Nov 142015

The Perth Mint recently released its 2015 Annual Report. This article discusses the Mint’s financial results with a focus on those areas where conventional financial analysis would fail due to the unique aspects of a the Mint’s business model. Below is a summary of the Perth Mint’s financial results (figures in thousands of Australian dollars) – the full report can be downloaded from our Annual Report webpage.


Some general comments on the figures:

  • Financial Year – Australia works on a 30 June financial year end.
  • Sales Revenue – this figure excludes loco swaps and other payments for metal by way of metal account credits, that is, it only includes transactions involving cash (the volume of metal we process inclusive of loco swaps is around $15 billion). It includes metal purchased back – for example, if we sold $100 worth of metal and bought back $50 worth, we would record the $150 worth of transactions as “sales”.
  • Trading Profit – Sale Revenue less cost good sold.
  • Tax – this is calculated at the Federal corporate tax rate of 30% that would apply if the Mint was a company. As a Statutory Authority, the Mint does not pay Federal tax and instead the tax equivalent is paid to the West Australian government.
  • Current Assets – the majority of this is the Mint’s precious metal that backs its Depository client holdings. Note that Allocated holdings are not recorded on the Mint’s balance sheet
  • Current Liabilities – the majority of this is the unallocated and pool allocated liabilities to Depository clients.
  • Shares – this represents the paid in capital of the Mint’s owner – the West Australian government.
  • Cash – this includes money held with the Mint by Perth Mint Depository customers, which is usually much higher than the Mint’s own cash balances.
  • Financing Activities – the Government requires the Mint to be self-funding, so this only represents tax equivalent and dividends paid to the Government.

The Perth Mint’s profit before tax for the year ended 30 June 2015 was just under $20 million, down from a high of $40 million achieved three years ago. The chart below shows that, unsurprisingly, the Mint’s profits are related to precious metal prices.


In 1999-2000 profits were boosted by sales of Sydney 2000 Olympic Coin Program numismatic coins and physical coin sales driven by Y2K fears of computer malfunctions. The 2009 financial year saw unprecedented investment volumes during the height of the global financial crisis.

To capitalise on the interest in precious metals as the bull market developed, the Mint invested in capital equipment (increasing annual expenditure from $4 million to $12 million post financial crisis) and expanded its Depository business and associated working inventory levels to allow its factories to operate more efficiently.


As the the Mint is required to be self-funding while at the same time paying tax equivalent at the rate of 30% and then 75% of remaining profits as a dividend, its ability to expand capacity is restricted. The chart below shows how much of its profit the Mint retains (the payout policy was not in place in the 1990s). Theoretically the Mint should be paying out 30% + (70% x 75%) = 82.5% but it varies depending on the application of arcane tax law.


This chart also demonstrates the difference a bull markets makes – the first eight years covers a somewhat stable precious metal price period during which the Perth Mint was being rejuvenated. The 1997-2005 covers a bear market and tentative bull market but the post 2005 period demonstrates the Mint’s potential envisaged by the architects of the Mint’s late-1980s modernisation.

Analysis of the Mint’s margins is made difficult by the fact that the products the Mint sells differ in gross margins dramatically in addition to the mix of products sold varying depending on precious metal prices. The chart below shows the Mint’s gross margin (trading profit / sales revenue) and profit margin (profit before tax / sales revenue) over time.


Normally such declining margins would be a cause for concern but this merely reflects increasing volumes of low margin bullion coin and bar and Depository sales relative to high margin numismatic coin sales as the bull market developed from 2001 onwards. The Mint has actually increased numismatic coin volumes and profits but these figures get overwhelmed by high value bullion sales when working out aggregate margins.

The increased capital expenditures and precious metal inventory levels would normally raise concerns about the profitability or capital efficiency of a business. The chart below shows the Mint’s return on equity (profit before tax / equity) over the last couple of decades.


Even after $90 million worth of capital expenditures over the past 10 years and holding $3 billion worth of working inventories, the Mint has exceeded a 15% return on equity. A key contributor to the Mint’s profitability comes from the unallocated balances of Perth Mint Depository clients, which is the major source of funding for the Mint’s working inventory. While the value of Perth Mint’s precious metal assets can be easily found in note 11 on page 27, the liability to Depository clients is note so clearly identified, merely being called “Current liabilities – precious metal borrowings” in note 21 on page 34 but the giveaway to its nature is the note that “These do not attract interest and are utilised in the consolidated entity’s operations”. Leasing from external parties in note 18 on page 33, which is clearly identified as interest bearing.


