SILVER AND THE PRECIOUS METAL CRISIS / MACLEOD FINANCE

Silver and the precious metal crisis

Steep price rises in silver lead to speculation about failures in derivatives. Mostly, it is ill-informed. This article sets out the true position and addresses the extent of the problem.

ALASDAIR MACLEOD

Social media commentary from at least one “expert” links the steep rise in silver with the Fed’s injection of $14.75bn into the repo market on Friday, saying it is a bailout of the big US banks’ silver positions which mark-to-market for margin purposes against soaring prices. 

It is simply not true, particularly when year-end book squaring across all banking activities is in progress. 

Comments about bank credit are usually made in the belief that bank credit is created on a fractional reserve basis and is therefore finite, which is incorrect.

Instead, banks lend credit into existence, and it is easy for a bank to create it out of thin air to keep its commodity dealing operations solvent. 

Banks enter into repos and reverse repos to balance their balance sheets, which is an entirely different function from financing positions. 

The Fed intervenes purely to keep repo and reverse repo rates within the FOMC’s target range.

It is also worth noting that banks are dealers in credit and for preference do not encumber their balance sheets with physical commodities. 

Instead, they deal in derivatives.

Margins in derivative dealing are slimmer than bank lending, which is why they are only profitable in very large quantities relative to a bank’s capital. 

Notional derivative obligations are large multiples of a bank’s access to underlying assets, which brings us to commodities and specifically precious metal derivatives where currently there are destabilising liquidity problems.

The problems are in non-US bullion banks

The table below, extracted from the US’s December bank participation report shows banks’ exposure on Comex, split between US and non-US banks:

Note that in theory banks short of a particular contract on Comex are usually covered by being long in London’s forward market. 

We don’t know their positions in London, but it is a reasonable assumption that bullion banks net short of Comex gold contracts are long OTC derivatives in London, because they were happy to forecast significantly higher prices only two months ago at the LBMA’s annual conference in Kyoto. 

Furthermore, gold is a liquid market and least likely of the four metals to see prices driven by a liquidity squeeze, though speculative demand on Comex is now increasing.

The same cannot be said of silver, platinum, and palladium. 

While designated precious metals, they are in fact industrial. 

Silver in particular has seen increasing industrial demand in recent years. 

As the second largest mining nation and the largest by refinery output, China was supplying the global shortfall and keeping the price suppressed. 

Until, that is, President Trump’s tariff wars provoked China to severely restrict exports of rare earths. 

From now and scheduled for 2026—2027, China is also restricting exports of silver under a tight licencing system at a time when Indian industrial demand is booming.

Indian and other industrial users have resorted to buying silver derivatives and standing for delivery of physical metal. 

The consequences were dramatically noted in early October, when lease rates for silver in London soared to over 30% in a scramble for scarce silver to deliver.

In a further sign of industrial users buying derivatives to obtain delivery, stand-for-delivery notices on Comex have increased significantly in recent years, totalling 14,810 tonnes of silver so far this year. 

That is the equivalent of 58% of total annual silver mine output.

This defines the problem: industrial users are now desperate buyers at any price from anywhere from anyone who will promise to supply. 

And derivatives are such a promise. 

Returning to the table above, we can see that the five major US banks have kept their heads and maintained level books — that is in derivatives. 

Stories of US banks being bailed out by the Fed through the repo market are simply not true. 

The shortages on Comex are in 117 foreign banks which are net short $17 billion, while at the same time there is a lack of physical liquidity in London. 

A similar but less desperate story can be seen in platinum and palladium.

While this appears to be a US problem, instead it is foreign banks being squeezed. 

It could be that they are long in London, but in forward contracts and options — derivatives and not the real thing. 

Derivatives are not the currency demanded by a market desperate for physical metal.

Normally, a foreign bank merely creates the credit to cover Comex’s margin requirements, so long as it has the balance sheet capacity under Basel 3 to do so. 

If not, it will require a coordinated bailout between the US, London and the jurisdiction of incorporation if different. 

There is also the possibility that having shorted silver, a hedge fund is in trouble. 

But in that case, it will probably have other assets such as equities which it can liquidate.

Whoever might be in difficulties having entered into derivative obligations to deliver silver, platinum, or palladium, it is of the highest importance for the authorities to ensure that any bank bailout is kept strictly confidential, and any hedge fund failure to be dealt with quickly. 

Counterparty risk can spread like wildfire through all derivative categories, with just one bank with OTC derivative exposure in other areas being the catalyst.

None of this deals with the industrial shortages of silver or Platinum group metals. 

That can only be resolved by China rescuing London and New York supplying physical metal. 

Alternatively, if the US has secret silver stocks, it could step into the breach to provide temporary relief. 

But even that is likely to be no more than a sticking plaster, given the scale of industrial demand, and the wider derivative problem.

The era of commodity derivatives is drawing to a close

The problem is larger than a seizure in the relationship between precious metal derivatives, which are always a promise to deliver the underlying asset, and the asset itself. 

After 54 years of fiat dollars the distortions in metals prices generally have become destabilising.

Copper is also a critical mineral, declared as such for future national security by China, the US, the EU, Japan, India, and Canada. 

The chart below shows how the copper price has changed since 1900 over 125 years in both dollars and gold.

It looks dramatic enough in dollars. 

But priced in gold this vital industrial metal is only 18% of its value in 1900, and only 8% of its value in 1970 which was just before the Bretton Woods gold standard was abandoned. 

The point to bear in mind is that over long periods, commodities priced in gold are relatively stable. 

Priced in fiat currencies prices rise reflecting their declining purchasing power. 

But the decline in currency purchasing power also has the effect of depressing the true value of commodities.

Markets are waking up to this reality, and because metals are now so undervalued in real terms, the use of OTC derivative markets for commodities is already declining. 

That decline is on the verge of accelerating, unleashing higher prices for all commodities depressed in real terms.

In conclusion, the derivative difficulties advertised so loudly in silver contracts tell us that there is a wider and larger commodity pricing problem. 

Baskets of other commodity and raw material categories are also telling us that if they are to normalise, their dollar prices will rise dramatically in 2026—2027. 

It is the currencies which are the problem. 

Meanwhile, there is nothing likely to stop silver prices rising much further. 

We can only hope it happens in an orderly fashion.