Gold and silver positioning: insight and analysis

17 August 2022

Dear Investor,

This week, ABC Refinery's Global Head of Institutional Markets, Nick Frappell, took some time to provide some insight and analysis on what drives gold and silver positioning, particularly centering around the CME.

What does data tell us and what drives positioning?

Many investors invest in gold and silver via futures exchanges, usually via pooled funds operated by CTAs (Commodity Trading Advisors). Generally, the CME combines all these entities that manage money on behalf of customers into one category called ‘Managed Money’, simply because that captures what CTAs and ‘money managers’ do; additionally, this category is reported as a single category by the CFTC, the US Commodity Futures Trading Commission.

Money managers like to invest via futures exchanges for several reasons.

The exchange itself provides:

A transparent price discovery mechanism
Access to liquidity
Reduced counterparty risk: participants face the exchange and not individual trading entities as the exchange operates a ‘centrally cleared’ structure
Revaluation prices and other data that is visible to money managers and the wider public, enabling money managers to benchmark their performance consistently.
Leverage. The manager can buy or sell a multiple of the contract after providing the initial margin.

The largest futures trading venue for gold is the Comex Division of the CME, the Chicago Mercantile Exchange, which accounts for about 75 % of all exchange trading volumes worldwide, and about 33 % of total reported liquidity across all exchanges, all OTC (Over the Counter) and gold ETFs volumes combined.

The CME has 8 gold depositaries to deliver into, and 9 for silver.

Hence the bulk of this piece will address specifically ‘Comex-related’ information.

Expressing a view...

Very simply, a CTA who wishes to gain exposure to rising gold prices will buy a futures contract, and one that believes that prices will fall will sell a contract. Each contract is 100 Tozs in size, and those buyers who wish to take delivery will take up gold at one of 8 CME depositories in and close to New York. The decision to take up physical delivery of gold, like any other commodity, will depend on commercial conditions and demand for warrants, which may be driven by positioning and demand for physical metal.
In general, investors don’t take up delivery. Why not? Importantly, funds who want exposure to commodities overall want to stay within a highly liquid marketplace, and whose investment mandate determines which liquidity ‘venue’ the fund trades within.

See the appendix for CME gold stocks.

For every buyer there is a seller

There are many different participants in any market, and even participants within the same category or economic group will express different views at different times.
CFTC ‘Commitment of Traders’ data enables observers to break down market activity in aggregate and relate the activity to different participants.
We will look at how different categories both position relative to each other. Is there a story that shows how investor positioning and other categories relate to each other?

Linking the CME to spot or OTC markets

To misquote metaphysical poet John Donne, ‘No market is an island.' Markets worldwide are linked via the forces of arbitrage, meaning that prices that move out of alignment with other markets attract buying or selling that push prices back together to exist within a window that prevents profitable arbitrage.

Delivery into CME short positions requires the shipping of CME-accredited kilobars* to CME depositary locations to be warranted and delivered. All this incurs shipping, financing, and delivery costs that introduce a degree of friction into taking gold from one location to another. Above that frictional band, it becomes profitable to buy metal in one location and deliver it into a sale made in another location, possibly at a much later date.

*400 FTozs large bars are also deliverable, but the seller must sell the relatively illiquid large bar contract.

Therefore, gold is generally one of the easiest commodities in this respect, as fineness and shape issues are rarely a consideration, and transport is fast and relatively cheap compared with energy products and bulk commodities.

Managed Money positions compared with positions held by the Swap Dealer category

‘Swap Dealers’ covers banks and non-bank financial institutions that are active in gold and other futures markets. Their business scale is sufficiently large to be reportable in this category, and therefore is of interest to market observers.

Nick Frappell represents ABC Bullion's sister company, ABC Refinery, for the Australian Financial Review.

Incentivising being long physical and short futures

Many Financial institutions and swap dealers are long at their Loco London accounts (or other physical locations) and short futures. Their short futures positions offset long positions held elsewhere, as noted above. Being long at one location and short at another means no overall price exposure* so is there an incentive to hold these positions?

Yes, there is. The normal configuration for the gold forward curve is for it to be upward sloping, meaning that forward prices are higher than the spot or nearby price. This condition is described as ‘contango’.

If you are short futures and roll forward (as you must to avoid taking delivery) then the curve will pay you for the simultaneous buy-sell that moves your futures position further forward along the curve.

This is called ‘Roll Return.’

This is a key incentive that frames the context of the Swap Dealer category shorts providing liquidity to the Managed Money or indeed other longs, as all participants respond to incentives.

Visualising the contrast between various categories

It is important to look at what the difference is between the various categories.
Please note that I have concentrated on showing the principal ‘short’ categories, so an observer will notice that the sum of the categories will offset, but not necessarily sum to ‘zero’.

Comparing ‘Net’ positions of Swap Dealers, Managed Money investors, Producers, Other and Non-Reportable categories.
It is notable how over time the different categories are relatively more or less important in terms of who is principally net long or net short. In the period between 2007 and 2013, producers shouldered the majority of the short positions, whereas more recently, the Swap Dealer category has been relatively shorter compared with producers.
Again, the vast majority of Swap Dealers will be price-neutral via having a long inventory position, and the producers are hedging their long position in terms of metal as yet unmined, or in the refinery circuit.

Summary

Exchanges are venues for pricing and exchanging economic risk. Participants price on exchanges because their investment or risk-management mandates promote them to do so, and they can take positions without being compelled to make or take physical delivery. Exchanges can mitigate counterparty credit risk via novating trades and acting as a central clearing counterparty. Exchanges can mitigate price risk via initial and variation margins to act as buffers and incentivise or enforce trading discipline.

Participants in an exchange may appear to have long or short positions via publicly reported information. However, those positions only reflect what is reported. OTC positions elsewhere often completely offset reported positions on the CME or other internationally traded exchanges such as the OSE (Osaka Stock Exchange). It is therefore important to bear that information in mind when judging what participants are doing when active on an exchange.

Importantly, participants price on bilateral or non-exchange venues when they want to buy or sell for a currency, settlement date, tenor, and location that isn't supported by a particular exchange.

In other words, when the client prefers a solution that is more specific to their intentions. Naturally, some of the hedging that flows from OTC trades flows onto exchanges. We hope that the very brief introduction above opens the door to a wider understanding of how exchanges operate, report data and how different traders relate to exchanges.

Appendix

The marked rise in CME inventory reflected shifting risk management rules in a Covid world. Concerns over flights, logistics and interrupted production from various refiners outside the US meant that traders sought more inventory local to the CME to cover the potential to deliver into shorts. More recently, a recovery in physical demand elsewhere in the world has seen CME inventory stocks decline as gold flows out of those depositaries.

Warm regards,