unsustainable and investors should position themselves accordingly.

Let’s take a look at the reasoning for the currency manipulation through silver, how they do it, and why it can’t continue forever.

Silver Manipulation for Currency Credibility: The Why

We are all aware that silver and gold were once used as money and that we now use fiat money: money that has no intrinsic value that a government has declared legal tender. Fiat money, like the US dollar, is based on faith. It only has value if everyone in the nation believes they can exchange it for goods and services. Conversely, gold and silver have physical and utility value; they look nice, are nice to have when displaying wealth, and can be used for industrial purposes. For those who disagree with their use in industrial applications, consider that there is gold in every cell phone and half of silver demand is industrial.

The faith in a nation’s fiat currency is tested when a government overprints it, relative to economic output, and the value of the fiat money declines. This is also known as inflation and is seen as a general rise in prices. When this happens, citizens and investors start looking at substitutes to the fiat money that is declining in value. Silver and gold are substitute stores of value and become attractive when a fiat currency depreciates. This is why silver and gold are threats to governments that issue fiat currencies; they can’t control silver and gold like they can their fiat money, and they don’t want to lose the power that comes with control over their currencies. Thus, governments have a reason to reduce the appeal of silver and gold and discourage their purchases. One way to do that is to keep them underpriced.

The United States fiat currency, the US dollar, is the currency that all commodities are priced in and also goes by the petro dollar. It also has the largest national economy with a gross domestic product (GDP) over $18 trillion. A large proportion of international loans are also priced in US dollars. Therefore, the United States has the most “skin in the game” and the biggest interest in defending the faith and strength of its currency.

But the US has been undermining its own currency by increasing the supply of their fiat currency in excess of a proportional increase in economic output – and substantially so. The US government, over the last decade, has increased the supply of its fiat currency far in excess of a proportional rise in economic output, as measured by gross domestic product (GDP). Since 2007, they have increased the supply of their fiat currency by around three times more than the increase in their economic output.

Numbers in Billions of US Dollars

2007 Q1

2016 Q4

% Increase

Compound Annual Growth Rate

Monetary Base

$847

$3,558

320%

15.43%

GDP

$14,233

$18,560

30%

2.69%

Source: Federal Reserve Economic Data (NASDAQ:FRED)

As you can see, the money supply in the US has increased 290% more than GDP since 2007. This is extremely inflationary and faith-testing, which has led to a surge in silver as a substitute store of wealth, especially in 2016, and given gold solid resistance just under its current price.

But Isn’t the US Dollar Strong at the Moment?

Yes, internationally. No, domestically. A currency’s strength has two contexts: inside its borders and outside them. A currency’s strength inside its borders relates to inflation, as seen by prices rising. This is influenced by the supply of money relative to the demand of money, and economic output, among other factors.

This is largely independent from its strength outside its borders, or, internationally. In this context, a currency is valued against other currencies, like the US$ vs. the euro. There could be economic/political reasons inside the US that are making the US$ strong or weak, AND/OR there could be economic/political reasons inside the compared-with currency, that are making the compared-with currency strong or weak relative to the US$.

The US dollar could have strength simply because other currencies that it is compared with are extremely weak. Looking at the negative interest rates, political uncertainty, and stagnant economic situations of the currencies that the US$ is compared with (England, the euro Zone, Japan, China) you can see that the US$ doesn’t have to be inherently strong to be strong, it just doesn’t have to be as weak as the other currencies to be relatively strong.

Therefore, a currency can be simultaneously weak (in terms of domestic purchasing ability as seen through inflation) while being strong internationally (in terms of one currency vs. another). This is the situation that the US finds itself in at the current moment: a depreciating domestic currency and an appreciating international currency. The former due to overprinting of the currency relative to economic output, the latter due to the positive interest rates in the US and the relative weaknesses and low or negative yields of other economies.

Given this substantial increase in the money supply over economic output in the last decade, which reduces the value and faith in the fiat US$, the US government, now more than ever, is interested in reducing the appeal in substitutes like gold and silver. Let’s see how they have been doing this.

