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.

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.