Gold Arbitrage and Backwardation Part I

Monetary Metals's picture

By Keith Weiner


Professor Tom Fischer has written three papers[1][2][3] about gold backwardation and arbitrage. Across these three papers, he makes a case against the ideas of Professor Antal Fekete. I write this response solely on my own behalf. I do not speak on behalf of Fekete or his New Austrian school of Economics. I have two motivations for writing. First, I have written myself extensively about the gold basis and gold backwardation. Second, I have discussed my basis theory[4], and used it both to analyze market events (e.g. the crash of April 12 and 15, 2013)[5] and to make predictions, via the Monetary Metals Supply and Demand Report[6]. Additionally, I want to present a fuller treatment of certain topics.

The best place to begin is with Fischer’s discussion of arbitrage. Before addressing what he thinks is the flaw in Fekete’s definition, I want to look at an important point that Fischer makes. He says that one is not free to arbitrarily change or broaden a definition, in order to smuggle one’s conclusions. In Fekete’s Arbitrage Fallacy, Fischer writes:

“His mistake is akin to someone who has decided that the notion of "gold" was too narrow when only used for actual gold, so, to generalize and broaden the concept, any other metal should be called "gold” as well.”

Of course, I agree that this would indeed be an egregious error.

In each of his three papers on this topic, Fischer offers similar wording to define arbitrage, so let’s take the most complete one, also from Fekete’s Arbitrage Fallacy:

“…arbitrage in any currency is an investment that outperforms the risk-free rate of interest in that currency…”

There are two principles that students of the Austrian School will recognize right away. First, there is no such thing as a risk-free rate of interest. Non-Austrians are discovering this too, for example the European Central Bank. ECB executive board member, on Dec 9 Peter Praet, said:

“Appropriately treating banks’ holdings of sovereign debt according to the risk that they pose to banks’ capital makes it unlikely that the banks will use central bank liquidity to excessively increase their exposure to sovereign debt.”[7]

Banks have been borrowing from the central bank in order to buy the bonds of sovereign governments. The cost of borrowing from the ECB is lower than the interest rate on those sovereign bonds. They would appear to be performing arbitrage, as Fischer defines it.

But, as Mr. Praet reminds us, these bonds do pose risks. If the sovereign bond is risky, then what real instrument pays a risk-free yield?

The banks are not doing this because it has no risk. They are doing it because the ECB is offering dirt-cheap credit. In proposing its new regulations, the ECB is saying that it does not intend to stop offering subsidized credit. It just wants to impose restrictions on what banks can do with this credit or how much they can qualify for.

By the way, Fischer’s definition above does not state explicitly that the arbitrage investment is also supposed to be risk free. Later in the paper, he does state it:

“Yes, an arbitrage is risk-free, but it also needs to be better than the risk-free rate.”

There is no such thing as a risk-free investment either. Even the simple act of buying shares in New York for 99 and selling them a few milliseconds later in London for 100 has certain risks. Defining the unreal risk-free investment in terms of the unreal risk-free rate of interest is the finance equivalent of defining a dragon as a creature which preys upon unicorns.

The second principle—and this should not be controversial—is that the purpose of economics is to study human action. This was the title chosen by Ludwig von Mises, the greatest 20th century economist, for his greatest work.

The acting man is the proper focus of the economist. Whatever the merits of the notion of a risk-free interest rate, it has no relationship to actors in the economy. Indeed, it has no relationship to reality, and therefore it has no place in a proper theory of economics.

In teaching physics to new students, there is some merit to first studying frictionless surfaces, mass-less strings, and so on. Oversimplification is useful here, to allow the students to concentrate on learning basic principles first. More advanced students must deal with the complexity of the real world including strings that have mass.

There are two differences between positing a mass-less string and a risk-free rate of interest. The real string with mass is quite similar to the mass-less string, especially when the weights it ties together are orders of magnitude more massive. And the physics instructor makes it clear from the beginning that mass-less strings are just for novice students.

