Like a game of silver Whack-a-Mole, the venerable army of silver bugs is armed and ready with their silver mallets, raining down fury on the iShares Silver ETF (NYSEARCA:SLV) as soon as it pops up and does something weird. And something weird it did, back on Feb. 3, just two days after silver popped briefly above $30 an ounce, premiums skyrocketed and physical markets were cleared out of monetary supplies across the world. The weird thing was, on Feb. 3, SLV amended its prospectus and added a new risk factor on page 7. The risk? That the fund may run out of available silver to source, and be forced to restrict the issuance of new baskets.
Ronan Manly of Bullionstar pointed this out on Feb. 14 when he spotted the change. Here's what he found (emphasis his):
…Wednesday 3 February, right after claiming to add 3416 tonnes of silver to SLV by frantically tapping the LBMA vaults in London, the iShares Silver Trust prospectus was changed, and the following wording added:
“The demand for silver may temporarily exceed available supply that is acceptable for delivery to the Trust, which may adversely affect an investment in the Shares.
To the extent that demand for silver exceeds the available supply at that time, Authorized Participants may not be able to readily acquire sufficient amounts of silver necessary for the creation of a Basket.
Baskets may be created only by Authorized Participants, and are only issued in exchange for an amount of silver determined by the Trustee that meets the specifications described below under “Description of the Shares and the Trust Agreement— Deposit of Silver; Issuance of Baskets” on each day that NYSE Arca is open for regular trading. Market speculation in silver could result in increased requests for the issuance of Baskets.
It is possible that Authorized Participants may be unable to acquire sufficient silver that is acceptable for delivery to the Trust for the issuance of new Baskets due to a limited then-available supply coupled with a surge in demand for the Shares.
In such circumstances, the Trust may suspend or restrict the issuance of Baskets. Such occurrence may lead to further volatility in Share price and deviations, which may be significant, in the market price of the Shares relative to the NAV.”
Manly already had done some meticulous work documenting that there already was a physical silver crunch going in London. He pointed out just days before he covered the prospectus amendment that 85% of the silver in London was already owned by ETFs, the implication being there wasn’t much left to add. You can read that piece here. Turns out by the SLV prospectus amendment, he was right.
The question is, what happens to SLV if it runs out of silver to add to the fund?
As a silver bug myself, I count myself a proud member of the army that wants to see a silver squeeze. But I’m on the fringes of the fringe, and so I’m here to respectfully clear up what I believe to be a major error some in the silver bug community are making regarding SLV, particularly as it relates to these changes in its prospectus.
Some silver bugs seem to believe that if SLV runs out of silver to source, the shares will fall, but I believe this is wrong. It’s just the opposite. If SLV runs out of physical silver to add to the trust, SLV shares are going to rocket higher. Here’s why. Here is part of the prospectus amendment that Manly did not quote in his article (emphasis mine this time):
A significant change in the sentiment of investors towards silver may occur. Investors may purchase Shares to speculate on the price of silver or to hedge existing silver exposure. Speculation on the price of silver may involve long and short exposures. To the extent that the aggregate short exposure exceeds the number of Shares available for purchase, investors with short exposure may have to pay a premium to repurchase Shares for delivery to Share lenders. In turn, those repurchases may dramatically increase the price of the Shares until additional Shares are issued through the creation process. This could lead to volatile price movements in Shares that are not directly correlated to the price of silver.
The trading price of the Shares has recently been, and could potentially continue to be, volatile. The trading price of the Shares has been highly volatile and could continue to be subject to wide fluctuations in response to various factors. The silver market in general has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to factors such as silver's uses in jewelry, technology, and industrial applications, or cost and production levels in major silver-producing countries such as China, Mexico, and Peru.
There are two things to point out about this part of the amendment. First, obviously, this is describing a short squeeze on SLV where shares rocket higher irrespective of the price of silver. It's not describing a fall in SLV. From a simple supply and demand perspective, if the demand for SLV shares exceeds the supply of silver available to back those shares, SLV will trade at a premium to silver futures. If shorts are forced to cover in that event, the premium could be significant, as the prospectus amendment implies.
An SLV premium to silver futures has never developed in the history of the SLV ETF. Below is a chart plotting silver futures with SLV since its founding.
You can see that as time moves forward, SLV (black line) gradually diverges more and more from the silver futures line. This is due to the natural decay rate of the SLV fund due to fees and expenses and such. It doesn’t mean the fund is failing.
The second critical thing to point out about this part of the amendment I quoted is where it says that the silver price has risen “unrelated or disproportionate to factors such as silver's uses in jewelry, technology, and industrial applications.” It's crucial to read between the lines here and take careful notice of what it does not say. It does not say anything about monetary demand for silver coins. It only quotes industrial applications. Jewelry as an industry is included in industrial applications, as jewelry also is an industry.
Understanding the Potential Positive Feedback Loop on Monetary Silver Demand
In my last article on silver being within months of moving to $50, the main point I was making there is that silver is both an industrial as well as a monetary commodity. The silver futures price is well equipped to clear industrial demand for silver, which is fairly smooth, but it's not at all equipped to clear monetary demand for silver, which can suddenly wake up in a torrent if doubts about the dollar’s stability as a monetary reserve suddenly awaken. These doubts did indeed awaken around Feb. 1, and consequently, the monetary silver retail markets were completely cleared out globally, over a single weekend.
