In Gold Stocks: Ready, Set, by Eric Sprott and David Baker say that “While the futures market is comfortably forecasting a continuation of today’s levels, the majority of sell-side analysts refuse to update their gold . . . → Read More: Futures furphies]]> Wikipedia: A furphy, also commonly spelled furfie, is Australian slang for a rumour, or an erroneous or improbable story.

In Gold Stocks: Ready, Set, by Eric Sprott and David Baker say that “While the futures market is comfortably forecasting a continuation of today’s levels, the majority of sell-side analysts refuse to update their gold price estimates to reflect its recent strength.”

It is futures 101 that futures prices are not a forecast by the market, they are just a mathematical derivation from the spot price, interest rates, freight and storage costs, with gold interest rates and dollar interest rates being key components. Backwardation is when gold interest rates are higher than cash rates. Contango is the reverse. Either way, the futures price isn’t forecasting anything. See this blog post for more on backwardation.

In that same article, Sprott raised the “excessive turnover” meme which Eric seems to be running recently – he must think he is on a winner with this. I dealt with it in this post and to that I’d like to add another counterpoint. First, the quote:

“In the LBMA market, for example, market participants traded an average 19.6 million ounces of gold PER DAY in July 2011. Keep in mind that the total gold mine production in 2010, globally, was approximately 86.5 million ounces. … so the LBMA is essentially trading a year’s worth of production in less than a week”

I think it is misleading to relate turnover only to new mine production. This assumes that there is no sales by any of the investors who hold above ground gold. Eric should at least be including privately held gold stocks of 30,000t, or 965 million ounces. Adding that to the 86.5moz then the 19.6 moz represents the “LBMA” turning over the stock once every 54 days, or 7 times a year. Not as dramatic, is it. If we included the 30,000t or so of central bank holdings then it is even less so. But don’t fear Eric, help is at hand.

The funny thing about the “large turnover is bad” idea is that in most markets this is seen as a good thing, as it indicates the particular market is liquid. On this line of thought, note that the recent Loco London Liquidity Survey was undertaken by the LBMA at the request of the World Gold Council “in order to strengthen its argument that the gold market is sufficiently deep and liquid to justify gold’s characterisation as both high quality and liquid.” with the objective of getting gold included in the Basel liquidity buffers for banks.

What did their survey show? “The average daily trading volume in the London market in this period was 173,713,000 ounces or $240.8 billion.” I can see Eric getting his calculator out now and dividing 86.5 by 173.7 and getting really excited. When you hear that the “paper” markets turn over annual mine production every 12 hours, remember you heard it here first.

The other thing I find interesting is the different way Sprott pitches this meme. For the gold/silver bugs we get:

“… I think all the paper markets are a joke. As you are probably aware, we trade a billion ounces of silver a day. A billion ounces. The world produces 900 million a year.” (link)

But in the Markets at a Glance article with Sprott branding on it for a more wider market it is less breathless and a bit more sophisticated:

“When price discovery is dictated by levered paper contracts with no physical backing, it’s extremely easy and relatively inexpensive to jostle the spot price around.”

Interestingly, the LBMA survey revealed that 90% of trading was spot, not forwards (sort of the over the counter markets version of futures), which equals 156moz. COMEX average daily trading during August was 278,000 contracts, or 27.8moz. 156 versus 27.8 – who do you thinks jostles who?

Continuing on with futures, we get this from Patrick A. Heller: “Increases in margin requirements make sense as prices are rising, as that helps keep the market in order, but it does not make sense when prices are falling.”

Now this is a very common misunderstanding. Margin increases (or decreases) are to do with volatility of the price, not the direction of the price. Dan Norcini explains it well:

When you get a market like silver that drops 15% in ONE DAY, you are going to get margin hikes. The reason – the very integrity of the Clearinghouse comes into play.

Silver closed down $6.48 today. In a single session, one long contract in this market cost the buyer a paper loss of $32,400! That is enormous. If you consider the fact that the previous old margin was $21,600, that was wiped out and then some.

During the clearing or settlement process, the winners get paid (have their accounts credited) by debiting the loser’s accounts. If the losers do not have sufficient funds in their accounts, the whole process breaks down.

