Gold And Silver Spot Prices Increasingly Detached From Reality

An insolvent Greece has defaulted. On June 30th, officials missed repayment of billions in lMF loans and declared a banking holiday. Predictably, many Greek citizens responded to the crisis and bought gold coins. So did a lot of people here in the U.S. and around the world. You just wouldn’t know it by looking at spot prices.

The regular disconnect between the futures markets, where spot prices are set, and the physical markets reveals a growing problem. The link between the spot price and physical demand is thin at best. That is why the base price for gold coins in an Athens coin shop can get cheaper, but the all-in cost of buying the coins goes up as the line of buyers grows.

The availability of metals in a retail form is one cause. But the disconnect also has to do with the mechanism for setting the spot price – the futures markets.

The exchanges are supposed to be a meeting place for rational buyers and sellers evaluating fundamentals and making decisions about what is a fair price. But, in reality, the exchanges are dominated by major banks and brokerages employing high-frequency trading computers, derivatives, and other tools to manufacture a price.

These powerful market players aren’t trading physical metal, and they care very little about the fundamentals that motivate the rest of us. They trade paper contracts, a claim for future delivery of physical metal that’s supposed to be in an exchange vault. But the number of contracts swapped in a single day can represent more physical metal than world mines will produce in a year! So the claim could be all but worthless the minute holders start asking for delivery.

Wall Street invented high frequency trading a few years back. These algorithms now generate a huge portion of daily trading volume. Computers with special access can see and front-run the trades of human investors. The topic has gotten some coverage in the financial media and many investors are aware.

Fewer are familiar with developments in the derivative markets for gold and silver futures. These markets, primarily for options, further detach the underlying spot price from physical reality. A put or call option is twice removed from the bullion bars they are supposed to represent, and the leverage used is exponential. Instead of buying a futures contract directly, options traders buy the right to buy or sell a futures contract. And this further multiplies the potential number of claims against actual metal in exchange vaults.

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