A Silver Heist: Part 1

The EFP (Exchange for Physical)

INTRO

We are headed down a trading rabbit hole.  We’ll connect a few dots and conclude there is a real chance that a large holder of physical silver will execute a rug-pull and the holders of “paper silver” are on the losing end of this great taking.  The probability of this happening is north of zero, so we want to go there.

We first need to set the trading table in order to explain how a potentially problematic position can be at the center of the precious metals market.  We want to demonstrate how a “risk-less” and benign position of long physical silver is being managed in a not-so benign manner.  A manner that carries large systematic risk.  This is a thought experiment that we like to call “Tail Talk”: when we discuss the different snowflakes that can start the next avalanche.

Before we jump into the fun stuff, we need to dive in and talk about some trades and concepts that will arm you with a stronger understanding and appreciation of the potential silver heist.  We’ll break our missive into three parts:

PART 1: The EFP (Exchange for Physical) – explains the “risk-less” strategy of long the physical asset vs. short the paper representation of that same asset (a derivative).

PART 2: Paper vs. Physical – demonstrates the value in the physical asset.

PART 3: The Silver Heist – a thought experiment, where the paper vs. physical set-up in the market is problematic.

THE EFP -- IT’S ALL ABOUT RATES

I learned about the EFP (Exchange For Physical) market when I worked on the index arb desk.  This was my first seat as an assistant trader where I ran the p&ls, monitored positions, and fetched the senior trader coffee, lunch, and whatever else he wanted.

One of my favorite stories (and a lot have been accumulated after 25-years in the derivatives trenches) was the lesson I received very early on when I started on the index arb desk.  My trader said, “It’s all about rates.  Learn as much as you can about rates.”  And boy was he right.  There exists a dizzying amount of different rates, calculations, and nomenclature.  There’s LIBOR, the Fed Funds rate, and SOFR (Secured Overnight Financing Rate).  Then there is the TED spread, the OIS Spread, long term rates, short term rates, and strips, collars, and caps, and on and on it goes.

The classic index arb trade is to trade a basket of stocks, specifically the S&P 500 stocks, against the S&P 500 futures.  This trade is long stocks/short futures or vice versa.  The simultaneous execution of both stocks vs. futures attempts to capture some spread between the two that is above and beyond the “fair value” to carry the position until the futures expire.

Rather than get too far into the weeds on this position, let’s conclude that the index arb position all comes down to a funding trade. The trader is simply locking up a rate to either borrow or lend, depending on the position.  Through this borrow/lend lens, index arb is just another funding game.

EXCHANGE FOR PHYSICAL

Another popular position on the index arb desk is the EFP.  Similar to index arb, this is a market-neutral transaction where the counterparties simultaneously cross (exchange) a basket of stocks vs. the corresponding futures at some agreed upon level/spread.  Again, the spread between the futures and the index level (basket of stocks) is mainly driven by the level of prevailing interest rates.

A popular application of the EFP could be a funding trade for a mutual fund manager.  In this example the client is an index manager like a Vanguard.  Assume Vanguard receives inflows of capital into their index fund.  Vanguard can quickly and easily put the new money to work with a simple purchase of S&P 500 futures.  When some critical mass of futures have been accumulated, Vanguard can execute an EFP trade where they sell their futures and buy stocks.  Here, Vanguard has used the EFP trade to replace/swap out of the futures and into the basket of long stocks, which they know they will carry for the long-term.

We know you did not come here for trading lessons, but we need to explain the basic position and market-neutral concept of stocks vs. futures.  This is a critical first step down the paper vs. physical rabbit hole.  In our example, the basket of stocks represent the physical assets while the futures are the paper representation of the asset.  Hence, futures are derivatives.

HARD TO BORROWS

By now you may be familiar with a hard to borrow (HTB) stock -- thank you GME (Game Stop).  A stock is HTB when there is a lot of demand to short the company (thinking the shares will decline in price).  In order to short a company’s share, one must first “locate”/borrow the shares in order to sell them.  GME was a classic HTB situation.  We now know there were more shares short than shares outstanding, and that is what got this party started.  The demand to short GME was huge.  Then things broke and GME shares soared…HIGHER.  This drove the demand to sell short even higher, and it did not help that holders of GME shares decided to stop lending their shares out, which drove the cost to borrow the shares higher still.

A FASCINATING DISCONNECT

It was a random market decline in 2011 when we witnessed the unthinkable: a broad-based index (IWM - The Russell 2000 ETF) became hard-to-borrow.  The market decline came on so fast that the market participants got caught off guard and long.  This market jolt created a mad scramble to borrow the IWM shares to short in order for the market participants to hedge downside exposure against these same smaller cap stocks/Russell 2000.

This anomaly raised our awareness to the size of the markets and its participants.  The inflation, creation of currency units, and financialization has grown so large that certain players and positions are possibly out-sizing the markets themselves.  This took our paper/physical curiosity to new heights.  My simple conclusion was — if a popular index ETF can become hard-to-borrow, then there is some real value in physical assets.  There was such a big price to be paid to short an asset via derivatives, that this actually increased the value of the physical asset itself.

CONCLUSION

You are now a pro.  We covered the index arb trade, EFPs, and hard-to-borrows in order to better understand the difference and dynamics between physical and paper assets.  This similar concept applies in many areas outside of stocks.  We also see this in other commodities that have an ETF (Exchange Traded Funds) like oil vs. USO (an oil ETF) and several others.  We also see this in Bitcoin, where we now have a host of different Bitcoin futures.  And of course we see this in the precious metals space, so stay tuned for the details behind physical and paper silver and gold.