The Commodity Exchange, or COMEX, acts as the primary exchange for the trading of precious metals futures contracts. The exchange guarantees that if a futures buyer wants to take delivery, the amount of gold or silver indicated on the contract will be delivered. Some traders worry -- and others hope to profit from the fact -- that the number of metals futures contracts often exceeds the amount of metal listed as available for delivery.
Futures Markets Drive Price Dynamics
Precious metals futures contracts that trade on the COMEX offer a very liquid and low-cost way to trade the price of gold or silver. Traders buy contracts to profit from rising prices, or contracts can be sold short if a trader thinks the metal will fall in value. The fact that COMEX precious metals futures trading is so active makes the futures prices the driving force concerning changes in the actual price of an ounce of gold or silver. If a trader hold a futures contract until it matures, he will either take delivery of or must deliver the amount of precious metals specified by the contracts. Standard futures contracts call for the delivery of 100 troy ounces of gold and 5,000 ounces of silver.
Precious Metals on Deposit
In most cases, a trader closes out futures positions before maturity to book a profit or loss in his commodity trading account. However, if a trader decides to hold contracts to maturity and take delivery of the specified amount of metal, the Chicago Mercantile Exchange, or CME -- owner of the COMEX -- keeps significant amounts of gold and silver on deposit for delivery to any futures trader who wants to turn a futures position into physical metal. For example, at the start of 2014, the CME website showed about 8 million ounces of gold and 175 million ounces of silver on deposit with precious metals storage companies that could be delivered against exercised futures contracts.
Low Probability of Default
The gold and silver represented by the number of open futures contracts significantly exceeds the amount of precious metal the COMEX has available for delivery. To prevent a run of delivery requests, the exchange puts a limit on how many contracts a single trader or organization can hold at any one time. The limits prevent a small number of traders from pushing the COMEX to the point that it cannot deliver gold or silver and must default. Another factor concerns the small amount of money needed to trade futures vs. the value of the metal that must be paid for to take delivery. A gold futures contract can be held with an $8,000 margin deposit, but it would cost more than $120,000 to take delivery of the 100 ounces of gold specified by the futures.
Gold and Silver Bug Fears Unfounded
Investment fans of gold and/or silver say there is enough potential for COMEX to default on delivery and that at some point, the prices of precious metals must go much higher. According to the imagined scenario, a large number of futures contracts presented for delivery would force the COMEX to go into the spot market to buy the metal it needs to deliver on those contracts. The extraordinary demand would quickly push gold or silver higher, forcing the COMEX to default when it cannot afford to pay for or even find the gold or silver it needs to fulfill its contractual obligations. However, the nature of futures contracts and the COMEX rules make this outcome very unlikely and -- according to one silver value expert interviewed by the TF Metals Report -- it is possible that the futures exchange could just elect to settle contracts in cash in a worst-case scenario.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.