Thursday, 21 May 2020

Understand the divergence of Physical versus Paper precious metals? Where and how gold and silver is traded, and what determines its price.

 WHERE IS GOLD TRADED?

LBMA
London Bullion Market Association (LBMA) in UK is the largest over-the-counters (OTC) clearing house in the world. This is also called the spot market. OTC refers to trading usually done directly between two parties in an agreement and can be done electronically or by phone via broker-dealer network. There is no centralized stock exchange. Most OTC trades are cleared in London and the international gold price is derived here via daily gold auctions taking place twice a day, 10:30am and 3:00pm, where the LBMA will publish the gold price in US dollars.  LBMA also own and manage the good delivery lists for both gold and silver and has over 140 members such as banks, financial institutions, bullion dealers, miners, refiners, trading, vaulting, manufacturing companies over the world.

COMEX
The Commodity Exchange Inc. (Comex) is the largest gold and silver derivatives (e.g. forwards, futures and options) exchange trading in the world owned and operated by CME. Comex allows traders to leverage position using futures. There are two kind of investors in Comex. One is the commercial hedgers which either really need the precious metals or buy the metals to hedge against inflation. The other type is the speculator, who tries to profit by speculating the future direction of the precious metals’ prices. And just like oil (refer to my recent article here), gold futures are physically delivered upon expiration. But to avoid storage and logistic costs, contracts are normally closed prior to delivery by the speculators.


SWISS REFINERIES

Gold refineries are typically set up close to the bank of England to process the physical gold market in London. The Swiss Confederation is the world’s largest importer and exporter of gold. This is due to the mountainous terrain of Switzerland which provides a natural environment to excavate underground vaults for storage of gold. Furthermore, Switzerland has the largest concentration of gold refineries in the world. Swiss gold refineries account for more than 65% of annual gold refinery output.

During WW1 wealthy Europeans fearing tax hike relocated their gold holdings into Swiss accounts for storage to avoid taxation. It is also illegal for Swiss banks to disclose client information following the enactment of Swiss Banking Law in 1934. During WWII, UBS also maintained accounts for German Jewish businessmen and households. At the same time, they also collaborated with Nazi Germans by helping to store their gold and cash in the underground vault. And until 1990s, the three largest Swiss banks (UBS, SBC and Credit Suisse) maintained ownership stake in Swiss gold refinery. UBS and SBC merged in 1998 to form UBS AG.

The four giant refineries are Argor Hereaus SA, Valcambi, PAMP, and Metalor Technologies. The former 3 refiners due to its location are called the Golden Triangle of gold refineries. Interesting for Singapore readers, Valcambi is 100% owned by Global Gold Refineries Ltd, which in turn is 95% owned by REL Singapore Pte Ltd, and 5% by Rajesh Exports Limited in India. Rajesh Exports is also the 100% parent of REL Singapore, hence a controlling shareholder in Valcambi.


HOW IS GOLD PRICE DETERMINED?

Auction
As explained earlier, the international gold price derived via auctions in LBMA in London.

Factors affecting the price
Gold price is closely related to interest rate. Central banks and IMF play important role as they hold the largest gold reserves, and lend and borrow gold.

It is generally accepted that if interest rates rise, gold price will fall. This is because gold earns no interest, and if interest rate rise, it is better to hold currency rather than gold. Conversely, if interest rate falls, gold price will rise. This is because gold is often seen as the true money with a store of value, while currency’s storage of value is dependent on the confidence of that particular currency. For e.g. Venezuela experienced hyperinflation in recent years, when there is no real demand and oversupply of its currency. It’s currency simply loss its value. Germany Weimar Republic in the 1920s is another notable case of hyperinflation.

That said, interest rate and gold price is not always inversely proportional. For e.g. during Apr 2011, ECB raised rate from 1% to 1.25%, the first since 2008 crisis, but gold price rose and hit new high. One of the possible reasons is that investors believed that rising of interest back then may puncture the balance sheet of smaller and weaker eurozone countries such as Portugal, Greece and Ireland leading to a collapse of Europe’s economy.

Therefore, gold price is affected by interest rate, macro-economic factors, and central bank’s monetary policies.


HOW IS GOLD TRADED?

Gold like currencies is borrowed and lent by central banks in the interbank market. Because the interest rate of currencies in US is lower, this encourages gold borrowings from the US by the central banks. Gold bought in spot in UK will have to be converted to USD in USA, hence gold trading is somewhat similar to forex also. It is also somewhat similar to oil futures also and can be in contango when forward gold price is higher than spot price, and hence can be relatively liquid in derivatives market. However, it is not really dependent on demand and supply like most commodities but more dependent on the auction pricing people willing to pay. Gold can also be traded as ETF such as SDPR gold shares (GLD). Others are ETNs, CEFs, gold certificates or gold and silver accounts issued by banks etc.

Gold is generally traded on unallocated spot market in London and New York. I will explain what is unallocated market in the following section. Both markets are derivative markets and neither is connected to the physical gold market. In a sense, the physical gold price is actually the price taker from the paper market. Normally, when the paper spot price rise, the physical gold price will also rise. Vice versa. The price difference of paper gold and physical gold normally differs by a few dollars.


