In an article dated June 1, 2015, I pointed out that COMEX clearing members had gotten themselves to the edge of a widespread default on physical gold delivery obligations. They faced net claims of 550,000 troy ounces against only 370,000 registered ounces left at the COMEX warehouses. That left a deficiency of 170,000 ounces, or 5.29 tons of gold.
That same day, JPMorgan Chase (JPM) transferred 177,402 troy ounces of gold into COMEX registered gold stockpiles - just enough to cover the shortfall at maturity, plus some extra to cover the additional buying that always happens during an average delivery month. All this raises a question: Did JPMorgan Chase just engage in a bailout similar to John Pierpont Morgan's 1907 bailout of the New York City banks?
At first glance, it may appear as if JPM bailed out other COMEX clearing members. If you look closer, however, you see something else. The June 2, 2015 delivery report shows that the gold that saved COMEX came from JPMorgan's house account. Then, after replenishing COMEX registered gold supplies, it delivered 246,800 troy ounces of bank-owned gold, representing 2,468 matured short contracts, as JPMorgan customers purchased and took delivery of 42,200 troy ounces.
The Commodities Futures Trading Commission (CFTC) regulates COMEX. It publishes a monthly report called the "Bank Participation Report," which tells us how much of the open interest, each month, is held by banks and how long or short the banks happen to be. As of May 5, 2015, taken together, all US-based banks, including JPMorgan, Citigroup (C), Goldman Sachs (GS), and Morgan Stanley (MS), held a net short position (after subtraction of offsetting long positions) of only 5.8% of the total. A report the next month, dated June 2, 2015, disclosed that all US-based banks had upped their shorts to a net total of 9.2%.
COMEX rules require that deliveries be assigned in proportion to the number of shorts a particular clearing member has open, for itself and its customers, as of the day the futures contracts mature. If the clearing member is delivering on behalf of a client, the gold is listed on the delivery report as having come from the member's "customer account." Even if JPM is engaged in proprietary trading and market-making at COMEX, it is virtually impossible for it to have ended up assigned to almost half of all deliveries. It is even more unlikely that every gold bar in those deliveries was sourced from the bank itself, rather than its customers.
In a previous article, I wrote:
If conspiracy theorists, like those at GATA, are correct (and I think they are), the worst case scenario would be a stealth government bailout. It is relatively easy to set up "location swaps", where gold bars owned by the government are promised in exchange for gold bars in the eligible bar category at COMEX warehouses. People could be persuaded to put their physical gold into play, in the registered category, if a government guaranty on return of the actual gold, along with a thick "envelope" of Benjamin Franklins, is thrown in as a sweetener.
For many years, conspiracy theorists claimed - without much actual proof - that JPMorgan Chase was the primary agent of the Federal Reserve in capital markets. Assuming that gold price management is a state secret, of course, no one is going to find a copy of JPM's contract with the government. However, we do have evidence that the bank administers other markets for the Fed. For example, there is a detailed contract appointing JPM custodian over $1.7 trillion worth of the Fed-owned QE bonds. You can read that contract for yourself to get some perspective on this issue.
I believe that the key is in the Federal Reserve policy to engage in what are known as gold swaps. In footnote 3 of a Bank of England document, we are instructed that:
Under a gold location swap gold stored in a particular physical location is swapped with a market counterparty for specified period with gold stored in another physical location. Under a gold quality swap, gold of a particular quality is swapped with a market counterparty for a specified period with gold of different fineness. In each case a fee is built into the transaction.
Technically speaking, the US Treasury is "in charge" of US gold reserves, even though all the gold has been legally transferred to the Federal Reserve. But we know that the Federal Reserve makes use of gold swaps against that gold. As far back as January 1995, Mr. J. Virgil Mattingly, the Fed's highest ranking lawyer, admitted it. The comments were recorded in the minutes of an FOMC meeting. But by 2001, Mattingly claimed he had been misquoted. Thankfully, in 2009, a Fed governor, Kevin Warsh, was honest enough to come clean. He admitted that the Federal Reserve engages in gold swaps. These swaps are critical to understanding what happened on June 1, 2015.
COMEX deliveries are supposed to be assigned in exact proportion to the number of short contracts each clearing member gets stuck with at maturity. Yet, JPM's own short position did not come anywhere near 50% of the entire COMEX short interest, and its own clients were net buyers, not sellers. It proprietary short position in both May and June amounts to only a few percentage points of the overall short interest. This means that JPMorgan made deliveries attributable to the trading activity of others.
