Sep 302015

Chris Powell of GATA took exception to my comments about the financialisation of the gold market in my post on Friday, saying that “the more that markets are ‘financialized,’ the more advantage passes to those with the greater access to financing”. I would argue that increasing financialisation increases the advantage of the average investor.

I was using the term “financialisation” in the sense of increasing use of financial instruments, like futures or ETFs. These products are another method by which investors can get exposure to gold, rather than traditional methods like buying gold over the counter and storing it at home. They are popular and have come to dominate over buy-and-hold because they reduce the cost of buying and selling and make it easier to transact. Do they introduce new risks, like exposure to promises of the parties at the other end of the contract? Yes, but then storing gold yourself is not riskless either.

Making it easier to buy, and yes, sell, gold does not give more advantage to the rich. If there were no futures markets the rich would have no problem contacting their private bankers and arranging to put $10 down and borrow the rest to control $100 worth of gold. If “only cash-on-the-barrelhead trading in gold [was] allowed” it would just limit leveraged buying (using borrowed money) and leveraged selling (using borrowed gold) to the professional players. The only advantage that would be “evaporated” would be that of the average retail investor, who would not have that ability in such a world.

Public futures markets, contracts for difference, FX platforms and so on provide easy access for retail investors to magnify their $10 into $100 of buying power. Given that retail investors have been observed to generally prefer long positions and not be comfortable shorting markets, it could be argued that increasing financialisation has been net positive for the gold market. Note also that ETFs opened up the gold market to funds who were restricted from holding physical gold by their terms.

Do such financial products make it easier to short markets? Yes, but that was always easy for the rich and professionals to do. I would also note the comment here that “numerous studies … agree that short selling is beneficial” and that “short-selling bans not only fail to achieve their intended aims, they also have adverse impacts on all market participants: reducing liquidity and increasing volatility”.

Financial gold products are just alternative tools for investing in gold. If a carpenter produces bad work, do we accept that the tools are to blame? Financial products make it easy to buy, or sell, gold. If market participants, including those with the ability to “create infinite money for futures trading purposes” as GATA claims, choose to sell gold then is that a problem with the financial tool, or the user of that tool?

I suggest the answer is to advocate, as GATA does, for transparency regarding public policy in respect of the gold market. As the BIS says, central bank autonomy requires clear objectives, balanced by transparency and accountability.

Sep 292015

On Friday I recorded an interview with Kerry Stevenson of Symposium, a firm which focuses on events promoting Australian resource companies and precious metals. The podcast was posted today and you can listen to it here. Kerry asks me how I got into the precious metals business and we discuss the purpose of precious metals in a portfolio. I talk about why I own gold, how banking has changed, money and debt and the Ponzi-like instability introduced into an economy if money is created for non-productive purposes. I also discuss how economies have been able to get away with excessive debt issuance, making mockery of calls for a reckoning.

The interview was a teaser for the Precious Metals Investment Symposium which will be held in Sydney on October 26-27th. I will be speaking on the Tuesday on:

Why hasn’t the bullion banking system failed?

For years commentators have said that the failure of bullion banking is imminent and futures will default, yet nothing has happened. Why have they been so wrong? Bron will look into the mechanics of the paper/physical nexus to answer the question: will Paper always beat (pet) Rock?

The talk will partly cover the material in my fractional reserve bullion banking series of posts, but in a more easy to understand graphical way.

Kerry and Marcus have put together a really good speaker list, in addition to the mining company presentations. Well worth $199 for an early bird ticket. Look forward to meeting and chatting with my Australian readers in Sydney.

While I’m on conferences, I will also be speaking at Mines and Money in Hong Kong April 5-8th. I’m talking to our dealers in the region to see if they can line up some client seminars in Hong Kong and Singapore around that time.

Sep 252015

Alex Stanczyk of the Physical Gold Fund has just posted a transcript of an interview with an executive at a Swiss refinery about the state of the market. It is well worth a read or listen to the podcast. Below are some quotes and my take on them.

“How difficult is it to source the metal you need today? … It is truly difficult. This is also reflected by the price. It is getting more and more expensive to get material out of the market, and also there is less liquidity in the physical precious metals market than there used to be in the past.”

I think the statement that the difficulties “is also reflected by the price” needs to be clarified as later on he says “the price does not reflect the realities at all.” This is not a contradiction! The first reference is to the premium, the second is regarding the spot (ie metal) price.

When acquiring physical, the professional end of the market settles trades by unallocated account debits and paying a small dollar premium for charges, freight etc, rather than buying a physical form on the spot market with dollars. The references to “price” and “expensive” were to that premium above metal. See this post if you want more detail on this aspect of the market.

It was a bit frustrating that the interviewer did not pick up on this reference and drill further – was this a premium on 99.50% 400oz bars, if so were bullion banks refusing/delaying redemptions from unallocated accounts, or was it for other forms or was he referring to loco premiums reflecting freight and funding costs?

I would have also liked to know to what extent that refinery’s feed stock comes from newly mined gold or do they rely more on scrap and 400oz bars. Each refinery has a different mix of source metal and contractual arrangements for supply that can affect their perception of tightness. The Perth Mint is primarily a newly mined supply refinery with scrap being a swing form of supply for us, so we have a strong base of supply.

“The other point is that nobody is interested in any physical delivery at the end. These products are all cash settled. People are happy just to use the spot market as a benchmark, and the product itself never ends up in the physical market.”

He is obviously talking about Western markets here, and he makes an important point and will tie in with my future posts on fractional reserve bullion banking. He goes on to note that this is a dangerous set up as if everybody wanted the physical it “would not be around”. However, this is not a risk as “it looks very much like people are very confident in general financial markets”. The question of course is how much physical reserve exists against bullion bank unallocated accounts versus how much of an increase in physical redemption activity occurs.

“As long as market participants are happy for cash settlements, this can go on forever.”

So true. This was in response to a question about a mismatch between the spot price, which has been low, versus the tightness in the physical market. This idea of a disconnect between paper and physical is an argument that the money in the futures market or other paper markets is somehow not legitimate, that their “view” on price is not valid. Yes markets are more financialised these days, get over it.

