The London Metals Exchange (LME) is the oldest and largest industrial metals exchange globally and processed over $3,000,000 worth of notional gold trades per day at the height of its activity in the international gold markets. But they have announced the upcoming closure of futures trading in gold and silver contracts by July 11 of this year, due partly to low trading volumes since several member banks have closed corporate metals trading desks. In light of increased penalties for manipulating gold and silver prices and in preparation for full implementation of the Basel III international banking regulations, gold and silver futures trading has become more of a source of risk than reward for shuttered trading desks. As a reminder, the LME was purchased by Hong Kong Exchange and Clearing Ltd in 2012 to facilitate growing trading demands in China and Asia.
Recently, there was controversial activity at the LME regarding nickel trading, as the exchange halted all trading and cancelled contracts during a recent 250% spike in nickel price. Some controversies involved a prominent Asian trader who was short nickel and faced $billions in losses. While the LME stated they were trying to protect smaller traders from being wiped out, speculation swirled that the LME was trying to protect Chinese traders and nickel producers from further losses. With recent spikes in gold and silver prices following the official connection of the Russian Ruble to gold, the closure of gold and silver futures trading on the LME will prevent a similar event to the nickel debacle on a much larger scale due to higher prices for silver and gold.
The Tax Connection
Believe it or not, changes in the US Tax Code are also partially to blame for banks and other entities such as the LME departing from the gold and silver futures business. As long as few people request physical delivery of a metals contract, there is little danger of default. But in light of the current instability in the international financial system and rampant inflation worldwide, governments, individuals, and even corporations are looking to physical metals such as gold and silver to hold as purchasing power protection for the years ahead. The risk that exchange customers could request physical delivery at contract expiration has substantially increased. This is largely why nickel trading was halted, as physical delivery became impossible at current prices. The scrambling for good delivery gold or silver bars would make the disruptions in the nickel market look mild in comparison.
For example, in the case of gold, only gold bars certified from certain countries or entities qualify as “good delivery” gold. Typically, one type of gold could be swapped for another type of gold to allow “good delivery” for those seeking physical metal for their maturing contract. But today, we have the sanctions conflict with Russia, preventing their refined products from being available for “good delivery” bars, and tariffs from 2018 totaling 25% on gold and silver from Chinese refineries. Refineries from China and Russia represent nearly half of the certified refineries able to produce “good delivery” bars, which are now expensive to use or completely unavailable. Not only is it more difficult to source good delivery material to swap for other gold/silver products, but a new U.S. Tax regulation change makes it a taxable event to complete such a swap.
Risk of Default vs. Tax Consequences
Therefore, exchange operators such as LME face the 1) risk of default for failure to deliver physical metal in short supply and 2) tax consequences if they make good on delivery demands by swapping metals around. In this environment, the risk of loss seems unacceptably high compared to the opportunity for reward. This is the perspective from the exchange viewpoint, but what does this mean for owners and potential owners of physical precious metals? From the perspective of a precious metals owner, the reverse is true. That is, there is more opportunity for reward than there is a risk of loss. The same tendencies pressuring the LME with a risk of loss (shortage of available gold and silver, with an abundance of demand for physical delivery) tend to favor those holding (or soon will hold) precious metals.
Metal Shortages Everywhere
One of the questions that arise when we look at other shortages the LME might face is answered when we look at current inventories available for delivery. The six central contracts offered on the LME, besides gold and silver, are for copper, aluminum, zinc, tin, lead, and nickel. Available stockpiles for these metals have dropped to the lowest levels in 25 years, with nickel trading at risk for further disruption and zinc inventories 60% lower than a month ago. Michael Widmer, head of Metals Research at Bank of America Corp, said in a recent phone interview that “It seems as though we are facing a new squeeze every week on the LME, at the moment.” Serafino Iacono, Executive Chairman of GCM Mining, makes an educated projection that we are entering a metals cycle that will see all metals, both industrial and precious, rise significantly over several years.
Could looming physical shortages of gold and silver provide even more significant disruptions and losses at the LME than those recently experienced in nickel? While the official narrative from the LME is that they are now experiencing “low volume” in the gold and silver futures business, part of the reason could be a lack of trust related to the cancelled nickel trades recently, and the shortages developing with other metals traded on the LME. The takeaway from my perspective is that we are entering a time when there is no substitute for owning physical precious metals.
Reading Between the Lines
When metal is plentiful, inflation is low, and people are willing to roll over maturing trades for more paper contracts, there is money to trade paper futures. But when gold and silver are in high demand, inflation is high, and people are clamoring for physical delivery, reducing exposure to paper promises makes sense. But you don’t have to take my word for it. Just ask the LME; they’ve been trading metals and paper for 145 years, since 1877. Their actions indicate that the time to reduce paper exposure and increase direct exposure to physical gold and silver is now.