Physical Trading

# Physical Trading in Silver and Precious Metals ## Opening Hook When silver prices crashed to $12 per ounce in March 2020, physical silver dealers faced an unprecedented crisis: futures contracts were trading at steep discounts to physical metal, with some dealers charging premiums of $8-10 over spot price for basic silver eagles. This **basis dislocation** between paper and physical markets revealed a fundamental truth that every serious precious metals investor must understand—the physical trading market operates by entirely different rules than futures or ETF investing. > As of 2024, over 19 million ounces of gold and 170 million ounces of silver are transferred daily in London's physical markets alone, representing transactions worth approximately $38 billion daily across both metals. The physical precious metals market represents the foundation upon which all other precious metals investments are built, yet it remains one of the most misunderstood aspects of metals investing. Unlike buying shares of a mining company or futures contracts, physical trading involves actual possession, delivery, storage, and authentication of metal—creating unique opportunities and challenges that can make or break investment returns. ## Core Concept **Physical trading** refers to transactions involving the actual purchase, sale, and delivery of precious metals in their tangible form—bars, coins, rounds, and industrial forms. Unlike paper investments that represent claims on metal, physical trading requires handling the actual commodity, with all the logistical complexities that entails. The modern physical precious metals market evolved from the ancient gold trading centers of London and Zurich. The London Bullion Market Association (LBMA), established in 1987, now oversees the world's largest physical precious metals market, operating on a private, over-the-counter basis without a central exchange. This **decentralized structure** means that unlike stock exchanges, there's no single clearing house or standardized trading platform—instead, transactions occur through a network of authorized dealers, refiners, and market makers. Physical trading operates on several distinct levels. At the **wholesale level**, transactions typically involve large bars meeting specific purity and brand requirements. London Good Delivery gold bars weigh approximately 400 ounces each and must be 99.5% pure minimum, while silver bars in wholesale markets typically range from 1,000 to 5,000 ounces with 99.9% purity. These bars carry specific serial numbers, assay certificates, and provenance documentation that affects their tradability and value. The **retail physical market** encompasses smaller denomination products designed for individual investors: one-ounce gold coins, silver eagles, maple leafs, and bars ranging from one gram to 1,000 ounces. This market operates with different dynamics than wholesale trading, including higher premiums over spot price, longer delivery times, and additional authentication requirements. A critical distinction exists between **allocated** and **unallocated** physical holdings. Allocated metal means specific bars or coins are segregated and identified as belonging to the investor—you own particular serial-numbered pieces. Unallocated holdings represent claims on a pool of metal, similar to a bank account where you own the rights to a certain amount but not specific pieces. Many perceived "physical" investments actually represent unallocated positions that carry counterparty risk. The pricing mechanism in physical markets involves several components beyond the spot price seen in futures markets. The **spot price** represents the current market value for immediate delivery of metal, typically derived from futures prices. However, physical buyers pay additional **premiums** that vary based on product type, quantity, dealer margins, fabrication costs, and supply/demand imbalances in specific products. ### Historical Development and Market Structure Physical precious metals trading predates modern financial markets by millennia, but the contemporary structure emerged in the post-Bretton Woods era after 1971. When President Nixon ended dollar-gold convertibility, precious metals transformed from monetary instruments to investment commodities, creating the modern physical trading infrastructure. The London market's dominance stems from its role during the gold standard era and its continued function as the global center for precious metals financing. London's **fixing process**—now administered by ICE Benchmark Administration—establishes twice-daily reference prices used worldwide for physical transactions. This electronic auction process replaced the historical room-based fixing in 2015, improving transparency while maintaining London's central role. Major physical trading centers have