In Anglo-American jurisprudence, we allow juries to reach verdicts based upon commonsense deductions arising out of the circumstantial evidence. Even a murder conviction can be based on strong circumstantial evidence. Over a thousand years of using this type of evidence has taught us that it is normally a reliable pointer toward the truth. The case here is not composed purely of circumstantial evidence. But the circumstances add to the direct evidence. The two, together, force us to an inescapable conclusion that JPMorgan did not rescue COMEX.
Back in 1907, of course, J.P. Morgan & Co. was a private partnership. In contrast, JPMorgan Chase is a publicly traded, profit-making corporation, whose executives would be in direct violation of their fiduciary duties to company shareholders if they used shareholder capital to bail out competitors. Therefore, it seems obvious that JPMorgan is administering the Federal Reserve gold lending window. A preponderance of the evidence indicates that the Federal Reserve bailed out COMEX, using a location and quality swap with JPM. That would guarantee that the bank-owned gold will be replaced by government gold. It doesn't matter if the replacements are non-eligible 400 ounce coin-melt bars. They can easily be melted and recast to current delivery standards.
The bailout's effect is to ensure that COMEX will continue to function as the primary price-setting venue in the world gold market. Unfortunately, it also ensures that an even larger part of the US gold reserves are now encumbered by swap liens or will soon be in private hands. The International Monetary Fund wrote that "central bank officials indicated that they considered information on gold loans and swaps to be highly market-sensitive". Federal Reserve officials are clearly among these secretive central bankers.
For example, even though Kevin Warsh was honest enough to finally admit to the Fed's gold swaps, he also refused to hand over the detailed documentation. He claimed, instead, that Fed gold swap details are "confidential commercial or financial information relating to the operations of the Federal Reserve Banks", not subject to disclosure. That refusal was upheld by a court of law, which, after a careful review of the actual documents, ended up agreeing with him.
As a practical matter, large physical gold buyers avoid COMEX partly out of a fear that they might end up with a cash settlement instead of gold. Now that it is clear that the US gold reserves stand behind delivery, this could change. We can now assume that COMEX is going to be backstopped by the biggest gold hoard in the world. It is "too big to fail". Delivery default will not be allowed unless it suddenly rises so exponentially that it becomes too burdensome even for the government to fulfill.
With increasing illiquidity in London, large buyers can feel safe in buying up to 9.3 tons per month (the position limit) at COMEX. That is important because if a large institution tried to purchase so much gold in London, it would be forced to pay a huge premium over spot. At COMEX, in contrast, smart buyers could potentially use an options strategy to accumulate such positions covertly. Then, having accumulated 3,000 options, exercise the options, converting them to futures contracts before the exchange had the time to change the rules. The Fed's obvious involvement means that the delivery will be made, one way or another.
Fed involvement also means that current gold prices are as "market-based" as zero percent interest rates. The central bank has taken it upon itself to suppress the bond yield curve. It appears to have also taken it upon itself to suppress the price of gold. The direct evidence consists of "admissions against interest" by officers and directors of the Federal Reserve noted above. The circumstantial evidence consists of:
A preponderance of the evidence indicates that the US government has been managing gold versus the greenback continuously for over 200 years now. During the time of the official gold standard, it was done by buying and selling openly. Now, covert action on COMEX is used as a tool of monetary policy. For some, this is "evil incarnate". But controlling gold prices is not different than controlling bond prices.
Backstopping the short-selling of gold is no worse than raising and lowering interest rates artificially. Nor is it any more essentially "evil" than giving hundreds of billions of zero percent "repo" loans to its primary dealers, supposedly "overnight", but endlessly renewed for years running. Nor is it more destabilizing than printing trillions of dollars through so-called "QE". The difference is that the gold price management is a covert operation.
By its nature, a covert action is always less than entirely honest. But it seems clear that the Fed shrouds its gold operations in darkness for a reason. It has no other choice. There isn't enough gold left to do it openly. That concern was noted by American officials many years ago, and the proof is found in recently declassified transcripts.
A conversation between Henry Kissinger and his Under-Secretary of State for Economic Affairs, Thomas O. Enders, that took place on April 25, 1974, for example, just prior the opening of the first gold futures trading at COMEX, went like this:
Secretary Kissinger: But that's a balance-of-payments problem.