As explained here, the Perth Mint’s unallocated is a win-win situation where the Mint has free funding for the precious metal it uses in its business while clients get 100% backed safe storage of their precious metal for free. The Mint also leases in precious metal from bullion banks to cover fluctuating operational requirements. The very small amount of metal the Mint owns is mostly related to pre-purchases of metal for numismatic coin programs where the selling price is fixed, otherwise the Mint has no exposure to changes in precious metal prices – this being borne by Depository clients or the lenders from whom the bullion banks have sourced metal.

The existence of this large funding source from Depository clients at zero interest rates does complicate traditional solvency risk assessment. For example, a classic Debt to Equity ratio for the Mint would result in a figure of over 25:1, as shown in the chart below.


It is not coincidental that the Debt to Equity ratio above increases along with the increase in Depository client metal – as Depository clients buy unallocated gold the Mint buys physical gold and willingly increases its inventory as this gives its operational flexibility. The purpose of such a ratio is to highlight the risk to a company’s profits due to excessive interest expenses. However, with unallocated metal incurring no cost to the Mint, including such metal in the calculation hides the true risk. If one backs out the unallocated liability then the ratio averages 0.90.

Solvency metrics like the Current Ratio also get tripped up by the large value of unallocated metal, and particularly so for more aggressive ratios like the Acid Test, which ignore inventory on the assumption that it is not easily converted to cash without some loss of value. The chart below shows the conventional current ratio in blue and a revised ratio in green, which excludes the Mint’s precious metal assets and liabilities.


The point of solvency ratios is to assess the ability of a company to meet its current obligations. However, as precious metal inventories are as good as cash in that they can be readily sold, one needs to remove the precious metal value (not cost of manufacture, which would be lost in a forced liquidation) from assets and the corresponding precious metal liability as these dominate the calculation – otherwise the ratio has no information value as it is basically 1, as the blue line shows. The green line thus gives a better representation of the Mint’s short term solvency.

While the Perth Mint is a profitable and financially conservative business on a standalone basis, ultimately our clients take comfort from the explicit Guarantee of the performance of the Mint’s obligations by the West Australian Government as enshrined in the Gold Corporation Act 1987.

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.

Aug 212015

Techniques for analysing and trading equities, looking at price and volume, can be applied to precious metal futures markets. Futures, however, introduce another data point – open interest – that has to be considered. With equities, the quantity of shares on issue is generally fixed and rarely changes. Therefore all buying is done from sellers who hold the shares.

With futures, the amount of contracts “on issue” or “open” changes daily, as a future is a contract to trade metal in the future and an exchange will create, or open, as many new contacts as people wish to enter into. If a seller of metal and buyer of metal want to enter into a contract, then a new contract will be opened. If an existing seller of a contact (a “short”) and an existing buyer of a contact (a “long”) want to exit their contract, then the contact will be closed.

Open interest represents the number of contacts created and in existence at a point in time. The table below summarises how open interest will change, depending upon who is buying and who is selling.


In the cases where open interest doesn’t change – that is, an existing long or short is being taken on by a new participant – there may be some information value in knowing who is closing and who is new/adding. This can be done by looking at the changes in the long and shorts held by the various categories on the Commitment of Traders report (material for another post).

It should be noted that a change in open interest indicates very little in and of itself as the opening or closing of a contact requires both a buyer (long) and seller (short). However, looking at changes in open interest in combination with changes in price may give an indication of market strength, as summarised in the table below (see Wikipedia).


Note that increasing open interest can be associated with strong or weak markets. The logic is that if the price is rising and open interest is increasing, then buyers are having to increase their price to induce new sellers into the market. If the price is falling and open interest is decreasing, then longs are having to decrease their selling price to induce shorts to cover and exit the market. The table above can be represented graphically in the stylised chart below showing a rising and falling price with a rising and falling level of open interest.


While this chart demonstrates the highly theoretical nature of the price/open interest trading rule, there is some value in including open interest in your market analysis, as demonstrated in the chart below of the gold price during July 2015.