How the Price of Silver (and Gold) is Manipulated

The Silver Derivatives Market Vs. the Silver Physical Market

In my last article, I showed that the price of silver has virtually zero correlation with physical surpluses and deficits over the last nine years; the price of silver is indifferent to its supply and demand fundamentals. How can this be so? It’s a result of the physical silver market being dwarfed by the silver derivative market. This difference in size creates the opportunity and framework for price manipulation. Let’s compare the two markets for a sense of scale.

Current annual silver mining production is around 880 million ounces (Moz). Current annual physical silver demand is around 1060Moz.

The Commodity Futures Trading Commission (CFTC) provides a weekly Commitment of Traders report that shows the amount of open interest (outstanding silver futures contracts) on any given day. On March 7th, 2017, open interest stood at 192,398 contracts. Each contract represents 5000 troy ounces of silver. This means that on that day, 962Moz of paper silver were traded.

Silver futures contracts are also traded on the Chicago Board of Trade at 1000oz/contract. On March 7th, 2017, open interest stood at 824 contracts. This means that on that day, 824,000 ounces of paper silver were traded.

Adding up the total amount of paper silver traded on a single day from both exchanges yields 963 million ounces of paper silver traded. You can see that more paper silver is traded in a day than is mined in a year. If you annualize the total daily open interest of silver futures contracts on March 7th you get 351 billion ounces of paper silver. Now you can get some scale of the silver derivatives market, and understand why silver’s fundamentals have a negligible effect on its price. The physical market is 0.0055% the size of the derivatives market.

Derivatives’ Leverage and Simultaneous Whole Ownership of Ounces

Futures contracts are leveraged instruments, meaning you only have to put up a small percentage of the total value of the trade. In fact, at current silver price and margin levels, silver futures traders on the Comex only have to put down around 7% of the total value of the contract as initial margin. Currently, a maintenance margin is required of around 6% of the total value of the contract. This means that in total, only 13% needs to be placed as margin. That low of a margin requirement offers seriously leverage and contributes to the size of the derivatives market.

What’s worse, these margin requirements aren’t a fixed percentage of the value of the contract, as they should be; they are set dollar amounts. As the price of silver increases, the fixed margin requirements become a smaller percentage of the contract value. This means that if the price of silver rises, futures traders gain access to more leverage in an already over-leveraged scenario.

As if extreme access to leverage wasn’t enough, an interesting situation arises in futures trading where multiple people own the same ounce of silver. The same situation exists for gold. In mid-2016, there were a record 44 owners per ounce of silver. This is a roaring red flag. Look at the increase in ownership per ounce over the last six years.

Given the difference in size of the physical and derivatives silver markets, one can conclude that any influence on silver’s price will arise from the much larger derivatives side. But what is the process by which the price of silver is influenced downward?

The Process

There are several strategies and processes for the repression of silver’s price. The general idea is something to the effect of:

-The Federal Reserve Bank, through bullion banks, sells naked shorts on the Comex in sudden and large quantities, dropping the price of silver significantly.

-This triggers stop-losses, margin calls, and related ETF withdrawals which further lower the price of silver.

-The bullion banks repurchase these lower-priced shares and redeem them for physical bullion. -The bullion is then sold on the London Bullion Exchange, further putting selling pressure on silver, lowering its price.

-The bullion is then, usually, sold to Asia to meet their physical demand. Asian investors and governments are getting wise to the game and are increasingly demanding physical delivery, which is what makes the game unsustainable; the game can continue for longer if no one wants physical silver.

Another strategy for reducing the price of silver is to sell a large quantity off-hours, when volume is low and there are fewer buyers to absorb the selling.

Can This Manipulation Continue?

No, but the treasure is in the timing. The western silver derivative market is simultaneously lowering its silver holdings and raising its ownership per ounce of silver. If the silver derivatives market continues this trend, faith in the system will strain and diminish. Traders will ask, how are we all trading the same ounce of silver at the same time? Is what we are doing making any sense at all?

This reduction in physical silver available to the West, remembering that silver is already in a physical supply deficit, will undermine the price manipulation process. When an ounce acquires more simultaneous owners and margin requirements drop as a percentage of contract value (if silver’s prices rises even a little), the volatility in the derivatives market increases. Increased volatility in the presence of margin requirements begets further volatility. This will put further strain on the silver derivatives market and erode faith.

