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Summary
The introduction of the net stable funding ratio (NSFR) as a central feature of
Basel 3 regulations will have a major impact on derivative markets.
There are two classes of gold derivative commonly dealt with, forwards and
futures as well as options in both categories.
Statistics on regulated gold futures are freely available, and fortunately for
analysts, Comex’s regular gold futures GC contract dwarfs all others, allowing
them to confine their comments to this one market.
With the introduction of Basel 3, commercial banking enters a new era of diminishing
involvement in derivatives. The nominal value of all derivatives at the end of last year
amounted to seven times world GDP. While we can obsess about the effects on
precious metals markets, they are just a very small part of the big Basel 3 picture.
However, gold remains central to global money and credit and the impact on gold
markets should concern us all. In this article I quantify gold forwards and futures
derivatives to estimate the impact of reversing anti-gold policies that date back to the
Nixon shock in 1971.
We are considering nothing less than the effects of ending fifty years of gold price
suppression. Through leases, swaps, and loans central banks have fed physical
bullion into derivative markets from time to time to keep prices from rising and
breaking the banks who are always short of synthetic gold to their customers.
Introduction
The introduction of the net stable funding ratio (NSFR) as a central feature of Basel 3
regulations will have a major impact on derivative markets. For the purposes of this
article, we are interested in how it will affect the exchange value for gold.
Derivatives break down into two broad categories. There are derivatives traded on
regulated exchanges, for which there are publicly available data, principally futures
contracts and options on futures. But these are the tip of an iceberg that consists of
over-the-counter derivatives, multiples larger in outstanding obligations. They consist
of forwards, swaps, loans, leases, and options, for which collective data is scarce.
Officially, the purpose of derivatives is to hedge risk. And since we turn to banks to
finance our activities either by drawing down on our deposits or obtaining bank
credit, they are the usual originators of derivatives, expanding their quantity as the
demand for underlying assets, such as gold, increases. Consequently, they have
become primarily a source of paper equivalents, because banks rarely deal in
physical commodities.
While risk management was the original function, banks have turned trading in
derivatives to lucrative profit centres. The banks have evolved products that permit
speculators and investors to acquire exposure without having to access underlying
products. It is a sophisticated version of betting, whereby you can buy and sell paper
from a computer terminal without having to touch the referenced asset. And when
you have markets populated by punters fuelled by growing quantities of paper
currencies which in turn fuel financial asset values, it is natural that banks
increasingly operate as their bookies.
For this and other reasons in recent decades the world of OTC derivatives has
exploded in size, as banks have diversified from expanding credit for manufacturing
and non-financial service businesses into expanding credit for purely financial
activities. Consequently, at the end of last year, according to the Bank for
International Settlements notional amounts of paper derivatives outstanding were
$582 trillion with a gross value of $15.8 trillion.[i] That represents gearing between
notional amounts and their value of over 36 times, and nearly seven times the World
Bank’s estimate of global GDP.
As the chart from The Bank for International Settlements above shows, total
derivatives expanded rapidly ahead of the Lehman crisis in August 2008. After a
brief wobble they continued expanding into 2014 before declining into 2016, since
when the uptrend has been gently rising.
Following the Lehman crisis and while admitting the usefulness of derivatives for the
purpose of risk management, as part of their overhaul of banking regulations the BIS
would have been concerned at the systemic risks to commercial banks from
increased position taking. This has led to two new definitions: high quality liquid
assets, which can be readily realised in a crisis; and the net stable funding ratio,
which ensures that a bank’s assets are suitably funded by its liabilities.
The Basel Committee on Bank Regulation finalised its NSFR rules in October 2014,
coinciding with peak derivatives in the BIS chart above. The publication of these
future regulations might have been one reason behind the subsequent 2014-16
decline. But another factor was the introduction of written bilateral agreements
between counterparties netting off common derivatives into one position. This has
the effect of reducing apparent outstanding derivatives, which had hit record levels in
2008 before netting agreements were in place.