WHAT IS ALLOCATED AND UNALLOCATED ACCOUNT?

Allocated account in simpler term means physical allocated to a specific customer. Unallocated account is a more popular way of transactions though which means that transactions can be settled by credit or debits. And if there is a credit in an account, it does not mean that the creditor is entitled to specific physical gold or silver. Instead these credits are backed by a general stock of precious metal with whom the account is held.

In other words, if you trade on unallocated account, your holdings of 10 oz of gold on paper does not mean that there is 10 oz of physical gold stored somewhere.

Perhaps if there is 10,000 tonnes of paper gold in unallocated credit account, in reality there may only have 1,000 tonnes (arbitrary) of gold backing these unallocated credit account. Essentially, they operates like a bank with a fractional reserve system. So what exactly is the ratio of Paper Gold versus the real physical gold stored in vault? We have no idea. The LBMA and its members provides no information on this fractional ratio!

Therefore if there is a “bank-run” scenario in the LBMA, that is all the Creditors requested for the delivery of the gold at the same time, the Bullion Market will crash. And it is likely that the creditor of the unallocated account of gold will not be able to retrieve any of the precious metals he/she owns.


WHY IS THERE A DIVERGENCE OF PHYSICAL VS PAPER?

As of end March, there is a huge divergence of London spot (Physical) and Comex (Paper) contracts, with a spread of over USD100 from the usual few dollars. Bullion banks maintain long on London spot and short on COMEX futures. I will explain why Bullion banks have this position later. When price of paper gold rises, Bullion banks have to cover their huge shorts positions losing a lot of money. The paper gold “bought” transactions drove up and the physical gold to back that paper gold is unable to keep up, hence causing a wide divergence of physical and paper gold.

Corona Pandemic
Many blamed the covid-19 pandemic when countries shut borders and grounded planes which limits the movement of physical gold from London to New York. Also, the refineries were short of capacity to meet the delivery of New York demand which are typically in the forms of 100 oz bar for standard COMEX gold futures. The physical gold stored in London are often in the form of 400 oz bars. As the pandemic struck with social distancing, the refineries in Europe are unable to produce the 100 oz bar in time to be delivered to US.

Lack of Physical gold to back paper gold
However, the main problem of the physical precious metals crunch is really due to the unallocated gold or gold credit or swaps which bullion bank issues through its fractional reserves system. This means that there is a lack of physical gold to back the paper gold traded.

Many countries stored their gold deposits with the Bank of England (BOE). These gold stored are used as a collateral against currency loans or can be redeemed/sold especially in a rising gold price environment. Just this week, Venezuelan government has been asking BOE to sell 31 tonnes of the gold worth more than 1 billion euros, but are met with loads of excuses from BOE to stop the sale of gold. Perhaps the reserves of Gold in BOE is getting low and they are worried of a “gold bank run”.

In the late 1960s, France President Charles de Gaulle soon realized that USA do not have gold to back the dollars. France asked for their gold and from USA in exchange of the dollars back to USA. Soon other countries follow suit. This resulted in a bank run on gold for USA in which she lost 50% of its gold from 1959 to 1971.

Fearing that US will eventually run out of gold and go bankrupt, U.S. President Richard Nixon ended international convertibility of the U.S. dollar to gold on 15 Aug 1971.

The world’s largest gold-backed ETF is SPDR Gold Trust (GLD) in which HSBC in London is the vault custodian. With the increasing paper gold demand in Mar-Apr this year, HSBC vault saw a massive inflow of 175 tonnes of gold bars with a holding of 1083 tonnes. The inflow of gold to HSBC vault coincides the period when HSBC revealed that it saw $200million single day loss because of the widening of the spot and derivative spread.

The question really is where does the additional 175 tonnes of gold came from? As of end April this year, HSBC has 46 tonnes of gold that was held in sub-custodian vault with BOE. It is highly possible that in the month of April, HSBC used the 46 tonnes of gold stored with BOE to add to the SPDR Gold Trust, instead of using gold at its own HSBC commercial London vault.

We ponder if there is really sufficient physical gold in HSBC vault in London to back the SPDR Gold Trust?  


WHY BULLION BANKS MAINTAIN LONG ON SPOT AND SHORT ON FUTURES?

There are many reasons, but one reason I can think of is because I assume Bullion banks in London are net lenders in general especially to the US COMEX market. And bullion banks work on the basis of fractional gold reserve system to earn an interest out of the lending.

In the event that interest fall, gold price tends to rise. The bullion banks will loss on their interest earnings. But because they are long on spot, the earnings from the rise of gold price can offset their losses in interest. Likewise, if interest rise, gold price tends to fall. Bullion can then earn higher interest on their spot lending and at the same time, they will earn in their shorted futures contracts. Both directions of interest and gold price, bullion banks are hedged!

Correct me if I am wrong in my explanation.

Other reasons of the long spot, short futures are as a result of Bullion banks being proprietary traders, as well as their role as financial intermediary for various gold market participants, such as gold miners, central banks, refiners, fabricators, hedge funds etc.  


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