I do agree with Fischer on the principle that a proper definition for each concept is essential. Arbitrary definitions will not do, whether invented by a lone dissenting individual or by the consensus of an entire profession.

The opposite of arbitrary is objective, which means based in reality. All proper concepts are based in reality. Therefore, to properly form a concept, and hence define it, one must begin by looking at the various facts that give rise to it.

Ayn Rand wrote about concept formation:

“A concept is a mental integration of two or more units possessing the same distinguishing characteristic(s), with their particular measurements omitted.”[8]

An example is the definition of chair. It’s a piece of furniture that you sit in. The definition does not include any mention of color, size, material, or number of legs. It must be broad enough to include every chair you will ever see in your life. At the same time, the definition must exclude all non-chairs such as tables, lamps, shelves, cars, and computers.

In Fischer’s example of a badly formed concept, gold is defined as all metals. All metals do share certain characteristics such as uniformity, divisibility, electrical and heat conductivity, etc. That is why we have the concept metal.

But we have the concept gold because gold is distinguished from all other metals. A definition of gold, which includes things such as zinc that do not possess its unique characteristics, is invalid. Such a definition is much too broad, and therefore unusable. It would cripple the thinking of anyone who accepted such a definition. Gold, iron, and zinc are all metals. Only gold is gold.

We’re now ready to build up to a proper concept of arbitrage. We will base our approach on something that exists in reality that’s performed by the acting man. Per our discussion of definitions, we must be thinking about what distinguishes arbitrage from all other kinds of actions.

Let’s look at certain principles described by Carl Menger, widely considered to be the founder of the Austrian School of economics. It is a fact that in all markets, there is not a single monolithic price. There is always a bid price and an ask price. Menger arrives at this by noting the problems in a then-popular notion. A certain quantity of one type of goods was assumed to be equivalent to another quantity of a different type of goods, if those goods were exchanged. In his book, Principles of Economics, Menger notes that if the goods were truly equivalent then any transaction could be reversed. But in reality, it does not work this way. If you buy 100 bushels of wheat at the grain market for 5 ounces of gold, then you cannot sell that wheat for 5 ounces unless the market moves upwards. Your loss is the bid- ask spread.

The bid and ask prices open up a whole new mode of thinking in economics. You can see that if you have wheat that you must sell then you must accept the bid price. If the wheat you provided to the bidder satisfies his demand, then this bidder will leave the market. The next-best bidder is the bidder below him. To sell something on the bid tends to cause the bid to drop. The opposite is true with buying at the ask price. It tends to lift the ask.

Consider the case of eggs offered in a farm town and bid in the city center. In this case, an actor can pick up and deliver the eggs. To do this, he must pay the ask price on eggs in the farm town, and be paid the bid in the city center. His profit is the city center egg bid minus the farm town egg ask.

In reality, it’s somewhat more complicated than this simple example. The would-be egg distributor must also buy fuel, a truck, and drivers’ wages in addition to eggs. He must pay the ask on all of these inputs.

The action of this egg-distributing actor will lift the ask price in the farm town and depress the bid price in the city center. As he scales up his activity (or his competitors do) the profit margin of this business will shrink. Will it go away entirely? No, the margin will never shrink to zero in the real world. It will shrink with each new competitor, until no new competitors are attracted to this business. More formally, we say that the marginal distributor walks away from this market; the spread is too small.

Marginality is another key idea introduced by Menger. Marginality provides an elegant and concise way to understand markets. If a bid ticks lower, then a marginal seller will leave the business of producing that good. If an ask ticks higher, then a marginal user of that good will either find a substitute or go out of business.

As markets developed, an actor appeared who was certainly not well understood at the time, and not well understood even today. The market maker stands ready to buy or sell. He makes a bid and an ask in the same good. In so doing, he narrows the bid-ask spread. He is the force that pulls down the ask if the bid is pressed, or pulls up the bid if the ask is lifted. Will the bid-ask spread ever be zero? No, it will compress until the marginal market maker walks away. Incidentally, each good has a different bid-ask spread, as a function of its liquidity (gold has the narrowest by far).

