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Much has been made recently about the “negative gold lease rates” derived from the London Bullion Market Association (LBMA) statistical gold and silver data. For example, there was coverage here and here late last week claiming that banks are having to lend gold at a loss. This implies that plenty of gold is available for leasing presumably because there is a declining desire to own gold, but in reality it is the reluctance to sell gold outright — including by central banks and despite the ongoing correction — that the market appears to be telegraphing via negative gold lease rates. This is a welcome change from a gold market recently dominated by weak-handed participants (Wall Street types like Paulson, Cramer, etc.) who primarily look to gold for its ability to generate speculative profits during periods of economic instability.
Moreover, we believe the focus on negative lease rates misses the point of the current gold market structure and instead we should be looking at changes in the gold forward rate. The gold forward rate has increased during both the late September and current sell-offs in gold, which probably means that gold is being leased by central banks in order to provide liquidity for the banking system. Importantly, central bank gold is probably not being sold outright despite rumors to the contrary. The implication is that the current gold correction is similar to past events where gold has been used as a liquidity management tool. We should not bemoan such a development since gold’s role as the ultimate form money with no counterparty risk is in fact the best-suited for liquidity management out of all the asset classes.
Alas, we don’t get a good sense of this from reading the financial media or blogs. Consider the following from Bloomberg:
It is quite typical of this time of year that banks look to offload metal in an effort to reduce their balance sheet,” Edel Tully, an analyst at UBS AG in London, said today by phone. “Clearly, there’s the added ingredient this year that certainly some of it is related to funding. I wouldn’t expect that it’s going to blow out considerably more from where we currently are.”
The Financial Times story (registration required unfortunately) carried some additional statements and quotes that really do nothing more than confuse gold investors. For example, consider the following:
Gold dealers said that banks — primarily based in France and Italy — had been actively lending gold in the market in exchange for dollars in the past week.
and
Large bullion-dealing banks take gold on deposit from a range of customers such as investors, central banks, and other commercial banks.
These statements and the reporting in general lack the background, substance or context required for many readers to even understand what information is being provided much less draw proper conclusions of their own from the reporting. Izabella Kaminska in the Financial Times blog has made a more serious effort to address the situation by looking at the collateral aspect of gold leasing but we believe it is premature to think about gold as useful collateral today while the gold business remains beholden to standard bullion banking practices as mastered by the likes of JP Morgan.
After all, the latest trend towards gold collateralised bank loans shows in some ways that the market is demanding the recollateralision of credit with gold.
Banks don’t need gold as much as they need cash. They use the gold to get cash. Cash is once again being backed by gold. In the interim, there is less demand for gold as a buy-and-hold asset, and more demand for its use as a funding instrument: collateral.
While we are not told how the gold collateralizing is currently taking place, it may indeed be true that important structural developments in the financial sector could soon mean that gold’s widespread use as collateral and eventually as money might actually not be that far off. If so, it would only be a natural progression for an asset with no counterparty risk in a post-credit-bubble world. Excessive leverage has transformed even the gold swap and leasing business, which by definition is supposed to involve physical metal, into a paper form a number of years ago:
From the research undertaken, it appears that a significant portion of, but not all, gold swaps and gold deposits are undertaken via unallocated gold accounts held with metal account providers.
Simply put, the gold market has become so removed from its physical roots that market participants now pretend that a “metal account” is the same as gold. While the recent reports from Bloomberg, Financial Times and elsewhere offer shreds of truth about this condition amid all the misdirection, they fail to examine underlying developments in the gold market that may change the sorry state of affairs. Izabella Kaminska takes it a step in the right direction by looking at gold as collateral but still doesn’t quite get to the point, which is the possibility that new ways of using gold — such as a collateral backstop in the tri-party repo market as we explain below – could transform a ticking time bomb into a new gold standard. The gold time bomb takes the form of a possible panic out of paper gold into physical metal when counterparty risk reaches an extreme level whereas a new gold standard would complement modern financial markets by serving as the ultimate asset: gold with mobility and no counterparty risk.
We believe such a radical development could take shape if the most popular paper gold product available today, the LBMA unallocated bullion account, is used increasingly as a source of secured funding between counterparties (such as in tri-party repos) rather than as credit between a bullion bank and its customers. Indeed, if the gold market is left to its own devices, the shunning of credit risk will eventually lead counterparties to demand that gold be provided in the form of risk-free collateral. The LBMA and bullion banks would then have no choice but to establish and market 100% physical backed unallocated gold accounts similar to BullionVault and GoldMoney, except on a grand scale. You heard it here first.