Zero Hedge has really went downhill in the past few years and this post by them I found very funny and symptomatic of the sort of readers they are now attracting:

We are only putting this up because we have been flooded with emails about an event which for some reason readers believe is relevant. The event in question is that according to its website, the London Gold Exchange (”LGE” or the “Joke”) has closed. The one thing we would like to say about this is that the LGE is nether an exchange, nor does it trade gold.

You have only yourself to blame Tyler. While he didn’t meant he post to be ironic, I read it that way. Yes, Tyler, your readers can’t tell between real gold news and rubbish, but guess what, neither can you, IMHO.

To close, I’ll quote myself from Ed Steer’s Gold & Silver Daily on the recent sell off in precious metals:

Here’s an interesting comment that I got from my friend Bron Suchecki over at The Perth Mint yesterday. I’d sent him an e-mail on the weekend asking him how sales were both on Friday…and their Monday, which started Sunday night here in North America. This was the reply that I got…

“The Perth Mint has been very busy this Monday morning with a lot of buying [but also some selling], however buying is outweighing selling by a fair margin [pun intended]…and the decrease in the AUD/USD has taken some sting out of the drop for Aussie investors.

I see this sell-off driven by leveraged “weak hand” money. In contrast, average investors [the real smart money] are looking at this as an opportunity to buy in or top up at cheaper prices. These buyers are “strong hands” and have been the ones who have been driving the trend all these years.”

A nice story about UIDAI, by Lydia Polgreen, in the New York Times.

A new insight into India’s north-east states: they are part of a region provisionally named Zomia. An interesting article in the Chronicle of Higher Education by Ruth Hammond. The book.

On 21 April 1956, Jawaharlal Nehru did the first convocation . . . → Read More: Interesting Readings for September 20, 2011]]>

A nice story about UIDAI, by Lydia Polgreen, in the New York Times.

A new insight into India’s north-east states: they are part of a region provisionally named Zomia. An interesting article in the Chronicle of Higher Education by Ruth Hammond. The book.

On 21 April 1956, Jawaharlal Nehru did the first convocation address at IIT, Kharagpur. It’s a good read, and it’s surprising how much of it makes sense in 2011. E.g.: in the larger context of history, and looking at it in this way it seems to me that at the present moment there is no more exciting place to live in than India. Mind you, I use the word exciting. I did not use the word comfortable or any other soothing word, because India is going to be a hard place to live in. Let there be no mistake about it; there is no room for soft living in India, not much room for leisure, although leisure, occasional leisure is good. But there is any amount of room in India for living the hard, exciting, creative adventure of life. In case you have not yet seen the Steve Jobs commencement speech, it is worth watching.

How civilised: Literature festivals in India, by Abhilasha Ojha in Mint.

A fascinating story from rural India about the differences between boys and girls on mathematics, by Maia Szalavitz in Time magazine.

Who’s to blame for India’s inflation and India’s Inflation Is a Lesson for Fast-Growing Economies by Alex Frangos in the Wall Street Journal.

When do stock futures dominate price discovery? by Nidhi Aggarwal and Susan Thomas, IGIDR working paper, has some surprising results.

Anupama Chandrasekaran and Vidya Padmanabhan, in Mint, on Indian ventures into farming in Ethiopia.

Raghu Dayal in the Business Standard on the huge opportunities in better India-Bangladesh relations.

Mobis Philipose in Mint, on recent developments in SEBI and on currency derivatives trading.

We need a Hazare in the financial sector by Tamal Bandyopadhyay in Mint. N. Sundaresha Subramanian in the Business Standard. Ex-SEBI member to PM: ID leaked, family at grave risk by P. Vaidyanathan Iyer in the Indian Express. CVC to Fin Min: Probe both sides’ complaints by Ritu Sarin in the Financial Express. And, reportage in India Today. Spat between Abraham, SEBI, finance ministry gets murkier by Appu Esthose Suresh in Mint. Supreme Court wants petition on SEBI refiled by Nikhil Kanekal and Appu Esthose Suresh in Mint. A first and then a second article on these issues, by R. Jagannathan, on FirstPost. An editorial in the Business Standard. Subhomoy Bhattacharjee in the Financial Express.

