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Like many investors, I've expressed skepticism about whether exchange traded funds like the iShares Silver Trust (NYSEARCA:SLV) are backed by physical metal as they claim. After some further digging, some of my initial skepticism has been allayed.

What Do the Custodians Do?

I contacted the sponsors of SLV (iShares) and SIVR (ETF Securities) with some questions that have been raised, but not, as far as I know, been answered for investors. These included questions about the daily activities of the trusts' custodians.

As most by now know, SLV's sponsor is iShares, a unit of BlackRock (NYSE:BLK). Its trustee is Bank of NY Mellon (NYSE:BK), and its custodian is JPMorgan (NYSE:JPM). SIVR is pretty much the same as SLV in its structure. It even has the same trustee. ETF Securities is the sponsor, Bank of NY Mellon is the trustee, and HSBC (HBC) is the custodian.

I would like to thank Tim Harvey, Senior Vice President of ETFS Marketing, LLC, and his colleagues for taking the time to answer my questions about SIVR. Their answers apply to ETF Securities' other physically backed exchange traded funds whose ticker symbols are GLTR, WITE, PPLT, PALL, SGOL, and AGOL. iShares hasn't gotten back to me yet.

SIVR's silver, in the form of LBMA Good Delivery bars, is stored at an HSBC vault in London. While HSBC may hold silver for other parties in its vault, it is required to segregate and allocate specific bars for the Trust's account. The silver is held as numbered bars on labeled shelves. Harvey explains, “Even though it is held in a vault it is neither the property of the bank nor the liability of the bank. As such it is safe from bank insolvency. The Allocated Bullion is not subject to third party claims.”

The bullion held by SIVR comes from the London Bullion market. When the metal is redeemed, it is sold back into the market by an Authorized Participant. The Authorized Participants are a familiar cast of characters. They are listed in the prospectus: Credit Suisse Securities (USA) LLC, Deutsche Bank Securities Inc., EWT, LLC, Goldman, Sachs & Co., Goldman Sachs Execution & Clearing, L.P., HSBC Securities (USA) Inc., J.P. Morgan Securities Inc., Merrill Lynch Professional Clearing Corp., Morgan Stanley & Co. Incorporated, Newedge USA, LLC, Prudential Bache Securities, LLC, Scotia Capital (USA) Inc., UBS Securities LLC and Virtu Financial BD, LLC.

Multiple Claims on the Same Silver Because of Shorting?

I also asked about so called phantom metal that is said to be produced when people short physically backed exchange traded funds. At the time of writing SLV had a short interest of over 28 million shares. SIVR's short interest was almost 200,000. Ted Butler, of Butler Research, writes,

Each share of SLV requires that one ounce of silver be held at the Trust's custodian (minus accumulated management fees), according to the prospectus. Since short sellers of SLV shares do not deposit metal with the Trust's custodian, this means that the buyers of the more than 36 million shorted shares of SLV [this was the short interest at the time he wrote] do not have metal backing, as required by the prospectus.

Butler's complaint can me made about SIVR too.

Harvey's response is that

SIVR is a ETF listed on the NYSE. As such shares in SIVR are eligible to be shorted just like any other listed stock. All shares issued by the Trust are backed by physical Allocated bullion held in accordance with the rules and regulations of the LBMA. It is not possible for the Trust to issue shares unless bullion has already been delivered to the custodian’s vault. Therefore a market maker for example that is short SIVR shares (I.e. selling to a customer) would simply be selling shares already created and therefore already backed by Silver Bullion. All shares issued by the Trust have to be backed by bullion; this means when a customer enters into a transaction to buy SIVR, on settlement date, the customer’s shares will always be backed by bullion. The notion of phantom ounces being traded is therefore a misunderstanding in the Trust’s operations.

Butler's contention may be that naked shorts are selling SLV (and, by extension SIVR). As the silver trusts are open ended, new shares can be created by Authorized Participants according to investor demand. If the Authorized Participants do not deposit bullion into the Trust's account, the shares that they have created aren't backed by bullion.

However, as Harvey states above, “It is not possible for the Trust to issue shares unless bullion has already been delivered to the custodian’s vault.” I assume that iShares would say the same sort of thing.


Do the Silver Bars Purported to Be in the ETFs Exist?


Both exchange traded funds have lists of the bars in the trusts' accounts on their websites. Rational readers who do not leap to conclusions about vast conspiracies by the evil banks often say that the conspiracy theorists should check the serial numbers on their bars and see if they match up with the ones on the lists.