At the banks’ treasury level, net long and short derivative positions are an inefficient
use of the balance sheet by curtailing more efficient uses. The same applies to
uneven positions in equities and commodities, though different ASFs and RSFs may
apply. Furthermore, note that no distinction is made between regulated and OTC
derivatives. The overall effect is likely to stem and reverse the tide of bank credit
expansion into purely financial activities. And given that banks have already reduced
their lending to non-financial activities relative to their total lending, by hampering
further expansion into financial activities Basel 3 appears to mark the peak of
commercial banking.
Gold derivatives
There are two classes of gold derivative commonly dealt with, forwards and futures
as well as options in both categories. The legal difference is that forward contracts
are bilateral bespoke agreements, while future contracts are standardised and
traded on registered exchanges.
Essentially, they serve two different markets. Futures are classified as regulated
investments while forward contracts are not. As regulated investments, investing
institutions have limitless access to futures contracts, whereas their access to
unregulated OTC forwards is strictly limited, if permitted at all. Therefore, the
speculating traders in Comex futures, for example, can be anyone. Traders in
forward contracts in the London market are predominantly acting as principals not
requiring regulation, which therefore excludes nearly all collective investment
schemes and investment managers. These principals include banks, family offices
and their ultra-rich principals, privately-owned corporations, sovereign wealth funds
and central banks.
We shall start by examining the OTC market, whose forwards and swaps are
predominantly dealt in by the members of the London Bullion Market Association
(LBMA) for settlement either in London (loco London) or in Switzerland (loco Zurich).
[iii]
Figure 2 shows that since gold bottomed against the dollar in December 2015
outstanding forwards and swaps had more than doubled from $351bn to $834bn and
OTC options had tripled from $101bn to $304bn by December 2020. And while the
multiyear shifts appear to be greater in percentage terms than for the whole OTC
universe, the expansion of outstanding obligations before the Lehman crisis shared
with the general trend, and the expansion from late 2015 does as well.
According to Dr. Fergal O’Connor writing in Issue 99 of The Alchemist, about 60% of
daily settlement volume in gold in London’s bullion market is for spot settlement,
while swaps and forwards accounted for about 30% of the total. Bear in mind that
these figures cannot be compared with those of the BIS derivatives, which are of
outstanding positions, including those of non-LBMA members. O’Connor’s figures
appear to be of settlement between LBMA members only and exclude trades with
non-members.[iv] This point was brought out in research by Paul Mylchreest for
Hardman & Co, where he points out that turnover volumes reported in 2011 were
approximately five times higher than in 2018.[v] However, it seems likely that
O’Connor’s figures, which is of LBMA members’ transactions only and provided by
the LBMA itself, formed the basis of the LBMA’s assumption in evidence to the PRA
consultation earlier this year that unallocated gold is spot physical by another name.
With LBMA customer transactions now excluded from the LBMA’s turnover figures,
we can therefore ignore the apparent mismatch between the proportions that are
shown as spot transactions and forward trades which seems to suggest that physical
settlements dominate the market. And we know from the BIS figures that at the end
of last year swaps and forwards totalling $530bn existed. In practice, forwards will be
reflected on bank balance sheets as liabilities in the form of unallocated gold
accounts (where in normal banking parlance there would be customer deposits)
while swaps are almost certainly off-balance sheet leading to on-balance sheet
transactions. We do not know the split between swaps and forwards, but that does
not matter.
We can get a feel for the use of gold derivatives by looking at the BIS’s OTC
Derivatives by Maturity tables (Table D9).[vi] Of the $834bn gold derivatives
outstanding, $757bn matured in one year or less, $62bn between one and five years,
and $20bn in five years or more. The remaining $5bn error may be due to rounding
or different data reporting methods.
Under the new British regulatory interpretation of the Basel 3 NSFR, either customer
unallocated gold accounts will end up being closed, or alternatively banks will have
to acquire unencumbered physical gold to back them to avoid financing
disadvantages for their balance sheets. The alternative of banks imposing charges
on unallocated accounts to offset the regulatory burden seems unlikely to happen,
because bank customers are likely to demand off-balance sheet custodial ownership
instead, costing as little as 8 basis points for the largest accounts. We must therefore
conclude that as the bullion banks rearrange their affairs ahead of the year-end,
demand for physical gold among LBMA customers is likely to increase substantially,
as precious metals business moves towards custody arrangements.