R. Jagannathan on post offices as banks (on firstpost). And, you might like this related document.

China’s A. Q. Khan problem: an article by Michael Wines in the New York Times.

A great story by Anthony Shadid in the New York Times about being on the run in Syria.

A great article by Paul Berman, in the New Republic, about Islamism.

Why is it so hard to find a suicide bomber these days by Charles Kurzman, in Foreign Policy.

Love and war, by Janine di Giovanni, in the New York Times.

What’s next for the dollar? by Martin Feldstein.

Sussane Craig has a great profile, in the New York Times, of how Howard W. Lutnick brought Cantor Fitzgerald back to life after the
firm was savaged in the 9/11 attacks.

The NSE data for June 2010 shows that Nifty futures have peaked at Rs.0.36 trillion of notional turnover in a day (27 Jan 2010) and Nifty . . . → Read More: Alternative Stock Market Indexes]]> I saw this interesting article about the mind-share of Nifty as opposed to the BSE Sensex. It is by Samie Modak and Muthukumar K. in
the Financial Express.

The NSE data for June 2010 shows that Nifty futures have peaked at Rs.0.36 trillion of notional turnover in a day (27 Jan 2010) and
Nifty options have peaked at Rs.0.89 trillion of notional turnover in a day (24 June 2010). Nifty has shaped up as one of the big
contracts by world standards. It is interesting to go back and read the original paper. Those were interesting times. Looking back, it
seems obvious that Nifty would dominate the derivatives market, but at the time, the outcome was far from clear.

This made me look at data on risk and reward of the alternative indexes. I start from the first data for Nifty Junior, which takes me back to 21 February 1997, thus giving data for 13.7 years.

Nifty and the BSE Sensex are a lot like each other.

The real surprise is Nifty Junior: Merely moving down from rank 1-50 to ranks 51-100 has given an enormous juice in the return and in the reward-to-risk ratio. But the volatility of Nifty Junior is also higher.

The CMIE Cospi index has roughly 2800 stocks today, and represents the broad market. It includes the Nifty Junior stocks and a host of other smaller stocks. But unfortunately, these numbers are not comprabale with the other three in that it includes dividends while the other three do not. With this combination of high diversification (giving a low volatility), small-cap stocks (which helps returns) and inclusion of dividends (which helps returns), it is not surprising that it scores the best reward-to-risk ratio.

In my mind, most of the claims of out-performance by active managers in India are purely about being invested in the non-Nifty
space. Nifty Junior ETFs are easily accessible and I get surprised that more people aren’t putting this into their investment strategy.

Currency options are obviously useful as a risk-management tool. I feel that futures are nice simple linear contracts: they ask the person to make only one decision — . . . → Read More: Who Will Make the Exchange-Traded Currency Options Market?]]> In a few minutes, NSE and USE will start trading in currency options. This will be the first exchange-traded options in India on a non-equity underlying.

Currency options are obviously useful as a risk-management tool. I feel that futures are nice simple linear contracts: they ask the person to make only one decision — are you long or are you short. But once a futures position is entered into, the person needs the ability to manage the position since daily marking-to-market is done, and since there can be large losses for either the futures long or the futures short.

Compared with this, long positions on call or put options appeal to the kind of person that is willing to think carefully about a position at the outset, but after that it is fire and forget. This better describes the life of many firms exposed to currency risk, particularly those with relatively weak treasuries.

Currency options have, of course, been traded OTC for some time now. But there are real problems with this market. Customers have sometimes been ripped off by banks on pricing, given the lack of a liquid and transparent comparison point. While currency options are offered by banks to customers, there is not much by way of an inter-bank market.

As far as I know, there is relatively little by way of a build-up of human and systems capability in the banks for currency options trading (whether OTC or on exchange).

In contrast, there is a remarkable build-up of human and systems capability in the world of Nifty options trading. Options on Nifty have shaped up as one of the biggest options markets in the world. This involves end-users who think and trade options, staff working for securities firms who understand options (and understand issues about their credit risk when their customer has an options position), analytical software systems, and (most importantly) algorithmic trading systems. Options trading inevitably involves trading in a large number of underlyings. Strong computer systems which are able to think about, and place orders in, all the underlyings at one shot are of essence in achieving option liquidity. Such capabilities are now found in the world of Nifty options, and are absent in banks or in the OTC currency options market.

