The alchemists of Dark Ages lore had nothing on Wall Street. Like everything else in financial evolution, it begins as a good idea and gets warped and bastardized into a means of scalping “free money” for banks. This is particularly true in the age of prop accounts and banks masquerading as prudent intermediaries but operating as the largest hedge funds ever conceived. The numbers look good, but nobody really knows what’s inside.
This was true of both securitization and credit default swaps. It was even true of the marriage of those – they were good ideas, and even a great idea together, but mass production was never fully considered. Once the profit potential infiltrated the sales force, there was no stopping the misuse.
Likewise, gold leasing began under modest circumstances, a relatively benign idea that ended up far from where it started. Gold leasing appeared as far back as 1975 and the official end to gold prohibition in the United States. However, it was the drop in inflation and the end of the 1970’s gold bull market that created the demand for leasing. In the early part of the 1980’s, Australian bullion banks began to see the appeal as it related to the desire of producers to hedge falling prices. Leasing provided the banks with another financial “product” to charge fees and scalp a revenue stream.
From there it quickly evolved into a means to finance gold production and mine production itself. A prospective producer could obtain financing from an Australian bullion bank by pledging future gold production. The bullion bank, acting solely as intermediary, would “borrow” physical metal from a central bank. The central banks had stores of gold that were inoperable toward financial returns, and were eager to disgorge given the monetary winds that were blowing in the developing fiat system.
The central bank would “lend” physical metal to the bullion bank and the bullion bank would sell it on behalf of the prospective miner. Having sold forward future production, the miner now had the proceeds to obtain equipment, labor, etc. As the miner engaged in production, it would replace borrowed metal with newly mined metal, paying an interest rate to the bullion bank for facilitating the process. The bullion bank was neutral with respect to gold prices.
This original leasing arrangement was relatively innocuous on its face, although it brought forward production supply by disgorging central bank stores. That was price negative, but the mechanics were largely driven by supply and demand of metal. However, there were quirks in the accounting that soon changed the entire incentive structure.
For the central bank, there always remained a desire to hold gold on its balance sheet. The old golden age of “backing” currency with metal had not completely disappeared, but it was balanced by a longing to monetize. Much like repos, gold swaps became accounted as collateralized lending arrangements despite the very real difference of physical metal dislocations. That meant central banks could continue to show gold bullion in its official accounts (under the category of gold and gold receivables) while receiving interest from the bullion bank passing through miner payments.
For the bullion banks, the accounting worked in their favor through unallocated accounts. The LBMA indicates the distinction:
“The units of these accounts are 1 fine ounce of gold and 1 ounce of silver based upon a .995 LGD (London Good Delivery) gold bar and a .999-fine LGD silver bar respectively. Transactions may be settled by credits or debits to the account while the balance represents the indebtedness between the two parties.
“Credit balances on the account do not entitle the creditor to specific bars of gold or silver, but are backed by the general stock of the bullion dealer with whom the account is held. The client is an unsecured creditor.
“Should the client wish to receive actual metal, this is done by ‘allocating’ specific bars or equivalent bullion product, the fine gold content of which is then debited from the allocated account.” [emphasis added]
Lease arrangements from central banks and even miner repayments of gold loans would end up in unallocated pools stored in London. For a bullion bank, this was a tempting opportunity. Instead of selling the metal outright to finance the cash loan to the miner (and thus be neutral to gold prices), the bullion bank could obtain financing itself from another cash counterparty. Better still, it could obtain more than one financing arrangement through rehypothecation.
Since the gold was stored in an unallocated account, it was a liability of the bank. The cash counterparty is only interested in collateralizing its lending arrangement and typically is not equipped to store the physical gold collateral on its own. Therefore, in lieu of physical collateral, the cash counterparty is most often content with a standardized paper indemnification. The gold leasing market, then, behaves no different from the prime brokerage market for credit hedge funds – banks use securities as collateral for margin balances in the hedge fund accounts as well as the bank’s own account.