Industrial demand for silver, or for anything really, is a self-balancing negative feedback loop. The higher the price goes, the less the demand for silver industrially. But monetary demand is something else entirely. Monetary demand is the exact inverse of industrial demand. Money is what you do not want to give up more of when the price of something rises, which is why higher prices bring down demand for things that are not money. But money is what you specifically want more of when the price of it rises. That’s part of the reason why Bitcoin keeps moving higher. Because people think it is a monetary asset. (Never mind the question whether it is or isn’t. That’s a different issue. I happen to think not, but I’ll save that for a different article.)
Therefore, the higher the price of silver (or gold) goes, the higher the monetary demand for silver as a monetary reserve becomes, potentially driving the dollar price of the stuff up in an unending positive feedback loop, which would constitute an existential threat for the dollar as a money.
There are only two ways to stop this threat. Either raise interest rates to encourage the holding of dollars, or keep the paper price of silver (and gold) low by selling futures into the market. Raising interest rates is, of course, completely out of the question, given the massive debt levels in the global economy.
Now, the big question is, what happens to silver, and to the dollar, if we suddenly see SLV trading at a premium to silver futures due to a lack of physical silver available to back additional shares? Here’s what I believe happens, and why despite the fact that SLV could trade at a premium to silver, it should be mostly avoided aside from maybe a small speculative stake for leverage on the silver price (which I do own for speculative purposes only, see disclosure at the end of this article).
SLV is designed to track silver futures. That’s the entire purpose of the fund. It does this by depositing physical silver (about 10 Comex futures contracts worth) and adding share baskets of 50,000 when the price of silver futures rises, increasing the share supply and keeping the two paper silver securities in synch. On the way down, authorized participants buy back SLV shares, subtracting baskets, withdrawing silver from the fund.
Where's the physical silver from the fund coming from though? It can’t come from registered silver stocks on the Comex used for delivery against contracts, because that would be the same as a dog chasing its own tail. If SLV tracks Comex silver futures by adjusting the amount of silver in SLV, then buying Comex futures to deliver into SLV would be like taking water out of the shallow end of a pool to add to the deep end. Nothing changes. The physical silver that SLV participants use to balance the fund with the silver futures price must come from outside Comex registered stocks.
It comes from independent vaults or Comex-eligible stocks not registered for delivery against the Comex silver contracts. It's that external supply that is running low, and it's that alarm that the amendment in the prospectus is sounding.
Now here’s the problem. Assuming this silver supply external to registered Comex stocks runs out and a premium on SLV relative to silver futures does indeed form, then there's no way to close it without new physical supply coming online quickly external to registered Comex stocks and being rushed into SLV. How would a premium like this be closed theoretically? By buying physical silver, delivering it into SLV, selling the shares and pocketing the arbitrage. But again, that can’t happen from registered Comex stocks because that would just push up both silver futures and SLV together, maintaining the SLV premium over futures and accomplishing nothing to close it.
But there’s a bigger problem in the wings here. Speculators could take notice of the premium and a short squeeze could develop on SLV itself, which the amendment to the prospectus explicitly admits to, pushing the SLV premium over futures even higher. This would in turn attract even more speculators, a positive feedback loop within a positive feedback loop, and most likely another run on the monetary silver markets would develop as well as we saw around February 1, draining any available supply into the physical monetary markets before it could get to SLV, in order to take advantage of the even higher premiums in the physical monetary silver markets.
In the end, SLV would just keep climbing, but there would be an even higher premium on physical monetary silver over SLV, as there always is. What I'm describing here is the very positive feedback loop on monetary demand that's so dangerous for the dollar.
That’s why anyone interested in maintaining purchasing power through monetary silver should avoid SLV. Not because SLV is going to collapse in dollar terms if SLV runs out of silver to source, but precisely because it will skyrocket in dollar terms. In that event, the dollar could lose all purchasing power and SLV holders would be left with nothing. They will have dollar gains, but they are not authorized participants and cannot redeem SLV shares for physical silver anyway. Those that could, would quickly do so, and the fund would be completely emptied out of all physical backing.
If an SLV premium over futures forms, then the three silver markets –
…would simply chase themselves higher and higher in a spiral and the dollar itself would be the primary casualty. This would spill into the gold market as well, and there’d be a global monetary crisis.
How close are we to this actually happening? Here’s Ronan Manly with the numbers:
Currently, as of the end of day 5 February, the COMEX daily silver inventory report shows the JPMorgan New York vault as containing 152,946,614.74 ozs (4757.28 tonnes) of Eligible silver. Exactly 103,176,253 ozs (3,209.21 tonnes) of this silver belongs to SLV. Therefore, on the COMEX silver vault report under JPMorgan’s Eligible category, there is only 49,770,361.74 ozs (1548 tonnes) which do not belong to SLV. Something that many people probably never thought of before.
Godspeed silver bugs. You know what to do. Go after the physical! Avoid SLV.
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This article was written by
I invest in the light of Austrian Business Cycle Theory and cover monetary trends for the purpose of timing the credit cycle. My marketplace service The End Game Investor helps subscribers manage the risks of, and profit from the ongoing fiscal and monetary crisis precipitated by the COVID-19 pandemic. I use gold, silver, and associated stocks and investment vehicles in a low-risk high-return setup.
Disclosure: I am/we are long SLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I own physical silver.