I guess some people think that if only futures markets could be banned and everyone had to trade physical, the price would magically shoot up. They forget that if you ban all forms of paper gold you ban paper longs. And in any case, any paper contract can be synthesized using physical and borrow/lend. They also seem unaware that the net position of paper trading is, by arbitrage, reflected into the physical market, and vice versa.

“The flows of metal end up in Asia. It is mainly China, also India, and to some extent the Middle East.”

Same here in Perth.

“Then there is price-sensitive scrap – very opportunistic – coming every now and then out of Asian countries; not China or India, but other countries in the area.”

This is not something you hear talked about a lot, but yes the Asians do actually sell gold but are very good at it. Having a location advantage to Asia compared to the Swiss refineries, we do pick up a lot of this business but as I mentioned above, it is a swing or volatile source of material for us due to its price sensitive nature.

“since the last move up, a lot of scrap has already come to the market, so if the price moves up again, I don’t know how much scrap will be around in order to compensate for the lower volumes coming from the mining industry.”

I note that at the Denver Gold Forum CPM Group saw that a decline in mine production from 2018 was baked into the cake given the lack of exploration. If our refinery guy is right about scrap then the next leg up in the gold price could be quite dramatic. It is hard to call the scrap market as really high prices may be the inducement to get women to look in the bottom of their drawers for that last bit of out of date jewellery, and you can be sure the cash for gold business will be promoting hard in that environment. In any case scrap has not been/will not be a major source of metal sufficient to dent bullish demand too much, when it comes.

“If you see in one of these products a paragraph that references the possibility of cash settlement, keep your hands off.”

Good advice, I don’t think investors really pay attention to the contractual terms of the products and read between the lines, and often it is about what is missing rather than what is there.

Sep 232015

In our last post we discussed the risks a bullion bank faces when operating a fractional reserve system due to the mismatch between when its assets and liabilities fall due. The main way this risk is mitigated is by borrowing gold from another bullion bank or central bank. To understand how this works in practise, we need to understand how the bullion banks interact with each other.


A couple of posts ago I gave an example of the transferring of unallocated gold between accounts. In reality the sender and recipient would likely bank with different bullion banks. Assume we start with two bullion banks as so:


If our Refiner banked with bullion bank #1 and our Miner banked with bullion bank #2, this is what the result would be if the Refiner requested a transfer to the Miner’s account:


There would be many of these transfers during the day, including clients of bullion bank #2 wanting to transfer to clients of bullion bank #1. Lets say a bullion Dealer A had sold 3 ounces of gold to bullion Dealer B so requested his bullion bank #2 to transfer 3 ounces to Dealer B’s account with bullion bank #1. This would be the result:


At the end of the day a bullion bank would net out its transfers with other bullion banks leaving it either owing gold to each bullion bank or being owed gold from each bullion bank. In our example above, it would net out to 7oz owed by bullion bank #1 to bullion bank #2.

Now while bullion banks are likely to be willing to extend credit to other bullion banks, that is, hold unallocated balances with them, each bullion bank has an internally set credit limit given to the other bullion banks beyond which it will not want to hold unallocated. For example, if bullion bank#1 only had refining clients, and bullion bank#2 only had mining clients, we would expect bullion bank#1 to owe bullion bank#2 an ever growing large amount of gold.

Once a bullion bank reaches this limit, if it wants to request any more transfers to the accounts of clients of another bullion bank, it would have to ship physical gold to that other bullion bank in settlement. Once you start adding more and more bullion banks, it would result in a lot of gold moving between vaults. You would end up with something like this (arrows indicating who owes who):


To the make the settlement of these positions between many bullion banks more efficient, the five major bullion banks formed a not for profit organisation called London Precious Metals Clearing Limited (LPMCL), which is a daily electronic settlements matching system that “avoids the security risks and costs inherent in the physical movement of metal.” Each member of the LPMCL has the right “to call for any one, or a combination of the following actions:

  1. a) Physical delivery of metal.
  2. b) Transfer of all or part of a credit balance to another member where the caller has a debit balance.
  3. c) Allocation of metal.”

Note that there is no “cash settlement” option, only net out or cough up physical. How would this work in practise? Lets put some numbers to the diagram above:


The first thing that a bank is going to do is use some of its credit balances (what other banks owe it) to transfer to (or pay off) bank to whom it owes gold (debit balances). Note that this means a bank can choose who they want to owe it gold – this is the first way they can control how much exposure they have to a bank. They will choose to transfer credits from banks that they have too much exposure to, to banks that they still have a willingness to have credit exposure to. Given the table above, lets assume the following instructions are given under LPMCL rule b):

  • JP Morgan asks UBS to transfer 8oz to HSBC
  • HSBC asks Scotiabank to transfer 2oz to UBS
  • UBS asks Barclays to transfer 4oz to Scotiabank
  • Scotiabank asks Barclays to transfer 1oz to HSBC
  • Barclays asks JP Morgan to transfer 5oz to Scotiabank

The result would be this table of who owes who, which is a lot smaller.


If after this a bank still had too much exposure for its liking to another bank, it would then request physical allocation under LPMCL rule c), as Allocated metal is not on the balance sheet of a bank and thus will remain the property of the owner in the case of bankruptcy. A bullion bank could also reduce credit limit exposure by choosing physical delivery but whether it did so would depend upon balancing out the shipment costs of a delivery versus the storage cost charged to the bullion bank for holding Allocated. Taking delivery would only be chosen if the bullion bank expected to continue to accumulate credit balances with the other bullion bank such that storage fees would accumulate over time and exceed any shipment cost.

Finally, if a bullion bank to whom gold is owed had requests for physical delivery from its clients and not much physical reserves of its own, it would request physical delivery under LPMCL rule a).

The LPMCL notes that the key purpose of the system is “to ensure that excessive exposures are minimised”; for bullion banks to “to minimise their credit risk exposures” to other bullion banks. This is reinforced by the fact that a LPMCL bullion bank member must provide “same-day allocation of metal to a creditor member and it is expected that such allocation will be provided within one hour under normal circumstances.”