One problem with this challenge is that not many people keep 1,000 ounce (around 60 to 70 pounds or 27 to 31 kilograms) silver bars in their homes. They store these in vaults maintained by such institutions as UBS (NYSE:UBS) and Morgan Stanley (NYSE:MS), which have been sued for selling and storing phantom silver. These suits, in part, are the reason for the skepticism regarding the silver ETFs.

A second problem is that if one happens to own a bar that is listed in the SLV or SIVR list, it is not conclusive proof that the silver bar lists are a fraud. Mistakes are bound to occur, especially with lists that are thousands of pages in length.

With these problems in mind, I contacted the refiners on the SLV and SIVR bar lists, asking them if they produced the bars. I didn't give them the entire list to save them time. Instead, I randomly selected a few bars for each refiner. To make sure that they actually checked my list against their records, I included bars that I made up. They had appropriate serial numbers but incorrect weights. The idea was that if the refiner caught my “mistake,” that meant he actually went through the list.

My hope was that all the refiners would confirm that they did in fact cast the bars. Unfortunately the responses have varied. Here are three examples.

Handy & Harman said, “we cannot discuss these questions.”

A public relations person for Johnson Matthey informed me that they do not keep a record of the serial numbers marked onto their bars.

JBR Recovery, on the other hand, stated that the refiner is “required to maintain a list forever of all bars ever cast by JBR” and confirmed that the bars on my list were cast. Their representative also caught my “mistake,” indicating that one of the bars I listed had an incorrect weight.

While some of the more ardent skeptics will no doubt conclude from the refiners' responses that the majority of the bars listed on the ETFs websites are fake, I think the replies that confirm the bars' existence, coupled with the analysis posted here, is good evidence that the silver bars on the SLV and SIVR lists do in fact exist. (A similar sort of analysis was done on the gold backed ETFs.)

Okay, the Bars Exist. But Do the ETFs Actually Hold Them?

Skeptics satisfied with the silver bars' existence might then ask whether the ETFs' trustee actually has the bars in its accounts. Inspectorate International has conducted third party audits of the ETFs' silver holdings. These inspections yielded certificates that are posted on the iShares and ETF Securities websites.

It has been alleged that Inspectorate International did not audit the silver and that the certificates are fakes. Unfortunately, Inspectorate didn't respond to my queries.

Allegations that the Inspectorate certificates are fake include the length of the certificates (what? only two pages for all those bars?), the Inspectorate logo differing in color from the first to second page, dates being in different formats, and a lack of “ugly paper edges” that apparently would result from scanning the document because British paper is narrower than standard American letter size. Comparing the SLV and SIVR certificates with the GoldMoney certificates, one might also ask why there are other differences, such as the lack of job reference numbers in the SLV and SIVR certificates.

Is it any wonder that the Inspectorate didn't respond? Are skeptics really reduced to examining documents for ugly edges?

Inspectorate can respond to all of these allegations. But will this erase everyone's doubts? Or will the diehards simply conclude that Inspectorate is part of the conspiracy? Surely Inspectorate wouldn't lie, more sensible investors might say. The company has a reputation to maintain. If its reputation is put in doubt, it'll lose business.

Will this be the end of it? Of course not. There's a community of people that will never trust anything that differs from their already held beliefs. I know right away what they'll say: remember Arthur Andersen? And what about Moody's, Fitch, and Standard & Poors? The latter three rated subprime debt. And how did that turn out?

In all four cases, one of the problems with the auditing arrangement was the huge conflict of interest. Who, after all, paid the auditor? Why, the party being audited. If we don't dismiss the possibility of collusion between banks such as this lawsuit against JPM and HSBC alleges, Inspectorate's position here isn't much different from that of Moody's, Fitch, S&P, and Arthur Andersen.

And the doubters may be right! Who knows? With all that's gone on in the last few years it wouldn't even be that surprising.

But if we are ever to be satisfied, at some point we must trust the information we're given. For even when we hold physical metals in our hands we must trust that the assayers, bullion dealers, etc didn't cheat us.

A Few Remaining Questions

The custodians facilitate the transfer of bullion in and out of the trusts. How is this accomplished? Is it mere book entries or do workers move bullion around on pallets? When the bullion is sourced from or sold back into the market, what happens at the vault?

Did Inspectorate International audit the vaults? I think they have, but confirmation would be nice.

Disclosure: I am long ZSL.

Additional disclosure: By the time this is published, I'll probably have sold ZSL. I'm waiting for spot silver to hit 35.50. I'm long physical silver.

Source: Some Answers and More Questions About Physically Backed Metal ETFs