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.