With the talk of COMEX possibly defaulting on gold deliveries I was curious what happens. Now I know that if the contract holder wishes physical delivery, COMEX will deliver the gold and if it doesn’t have gold it can settle in cash. But what happens on the other end. If I write a July gold contract for 100 oz then
Am I expected to deliver 100 oz to COMEX or the contract buyer?
If July shows up and I don’t have the physical gold for delivery, what happens to me? I’m assuming COMEX doesn’t say, “That’s cool. We’ll cover it for you. Don’t worry about it”
Just going by general contract theory, the contract should specify what happens if one party does not perform. If there is no specification, or if the counterparty fails to abide by that part of the contract as well, the party expecting performance goes to court and tries to get things their way ordered by a judge. With a judgment against the other party they may be able to seize assets.
But what really happens is that no one wants to trade with you any more.
In general, in futures contracts, the original agreement between the buyer and seller is novated so that the exchanges clearing house is everyone’s counterparty, so definitely on your end the contract buyer is not involved.
I’m assuming, based on other futures contracts, that the exchange takes your collateral, and kicks you off the exchange forever.
From the sound of it, if you are the kind of trader who is going to physically delivering gold, you already have gold in one of the exchanges depositories, and are just passing a warrant on that gold around. So if you are expected to deliver gold, you actually need to acquire one of these warrants on the spot market if you don’t have one.
But if you are trading on the exchange at all, the exchange (or rather, whichever clearing house member you or your trading institution works with) has demanded enough colateral of you that it can perform for you even if you don’t deliver.
And that’s my question. What does the COMEX agreement say if you don’t deliver? Settle in cash? Something else? And if you don’t deliver do you get a warning? Banned from writing contracts?
The nearest thing I know is the story a fellow student told me back around 1960 about his father, a stock speculator who got caught unknowingly in a proxy fight for control of a company. He saw the price rise way beyond the inherent value of the company and started shorting it. When the time came to cover the short he simply couldn’t. Well, I suppose with unlimited money he could have. Eventually he settled for some gigantic amount and got out of stocks and into commodities trading. One day the same student came in and announced that his father had just bought 144,000 dozen eggs.
Every brokerage firm has a process where they will make sure you are out of a futures contract, either long or short, well before physical delivery becomes possible. If you don’t take yourself out, the brokerage firm will close the position for you.
If there is an intent to actually buy to or sell gold, then there’s paperwork that the party will fill out in regards to which depository the gold is currently stored at or where it will be stored at. My cousin Bubba is sitting on gold bars in the shed with a shotgun in his hands or drop off the gold bars like it’s an Amazon delivery won’t work.
Keep in mind that the contra parties on a futures contact don’t know who they are.
The problem is that contract holders want to take delivery of the gold and from the news COMEX doesn’t have it and will settle in cash. How is that possible if every contract writer has a warrant? What happens if the seller doesn’t have the 100 oz and what are the repercussions for them? I’m not discussing the receiving of gold that is there.
It has been decades since I did this, but the way I remember, the seller controls the delivery process. The seller MAY indicate after First Notice Day that they intend to deliver. If they still hold the contract after Last Trading Day, they MUST indicate their intent to deliver.
If they don’t? I dunno, their clearing member sues them?? Or their clearing member makes sure beforehand that they hold the needed warrant?
To emphasize, the Rulebook has whole sections on failure to pay, delivering substandard gold, etc. But I can’t find (right now) where it says what happens when a seller simply fails to render the notice to deliver. Is that another chapter of the Rulebook? Or just general contract law?
It only says “you must do it”. It doesn’t say “… or else”. Let alone what else.
I am also interested in the OP’s question. In particular, what’s the risk that the buyer doesn’t get the gold they are expecting to get, due to nonperformance of the seller?
Investopedia article on failure to deliver. It says it’s bad. Plague and famine, death and destruction, cats and dogs lying together. It also says it has happened on occasion. It doesn’t say in so many words WHAT happens to the perpetrator.
I think I got it. So it sounds like the current COMEX crisis is something like this.
<contract writer> I’ll sell this contract and buy it back later. That’s what happens 99.4% of the time. It’s just paper gold. A while later
<contract buyer> I’ve decided I actually want the physical gold. Can’t wait for delivery.
<contract writer> Oh sh…!
Yes, I actually remember that happening this one time in Silver contracts. I think nineties or early 2000’s (not the Bunker Hunt thing). Some fund or big speculator unexpectedly took delivery on a large number of long futures. They agreed to accommodate the sellers by offering to be a little flexible. Unfortunately can’t find any cites or details.
The Jun Gold contract will stop trading on third last business day of Jun. Say it finally settles at $1750. Any short still holding an open position must deliver 100 ounces per contract to a long (the exchange will pair them with) during July in return for $175,000 per contract from the long. If the short can’t deliver come the end of July, the long can go out and buy 100 ounces per contract in the market. Say that costs by then $185,000 per contract. The short must pay the long the extra $10,000 per contract. If the long can by then buy the 100 ounces for $170,000/contract, then they actually gain from dealing with somebody who couldn’t deliver.
If the short can’t come up with money required to make the long whole, that’s in the same general category as long or short not being able to come up with variation margin at each daily settlement. It comes first out of the initial/maintenance margin (collateral) they placed with the exchange, but then potentially costs the exchange money if the shortfall is big enough.
But outsiders like retail investors trading gold contracts are generally prohibited by their clearing brokers from holding physically settled futures positions till expiry. The fine print of your agreement with the broker will allow them to trade you out of a position in a physically settled contract at some deadline before expiry if they haven’t received a specific order from you to do so. So failure to deliver would usually only happen when exchange members had a good excuse for it happening, rarely. If not I suppose they might eventually get kicked out as members.
I think this misses the fact that the original contract buyer is not connected to the seller after the original exchange, since the contract is novated into two contracts where the exchange is the counterparty (i.e. a contract to deliver gold to the exchange by the original contract writer, and a separate contract to receive gold from the exchange to the original contract buyer).
So the original contract writer doesn’t have any risk of being on the hook to deliver the gold just because the original contract buyer wants physical delivery. The exchange has some risk that a lot of buyers will not perform and it won’t have enough gold, or collateral to buy gold, to do its own deliveries.