Now let’s move to a different kind of example, a consumer who buys apples every week. On the next visit to the grocer, he sees that pears are on sale. He switches his custom, refusing the apples and buying the pears instead. What will his action (along with the actions of many similar consumers) do? What will be the effect on apples? Without his buying, there is less pressure lifting the ask price. Instead, the apple merchant may have to dump apples on the consumer bid. In the pear market, his action lifts the ask.

The simple act of switching his custom is motivated by a certain kind of incentive offered by the market. And it will have a particular kind of effect on prices in the market.

We have looked at distributors, including those who buy multiple inputs to sell one output, market makers, and consumers who switch goods based on a sale. There are many other kinds of economic action that have something in common with these examples, but these few are sufficient. From them we can identify the essential. What do they have in common? What characteristic unites our examples and at the same time distinguishes them from all other kinds of action?

In my dissertation[9], I offered a definition of arbitrage as, “the act of straddling a spread in the markets.” In arbitrage, the acting man is offered an incentive to act, in the form of a spread. Whether this spread is used to earn a profit, or whether it is simply an inducement to try pears for a change, the spread is constantly signaling the incentives to take certain actions and to avoid taking others. There is also a feedback mechanism. The very act of taking the incentive—of straddling the spread—compresses it.

These are the two universal, absolute, immutable, and essential facts that give rise to the need for a broad concept of arbitrage. First, spreads signal an incentive to the acting man. Second, when an acting man takes the spread he causes it to become narrower; thus he reduces the incentive for the next actor to come along.

Arbitrage is what drives economic action and, therefore, it drives prices, changes to prices, spreads, and changes to spreads in markets.

Fischer asserts that arbitrage opportunities should all be arbitraged away. We can now refine this, and state with precision and clarity that every spread tends to compresses until the marginal actor is not attracted to straddle it. The spread does not go to zero.

It is not necessary to assert that everyone acts to straddle every spread offered; this would be impossible and is obviously false. It is sufficient, if we see an actionable spread, to predict that someone or many someone’s will take the arbitrage.

For those interested, a major part of my dissertation was to show that every attempt by the government to interfere with markets forces spreads to widen. This is why the presence of wide spreads today—with worldwide government intervention gone mad—does not invalidate the concept of arbitrage.


In Part II, I discuss Professor Fischer’s assertion that gold is a currency and hence conclusions may be drawn based on comparing its lease rate to LIBOR.

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dogbreath's picture

Every so often someone comes along and tries to discredit Dr. Fekete.   The good doctor should have a graveyard named after himself.


eclectic syncretist's picture

You're way overthinking it dude.  Better get a job at the Fed and stay away from trading/investing for yourself.

supermaxedout's picture

Why not just stick to basic facts, like gold supply is tight while demand is huge.

Consumers like gold, the industry likes gold, speculators and hoarders like gold, women like gold, Indians like gold as well as the Chinese and the Arabs etc. central banks clinge to gold.

And the question is always why do the Central Banks clinge to gold: The answer is simple because gold is the only universal bartering tool. Its the base for all the currencies like it or not. The gold stays always in the bank while only the printed paper is going around (currency).

Only during the time when the USA Dollar was the undisputed curency of this world gold was pushed to the side. The Dollar backed by guns and oil was forced upon the world economy and the US enjoyed the privelege to print more or less all the money for the world.

But this is soon over, the empire is crumbling and so is the US Dollar. And then gold is finding its value based upon a free gold market.  And one thing is sure: Gold is scares, durable and has a universal recognized value and many would like to have it. Therefore the free market price for gold is going to be the only reliable standard (the gold standard)  within the financial world.  The only way is up.

kaiserhoff's picture

Incoherent, disorganized, pompous drivel, even by academic standards.

This fool got his degree?

Please do not inflict part II of this piece of shit on the readership.

On the bright side, it appears that no trees were molested to propagate this nonsense.

