Having introduced the concept of derivatives last week and given some examples of how they work, we move on to how commodities are also influenced by the wide-ranging effects of manipulations especially gold. Here is the link to last week: Issue 40
I promised to look at gold price manipulation this week and the use of ‘paper gold’ to suppress the price of bullion on the market. This is an important aspect of financial engineering which has evolved over time as more innovations and financial products have become available. There is much controversy about how far the mega banks engage in this manipulation but it is fairly certain that some degree of artificial distortion is present. This short article makes the point: https://www.goldbroker.com/news/three-banking-giants-charged-for-manipulating-the-gold-market-1258
CHAPTER 8
Financial Engineering
“Something hit me very hard once, thinking about what one little man could do. Think of the Queen Mary — the whole ship goes by and then comes the rudder. And there’s a tiny thing at the edge of the rudder called a trim-tab. It’s a miniature rudder. Just moving the little trim-tab builds a low pressure that pulls the rudder around; takes almost no effort at all”.
Richard Buckminster Fuller
Gold market manipulation in futures contacts by major prime dealers
There are a lot more paper contracts for the sale of gold on the COMEX than there are for real, physical gold. The traders are betting that most buyers on the other side of the contract (the counterparties) will not want to take delivery of the physical gold.
The COMEX remains the largest and most sophisticated meeting place for buyers and sellers to express their gold price opinions, in the form of bids and offers, on what the market price should be set at any one time; COMEX remains the beating heart of gold ‘price discovery’ throughout the world.
Gold futures contracts are referred to as “paper-gold” because the size of this market is estimated to be over hundred times greater than the market for physical gold available above ground! In theory investors and speculators are able to take delivery of the futures contract on expiry, although few do, instead choosing to roll over to the next contract month; although it remains that all the buying on COMEX cannot be settled in physical gold.
They can issue an unlimited supply of paper contracts whenever they wish to suppress the price and if required, can indefinitely roll contracts over, artificially reducing the price, until the counterparties (the buyers) are unable able to meet their margin calls and leave the market, often with severe losses, which keeps the price of paper gold suppressed as happened in April 2013 when the spot price of paper gold dropped USD 250 in 48 hours!
Other examples of derivative contracts
All these contracts we have discussed are derivatives and were famously described by Warren Buffett as: “financial weapons of mass destruction,” because they can become like time-bombs embedded in the financial system waiting to explode if conditions allow, for example, if interest rates suddenly rise as happened prior to 2008 and briefly in July 2013.
Because these contracts are highly complex, often running into hundreds of pages, they are little understood even by those investor/speculators actually dealing in them. A further complication is that a large percentage of these financial instruments are not traded through an exchange but remain as private contracts between the parties and are known as ‘Over The Counter’ (OTC) securities.
OTC contracts cannot be easily valued because there is no market for them and therefore no ‘price discovery’ but because they remain on a banks’ or financial institutions’ balance sheet the valuation (using computer modelling) by the institution itself is rendered uncertain and referred to as ‘mark-to-model’.
Derivatives can also be used not only to produce outrageous profits but also to deceive banks, investors and even governments by hiding the true nature of sovereign debts, mortgages and bonds as well as their rates of interest. Indeed some derivatives are created only for deception and are the only reason they exist which allows those who own them to evade taxes or accounting rules. Banks use derivatives which they create to help their clients deceive the public or even enable banks to deceive their own clients!
Examples of derivative contracts used to misdirect investors
One example of ‘deception by derivative’ came in Italian government documents leaked to two newspapers, La Repubblica and The Financial Times. The Financial Times reported that it appeared Italy had used derivatives in the 1990s to allow it to make its budget deficit seem smaller than it actually was thus enabling it to qualify for admission into the Eurozone.
It seemed that these derivatives, now restructured, could have exposed the Italian government to losses of some eight billion euros. La Repubblica further noted that the director general of the Italian Treasury Department at the time, Mario Draghi, moved on to become President of the European Central Bank which leaves observers to question the very nature of financial markets operations.
This is similar to something that we already know about Greece. Rather than borrow money in the normal way by issuing government bonds, which would increase the country’s reported budget deficit, Greece entered into a derivatives contract, led by Goldman Sachs, that required the lending banks to make large, upfront payments to Greece in return for even larger payments later on down-stream. This had the effect of ‘deferring’ the debt allowing Greece to understate its financial status; it is an accounting gimmick well known to practising accountants and colloquially known in finance circles as: ‘kicking-the-can-down-the-road’.
Derivative contracts are specialised financial products
So how do these derivative instruments differ from traditional loans? In practice they differ very little but are much more to do with accounting rules and how published accounts are presented to shareholders and the public.
It is ‘creative accounting’ or ‘smoke-and-mirrors bookkeeping’ which allows creditors to keep their loans away from their published balance sheet by residing in the hidden corners of the accounting labyrinth; by calling a loan a derivative it is kept ‘off balance sheet’ or if kept ‘on balance sheet’ it is described in a misleading way.
In hindsight the Financial Times report was right on target as this arrangement ultimately caused Italy’s ‘reported budget deficit’ to be much smaller than it really was just at the time when the country needed to join the Eurozone.
It can be contended that the ‘chickens are now coming home to roost’ as these derivatives are becoming toxic and are revealing losses which have been hidden for many years. There is a lot of evidence that the EU and other European entities knew exactly what was going on but chose to ignore it because expanding the EU is seen as more of a political policy than an economic one; it has become a symbol of ‘European unity’ as we have reviewed in previous Chapters.
The unintended consequence of this deceptive accounting is similar to that of a student cheating in an examination. Although the student may be undetected and enter university they will be unable to compete with competent colleagues and the deception comes to no avail.
Likewise Italy, Greece, Spain, Portugal, Ireland and Cyprus find themselves unable to compete in the Eurozone, where their economies are at a significant disadvantage to others such as Germany, because a common currency requires economies to be compatible (in the EU known as ‘convergence’) to maintain economic stability; the outcome of the whole EU project will depend on how well the bureaucrats deal with these issues going forward as it is hoped that the national economies of the EU members will eventually converge and all will be well; however the truth will always come out in the end and at present the strategy in the EU seems to be “papering over the cracks”.
To be continued next Saturday
PM ETFs are akin to Three Card Monty somehow. Imagine they are like short loans that automatically roll over, and the buyer is in it for the stated interest (they know they will not be handed physical gold). I suspect that the interest paid to buyers comes from Central Bank printed money (the ETF Seller is probably not earning the paid out interest); that source of money is unlimited, making the amount of ETFs unlimited, and the PM price suppression scheme unlimited (100 to 1 now; 1,000 to 1 tomorrow?). I don’t know how this scheme can “unravel” so that the ETF buyers wind up bankrupt one sad day, but they will.
You are so right, Robert, and thanks for your observation. There is indeed no limit to the amount of money creation by primary dealers (the banks involved) and of course they can just go on issuing as many dollars as they wish. I, like you, can’t see how this manipulation can unravel until the whole economy enters crisis again like 2008.
I monitor the markets etc every day and try to get a handle on the coming collapse, posting some of the recent issues here each week. Share buybacks are the big financial engineering flavour of the month these days and there is speculation that the massive debt overload thus created could be the next catalyst – we can only wait and observe as events dictate.
https://www.marketwatch.com/story/misguided-share-buybacks-are-hollowing-out-companies-balance-sheets-and-will-lead-to-even-bigger-trouble-2018-11-20