A Rocky Start to Q3

It's been a week since the Brexit vote.  And silver, not gold, has been taking off.

Usually in lock-step with gold, silver has outperformed gold by roughly 9.2% over the last 4 days.  Gold has been up 1.3%.  Silver, on relatively high volume, has gone up more than 10%.

This graph shows silver in green, each day adding to its gains over gold, in white (both were normalized at 100 for the comparison).  And we're again pointing out the suspicious volume, in red, at roughly 3:33 pm yesterday in SLV, which we commented on yesterday, almost a half hour before the day's close, (which was importantly also quarter-end).  

By yesterday, silver had moved 4.5% relative to gold.  Today, it moved another 4.5%, after opening again far higher on high volume.

Silver futures, too, show similar patterns to the ETF, and volume spikes.  Our hunch is that a bigger play was at large here behind the scenes, possibly involving or culminating in the squeezing our of some silver shorts.  Certainly, if it were a drive purely to protect against economic concerns, pertaining for example to Brexit, we would have expected to see the gold markets move in similar fashion.

Was Information Fed Pre-Fed?

Last Wednesday the Fed concluded its two-day Federal Open Market Committee (FOMC) meeting and issued its statement, deciding to hold the Fed Funds rate between 0.25% and 0.50%, as expected. The accompanying economic projections show that Fed policy-makers currently expect to raise rates only twice this year, down from their December median projection of 4 rate hikes in 2016. Markets responded in kind to the Fed’s more accommodating monetary stance, with 2-year yields falling, the dollar weakening, and gold rallying. 

One of our readers passed along a chart showing an 890,000 share spike in volume in GLD (the SPDR Gold Shares ETF) about 20 minutes before the 2:00 FOMC statement release — a volume spike which doesn’t create any noticeable spike in the market. We dug into Bloomberg’s “Trade/Quote Recap” data and found that there was a single execution of 825,000 shares. 

Source: Bloomberg 

Our reader was suspicious of the timing, suggesting that perhaps the statement and updated projections had been leaked. 

We certainly would not dismiss the possibility of information leakage and the timing of the block trade certainly is curious, but it’s worth being skeptical in this instance: there are plenty of innocent explanations for a block trade in GLD — even one so close to the release of the FOMC statement: 

First up, is a trade of 825,000 shares of GLD all that unusual? According to Bloomberg, and not counting opening and closing crosses, there were 36 trades of 500,000 shares or more (ranging up to 1.8 million shares per trade) in the previous 30 trading days. So while trades of half a million shares or more of GLD are not exactly an hourly occurrence, they do occur slightly more than once per day. 

Next, we cannot ignore the (albeit remote) possibilities that (1) investors (or traders) weren’t targeting the vanilla GLD, as much as delta-hedging a large options position or (2) that the GLD transaction was part of an arbitrage strategy in which a trader bought or sold GLD shares against a short or long position in gold futures. (If we assume a delta of .50 for an at-the-money option, then an 825k share cash position suggests the options position would be around 1.65 million shares, or 16,500 contracts.) 

Finally, we can’t be sure that this trade was initiated by a buyer — there are, of course, two sides to every trade.[1] Perhaps the customer initiating the trade was a seller and the broker-dealer bought the block (or found the other side of the trade) in order to facilitate a customer sell order.  In other words, maybe it was a large seller, looking to get out of a long position before the Fed decision. We have no way of knowing which side of the trade the customer was on, nor whether the broker-dealer took principal risk or found the other side of the trade. (FINRA would, however, be able to dig further, if so inclined, via the OATS system, which enables them to monitor the detailed history and execution of orders.)

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[1] We do know, per Bloomberg, that the trade was reported via FINRA’s ADF, which means that the execution did not occur on an exchange. So, it could have occurred in a dark pool or other Alternative Trading System (ATS) venue, but more likely it was done through an institutional broker. 

Digging and Drilling in the Commodities Markets

Last week we updated you on the FX investigations.  This week, we learned just a little more about the supervisory interest in keeping tabs on the potential for commodities misconduct.

Early in 2014, German regulator BaFin expressed its concern that precious metals manipulation (like currency manipulation) may be worse than the LIBOR-rigging scandal.

The LIBOR rigging is essentially centered in the window around 2007 to 2009/2010 and the FX and commodities misconduct may both have lasted longer.  From a benchmark rigging angle, the regulators have generally focused on 2009 - 2012, but the class actions are much broader, now often going all the way back to 2004.  Insofar as the guilty pleas are concerned, much of that is for misconduct after 2009/2010.

On Friday, the WSJ ran a very interesting story covering the FCA's (UK regulator) concerns about the monitoring of abuse in the commodities markets.  The WSJ article points out that the FCA's review "comes after recent changes in the market, in which a number of large banks, such as Barclays PLC and Credit Suisse Group AG, left commodity markets."

The FCA was really looking into internal surveillance procedures, but it did find certain lapses in (1) firms' monitoring of internal communications and (2) in their limited interest in submitting Suspicious Transaction Reports (or STRs) when noticing suspicious movements. This extract from the FCA's report captures some of their concern.

