Financialization and Broken Markets

As Fridays go, it was busier than most. Back-to-back team and client meetings. Between meetings I would run back to my office, try to catch up on emails, and gauge the world through the TV in the corner of my office running CNBC on mute. Silver was getting clobbered — and I mean clobbered. After my morning meetings going into lunch, it was down about 25%. The precious metal has exploded in value over the last year, up about 300%. I found myself distracted by the trading action.

When I came out of my next meeting, the blood bath had deepened. My interest now went beyond curious to tactical. I called my teammate Jonny at the St. John office. "You doing anything with silver today?" I asked. "Nope, just watching it get killed," was his response. I decided to stage an aggressive derivatives-based silver trade in my online play money account. If silver recovered, I would make good money. If it didn't, I would lose the entire investment. Please don't do this.

I entered the order. Immediate rejection. I tried again. Immediate rejection. After navigating through a chat robot, a real human came on: "These orders were rejected on the exchange level due to unusual trading action in the underlying commodity." I had five minutes until the market close. I switched tactics — the order didn't reject, it just didn't fill. The market closed, the weekend arrived. Down the rabbit hole of financialization I went.

We all know silver is a real thing. It is utilized prolifically in modern electronics and industry. But financial markets trade silver in a variety of methods — futures contracts, options contracts, and exchange-traded funds — all conducted on the assumption no real silver will ever actually change hands. These traders rely on cash settlement, which has enabled financial markets to determine silver prices independent of any actual silver. And once something can be securitized, it can be leveraged through borrowing and derivatives.

Various estimates published by research firms online indicate between 250 and 350 ounces of financial silver is traded for every one ounce of physical silver. I've never actually heard of any other leverage ratio like this. It seems like lunacy to me — and on that Friday, lunacy broke the silver market. I've only experienced broken markets a couple of other times in my career, and none of them ended well. I simply want to encourage anyone active in these markets to work on understanding these risks. There may be a lot more going on here than is easily apparent.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The fast price swings in commodities will result in significant volatility in an investor's holdings. Commodities include increased risks, such as political, economic, and currency instability, and may not be suitable for all investors.

Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.