The light blue lines show the price falling while open interest was increasing, and indeed the market was weak, subsequently breaking through the $1140 support level. The light red lines show open interest decreasing while the price continued to fall and subsequently the market bottomed. Note that the chart also shows violations of the “rules”, so it is not fool proof.

The chart above also includes volume. While volume and open interest are related (they have a simple correlation of 0.81 over 40 years) they do not always move together, so one has to consider changes in both. Keep in mind that, everything else being the same, increases and decreases in open interest will both increase volume.

There are various technical indicators that combine price, volume and open interest, such as the Futures Volume Open Interest (FVOI) Indicator (a variation of On Balance Volume), which Sharelynx calculates and maintains charts for.

For those coming from equity investing, it is important when analysing futures data to remember that the precious metal markets are global and significant volumes are traded in the opaque over-the-counter (OTC) market. While Comex, and increasingly the SGE, have a significant impact on prices, they are not self-contained markets like those for the shares of a company.

Bullion banks and other traders arbitrage between futures markets, ETFs and the OTC market (otherwise prices would not stay in alignment) so action you see in public exchanges could be balanced by offsetting positions in other markets that are not visible to you. The relative wealth of data available on futures markets, and lack of data on OTC markets, can lead analysts to become myopic and forget that there may be other market forces from the OTC market impacting on the “visible” public exchange traded contracts.

Aug 182015

One of the best ways to learn about precious metals is to engage with other investors on a discussion forum. There can be a lot of rubbish on them (as with the internet in general) but generally you’ll get good advice from others who have been there before. The list below has the main active PM forums (or sub forums) where precious metals are discussed from an investing point of view. I have ranked them by total membership numbers, which is not perfect as it doesn’t necessarily represent active users but it is a fair indicator of either popularity or longevity of the forum.

Each forum has its own personality and particular focus – some skew towards one metal or the other, or peer to peer trading, or prepping. I’d suggest checking them all out and reading topics/threads to get a feel and see what suits you. Alternatively, you can subscribe to my Precious Metals Forums bundle on the feed reading service Inoreader, which aggregates threads from Kitco, Silver Stackers, SilverSeek, GoldEagle, Goldtent, Gold is Money, Reddit and Gold Club Asia forums if you want to keep your finger on the pulse of global PM discussion.

My favourite is Silver Stackers, which started out as an Australian PM forum but has broadened since then. I think it has retained an Aussie laid back feel. I’m active on a few other forums and you can check what my legitimate user accounts are here.

If you find other active forums not on this list leave a comment and I’ll add them in.

Forum Total members Total threads Total posts
Kitco 47,262 120,363 2,223,250
Silver Seek 15,329 19,572 174,191
Gold is Money 9,928 78,783 876,332
Silver Stackers 9,538 32,424 529,510
Reddit / Silverbugs 9,129
Silver Doctors 7,651 1,371 17,172
Le Metropole Café 4,103 307,725
Bullion Stacker 3,462 14,611 308,177
Reddit / Gold 2,416
Gold Eagle 2,126 3,419 4,574
Gold Club Asia 1,676 10,647 92,045
Gold Silver Chat 1,222 27,868 221,461 954 60,957 588,309
PM Bug 941 3,321 30,682
The Silver Forum 625 3,027 55,099
Collectors Universe – Precious Metals 11,082
CoinTalk – Bullion Investing 4,895
Coin Community – Precious Metals 3,946
Aussie Stock Forums – Commodites 460 24,307
Hot Copper – Commodites 84,063
Investors Hub – Metals
Goldtent TA Paradise
Kitco Refugees’ Gold and Metals Forum
Yahoo Finance – SLV
Yahoo Finance – GLD
Top Stocks – Gold
Top Stocks – Silver

Statistics as at August 2015.

Aug 122015

If there is a shortage of coins does that mean there is a shortage of gold/silver and prices will go up?

Shortages of retail forms of gold and silver, which are anything less than 400oz gold bars or 1000oz silver bars, does not necessarily tell us about whether there is a real shortage/price disconnect in the wider precious metals markets. Retail shortages to-date have reflected a shortage in production capacity, rather than a shortage of wholesale gold or silver.

How can I tell if it is a real shortage, or just a production capacity shortage?

A real gold bank run will manifest itself in the wholesale markets for 400oz gold bars or 1000oz silver bars, so to identify a real physical-paper disconnect occurring you need to look at the premium above spot for 400oz or 1000oz bars.

