A Deep Walkthru For Silver Manipulation - Redux

Tyler Durden's picture

Now that silver continues hitting nominal high after high (except of course for the record price hit during the Hunt Bros period), and there is a very distinct possibility we may see an unprecedented melt up in the price of silver to over triple digits for a variety of previously discussed factors, here is a post we produced a year earlier, courtesy of a "deep insider" which dissects with exquisite detail the nuances of silver market manipulation, which in retrospect may have been just a little early. Considering that every single trope mentioned is now in play (even the unmasking of Buffett's unbelievable PM bashing hypocrisy when he himself was one of the people who utilized blatant silver market manipulation for his own purposes when it suited him back in 1997 to send silver soaring), we believe readers should re-read this post in its entirety as it presents a walk-thru for the mechanics, and strategy, of the ongoing unprecedented move higher in the shiny metal.

From A Deep Insider's Walkthru To Silver Market Manipulation, posted originally in April 2010, when silver was lower.... way lower.

As the topic of physical delivery has gained prominent attention
recently, it is crucial to complete  the circle and show how this
weakest link in the PM market is (ab)used by the big boys: Phibro and
Warren Buffet. Pay particular attention to the analogues between the
methods employed in the 90's commodity market and how the PM (and
equity) market is being gamed currently. And to think that each new
generation of traders believes it has discovered something new... (All emphasis below is ours)

 


Background

 

  • As
    a market maker in silver options from 1989 to 2000 I was present during
    both the 1994 and 1997 silver events. They were seminal in my education
    of gamesmanship in trading and how probabilities can come up short.
  • Prior
    to going out on my own, I traded at a small market making firm. When a
    trader finished training there, he had top-tier options knowledge but
    was not educated in whom the players were, the fundamentals of the
    markets, and how probabilities were useless when information was
    asymmetric. That wasn’t their business, they taught option’s theory.
    Since I had drunk the kool-aid, I thought fundamentals and gamesmanship
    were useless in the face of the almighty Standard Deviation model. That
    was a mistake. 

Phibro Early Exercise

  • In
    April 1994, the Thursday before Easter, the trading day ended with a
    rather unusual run up of 15 cents near the close to finish at 435ish
    around noon. Options expired that day at 4pm but we weren’t anywhere
    near the closest strikes (425 and 450) so most of us left. It was a 4
    day weekend in the U.S. but silver traded globally, albeit il-liquidly
    in Asia. Comex wouldn’t open until next Tuesday. My education in
    gamesmanship started that afternoon at JFK airport as I was waiting for a
    flight, my first vacation in 5 years.
  • My backer paged me at the
    airport to inform me that someone was exercising the K 450 calls. I
    scoffed thinking it was a retail sap that was talked into exercising
    some 5 lot piece by an overzealous broker. “Great I said, let them, the
    options are out of the money.”  And I hung up
  • 10 minutes later
    he had me paged again. “You don’t understand, it’s Phibro exercising.”
    Again I naively said, “So what, they are energy guys.” But I was
    curious, “How many? “ I asked. “All of them, five thousand, he replied.
    Now I was really curious, but still woefully ignorant that it was I who
    was the sap at the table. “Why would they do that?” and he explained it
    to me. I nearly shit myself and bent over in the cab vomiting on the
    ride back.
  • Cancelling my trip, I headed back to the office to
    assess the reality of what would happen, probabilities were no longer
    important.  Survival was important.  I had no money and was trading on a
    $25k note lent to me by my backer.
  • We covered by buying futures
    on my entire short open Interest equivalent of EXPIRED OUT OF THE MONEY
    OPTIONS in Singapore with a dealing firm.  We did this prior to even
    actually knowing if I was exercised, probabilities be damned. How did I
    know they exercised? The price covered at was $462; that is how. The
    450s were already in the money by 12 cents.
  • Phibro exercised all
    5k lots. I had a fraction of that but big enough to be carried out on a
    stretcher had the rest of my position not bailed me out/ performed on
    Tuesday next week.
  • The weird part was, the market stabilized
    that Tuesday and did not run to “infinity” as it could easily have. We
    found out later it was because Phibro’s exercise was a no-no and Warren
    Buffet ordered them to shut the trade down as it was too big of a
    potential scandal. Especially in light of his coming to Solly’s rescue
    and lending his good name to fix their most recent Treasury scandal. A
    couple head’s rolled there if I remember correctly.
  • My guess was
    that the client was a Buffet or Soros type. Someone that would only go
    to Phibro, as these guys were the best at preventing information
    leakage, and always aligned themselves with client interests, where as
    if IB had an order  and acted in dual capacity as a dealer, he would
    potentially front-run the order or stop it out poorly on an exit. Phibro
    didn’t take other side of their client’s orders. They ran with them,
    and took care of the clients first.
  • Phibro got a big order for a
    client to buy silver, one that had to be handled expertly, and filled
    over time, no information leakage would be tolerated.  These guys were a
    prop desk that took orders as brokers once in a while.
  • They accumulated options for their own account (K 450C) to piggyback but not front-run the client.
  • They must have bought futures for themselves as well as the client with his permission.
  • They beat the VWAP by gunning the market on light volumes 1 hour before a 4 day US holiday. [TD: compare and contrast with the daily patterns seen every single day in the endless move up in the S&P]
  • They
    exercised the 450 Calls that day and then lifted the offers of the 1 or
    2 OTC metals dealers left open during Singapore hours, running them
    over during illiquid markets.

