More Questions About The Silver ETF

January 28, 2008 – I received an interesting email the other day from Nick Laird, the proprietor of www.sharelynx.com. He brought to my attention an eye-catching year-end change in SLV, the silver exchange-traded fund.

According to the SLV website, 19.8 million ounces of silver were added to the fund on December 31^st, but it didn’t stay there long. The next day 17.9 million ounces were withdrawn. That’s 555 tonnes of silver.

Did that much physical silver really move in one day and then out the next? Or are some games being played at SLV?

I’ll address these questions, but first, some background. I analyzed the SLV disclosure documents in detail last year and wrote about my conclusions. My report, entitled “Unanswered Questions About the Silver ETF“, can be read at the following link: news.silverseek.com

I recommend that you read this report, but my basic conclusion was very clear: “If you own SLV or are planning to buy it, the guiding principal is caveat emptor.” There were for me enough loopholes in the disclosure documentation to suggest that contrary to popular belief, SLV is not fully backed by physical silver. This latest 555-tonne year-end shuffle reinforces my skepticism.

I question whether that much silver really moved in and out of SLV in one day. It is more likely that there was just some shuffling of paper. The physical effort to move that weight of silver is considerable, and unlikely to be accomplished in only one day. So let’s put this transfer in the best possible light.

Let’s assume that the silver was already in allocated storage at the vault, and merely transferred from the owner’s name to that of SLV. But why? What is the motivation?

I can’t think of any. The newly issued SLV shares can’t be used for margin, given that they existed for just one day. The only possible answer is that someone who owned physical silver (possibly a hedge fund) wanted to show on their balance sheet a tradeable security instead of physical silver for year-end window dressing.

But think about this for a moment. Why redeem the SLV shares and withdraw the physical silver the next day, and incur the cost? Clearly, the owner wanted physical silver instead of a share purporting to be backed by physical silver. The owner didn’t want the counterparty risk that arises from owning a share instead of physical metal, which clearly shows that SLV is not the same thing as owning physical silver.

This analysis puts SLV in the best possible light. The worst possibility would of course be that the 555 tonnes never existed, but SLV shares were nonetheless issued for one day. In this case, the shares were not backed by physical silver, but rather, just some paper promise by one of SLV’s so-called Authorized Participants who create and redeem shares. The soundness of SLV rests upon their capacity to come up with the silver if it is needed to meet withdrawals.

This practice would be akin to fractional reserve banking in the days when national currencies were defined as a weight of gold. Banks always held less gold in reserve than their total gold liabilities to their depositors. All was fine until the depositors became concerned about the creditworthiness of the bank and demanded their gold, which inevitably was far short of the amount needed to satisfy all depositor claims. Only time will tell whether SLV faces a similar fate.

There is one other point I would like to mention about SLV. It recently started reporting bar lists on its website. I could not find any explanation on SLV’s website clearly explaining what the bar list is supposed to provide. In the absence of any explanation, readers of the bar list are left to draw their own conclusions. Most interpretations I have seen inferred that the bars in the list are the ones owned by SLV, and more particularly, that they represent physical silver being stored in a vault. I have problems though with this conclusion.

First, why doesn’t SLV explain exactly what this new bar list is supposed to be? Why let people draw their own inferences? Is it because most people will draw the wrong conclusion or otherwise give SLV the benefit of the doubt? A bar list by itself is not full disclosure. Explanation is needed, which leads to the second point.

The bar list uses the term “allocated”, but there is no reason to believe that this term is being defined as we normally use that term. In fact, there is good reason to believe that it does not mean “allocated” in the normal way that term is used, which is that specific bars of precious metal are stored in a vault and are not encumbered in any way.

For example, in my report referenced above I write the following about the SLV prospectus: “in the glossary “Unallocated” custodial control of silver is defined, but allocated storage is not. Allocated is only mentioned within the definition of “Unallocated”, but allocated storage is not itself listed as a defined term, which is very odd for a fund that is supposed to own physical silver. Does this mean that the custodian is not restricted to any predetermined definition of “allocated”, so this term can mean whatever the custodian wants it to mean?” My point is that the word “allocated” on the bar list posted on SLV’s website may not mean what you think it does.

To reinforce this point, consider the lawsuit brought against Morgan Stanley and its storage practices that was settled last year.(www.investmentnews.com)

Morgan Stanley was selling ‘allocated’ gold to its customers, but they had their own definition of ‘allocated’, which was far different from the customary use of that term. It’s sort of like Bill Clinton telling the Grand Jury his guilt or innocence depends on what the definition of “is” is.

Third, and most importantly, the bar list is not audited. It has been my point that in the absence of an audit by an independent third party to prove that the physical silver exists and is not encumbered in any way, SLV buyers are accepting on blind faith that there really is unencumbered physical silver backing their shares.

Being trained as a banker, I for one cannot make that leap on blind faith alone. I need independent verification. I cannot understand why SLV does not have the metal audited, just as we do in GoldMoney and provide that audit to customers upon request. The absence of an audit defies reason, and therefore makes me wonder what SLV is trying to hide.

So my conclusion about SLV remains unchanged. When you own shares in SLV, you do not own physical silver, you own an equity that gives you exposure to the silver price. That makes SLV a trading vehicle, like a futures contract. SLV is not an alternative to owning physical silver.