Unless you are in the professional market you won’t see such bars attracting a premium and/or being difficult to source, or bullion banks desperately bidding on the output of refineries like The Perth Mint. However, there are many online pool allocated storage services which back their accounts with wholesale bars. If there is a real shortage of 400oz or 1000oz bars and thus premiums being asked, then you should see the following being reported by these services (in likely order of occurrence):

  1. Reports of difficulties in getting 400oz/1000oz bars
  2. Temporary restrictions on how much gold or silver can be bought
  3. A widening of their normal buying/selling spreads, or increases in trading fees (to cover the additional premium they are being charged)
  4. No longer accepting new clients due to an inability to source wholesale bars

While previous bouts of shortages have been temporary, don’t be complacent. It is possible that a temporary liquidity squeeze in the wholesale markets could turn into a gold bank run which can then turn into a price squeeze. It is important to keep your gold close or stored with non-banks, like The Perth Mint, who don’t engage in fractional reserve banking activities or lending your gold out.

What do you mean by production capacity shortage?

Getting gold/silver from a mine to a coin in your hand involves lots of different people and processes: mining, refining, blanking, minting, distribution and retailing. The amount of coins/bars that chain of processes can produce is limited by the process with the smallest capacity. When the capacity of this bottleneck process is below the quantity demanded by investors, then there is a shortage of capacity to service the demand.

For example, if a baker only has one oven it doesn’t matter how much flour, mixing machines or staff they have, they are only going to be able to produce so many loaves of bread per day. The same constraints exist in the precious metals market.

So what is the bottleneck in precious metals?

Raw Metal – as long as metal prices are above cash mining costs, mines will continue to produce. Even if there was a reduction in mine output, gold has over 60 years of mine production held above ground and this comes back into the market as scrap. Raw metal is therefore unlikely to be the bottleneck.

Refining – the refining industry is highly competitive and by Perth Mint estimates, has had excess capacity for decades, at least double normal mine and scrap volumes. It is also relatively easy for refiners to add additional electrolytic cells and expand capacity, so this process will not be a bottleneck.

Blanking – turning refined gold/silver into blank disc (also called a planchett) with an exact weight and imperfection free surface is a complex process performed by only a handful of manufacturers. This is the key bottleneck in coin production.

Minting – in contrast to blanking, the stamping of a coin is a much simpler process and there are a lot of private and public mints with large capacities, so this is less of a bottleneck.

Distribution/Retailing – while there has been a resurgence in the number of distributors and retailers (bullion dealers) in recent years, given the low profit margins bullion dealers are unable to hold large inventories of gold/silver, as the interest cost of borrowing the money to buy the inventory can significantly reduce their profits. Hence most dealers hold small inventories and/or buy from distributors and mints only when customers place an order. This can mean that dealers will run out of stock on a surge of demand, but should be able to restock quickly.

Why are blanks the problem?

Making coins is a two-step process: make blanks, stamp coin. The stamping part is relatively straightforward from a manufacturing point of view with the most complex part being the making of the dies to stamp the coin. Making a blank disc/planchett is lot more involved:

  • metal has to be melted in a continuous caster and turned into coiled strip
  • heating metal results in evaporation, so you need ventilation scrubbers
  • the strips are then rolled multiple times to an exact thickness
  • the strips are annealed between each rolling
  • the strips are then decoiled and blank discs are punched out
  • metal left over after punching needs to be remelted or re-refined
  • each blank needs to be weighed
  • depending on the quality of coin you want to make, the blanks may undergo various surface treatment processes (eg chemical pickling)

Given the greater complexity of the above process blank manufacture benefits from economies of scale and thus few mints make their own blanks and would rather outsource to simplify their manufacturing facilities. For example, the US Mint buys it blanks from outside suppliers, which was “part of the Reagan outsourcing of non-value added to the private sector. Mint’s value added is stamping” according to Edmund Moy, 38th Director of the US Mint.

But mints make millions of circulating coins, why can’t they do the same for gold and silver?

Mass base metal blank manufacturing deals in metals that are significantly less value that the face value of the coin. As a result, the process is optimised for speed, not quality or security: if a blank is no good, throw it away; weight control tolerances are lax (do you care if your copper coin has slightly more or less copper in it?); metal evaporating when it is melted is not recovered and so on. You cannot allow any of these things with gold or silver, due to their high cost.