Mr. Enders: Yes, but it's a question of who has the most leverage internationally. If they have the reserve-creating instrument, by having the largest amount of gold and the ability to change its price periodically, they have a position relative to ours of considerable power. For a long time we had a position relative to theirs of considerable power because we could change gold almost at will. This is no longer possible - no longer acceptable...
There is also a declassified memorandum dated March 6, 1974, wherein another high US official, the Deputy Assistant Secretary of State for International Finance and Development (Weintraub), wrote to the then Under-Secretary of the Treasury for Monetary Affairs, Paul Volcker (the man who would become Federal Reserve Chairman), to explain the reason for the Federal Reserve's activity in the gold market. He wrote in pertinent part:
U.S. objectives for world monetary system - a durable, stable system, with the SDR as a strong reserve asset at its center - are incompatible with a continued important role for gold as a reserve asset... It is the U.S. concern that any substantial increase now in the price at which official gold transactions are made would strengthen the position of gold in the system, and cripple the SDR.
The world's financial situation now is considerably more unstable than in 1974. We face a flux that may be terminal to the current system. Extraordinarily high peace-time levels of debt are choking virtually all western nations, including America. The euro may collapse soon. China and Russia are eager to take the opportunity to make trouble. They want to dethrone the US dollar, believing that America receives an exorbitant privilege from printing the world's reserve currency.
In yet another declassified document, when explaining to Kissinger's Deputy Secretary of State, Ken Rush, how the United States would "bust" any country that kept up the pressure to put gold back in the monetary system, that same Thomas O. Enders stated:
Mr. Enders: I think we should look very hard then, Ken, at very substantial sales of gold-U.S. gold on the market-to raid the gold market once and for all.
Mr. Rush: I'm not sure we could do it.
Mr. Rush's hesitancy came out of fear that US gold reserves were not sufficient. In those days, the US typically intervened openly in the gold market. No more. Policymakers have found a different way. Paper gold futures contracts have replaced open interventions. The COMEX delivery fiction allows futures contracts to serve as a psychological substitute for physical gold. As a result, the world gold market accepts COMEX prices, even though price discovery does not reflect real supply and demand.
On occasion, the Fed has managed gold incompetently, and even triggered COMEX computers to stop gold trading. But mostly, the mission has been accomplished brilliantly. On Thursday, April 11, 2013, for example, the CEOs of every "too-big-to-fail" financial institution met with President Obama and his Treasury Secretary. The very next day, Friday, April 12, 2013, COMEX opened to a sudden short sale of 3.4 million ounces (100 tonnes) of gold. Two hours later, another 10 million ounces of selling (300 tonnes) hit the Street in only 30 minutes of trading. Naturally, gold prices dropped like a stone, in spite of high worldwide physical demand.
Meanwhile, afterwards, in the 2nd quarter of 2013, stock market "gurus" were busy telling us that gold had been torpedoed by everything from the position of the sun, moon and stars, to so-called "Elliot Waves", to "Economic Confidence Models". Some even claimed that the price drop came from a diminished desire to own gold by a world that now trusted central banks. This was said, incredibly, in the midst of an unprecedented boom in physical gold sales! As usual, the hot-money hedge fund denizens of Wall Street swallowed it all, and cooperated by taking on the COMEX short positions.
Part of what is underpinning US government policy right now is probably a reaction to outside pressure. Two key trouble-makers, Russia and China, want the US dollar dethroned. Neither can do it with a paper currency sufficiently credible to openly compete with the American unit. Antiquated, in-your-face authoritarian political systems make it hard to achieve credibility in the outside world. So, both are busy buying up gold as cheaply as possible. Gold is their perceived key toward achieving their view of a "fairer" distribution of world power.
Eventually, to accomplish their objective, they will be forced to take affirmative action to stabilize gold prices. Price stabilization would increase the credibility of gold and undo years of damage from America's policy of removing gold from the financial system. But there is no rush. Unlike paper and electronic money printing presses, high physical gold demand will exhaust even the largest gold reserves. All they need do is sit back and wait.
Making the long-term view worse for those holding short positions at COMEX, the worldwide supply of gold is going to shrink precipitously. The 2014 Society of Mining Professors report, using data from Credit Suisse, Morgan Stanley, Société Générale (SG), AME, and Bloomberg, determined that world gold supplies (from mines, scrap recovery, ETF sell-offs, and hedging) were about 4,476 in 2012, 4,850 in 2013, 4,155 tons in 2014, and will be 3,845 tons in 2015 and 3,585 tons in 2016.