The same-day allocation within one hour requirement means that when the clients of a bullion bank request the transfer of unallocated gold to accounts at other bullion banks, then that request will require the bullion bank to have physical gold if:

  1. it expects on a net basis across all the other LPMCL bullion banks to have a debit balance (ie it net owes other bullion banks); and
  2. it expects that the amount it will end up owing to the other bullion bank(s) will exceed the credit limit that the other bullion bank(s) have given it.

Note that the transferring credit balances also allows a bullion bank to choose who it ends up owing gold to, so it has a little bit of control over the probability of whether it will be required to allocate or deliver physical, as it can pick a bullion bank with whom it expects it still has credit with. Ultimately, the total extent to which all other bullion banks are willing to extend credit to a bullion bank will impact on how much physical reserves that bullion bank needs to keep. It will also determine how much of a bullion bank’s unallocated liabilities end up being “backed” by unallocated claims on other bullion banks, which just means it is “backed” by the quality of the gold assets held by those other bullion banks.

One final observation. Each of the five major bullion banks also hold accounts with the Bank of England, with the LPMCL noting that being a bullion bank clearing member involves “close liaison with the Bank of England”. The Bank of England acts as a custodian to the bullion bankers, a neutral counterparty, but is not part of the LPMCL itself. So allocations could also occur by a bullion bank requesting transfer of its allocated with the Bank of England to another bullion bank’s account with the Bank of England.

Free Banking

The bullion banking clearing system described above has a lot in common with free banking, which is “the competitive issue of money by private banks as opposed to the centralised and monopolised issuance of currency under a system of central banking.”

That quote comes from George Selgin’s 1988 paper The Theory of Free Banking: Money Supply under Competitive Note Issue, which provides a good explanation of it. It is 192 pages however, so I would only recommend it to the most dedicated. I’ll do my best to draw out the parts of Selgin’s paper relevant to this topic.

The key features of a free banking system as described in Selgin’s paper include:

  • no central bank, ie no monopoly of currency issue
  • each bank issues its own branded bank notes
  • banks compete against each other for deposits and loans
  • banks hold physical gold as reserves (not government fiat)
  • people are paid in different branded bank notes and deposit these with their bank
  • banks settle/clear the notes of other banks deposited with them by their clients with gold
  • banks establish a clearinghouse to facilitate inter-bank settlements

For the moment let us leave the question of a central bank and consider the above in terms of what I have described over the past few posts. In the case of bullion banking, while there are no physical gold notes circulating, we can consider unallocated accounts as equivalent of the branded bank note – unallocated is specific to the bullion bank with whom you hold it. The bullion banks do compete with each other in a light touch regulatory environment, depending on the jurisdiction, and the bullion banks hold physical gold reserves and settle in physical gold via a clearinghouse. So bullion banking appears to operate like a free banking system.

One of the key conclusions that Selgin comes to in his paper is that under a free banking system, the supply (creation) of money only responds to changes in demand for money by people. In other words, central bank created inflation as we know it does not occur and “the value of the monetary unit is stabilized, and events in the money market do not disturb the normal course of production and exchange.”

The implication for bullion banking is that if it operates along free banking lines, then there is no excess unallocated gold created, that is, no “inflation” in gold credit and thus no resulting deflation/fall in the fiat price of gold.

The reason no excess unallocated gold is created across the system is that if an individual bullion bank creates/lends too much gold credit (unallocated) then when its clients use/transfer that unallocated to clients with accounts at other bullion banks, it will result in that bullion bank owing a disproportionate amount of gold to its competitor bullion banks and they will request physical to settle the growing LPMCL imbalance resulting from that bullion bank’s over lending. So all bullion banks are restricted in their unallocated gold lending to the extent of their physical reserves.

However, Selgin notes that the mathematics of inter-bank clearing mean that if all banks expand credit at the same rate, then there will not be any adverse inter-bank clearing balances between them and thus the possibility exists that gold credit across the system could increase beyond what is required. He notes only two controls over such collusive (or game theory type response – ie if you are expanding credit, I will/have to as well) behaviour:

  1. The growth in money supply will result in a growth in clearings, which will bring with it a growth in the variability of clearing debits and credits. This will require banks to increase their precautionary reserves, and this increase in reserves constrains money creation.
  2. The redemption of physical gold by the public (ie, the reduction in bank reserves).

For bullion banking, the implications are that inflationary gold credit creation (which would push the fiat price of gold down) is restricted only if there are a few prudent bullion banks that do not follow their competitors. If not, and all bullion banks increase at the same rate, there will be inflationary gold credit but it will stabilise at some higher level (other than that required by legitimate gold credit demand) due to the variability of clearing debits and credits.

However, we know that central bankers hold gold and lend it to bullion banks, so we do not have a true free banking system. Then again, it is also not like a fiat system as gold can’t be printed, so it is a half-way house or a Semi-Free Bullion Banking system.

Selgin notes that with a monopolised currency supply, central banks can create more reserves and “since such expansion is a response to the exogenous actions of the monopoly bank and not to any change in the money-holding behavior of the public, it involves “created” credit and is disequilibrating”.

So in our Semi-Free Bullion Banking system, the lending of gold to the bullion banks by a central bank increases the bullion banks reserves and thus increases the bullion banks’ ability to create more gold credit (unallocated). This inflation in gold supply naturally results in its fiat price falling. If so, why then would a central bank actually sell its precious physical gold if it wanted to manipulate the gold price when it can do so via reserve expansion instead? An answer to this rhetorical question tomorrow.

Sep 212015

Fractional Reserve Ratios

In our last post we showed a simple bullion bank balance sheet. In reality, there are many different types of assets and liabilities that mature over a range of different time periods. Below is a more complex gold balance sheet.


I’ve also added in an additional column called Due Date, which shows the date the asset or liability comes due.

In our example above many would say that the bullion bank is running a 10% fractional reserve ratio – 5oz of physical in their vault plus 5oz at the Bank of England divided by 100oz of liabilities. However, 80oz of the bank’s gold liabilities cannot be called by the holders until they are due and there are only 20oz of unallocated liabilities that customers could demand the bank to repay immediately. In this case the bank only has risk to 20oz, against which it holds 10oz, giving it an on-call fractional reserve ratio of 50%.

