Backwardation in the Case of a Monetary Metal
27 February 2011 7 Comments
Silver has been in backwardation at the LBMA according to the published SIFO (Silver Forward Offered Rates) since January 19, 2011. It has also been in backwardation at the COMEX (New York Commodity Exchange) since around February 7, 2011. Figure 1 shows the LBMA Silver Forward Offered Rate from November 22, 2010, to May 19, 2011.
I was dissatisfied with much of what has been written on this topic. This is an attempt of a better explanation.
I explain that silver should not be viewed as an industrial commodity that is consumed, but that one should rather view US$ and silver as a currency pair. If one takes this point of view, backwardation is not a market inefficiency due to a supply shortage, but rather indicates counterparty risk.
Update (27 February 2012): Backwardation is also possible if US$ deposits are subject to carrying charges or if nominal interest rates are negative, see Red Alert Update.
Term structure. In the futures market of any commodity,
- the spot price reflects supply and demand
- the term structure of the futures contracts, i.e. the amount by which the futures contracts with long maturity are more or less expensive than the spot price, is enforced by arbitrage.
Usually, backwardation in the commodities markets is explained by a market inefficiency due to a temporary shortage of supply. Temporarily, the arbitrage that usually determines the term structure, cannot take place, and the spot price can stay higher than the futures prices.
For an industrial commodity, i.e. one that is traded and then industrially consumed, the term structure is determined by the prevailing interest rate of the US$ and by the storage expenses for that commodity. As long as the market is efficient and term structure arbitrage takes place, the market is in contango, i.e. the futures contracts with longer maturity trade at a premium over the spot price, reflecting that with delivery only at some future time, the traders can invest their money and earn interest in the meantime, and they need not pay for storage either. Backwardation, i.e. the situation in which the spot price is higher than the price for future delivery, is only possible if the market is temporarily inefficient. A good example are wheat futures contracts. If last year’s harvest has already been sold and consumed, but this year’s harvest not yet been brought in, a sudden surge in demand for wheat for immediate delivery cannot be satisfied at any price so that term structure arbitrage cannot take place.
Silver, however, is not only a commodity, but also a monetary metal, i.e. one that is held for investment purposes. It is also used as a banking reserve asset that can be used as a collateral for loans, so-called silver swaps. Vast quantities of investment silver are stored in the vaults. This includes all the well-known physically backed silver ETFs, customer inventory at the COMEX, privately held allocated silver in bank vaults, and all sorts of silver coins and bars held by individuals and stored at home. If the price is high enough, some of this silver will be for sale. Some of it will be available immediately, at the click of a mouse, and in tradeable good delivery bars. What matters is that there exists a price at which supply and demand can be matched. There is always a spot price (perhaps quite high) that reflects supply and demand.
Therefore, blaming the presently observed backwardation on a shortage of supply and thereby on a market inefficiency clearly contradicts the evident facts. Backwardation is not a market inefficiency and the usual interpretation does not apply. We have to find out what backwardation tells us in an efficient silver market.
The solution to this puzzle is to view the term structure of the silver futures market not as that of an industrial commodity, but rather as that of a currency pair: silver/US$. If we assume that both currencies have an interest rate, storage expenses, and a default risk, then the conclusion is that backwardation in the silver market indicates counterparty risk in silver swaps, namely that the swapped silver might not be returned.
SIFO. The LBMA SIFO (Siver Forward Offered Rate) is the rate charged for an n-month swap of silver against US$ (n=1,2,3,6,12). This means that if you own silver, and you swap your silver for US$ for a period of n months, then you need to pay the SIFO. In other words, if the SIFO is positive and you borrow US$ handing over your silver as the collateral, then you have to pay interest. See Figure 1 above for SIFO between November 22, 2010, and May 19, 2011.
The base rate. In order to realize a similar silver for US$ swap using physical silver, you can use the COMEX futures exchange at which the precious metals futures contracts are traded. For example, in order to swap your silver for US$ for n months, you can sell your silver in the spot market and purchase the silver futures contract with maturity in n months. Since you receive US$ for the sale of the silver while you need to post only a small margin in order to hold the futures contract, this is essentially the desired swap of silver for US$.
Which rate does the futures market charge for this swap? This rate is called the n-month base rate which is the price of the n-month future minus the spot price. If silver is in contango, i.e. the n-month futures contract is more expensive than spot silver, you have to pay interest on the swap.
Silver swaps: Therefore the LBMA SIFO is very similar to the COMEX base rate. At the LBMA, you trade ‘book silver’ in an unallocated account whereas at the COMEX, you trade physical silver. At the LBMA, your counterparty for the swap is one of the bullion banks whereas at the COMEX, your counterparty is some other market participant who is assigned to deliver on your long contract.
