About That Big Change To SLV’s Silver Inventories

Last week, Zerohedge noticed that the Ishares Silver Trust ($SLV) reported a sizable increase in its silver inventories on Wednesday night (January 16, 2013).    You can see all of SLV’s historical data by going to their web page and clicking on the “historical data” spreadsheet.   So let’s take a step back and remember how SLV (and other ETFs) work.

SLV does not go out and buy silver.  They don’t have to go procure silver.   Rather, their creation/redemption mechanism lets the market (Authorized Participants, of course) bring silver to them (and, vice versa: take silver from them).   When you buy shares of $IBM, your money doesn’t go to the Company – it goes to the seller of the shares, and when you buy shares of SLV, your money doesn’t go to the Trust for them to buy silver with.  If you read anyone suggesting otherwise, you should immediately put them on your “suspect” list, as they have no idea what they are talking about.

The next question noobs always ask is “How on Earth can they possibly move so much silver overnight?”   Well, that’s why SLV has their vaults in London, alongside the center of the bullion-trading universe.   When an Authorized Participant wants to create shares of SLV, they just transfer the title of the allocated bars.   There are almost certainly no 18-wheelers and forklifts involved (although there may be some eventual intra-vault movement via forklifts).  In other words, they just record the change:  “BankXYZ used to own bar JM20131003, but now SLV Trust owns it.”

Final noob point:  the availability of 1000 ounce London Good Delivery bars is totally separate from the availability of 1 ounce silver rounds used by the U.S. Mint.   The next common question is usually “HOW CAN SLV FIND 18MILLION OUNCES OF SILVER WHEN THE US MINT CAN’T FIND ANY?!?!”   Well, the U.S. Mint can have all the 1000 bars it wants.   This is the difference between shortages of silver and delays in processing silver rounds.   So can we move on to the interesting parts?

The question at hand, of course, is: “What does this large SLV inventory add mean?  What does it imply?  Is it bullish or bearish?

In ETF-101-thought, we generally associate increasing inventory of ETFs as indicative of rising demand for the ETF or the underlying product.   As I explained in ETF Lesson Part I, increased demand (buyers) results in the ETF trading “rich” to its fair value, at which point arbitrageurs step in to short the ETF and buy the underlying asset (silver, in this case).   The arbitrageur then delivers the silver to the Trust (“creation”) and receives newly created shares which are backed by the metal that has been delivered.   He uses the new shares to cover his short position and his arbitrage is complete:  demand has resulted in increased ETF inventory, facilitated by the arbitrageur.

But if we look at the trading volumes of SLV last week, it seems pretty clear that this wasn’t a case of rabid investor buying of SLV shares resulting in this share creation arbitrage.  In other words, it seems pretty unlikely to me that this creation was the result of normal market-making arbitrage reactions to mispricing.

So perhaps it was just a cleanup of a position that an Authorized Participant had sitting on his books for a while?  In other words, perhaps the AP was sitting with a large short SLV position vs a long bullion position and decided to close it out (again, by delivering the bullion to the Trust and creating new shares to cover the short)?    We can better evaluate this possible explanation when updated short interest data comes out, but I also find this explanation unlikely for the following reason: that’s something that the APs would tend to do in order to clean up their books and balance sheets for year end – not during the 3rd week of the year.

My next thought was that perhaps this was a case of someone wanting to take a large bullish position in silver.  In other words, InvestorX calls up his Authorized Participant and says “I want to buy $ 600MM of silver for a trading position – I don’t need to bother with vaulting the bars and all that headache – just give me SLV shares.  I’ll pay you a penny a share above your equivalent NAV cost basis.”   We’d call this a “basis trade” – because the AP wouldn’t just go out and buy SLV shares, he’d take advantage of all sources of silver liquidity to get long silver, figure out his cost basis, and “flip” it to his customer in SLV form at the agreed upon mark up.   If we look at the price action of silver recently, this explanation is still the one I find most plausible:

silver_week

 

Silver has been strong, and selloffs have been met with demand.   This explanation still falls into the “ETF-101-thought” I explained above: bullish silver demand drives increased inventories.

But there are other possibilities as well.   FT Alphaville’s Izabella Kaminska notes that the big bullion banks trade the various products (ETFs, futures, LBMA OTC, etc) as near equivalents (varying in financing cost), and that trades like this can be used to mask and confuse market sentiment.   I exchanged dozens of emails with Izabella on Friday before her post was published, and I think that our correspondence clarified her view for me much more than her eventual blog post did (note: I think her blog post has some errors, such as her mention of avoiding the “public market”), but her basic point is that the “ETF-101″ train of thought I outlined above can be exploited, and that large inventory changes of this nature can be a contrarian price signal.   A related view has been voiced in the theory of the “GLD Puke Indicator” which is evaluated by blogger Victor The Cleaner here.

In line with Kaminska’s point,  changes in the futures curve, SIFO, and the borrow rate for SLV would all affect an AP’s decision to hold one product vs. the others.   I have easy access to rough data for SLV borrow costs, via Interactive Brokers, and this is what I found from last week:

slv_borrow

Notice how at the beginning of the week it cost 36 basis points (annualized) to borrow SLV shares, but that cost spiked to 92 basis points on Wednesday, Jan 16th (the day of the big SLV share creation).   It is absolutely reasonable to think that the SLV share creation may have been driven by increased bearishness in silver: desire to make bearish price bets by shorting SLV, which drove up borrow costs, and incentivized APs to deposit silver into the Trust to create new shares and capture this enhanced financing arbitrage.

In the end, I cannot state with confidence what the root cause of the large increase in SLV’s inventories was.   My instinct, given the price performance of silver over the last week or so, is still that it’s bullish, and was related to a customer seeking bullish price exposure, but alternatives cannot be ruled out, and there is some data to support the other side as well.   Of course, if you agree that the increase in inventory was driven by end customer demand which result in an AP effecting a bullion basis trade, you’ll also have to notice that a very large amount of silver was bought with very little price impact – but that’s a post for another day…

 

ETF Lesson Part 1

Facts – The Enemy of the Precious Metals Blogger

SLV and the Mystery Inventory BuildUp

GLD – The Central Bank of the Bullion Banks

-KD

disclosure: no directional positions in silver at this moment. I have some small $SLV and $PSLV spread trades on

postscript:  silverbugs: before leaving me ignorant comments, please read my most recent post where I probably already clearly debunked what you were about to say

 

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