Availability of physical gold in London
At end-December 2020, $530bn —the total of forwards and swaps mostly between
members of the LBMA — was the equivalent of 8,676 tonnes of gold. Total holdings
of vaulted gold reported by the LBMA at end-June was 9,587 tonnes, which at first
sight and as promoted by the LBMA’s reporting might be taken for the market’s
underlying liquidity. But more than half of it is the Bank of England’s 5,756 tonnes,
which is not a LBMA member and nearly all its gold is earmarked for central banks.
The true figure for LBMA member vaults is therefore 3,831 tonnes. And of that,
approximately 1,500 tonnes are custodial gold for ETFs, leaving 2,331 tonnes. This
balance is held between allocated accounts on behalf of large investors around the
world and as backing for unallocated accounts on bank balance sheets including the
four owners of the LBMA’s settlement system. The LBMA and vault operators do not
provide breakdowns of these categories but given that allocated bullion can be
stored and insured for less than ten basis points annually, custodial gold could easily
exceed 1,500 tonnes, leaving a pool of physical gold of under 1,000 tonnes.
From the bullion banks’ point of view, preserving physical liquidity is vital to their
operations. And the obvious variable is ETF custodial gold. It explains why
discouraging the wider public from becoming bullish is paramount, and in times of
illiquidity the best policy is to just tough it out, knowing that investors always turn
sellers when the panic of the day subsides, thereby releasing LBMA-vaulted bullion.
And the LBMA trumpeting headline vaulting figures ten times the true liquidity adds
to the deception. Let us not forget that the LBMA primarily represents the interests of
the ringmasters in this market.
Basel 3 will fundamentally change the London market, removing lucrative gold
trading under strictly managed conditions from the bullion banking cartel. This is why
the LBMA vociferously opposed its introduction. They were relying on an approach of
calling out the regulators for not recognising that gold is a High Quality Liquid Asset
as defined in Basel 3: on this point they are certainly correct. But they then appear to
have relied on the preponderance of spot transactions between settling LBMA
members, published in The Alchemist Issue 99 and referenced in footnote iv to this
article, to claim that unallocated is simply a convenient form of physical gold.[vii]
The PRA was not taken in by the LBMA’s lobbying efforts and would have looked at
the underlying contract templates between LBMA banks and their customers and
decided that these accounts were backed by derivatives as defined by Basel 3 and
correctly recorded in the BIS’s derivative statistics. One wonders at the damage that
the World Gold Council, which is meant to represent the wider case for gold while
relying on its income from a physical gold ETF, would have done to its own
reputation at the BoE by being sucked in to support the LBMA’s self-interested
lobbying.
Obviously, the Bank of England (which hosts the PRA) was looking at gold trading in
a wider context. The unallocated jig was up, and the Chinese were making a good
fist of gaining control over global physical trading. That had to be countered. And in
the near-final version of the PRA’s article 428f, not only was the London Precious
Metals Clearing Limited put onto a proper clearing house footing (#1), but bullion
banks were told that unallocated accounts must become pooled accounts backed
entirely by unencumbered physical gold (#s 2 and 3).[vii]
Clearly, the BoE and its regulator desire a future for gold trading in London. It is likely
that the UK’s Treasury and even the US authorities might have been consulted,
given the US’s financial interest in curbing China’s strategic expansion into physical
gold. The wider strategic implications of creating a rival to China’s growing global
dominance of physical gold trading will not have been lost on the highest levels of
government.
