A second whistleblower speaks. As the topic of physical delivery has gained prominent attention recently, it is crucial to complete the circle and show how this weakest link in the PM market is (ab)used by the big boys: Phibro and Warren Buffet. Pay particular attention to the analogues between the methods employed in the 90's commodity market and how the PM (and equity) market is being gamed currently. And to think that each new generation of traders believes it has discovered something new... (All emphasis below is ours)

Background

As a market maker in silver options from 1989 to 2000 I was present during both the 1994 and 1997 silver events. They were seminal in my education of gamesmanship in trading and how probabilities can come up short.

Prior to going out on my own, I traded at a small market making firm. When a trader finished training there, he had top-tier options knowledge but was not educated in whom the players were, the fundamentals of the markets, and how probabilities were useless when information was asymmetric. That wasn’t their business, they taught option’s theory. Since I had drunk the kool-aid, I thought fundamentals and gamesmanship were useless in the face of the almighty Standard Deviation model. That was a mistake.

Phibro Early Exercise

In April 1994, the Thursday before Easter, the trading day ended with a rather unusual run up of 15 cents near the close to finish at 435ish around noon. Options expired that day at 4pm but we weren’t anywhere near the closest strikes (425 and 450) so most of us left. It was a 4 day weekend in the U.S. but silver traded globally, albeit il-liquidly in Asia. Comex wouldn’t open until next Tuesday. My education in gamesmanship started that afternoon at JFK airport as I was waiting for a flight, my first vacation in 5 years.

My backer paged me at the airport to inform me that someone was exercising the K 450 calls. I scoffed thinking it was a retail sap that was talked into exercising some 5 lot piece by an overzealous broker. “Great I said, let them, the options are out of the money.” And I hung up

10 minutes later he had me paged again. “You don’t understand, it’s Phibro exercising.” Again I naively said, “So what, they are energy guys.” But I was curious, “How many? “ I asked. “All of them, five thousand, he replied. Now I was really curious, but still woefully ignorant that it was I who was the sap at the table. “Why would they do that?” and he explained it to me. I nearly shit myself and bent over in the cab vomiting on the ride back.

Cancelling my trip, I headed back to the office to assess the reality of what would happen, probabilities were no longer important. Survival was important. I had no money and was trading on a $25k note lent to me by my backer.

We covered by buying futures on my entire short open Interest equivalent of EXPIRED OUT OF THE MONEY OPTIONS in Singapore with a dealing firm. We did this prior to even actually knowing if I was exercised, probabilities be damned. How did I know they exercised? The price covered at was $462; that is how. The 450s were already in the money by 12 cents.

Phibro exercised all 5k lots. I had a fraction of that but big enough to be carried out on a stretcher had the rest of my position not bailed me out/ performed on Tuesday next week.

The weird part was, the market stabilized that Tuesday and did not run to “infinity” as it could easily have. We found out later it was because Phibro’s exercise was a no-no and Warren Buffet ordered them to shut the trade down as it was too big of a potential scandal. Especially in light of his coming to Solly’s rescue and lending his good name to fix their most recent Treasury scandal. A couple head’s rolled there if I remember correctly.

My guess was that the client was a Buffet or Soros type. Someone that would only go to Phibro, as these guys were the best at preventing information leakage, and always aligned themselves with client interests, where as if IB had an order and acted in dual capacity as a dealer, he would potentially front-run the order or stop it out poorly on an exit. Phibro didn’t take other side of their client’s orders. They ran with them, and took care of the clients first.

Phibro got a big order for a client to buy silver, one that had to be handled expertly, and filled over time, no information leakage would be tolerated. These guys were a prop desk that took orders as brokers once in a while.

They accumulated options for their own account (K 450C) to piggyback but not front-run the client.

They must have bought futures for themselves as well as the client with his permission.

They beat the VWAP by gunning the market on light volumes 1 hour before a 4 day US holiday. [TD: compare and contrast with the daily patterns seen every single day in the endless move up in the S&P]

They exercised the 450 Calls that day and then lifted the offers of the 1 or 2 OTC metals dealers left open during Singapore hours, running them over during illiquid markets.

Never Again!

I became infatuated with Phibro gamesmanship and made it a point to understand that particular type of player.

Libertarian Darwinist that I was I did not blame them. At the time It was a buyer-beware market for big businesses and they did nothing wrong. They took risk and they aren’t bigger than the market. I wanted to play with the big boys, and that was the price.

For me it was about learning how to read the signs and not be on the wrong side of one of those events again, even if I was not privy to their meetings.

Here is some of what I learned:

In metals (and energy and anything else with an OTC market) the IB firms have dealing desks along GS, MS, Republic, JPMorgan, Scotia Mocatta, all were essentially broker dealers in precious metals. All had clients: miners who hedged production and hedge funds who speculated OTC. They provided liquidity by taking the other side of their client’s trade and “back-to-backing” them in the futures markets or held onto them in their prop books as counterparty because of something else they saw.

Their client left resting orders with them in the IB’s Central Limit Order Book (CLOB) which served as good information to trade around for the IB. Sometimes they front-ran the client, other times they go for stops to force the client to puke. Sometimes they’d just make markets, depending on many things. It was poker to them.



Sometimes they’d just make markets, depending on many things. It was poker to them. Phibro was different. These were smart guys but they weren’t a dealing bank. They exploited imbalances in markets and took positions. They had ideas. They also took orders for heavyweights who needed absolute discretion. They did not make it their business to fleece their own clients and instead aligned their interests. And they made the banks look like pikers when a client came to them with an order.