Since the silver for US$ swap consists of two components, lending silver and borrowing US$, let us disentangle the contract.
The following argument is basically the usual arbitrage argument that enforces the term structure of the futures contracts of a currency pair. It dictates that the term structure is determined by the interest rate difference. Here, however, I explicitly list the risk-premiums for the counterparty risk involved.
Lending US$. If you own US$ and you consider lending a certain amount as an unsecured loan, which nominal interest rate do you charge?
rate charged =
+ nominal yield you could have earned if you had kept the money and invested it yourself
– deduction for potential loss or default if you had invested the money yourself
– carrying charges (negligible)
+ risk-premium (your counterparty might not pay back the principal of the loan)
Let us put the first three into one figure and write:
rate charged =
+ nominal risk-free yield
where nominal risk-free yield is the yield minus deduction for possible loss, i.e. the risk-free yield.
Lending silver. If you own silver and you lend your silver, which nominal interest rate do you charge?
rate charged =
+ nominal yield you could have earned if you had kept the silver (zero: silver does not pay any dividends)
– deduction for possible default (zero: silver is nobody’s liability and does not default)
– carrying charges (the storage expenses)
+ risk-premium (your counterparty might not return the silver)
It is obvious that lending silver in itself is not a very profitable business. But in combination with a US$ loan in a silver for US$ swap, lending silver does make sense because the two risk-premiums may offset each other.
Swapping silver for US$. Combining the two types of loans to a swap, you see that if you swap your silver for US$, i.e. you lend silver and borrow US$, you should pay
swap rate paid =
+ nominal risk-free yield of US$
+ risk-premium because you might not return the borrowed US$
+ storage expenses for the silver
– risk-premium because your counterparty might not return the silver
This swap rate paid is basically the SIFO in the case of the LBMA or the base rate in the case of the COMEX.
Contango. From the swap rate paid above, it is clear that if counterparty risk is negligible or if the two risk premiums offset each other, the SIFO and the base rate should be positive, namely the risk-free interest rate of US$ plus the storage expenses for the silver. Swapping the silver for US$ therefore serves the purpose of obtaining a US$ loan at the risk-free rate. Without the silver, we would in addition be charged a risk-premium because we might not return the borrowed US$. The silver in the swap is used as the collateral for the US$ loan.
If the n-month base rate is positive, i.e. the futures contract with maturity in n months trades at a higher price than spot silver, the market is said to be in contango. Similarly, if SIFO is positive, the OTC forward market is in contango. This is the normal situation.
Backwardation. This is the condition in which the n-month base rate (or SIFO) is negative, i.e. the spot price trades at a premium to the futures price. This means that if you swap your silver for US$, you do not pay, but rather receive interest, i.e. the swap rate paid above is negative. The above calculation shows that this can happen only if there is a significant risk that your counterparty will not return the silver.
Term structure arbitrage. As explained in the introduction, there is enough tradeable silver available that can be for sale at any moment, depending on the spot price. Term structure arbitrage is possible at any time. If we observe backwardation, this means that a negative swap rate paid is discovered in an efficient market.
The recently observed backwardation of silver at both the LBMA and the COMEX therefore indicates a non-negligible counterparty risk in silver swaps: the risk that your counterparty might not return your silver.
Just as a spike in LIBOR in the financial crisis of 2007/8 signaled the expected failure of commercial banks, the backwardation of silver occurring right now signals the possible failure of some participants in the bullion market.
An additional delicate detail is the observation that backwardation in the LBMA SIFO (January 19, 2011) predates backwardation an the COMEX (around February 7, 2011). LBMA SIFO reveals what bullion banks know about bullion banks.
Some consequences of backwardation relevant to COMEX inventory and COMEX delivery are explained in Backwardation and Declining COMEX Inventory.
27 February 2012: Backwardation is also possible if US$ deposits are subject to carrying charges or if nominal interest rates are negative, see Red Alert Update.
 Antal E. Fekete has published closely related ideas about backwardation in gold and silver. As I understand his work, his starting point is to view the public precious metals exchanges as warehouse managers who swap their US$ for gold and silver and back. In backwardation, i.e. with a negative base rate, they cannot work profitably. Therefore, gold and silver will leave the public exchanges and disappear into private hands. This idea is also explained in Section 4 of The Many Values Of Gold.
 Sandeep Jaitly proposes to watch GOFO and SIFO and interprets persistent backwardation as an Armageddon Alert indicating the impending collapse of the paper currency.
My argument on the currency pair suggests a more specific interpretation: persistent backwardation in the monetary metals indicates potential counterparty failure among the bullion banks.