Our goal today is to provide some background information on the gold market so that readers can make sense of these important potential developments instead of getting confused by the misinformation being generated by the financial media and bloggers. Our qualification to address the subject matter comes by way of the extensive work we have done in this area including the seminal Gold and Silver “Leasing” Examined in 2007 that described the historical relationship between gold and leasing and has so far accurately predicted its future (the present) as well. Instead of reprinting parts of that earlier work, we’ll borrow a few concepts from it today while using mostly new material to focus on the present implication of negative gold lease rates and the emerging use of gold as collateral in secured funding.
A Bank by any Other Name …
First, we need to consider the term “bank” and separate it into three constituencies. There are central banks, which coordinate monetary policy and are the only banks that actually own physical gold in any consequential amount.
Then there are commercial banks, which are the banks that take deposits from you and me and make loans. These banks are the ones we normally think of when somebody uses the generic word “bank”. Their involvement in the gold market is quite minimal.
Finally, there are the bullion banks that are basically dealers in physical and paper metal contracts, acting as intermediaries. An intermediary is simply a party that serves as a middleman between customers on opposite sides of a transaction. These customers normally would not be able to find each other when the transaction is over-the-counter (as opposed to an exchange such as COMEX gold futures contracts). Even if they can find each other – let’s say on Craigslist (yes, that’s a joke) — they may not know enough about each other to trust that the other side will perform under the contract. The bullion bank therefore becomes the counterparty to the opposite sides and uses its own balance sheet to offset or hedge the risks. Bullion banks are also increasingly using tri-party arrangements in which they primarily serve a clearing function and as a custodian of collateral instead of managing the risk on their own balance sheets. We’ll look at that in a bit.
The term “gold dealer” could mean a bullion bank or it could be any company that trades gold on behalf of customers but does not act as an intermediary.
From the above distinction we can already see the sloppy quotes in the Financial Times story. The article mentions that “gold dealers” are talking about “banks” but are those just gold dealers or are they bullion banks? And are the banks the gold dealers talking about commercial banks or central banks? Regardless of what definition we choose, the statement is problematic for reasons we’ll get into shortly.
Fun and Profit with Gold Leasing
But first let’s do a little more background work — figuring out exactly what gold leasing and lease rates are. When leasing gold, the lending party is temporarily exchanging gold for another asset (collateral). It is similar to leasing a car or capital equipment where you get to use it for a period of time in exchange for lease payments while the legal registration (collateral) stays with the lessor. The difference with gold leasing is that the gold is not kept by the borrower but immediately sold in the spot market. Alternatively, the leased gold is delivered against an imminent delivery obligation such as a short sale. But in any case, there is no exchange of cash up front between the lessor and borrower of gold. In effect, the borrower is simply using the gold to get cash or avoid having to pay cash in the case of gold delivered against a maturing short position.
If the lessor of gold were to receive dollars, it would be a gold swap by definition and not a gold lease. A swap is merely an exchange of the cash flows generated by different assets but since gold has no cash flow and cash itself doesn’t generate anything, the gold swap represents an exchange of the underlying assets (gold and cash) themselves. Importantly, central banks do gold swaps mostly among themselves — for example to manage foreign currency positions — and rarely with commercial banks. It is the bullion banks that are typically involved with gold swaps (in the over-the-counter market) but again the counterparty is rarely a commercial bank. As noted earlier, commercial banks are usually not big participants in the gold market with the present situation being an exception.
One reason central banks typically do gold swaps only between each other is because a transaction with a commercial bank or other market participant effectively results in monetary tightening (less currency in circulation since the central bank receives cash under a gold swap) and this can require accommodation elsewhere to avoid a deflationary effect. The solution is therefore for the central bank to lease gold, which is simply an exchange where the “collateral” is something other than cash. And there you have the gold lease in its stark simplicity.
From there things get a bit more complicated — the how of gold leasing– but it is arguably worthwhile for most readers to continue. The substance of the gold lease is predicated on the fact that the central bank or other lessor doesn’t actually need a specific party (borrower) in order to effect a transaction that has the exact same financial result from its own standpoint. Instead of exchanging gold for collateral in a gold lease, the central bank could simply sell its gold in the spot market and concurrently buy the gold back on a forward basis, meanwhile investing the proceeds in an asset that earns interest. The result is exactly the same in both cases: interest is earned on an asset exchanged for gold while exposure is retained to changes in the gold price.
A contract to purchase gold at some future date for a fixed price is called a gold forward contract. The future fixed price, unsurprisingly, is called the gold forward price. The difference between the spot price and forward price is the forward rate, which also represents the gold swap rate. As noted above, a gold swap is simply an exchange of gold for dollars that will be reversed at a future date. When buying gold forward, a market participant will typically contract with a bullion bank. The “bank” part comes into play because theoretically the way the forward contract gets created is that the bullion bank goes into the market and buys gold using its own money. It then theoretically stores the gold until the delivery date specified in the forward contract. In practice, the bullion bank doesn’t actually buy gold in the spot market but rather contracts with a third party that seeks to lock in a future gold price by selling its gold forward.
