April 16, 2020 - (Gold Market Wire) - Today will start with some wry market wit:

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How can you be naked if you have shorts on?

Ok, that was it.

The subject of 'naked shorts' in the Gold market, or any market for that matter, has exercised the Gold market commentariat so much that I felt it was time to chime in with, yes, another explanation. This time my own observations. In this first part of the two part series, we need to look at the basics of commodity trading as a business and why the specter of a "massive naked short in the market" needs to be disabused. Then we will move on to what exactly a naked short is, and what a covered short is.

At the outset of the “naked shorts” story, it would help everyone immensely if they would remember one thing above all: The Commodity trading business is a high volume, low margin game. It is not the reverse, and it most certainly not a high volume/high margin game, which those who profess to know JP Morgan's trading book imply. The idea that JP Morgan simply runs a “naked short” position in Gold and Silver doesn't hold water.

Perhaps the most incisive, initial, counter to this argument is the one that comes from Bob Moriarty, when he says that JP Morgan's Gold position is so insignificant to the firm it is what they “use to tip the shoe-shine boy” with. That is doubtlessly true.

JP Morgan, as an entity, really doesn't care much about Gold, because its such a small part of their operations. That said, they make money in Gold by charging fees on all commodity transactions and neutralizing the risk parameters to protect those fees. A 3% transaction take, maybe to include the sale of imbedded derivatives and potentially storage fees is a nice profit for what amounts to money for old rope, as the saying goes. In one transaction JP can take 4-7%. If you 'round turn' that in a year you've done very well indeed. Banks like JP like doing trades because it makes them money in fees. Not because it lets them add to positions.

Although everyone may hate to hear it, Blythe Masters wasn't lying when she said the JP Morgan Gold book was a “matched book”. It is. JP Morgan does transactions and lays off the risk. (I've personally done many of these commodity trades with them.) They don't warehouse these things on the book. What would be the point? If a trader at JP held a massive position and it went against them, senior management would close them down fairly quickly. Anyone who has watched “The Big Short,” intelligently, can see this. Management might let you wear risk for a little while, but if it starts to move against you, or the carry starts to dig away at the position, they will shut you down. That is, of course, if management can see what you're doing and if management actually knows what you are doing. That is not always the case.

In the world of OTC Derivatives we have located the magical land of thinking you are making money when you are not. This is the infamous Howie Hubler trade in Mortgage Backed Securities at Morgan Stanley. He started selling AA and A CDO's to cover the losses that time premium was exacting (carry) on his short BB and BBBs. (The mistake was in failing to recognize that they would all fall simultaneously and not in an orderly fashion as their ratings would imply.) And it is true that the above can also be amended to 'you can take risk, but if it goes against you, you can then neutralize the risk by performing further transactions that in fact, unknown to your MD (who you've convinced of the opposite) actually amplify the risk, because no one can model the risk you've taken any longer in the convoluted set of bespoke trades you've done.' That's why complexity rules and is everywhere in the world of OTC derivatives. Terms and Conditions can be made up on the fly, like “Hey can we embed a lock-out (option) strangle into this deal that triggers if it rains more than there days in row at Gatwick airport?” Don't laugh, these deals used to be done.

Management wants risk free money, or, at least, money that has been made through risk that is taken for a short period of time. That is why, as one great OTC broker told me early in my career, “These people aren't traders' they're back-to-back artists.” (a back-to-back is when you get someone to pay the wrong price, because the discovery mechanism is clouded. You have the right bid, the other guy doesn't … Boom Boom - - free money.) No OTC trader likes transparency – it ruins his/her margins. The game is to charge fees and get great back-to-backs on, which really amounts to (almost) the same thing – risk free money. The free trade is what all bankers seek. Not a massive short which could hurt if the market ganged up on them. Serious position taking, banks reason, is for fools, and there still seem to be enough of them around, so they're happy to take the other side and then lay off the risk. They don't really do “naked shorts.” But they can do “derivatives gone wrong” like Hubler.

However, none of this means there is a massive “naked short” position somewhere in Gold. Or, as Jim Sinclair opined to the world of Gold commentators years ago, “Wake up! You've all been had... it's a long cash/short gold futures position that makes it look like the largest short in history.” The long cash position is OTC, so no exchange or regulatory body reports it. That means the public can't see it. As Sinclair rightly pointed out, when the Gold fever got hot enough in the 1970s, like the last year of the rally, management of the big houses let the short futures side matched to the long cash side melt away for a few months, and that was the parabolic move.

Sinclair also ran a matched book during the '70s bull market, although it was a bit of a chaotic one. He was long futures and short physical around the world. If you only looked at his futures position he appeared “naked long”, but he wasn't. At the end he turfed the book out to Mocatta, who then booked it out. He could have easily gone (naked) short the market at that time and made a killing, as his long futures position was one of the biggest in the market – but he was no fool. The authorities would have fried him, and sent him to jail for 20 years. Instead, he bought a 47 room house on a 300-acre lot in Scarsdale, New York... all with a matched book. Did he push the long positions beyond perfectly matched? Most likely, in some periods. But he was not “naked long” for the whole ride.

And herein lies the basic stumbling bloc over the term “naked short”, or “naked long” for that matter.

Semantics.

In Part II we will explain the mechanics of being “naked” or “covered”.