Never Again!

  • I became infatuated with Phibro gamesmanship and made it a point to understand that particular type of player.
  • Libertarian
    Darwinist that I was I did not blame them. At the time It was a
    buyer-beware market for big businesses and they did nothing wrong. They
    took risk and they aren’t bigger than the market. I wanted to play with
    the big boys, and that was the price.
  • For me it was about
    learning how to read the signs and not be on the wrong side of one of
    those events again, even if I was not privy to their meetings.

Here is some of what I learned:

  • In
    metals (and energy and anything else with an OTC market) the IB firms
    have dealing desks along GS, MS, Republic, JPMorgan, Scotia Mocatta, all
    were essentially broker dealers in precious metals. All had clients:
    miners who hedged production and hedge funds who speculated OTC. They
    provided liquidity by taking the other side of their client’s trade and
    “back-to-backing” them in the futures markets or held onto them in their
    prop books as counterparty because of something else they saw.
  • Their
    client left resting orders with them in the IB’s Central Limit Order
    Book (CLOB) which served as good information to trade around for the IB.
    Sometimes they front-ran the client, other times they go for stops to force the client to puke. Sometimes they’d just make markets, depending on many things. It was poker to them.
  • Phibro
    was different. These were smart guys but they weren’t a dealing bank.
    They exploited imbalances in markets and took positions.  They had
    ideas. They also took orders for heavyweights who needed absolute
    discretion. They did not make it their business to fleece their own
    clients and instead aligned their interests. And they made the banks
    look like pikers when a client came to them with an order.
  • For
    the next 4 Years I paid attention to how those dealing banks and phibro
    played the markets. It was all about gamesmanship, Bayesian probability,
    and knowing your counterparty’s motivation with these guys. Information
    and misinformation.

Some methods:

  • How
    I.B firms would use a thinly traded floor to print the price that would
    trigger a massive stop loss in the OTC markets and bury their own
    clients.  Or how they would buy for their own accounts in front of
    resting limit orders for clients and simply use their clients to stop
    themselves out if the market printed thru their buy levels.  Or how they
    would use dual representation to show loudly they were buyers on one
    side of the ring, while they were selling quietly upstairs to other OTC
    dealers.  Trading with themselves in multiple entities, etc.
  • An
    IB with a Commodity Index was in heaven. Prop trading, captive client
    flow from IB deals and OTC dealing and Brokerage. The good ones knew how
    to integrate and hedge macro risks, whether to front run their own
    index clients or get out off their way.  “Chinese walls” did not exist
    in Commods.
  • Commods were mostly self regulated and that lead to predatory yet mostly legal behaviour. 
  • Some
    of these were necessary to protect their interests with such a small
    number of players. Some were possibly unethical, but most were legal.
    Their clients were all big boys who left resting orders with the IBs at
    their own risk. Clients themselves had to resort to some of the same
    tricks to keep the IB desks honest, like Coming in backwards,
    “spoofing”, leaving buy stops to get sell orders filled. The alternative
    for these clients was to put massive orders in the floor where
    liquidity was subjective, non continuous and information leakage was
    massive.

1997- Warren Buffet.

  • I got my chance to not get run over in 1997, when Warren Buffet gave an order to Phibro to buy silver.
  • Short version. Here is what went down.
  • Buffet gives Phibro the order- fact
  • Phibro
    begins filling it as a broker using various OTC dealers as
    counterparties, and letting the I.B dealers sweat getting out of the
    risk. - fact
  • Phibro buys options for their own account (no exercise game this time tho)- fact
  • Phibro buys futures for their own account. – not confirmed.
  • One
    by one the IB dealers start to catch on that this is no ordinary order
    Phibro is handling. They back away and liquidity gets harder to find.-
    fact
  • Other bigger hedge funds in the small circle of professionals, and other smart firms start getting long.- fact
  • Silver
    starts getting delivered from the Comex vaults. Some of it actually
    removed. Some of it just “covered with a sheet” for removal. But ounces
    begin to be removed from the warehouse. Phibro was rumored to be taking
    delivery and beginning to telegraph fear in the markets to start
    spoofing the VWAP. Rumor was they had a warehouse in Red Hook where they
    stored it.  Never confirmed.
  • Point here is, the saps for the
    last part of this play were the producers and refiners who were
    complacently net short and dependent on above ground silver to satisfy
    delivery requests.
  • Producers had been over-hedging for years in
    this market, as silver was cheap and they had business cash flow issues.
    It was their habit to sell forward production not yet available to
    them. And if forced to, they would lease already above ground silver and
    make delivery, collateralizing it with silver yet to be mined. Their
    positions were habitually synthetically long the contango as they rolled
    their deliverable production further and further out the curve in an
    attempt to squeeze much needed cash (cost of carry)for their businesses.
    The net effect was that sometimes they had to borrow silver for prompt
    delivery while they rolled their production hedge back further. – my
    interpretation of what I learned. May not be accurate to the “T”, am not
    a physical guy.
  • Example: in 1995 a miner has silver due above
    ground in 1997. He hedges it in Z-1997 contract.  Z 1997 comes and if he
    doesn’t have that silver available for some other reason; he covers the
    short and rolls it back. How much he needs to do this is a function of
    his obligations, cash flows, and his greed for carry. If leases are
    cheap, he will seek to capture all the contango and lease it until he
    gets the silver available.
  • If lease rates go up, it is not
    unlike a miner strike. Silver is needed for delivery now, and term risk
    becomes the issue. Contango collapses and market goes backwardated. He
    will be forced to sell the contango to get that prompt silver short back
    if he cannot make delivery. He has to defer delivery.
  • These guys were dependent on the specs NOT taking delivery for years. Specs didn’t have balance sheets to take and store physical metal. Specs usually were the weak hands at futures expiry.
  • But then…..Entities
    that stored silver in bank vaults (like the Republic vault) begin to
    remove silver from the available pool for leasing. This made the “easy
    money” portion of production financing no longer easy.  Think: smart
    money getting the word that a squeeze was on and playing along with it.
  • Phibro
    (and others) start selling the contango in the futures market to
    prepare to take delivery of even more contracts. Or at least put
    pressure on the producers who had front month shorts they would have to
    make a decision on delivering. Phibro KNEW that the producers had to
    sell the spreads to get their shorts back. But they couldn’t lift their
    shorts altogether as part of their financing deals with their bankers.
    Their own positions were now breaking down in every way except flat
    price. The market really didn’t move much. This let them stay in denial.
  • Buffet announces he is long and intends to take delivery of silver. Contango collapses. Market spikes to 7.40.
  • Rumor
    is gov’t intercedes and asks Buffet to not do this, it would break the
    industry. (Kind of like how the exchange begged the gov’t to help it
    shut down the Hunt Bros.)  He says ok, and agrees to lend then their
    silver back to them. Essentially charging them 40% interest to delay
    delivery for a year