evolved regionally: London dominates global wholesale markets, Switzerland serves as the refining and storage hub, Hong Kong facilitates Asian trade flows, and New York (through COMEX) provides the primary futures-to-physical conversion mechanism. Each center has developed specialized infrastructure for different aspects of physical trading. ## How It Works Physical precious metals trading involves multiple steps and participants, each adding complexity and cost but also providing essential services. Understanding these mechanics is crucial for making informed decisions about when and how to engage with physical markets. ### The Trading Process Physical transactions begin with **price discovery**, which differs significantly from stock or bond markets. Since there's no central exchange, dealers quote bid-ask spreads based on their inventory, funding costs, and risk assessment. A typical gold dealer might quote "$1,950 bid, $1,955 ask" per ounce, meaning they'll buy at $1,950 and sell at $1,955. These spreads widen during volatile periods or when dealing with less common products. **Order placement** requires specifying exact products, quantities, and delivery preferences. Unlike buying 100 shares of stock, purchasing physical metal involves decisions about purity, brand, delivery location, and settlement timing. A wholesale buyer might order "10 LBMA Good Delivery gold bars, assay weight approximately 4,000 ounces total, delivered to Brinks London" while a retail buyer orders "20 American Silver Eagles, current year, shipped to home address." The **authentication and verification** process is critical and time-consuming. Reputable dealers verify product authenticity through multiple methods: visual inspection, weight and dimension measurement, electronic testing for purity, and verification of serial numbers and assay certificates. This process can take hours for large wholesale transactions or days when dealing with unusual products or unclear provenance. ### Settlement and Delivery Mechanisms Physical settlement occurs through several mechanisms depending on transaction size and customer preferences. **Vault-to-vault transfers** handle most wholesale transactions without metal leaving secure storage facilities. When a pension fund sells gold to a sovereign wealth fund, the transaction might involve changing ownership records at a London vault while the metal never moves physically. For transactions requiring physical movement, **insured transportation** becomes necessary. Specialized carriers like Brinks, Loomis, or Malca-Amit handle precious metals shipments using armored vehicles, specialized aircraft, and comprehensive insurance coverage. These services typically cost 0.1-0.3% of shipment value but provide essential risk mitigation. **Retail delivery** involves additional complexity and risk. Domestic shipments under $10,000 value often use registered mail or private carriers with signature requirements. Larger shipments require specialized courier services with full insurance and chain-of-custody documentation. International shipments involve customs declarations, import duties, and compliance with money laundering regulations. ### Storage and Custody Options Physical trading necessitates secure storage solutions. **Allocated segregated storage** provides the highest security level—your specific bars or coins are identified, segregated, and regularly audited. Leading facilities like Brinks, Delaware Depository, or Switzerland's Via Mat charge annual fees of 0.5-1.5% of metal value but provide comprehensive insurance, audit reports, and easy liquidity when selling. **Allocated non-segregated** storage pools metals from multiple customers while maintaining individual ownership records. This reduces costs to 0.3-0.8% annually while still avoiding counterparty risk. However, liquidation may require additional time if specific pieces aren't readily available. **Home storage** appeals to some investors seeking maximum control but involves significant risks and limitations. Homeowner's insurance typically covers only $1,000-2,500 in precious metals, requiring separate valuable items policies costing 1-3% annually. Home storage also complicates eventual resale, as dealers may require additional authentication before purchase. ### Documentation and Compliance Physical trading generates extensive paperwork requirements. **Chain of custody documentation** tracks metal from initial refining through each ownership change. This includes refiner certificates, assay reports, transport records, and storage confirmations. Gaps in documentation can significantly impact resale value and marketability. **Tax compliance** varies by jurisdiction but generally requires detailed record-keeping. In the United States, precious metals sales above certain thresholds trigger Form 1099-B reporting requirements. Sales