The Golden Shell Game

The infamous “shell game” con works as follows. The mark (the victim or investor in this game) wages (places a bet) that he can pick which of three shells has a tiny ball hidden underneath as the con artist (the crook), moves the three shells around on a table. If the mark picks the correct shell, he wins the wager. If not, he loses his money. What the mark doesn’t know, however, is that the ball has been removed from the game by the con artist and that he has no chance of winning.

Apparently, many aspects of the precious metals market are similar to the shell game and gold and silver investors are well advised by taking a note of what might be happening in this market.

Recent testimony before the US Commodities Futures Trading Commission (CFTC), revealed that leverage in gold and silver traded by the London Bullion Market Association (LBMA) in the United Kingdom runs at 100 to 1. In other words, for every 100 ounces of metal bought and sold only one ounce of the physical metal actually exists. In the “futures trading” world, selling a commodity without actually owning it is called a “naked short position”. In stocks, it is illegal to have a naked short position, but in future trading it is both legal and common.

But the LBMA is not a futures trading market where commodities could be bought and sold without owning them. It is an over-the-counter market where gold and silver bullion must be physically present when traded. LBMA is nonetheless behaving like a futures market and is trading metals without physically owning them and at a very high leverage of 100 to 1. Knowing that, will scores of investors who thought they owned gold in reality hold only a paper promise of gold from banks that are technically insolvent? Has the ball been removed from the “shell game”?

Metal bought on the London Bullion Market Association (LBMA) and futures contracts on the New York COMEX taken for delivery are supposed to physically exist in the network of bank storage facilities. But it may not, and delivery often takes the form of a paper transfer of ownership of gold instead. There have been instances in which banks claimed to have had physical metal in storage for investors and, indeed, had charged these customers storage fees, but might never actually had the metal. A class action lawsuit was leveled in 2005 against the investment bank Morgan Stanley accusing it of just this behaviour. The lawsuit was settled out of court for 4.4 million dollars. At the above-mentioned CFTC hearing, another investor was prepared to testify with a similar story of how during a visit to Canada’s only bullion bank vault, Scotia-Mocatta, his son discovered that the metal they claimed to have in storage for him, and had charged him storage fees for it, did not exist. Interestingly, the CFTC decided not to hear his testimony. However, the investor made his information public nonetheless.

The question then becomes, is physical metal, particularly gold, becoming difficult to find? Apparently the Hong Kong Monetary Authority thinks so. They have built their own facility and will remove their stored gold from London storage facilities in order to ensure that they actually have gold in their possession and not a mere paper promise of gold that may or may not exist. They found in Hong Kong that some of the gold bars that they had purchased turned out to be clever fakes made of a gold coating with thirty-dollar-per pound tungsten in the center. The tungsten has nearly identical specific gravity as does gold, and as a result, the fakes were impossible to detect by simply weighing the bars. No one knows how much of this fake gold is out there but some have speculated that over a million such bars were made.

There appears to be more to this story than a few crooks scamming investors. The LBMA trades approximately the annual world production of gold on a daily basis and is the largest commodity market in the world. To make matters worse, there are large naked short positions on New York’s COMEX in gold and silver futures. Given the leverage in gold and silver trading, the incidents of non-existent gold in storage, and the fake bars of metal, there may be a serious shortage of physical gold and silver. Last year, central banks added the most gold to their reserves since 1964. Moreover, when a group sued in US federal courts in an effort to document what they believed was downward manipulation of precious metals prices, the case was thrown out of court. The reason the case was dismissed was that the defendants, JP Morgan and Barrick Gold, argued that they were acting as agents for the Federal Reserve, the US central bank, and were immune from prosecution on national security grounds. What have gold and silver have to do with national security?

Gold and silver may have lost some of their monetary roles, however they presently hold a competitive edge over currencies. The US monetary authorities, in their efforts to slow the decline of the dollar, may have enlisted the bullion banks and their network of dealers in the US and the UK to suppress the price of precious metals. If this is so, they have in essence opened the door for speculators to carry out a short squeeze and thereby increased the risk that COMEX and LBMA will default. All that spectators need to do to carry out a short squeeze is to go long on gold and silver and then demand delivery. When no metal is available, the COMEX and LMBA will have no choice but to default. Contracts will be settled in cash but first the precious metals prices will have spiked upwards.

It is likely that precious metals prices can be held down for a few more weeks, perhaps until June. Afterwards, investors should expect prices of metal commodities to rise, potentially violently if the right people discover the golden shell game.

* With contribution from Bruce H. Pugesek, President of Voyageur Research

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