There is nothing inherently wrong and certainly nothing "illegal" about J.P. Morgan Chase (NYSE:JPM) gaining a vault license for storing and taking delivery of gold/silver/platinum/palladium from the futures markets known as NYMEX/COMEX. However, the speed, timing and manner in which the exchanges just granted it troubles us.
The process of being approved as a licensed vault or weigh-master/assayer for the NYMEX/COMEX futures exchange usually involves a careful security inspection of the vaults, a full report of that inspection, and a completely transparent package submitted to the U.S. Commodity Futures Exchange Commission (CFTC) for approval. This process will ordinarily consume considerably more than 45 days. Apparently, such correct and careful practices apply only to banks and independent storage facilities that are not J.P. Morgan Chase.
Some vault operators are more equal than others. JPM appears immune from processes that everyone else must suffer through. On March 15, 2011, the Commodity Exchange (COMEX) and the New York Mercantile Exchange (NYMEX) advised the CFTC that they had approved J.P. Morgan's application to become a licensed vault facility, using a "self-certification" process. The newly licensed vault, located at 1 Chase Manhattan Plaza, NY, NY, is ready to roll as both “weighmaster” and depository, for delivery of gold, silver, platinum and palladium contracts, as of March 17, 2011, two days later.
As a smaller player, the NYSE-Liffe exchange uses COMEX licensed depositories for delivery and storage of its metals. The new JPM vault, therefore, will also qualify to accept delivery of metal coming from the maturity of NYSE-Liffe gold and silver futures contracts, including the smaller 1,000 ounce silver contract.
Departures from usual practices, and special treatment in favor of some over others are events that lawyers describe as having "the appearance of impropriety", if nothing more. J.P. Morgan is a huge player in the London precious metals market, especially in derivatives. It has always been a very important player at NYMEX/COMEX, especially if you include its Bear Stearns division. The bank is heavily involved in infamous "unallocated storage" schemes in London. A more complete description of London-style storage can be found in my previous article.
JPM is one of six big bank owners of the London Precious Metals Clearing Limited (LPMCL) which clears, “delivers” and sets standards for “storing” precious metals allegedly “sold” at the London Bullion Market Association (LBMA) and the London Platinum and Palladium Market (LPPM). Unallocated storage is the norm at LPMCL member banks, including J.P. Morgan Chase.
Allocated storage, however, is the norm for precious metals vaults licensed by NYMEX and COMEX. The two futures exchanges have approved a small group of vault operators, who provide allocated storage to clearing members and their customers. This has given greater legitimacy to the NY exchange traded precious metals venue than the LBMA now has. It is true that NYMEX/COMEX warehouse supplies are wholly insufficient to cover the number of short contracts the exchange allows its clearing members to write. However, at least the numbers are transparent and published. That is more than can be said for the storage facilities that participate in the secretive LPMCL in London.
Allocated storage, under the common law, is known as a "bailment." When precious metal is allocated, the vault is the "bailee" and the owner is the "bailor". The bailee is keeping the property safe for the bailor and, in return, it charges a fee for its services, but the property belongs to the bailor at all times. The property cannot be legally leased, loaned, borrowed or used in any way without overt consent by the bailor. Whereas unallocated metal is an asset that is seized by a vault's creditors in bankruptcy, allocated metal is immune from this.
A bailment cannot be legally seized or encumbered by the bailee's creditors. Some of the NYMEX/COMEX vaults require a written bailment contract, setting out all rights and responsibilities of the customer and vault. Others operate in the old fashioned way (though the handshake is now often electronic) and, in such cases, the agreement between bailor and bailee is governed by traditional common law standards with no need to sign anything.
There are two storage categories in the NYMEX/COMEX scheme, known as “registered” and “eligible”. Regardless of the category, all bars are allocated by title, and are always of a size, weight and composition that would satisfy "good delivery" if the owner decided to deliver it. An exception to the idea of "global" allocation may occur if "registered" metal is kept in the name of a clearing member, but the bars actually belong to a customer.
This might happen when and if the clearing broker uses the bars as a form of "collateral" to back up performance bonds in a customer account. In such a case, the "bailment" (and allocated storage) would exist between the vault and the clearing member. I use the word "collateral" loosely because true collateral would remain titled to the debtor. In the NYMEX/COMEX scheme, registered bars are always titled in the name of a clearing member of the exchange, whereas eligible bars can be titled in the name of a customer or a clearing member.