The way that the forward price is determined, however, is still based on the theoretical approach. Bullion banks that are members of the LBMA are asked to provide their daily gold forward offered rate (GOFO), which presumably represents the rate at which they are willing to do gold swaps with credit-worthy counterparties over various time frames up to one year. This GOFO is the rate that the LBMA publishes under its “Gold Forwards” statistics page and is presumably also what central banks and other prospective lessors of gold would have to pay in lieu of a gold lease in order to temporarily “monetize” their gold holdings while remaining protected against changes in the gold price.
Simply put, the forward rate — also called contango or backwardation if negative — represents the carrying cost of gold in the form of storage, insurance and financing costs. Recall from above the theory that bullion banks buy and store gold for their customers who buy gold forward from them. You and I can probably bury our gold in the back yard or otherwise hide it effectively. Really wealthy owners, institutions, central banks and bullion banks, however, have real costs associated with secure and safe storage. In other words, there is some value in having the right to possess gold at some future date (while holding cash in the meantime) and this value is theoretically based on the costs avoided by not possessing that gold today.
These avoided costs include the aforementioned storage and insurance as well as the fact that funds not tied up in gold can be used to purchase an interest-bearing asset. When interest rates are very low, as they are now, the financing cost — or so-called “opportunity cost” — is minimal and therefore this component of the forward rate tends to approach zero. Since storage and insurance costs are, however, not nominal (they can range from 0.2% to 1.0% per annum of the gold’s value for large holdings), the forward rate as a whole will remain positive. In fact, it would take an extraordinary aversion to counterparty risk — universal recognition that a gold forward contract requires performance by a counterparty to deliver gold at some future date, which might be difficult if not impossible under some circumstances– before the forward rate was to become negative. A negative forward rate is the same thing as backwardation, the elusive and rare market event that is veiled in perhaps even more mystery and confusion than the gold lease. We’ll have to save that interesting topic for another day.
As just mentioned, the central bank would pay the forward rate on gold and earn interest on the purchased asset in the alternative to gold leasing. The reason it doesn’t do this, however, is that an over-the-counter sale of gold would need to be recorded on the books as a disposition while the assets being purchased (using the gold sale proceeds) would also need to be recorded as an acquisition. A gold lease, by contrast, can be treated for accounting purposes as a “non-event” under lenient guidance promulgated by the IMF and BIS. This is because the lease is undertaken with a single counterparty presumably in order to manage monetary reserves and is therefore considered an operating instead of financing activity. Going back to the car leasing example, an operating lease would have a relatively short term resulting in substantial value being retained when the lease expires whereas a capital lease is long-term financing such as a “lease-to-own” arrangement provided to the buyer by the seller (instead of being provided by a bank, which would be a car loan). In any case, a gold lease will allow the gold to be kept on the central bank’s balance sheet while the exchanged collateral can remain off-balance-sheet. The only accounting impact is the receipt of gold leasing income, which we have already seen is based on the difference between the forward rate on gold and the hypothetical interest earned on an equivalent amount of assets.
With the above understanding, we can now make sense of the LBMA statistical tables from which gold lease rates are derived. We simply take the gold forward rate that the central bank would otherwise pay but for the lease and subtract it from the interest rate the central bank would receive from safely investing the proceeds of a gold sale. In a gold lease the two rates are simply netted into a single lease rate.
The interest rate used for the lease calculation is LIBOR, which is the dollar rate at which commercial banks purportedly lend and borrow money between each other on a short term basis. The reasons for using this particular interest rate are simple. First, gold is priced in dollars and the U.S. Dollar LIBOR is a widely-available rate. Second, LIBOR is determined by banks with offices in London where the LBMA is also located. Third, LIBOR is derived by the market itself, unlike for example the U.S. federal funds rate for interbank borrowing set by the Federal Reserve. As such, the USD LIBOR is deemed to be a pretty good approximation for the short term interest rate that can be safely earned from the proceeds of a gold sale. This doesn’t prevent gold leases from being negotiated using rates other than LIBOR and in fact many leases are negotiated at higher rates. As such, the lease rate derived from LIBOR and the gold forward rate should be considered a minimum.
That, in a nut shell, is the gold lease rate. It works essentially the same way for silver as well, except that central banks do not as a matter of course engage in silver leasing. Therefore silver lease rates — including negative rates — are less meaningful than they are for gold.
Negative: The New Positive
As just mentioned, the gold (or silver) lease rate does not represent the actual rate at which lease transactions are being done in the market. The published lease rate is simply an indicated value derived from two related variables, the gold forward rate and LIBOR. These rates can and do move in opposite directions for reasons unrelated to gold leasing activity given that both rates are used in many types of large transactions that dwarf gold leasing.