As long as gold flows through unallocated pools, the leasing system provides a stream of collateral for the bullion bank to use to finance both the miner loans and its own operations. Rehypothecation is a wonderful financial arrangement, making unallocated gold liabilities much more “efficient” for liquidity and capital management purposes. The new alchemy of Wall Street extended even to gold. What was once the preference of financing mine production became a financial tool for the bullion banks to self-finance. It stopped being intermediation and evolved into the modern monetary shell game, and it took banks from being neutral to gold to being active hedgers (once they adopted a liability position).
According to a confidential 1999 internal IMF memo, obtained by GATA, the total outstanding amount of leased gold from the official sector (central banks) at that time was about 4,275 tons (out of total leasing of 4,725 tons). The memo is careful to point out that the IMF undertook a survey of central banks and bullion banks to derive that estimate – there are no official records available and central banks are not exactly forthcoming. In 1988, the amount of gold leased by central banks was estimated at only 550 tons (1,200 tons total). That means central banks increased gold leasing by about 3,725 tons while other private sources removed 200 tons in the 1990’s. Leasing was apparently far more attractive to central banks than private sources.
The memo also indicated that some 80 central banks were party to leasing or swap arrangements.
In a June 26, 2000, speech to the Financial Times Gold Conference Hervé Hannoun, First Deputy Governor of the Banque de France, stated that his central bank was not among the active players in the gold leasing/lending marketplace. He did note the common reasons for the desire to engage in financialization of money, managing reserves and producing a return on a central bank’s asset portfolio, but he illustrated that policy at the Banque was unfavorable to gold financialization because:
“Central banks must be aware that their deposits may favour the financing of speculative gold sales. In other words, for a speculator (or a producer) who wants to take a position against gold, it would be very easy to be short because he can easily borrow from the official sector, which is a potential lender on this market. The result of this policy then would be a drop in the price of gold.”
This is particularly noteworthy due to the timing of the acknowledgement, coming both after the Washington Accords in 1999 and the adoption of the euro common currency. The ECB had pledged in July 1998 to hold 15% of its reserves in gold from the outset. The Banque was joined in its preference for holding over leasing by the Bundesbank.
That makes the behavior of gold since its peak in September 2011 tantalizing in regard to the ongoing paradigm shift in finance begun in August 2007. Prior to that month, the international banking system operated on an unsecured overnight basis to transmit monetary policy objectives. The Federal Reserve, or ECB, operating through open market operations influenced the Fed funds rate, or Eonia, and then onto eurodollar/LIBOR and wider interest rates. Once the eurodollar market froze in the context of counterparty risk re-evaluation, the marginal funding system has reverted/evolved into an almost entirely collateralized regime.
In the gold leasing markets, gold as collateral becomes both more valuable and less certain at the same time. It is more valuable in that, overall, usable and highly liquid collateral has become so much more important in the framework of liquidity management, but less certain in that gold participants are well aware of rehypothecation and leasing. At some point, particularly in times of real liquidity stress, the collateral repudiation we saw in first mortgage bonds and then troubled PIIGS bonds will extend to gold paper indemnifications.
That is why the recent and dramatic withdrawal of physical gold from places like the COMEX capture so much attention and thus demand some kind of explanation. However, no straightforward explanation is forthcoming because all of this is conducted under intentional secrecy. All we are left with is the diametrically opposed results – a huge increase in demand for physical metal that produces a huge decline in price?
If backwardation has set in to be a permanent fixture, it means that physical gold is increasingly not for sale in dollars. Marginally speaking, gold holders will not part with it for any “free” arbitrage in dollars (spot prices above futures). With published leasing rates (we have no idea what terms are actually given and transacted for banks outside LBMA “contributors”) so low and getting further depressed by various ZIRP and near-ZIRP regimes, the liquidity available for gold leasing falls as there is no spread available to cash owners. So gold rises in esteem and expectation, but falls in dollar value as the rollover of leasing becomes harder and harder – and thus forces dramatic moves to squeeze any marginal dollars into this process.
It only gets worse for lessees as counterparty risk is re-evaluated in the context of rehypothecation and allocated vs. unallocated accounts. The big 2 Swiss banks are already discouraging unallocated pools (they claim due to awareness of Basel 3, but I don’t buy that).
This is all a very verbose way to say that the gold bull market is far from over. The only way to “kill” the gold bull is to simultaneously and successfully restore paper trust at the same time the banking system regains unsecured lending and the real economy (globally) steps out of depression.