For gold trading, this is the other bookend to London’s big bang of the mid-1980s,
which gave birth to the banking industry’s love affair with derivatives. That episode is
now ending with Basel 3. London must adjust to predominantly physical trading. And
the demand for physical gold is growing, not only as implied by Basel 3 regulatory
changes, but more obviously driven by the increasing inflation of fiat currencies. It is
no wonder that the most active Chinese bank in London’s gold market, ICBC
Standard Bank, one of the four owners of London Precious Metals Clearing Limited,
recently bought Barclays' 2,000 tonne vault, because vaulting capacity for London’s
physical demand in the wake of Basel 3 and considering current monetary
developments will be extremely scarce.
Besides the EFP facility (a misnomer because it is an exchange between futures and
forwards — no physical is involved), the relationship between the two markets is very
different from the conventional story. If anything, the hedging requirements out of
London are for LBMA member banks to access net longs on Comex, because the
bullion banks are short to their depositor customers’ unallocated gold accounts to a
far larger extent than the drip-feed of physical bullion coming into the market. In
London, banks job on the short tack, just as they do on Comex.
Bullion bank trading desks are included in the Swaps category, which is defined by
the CFTC as, “an entity that deals primarily in swaps for a commodity and uses the
futures markets to manage or hedge the risk associated with those swap
transactions”. In other words, not exclusively the Swaps category includes to bullion
bank trading desks. Referring to the CFTC’s Bank Participation Report, we see that
on 6 July (the last report available) banks accounted for 59% of the Swaps category
longs, and 73% of the Swap’s shorts. Of these, 31 are foreign, likely to be LBMA
members.
Based on the weekly Commitment of Traders Report issued by the CFTC, the table
is arranged to show the non-speculator categories separated from the speculator
categories, along with the position changes from the previous week (the panel to the
right). Of the 500,187 contracts of open interest on 27 July, 403,286 were not
spreads (81,518 + 321,768). Of these, the Swaps were liable for 77% of the net short
position, representing 536.6 tonnes equivalent.
For the purposes of Basel 3 and its NSFR, regulated derivatives are little different
from OTC derivatives, so we can expect banks dealing on Comex to reduce their
involvement as soon as they can practicably exit, especially as the same banks run
books in London as well. But the overall Swap category’s position is proving difficult
to reduce, as Figure 3 illustrates.
Total swap net shorts stand at $31bn. According to the most recent Bank
Participation Report, the banks' share of this works out at $24.4bn. There are two
problems standing in the way of these banks eliminating their short futures position.
The first is growing interest from the speculator managed money category in selling
dollars for gold futures, and the second is a new trend whereby the
Producer/Merchant category is reducing its net short position, increasingly throwing
the onus for supplying longs to speculators onto the swaps.
There is little doubt that government-owned gold has been used to “manage” the
gold price. In the 1970s, the US Treasury openly sold bullion by auction, but stopped
doing so when they merely stimulated demand. Regulatory encouragement for the
expansion of derivative markets has subsequently absorbed demand that would
otherwise have driven bullion prices even higher. And there is the stubborn refusal
by the US Treasury to quash rumours of missing gold by appointing an independent
metal audit of monetary gold in its possession.
But perhaps the most damning evidence was the refusal of the New York Fed,
responsible for storing earmarked gold for foreign central banks, to firstly let
Bundesbank officials inspect its earmarked gold, and then to refuse to deliver it to
Germany as requested. After some haggling, in 18 months the Bundesbank only
managed to get back 37 tonnes of the 1,500 tonnes held in New York on its behalf.
There should have been no argument about it: earmarked gold is gold held in
custody and as custodian the New York Fed should have responded immediately to
the Bundesbank’s instructions.
They didn’t. Did the Bundesbank suspect the US authorities were misappropriating
its gold, and that was why it wanted it back? And why were its authorised
representatives denied access? And the tonnage that came back from America was
melted down immediately to “bring the bullion up to the current bar standard”.
Unsurprisingly, this action stoked speculation that it was to eliminate bar details
which didn’t match the Bundesbank’s records.
The message seems to be that the central banks, which have between them
declared ownership of 35,544 tonnes, are concealing old leases, more recent swaps
and loans, and outright misappropriation of earmarked gold. It is a market deception
that has been brewing for half a century. It was a problem likely to remain hidden so
long as two conditions continued to be fulfilled: derivatives would continue to expand
to soak up excess demand synthetically, and global money-printing would not spiral
out of control. Even back in 2002, Frank Veneroso reckoned up to 50% of monetary
gold in the central banks might have vanished in leases. Circumstantial evidence,
such as the Bundesbank’s experience, suggests it is a trend that has continued, in
which case a major portion of the West’s monetary gold has simply vanished.
At a time of mounting evidence that the destruction of purchasing power for fiat
currencies is approaching, for some central banks the backstop of turning their fiat
currencies into credible gold substitutes may not be available, and nowhere is this
more of an issue than the future backing for the dollar itself.
Silver was finally demonetised in the 1870s. Its replacement with gold in monetary
standards for the few remaining European nations on silver standards led to its lower
repricing as a predominantly industrial metal today, and the gold-silver ratio rose
from 15—16 or so to over 70 currently.
We are so used to the state defining money for us that we forget that all theories of
state money are fatally flawed, because its promoters can never resist actions that
lead to its destruction. And when state currencies die it is the people who decide
what will replace them as money, and the most reliable replacement that people
have always returned to through the millennia is gold and silver. Following the chaos
of a currency collapse the decision as to whether silver can circulate again as money
is a decision for the people.
On a practical level, silver is more accessible than gold to most people. Today, a one
ounce silver coin buys $25-worth of goods, and as fiat currencies slide, a silver
ounce buying, for example, a value of one-twentieth of a gold ounce in silver is
practical money for most people faced with exchanges of goods in the absence of
fiat currencies.
Conclusion
This month marks the fiftieth anniversary since the last vestiges of a gold standard
for the US dollar were abandoned. We can surmise that it was by design that the
banking reforms that followed in the 1980s contributed the suppression of gold by
expanding the availability of derivatives substituting for physical bullion. And it
became central to the promotion of the dollar as gold’s permanent monetary
replacement.
[ii] NSFR = Available Stable Funding/Required Stable Funding, and must always be
greater than one
[iii] A swap contract is where two parties agree to exchange between them a variable
rate for a fixed sum. It is principally a means of insuring against price volatility.
[iv]See Digging into the LBMA Precious Metals Trade Data | Alchemist
[ix]See the IMF’s Monetary and Financial Statistics Manual and Compilation Guide
available from IMF.org
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not reflect those of Goldmoney, unless expressly stated. The article is for general
information purposes only and does not constitute either Goldmoney or the author(s)
providing you with legal, financial, tax, investment, or accounting advice. You should
not act or rely on any information contained in the article without first seeking
independent professional advice. Care has been taken to ensure that the information
in the article is reliable; however, Goldmoney does not represent that it is accurate,
complete, up-to-date and/or to be taken as an indication of future results and it
should not be relied upon as such. Goldmoney will not be held responsible for any
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17 Likes 29 Comments
A nice Sunday night smackdown of gold, about a bazillion tonnes of derivatives dumped
at a low volume point in the day… not an ounce of real gold traded. Gotta love this
scam.
The article describes the theory and the high matter of the silver market. it is easier and
closer to me to buy silver at 22$ sell at 27 and do not puzzle over how much is the % of
profit
Reply Like
582 Trillion dollars in paper derivatives? Who was supposed to be the guards of integrity.
My god the world economy shot both of its feet off. How will we stand going forward? Lol
LLAP
I knew about the 18 months delay in Germany getting some of its gold from the US. But
did they really get back only 37 of 1,500 tonnes? And I didn't know they then did a quick
meltdown for a clearly questionable reason. Reminds me of when Bob Pisani held up a
gold bar inside a vault that was supposedly "owned" by GLD but was found out to be
owned by ETF Securities.
@Uncommon Wisdom investors are stupid, they buy gold derivatives with infinite
supply and they wonder why it doesn’t go up.
If investors and speculators bought bullion, supply would run out in an hour.
@Uncommon Wisdom No - Germany got back all that it requested, but it was
delivered in tranches over an elongated period. Why the USA could not return all
the gold requested in a timely manner is open for speculation (leased out?).
Germany, wisely I feel, sought to have at least half its gold held domestically
(post WW2 upto 98% was held abroad) - large parts being returned by the UK in
2000 (when Gordon Brown was busy selling the UKs gold at the gold price
nadir). Some is still held in London as it's a key gold trading hub, some in New
York but all was returned by Paris (no point as France also uses the Euro and
equally susceptible to the historically feared Russian invasion).
@Diottica I totally agree with all your points. China, Russia and others are smart
to have bought much gold in recent years and hold it themselves. I've read that
there hasn't been any audit (at least not in many years) of US gold reserves. I
wonder why? :)
@AbolishtheFed Indeed, many of us have noticed in the past two years when Ag
and Au had significant spot price declines, like in March, 2020, either retailers
had no stock of the products we wanted, or premiums were outrageously high.
Spot prices are fabricated fiction. Real precious metals prices are what one must
pay buying retail. Of course, coins have numismatic value; US Mint coins will
always sell at a premium to spot prices, of course. But I've seen even 1kg gold
bars with no numismatic value, just bullion value, selling at 1% - 2% premium
($5.5K - $11K) over the past two years. 1.3% premium today at my favorite
dealer. I'm heavily long precious metals and hope Basel III has some teeth and
contributes to curtailing the wild derivatives market. Long contract buyers
continuing to take physical delivery is also a big help to force more realistic price
discovery.
@Uncommon Wisdom I have a feeling that PMs will be carved out or the rules
weakened. There is too much money being made by the banks selling fake gold
to walk away.
Real price discovery on gold will be eye opening, but I doubt we will see it
anytime soon.
Reply Like
@Diottica
Do you have a source for Germany getting all its gold back? Thanks.
@Diottica
The popular legal phrase, "possession is nine tenth's of the law" remains
surprising true on almost every scale.
seekingalpha.com/...
Reply Like
Reply Like
@Analytical Investors
There are nine POINTS of law involving possession. Please get it right.
Reply Like
www.bullionstar.com/...
that puts the German gold repatriation into context with similar actions by
neighbouring banks and speculates about a possible motive - a planned reset.
It belongs in the 'conspiracy theory' camp (which I frequent, being also a huge
Covid sceptic) but, imo, is deserving of consideration.
a "pass through" much like the NYSE acts as a pass through for
Reply Like
your read is not for the average gold investor. We know gold has been around for
thousands of years, is rare, beautiful, very durable. In the end, it is the best medium for
exchange...fiat be damned.
that Basel 3 LCR & NSFR brings to the LBMA's Unallocated paper Gold.
the games continue.The BIS,BOE & FED Denied the LBMA both
@jjtompson6
What do you mean by: "putting in place a 50yr book end to the paper games!"
Do they have 50 years to stop the games?
seekingalpha.com/...
@Analytical Investors Their paper games that began in 1974 will end
@ababich1
Reply Like
AbolishtheFed 06 Aug. 2021, 7:47 PM
A
Comments (7.82K) | + Follow
Lots of information there. I am skeptical that the Basel III rules will remain as they are
written.
“Settlements notional amounts of paper derivatives outstanding were $582 trillion with a
gross value of $15.8 trillion.[i] That represents gearing between notional amounts and
their value of over 36 times, and nearly seven times the World Bank’s estimate of global
GDP.”
Gold is such big business, trading stuff that doesn’t exist charging fees both ways and
never delivering is the perfect scam.
If gold Rules change, like you say… bullion prices to the moon.
to change their minds & give the LBMA what they had wanted
@jjtompson6 let’s see what happens, maybe you are right, I’m definitely not as
well versed in it as you.
So… then what happens? Let’s assume prices rise, let’s assume that people buy
bullion instead of futures. There will still be paper gold out there, just less
levered.
Basically, if you don’t have a stack by now, one is going to be tough to build.
We’ve all seen gold shortages on the retail level, maybe more of the same?
to get back to a one to one market so they avoid the penalty costs.