10 October 2008

The Price Finding Mechanism

I received this email below today from a long time client:

Bron, Hi.

I trust all is well with you, especially in these turbulent times.

I have a question, maybe you can help with.

What is, or will be Gold Corporation/Perth Mint's position in regard to the valuation of account holder's unallocated storage bullion when the gold and silver paper/futures market deleverages from the physical market and loses its role as the price finding mechanism?

Do I need to explain the question more? If at some time in the future Comex goes into default on physical delivery - say at around $US25.00, how might the Perth Mint ascribe a price to unallocated account holder's holdings?

It seems there is a price premium already emerging for physical gold bullion.


Firstly, not all bullion traders look to COMEX for a price. There are two other markets that are used and will take up the price finding role if COMEX fails:

1) the over-the-counter (OTC) market
2) the London Fix

Both of these are spot markets, by which is meant they are for immediately delivery of wholesale (i.e. 400oz gold, 1000oz silver) physical metal. Actually probably more correct to say “2 day delivery”, as the OTC spot market works on 2 day settlement. If you are looking for the “real” price of precious metals, you need to look at the spot price, not COMEX price as that is a futures price. It therefore does not represent the price for immediately delivery.


This price finding mechanism is simply a trader ringing up other traders to find what prices they are willing to trade at and choosing the best one. The more accounts one has (which is a factor of your creditworthiness) the more traders one can deal with and thus the better the price one is likely to achieve. It is therefore really only a professional/corporate market and is unfortunately opaque to the average investor.

To facilitate this price discovery, various trading platforms and/or information services are used. Traders use a service like Reuters as a bulletin board on which they publish their current bid and ask prices as a way of attracting business. Unlike an exchange, however, such prices are merely offers and not commitments to deal at those prices.

It a lot of case the so-called “spot price” is the price published on these services. I understand that the Kitco prices are a delayed feed from Bloomberg, for example. They are reliable indicators of the price for precious metal but sometimes do not always reflect the actual spot market. This can occur when traders are very busy and do not have time to update their quotes on services like Reuters. One needs to take this into account when using these information sources.

London Fix

I won’t go into the details of how the London Fix works, that can be found at the link above. Important feature of the Fix is that unlike the OTC price, it is a transparent price and is published. This makes it ideal for “valuation” purposes, as it is independent in nature. Also note that the Fix price will, by the force of arbitrage, reflect the spot price at the time of its fixing. Of all prices, it is the “most real”; as it reflects the price actual physical deals were transacted at.

A negative for the Fix is that it is only done twice a day (once for silver). This does not make it suitable for live trading, unlike the OTC price, which is a 24 hour market. However, if one is not too price sensitive and prepared to wait for the fix to occur (and you have a sizable trade that can be put on the Fix), placing an order with your dealer to buy or sell on the Fix is a great way to know exactly what you are being charged. The fact that the Fix is published means that your dealer has to be explicit about what fees they adding to the price. With OTC trading’s opacity, one can never be sure exactly what the dealer is adding to the spot price they are actually paying.

Retail Spot vs Wholesale Spot vs Futures

Just a final word on the “premium emerging for physical gold bullion”.

If by this one means the difference between the prices for retail forms – coins and bars – and the wholesale spot, then I agree. By definition, the spot price is the price for wholesale physical metal - 400oz gold, 1000oz silver. This is gold or silver’s “base price”, the price for the raw material for retail coins and bars. The current inability of the industry to covert the raw material into retail forms to meet the demand has caused a shortage which has caused the price to be bid up.

If by this one means the difference between the futures price and the wholesale spot, then I am not so sure. There will always be a price difference because a futures price is a mathematical function of the spot price plus the “time value of money”, with the price only converging to the spot price at expiry. This difference does not mean it is not “real” or in disconnect. To argue that it is in disconnect means that you believe traders are going to miss an opportunity to earn easy money by not arbitraging the divergence.

This is not to argue against manipulation of the markets or that futures markets may close at some point. Indeed it is essential to believe that futures prices and spot price are kept in alignment by arbitrage, because if they were not then there would be no way to transmit the manipulations in futures into the physical spot market. Indeed, the whole reason a futures market may close is precisely because arbitrageurs see a divergence and seek to correct it by taking delivery to settle their positions in the OTC spot market.


  1. This explanation does make sense.

    But what if arbitrageurs are prevented from taking delivery?

    This is not unthinkable, the LME just did it in Copper, and the Hunts were forced out in the same way ultimately.

    How can arbitrageurs function if they can not connect the paper world with the physical by being unable to take physical delivery?

    True that would end up making the notion of a futures exchange obsolete, but stranger thinks have been done. Funny enough, with the tiniest of quantities of contracts ever seing delivery, most holders would not even complain as much as one would think, so long as their paper settlement left them with a hefty profit over the initial paper assumptions (while still leaving the actual arbitrage gap in tact).


  2. If taking delivery is stopped then the futures price would likely disconnect from the real spot price and from the ETF (assuming it is still allowing delivery and redemptions).

    It would still be possible for a bullion bank to run a position in futures against an opposite position in the over the counter market, on the expectation that the future price would get back to its correct relationship to the spot price, but if this did not occur (eg continued buying or selling), then the inability to deliver or take deliver would mean it was "trapped".

    Note also that there is another control in that those who are natural sellers (eg miners) may chose not to deliver metal into COMEX if the price was not representative of the real price they could obtain. Bullion banks can easily offer miners forward sales that are the same as a futures contact.

    Ultimately the ability to deliver into or take deliver from any product (be it a futures market, ETF, storage program such as Gold Money or unallocated pools) is essential to "keep em honest" - both from the point of view of pricing and ensuring they have the metal. I'd stay well clear of any product that doesn't allow delivery.

  3. Bron,

    I agree with you on this in principle (meaning in a truly free market), but the example of the forced paper settlement in copper by the LME shows what allowing delivery means in a crunch.
    The LME should have been called on this bluff by the markets, but that didn't happen. Seems as though no one wants to uncover the fiction.

    Another pointer here is the delivery limit per month and per position that the COMEX has imposed. In a crunch, they can (as they have before), just change the limit to a 1/10 or a 1/50 of that, and force paper settlements of the rest.

    While the miners could certainly do forward sales, they would not "screw" the official exchange in that way. As Jason Hommel only recently pointed out, the miners will never rock the boat, either because they are in league with "them", or because they know that there are too many ways of implementing reprisal (new sites might be delayed in approval for production, environmental laws just might happen to be enforced, etc) if they were to by-pass the exchange.

    Sounds conspiratorial, but I think the manipulation of the PM markets has been demonstrated convincingly by so many others, that there definitely is this conspiracy going on (coudn't do this without conpsiring).

  4. All the more reason not to trade futures. It may be an efficient and leveraged way to trade gold in "normal" times, but if you are investing for safety reasons, then not so good.