According to Shanghai Gold Exchange (SGE) officials, withdrawals from the SGE are approximately equal to actual Chinese gold demand. Withdrawals of 2,102 tons took place in 2014. From January 1st to May 16th, 2015, 858 tonnes were withdrawn, which means that 2015 demand is up 9 % y/y from 2013 and up 19 % y/y from 2014. Bloomberg Intelligence says that Chinese national gold reserves have increased by an amount approximately equal to China's domestic gold production over the last 6 years.
In short, China is going to consume much more gold in 2015 than 2,102 tons. But to be ultra-conservative, we'll use the 2014 numbers. Indian gold demand for 2015 has been conservatively estimated to be somewhere between 900 and 1000 tons. An increasing problem with gold smuggling done to avoid high tariffs could make this number even higher. But again, to remain ultra-conservative, we'll use last year's number of 842.7 tons.
I have not used the World Gold Council (WGC) for China, because they have been so notoriously inaccurate in the past. They were forced, for example, to dramatically revise their numbers upward when faced with the arguments of Koos Janssen. The organization's statistics, outside of China, however, seem fairly accurate. According to the 2014 publication "Gold Demand Trends", consumer gold demand outside China and India amounted to 1,506.4 metric tons. In addition, beyond the consumer, the IMF reported that, excluding China, which has failed to report, central banks purchased 267 metric tons of gold in 2014.
Adding up total world demand, we have 4,451.1 tons versus about 3,845 tons worth of supply. Note, again, that demand is already sharply up in China and India, from 2014 to 2015, year-over-year. But, even using last year's low numbers, there will be a deficiency of at least 606.1 tons in 2015. As the years pass, the deficiency will get bigger and bigger. If we assume that gold demand will continue the trend of Q1 2015 for the rest of 2015, for example, demand will be approximately 5,200 tons and supply will still be 3,845 - meaning the deficit will end up at 1,345 tons.
Who is going to fill this gold deficit? Where is it going to come from? Probably from the same place it came from in the past, when the gold deficit was much smaller. It will come from the US gold reserves in the form of location and quality swaps with places like JPMorgan or the Bank of England's vault. Obviously, then, there is a practical limit to how long this can go on. About 8,133.5 tons of gold reserves cannot last forever, especially against a tidal wave of gold demand and a paucity of supply.
We know that the swap lien strategy has been employed at least as far back as 1995, when physical demand was much lower. The fact that gold prices rose so much between 2001 and 2011 indicates that US officials are not willing to fritter away every last ounce of gold. Bush administration officials, at least, weren't that stupid. Everyone is aware that only God can create more of the yellow stuff. Unlike the dollar, gold cannot be printed.
Apparently, for the moment at least, COMEX is considered a "too-big-to-fail" institution. Therefore, it will be a safe alternative, for a while, for the LBMA to meet the needs of large institutions smart enough to make use of it. Institutions can buy up to the position limit of 9.3 tons per month. When administration policy changes, there might be a forced cash settlement, but that won't happen right away. When it does, it will happen at the LBMA also.
Former Deputy Secretary of State, Ken Rush, will eventually be proven correct, resulting in a forced change in US gold policy. The switch from open to covert interventions caused a delay in proving him right, but plugging the upcoming gold supply deficit is an impossible task. The entire remaining US gold reserves are insufficient. That does not mean that the US dollar gets dethroned. It means that the government has to ignore gold, not merely in word, but also in deed. If sober fiscal and monetary policy replaces intervention, the US will retain the power to set world reserves.
The big losers are likely to be the hapless hot-money hedge funds, who now seem to hold a vast majority of COMEX short positions. Although their clearing brokers appear to have just gotten a bailout, when the administration's policy changes, they will end up holding the bag. Although their delivery month positions will be settled in a sum of cash fixed by the exchange, the hedge funds will not be able to escape fast enough from the fast-rising prices on their non-delivery month short positions.
The huge gap between supply and demand means that the well will eventually run dry, and that current policy must change. It also means that physical gold and the shares of companies that mine the stuff are a very good deal right now. It is no wonder that former Fed Chairman, Alan Greenspan, when asked his opinion on gold prices, laconically replied simply that they are headed "measurably higher."
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