Precious metal blank manufacturing requires additional weight control machines, scrubbers to collect evaporated gold, security to lock down the factory, etc. These add additional costs and time to the production of precious metal blanks.

On the minting side, circulating coin production is optimised for high volume/low quality production utilising high speed presses (12 coins a second) to mint coins of a small size, with low relief designs, and on blanks made of metal alloys that are hard enough to withstand such speeds (gold and silver are far too soft relatively speaking).

So why haven’t blank makers expanded their factories?

They have. Sunshine Minting Inc, who supplies the US Mint, was reported as having “almost quadrupled its staff to 270 since 2007”. The Perth Mint, also a blank supplier to the US Mint, has spent tens of millions on new equipment over the past decade.

However, this expansion has been conservative, based on modest projections of coin volume growth. The reason for this is that the cost of a modern blanking production line is high, given all the production steps involved. In addition, you have large working capital requirements cover cash costs and work-in-progress inventory.

Investing capital in production facilities only pays off if current demand for gold coins will continue for a number of years, otherwise one will not recover their investment. The question that executives in mints ask themselves is whether the increase in retail demand is permanent or temporary. If temporary, they don’t want to waste money on capacity that will be left idle. Additionally, since gold coin demand changes with the gold price it is hard to forecast future demand with reliability, making business cases difficult to justify to bankers.

For government owned mints, like The Perth Mint, getting agreement from bureaucratic government advisors to make an entrepreneurial decision to invest to meet future demand is hard, particularly since it will reduce the immediate cash flow that the government gets from the business.

Finally, once a decision is made to expand production capacity, it is not like turning on a tap – there is a big lag in getting additional the machines delivered and operational.

Why don’t mints stockpile blanks?

This would help but often the cost of funding the high dollar value of the blanks is not justified given the low margins earned on coins. Inventory funding costs are an issue throughout the whole industry and the resulting tight inventories (based on normal demand patterns) can be exhausted if there is a demand surge.

When mints run out of capacity, why do they ration production rather than increasing prices?

Most mints rely on a network of distributors to sell their coins. These distributors are often long-term customers of the mint who buy in volume. Rather than picking favourites, or those with the biggest cheque book, mints ration to maintain fairness of supply across all of their distributors (if one dealer cannot get any product they may go out of business).

For those mints who also retail their bullion coins directly to the public, yes they could make their long-term distributors compete at auction for their production with retail buyers. However, mints are at risk that when retail demand declines (which has often occurred in the past) their long-term distributors will remember how the mint took advantage of them and they will either take their business elsewhere or aggressively negotiate terms in retaliation. So based on past experience of the fickleness of retail demand, mints often decide to continue to supply their long-term distributors on a rationing basis rather than move to a “who pays the most wins”.

So what should I do if I see shortages and coin premiums increasing?

If it is not a real shortage of wholesale gold and silver, then don’t panic. Keep in mind that higher premiums mean you are getting less ounces for your dollar. Some strategies to maximise the amount of ounces you are buying include:

Wait – demand surges can occur when prices are high (bubble like herding) or low (bargain hunting). Check the price chart – if the price is high or spiking consider holding off as you may be able to pick up your coins at a lower spot price later, and at a lower premium, when the herd has stopped panicking. If the price is low or bottoming, then it may be cheaper to pay the higher premium rather than wait and pay a higher spot price.

Buy something different – premiums often surge in the most popular coin first (people usually favour their domestic government mint). Consider coins from other mints, government or private. Cast bars from recognised refiners are often cheaper as the casting process is simpler. However, check with your bullion dealer that they will buy back those other coins/bars at a fair price – you don’t want to pay less but receive less back when you sell, it is the spread between buy and sell that matters.

Buy pool accounts – because these are backed by wholesale bars, you can avoid high premiums but still buy at a low spot price. Many facilities will allow you to convert to allocated coins or bars and take delivery later, which you can do when premiums are back to normal. Even for those services which just offer online buying and selling, the total buy/sell fees may be lower than the excess premium you may pay, so it can make sense to sell your pool metal later and buy your coins/bars when premiums are back to normal.

Keep calm and carry on stacking.