of specific products—like 25 or more ounces of gold coins or 1,000 or more ounces of silver coins—require dealer reporting regardless of total value. International transactions involve additional customs and anti-money laundering compliance. ### Exchange for Physical (EFP) Mechanisms The **Exchange for Physical (EFP)** market provides crucial linkage between futures and physical markets. EFP transactions allow futures positions to be converted into physical metal or vice versa. This mechanism proved critical during March 2020 market stress when physical delivery demands nearly overwhelmed COMEX's delivery system. EFP pricing reflects the **basis** between futures and physical prices, incorporating storage costs, financing rates, and supply/demand imbalances. During normal conditions, EFPs trade at modest premiums or discounts to futures prices. However, during market stress, EFP premiums can spike dramatically—reaching over $70 per ounce for gold and $3 per ounce for silver during 2020's supply chain disruptions. COMEX offers the world's largest precious metals EFP market, with over 1.25 million ounces of gold and silver trading daily through these mechanisms. Understanding EFP dynamics is essential for large-scale physical traders who need to manage price risk while arranging physical delivery. ## Real-World Application ### Case Study 1: The March 2020 Physical-Futures Basis Explosion The COVID-19 pandemic created the most dramatic physical-futures basis dislocation in modern precious metals history, demonstrating both the risks and opportunities inherent in physical trading. On March 9, 2020, silver futures closed at $16.12 per ounce while retail dealers were quoting American Silver Eagles at $23-26 per piece—a premium of nearly 50% over futures prices. This massive dislocation occurred due to several converging factors. First, **supply chain disruptions** shuttered major mints including the U.S. Mint, Royal Canadian Mint, and Perth Mint for weeks during lockdowns. Second, **transportation restrictions** severely limited precious metals shipments between countries and regions. Third, **retail demand surged** as investors sought tangible assets during unprecedented monetary policy responses. The situation created extraordinary opportunities for sophisticated physical traders who understood the mechanics. Traders with existing physical inventory could sell at massive premiums while simultaneously buying futures contracts to hedge price risk. One documented case involved a Texas dealer who sold $2 million in silver inventory at 40% premiums over spot while buying COMEX futures, locking in profits of over $600,000 in two weeks. However, the crisis also demonstrated physical trading risks. Many retail dealers ran out of inventory entirely and stopped taking orders for weeks. Customers who had placed orders before the crisis faced month-long delays and, in some cases, order cancellations when dealers couldn't source product at quoted prices. Several smaller dealers filed bankruptcy when locked-in pricing commitments became unsustainable. The recovery process illustrated how physical markets eventually converge with paper markets. By June 2020, mint operations resumed, transportation normalized, and retail premiums contracted to more typical 15-20% levels. However, the entire episode reinforced that physical and paper precious metals are distinct markets with independent dynamics during stress periods. ### Case Study 2: The 2011 Silver Hunt Brothers Echo During silver's spectacular rise to nearly $50 per ounce in April 2011, physical trading markets experienced dynamics reminiscent of the 1980 Hunt Brothers manipulation, but with modern market structure differences that created unique opportunities and risks. Between September 2010 and April 2011, silver prices increased 170% while physical premiums remained surprisingly stable. One-ounce American Silver Eagles traded at premiums of $2-3 over spot throughout most of the rally, indicating adequate physical supply despite massive price appreciation. However, **wholesale physical markets** showed more stress, with 1,000-ounce bars trading at premiums of $0.50-1.00 over futures prices compared to typical premiums of $0.10-0.20. The situation changed dramatically during silver's final parabolic phase in April 2011. Between April 25-28, as silver approached $50 per ounce, physical dealers began experiencing severe supply shortages. Retail premiums spiked to $8-12 per ounce for common products while many dealers stopped taking orders entirely. Wholesale premiums reached $2-3 per ounce as industrial users competed with investors for available supplies. A sophisticated physical trading operation in Switzerland capitalized on these dislocations by implementing a **triangular arbitrage strategy**. The firm sold high-premium retail products in North America, purchased