Indeed, there have been stretches during the past few years when the derived gold lease rate was negative — yet at no time were central banks actually leasing gold at a loss. Since LIBOR is a minimum rate at which prime banks are willing to lend to each other, the actual rate can be significantly higher based on the creditworthiness of the individual bank or borrower along with other factors. In the case of gold being leased to provide liquidity, the assumption must necessarily be that the borrower is desperate and therefore the corresponding rate that it must pay is higher than the minimum a prime bank would pay.
Keep in mind also that the borrower is not just paying the lease rate to the central bank or lender, it also pays the gold forward rate to the bullion bank in order to lock in the price at which it buys back the gold. The total cost is therefore the lease rate plus the gold forward rate, which is just LIBOR plus the credit risk premium. In other words, there are no free lunches. Any borrower that has to pay more than LIBOR to borrow funds using conventional means will also have to pay more than LIBOR to lease and hedge gold as well. Readers are encouraged to explore the observations presented in Gold and Silver “Leasing” Examined for additional insight.
To fully understand the potential implications of the present scenario in the gold market, we need to go over one last thing about gold leasing: why it is done.
From the perspective of the lender (typically a central bank), gold was historically leased as a way to generate income from a monetary reserve asset. Low market interest rates combined with systemic risk during the past few years, however, have obviated the central banks’ desire for returns in favor of capital preservation (such as it is) and monetary stability. Instead, gold leasing in the recent past has been done primarily as a means to provide backdoor liquidity to commercial banks and other parties deemed important for economic stability.
From the perspective of the borrower (typically a bullion bank or its customer, a hedge fund), gold was historically leased as a way to fund a gold carry trade under which excess returns could be earned by using the sales proceeds from leased gold to purchase highly-rated securities meeting the central bank’s collateral requirements. For example, if the lease rate was 2% and the purchased security yielded 5%, the borrower could generate a hypothetical return of 3%.
This return was not risk free since a rising gold price would mean that the borrower has to pay more to buy back the gold then it originally received when selling it, but the borrower could always hedge the gold carry by repurchasing gold using a forward contract and thereby locking in the gold price. As long as the cost of the forward contract is less than 3% using the above example, the borrower could generate a seeming risk-free arbitrage … although delivery of gold under the forward contract and repayment on the purchased security are still subject to credit and counterparty risk.
Recalling from above that the effective borrowing cost of a hedged gold lease is just LIBOR, the fully-hedged gold carry trade is profitable as long as the borrower can use the gold sale proceeds to purchase securities that are no riskier than LIBOR, yet yield more. Alternatively, the borrower could opt to be unhedged (“naked short”) while gold prices are falling and thereby potentially earn not only the full unhedged spread (3% in the above example) but also generate a profit from a lower gold price. In practice, the borrower would just let the unhedged gold lease ride until a rise in the gold price threatened the profit margin. At that point a gold forward contract would be acquired to fix the gold price and the profit would be locked in. This practice resulted in big profits during the gold bear market of the 1990s.
Returns on gold carry trades have plummeted in recent years and therefore leasing has been done primarily by commercial banks as a way to obtain dollar liquidity. To be more precise, the leasing is probably done directly by the bullion banks on behalf of commercial banks for a fee. Instead of pledging the assets acquired with the sale proceeds of gold leased pursuant to a carry trade, the borrower of gold now pledges existing collateral that it could not otherwise sell without incurring a loss. The central bank accommodates the gold leasing by accepting a wide range of collateral that would be otherwise prohibited in conventional funding schemes.
Regardless of the reason why gold is leased, one thing is always in common. The borrower will invariably sell leased gold in the spot market (or deliver it against a short position, which is effectively the same thing) since the gold lease isn’t about the gold but rather the cash that selling it can generate. Recall that the central bank would have done the same thing — sell gold and either use the proceeds to acquire interest-earning assets or to provide cash to the banking system under a liquidity facility — in order to effect a similar financial outcome if the accounting permitted it. Thus the singular outcome of leased gold always being sold should not come as a surprise at all. A weak gold price at the moment shouldn’t be a surprise either, if in fact the general gist of the Bloomberg and Financial Times stories is correct that gold lending is on the uptick.
So, is anybody else lending gold other than central banks? Probably very little since the derived negative lease rate does make it difficult for non-central banks to earn much of a premium in excess of LIBOR. It is already difficult enough for banks themselves to determine what risk premium they should charge each other, so non-banks have little chance of getting it right. Recall that central banks themselves are only leasing gold at this point as a backdoor liquidity measure. In any case, anybody looking to generate liquidity right now from gold that it owns would probably not lease it but either swap or sell it outright.
An outright sale of gold could always be hedged by acquiring a gold forward contract. Therefore, even if gold leasing has not experienced a recent resurgence, the increase in the gold forward rate indicates that owners selling gold to generate liquidity still want their gold back once the funding need has abated. The combination of a falling gold price and rising forward rate is quite a bullish feature of the gold market that is lost in the reporting on negative gold lease rates.
