Silver Squeeze Success or Debacle? Historical Lessons for the Curious

Summary

• Silver prices and physical premia have spiked of late, with inventories depleting
• Rumours are a ‘Reddit Army’ is partly responsible
• The 1980 Hunt Brothers episode suggests regulatory risks lie ahead

Market Implications

• If silver inventories continue to be drawn-down, physical premia will continue to rise
• Rising silver prices could also drag up other precious metals

Ginned up on their spectacular success squeezing the naked shorts in GameStop ($GME:US) last week, a diverse, growing army of populist prop-traders has subsequently turned its attention to silver. And, so far at least, it has met with some success. The price of silver has surged over the past two days and at one point nearly reached $30/ozt, a level not seen since another spectacular silver rally back in 2011 (Chart 1).

The rationale for the silver attack is similar in certain respects to that for GameStop: widespread, publicly available evidence of large, uncovered short positions in relatively thin markets. In the case of GameStop, the share float was only a tiny fraction of the reported short interest in the stock. And so the thinking went, if enough of the narrow float is acquired, driving up the price, then the leveraged, naked short sellers would be forced via margin calls to pay exorbitant amounts to acquire the shares required to close out their positions. (Of course, this would then leave the new owners of the shares with large positions in what would appear, on fundamental grounds, to be a massively overvalued company. But that is another story.)

In the case of silver, there is far less reported eligible and registered physical inventory available than that required to back the open interest in the silver contracts. Also, the ‘commercials’ – primarily financial institutions – are overwhelmingly on the short side, whereas the non-commercials – investors and speculators – are correspondingly overwhelmingly long. And so, if enough of those non-commercials decide to stand for physical delivery of their contracts, or do so indirectly by buying up the available inventory of physical bars and coins, then the shorts will be forced to pay exorbitant amounts for whatever scraps are left, potentially being unable to deliver and facing default.

This is where the silver game acquires another dimension entirely. The counterparties here facing potential default would not be leveraged hedge funds but rather Too-Big-To-Fail (TBTF) banks such as JP Morgan, which lie at the centre of the financial system. The same can be said of the Comex exchange itself, part of the CME group. It is highly unlikely that the US financial regulatory regime would allow that to happen.

The Infamous (or Heroic?) Hunt Brothers

History provides a rhyme: the Hunt Brothers’ thwarted attempt to corner the silver market in the late 1970s. Quietly accumulating inventory for years, in 1979 the Hunts accelerated their buying dramatically, driving the Comex silver price from just over $6 to $50/ozt by January 1980. On 7 January the Comex, no doubt with the knowledge of the US Commodities and Futures Trading Commission (CFTC), changed the margin rules for silver contracts. This, in effect, required the Hunts to put up huge sums of additional margin against their positions, or close them out.

The Hunts quickly realised they could not raise the necessary funds quickly enough, and so they were forced to sell. By March, the silver price had collapsed to just over $10 and the Hunts were reported to have lost around $1bn as a result, which in today’s dollars would be several times greater.

Plucky populist investors taking on a handful of hedge funds is one thing. As the Hunt episode demonstrates, taking out TBTF SIFIs is quite another. There is a political and regulatory dimension involved.

Strange Bullish Bedfellows

Today’s Millennial ‘Reddit Army’, as some call it, should take notice. Interestingly, however, they may have found some Boomer bedfellows: dyed-in-the-wool silver and gold bugs, who have been pointing out for years that silver was hugely undervalued. From the perspective of the silver shorts, this populist ‘unholy alliance’ of investors across the generations could be cause for great concern indeed.

With such multi-generational buying force behind it, silver’s big rally in recent days has seen it outperform not only outright but versus gold, by the largest amount in many years. And the gold/silver ratio has slipped below 70 as a result, which begs a question: if silver continues to rise, at what point does gold begin to look cheap by comparison? Given that the open interest in Comex gold is also many times greater than the eligible and registered inventory, might the same logic apply?

Yes and no. The overall situation in gold is qualitatively comparable to that for silver, if less extreme. But it is important to note that the actual physical silver market is tiny compared to that for gold. Investors can drain the physical silver inventory quickly, and US coin dealers have seen this depletion first-hand in recent days. While Comex silver has risen to nearly $30/ozt, the going rate for coins at US dealers is now reportedly over $40. That is a huge gap between the paper and physical markets and, if it continues, then the paper price must rise. Otherwise, Comex inventories will eventually be depleted and an exchange or counterparty default of some kind becomes almost certain.

As per the Hunt Brothers debacle, however, the regulators are unlikely to allow things to go that far. Precisely what action they might take, and when, is unclear. It is worth noting that the CME increased silver margin requirements by 18% yesterday, making leveraged silver positions more expensive to hold. Yes, in theory this affects both longs and shorts equally, but if the shorts have deeper pockets or, better yet, regulatory and political backing, then it primarily weakens the longs.

In any case, it will be interesting to see how this plays out. If the silver short squeeze continues, no doubt the price will continue to rise and physical stocks will get tighter and tighter. Gold and other precious metals prices might also get dragged higher, if by much less.

If the regulators do eventually step in, they will need to take care to be seen to act fairly. It was one thing to shut down the Hunt Brothers, who were Texas oil billionaires with few friends (and possibly some enemies) in New York and Washington, DC. Going after a populist army of ageing silver and gold bugs allied with moralistic Millennials is another matter politically.

Limiting non-commercial positions on the Comex, driving margin requirements ever higher, or temporarily banning the sales of silver coins and bars to private investors would be seen as yet more examples of the regulators favouring TBTF institutions over the ‘little guy’. The moves would echo the 2008 bailouts, which ignited a populist wave in US politics contributing to Trump’s surprising victory eight years later.

Facilitating genuine price discovery is the entire point of efficient markets. The Comex and other exchanges are set up and supposedly regulated for this purpose. Whatever regulators do, if anything, in response to the current silver squeeze may reveal much. Regardless, a new generation of investors is learning about how markets really work, or don’t work, and hopefully the lessons will contribute to the healthy future development of financial and commodities markets generally.