wholesale bars in London, and hedged price exposure through short positions in Shanghai Gold Exchange silver contracts. This strategy generated profits of approximately $4 per ounce on 50,000 ounces traded during the peak volatility period. The crash that followed proved equally dramatic for physical markets. Silver prices fell 30% in four days (May 2-5, 2011), but physical premiums initially remained elevated due to **supply pipeline effects**. Dealers who had committed to purchase inventory at high prices continued honoring those commitments even as spot prices crashed. This created a brief period where retail silver traded at larger premiums over spot than during the peak price period. ### Case Study 3: China's Physical Gold Market Integration (2014-2016) The Shanghai Gold Exchange (SGE) launch of international board trading in 2014 provided a real-time example of how new physical trading infrastructure can impact global markets. Unlike paper gold markets that settle in cash, SGE contracts require physical delivery, creating unique arbitrage opportunities and market integration challenges. Prior to SGE international board launch, Chinese gold prices often traded at premiums to London prices due to import restrictions and strong domestic demand. These premiums typically ranged from $5-15 per ounce but occasionally spiked to $25-30 during periods of restricted supply. The new SGE mechanism allowed international participants to deliver gold directly into Chinese markets for the first time. A Hong Kong-based physical trading firm developed a systematic arbitrage strategy exploiting these price differentials. When Shanghai prices exceeded London prices by more than $8 per ounce (covering transportation, insurance, and financing costs), the firm would purchase gold in London, ship to Shanghai, and deliver against SGE contracts. This operation processed over 2,000 tons of gold between 2014-2016, generating profits of approximately $12-15 per ounce on average. The arbitrage activity gradually reduced price differentials between Shanghai and London from an average of $18 per ounce in 2014 to $6 per ounce by 2016. This integration demonstrated how physical trading infrastructure development can improve global price efficiency while creating profitable opportunities for traders who understand the mechanics. However, the operation also illustrated regulatory risks in physical trading. In late 2015, Chinese authorities implemented stricter documentation requirements for gold imports, increasing compliance costs and processing times. The trading firm had to hire additional staff and implement new systems, reducing per-ounce profitability by approximately $3-4. Some smaller operations abandoned the strategy entirely due to increased regulatory burden. ## Advanced Considerations Physical precious metals trading involves sophisticated considerations that separate professional participants from casual investors. These advanced factors can significantly impact profitability and risk exposure in ways that aren't immediately apparent to newcomers. ### Assay and Purity Considerations Not all precious metals are created equal in physical markets. **Good Delivery specifications** established by the LBMA represent the gold standard (literally) for wholesale trading, but these requirements eliminate many otherwise legitimate products. LBMA Good Delivery gold bars must be 350-430 troy ounces (approximately 400 ounces average), 99.5% minimum purity, and produced by approved refiners. Only 75 refiners worldwide currently hold LBMA Good Delivery accreditation. This creates a **two-tiered market structure** where Good Delivery bars trade at minimal premiums while non-conforming bars—even those of equal purity—trade at discounts of $5-15 per ounce. A 400-ounce bar produced by a non-accredited refiner might assay at 99.9% purity (higher than Good Delivery requirements) but still trade at substantial discounts due to limited marketability. **Fineness variations** create additional complexity. Silver products range from 90% silver (junk silver coins) to 99.99% pure investment bars. While spot prices typically reference 99.9% silver, each purity level trades in distinct markets with different liquidity characteristics. Experienced traders maintain detailed databases tracking premiums and discounts for dozens of different purity levels and product types. ### Counterparty and Credit Risk Management Physical trading involves multiple counterparties, each presenting distinct risk profiles that require careful evaluation. **Dealer creditworthiness** becomes crucial when making substantial purchases, as the failure of a dealer holding customer funds or metal can result in total loss. The 2008 financial crisis saw several precious metals dealers fail, leaving customers with unsecured claims on bankruptcy estates. **Vault