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Federal agents are probing JPMorgan Chase’s silver trading activity in order to determine if the bank used derivatives to artificially lower the price of the precious metal.

Part of a larger problem

It is estimated that JPMorgan holds up to 40% of the world’s silver short.  If this is true it is certainly indicative of price manipulation as JPMorgan doesn’t possess 40% of the physical silver.

Derivatives played a large role in the market collapse that began in 2006 that was largely blamed on subprime loans.  Because these mortgage backed securities, credit default swaps and other instruments weren’t on exchanges there would be a very wide difference between the bid and ask (or the spread), especially during market volatility.

This could lead to huge price swings in the instruments, making holders uncertain what the true value really was.

Light must be shed

When reflecting on this opaque market’s role in recent events it’s clear that something must be done.  We need more transparency with derivatives.

They should be traded on open exchanges where they can be settled every trading day.

Shorting silver

The reason silver (and to a large extent gold) have been shorted is to artificially depress the prices of precious metals vs. the prices of stocks and bonds, helping to hide the true effects of inflation.

In fact, using these derivatives to add liquidity to their balance sheet by shorting silver, it’s likely that JPMorgan would use that cash to invest in stocks and US Treasury bonds.

Bribing Washington

Wall Street sends $500 million to Washington every year, using lobbyists to shape the opinion of lawmakers.  There is also a shameful revolving door between government and the private sector that often hinders regulators from employing their full might.

Consequences of manipulation

The DOJ and CFTC are looking at both civil and criminal charges as the investigation continues.  They are examining trading tickets and other information.  I expect the probe may expand to other assets, too.

It is possible that the firm will be fined, but I’d be very surprised if anyone goes to jail.

Since the SEC eliminated the uptick rule on July 6th, 2007 there has been a marked increase in volatility.  Of course other factors significantly contributed, but in all likelihood with the uptick rule in place, selling would have been more controlled and orderly.

Another Black Thursday

After the most recent Black Thursday on May 6th the market dipped almost 1,000 points because of what the exchanges claim were computer errors (and probably the bid disappearing because market makers were running scared), it’s time to look at reinstating the uptick rule.

Black Thursday resulted in many investors losing money, including retirements and pensions. Whether it was a computer event, human error or some combination of both the fact remains that a rule to prevent short selling without first an uptick in prices would have curbed losses.

History of the rule

The uptick rule was originally enacted in 1938 as a response to concentrated short selling.  It forbid short selling a stock unless there was first a positive tick in prices.

Short sellers today claim that the rule was largely symbolic and only affected a few exchanges.  They’re right, it was not broad enough and regulation did not keep up with the way markets changed.

A better rule needed

The new uptick rule should affect all US stock, options, forex and futures exchanges to ban short selling except on an uptick in prices.  This would, in effect, buffer investors and exchanges from the cataclysmic stock market losses that we saw on Black Thursday.

Another benefit is it would force the computerized programs to, by law, have protection mechanisms built in to prevent endless selling.

Regulators must regulate

Now that the carnage that’s only possible without more balance in the market has been witnessed, it’s time for regulators, like the SEC and CFTC, to stand up and enforce existing regulations more stringently and insist on new regulations, such as a new and improved uptick rule.

Yesterday at about 340pm, the US government, through Geithner’s treasury department, leaked a plan that will allegedly help distressed mortgage borrowers lower payments.  The plan boosted the mood, forcing end of day short covering, raising the S&P 500 back to a key resistance level around 835.

Today is the last trading day before a three day weekend.  We could certainly see an increase in volatility as a result.  Mr. Geithner’s department leak seems to have been strategically delivered to stave off another leg down.  Yesterday we were testing the 813 level of support, which looked to be giving up as the S&P traded as low as 810.  After 813, the last major support is 800 before we look at the November ’08 lows in the face again.

Nonetheless, significant technical damage is being done.  The Dow Jones industrial average made a new multiyear low yesterday, the transports continue to sag and the only index with promise, the Nasdaq, seems to be finding less buyers lately.

The VIX has bounced off the 20 day moving average after briefly testing it earlier in the day.

We saw it hit the top bollinger band, as we have many times in the past.  Each time it reverts to the 20 day moving average.  Once there, it reverts to a higher high.  Today’s earnings disappointments from GOOG, MER, MSFT and opening up with C’s likely bad earnings seems a setup for more losses.

 Every financial was oversold, and every financial rallied.  Seems to me the most logical course now is to continue down.  Most shorts in the oil market will cover before the day is over.   Fridays are tough for equities because no one feels like they are safe in the market over the weekend.   Should play out well for our positions.