Arbitraging the Precious Metals Space...without getting Physical...
- Precious metals are commodities just like oil, gas and agricultural products. As such, we can trade them via multiple security classes, including futures, options, funds and exchange-traded funds (ETFs). However, because investors trade these metals on global markets, price mismatches often arise. So, many investors use arbitrage to leverage mispricings for low-risk profits.
- Anant Jatia, the founder and CEO of Greenland Investment Management, specializes in systematic commodities arbitrage with an emphasis on precious metals. He says the fundamentals of commodity trading still apply; the main difference is that the Greenland team executes these trades with the latest high-frequency trading systems.
- How exactly does commodities arbitration work, and what should investors know before getting involved in this space? Anant breaks down concrete examples of typical trades from start to finish.
Commodities are in Anant Jatia’s blood. His grandfather founded an international commodity merchant business in the 1980s. Anant’s dad and uncle took that over. Now, 40 years later, Anant’s brother minds the family firm.
Growing up, conversations about physical commodity trading became “second nature,” says Anant, who is the founder and CEO of systematic commodity arbitrage management firm Greenland Investment Management.
“Terms like Cost and Freight [CFRs], bills of ladings and letters of credits are things that I knew of as a teenager — because we used to hear about all the real-world challenges that physical traders actually face as these conversations in the family business were ongoing.”
So even though he isn’t involved in the physical aspects of commodities trading today, he considers himself fortunate that he learned every facet of the trade (pun intended) when he was young.
“We can learn a lot from what goes on in those physical businesses and implement that in our strategies,” he says.
With at least $1 billion in assets under management and unpublished (but quite impressive) returns, Greenland’s work is “very differentiated and uncorrelated to what other systematic traders do,” says Moritz Seibert, the host of our new Top Traders Unplugged series, Open Interest.
As Moritz sees it, Anant (as a systematic commodities arbitration trader) uses Greenland’s formidable tech stack to find arbitrage opportunities across a number of commodity pairs and other pre-defined relationships — instead of basing his investment moves on fundamentals or discretionary analysis of one market versus another. Sometimes, Anant holds his commodities trades for days or weeks; other times, he scales up and down positions and exposures on an intraday basis.
But the basics are still crucial, Anant says.
“Our entire thinking and philosophies are still driven around the fundamentals of these markets; how different agents in these markets, whether it’s the commodity merchants, producers or consumers, might be thinking about holding or trading of these commodities,” he explains.
“And then we look to just apply a systematic decision-making process on how we go around betting on these fundamentals that we’ve looked to model and then trade it in this best-execution manner through these high-frequency trading [HFT] systems.”
Anant joined Moritz for a wide-ranging, highly technical, challenging yet enlightening episode to discuss Greenland’s evolution from currency market-making to HFT-driven commodities arbitrage as well as how this kind of trading works, using hypothetical but realistic, plausible examples. Read on for highlights of their conversation about the basics of commodities arbitrage.
(Gold) nuggets of wisdom
Moritz proposes that Anant walk us through a straightforward example of a location arbitrage trade: arbitraging the price of gold or gold futures in one location versus the price in another location; say, COMEX gold versus Shanghai gold.
Anant says that first, we must identify whether the quality of gold on different exchanges is fungible — that is, the same grade of gold. We also need to consider whether the gold can be picked up from one location and delivered to the other — and how much it will cost.
“If I have gold in a vault in London or in New York and I want to ship it to Shanghai, what’s that end-to-end cost going to look like?” he asks. “You’ve got to price the gold in Shanghai in appropriate currency-adjusted terms because the local gold there trades in RMB. You have to price it appropriately in USD, taking into account when you would actually be converting your USD to RMB — or when you would receive RMB for delivering your gold into China.”
Then, we would have to decide whether an excess spread is available, given the pricing differentials across the two markets — “if net of this end-to-end logistics costs,” Anant adds.
In this example, if Shanghai gold trades at a premium (after logistics costs), a genuine physical arbitrage might be possible for a gold importer in China willing to physically make the arbitration.
“That’s really what we’re going to look to bet on,” he explains.
“So we’re going to go short on Shanghai. We’re going to go long on the global gold market, whether it’s London or New York that we’re pricing against, and look at what that pricing differential is,” he adds.
Let’s not get physical
From a “first principles philosophy,” this hypothetical arbitrage opportunity is very real even in our increasingly digital world. The crux of this bet is that when physical gold traders move inventory into Shanghai, they won’t just increase the supply in Shanghai. They’ll reduce the supply offshore and push the gold market back into equilibrium, which causes “convergence of the spread to eventually play out.”
Anant says that while Greenland “expresses its views” through the paper markets or the derivative markets — the underlying function it performs as a firm is betting on physical players’ ability to perform the arbitrage, given a particular scenario of relative pricing across two or more markets.
Moritz remarks that Greenland’s activities are akin to taking positions in futures markets: “You wouldn’t be seeing the trade to its end, or see it through on the physical side, right?” he asks.
“In this example,” Moritz continues, “the Shanghai-based physical gold dealer may actually be taking advantage of the arbitrage opportunity by engaging in a physical arbitrage trade; actually ordering the gold from New York or London, having it shipped, paying for the freight, having it arrive in Shanghai where the local business needs it. … Essentially, they were able to source it for a cheaper price. But you don’t go through all of that trouble. You take the position in the futures markets and you wait for that spread to close and narrow and come back into equilibrium for preferred pricing.”
Anant confirms that’s correct.
“We’re not looking to actually hold or ship the physical gold,” he says, noting that given his family business, Greenland could do that legwork — but it’s not part of any of its investment programs.
Intel is everything
Because Greenland relies on commodity merchants to physically perform trades and get markets back in equilibrium, Anant and his team are “very sensitive to events that might disrupt that particular trade flow of that commodity,” he explains. “So the arb only works, or that spread only converges, if physical traders can actually physically move that material and take advantage of that excess return — and that there are enough of those physical players, such that enough inventory can move over to address the excess demand, [such as] the Shanghai market in this example.”
Moritz points out that gold has a “very stable forward or futures curve — it’s essentially a funding trade. It doesn’t have the backwardation, contango dynamics or seasonal dynamics that some other commodities, say the agricultural commodities, have.”
He asks Anant how they determine whether gold and other precious metal trades are attractive — does Greenland keep track of the costs of air freight and insurance premia?
Definitely, says Anant. Without an understanding of the storage, transportation and security costs inherent to the physical commodity (as well as any other market intelligence), Greenland can’t accurately predict risk and reward.
“We do actively track on a daily basis what the insurance premiums are and what the air freight is for transporting the gold across each of these routes that we care about,” Anant explains. “We price what the cheapest delivery path for the gold is going to be — and that’s what we’re going to look to define as our fair values. But as you said, because gold trades a lot more like a currency than a pure commodity — very differently from agricultural commodities — the spread that we’re looking to trade or the volatility of that spread is quite muted.”
That’s why most of the time, the precious metals arbitrage game doesn’t feature huge deviations.
“You’re really going to play for some BIPS [basis points] when you’re looking to take advantage of the spread movements across that fair value,” Anant adds.
That’s where the HFT technology comes in. High volumes and high speeds are the keys to making small margins pay off over time.
I’m not surprised: As (almost) always, algorithms are the answer.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.
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