The bullion bank’s ratio changes over time as the assets and liabilities mature. In one month’s time the bank receives 20oz from its expiring long futures contract, giving it 30oz against 20oz of liabilities, a ratio of 150%. In three months however it has to pay back a 30oz loan to bullion bank B and at that point in time it would have zero physical gold to back its unallocated liabilities.

By six months it receives 40oz and has to delivery 20oz into its short contract, leaving it with 20oz and a 100% reserve ratio. Finally, after one year, its maturing liabilities are matched by maturing assets and it remains covered 100%.

While banks do publish information about the maturity of their assets and liabilities, their bullion banking activities are usually so small relative to the size of the whole bank that they are not required under accounting standards to disclose their precious metal activities separately. It is therefore impossible to establish the ounce reserve ratios for bullion banks.

It is worth noting that the following terms are often confused:

  • Fractional – ratio of physical gold to total liabilities
  • Leverage – how much capital (your own money, also called “equity”) you invested into an asset. The rest is borrowed. Leverage increases your returns but also your losses, making your investment more risky.
  • Turnover – trading volumes versus total stock on issue/available.

Jeff Christian, of precious metal advisory firm CPM Group, indicated that bullion banks generally operate with a fractional reserve ratio of 10% and that the turnover ratio is around 100:1.

Maturity Risk

A bullion bank manages the risk that its on-call unallocated holders request delivery by holding some amount of physical gold. How much depends on its assessment of the make-up of its on-call depositors and their historical redemption rates.

For example, a bullion bank could probably be sure that a large hedge fund is just after cash profits and unlikely to want physical. Gold industry unallocated holders may also be historically reliable, as individually they would hold small balances (using them primarily for settlement purposes) and redemption behaviour as a group would be consistent.

However, there is a risk that a bullion bank gets too confident about the reliability of its historical redemption rates. In 2008, for example, The Perth Mint experienced a surge in demand for its silver coins which exceeded the output from our refinery, so we began to withdraw 20 tonnes of silver a week from London for a number of months, which was well beyond our usual activity.

Even if we assume that a bullion bank has 100% physical backing its on-call liabilities, we could still have a problem in the future where all of the bank’s counterparties could honour their commitments, but the maturities don’t match up, leaving the bullion bank short gold. This is the situation in our example above where after three months the bullion bank B would have zero physical gold to back its unallocated liabilities. The way a bullion bank can manage this maturity mismatch is to:

  • request an extension from customer and pay them an interest penalty
  • borrow gold from another bullion bank or central bank

Even if all maturities are perfectly matched, a bullion bank can have the problem where a counterparty fails to honour their commitments when they fall due (ie defaults) and the bullion bank is short gold. In this case the bullion bank needs to determine if:

  • the counterparty is just having their own liquidity problems, in which case the bullion bank can borrow gold from another bullion bank or central bank and charge their counterparty a penalty
  • the counterparty is permanently defaulting (bankrupt), in which case is the bullion bank:
    • Secured – then the bullion bank can draw on the collateral and margin and use that to purchase gold
    • Unsecured – then the bullion bank has to book a loss and use their own cash to purchase gold (and maybe recover some cents on the dollar from the counterparty later)

You’ll notice a certain commonality in the mitigating controls mentioned above, which gives us another two points of risk:

  1. will the bullion bank be able to buy enough missing gold with the cash (ie, we have trading liquidity, volatility and gap risk); or
  2. will another bullion bank or central bank be willing to lend the bullion bank gold (note, depending on the type of depositor, this could just be a need for unallocated, not a physical gold loan)

The size of the problem also matters. In our example above, if the amount redeemed was 11oz then that means the bullion bank only needs to find 1oz but if the amount redeemed was 20oz then the gap is 10% of the bank’s balance sheet. In addition, if the size of the bullion bank’s problem is large relative to the overall market, then buying or borrowing gold may be more difficult.

In our last post we mentioned the risks associated with point 1 in terms of valuing gold derivatives and trading them. In our next post we will discuss point 2 and how the clearing and lending of gold between bullion banks works and the involvement of central banks in the process.

Chill out, gold-dudes

 Posted by at 12:20 pm  Investing
Sep 182015

On Wednesday Bill Holter responded to my post Who is the player and who is being played? finishing up with “comments welcome (even from Bron Suchecki)”. So I emailed him last night. Right up I apologised for the inference that he was playing people – that was a rhetorical step too far. People who have been reading me since 2008 when I started my personal blog will know when I go after something I usually go hard. Probably something to do with growing up in a working class suburb, where you learn quick to get on the front foot.

Bill was surprised to get a reply from me, which I think reflects the expectation these days that many on the internet are willing to dish it out but can’t take it. I didn’t know how Bill would respond but the way he did speaks volumes. Others I’ve butted heads with get all personal or you can see the hate flowing through their responses. Indeed there was a lot of anger in some of the comments and tweets to my post and I found myself asking, why?

No doubt my calm approach to trying to understand these opaque precious metals markets infuriates those I disagree with. How can I be so cool when so much is wrong about how our economy operates? Simple – I own gold! (and I eat what I cook, storing it at The Perth Mint). Do I think the precious metals market will default any day soon? No, but if I’m wrong my gold has me covered.

I mean, chill out, gold-dudes, why all the anger? Isn’t that is the point of holding gold – insurance to give you peace of mind? If you not getting that from your metal, then you’re doing something wrong.

While many may find this hard to believe, the fact is The Perth Mint is on your side. That the West Australian Government has retained ownership of the Mint through waves of privatisation is, I think, a demonstration of its support for the gold industry. Precious metal ownership is only a few percent of the population so we should focus on what we have in common rather than what divides us.

Does this mean I’m not going to pull people up when I think they have the wrong end of the stick? Nope. But I will make a resolution to be civil about it, keeping in mind that we are striving for the same thing. For those  also after the truth that shouldn’t be a hard ask.

Sep 162015


Bullion banking is integral to the function of the modern gold market. Unallocated and allocated gold accounts and associated clearing mechanisms centred in London facilitate the efficient transformation of gold from mine to end consumer. However, banking involves risk – for an individual bank should borrowers fail to repay their loans and also at a systemic level.

This series of posts on the fractional reserve bullion banking system explain how bullion banking works and where the risks are.