Moreover, its unsustainable. Asia’s appetite for physical silver won’t disappear overnight, despite a reduction to a still-high Chinese growth rate. (China’s silver-consuming solar panel splurge, anyone?) Additionally, the Shanghai Bullion Exchange needs silver reserves so it can be a price setter and acquire credibility; it is still in the accumulation phase.

Asia will continue to demand physical delivery of silver (and gold), which will continue draining Comex reserves and reducing the amount available for restocking of Comex’s reserves continuing the current trend.

Have a look at the recent inventory reduction in the Comex silver warehouse.

This decline in Comex silver holdings is paralleled by increases in the Shanghai Bullion Exchange holdings, as seen the next graph.

The requirement of physical delivery by Asian nations is what makes the price manipulation process unsustainable. Moreover, the size of the derivatives market, even silver’s, is so large it is largely unmanageable, especially in the presence of worsening conditions. If 351 billion ounces of paper silver are traded in a year at $17.01/Oz, then around US$5.9 trillion dollars of paper silver are traded each year. The Federal Reserve’s assets, as of November 2016,

total US$4.4 trillion. The FED is biting off more than it can chew.

When Will the House of Cards Fall?

When will the price manipulation of silver end, if it is unsustainable? Will the entire derivatives market collapse? These are the relevant questions that come to mind. I won’t pretend to know the year that this will happen. There are many variables to consider that make it impossible to accurately estimate the end of silver’s manipulation. But considering the recent increases to the money supply in the US (and globally in advanced nations) relative to economic output, the unsatisfactory economic growth struggling to support our current financial system, the rate of physical silver (and gold) leaving western vaults for eastern ones, the rising ownership per ounce of silver ratio, and the unmanageable size of the derivatives market, I would hazard a guess that the jig will come to an end in the next four years.

One thing is certain: the game is unsustainable and it will end. Investors should keep an eye on increasing owners per ounce of gold or silver, decreasing margin requirements as a percentage of contract value (if the price of silver rises), and Asia’s demand for physical silver delivery. These are the indicators of the strain on the current price manipulation system and will show whether further strain is expected or occurring.

Conclusion

I am not alone in believing the end of the derivatives market, and therefore price manipulation, is imminent. There are many people who believe a collapse of the silver derivatives market, due to the decreasing inventories, increasing leverage, over-complexity, and lack of adequate regulation, is on the horizon.

The Collapse of the Derivatives Market is always a fun Google search. Even Warren Buffet, who labeled derivatives as “weapons of mass destruction”, continues to warn Berkshire Hathaway shareholders at their annual meeting about the looming risks that derivatives pose.

I believe that the price manipulation of silver is unsustainable. The process for the manipulation will become extremely strained and stressed as Asia continues to demand physical delivery of silver, causing the derivatives scheme to operate on less physical silver and become more leveraged than it already is.

Traders will only allow ownership of the same ounce of silver to get so leveraged before they realize that what they are doing makes no sense and is extremely risky. All it will take then is a small amount of traders and institutional and retail investors to realize the tiny amount of physical silver that trillions of dollars are being traded on for them to wake up and start demanding physical silver (and gold) themselves. That will be the end of the derivatives games, and the price manipulation game. In essence, it will be a precious metals run like never before.

Silver and gold will see substantial, even exponential, price rises as trillions in derivative “wealth” is wiped out, the US dollar crashes, and a general amount of financial mayhem ensues.

I don’t mean to be dramatic, this is just what I truly expect to happen. Society and the financial system will bounce back as they always do. But hopefully new and effective regulation will prevent the same situation from occurring so that the general investor has at least a few years before the same entities responsible for the last disaster find new ways of setting the groundwork for another.

As such, I am investing heavily in junior silver and gold miners who stand to gain the most from an increase in the prices of gold and silver; particularly producers that I can buy in Canadian dollars as I believe the Cad not to be overvalued.

Investing in physical gold and silver is also appealing as you can diversify away from currencies and protect yourself from a currency drop or volatility.

I hope this article has been informative and thought-provoking.

The manipulation of silver (and gold) is a controversial and complicated topic. I have spent a lot of time piecing together the why, how, and if it can continue but I realize, due to the topic’s breadth and depth, that I may have made an error somewhere, overlooked something, or made an erroneous realization at some point. Helpful and constructive comments are encouraged to further raise the clarity and awareness of this pertinent and complex issue.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.