So, is anybody else borrowing gold other than the commercial banks in need of liquidity? Probably not, because there is no money to be made from a gold carry trade at this juncture. Since the effective cost of leasing gold exceeds LIBOR when considering the cost of a hedge (gold forward rate), borrowers are likely to look for cash elsewhere.
The Fog Clears
With the above understanding, hopefully you can now go back and pick out the kernels of truth from the confusing and misleading information found in the recent (not to mention future) reporting on gold leasing.
We’ll help get you started by pointing out a few likely truths:
(1) Commercial banks are probably running short on liquidity and as a result LIBOR rates have been rising.
(2) Commercial banks are probably leasing gold from central banks (or more correctly, bullion banks are leasing gold from central banks on behalf of commercial banks). See why we spent time at the beginning on the definition of “bank”.?
(3) Commercial banks that have leased gold are probably not willing to bear any gold price risk and therefore they are buying gold forward, causing the gold forward rate to rise even faster than LIBOR. The result is a larger negative gold lease rate. Under these market circumstances, the negative lease rate says nothing about the supply of gold available for leasing since rising LIBOR is a dollar supply phenomenon while the rising gold forward rate is a forward gold demand phenomenon. Overall this is bullish for gold even if short-term bearish for gold prices.
Now for some of the falsehoods:
(1) “It is quite typical of this time of year that banks look to offload metal in an effort to reduce their balance sheet,” Edel Tully, an analyst at UBS AG in London, said today by phone.”
Although it is not known what “banks” she is talking about, really the only banks that have gold on their balance sheets are central banks. There is neither a typical time of year nor a need for central banks to “offload” gold and in any case leasing doesn’t actually cause any gold to be offloaded. Rather as we have already explained above, central banks are probably leasing gold to add liquidity to commercial banks within their system (“funding” as the UBS lady avers).
(2) “Gold dealers said that banks — primarily based in France and Italy — had been actively lending gold in the market in exchange for dollars in the past week.”
Who are these gold dealers? Clearly not the bullion banks, in which case they really have little clue as to what lending activity is taking place in the gold market. And in any case, it isn’t “banks — primarily based in France and Italy” (implying they are commercial banks) but rather the central banks of France and Italy that are probably leasing gold to the commercial banks so the gold can be sold in the spot market and the cash proceeds used to fund dollar liquidity needs. Once again, there is no exchange of dollars in the leasing transaction itself since that would constitute a gold swap and central banks don’t tend to do that with commercial banks. Instead, what is probably happening is that commercial banks are entering into gold forward contracts to protect against price risk on the leased gold they have sold. This causes gold forward rates to rise and the gold lease rates to turn more negative. Yet the commercial banks are still paying a positive rate for the privilege of leasing gold. This rate is necessarily higher than LIBOR since it must necessarily include the gold forward rate paid to the bullion bank to hedge the gold lease and a risk premium paid to the central bank to compensate it for credit risk. Yet not much gold leasing will take place if the effective cost exceeds LIBOR by a significant amount. That makes gold leasing a “Goldilocks” market where transactions only get done when things are neither too hot nor too cold.
(3) “Large bullion-dealing banks take gold on deposit from a range of customers such as investors, central banks, and other commercial banks.”
This appears to be a non-sequitor, meaning that it doesn’t pertain to the subject matter, which is gold leasing. Fortunately Izabella Kaminska has connected enough of the dots by focusing on the idea of gold collateral, which reveals that “deposit” is really a code word for the LBMA unallocated bullion account.
To understand the unallocated account, first we start with the allocated account. Bullion banks have warehouses whereby they store gold deposited by customers. These are not “deposits”, however, in the legal sense but rather custodial arrangements where the service provided is the safekeeping of collateral — specific gold bars allocated to individual customers: the LBMA allocated bullion account. On the other hand, bullion banks also offer accounts where the customer doesn’t have a claim to specific bars of bullion stored on its behalf but rather a general claim against the issuer of the “metal account”. Moreover, the account issuer does not need to keep all the physical metal in a vault but rather it may be used in the course of the issuer’s business. This is essentially how bank deposits work and therefore the LBMA unallocated bullion account can be thought of as a deposit of gold or other metal.
The reason this distinction matters in the case of gold leasing is that a substantial amount of gold leasing is actually done using LBMA unallocated accounts and not physical gold. While most types of unallocated accounts are claimed to be backed 100% by metal inventory (Kitco pool accounts, Perth Mint certificates, BullionVault, GoldMoney as well as various accounts termed “unsegregated”), LBMA unallocated bullion accounts may have at least part of their backing in the form of paper. This is because unlike Kitco, Perth Mint, BullionVault, etc., the business of the bullion bank that issues LBMA unallocated bullion accounts is not to store or fabricate physical bullion products but rather to act as an intermediary for (paper) transactions in the gold market. In other words, gold in an LBMA unallocated account is used in the bullion bank’s “business”, which is primarily paper, and therefore customers should expect that some of the account backing is paper as well.