For the next 4 Years I paid attention to how those dealing banks and phibro played the markets. It was all about gamesmanship, Bayesian probability, and knowing your counterparty’s motivation with these guys. Information and misinformation.

Some methods:

How I.B firms would use a thinly traded floor to print the price that would trigger a massive stop loss in the OTC markets and bury their own clients. Or how they would buy for their own accounts in front of resting limit orders for clients and simply use their clients to stop themselves out if the market printed thru their buy levels. Or how they would use dual representation to show loudly they were buyers on one side of the ring, while they were selling quietly upstairs to other OTC dealers. Trading with themselves in multiple entities, etc.

An IB with a Commodity Index was in heaven. Prop trading, captive client flow from IB deals and OTC dealing and Brokerage. The good ones knew how to integrate and hedge macro risks, whether to front run their own index clients or get out off their way. “Chinese walls” did not exist in Commods.

Commods were mostly self regulated and that lead to predatory yet mostly legal behaviour.

Some of these were necessary to protect their interests with such a small number of players. Some were possibly unethical, but most were legal. Their clients were all big boys who left resting orders with the IBs at their own risk. Clients themselves had to resort to some of the same tricks to keep the IB desks honest, like Coming in backwards, “spoofing”, leaving buy stops to get sell orders filled. The alternative for these clients was to put massive orders in the floor where liquidity was subjective, non continuous and information leakage was massive.

1997- Warren Buffet.

I got my chance to not get run over in 1997, when Warren Buffet gave an order to Phibro to buy silver.

Short version. Here is what went down.

Buffet gives Phibro the order- fact

Phibro begins filling it as a broker using various OTC dealers as counterparties, and letting the I.B dealers sweat getting out of the risk. - fact

Phibro buys options for their own account (no exercise game this time tho)- fact

Phibro buys futures for their own account. – not confirmed.

One by one the IB dealers start to catch on that this is no ordinary order Phibro is handling. They back away and liquidity gets harder to find.- fact

Other bigger hedge funds in the small circle of professionals, and other smart firms start getting long.- fact

Silver starts getting delivered from the Comex vaults. Some of it actually removed. Some of it just “covered with a sheet” for removal. But ounces begin to be removed from the warehouse. Phibro was rumored to be taking delivery and beginning to telegraph fear in the markets to start spoofing the VWAP. Rumor was they had a warehouse in Red Hook where they stored it. Never confirmed.

Point here is, the saps for the last part of this play were the producers and refiners who were complacently net short and dependent on above ground silver to satisfy delivery requests.

Producers had been over-hedging for years in this market, as silver was cheap and they had business cash flow issues. It was their habit to sell forward production not yet available to them. And if forced to, they would lease already above ground silver and make delivery, collateralizing it with silver yet to be mined. Their positions were habitually synthetically long the contango as they rolled their deliverable production further and further out the curve in an attempt to squeeze much needed cash (cost of carry)for their businesses. The net effect was that sometimes they had to borrow silver for prompt delivery while they rolled their production hedge back further. – my interpretation of what I learned. May not be accurate to the “T”, am not a physical guy.

Example: in 1995 a miner has silver due above ground in 1997. He hedges it in Z-1997 contract. Z 1997 comes and if he doesn’t have that silver available for some other reason; he covers the short and rolls it back. How much he needs to do this is a function of his obligations, cash flows, and his greed for carry. If leases are cheap, he will seek to capture all the contango and lease it until he gets the silver available.

If lease rates go up, it is not unlike a miner strike. Silver is needed for delivery now, and term risk becomes the issue. Contango collapses and market goes backwardated. He will be forced to sell the contango to get that prompt silver short back if he cannot make delivery. He has to defer delivery.

These guys were dependent on the specs NOT taking delivery for years . Specs didn’t have balance sheets to take and store physical metal. Specs usually were the weak hands at futures expiry.

. But then….. Entities that stored silver in bank vaults (like the Republic vault) begin to remove silver from the available pool for leasing. This made the “easy money” portion of production financing no longer easy. Think: smart money getting the word that a squeeze was on and playing along with it.

Phibro (and others) start selling the contango in the futures market to prepare to take delivery of even more contracts. Or at least put pressure on the producers who had front month shorts they would have to make a decision on delivering. Phibro KNEW that the producers had to sell the spreads to get their shorts back. But they couldn’t lift their shorts altogether as part of their financing deals with their bankers. Their own positions were now breaking down in every way except flat price. The market really didn’t move much. This let them stay in denial.

Buffet announces he is long and intends to take delivery of silver. Contango collapses. Market spikes to 7.40.

Rumor is gov’t intercedes and asks Buffet to not do this, it would break the industry. (Kind of like how the exchange begged the gov’t to help it shut down the Hunt Bros.) He says ok, and agrees to lend then their silver back to them. Essentially charging them 40% interest to delay delivery for a year.

What to look for:

Find the overleveraged/ extended party- and you will find the weak hand at the table. (Producers in 1997)

Tail wags dog: if the pricing venue trades smaller volume than the OTC, then manipulate price with small volumes to execute trades with big volumes favorably. (OTC vs Comex floor)

Divide and conquer- if counterparties are undercapitalized and/ or fragmented, then it will be easier to get them to move like a herd. (happens in options ALL THE TIME at expiration)

Manipulate data- take delivery of metal, take risk off books, manipulate MTM data.

Create an exit strategy- a good catalyst like Easter weekend, an announcement by an investor etc. or develop a market and grow your own bigger fool. ie – retail.

Comments - So many points to make here: