(REDUX) On Physical Metal ETF Stock Loan Risk

The volume of content on the internet has always produced a conundrum - so much information but so little time to process it. A few astute readers (like Robert LeRoy Parker) noticed that Brian O'Flanagan recently dismantled his blog, and with it, Brian's articles written on the precious metals industry.

For the last 6 months Brian's blog has been on my reading list - primarily for the different perspective on silver and gold, but also because his content filled in the gaps I was missing from a metals trading perspective.

Recently some of the popular silver blogs discussed the mechanics of shorting silver, and some of the discussion made it into my digital scrapbook - specifically GG Turdle's email discussion with Ted Butler [link]. The reason I found the discussion significant is that I recognised this as the next phase of my SLV database research which would occur once the question of 'do-they-have-the-silver' was answered - namely the precise mechanics by which the alleged 1-ounce-of-physical for 100-paper-shares took place.

I'll be frank - this stuff confuses the heck out of me and I still don't completely understand it. But I do have a knack for sniffing out interesting stuff and can usually intuitively find the answers I seek even when I can't fully articulate it yet.

Brian's post was one of those explanations that I found useful and was intending on linking to it - unfortunately it has now disappeared from the internet! However, with permission from Brian I do reproduce the post here, where it will remain for future analysis and reflection ... primarily because I want to refer to it later (i.e. this is for me) but also because the discussion about the core matter didn't really reach it's zenith and because it's a good starting point for clues. And to the heart of the matter ... I want to participate in this precious metals bull market because it's amazing fun - but I don't want to have my market knowledge shaped solely by internet hearsay. To this end, I hope that Brian will continue writing in some form, and if he wants to use our forum he is most welcome to do so. Turd, reposting this here is not a dig at you, it is purely to keep the questions and debate running to help get a clearer picture of the metals markets.

--Warren

The below is some reproduced text originally written by Brian O' Flanagan (brian@aurumtradingllc.com) July 13th at his previous blog "Darien Wealth Strategies" (website now remodelled).

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On Physical Metal ETF Stock Loan Risk

A few weeks ago, a certain silver analyst published a report decrying the growing short interest in the Ishares Silver Trust ETF (SLV). His argument was in essence that because shares are being borrowed and resold into the market by short sellers, there were thus a large number of shares outstanding that did not have silver backing it. That article sparked a wave of outrage in the silver conspiracy community, causing some to even write letters to the CFTC and SEC, calling such action fraudulent, manipulative and a “violation of the prospectus”. While Gene Arensberg of the Got Gold Report make an excellent attempt to address this issue with a post “Record Net Short Position for SLV Rally Fuel?”, I’m going to talk a little bit more about what it means to holders of physically backed ETFs and the advantage of futures with respect to this risk.

First, a discussion of how stock loans and short sales work. In order to short a stock, one must borrow the shares from another holder and then sell those shares to the market. The person who lent their shares did so by approval - either by holding the shares in a margin account or otherwise giving their broker the right to lend their shares. In return for lending the shares, the holder gets cash collateral and a promise to return the shares on demand. In effect, the lender no longer owns the physical shares - they belong to whoever bought them. That’s the key point missed by the conspiracy bloggers - shares sold short do not create new shares. The original owner has only a derivative interest in the ETF - he has no voting rights and does not receive dividends directly (but does receive a payment in lieu from the borrower to cover the dividend). If for whatever reason the borrower cannot return the shares, the original owner only has a claim on the cash collateral.

Don’t believe me? Read some of the risk factors from Interactive Brokers regarding their stock loan program from the lender’s (stock owner’s) perspective:

Considerations and Risks

• Shares loaned out may not be protected by SIPC
  The Securities Investor Protection Act of 1970 may not protect shares loaned out. This is why under SEC rules IB must provide you with cash collateral in the same amount as the value of your shares to protect you in the very unlikely event that the stock is not returned to you.
  
• Shares loaned out are typically used to facilitate short sales
  Shares are attractive in the stock loan market because other traders want to borrow and sell them short, possibly affecting the value of the shares.
  
• Potential adverse tax consequences from receiving cash Payments in Lieu of Dividends on loaned shares
  When you lend stocks, you receive the full equivalent of all dividends. However, because you have loaned the stock, the cash you receive “in lieu of” dividends may be taxed as ordinary income instead of at the qualified dividend rate of 15%.² IB will try to return shares to you prior to a dividend to reduce or avoid any potential negative tax consequences.
  
• Voting rights go to the borrower
  During any period in which your securities are loaned out, you will forfeit your right to vote those shares by proxy.

The point here is that regardless of any conspiracy theories, the position is controlled by the stock owner. If he holds his shares in a cash account and does not agree to otherwise lend out his shares, he owns a share fully backed by metal. Alternatively, if he holds the shares in a margin account or agrees to lend his shares out and they are then lent out - he owns cash collateral and a promise from the borrower. Again, it’s the owner’s choice.

I have always been uncomfortable with stock loan risk - not from the standpoint of somehow ending up with an ETF share unbacked by metal - but from taking on counterparty risk for no reward. Sure, that is the price to be paid to get leverage in a margin account, but I’d rather just buy a futures contract. With futures, the contract is backed by metal in Comex warehouses, the counterparty risk is known (the clearinghouse) and one could get higher leverage (if wanted) at a lower implied cost (in most cases). But if I didn’t want leverage, I would own physical and/or a physically backed ETF in a fully-paid cash account only.

(Please note that this is for discussion purposes only and is not advice. There is a high risk of loss in trading futures and it may not be suitable for you. Please do your own research. Past performance is not indicative of future results).

Brian O' Flanagan (brian@aurumtradingllc.com)

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