For example, a customer may execute a gold swap with a bullion bank pursuant to which the customer’s physical gold is initially stored in an unallocated account and used as the collateral for dollars loaned to the customer. The bullion bank then sells the gold from the unallocated account to replenish its funds and concurrently enters into a gold forward contract with a gold refinery. The forward contract is then used to back the gold liability to the customer. A similar process, though more convoluted, would allow the unallocated account to be used in gold leasing.
Other than the use of unallocated gold for swap, collateral or trading purposes, the only other reason why an owner of gold would seek to “deposit” physical gold with an LBMA member in an unallocated bullion account would be to avoid storage fees associated with allocated gold. It is not know to what extent the LBMA unallocated account is used by customers to avoid storage fees but a significant amount of gold, perhaps several thousand tonnes, has been converted to paper form as a consequence of the bullion banks’ business. The theoretical result is that the paper gold will have to be converted back to physical metal in the future when the customer requests a withdrawal. We say “theoretical” because the gold market may not be able to handle mass withdrawal requests from unallocated account holders should a future monetary crisis make all counterparty risk untenable. In fact, mass withdrawal requests would probably lead to a default in those LBMA unallocated accounts that are not backed by physical metal. At the present time, that would be most if not all of them.
The substitution of unallocated metal for physical in the gold lending as described by Bloomberg and the Financial Times means that some of the statements being made are even further from the actual truth than we’ve demonstrated them to be. In reality, the gold bugs are essentially right that the gold price is falling this time because paper gold is flooding the market. Surely this prospect isn’t what has Ms. Kaminska so excited as she extolls the collateral virtues of gold. In fact, the use of gold for funding purposes has precedence in the annals of modern central banking reserve management, but unlike today, it used to be that only physical gold was given collateral recognition. That even paper gold is given such benefit today is a bastardization of gold’s fundamentals and is no cause for celebration. Still, gold’s role as the ultimate collateral in a risk-averse world should have positive long-term effects in the gold market. We believe this may take place initially in the area of tri-party agreements and central clearing facilities.
Hands Off My Gold
We suspect that all this talk about negative gold lease rates may represent the initial glimmer of recognition that a major development is afoot in the gold market. Pieces of the puzzle are being put together without most people really knowing or understanding what the completed picture looks like. For example, we think what the Financial Times reporter and others are really trying to say is that bullion banks essentially make gold loans by taking physical gold from customers, trade that gold for paper and use the paper as backing for unallocated accounts. Therefore, bullion banks are little different from commercial banks: the first takes deposits in the form of gold and makes gold loans and the second takes deposits in the form of cash and makes cash loans. Neither of them, however, actually retains the underlying assets (gold or cash).
What nobody seems to address, however, is how gold is going to be used in the future now that leasing and other paper-based forms of monetizing gold appear to be on their last dying legs (despite the present uptick). Ms. Kaminska, too, misses the intricacies of this how point and therefore her argument — that gold being increasingly used as a funding source will depress its price — only stands to be correct if gold continues to get sold to generate liquidity in a manner similar to traditional gold leasing (such as happens right now) or in the process of physical gold being converted to paper (the unallocated bullion account).
But … what if gold has a future in the tri-party or over-the-counter clearing market as a collateral backstop? We note below that efforts are already being made to introduce gold to the tri-party system (though for now using conventional unallocated accounts) while the Chicago Mercantile Exchange among others has introduced over-the-counter gold clearing. Let’s see what this might look like.
Tri-party repos or more generally tri-party arrangements are fundamentally different from the bi-lateral manner in which most over-the-counter derivative transactions in gold and commodities have been intermediated up until now. Recall that an intermediary is simply a financial middleman. In the case of gold , the intermediary (a bullion bank) would execute contracts with different parties who were long and short a series of gold transactions. These transactions, whether for paper or physical metal, are grossed up and offset by the bullion bank with any net exposure carried on its own balance sheet. The intermediary is essentially the counterparty to each transaction and guarantees performance using its balance sheet strength and good name. One counterparty’s loss was another’s gain and the bullion bank made its living netting the two. It basically charged spreads and fees for financial matchmaking.
Balance sheets not being what they used to be, and not to mention the passage of new regulation such as the Dodd-Frank financial reforms, intermediaries are finding it much more difficult to find customers these days who are willing to trust them with performance should extreme market conditions — or customers defaulting en masse — leave balance sheets in tatters. This erosion of trust continues with the recent bankruptcy of MF Global amid allegations the customer funds were misappropriated to cover failed bets on European sovereign debt.