It is fairly easy for a person trading Nifty options to move to trading currency options. Hence, the brainpower and systems that have made Nifty options one of the world’s top contracts will easily be able to move to currency options trading, and make it work. I expect that the securities firms who dominate Nifty options trading will now dominate currency options trading.

I think three kinds of stories will now kick in:

1. Liquidity in currency options will fuel liquidity in currency futures, and vice versa. Corporate hedgers will be more interested in either, given that the other is also a possibility.
2. Skills and systems from Nifty options will flow into currency options. Banks will be able to rapidly bulk up their options capabilities by recruiting from the world of Nifty options, and by purchasing the software systems that have sprung up in that space.
3. Conversely, trading in both currency options and Nifty options will generate an increased business size for people who build knowledge and systems for options; it will also improve knowledge of options trading through an understanding and comparison of the nuances of two different underlyings. The number of FRM and PRM certified people in India will go up.

I think an accurate definition of “paper” and “physical” is important to the accuracy of your statement: “I am reasonably confident that paper and physical are bound together.”

“Physical” to me means real physical gold that has been delivered in settlement. Anything else I deem “paper”. Note that my . . . → Read More: The Basis Does Not Lie!]]> My answers to FOFOA’s response.

I think an accurate definition of “paper” and “physical” is important to the accuracy of your statement: “I am reasonably confident that paper and physical are bound together.”

“Physical” to me means real physical gold that has been delivered in settlement. Anything else I deem “paper”. Note that my definition of physical includes Allocated or GoldMoney for example, as they purchase real physical gold and store it, ie it comes off the market and is unable to be lent/fractionalised.

“Physical” does not include the near month futures contract. There is a place for buying 3 month and selling 6 month in which case you are arbitraging paper “gaps”, but what we are interested in is the effect on the real physical cash price.

But what if you could play the arbitrage (closing the gap) game without actually putting any physical at risk of delivery? Would this change the accuracy and credibility of the basis signal?

I assume you are talking here about using unallocated. OK so lets scenario it. Assume a stable supply/demand for both cash and futures so without the actions of an arbitrageur the cash price would remain at $1200 and Dec futures at $1195 for a period of 6 months. Hedge fund notices this and wishes to profit from it but it does not want to (or have) physical gold it wants to risk.

Hedge fund contacts their friendly bullion banker and asks to lend gold. Bullion bank conjures out of thin air some fake unallocated gold, merely recording an asset in its books (loan to hedge fund) and a liability (unallocated owed to hedge fund). Let us assume the amount of ounces is enough to move the price in our otherwise stable market by $3.

Hedge fund’s first step is to buy the Dec futures at $1195 but in doing so its price increases to $1198 (lets say that is the next offer price). Secondly they have to sell spot. Say they find a trusting investor who is willing to accept a transfer of the fake unallocated gold for $1200. Again, this action decreases the spot price to $1997 (next marginal bid price) and the market is now in contango. So far so good.

But what happens in six months? The hedge fund only has two choices – cash settle or physical settle.

If they cash settle then they have to sell back their Dec futures contract, but doing so will cause the price to decrease from its new equilibrium price of $1198 to $1195. Likewise, they have to buy unallocated to repay the loan to the bullion banker, but that will increase the spot price from $1997 to $1200. All that cash settling has done is delay the appearance of backwardation but not eliminated it.

If they physical settle then they get their gold from COMEX and deliver it to the bullion bank to repay their loan. Now this would have no effect on prices. However, the bullion bank now has physical 1:1 backing its unallocated liability to the trusting investor. If that investor asks for delivery, it will have no effect on price because the bullion bank has the physical. In a roundabout way the hedge fund eventually did sell real physical gold to the trusting investor.

Now your retort may be that the fact that the trusting investor was willing to accept fake unallocated allowed the manipulation of the basis to turn backwardation into contango. You would be correct, and that is the point of my scenario. The basis is therefore reflecting reality, the reality that there are idiots prepared to accept paper gold.

The basis IS telling the truth. It is not the hedge fund or the bullion bank who have “manipulated” the basis, it is the trusting investor. But in a sense the basis has not be manipulated, arbitrage is ensuring it reflects reality, that there are idiots who are prepared to bid dollars for paper gold.