Unallocated bullion bank accounts are fractionally backed, no different to fiat banking. Indeed most unallocated accounts are fractional, as it is impossible to offer a 100% backed account with no storage fees unless you are a physical user of gold like The Perth Mint.

Unlike refiners, manufacturers or distributors, a bullion bank has no real need for physical gold itself. Unless they are storing it on an allocated basis on which they can charge storage fees, having a (free, or very small fee) unallocated account backed by physical gold in a vault is, if not an outright loss, at least a not very productive and profitable use of their client’s gold deposits.

Therefore bullion banks are incentivised to lend gold. This naturally leads to the question of how much do they lend and how much do they keep as physical reserves. The fact is no one really knows. Jeff Christian of CPM Group gave us an insight into the possible fractional reserve ratio here, where he says that most banks are operating on a 10:1 ratio, but notes that AIG was operating at 40:1.

In terms of fractionalisation, it is important to distinguish between on-call deposits and term deposits. For example, if a bank borrows gold for a term of 1 year and lends it out for 2 years, that does not present any immediate risk of a bank run as the lender to the bank has no right to the gold now, only in 1 year.

Bullion banks lend their on-call gold deposits (that is, unallocated account credits) to borrowers for fixed terms into the future. This is called maturity transformation and I tend to agree with this blogger that “that, without any government protection, it is incredibly unstable and will melt down at a drop of the hat. With full government protection, it is stable”.

So in addition to how much physical does a bank hold relative to on-call deposits (fractionalisation), how long a bank has lent out gold for also matters. For example, if a bank only had 10% as physical but had lend the remaining 90% for no longer than, say, 1 week, then you may conclude that they are unlikely to suffer from a bank run as they will quickly get gold back to repay those on-call depositors.

However, that assumes the people they lent it to actually deliver against their promise to repay their gold loan. In other words, to whom did the bank lend and how credit worthy are they? This is called credit risk.

But, the bank may claim, we have collateral against the loan, so if the client doesn’t pay up we can sell their collateral and buy the missing gold. This of course assumes that the collateral does not go down in value or that the gold price does not go up, in a market stress situation. This is called price risk.

So the risk a bullion bank’s unallocated accounts presents to them depends on the bank’s:

  • Fractionalisation – percentage of physical gold reserves they hold
  • Maturity transformation – degree of mismatch between maturity of assets and liabilities
  • Credit risk – the credit worthiness of unsecured counterparties
  • Price risk – amount and quality of collateral and gold price exposure for secured counterparties

All of these factors apply to fiat banking as well, but as our blogger notes, fiat banking is ultimately backed by government. This is possible because a government can print fiat and exchange it for a bank’s long term assets, suddenly increasing the bank’s physical (banknote) fractional reserves to give to depositors, and thus avoid a bank run.

However, while one can’t print gold, a bullion bank experiencing a run where its unallocated holders want physical delivery can approach central banks to borrow physical gold on the basis that its gold assets will mature into gold eventually, with which it can repay the loan.

Gold Assets

Understanding the types of gold “assets” a bullion bank can hold, and the risks associated with each of them, is essential to assessing the stability of the bullion banking system.

In the case of gold lending, there are two types of borrowers as there are only two things you can do with borrowed gold (no one borrows gold just to keep it at home to look at):

  1. Use it as inventory in your gold business (eg jewellery, minting)
  2. Sell it (that is, short the gold price to benefit from it falling), the sellers being either mining companies or investors/speculators (hedge funds, individuals)

If you are someone without creditworthiness, which just means that a bullion bank makes an assessment that you may not repay your debts, then a bullion bank will require some security or collateral which they can access if you don’t pay. An example of this in consumer lending is a bank holding a mortgage on “your” home.

For gold manufacturing businesses the bullion bank can be reasonably sure you have physical gold to repay and can put in place some sort of lien or mortgage type arrangement against the physical inventory and/or other assets of the business. There is still a risk that the business goes bankrupt with the gold being sold and not replaced or maybe the owners just steal the gold. However, lending to and monitoring business is what banks do, and generally do well and while people want to buy jewellery and invest in gold the risk of default is low for these businesses (if the gold market was to go into a protracted bear market that may be a different thing).

The borrower who is short selling gold presents a bigger risk because neither the bullion bank nor the short selling borrower has any physical gold to mortgage as it has been sold. As a result, bullion banks will lend short sellers gold on the condition that they sell it and keep the resulting cash from the sale as collateral. Since the gold price is volatile, the bullion bank will also require the short seller to put up additional margin. So a bullion bank has both cash from the sale and margin to cover themselves.

Mining companies are sort of like our jeweller or minter, in that they are a business involved in physical gold, the only difference being that the gold they hold is in the ground and not in a factory. This is a bit more risky than a gold manufacturer as they may not be able to get the gold out of the ground at a reasonable cost or have some other operational problems. They are also more risky than a speculator as the mine used the cash to pay expenses or buy equipment, so there is no cash left to use as collateral (the bullion bank could mortgage equipment etc, but resale value of that and an unprofitable mine would be low).

If you are someone with creditworthiness, then the bank will let you do the above things without a need for margin or collateral, at least up to whatever credit limit they set for you. This is obviously a lot more risky than secured lending.

Finally, a bullion bank can also “lend” gold to themselves in the process of creating derivative products, which may be best explained by two examples.

If there are speculators who want to sell futures contracts a bullion bank can take the other side and go long a futures contract. To offset that obligation to buy gold in the future, the bullion bank can borrow gold (that is, from their on-call depositors) and sell it. They then invest the resulting cash and when the futures contract is delivered, the bullion bank uses the cash to pay the short futures contract holders and receive their gold. That gold goes back into the bank’s physical reserves to back their on-call depositors’ accounts. The result is that the on-call depositors’ accounts were being “backed” by the long futures contract the bullion bank was holding.

Another more complex example would be someone wanting to buy a put contract on gold (they have the option to sell gold to a bullion bank). If a bullion bank sells a put contract that means they have a potential obligation to buy gold in the future. As with the long futures example above, the bullion bank hedges that obligation by borrowing gold and selling it (technical note, with options the amount of gold the bullion bank will sell varies depending on the volatility of the gold price, for example, against a put option for 1000oz, a bullion bank may only sell 100oz of gold – this is called delta hedging).