Temporary coin shortages first started in 2008 after the global financial crisis and they have occurred repeatedly since then. Don’t get caught up in the marketing hype the next time a shortage occurs – if you follow the advice above on how to tell if it is a real shortage, or just a production capacity shortage, then you will be able to keep calm and carry on stacking (economically).

Aug 072015

Last month I covered Comex warehouse stocks in response to “a lot of chatter about the potential or certainty of failed settlement and Comex default”, making a number of points:

  • inventory can be converted from eligible to registered relatively quickly
  • including eligible inventory give a very different picture of warehouse stocks and owners per ounce
  • the actual percentage that stand for delivery is only 2-4%
  • current registered stocks vs open interest is well within current delivery rates

For those who focused on the registered stocks only, recent Comex deliveries have caused some disbelief. The best example of this is this piece by Zero Hedge. They way they word some statements could be misconstrued by investors new to precious metal, so as an education service below are some quotes from the article and some clarifications.

“the most recent drop in Comex registered gold”

When you see articles referring to “Comex” this or that, the writer is just using that as a shorthand for “client owned metal stored in independently run vaults licensed/recognised by CME Group”. Comex/CME Group does not own or operate any vaults or own any metal itself.

This sort of shorthand you will also see used in respect of “LBMA” or the London Bullion Market Association. The LBMA is just a trade association and does not operate vaults or own metal.

“the Comex once again succeeded in sweeping default fears under the rug by boosting its eligible gold by a whopping 78% overnight”

As per the above point about shorthand use of “Comex”, please do not read this as Zero Hedge saying that the CME Group owned eligible gold and transferred it to registered. What they are referring to is the fact that clients who were holding short contracts would have instructed the warehouse where their metal was stored to move it to registered (or warrant it). This is an electronic process and as the metal is eligible (ie meets delivery requirements), no further verification etc of the physical bars is required, it is just a computer entry.

The reference to whopping I do think is overstated. That 281,000 ounces is not a lot when you look back historically. The chart below goes back 5 years and I’ve circled Zero Hedge’s “whopping” in red.


As you can see with my purple circles, there have been many times that registered stock has increased dramatically and by much more than 281,000 ounces, and in a number of cases, these have occurred not from transfers from eligible stocks but from shipments directly into the warehouses. Hence why I made the point last month that one is bound to get disappointed if one just focuses on registered stocks.

“thanks to JPM reclassifying 276K ounces of gold from the Eligible into the Registered category”

Again, please note that Zero Hedge is not saying that JP Morgan themselves just decided to reclassify gold, as it is the client who owns the metal that has control over that decision. Note that some warehouse operators also trade on Comex for their own account. In this case it could be that JP Morgan may have done the reclassification (or more correctly, the trading desk of JP Morgan instructing the warehouse division of JP Morgan) but we cannot deduce this solely from that Comex report.

“even as actual eligible gold continues quietly hemmorhaging out of the Comex”

I’m a bit puzzled by this “hemmorhaging” as you can see from this chart of total eligible gold held with Comex licensed warehouses below.


While the 1 million or so that has moved out of eligible over the past few weeks is about 10% of the total, it is not a big drop when you look at the big picture: apart from a bump post financial crisis and drop off after gold fell from its peak, it looks to me that Comex warehouse operators have been growing their storage business quite successfully.

“will JPM be as eager to continue “adjusting” eligible gold into registered if the recent trend in gold redemptions not just in its vault, but across all Comex gold warehouses continues”

Again, Zero Hedge here are in shorthand referring to JP Morgan’s customers doing the “adjusting”. What is meant by “all warehouses” is that a client of a futures broker who is short is not limited to tendering metal in a specific warehouse, or a warehouse associated with that broker if the broker also operates a vault. Customers may have metal in any or multiple warehouses and can choose any such warranted metal to make delivery with.

If you are new to precious metal markets, hopefully the above has been of use, otherwise you may have come to the conclusion from reading that article that the CME and/or warehouse operators somehow had some responsibility to make delivery of metal to rescue Comex from default, which to anyone with a basic understanding of how futures markets operates, would be a very silly thing to think.

Jul 162015

The drawing of horizontal trend lines, support and resistance levels, Fibonacci levels and so on is a common technique for analysing price behaviour, setting stop losses and making trading decision. For examples of what I mean, see here, or here. However, in the case of GLD (and pretty much all metal ETFs) drawing them horizontally can be misleading.