operators** present another layer of counterparty risk that's often underappreciated. While major operators like Brinks or Via Mat maintain comprehensive insurance and segregation procedures, smaller operators may lack adequate capital or insurance coverage. Due diligence should include reviewing vault operator financial statements, insurance coverage details, and audit procedures. The **unallocated vs. allocated distinction** represents perhaps the most critical counterparty risk consideration. Many investors believe they own physical metal when they actually hold unallocated positions—essentially unsecured loans to precious metals dealers. During the 2008 crisis, several firms offering "physical" storage services revealed they held fractional reserves, leading to significant losses for customers who believed their metal was safely segregated. ### Regulatory and Tax Arbitrage Physical precious metals face varying regulatory treatment across jurisdictions, creating both opportunities and compliance challenges for sophisticated traders. **Value Added Tax (VAT) treatment** varies significantly: the European Union generally exempts investment-grade gold from VAT but applies standard rates to silver, while Switzerland exempts both metals for qualifying transactions. These regulatory differences created profitable arbitrage opportunities. Prior to 2014 EU tax harmonization, traders could purchase silver in Switzerland VAT-free, store it temporarily, then sell into EU markets where buyers paid only 7% VAT on qualifying coins. This arbitrage generated profits of 8-12% on successful transactions but required sophisticated understanding of evolving regulations. **Reporting thresholds** vary dramatically by jurisdiction and transaction type. U.S. dealers must file Form 8300 reports for cash transactions over $10,000 but different thresholds apply to different products for Form 1099-B reporting. These requirements can impact marketability and should influence purchase decisions for large positions. ### Financing and Carry Trade Dynamics Physical precious metals can be **leased or borrowed** similarly to other financial instruments, but with unique characteristics that create trading opportunities. Gold lease rates—the cost to borrow gold—typically trade at 0.1-0.5% annually during normal conditions but can spike to 2-3% during supply shortages. **Carry trades** involving physical metal can generate steady returns but require sophisticated operational capabilities. A typical precious metals carry trade involves borrowing metal at low lease rates, selling it spot, investing proceeds in higher-yielding instruments, and repurchasing metal forward. This strategy generated consistent returns of 1-3% annually during the 2010-2015 period when gold lease rates were low and forward curves were in contango. However, carry trades face **squeeze risks** when physical supply becomes constrained. During March 2020, gold lease rates spiked above 5% as refineries closed and transportation was restricted. Traders with large carry positions faced margin calls and potential losses exceeding annual profits. Understanding these dynamics requires monitoring lease rates, refinery production schedules, and transportation capacity. ### Quality and Authentication Risks Physical markets face ongoing challenges from **counterfeit products** that have become increasingly sophisticated. Modern counterfeits can include correct weight, dimensions, and surface appearance while containing significantly less precious metal content. Tungsten-filled gold bars represent a particular challenge since tungsten's density closely matches gold. **Authentication technology** continues evolving in response to counterfeit threats. Ultrasonic testing can detect internal voids or density variations, while X-ray fluorescence analyzers can verify surface purity. However, sophisticated counterfeits may include precious metal plating over base metal cores, requiring destructive assaying for definitive authentication. The **chain of custody** becomes critical for avoiding authentication problems. Metal with complete documentation from accredited refiners through authorized dealers carries minimal authentication risk. However, metal with gaps in documentation—even if genuine—may face authentication challenges that impact marketability and value. ## Practical Takeaways ### Decision Framework for Physical vs. Paper Exposure Choose physical exposure when: - **Portfolio allocation exceeds $50,000** in precious metals (economies of scale make storage costs reasonable) - **Investment horizon exceeds 3 years** (transaction costs amortize over longer periods) - **Counterparty risk concerns** outweigh convenience factors - **Direct control and possession** align with investment philosophy Choose paper exposure (ETFs, futures) when: - **Frequent trading** is anticipated (transaction costs favor paper instruments) - **Position sizes are small** (under $10,000 where storage costs become prohibitive) - **International diversification** is needed (paper instruments avoid customs/transport issues) - **Leverage or hedging** strategies require derivatives ### Storage Cost Analysis Annual storage costs typically break even with ETF management fees at approximately $25,000 in metal value: **Professional Storage Costs:** - Allocated segregated: 0.5-1.5% annually - Allocated non-segregated: 0.3-0.8% annually - Insurance (if separate): 0.1-0.3% annually **ETF Comparison (Annual Expense Ratios):** - SPDR Gold Trust (GLD): 0.40% - iShares Silver Trust (SLV): 0.50% - Aberdeen Physical Silver (SIVR): 0.30% ### Premium Threshold Guidelines **Gold Products:** - Krugerrands, Maple Leafs: 2-4% over spot (acceptable) - American Gold Eagles: 3-5% over spot (acceptable for liquidity premium) - Generic bars: 1-2% over spot (optimal for large positions) - Numismatic coins: Avoid unless collecting, not investing **Silver Products:** - American Silver Eagles: 15-25% over spot (high but liquid) - Generic rounds: 8-15% over spot (good compromise) - 100-oz bars: 3-8% over spot (optimal for large positions) - Junk silver: 5-12% over spot (good for smaller denominations) ### Dealer Selection Criteria **Essential Requirements:** - **BBB A+ rating** or equivalent third-party verification - **Minimum 10 years** operating history - **Segregated customer funds** (verify through financial statements) - **Transparent pricing** with real-time quotes - **Buy-back guarantees** on products sold **Warning Signs:** - Pressure to purchase specific products - Unusually low premiums (may indicate quality issues) - No physical address or local phone number - Reluctance to provide references or credentials - High-pressure sales tactics or time-limited offers ### Exit Strategy Planning Successful physical trading requires planning exit strategies before making initial purchases: - **Establish relationships with multiple dealers** to ensure competitive buy-back quotes - **Maintain complete documentation** from initial purchase through storage - **Monitor liquidity conditions** in chosen products (some become illiquid during market stress) - **Consider tax implications** of sale timing (long-term vs. short-term capital gains treatment) - **Plan for estate considerations** (physical metal complicates inheritance compared to paper assets) ### Risk Management Protocols - **Never exceed 25%** of total investment portfolio in physical precious metals - **Maintain adequate insurance coverage** through specialized valuable items policies - **Diversify storage locations** for holdings exceeding $100,000 - **Regular auditing** of stored positions (annual minimum for large holdings) - **Emergency liquidity planning** (maintain 6-12 months expenses in more liquid assets) ## Key Terms **Allocated Storage**: Physical precious metals storage where specific bars or coins are segregated and identified as belonging to individual investors, eliminating counterparty risk but typically costing more than unallocated alternatives. **Basis**: The price differential between physical precious metals and futures contracts, reflecting storage costs, financing rates, and supply/demand imbalances in physical markets. **Exchange for Physical (EFP)**: A mechanism allowing futures contract positions to be converted into physical metal positions or vice versa, providing crucial linkage between paper and physical markets. **Good Delivery**: LBMA specifications for gold bars (350-430 ounces, 99.5% minimum purity, approved refiner brands) that represent the standard for wholesale physical trading and maximum liquidity. **Lease Rates**: The cost to borrow precious metals, typically quoted as annual percentage rates, that can spike during physical supply shortages and create opportunities for carry trades. **Premium**: The amount above spot price charged for physical precious metals products, varying by product type, quantity, dealer margins, and supply/demand conditions in specific products. **Spot Price**: The current market price for immediate delivery of precious metals, typically derived from futures markets but potentially diverging from physical market realities during stress periods. **Unallocated Holdings**: Precious metals positions where investors hold claims on pooled metal rather than specific identified pieces, creating counterparty risk similar to bank deposits. **Warrant**: Documentation representing ownership of specific precious metals stored in exchange-approved depositories, used for delivery against futures contracts and wholesale trading. **Vault-to-Vault Transfer**: Movement of precious metals ownership through record changes at storage facilities without physical transportation, reducing costs and risks for wholesale transactions.