From the above, we can construct what sort of gold “assets” a bullion bank can hold:

  • Unsecured mine short sales
  • Unsecured speculator short sales
  • Unsecured gold business lending
  • Secured mine short sales
  • Secured speculator short sales
  • Secured gold business lending
  • Futures (long)
  • Options (sold puts, purchased calls)
  • Other derivatives
  • Unallocated gold held with other bullion banks or central banks
  • Allocated gold held with other bullion banks or central banks
  • Physical gold in vaults under their control

In addition, each of these (except for the last three, which are on-call) will have different dates at which the contracts mature, that is, when the bullion bank gets the gold back.

Gold Credit

The discussion above about on-call deposits funding gold assets implies a traditional view of banking that banks take in deposits and lend them out. This overlooks the creation of credit money directly by banks, as the Bank of England explains here. In the same way, bullion banks can create credit gold (that is, unallocated). So their gold balance sheet can consist of unallocated liabilities created “out of thin air” backed by promises to repay gold.

Consider a simple world with one Miner, one Refiner, one Bullion Bank, and an Investor.

A Miner delivers dore to the Refiner for refining. Due to competition, these days Refiners pay Miners for their dore once an assay has been completed, which is usually in a couple of days and well before the Refiner has been able to actually refine the dore. The assay reveals that the dore contains 12oz of pure gold and the Refiner quotes an outrageous (but easy for me to calculate) charge of 2oz in refining fees.

As the Refiner does not have any gold to pay the Miner, it asks the Bullion Bank for a 10oz gold loan. The Bullion Bank agrees to do so at an outrageous rate of 10%, and creates unallocated gold credits out of thin air. At this point the Bullion Bank’s balance sheet looks like this:


The Refiner then instructs the Bullion Bank to transfer unallocated gold to the Miner, as payment for the dore (usually done via loco swaps). The Bullion Bank’s balance sheet now looks like this:


Note: while the Bullion Bank does not hold one ounce of physical, the Refiner is holding physical, making their promise to repay the gold loan credible, but not without risk. The Miner needs cash, rather than gold, to pay wages and other expenses, so they enter the marketplace to sell their “gold”. As it happens there is an Investor who is interesting in holding some (unallocated) gold. The Miner instructs the Bullion Bank to transfer gold to the Investor. The Bullion Bank’s balance sheet now looks like this:


Meanwhile, the Refiner diligently works to turn the dore into 99.99% pure 1 oz gold bars. After one year (very inefficient but easy to calculate interest), the Refiner delivers 11 x 1 oz gold bars to the Bullion Bank as repayment of the loan and interest of 10%. The Bullion Bank’s balance sheet now looks like this:


The process above in effect is no different to a gold real bill (see here for a discussion of real bills by Professor Fekete), where the Refiner issues the Miner with a real bill for 11 oz of gold and the Miner discounts that bill with the Bullion Bank for 10 oz of gold. It is why Keith Weiner says that the gold lease rate is really a discount rate. People who understand the real bills doctrine may find it interesting that in the professional market, bullion banks charge a small fee on unallocated balances – discounting in another form perhaps?

The gold credit creation process above is in my opinion a legitimate function of bullion banking that facilitates the business of gold manufacturers and distributors getting gold into investors’ hands, a good thing we would all agree. The Investor in our example is saving in gold and financing the industry by the act of holding unallocated and deferring a desire for physical gold.

Our simple example can be expanded to many more participants, like bullion distributors and the like. Indeed, most of The Perth Mint’s large bank distributors pay for coins by unallocated credits and the Mint uses these unallocated credits to pay Miners for dore, which is made into coin and so on in a continuous flow. Another quote from Professor Fekete is relevant here to explain why this type of fractional bullion banking is OK (and 100% reserve banking is flawed):

“The notion that the bank’s promise, if it is to be honest, forces it to have a store of gold on hand equal to the sum total of its note and deposit liabilities stems from a fundamental confusion between stocks and flows. The promise of a bank, as that of every other business, refers to flows, not stocks. The promise is honest as long as they see to it that everything will be done to keep the flows moving. In the case of the bank, the promise is honest as long as the bank carries only self-liquidating bills, other than gold, in the asset portfolio backing its note and deposit liabilities.”

Note the last sentence in that quote. Bullion banking is safe “as long as the bank holds only gold and self-liquidating bills [ie loans to the gold industry] to cover the bank note [ie unallocated] issue, it changes neither the supply of nor the demand for credit”. Maturity transformation risk is the extent to which the gold assets a bullion bank holds do not mature into physical gold within a short time and instead are being used to fund outright speculative short selling and much longer term financing.

Risk of the Gold Assets

The many gold “assets” mentioned earlier have varying levels of certainty that they will mature into physical gold, or risk of non-payment. These assets are often referred to generically as “paper gold”, but this hides great differences in riskiness between them and is so overused that people fail to appreciate the real risks involved. So what are these risks?

For some paper gold instruments it is quite easy to estimate the size of the exposure, for other more complex derivatives, a bullion bank would rely on something like Black Scholes model and it is here that a lot of risk is introduced. Consider these limitations of Black Scholes from that Wikipedia link:

  • the underestimation of extreme moves, yielding tail risk, which can be hedged with out-of-the-money options;
  • the assumption of instant, cost-less trading, yielding liquidity risk, which is difficult to hedge;
  • the assumption of a stationary process, yielding volatility risk, which can be hedged with volatility hedging;
  • the assumption of continuous time and continuous trading, yielding gap risk, which can be hedged with Gamma hedging.

The article I think naively says some of these risks can be hedged, with other derivatives! But then how are these valued, using similar formulas? Ultimately, there is just another counterparty on the other side and we get back to these assets being either an outright promise (unsecured) or a promise covered by collateral or margin. But that collateral itself needs to be valued – by those same formulas in many cases. And how to determine the amount of margin? By those same formulas.

It is the false assumption underlying much of the formulas used by the bullion banks to work out how to “hedge” themselves that can introduce systemic risk, as this article The mathematical equation that caused the banks to crash explains.