What to look for:

  • Find the overleveraged/ extended party- and you will find the weak hand at the table. (Producers in 1997)
  • Tail
    wags dog: if the pricing venue trades smaller volume than the OTC, then
    manipulate price with small volumes to execute trades with big volumes
    favorably.  (OTC vs Comex floor)
  • Divide and conquer- if
    counterparties are undercapitalized and/ or fragmented, then it will be
    easier to get them to move like a herd.  (happens in options ALL THE
    TIME at expiration)
  • Manipulate data- take delivery of metal, take risk off books, manipulate MTM data.
  • Create
    an exit strategy- a good catalyst like Easter weekend, an announcement
    by an investor etc.  or develop a market and grow your own bigger fool.
    ie – retail.

Comments - So many points to make here:

  • How
    derivative markets can create a problem thru too much liquidity that
    cannot easily be reconciled by bringing physical production on line fast
    enough.
  • How this works both ways, and that dealing banks have
    been playing the gold/silver carry game for easy funding of other trades
    for years.
  • How, even though I personally think that what the
    OTC does is their own business, but the increasing securitization of
    commodities leaves regulatory arbitrage and OTC games to affect a new
    generation of ETF buyers, either thru incremental banking or thru
    contango cancer. That Wall Street salesmen and players with
    access to both markets retail and professional can exploit the captive
    audience created with ETFs and other fund type instruments to shear and
    in some cases skin the sheep.
  • That much of this happens
    because the gov’t is too stupid to see the inherent conflict of
    interest in what a broker-dealer does. Regulation will not stop gaming
    the law.  Ethics do, and not everybody has ethics. So best you
    can do is prevent situations of conflict of interest, like the existence
    of Broker-dealer type entities. Either you trade for yourself, or you
    trade for others. Period.
  • Fact is, if there were retail
    public in this game back then, the IB firms would have somehow sold
    them on the idea to BUY contango, or short silver. But the
    financialization of commodities wasn’t there yet. And the “bigger fool”
    game stopped at the producers. If it happened again, with ETFs, cross
    regulatory semi fungible products, asymmetric access to venues and other
    factors in a global market, the public would be killed, short squeeze
    or long puke (like in UNG now) take your pick.
  • You can never
    know intentions, and no one is bigger than the market, but the
    consequences of a lack of transparency and the free reign in which banks
    can tell half-truths to investors is a big factor in enabling strong
    hands to fleece weak hands with little market risk. It’s all a con game.
    And when the IBs figured out how to change the rules, then they
    were free to use their killer techniques to exploit a million little
    fish instead of the 10 big fish they usually competed with.
  • Phibro
    was a ballsy cowboy trading firm. The banks at the employee level are
    as well, but corporately, they first seek to make money and secondly
    provide a service. When they should be providing a service that makes
    money.
  • Everything that was done I’ve seen done the other
    way, keeping prices low, shaking out weaker players. Rarely does it
    happen in such a dramatic way. It is usually a series of “short cons” as
    opposed to Phibro’s home run. It’s all Darwinism. But when civilians
    are involved as they are now, then it is no longer caveat emptor
    .
  • Instead of taking a million dollars from a hedge fund, these guys take a dollar from a million people now.