The tri-party arrangement, by contrast, redefines the role of the intermediary (the clearing bank — and you thought we were done with naming different types!) so that it is no longer the matchmaker between customers but rather acts as a clearing agent, administrator of collateral and a funding backstop. In effect, the tri-party format takes over the balance sheet management and financing role from the bullion bank, which can instead focus on being a gold dealer or broker in the conventional sense. The bullion bank can therefore hold physical gold in inventory with little effort and no price risk using a tri-party system while continuing to offer many if not all of the same services that it has traditionally provided to customers.
Importantly, in a tri-party arrangement one party posts the collateral that the other party desires. And that desire for specific collateral is where things could get interesting for the gold market. As mentioned in Gold and Silver “Leasing” Examined, the persistence of negative lease rates could be accompanied by the emergence of something entirely new:
The result could be negative gold “lease rates” as gold price expectations may create an entirely new phenomenon: cash borrowed to buy gold for future delivery (what I call “gold bonds”). In effect, this is the equivalent of gold owners forward selling their gold at higher and higher prices, and receiving cash up front to be used for current liquidity needs.
The above scenario might at first seem a lot like the current futures market because it appears to involve leverage but the difference is that “gold bond” transactions are 100% backed by metal. It’s as if every outstanding futures contract required an equal amount of bullion stored in the COMEX warehouses. Mind you, there is no reason to have regulators force something like this on the market as advocated by some pundits — it will happen when people demand it.
The reason it may happen in the tri-party repo market is because tri-party repos present a menu of collateral choices out of which a bullion account fully backed by physical metal could become an important liquidity stopgap. A major risk in the past (and still present today) is the withdrawal of counterparties when a dealer experiences a sudden departure of customers and a corresponding decline in funds available to run its business. For example, consider the decline in collateral quality in the tri-party book of Lehman immediately before its collapse. Lehman was forced to sell its most liquid assets as it desperately sought cash, but doing so placed increasing pressure on the remaining collateral. At the end little to no funding could be obtained for the lower quality collateral that was left, creating a multi-billion dollar doughnut hole in Lehman’s balance sheet.
The beauty of gold is that it is not very liquid (compared to Treasury securities for example) but it can always be sold for cash. Therefore gold can potentially serve not only as a liquidity management tool for generic tri-party repo dealers but as the main form of collateral (if 100% physically-backed) in the tri-party dealer book of a bullion bank. In both cases, a financial panic that might decimate the collateral value of most other assets could actually enhance that of gold. So instead of withdrawing funds from the dealer’s tri-party account, the customer can continue to post or fund gold collateral according to its needs. Moreover, there is a regulatory push for automatic substitution of collateral in tri-party arrangements in order to avoid liquidity freezing up when the proper collateral is not available. Gold could serve an important role here as the ultimate collateral.
For the above reasons, a tri-party gold market cannot be developed using LBMA unallocated gold accounts issued by bullion banks that are not 100% backed by physical metal. Rather, the selective collateral nature of the tri-party format may force bullion banks to eventually declare their unallocated LBMA gold accounts as backed by 100% physical bullion. Indeed, the very reason for the bullion bank to “use” (sell) physical bullion in the first place — in order to offset risk on the balance sheet and allow simple netting between customers — will no longer exist under the tri-party format because the administrative and clearing role will be assumed by the operator of the tri-party or central clearing facility. True, the alleged desire to suppress gold prices would still be there, but then again why would an entity want to weaken the value of a product (physical gold) that its business increasingly depends upon? Even subservience to a fiat master starts to sound like a lame reason.
Here is part of JP Morgan’s clueless explanation of how it plans to offer tri-party facilities in the gold market as a clearing bank:
And, as clients seek that optimisation, they can now use their gold holdings as collateral within J.P. Morgan tri-party. With the CME and LCH.Clearnet accepting gold as collateral and Swiss Securities Services settling gold as a currency, J.P. Morgan has launched its own initiative to make the most of the yellow metal through the unallocated London gold market.
“Gold is just another asset, says Rivett. “From a collateral management perspective, it is operationally akin to a treasury, a corporate bond, an equity or an ADR. As collateral agent, we manage the book entry movement. Once gold is held in J.P. Morgan’s London account, it is a dematerialised asset that can be moved back and forth.
“Gold in the London unallocated market is relatively straightforward; it is how the markets operated for a very long time. We are quite pleased we have been able to leverage gold as a collateral asset by linking two J.P. Morgan businesses. Clients are looking at all the inventory on their balance sheet and where they can place all of their assets. Although gold is a very high quality asset, it has historically been viewed as relatively immobile. When you are looking at financing and funding, you want to be able to mobilise all of your assets. Being able to use gold as part of your collateral mix is a definite advantage,” he says.