The reason is that almost all precious metal ETFs pay for their management fees by selling gold from the fund to pay for the fees (while the number of shares outstanding remains the same). The result is that the amount of metal backing each share declines over time. This means that a share today is not equal to a share from the past – the prices are not equivalent. You are not comparing apples with apples, actually, you are comparing an apple with a fractionally smaller apple.

Most funds disclose the amount of gold behind each share on their website, usually listed as net asset value (NAV) in ounces. For the largest gold ETF in the world, GLD, its website was showing “NAV (in gold oz) Per Basket” as 9,585.06 ounces on the 14th. A basket (which is used by market makers) for GLD is 100,000 shares and when GLD started in November 2004 each share was equal to 0.1 ounces, so a basket in 2004 was equal to 10,000 ounces. Compared to 9,585.06, that is a loss of 414.94 ounces, or one London Good Delivery bar over the past 10 years – a fair bit when you think about it.

That loss is equal to 4.15%, which is basically GLD’s management fee of 0.4% per annum over 10 years. You can see the decline in the real underlying value of GLD’s shares by downloading its historical data. According to that spreadhseet, GLD’s closing price on the 14th of July was $110.74. Simplistically dividing by 0.1 would give you $1107.40 per ounce, yet we know that gold never got that low. If you divide the $110.74 by GLD’s actual gold backing of 0.09585063 you get $1155.34, which makes a lot more sense.

For a graphical example, the chart below takes GLD’s closing prices and draws some Fibonacci retracement levels from gold’s high, and from the 2008 low, but corrected for GLD’s declining gold backing.


You can see how they slope downwards over time, reflecting the loss of gold from the fund. It might not look like much on the chart, but consider the table below which shows the difference between the figures that would be normally be drawn horizontally and what those levels are adjusted to today to reflect the reduced gold backing.

Level August 2011 Figures Adjusted to Today
100% Fib $184.59 $181.71
61.8% Fib $114.08 $112.30
50% Fib $92.30 $90.85
38.2% Fib $70.51 $69.41
2008 Low $70.00 $68.17

A $2 to $3 difference on a $100 share is a fair margin of error, causing you to make a decision earlier than you should. Given the relatively small management fees, the effect is not material if you are doing analysis for period of less than a year. Something to keep in mind if you do draw levels on ETF charts, or the next time you see a technical analyst doing the same.

Apr 122015

Loco swaps are a way to move gold or silver to another location without physically shipping it. It is a transaction where two parties agree to exchange (swap) gold they have in different locations (locos) with each other.

As discussed in Loco, gold trades at different prices in different locations. This means that the loco discount or premium needs to be transferred between the swap parties in addition to the metal itself.

The Perth Mint records loco swap trades as linked buy and sell trades. For example, a mining companying swapping its Perth gold for London gold would be entered as (assuming a gold price of $1000 and a loco Perth discount of $1.00):

Trade Number 1 2
Perth Mint is Buying Selling
Metal Gold Gold
Currency USD USD
Price $1000.00 $1001.00
Ounces 100.000 100.000
Loco Perth London
Trade Value $100,000.00 100,100.00

While there are two separate trades, on settlement the USD trade values are netted against each other and the mining company pays the Perth Mint $100.00. The metal values however are settled independently as they are for different locos – the Perth Mint would deposit 100oz into the mining company’s London metal account and withdraw 100oz from its metal account with the Perth Mint.

The most common type of loco swap the Perth Mint does is with mining companies. The reason for this is many mining companies trade their gold or silver in the over the counter (OTC) market in London with bullion banks, or have other contractual obligations to deliver metal they need to meet. Miners could ask for the Perth Mint to refine their gold and ship it to London, but from the point of view of the industry as whole, however, this is not always efficient. For example, with a huge demand in India for 99.99% kilo bars it would not make much sense for:

  1. an Australian miner to ship 99.5% 400oz bars to London;
  2. a bullion bank to then ship those bars to a refinery;
  3. a refinery to reprocesses those bars into 99.99% kilo bars; and
  4. a refinery to ship the kilo bars to India for sale.

So it is more efficient (cheaper) for all parties for the Perth Mint to keep the miner’s gold, refine it directly to 99.99% purity and then ship the kilo bars to India.