Firms that did not fully recognise the risks of market abuse were more likely to employ inappropriate surveillance, in terms of the choice of automated or manual systems, calibration of systems and frequency of monitoring. Overall, there was little order level monitoring, making it difficult for firms to demonstrate effective monitoring for market manipulation, and we often found surveillance being done on an inadequate or poorly targeted sample basis.  

Most firms’ communications surveillance captured Instant Messenger and recorded lines, but did not monitor these on a systematic basis. We observed more effective monitoring at firms where sampling was targeted at higher risk periods (such as at contract expiry or around important announcements) and at higher risk individuals.  

Many firms had inadequate STR procedures, with typically no written procedures and a lack of clarity on what constitutes an STR. The number of STR submissions within the commodities sector is low in comparison to other asset classes, which may indicate that potential suspicious transactions are not being appropriately reported. 

It will be interesting to see whether the FCA will succeed in getting the banks to self-police in the commodities space, especially given so many of the large banks are so heavily short, notably betting against silver and gold.  Courtesy of Ed Steer, here's a graphical depiction of the bank's overriding short interest in silver (via CFTC's data on futures contracts).

As you'll see, the banks really started to get short (particularly the US banks) in mid 2008, and have been heavily net short ever since. The dynamic is still true of non-US banks, but is far less pronounced.

Are "Dark Pool" Probes Pending?

Banks' so-called "dark pool" trading venues are all the rage these days.

The media jumped when dark pools were cited in federal authorities' and investor class action complaints against SAC Capital and its executives. The focus was on how the anonymity associated with dark pools, and the levels of secrecy they provide, allowed SAC and/or its members to avoid detection and potential losses on its sale of stock. (See also Gazing into 'dark pools,' the tool that enables anonymous insider trading)

One quote from a complaint reads:

“We executed a sale of over 10.5 million ELN for [various portfolios at CR Intrinsic and SAC LP] at an avg price of 34.21. This was executed quietly and efficiently over a 4 day period through algos and darkpools and booked into two firm accounts that have very limited viewing access.”

Next Goldies brought its dark pool, Sigma X, to the fore.  Having discovered pricing errors within the opaque pool, Goldman reportedly decided to send refund checks to customers to compensate them for the mistakes.

Michael Lewis didn't make matters any easier for Goldman or dark pools, giving them a hard time in his new book, Flash Boys.  Among other things, he casts doubt on whether investors got "best execution" through the dark pools:

“A broker was expected to find the best possible price in the market for his customer. The Goldman Sachs dark pool—to take one example—was less than 2 percent of the entire market. So why did nearly 50 percent of the customer orders routed into Goldman’s dark pool end up being executed inside that pool—rather than out in the wider market.”

That quote, alone, might not be altogether convincing: it's not clear whether he's looking at scenarios in which Goldman's clients have requested execution through the Sigma X, or whether Goldman's clients, requesting best execution, were oddly quite regularly executed through Sigma X, despite the potential for sub-optimal execution through that platform.  It's probably fair to say that those requesting execution through the dark pool would agree that they were foregoing "best execution" in the market - which is something one typically foregoes even with "hidden" orders submitted to an (open) exchange.

But now Goldies is back in the spotlight.  According to today's WSJ, they're considering shutting down their dark pool.

But why?

According to the Journal article, Goldman executives are weighing the benefits of the revenues it produces, against the burdens dealing with trading glitches and negative press.  Some burdens those must be, given Sigma X is purportedly one of the largest bank dark pools, and is likely producing significant flow.

Perhaps there's another theory...

Consider these stories:

In January 2014 Barclays decided to shut down its retail / margin Foreign Exchange business, Barclays Margin FX; in February, NY regulator Lawsky opened a currency markets probe.

In January 2014 Deutsche Bank AG (DBK) announced that it will withdraw from participating in setting gold and silver benchmarks in London;  in March, the CFTC announced that it is looking at issues including whether the setting of prices for gold—and the smaller silver market—is transparent. 

In July 2013, the CFTC put metals warehouses on notice of a possible probe. By November 2013 Goldman was resuming talks to sell its metals warehouses and seeking a buyer for its uranium trading unit; and by March 2014 we had various notices of JP Morgan's intent to sell its physical commodities divisions.

Probe and Sale

We could go on and on, but ultimately these are all anecdotal and we aren't wanting or looking to prove statistical significance at this stage.  We're also not too concerned about what comes first: the probe or the sale.  There's certainly no one-to-one mapping.  Not every regulatory probe is followed by a sale, or vice-versa.  We're only wondering if there's a pattern. And if there's a pattern, could there be an explanation as to why there's a pattern?

Here's one theory.  (We welcome yours.)  Might it be that, pending a likely or imminent (and embarrassing or expensive) enforcement action, banks may take preemptive action in selling "problematic" divisions ... to enable the negotiation of a more lenient settlement as they're (now) less likely to be repeat offenders of whatever activity was the subject of the probe?

In other words, is a dark pool probe pending?