In it Professor Ian Stewart notes that even though the Black-Scholes equation was based on false assumptions “the model performed very well, so as time passed and confidence grew, many bankers and traders forgot the model had limitations.” Are the people within bullion banks considering tail, liquidity, volatility and gap risks? And if they are, are they looking at it from the same viewpoint that gold investors do, which is one that looks over a long timeframe and is more adverse to extreme events?

By way of example, some years ago The Perth Mint was looking at Treasury software packages. I remember the salesperson saying that the software had all the complex “formulas” inside it and worked them all out for you. I asked where it got the key inputs from, like volatility. The answer was from one year’s worth of data of the underlying asset! That didn’t seem to me to capture events like the 1980 $850 boom and bust.

In addition, will a bullion bank’s gold assets be robust in the face of extreme events? Consider the new branch of mathematics called complexity science, which Professor Stewart explains “models the market as a collection of individuals interacting according to specified rules” and which reveals that “virtually every financial crisis in the last century has been pushed over the edge by the [traders] herd instinct. It makes everything go belly-up at the same time.”

The liability, or sources of funding, side of a bullion bank’s balance sheet are also relevant here. It is obvious that people buying and leaving gold with a bullion bank, as unallocated, is a big source of funding. But bullion banks can also acquire funding via derivatives, or to be more accurate, net off their assets with opposite ones of a similar type. For example, long futures against short futures, or options against options.

However, these would rarely line up in terms of maturity, so on top of the misestimation of the value of these paper gold instruments, outright counterparty exposures, inadequacy/variability of the collateral/margin calculation, you have maturity transformation – a deliberate mismatching of maturities of these products to their sources of funding, which requires that if needed, new sources of funding can be found or existing ones rolled over with little problem.

Considering all this complexity and room for error one would conclude that we have a highly unstable system, one that Nassim Taleb would call fragile and sensitive to stress, randomness and disorder.

However, the fact is that the bullion banking system has not failed, notwithstanding the many calls that it would default or fail. For example, in 1998 open interest vs stocks exceeded 40:1 yet there was no failure. What about LTCM, or AIG (40:1 gold leverage as per Jeff Christian) – shouldn’t that have been enough to blow up the system? So how do we explain this apparent robustness? In our next post we will delve deeper into the risks and the mechanisms that control it.

Sep 142015

Last week I got into a Twitter debate with Jan Nieuwenhuijs ‏(aka Koos Jansen) on his tweet about Peter Hambro’s Bloomberg interview:

I sarcastically replied that if it was virtually impossible to get physical “then Bullion Vault and Gold Money must be running fractional scams, alert James Turk immediately to put a stop to it”. As I said in this post, when physical pool products start to increase premiums or limit inflows, then you know there is a real shortage.

Don’t get me wrong, there is a shortage of retail coins and bars – at The Perth Mint we are seeing huge demand for silver and we are trying to get back in stock on 1oz Koalas but struggling to keep up. However, turning what is a production capacity issue into a meme that there is a shortage at the wholesale level and that the gold and silver markets will “fail” or “default” is fear mongering.

The level of hype does get quite silly. I saw one dealer referring to the high price of junk bags of silver relative to spot as an example of backwardation. Some got very excited about this Financial Times reference that the “cost of borrowing physical gold in London has risen sharply in recent weeks”, which would not have been news to anyone following the work of Keith Weiner, whose basis charts showed increasing scarcity since mid-July.

Zero Hedge, unsurprisingly, got into the act with this claiming that the shortage of US Mint coins was proof that there was no metal in Comex warehouses:

“IF that silver were actually in the [Comex] vault, the U.S. mint could buy a spot contract – September has a silver contract open – and take immediate delivery.”

I find it surprising that Zero Hedge/article’s author are completely unaware that the US Mint cannot accept 1,000oz bars and instead has outsourced blank manufacture (see here). They also seem oblivious that their logic can be equally applied thus:

“If Eric Sprott’s PSLV fund’s silver were actually in the vault, the US Mint could buy the fund and request a physical redemption.”

Of course PSLV is backed by physical metal so how can we explain the fact that PSLV has not had one physical redemption since it listed and is only trading at a very small premium to net asset value if the “silver market is seizing up”? Obviously because wholesale players have no problem acquiring 1,000oz bars and thus don’t want to pay the costs of redeeming from PSLV. For additional proof of that, consider this recent interview with Sunshine Minting’s CEO Tom Power by Silver Doctors:

  • “We act as a conduit for the US Mint for acquisition of silver on the market. We go out on a weekly basis and puts bids out for the supply of the 1000-ounce bars – the raw materials – that we use for the US Mint”
  • “we have seen a push on premiums … subtle changes … little push on premiums”
  • “as soon as we start to see the physical shortage on the supply side for 1,000oz bars because the refining output is down then that’s when I normally would believe that’s when the price would start to escalate again and we just quite haven’t hit that point yet”

He does note that some suppliers “seem to be digging deep into the vaults and pulling out a lot of old stock that has been sitting there for a while … you can always tell when the market starts to get a little tight” but then only talks about subtle changes and little premiums and does not say there is a shortage on the supply side.

Furthering the hype is the recent reduction in Comex warehouse stocks and resulting owners per ounce (open interest vs stocks) moving to over 200:1. This is a perennial favourite of bloggers and while a useful statistic it is often presented using a narrow definition of stocks (eligible) which can give a distorted view – see here and also this recent tweet:

As Kid Dynamite (widely hated in goldbug circles so I guess most will ignore his quote) noted to me in an email, “the key to this meme is to start with the false equivalency: registered gold equals deliverable gold” and it ignores the fact, as this commenter notes, that “the percentage of the open interest that is actually positioned in the front months to take possession of any gold is about 5%, so that drops his 200:1 to about 10:1”.

In my tweet debate with Jan Nieuwenhuijs he questioned my scepticism. Why am I so cynical about shortages? Maybe it has something to do with the fact that I first covered this topic in my personal blog way back in August 2008 and repeatedly since, without any of the predicted failures of “the system”. Alternatively, try this video which covers the repeated claims of Comex’s imminent default (h/t Jan and Frank) – which I personally think would work better with the Benny Hill theme.

