The CME Opens Pandora's Box - Craig Hemke (31/03/2020)
With mines, mints, and refineries closed around the world due to coronavirus, the demand for physical gold has blown through the roof. This has led to some drastic measures by the CME Group, which in turn may have unwittingly sealed the fate of the COMEX and the entire fractional reserve and digital derivative pricing scheme.
This latest crisis began last Tuesday, when the spot market for gold appeared to seize up as the futures price roared ahead following the announcement of formalized QE∞ by the U.S. Federal Reserve. The event has been chronicled by many analysts and experts, with even Reuters and Bloomberg joining in the reporting.
As the Reuters article notes, a clear shortage of the COMEX standard 100-ounce bars had developed. To counter this— and in a desperate attempt to maintain the integrity of their trading system —the CME Group immediately responded by amending the delivery procedures of their standard COMEX contract. Instead of the required 100-ounce bars, the COMEX would now be able to deliver fractions of 400-ounce London Good Delivery bars as well.
First of all, this exposes the charade of what has always passed for the bi-monthly physical settlement process on COMEX. Oh sure, the COMEX vaults may have always shown 8,000,000 ounces of gold, but quite obviously, none of that was actually available for physical delivery. Instead, each delivery month consisted of simple journal-entry transfers of nothing but warrants and warehouse receipts. To maintain the charade, one bank would issue some "gold" and another would take delivery. We've written about this scheme on countless occasions, most recently here:
But, whatever. Let's get back to the crux of the matter.
Obviously, the CME Group knew that they had a problem on their hands last week, which is why the sudden rush to amend the COMEX delivery rules to allow for London bar usage. The current front and delivery month is the Apr20, and that contract was due to go "off the board" and into delivery yesterday, Monday, March 30. Due to the virus-related shortages, The CME clearly anticipated a sudden surge of demand for actual physical delivery in April.
And did they ever get it! As of the COMEX close on Monday, the total amount of Apr20 contracts still open and "standing for delivery" was 25,595! A usual/normal delivery month on COMEX usually sees 8,000-10,000 "deliveries" for up to 1,000,000 ounces of warrants, etc. For Apr20, however, there is a request for 2,559,500 ounces, and because of the current shortages, most of these contract holders actually want real, physical metal.
Apr20 delivery notices began to be posted on Monday evening...and look at the volume! Be sure to note that the House Account of JPMorgan had to make a delivery of 7,000 contracts for 700,000 ounces. Not only is this close to 22 metric tonnes of gold, it's also more than 2X the stated position limit of 3,000 contracts.
Note, too, that ScotiaBank was also forced to make delivery from their House Account of 235,100 ounces or about 8 metric tonnes. And note that, so far, HSBC has not posted a single delivery. But they're next. How do we know this? Check this massive, unprecedented re-allocation of gold from eligible to registered that took place late last week. JPM took the steps necessary to deliver 7,923 Apr20 contracts, while HSBC looks to have prepared for 3,129.
OK, so now let's look ahead and consider the title of this post.
It's clear that the virus-related shutdown of mines, refiners, and mints is having a dramatic impact on the supply of immediately-deliverable gold. And this comes at a time when physical gold demand is surging. This places wholesalers and dealers in a very tough position. They need physical gold NOW but have very few options for acquiring it.
And so they're turning to the COMEX. And why not? The CME Group has maintained for years that their pricing scheme is fair, sacrosanct, and backed by physical delivery. They post vault stock reports every day of the week that purport to show a physical vault inventory of over 8,000,000 ounces. So if you're a dealer and you need immediate metal, why not just pony up to the bar at COMEX and stand for delivery? After all, the CME itself claims that the gold is all there and just waiting for someone to ask for it.
This "delivery" illusion worked out just fine...until last week. And now the CME Group, in their rush to maintain "the integrity of their exchange", may have just sealed the exchange's fate.
Why? Because they've opened Pandora's Box. By stop-gapping COMEX delivery with London bars— and by forcing The Bullion Banks that operate on COMEX to actually deliver physical metal versus their paper short positions —the exchange itself may now be put in an untenable position.
Watch closely what happens next. After Monday's initial deliveries, there will still be about 8,000 Apr20 contracts standing and open. Most of these will likely be demanded for true physical settlement, too. Well, now that COMEX is open for business as a physical distribution vehicle, what's to stop funds, wholesalers, and dealers from paying full margin and buying even more Apr20s as the month progresses? Nothing! So watch to see if that Apr20 open interest number continues to climb through the month.
Next, watch to see what happens in May. Though the May20 is not a front/delivery month on the COMEX calendar, there’s nothing to stop an entity from buying a contract and demanding immediate delivery in May. As of Monday, total open interest for this contract was at 2,338. In the days ahead, watch very closely to see if that total begins to grow.
And finally, even though the CME/LBMA/COMEX may survive April, who's to say they'll survive the next major delivery month of June? Now that the proverbial cat is out of the bag and the entire world knows that COMEX will deliver actual physical metal if pushed—and with no other readily-available stores of metal around due to the virus—what if 50,000 contracts stand in June? What if 100,000 stand?? Do you see where this might be headed???
In the end, the CME may have unwittingly sealed the fate of their pricing scheme last week by rushing to make COMEX a physical delivery facility. While the exchange is likely to survive April, the months of May and June will likely pose a significant challenge. Only a quick containment of the coronavirus may assuage their crisis. If the mines, mints, and refineries can re-open in the next 45-60 days, perhaps the fractional reserve bullion banking system will be salvaged. If not? Well, let's just say that gold investors and stackers are in for a VERY interesting summer.
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