In order to be delivered, eligible bars must be transferred into the registered category. This involves nothing more than an electronic entry, "wrapping" the correct number of units into what is called a warehouse "warrant." Each warrant constitutes a "good delivery" unit of metal sufficient to satisfy one short contract obligation. "Good delivery" means that each bar must be of a standard weight sufficient to meet the rules of the exchange and must be numbered and weighed. Each storage facility must always keep a "chain of title" history record for each bar.
Delivery at NYMEX/COMEX is first made to any licensed vault facility. Once the unit of metal arrives, title is transferred to the new owner. The new owner can do whatever he wants with his property. He can remove it from the bailment and take it into his own personal possession. He can transfer to a different vault. Or, he can keep the metal at the initial point of delivery. In many cases, the last option is chosen, so, often the bar never leaves the delivery vault until it is eventually resold and, usually, not even then. Bars can be delivered, and title transferred, without ever having left the vault.
Until now, JP Morgan did not have a NYMEX/COMEX vault license. They had to send silver, for example, to HSBC, Brinks, Scotia Mocatta and/or the Delaware Depository in order to "deliver" it on COMEX. Those vaults have been NYMEX/COMEX licensed for a very long time. But now J.P. Morgan has its own vault license, and the manner in which it seems to have obtained it, is troubling. The bank can now, potentially, deliver short obligations to itself. Yes, you read that correctly. The bank itself, if it still holds short silver positions, and/or the hedge funds/related financial institutions who may have taken over the positions, can now deliver the alleged metal to J.P. Morgan's own vault.
The American legal standard requires us to maintain a presumption of innocence until guilt is proven. That doesn't mean Americans are stupid. Only a fool would ignore the testimony given at the CFTC hearing held on March 25, 2010, or the fact that J.P. Morgan Chase is being sued, in two different class actions, accused of being a racketeering and corrupt influenced organization (RICO). Both lawsuits claim that the bank is using allegedly immense silver short positions in various venues, including COMEX, to manipulate prices.
If a short seller must deliver a commodity, and the commodity is not readily available, there is no better way to buy extra time than to be able to deliver into its own vault. Most of the metal will never leave the vault, and most delivered metal that will leave the vault won't leave right away. Indeed, paperwork tasks of transferring title can consume a few days. Thus, a late delivery may not be noticed if it is to the short seller's own vault if the vault operation staff chooses to remain silent.
Why was JPM awarded a vault license almost overnight, avoiding the lengthy vetting process others must undergo? Why did it happen in the middle of a major COMEX silver delivery month, during a massive worldwide silver short squeeze, at a time when physical silver is in severe shortage? We do not know the answers to these questions. The exchange rules should prohibit proprietary trading divisions, hedge funds and other closely associated or controlled financial institutions, from delivering to vaults owned or controlled by their own family of companies. Yet, no such rules exist.
Does the licensing of a NYMEX/COMEX JPM vault reflect short-seller panic? Paper money can be printed, of course, ad infinitum and endless reams of it can be borrowed from the Fed. The issue is how much paper money is needed to pry sufficient physical silver loose from the hands of its owners. We believe that an equilibrium level of about $52 per troy ounce would be sufficient. Assuming that the holdings of the various ETFs are not the scam that some have claimed, there is a huge potential supply right there.
Large delivery requirements can be met by cashing in on "baskets" of ETF shares for silver. There is also a huge supply of hoarded bars outside of ETFs, waiting for the right price to set them free. If supply problems continue, the price must rise further until sufficient selling occurs. Most owners of ETF shares, as well as holders of real physical silver, are not momentum chasers. They buy low and sell high in a traditional manner. Momentum chasers are irrelevant because they generally have only paper, and no real metal to deliver.
Remember, your bars can be transferred from one licensed facility to another very quickly. If any storage facility imposes a significant delay, that should be publicized, and met with resolute opposition. Neither silver nor other metals must be stored at licensed vault. They certainly need not be left at the first point of delivery. If you intend to use silver, for example, in commerce (such as a jeweler or industrial user might) or if you expect to keep it off the market for 20 years or so as a retirement fund, it is economically more efficient to physically remove the metal.
If anyone has any positive or negative experiences with the newly licensed J.P. Morgan vault, we would be very interested in learning about them.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I hold long positions in precious metals.