For all the conspiracy theories commentators are willing to believe, the one that they do not consider is that maybe Comex warehouse stocks aren’t what they appear to be and that maybe they are the ones being played, just like it has been done before:

“They were moving silver from New York to London where the Buffett orders were being executed. This made the US warehouse inventories drop sharply. Go look at the analysts who talked silver up on that very fundamental. If they said there was a shortage of silver and you better buy it is going to $100, then you may be dealing with a shill or a biased analyst.”

Bill Holter may not think that you should be shocked about 25% premiums in silver and that “whatever you must pay to get it into your hands” is fine. Personally I can’t see the sense of paying 25% when for a few percent you can buy physically backed pool accounts.

Think of it this way: when people are willing to pay 25% premium then for every $100,000 spent, only $80,000 goes to buying silver, which would be 5,333 ounces at $15/oz. If those people would be prepared to buy pool allocated at 1% fees, then the pool operator is going out and buying 6,600 ounces. That is over a full extra 1000oz bar pulled out of the physical market for each $100,000 spent on silver.

Guess who loves the fact that they are being saved from having to find and extra 1,000oz bar for every 5 bars currently being bought? Bullion banks. So silver buyers are so distrustful of The Perth Mint, Eric Sprott, James Turk and any other pool allocated operator that they are willing to take pressure off the silver market by spending their hard earned dollars on premiums rather than metal.

I will conclude with this comment from the owner of the Australian bullion dealer Gold Stackers: “A few core distributors in the U.S. are making an absolute killing in this market. Not a bad gig when wholesale margins go from 5c/oz to over 80c/oz, and the market is silly enough to say ‘Moar! Moar!’.”

So when you see the next article screaming about shortages and telling you to stock up on physical at any premium, ask yourself: who is the player and who is being played?

Sep 102015

Would you lend money to someone in another country who told you they were doing it because interest rates in your currency were cheaper than their currency and not to worry about them paying you back if the size of the loan amount in their currency increased due any weakening in their exchange rate as they would set aside the money they saved in interest to cover that risk? I hope you answered NO!

Such foreign currency denominated loans are attractive to borrowers facing high interest rates who are willing to overlook the exchange rate risk (or be sold them by a bank underplaying that risk). Polish Swiss franc mortgages, which blew up when Switzerland dropped its currency peg, are the latest in a long line of such exploitation of unsophisticated or desperate borrowers. My Australian readers of mature age are no doubt familiar with the 1980s foreign currency loan scandal that “involved significant financial losses and personal suffering for many borrowers”.

So who is the latest desperate borrower to ask investors to lend them their foreign currency at cheap interest rates? Well if you only read mainstream media who just report press releases without any analysis, you’d have missed that it was the Government of India (GoI) asking average Indians to lend them their gold. Although in this case I think it is the lender than is going to lose, not the borrower.

Lest you think I am exaggerating, here it is clearly stated in this official press release on the Indian Sovereign Gold Bonds Scheme:

“The amount received from the bonds will be used by GoI in lieu of government borrowing and the notional interest saved on this amount would be credited in an account “Gold Reserve Fund” which will … take care of the risk of increase in gold price that will be borne by the government.”

What could go wrong with that? Certainly the Government doesn’t think there is much risk as the borrowing “will not be hedged and all risks associated with gold price and currency will be borne by GoI”. But don’t worry, “the Gold Reserve Fund will be continuously monitored for sustainability”, with sustainability being lovely bureaucratic speak for “are we losing money”.

The Government only seems concerned about the risks to the lenders, noting that “investors will need to be aware of the volatility in gold prices” and that the bond tenor “could be for a minimum of 5 to 7 years, so that it would protect investors from medium term volatility in gold prices” and giving investors the option to roll over the bond if the gold price falls. But don’t those same risks equally apply to person on the other side of the loan?

Why is the Government so confident that the Rupee price of gold will fall? Possibly they think that by “reducing the demand for physical gold by shifting a part of the estimated 300 tons of physical bars and coins purchased every year for Investment into gold bonds” the global gold market will be weakened?

I should note that this Sovereign Gold “Bond” is another example of government doublespeak as one does not initially lend gold but instead pays Rupees and is given a loan denominated in grams of gold, receiving Rupees back at the end (based on gold prices at maturity). There is a Gold Monetization scheme where you can deposit actual gold but there is little difference to the Gold “Bond” as the medium and long-term deposits are redeemable “only in cash, in equivalent rupees of the weight of the deposited gold at the prices prevailing at the time of redemption”.

I will at least give the Government credit for being explicit about what they are doing as they say “the deposited gold will be utilised in the following ways …

  • Auctioning
  • Replenishment of RBIs Gold Reserves
  • Coins
  • Lending to jewellers”

The first and the third point are basically the Government selling the gold and taking a (vaguely Gold Reserve Fund hedged) short position against the depositor. The last one is the only legitimate and minimal risk use of gold (but as I explained here, it has limited use in throttling Indian gold imports). The second is the Government effectively buying the depositor’s gold on the cheap, as long as interest savings outweigh Rupee price changes.

The key question of course is what will happen to Rupee gold prices. Yes, Rupee prices have been stable the past few years, but note the general downward trend in the INR/USD rate.


What would happen if the Gold Reserve Fund became “unsustainable”? Would the Government just give up all its interest saving gains and incur the cost of hedging its position, or decide that it might need to roll over the bond to protect itself “from medium term volatility in gold prices”. What me worry indeed.

Sep 092015

Last couple of days I was in Malaysia meeting with our distributor Quantum Metal and their clients. While it is trite to say that the East views gold differently to the West, it is still striking when sitting in a meeting with a senior executive of a bank to hear them say “buying gold is not actually spending, it is just buying another currency”. Not something I could imagine a Western bank saying. Or for a Chairman of a large Malaysian co-operative to be keen to make it easy for their members to buy gold, seeing it as a smart way to save.

For Western “sophisticates” this would be considered backward but if they lived in a country where their exchange rate had depreciated over 30% in the space of one year, like the Malaysian Ringgit has, their views may be different.

While one does not need to educate Malaysians about why to hold gold, confidence in buying gold has been damaged by businesses like Genneva Sdn Bhd. It is unfortunate that gold trading is not regulated in Malaysia as this makes it a target for Ponzi schemes to use the affinity for gold as a way of attracting customers (although high monthly returns on investments should be a warning sign).