If that trusting investor was not so trusting, then the hedge fund would not have been able to execute their arbitrage because there would be no one willing to accept their paper gold. The cash price would have remained at $1200 and the market in backwardation, and the basis would reflect reality, the reality that people were only willing to bid dollars for real gold.

You said “If gold stops bidding for dollars (low gold velocity), the price (in gold) of a dollar falls to zero. This is backwardation!” My reply would be that even if all (real) gold stops bidding for dollars, but there is plenty of paper gold bidding for dollars which are being accepted, then there is no backwardation.

My logic therefore leads me to the conclusion that the basis does not lie, that it cannot be manipulated. Professor Fekete was right all along, long live the basis. However, I don’t feel totally confident in this statement, as I said I’m not an expert in futures so there is probably a flaw in my scenario and logic. If so what is it?

Over time, group 1 will swell and end up holding most of the above-ground physical gold in the world. Group 2 will shrink and end up holding mostly paper gold. Group 3 will be financially sucked dry by the vampires in group 4. And group 4 will ultimately find it has no more markets to churn.

This is the theoretical process that gold backwardation should represent. A healthy and REAL gold contango SHOULD send this process into reverse, perhaps slowly at first, but reverse nonetheless.

So the question I am asking is which direction are we heading right now in this process? How close are we to the end of this process? And why aren’t the market signals matching the rest of the picture?

If group 1 already has most of the physical gold and is now a one-way flow, is that not the state-of-the-market that backwardation should signal? And if the state is present but not the signal, what does that say about the signal?

Following from my conclusion that the basis does not lie, then the “signal” must be correct, which means “the state” of group 1 strong hands having most of the physical gold is not correct and we not close to the end of the process you describe. This is consistent with the defence by goldbugs to claims we are in a gold bubble that investment in gold is still a fraction of portfolio allocations and the mass market is not buying gold. Dollars are not being bid for gold, real or paper.

If you don’t like the conclusion, then you must find a flaw in my logic about the basis. I am more than happy to be proven wrong. Well, maybe not just yet, I’d like to pick up some more cheap gold

The tick size of this market is 0.25 paisa, . . . → Read More: Liquidity on the Currency Futures vs. the Nifty Futures]]> India is the second country of the world, after Brazil, where the currency futures are more liquid than the currency forwards. Today when I glanced at the order book of the near month rupee-dollar futures, I was struck by the big numbers that are visible:

The tick size of this market is 0.25 paisa, so the top five prices cover 1.25 paisa on each side. So there’s nothing interesting about the prices: I focus on the quantities. I’m used to generally seeing quantities at each prices running all the way to 1000 to 2000 contracts which is $1m to $2m. Today I was surprised to see two quantities with much bigger values: $6m and $11.3m. This is huge. [NSE currency futures page; the order book for this (April) contract] I was also impressed at the fact that $32.6m and $42.4m of orders are sitting on this order book. These are big numbers.

For a comparison, I popped over to look at the April expiration Nifty futures contract, which is the biggest financial product in India. This order book shows:

This contract is five times bigger than the currency futures contract, so in your mind you have to multiply the quantities by five to make them comparable. So the big two quantities here are around 2000 contracts which corresponds to 10000 contracts of the currency futures contract. The total orders present on the book here are staggeringly large when compared with the currency.

Theory tells us that liquidity should vary with asymmetric information and volatility. Both Nifty and the currency are macroeconomic underlyings with relatively little asymmetric information. But Nifty is more volatile. So if both markets worked well, we would expect Nifty to be less liquid. We are not yet there – the currency futures market is not yet more liquid than the Nifty futures market. Some key differences are obviously visible: foreigners trade on the Nifty futures but are banned from the currency futures, and Nifty options are available while currency options are not yet available (though without foreigners).

A paper idea: When a central bank shifts to a more transparent framework on currency trading, or when a central bank steps away from currency trading altogether, asymmetric information on the currency market goes down so currency impact cost should go down. I wonder if one can find some natural experiment of this fashion. Matters are complicated because the date on which a float commences if often not the date on which the float is announced. This can be dealt with by identifying the date on which the exchange rate regime actually changed, as opposed to what is claimed by the central bank.