The choice of words by JP Morgan sure does seem nefarious and fails to consider the growing distinction that gold market participants are making between paper and physical gold. There are also plenty of quotes here that Zero Hedge could use to condemn JPM once again as an evil force in the gold market. Thus we think that the lack of outrage or intense coverage of this relatively recent development of tri-party gold facilities in either the financial media or the blogosphere demonstrates the lack of understanding about the gold market that continues to exist on virtually all fronts today.
It may be true that plans to use LBMA unallocated bullion accounts with tri-party repos in the same way as they are currently used in the bullion bank’s business (including gold leasing) could have a negative impact: the gold price is depressed when physical metal is “deposited” as collateral with the bullion bank (that is, sold in exchange for paper). On the other hand, if there is increasing use of gold as collateral in paper form (LBMA unallocated bullion accounts not 100% backed by physical gold) then the magnitude of any eventual panic out of paper and into physical would be that much greater.
The above is certainly what we should expect but … but … but … there are reasons to suspect that the tri-party system will not work with just any old paper gold as already mentioned above. This has to do with why there is growing attention on gold as collateral in the first place: asset quality. If somebody specifically wants gold as collateral in a tri-party arrangement, they will not accept the good credit (or dodgy as the case might be) of a bullion bank. Meanwhile, access to quality assets may perhaps be the only salvation of the credit markets.
Simply put, sane market participants will naturally demand that gold as a financial instrument retain its utility as the ultimate collateral for non-recourse funding. Under these circumstances, the appearance of 100% physical backed LBMA unallocated bullion accounts seems like a very good possibility. The creation of these accounts, or the conversion of existing accounts that are partially backed or unbacked by physical metal, could counteract and even overwhelm the effects of gold-collateralized funding of the type that Ms. Kaminska identifies in her analysis. While there certainly will be gold appearing on the market from time to time in the form of gold leasing or similar funding arrangements, the 300 year history of archaic bullion banking may be coming to an end. If so, it could ironically be JPM that modernizes the gold standard by establishing gold as the premier monetary asset with no counterparty risk and infinite mobility.
Conclusion
We view the potential developments in the tri-party repo and gold markets described above as speculative with few short term effects but major implications in the longer term. There are certainly risks within collateralized lending given the central role it played in the collapse of Bear Stearns and Lehman Brothers. Regulatory and other issues remain to be worked out and tri-party customers will need to demand proper gold collateral since JPM and other bullion banks have little incentive to store physical gold given the associated costs. At a minimum, such costs will need to be built into the tri-party structure.
Yet the increasing use of gold as a secured funding mechanism in a world devoid of safe assets — witness the downgrade of U.S. sovereign debt by S&P and the threats to downgrade all remaining triple-AAA credit — means that a strong incentive exists for the emergence of physical products that combine gold’s lack of counterparty risk with greater prospects for its use as a means of exchange. This is essentially what BullionVault and GoldMoney have tried to do on a smaller scale. If it can be accomplished on a systematic basis, perhaps using tri-party gold swaps involving 100% backed LBMA unallocated gold accounts, then gold will have finally arrived again at its starting point: money in the functional sense.
Meanwhile we suspect that liquidity needs at commercial banks could continue to result in an uptick in gold leasing activity that is short term bearish, but once reversed should become bullish for gold. A few tens of tonnes (perhaps several hundred tonnes at most although the new Central Bank Gold Agreement effective for 2009-2014 contains no limitations on derivatives activities) of leased gold will need to be repurchased in the spot market during the next few months once liquidity is again being provided to European commercial banks using exclusively conventional means. We would expect such an outcome to be accompanied by declining LIBOR, or at least one that isn’t rising, as well as a falling gold forward rate all other things being equal. The amount of gold involved could easily lead to a $100+ per ounce price rally (assuming it has resulted in a similar decline since the September high due to gold leasing) or even more if the buying takes placed during the seasonally strong late January to May timeframe. Beyond that, any uptick in gold leasing during the months ahead will probably not have long-term negative effects but rather to the contrary given the market’s gradual loss of confidence in paper.
In summary, LIBOR has probably risen recently as a result of tightening in commercial bank liquidity. Banks simply have fewer dollars to loan out to each other. Since central banks themselves do not have a large inventory of dollars, they have likely been relying on leasing some of their gold reserves to the commercial banks as a backdoor liquidity measure. The commercial banks in turn would sell the gold in the spot market and use the dollars to meet their short-term liquidity needs. Such selling would be expected to drive the gold price lower even if the leased gold was in the form of unallocated accounts. At the same time, commercial banks buy the gold back on a forward basis since they are not speculating on the gold price but rather using the gold leasing as a source of dollar liquidity. This places upward pressure on the gold forward rate. Eventually this reverses and gold prices rise while the gold forward rate (and presumably LIBOR as well) fall. And the drumbeat of the gold market goes on.
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