Amagnonx's picture

Er huh?  The only criticism I have for this piece is that it tends belabor the obvious slightly, it could have eliminated a couple of examples imo and still been crystal clear.


Far from finding it disorganized or incoherent I found it slow, but it seems by your response at least that the extra effort was warranted.

Seize Mars's picture

This may just be the single worst article ever written, and I'm including my contributions to "letters to Penthouse."
Rambling, pretentious, vapid, dry, the author blissfully unaware that there exists a complete and full mathematical framework for arbitrage? I guess not.
Defining a chair? Wait, it was Ayn Rand's definition of a chair. Wait, it was Fekete's reference to Rand's quote. Wait, it was Weiner's description of Fekete's reference to Rand's quote.
What the fuck?
Stick to YouTube and let the writing alone. And for God's sake stay away from mathematical finance.

Imminent Crucible's picture

I'm not a big fan of this guy, but this may be the clearest and most useful thing he's written yet, and it's only the first part.  If you saw it as pretentious, vapid and empty, I suggest it's because it went completely over your head. Weiner doubtless understands the principles of arbitrage far better than you do.

"Single worst article ever written".  If they send people to hell for hyperbole, you'd better get started on your 700 million novenas to St. Fekete. 

Oh, BTW, Fekete will be right in the end and Fischer will be wrong. Fischer is just another pseudo-academic trying to get noticed.

Seize Mars's picture

Imminent Crucible

I like Keith Weiner's stuff. Or at least I have up 'til now.

Now, as far as being "over my head," well, let's just say that those who know me know that I have more than a passing interest in mathematical finance. So in other words, fuck yourself.

Anyways this article could have been done in about two paragraphs.

Amagnonx's picture

I agree, this article is concerned specifically with definitions - and it goes to some lengths to prove their neccessity, and create a useful and accurate definition.  


I dont have any issues with this article, only in its length - it could have been accomplished in a more concise fashion.

kaiserhoff's picture

I'm an arb, an academic, and quite interested in backwardation.

Let me assure you, none of this went over my head.

This clown couldn't organize a two car funeral.  Did this "Tyler" read past the headline?

kaiserhoff's picture

This is a great example of why and how academia fails.

Less, much less is expected of foreign students.

Sometimes, as above, nothing at all is expected of foreign students.

Silveramada's picture

Well, the day of reckoning for physicalPM's  is coming, Comex vault is at lowest inventory on record, and, just few days ago, someone placed a trade for 2500 Gzold eagles and 400 monsterboxes of Silver Eagles....some is brewing.

Ban KKiller's picture

Wall Street accounting is a massive circle jerk played to the tune of musical chairs. The one left holding his dick without a place to sit is rescued by taxpayers. That is it...

Add "gold" into the mix while sitting on a massive pile of fiat...that one claims is more like "money" than "gold". OK..then. 

stant's picture

if i am reading martin armstrong latest correctly. now is the time to buy gold.

Bluntly Put's picture

First, there is no such thing as a risk-free rate of interest.

I think Fekete means that when the fed has the banks backs, it is risk free. The banks can show up at a new bond auction and be assured the price on the bond will increase as the fed pushes rates down (supposedly the fed is in control).

Or, another possibility is that when the primary dealers show up at an auction they must use federal reserve credit to buy the new bonds. What exactly do they post as collateral to buy the bonds? It wouldn't by any chance be the same bonds they are going to buy with the credit would it?

MeelionDollerBogus's picture

but it's still NOT risk-free, transferring risk directly into the currency and/or causing credit booms that risk the companies themselves rather than their singular holdings.

Bluntly Put's picture

That is what derivatives are for.

This is so because the total notional value of derivatives represents the liquidation value of insured bonded debt.


MeelionDollerBogus's picture

to ADD risk? You can lose the holdings PLUS the derivatives.
have you been paying attention to the black hole of debt & counter-party risk, MF Global, these past few years?
One Corzine-minute later & the entire balance of all holdings INCLUDING derivatives are vanished.