Posted by on December 15, 2016 3:00 pm
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Categories: B+ Bank of England Bank Run Bullion Business Central Banks Commodity markets Dubai Economy Exchange-traded fund Finance gold Gold as an investment Good Delivery ICE ICE Benchmark Administration India Investment London bullion market London Metal Exchange LPMCL money Physical Settlement Precious Metals Reality Speculative Trading Transparency

Submitted by Ronan Manly, BullionStar.com

The first part of this series Bullion Banking: Part I – The Mechanics and the Players highlighted that contemporary bullion banking operates as a fractional reserve gold banking system in which paper gold is created out of thin air. It also looked at the identities of the 30-40 bullion banks operating in the global gold market and explored some of their activities. Part II now looks at the structural risks inherent in the modern bullion banking sector and the concerns posed by bullion banking activities.

Unallocated Positions rarely result in Physical Delivery – Demand is Diverted to Paper

Since unallocated account transactions in the London bullion market are rarely used for physical delivery of gold, the trading of such paper gold diverts demand into paper gold that would otherwise have been channelled into real physical demand. Therefore, the price of physical gold is not reflecting the demand that it would have reflected if paper gold alternatives did not exist.

In a recent commentary about how to classify unallocated bullion accounts in the context of new MiFID rules for financial instruments, global law firm Dentons described unallocated bullion as synthetic gold and as a derivatives transaction and Dentons also highlighted that paper gold’s holders never intend to take delivery:

“Although the terms of the unallocated bullion account usually provide for the account holder’s right to demand the physical delivery of gold, the reality of unallocated bullion trading is that buyers and sellers rarely intend for physical delivery to ever take place. Unallocated bullion is used as a means to have “synthetic” holdings of gold and so obtain exposure to the price of gold by reference to the London gold fixing.

“If physical settlement and cash settlement are two mutually exclusive concepts (as they are in our view) and if cash settlement entails a derivatives transaction it follows that, if physical settlement does not take place in connection with unallocated bullion, then unallocated bullion is a form of derivatives transaction.

Only a Tiny Fraction of Gold Trading in the Bullion Banking System is Physical Trading

Each month the LBMA publishes gold and silver clearing statistics which are sourced from LPMCL data. This data represents average daily clearing volumes of loco London gold transfers between the five LPMCL members during that month. The clearing figures reflect three components:

a) transfers of unallocated gold between parties within a member’s book and between the books of the five LPMCL members

b) transfers over the five members allocated gold accounts at the Bank of England

c) physical shipments of gold from LPMCL members accounts

In August 2016, the average daily clearing figure for gold between the five London gold clearers was 18.8 million ounces per day. This equates to 585 tonnes of gold loco London transfers cleared per day. With approximately 250 trading days per year, this equates to 146,250 tonnes of gold cleared per year in London. Given that the LBMA is on record as saying that trading volumes in the London gold market could realistically be 10 times more than clearing volume (since clearing volume represents netted trading volume), then this would imply 5,850 tonnes of gold traded each day in the London market, and 1,462,500 tonnes of gold traded each year in London.

Given that world gold production (physical gold) throughout history is about 190,000 tonnes, half of which is held in the form of gold jewellery, and given that production from gold mining operations is about 3,000 tonnes per annum, then it should be obvious that the astronomical trading figures in the London gold market have nearly exclusively nothing to do with physical gold demand and supply trading and everything to do with speculative trading and other forms of unallocated account churning and transfers. This level of activity can only be possible if bullion banks have created huge amounts of paper gold through the use of unallocated account balances.

The LBMA does not currently publish any trading figures for the London gold market, nor any data on the volume of physical gold trades or transfers undertaken in the gold market by its bullion bank members versus the volume of unallocated or paper trading transfers. Could this be so as to hide the mammoth activity of paper gold trading?  Note that as of late 2016, the LBMA has promised that it will begin to implement some type of trade reporting of bullion market trades in 2017, but the details of such planned trade reporting remain unclear at this time.

95% of Transactions in the London Precious Metals Markets are in Unallocated Metal

Although the unallocated account market is opaque, the representatives of the London precious metals markets did publish one eye-opening statistic about unallocated account trading a few years ago, perhaps inadvertently. This statistic was in an April 2013 HMRC / LBMA / LPPM joint publication on metal transactions and Value Added Tax. This HMRC/LBMA/LPPC memorandum stated that:

“Investors acquire an interest in the metals, although in most situations, physical delivery will not occur and in 95% of trades, trading in unallocated metals will be undertaken.

“95% of transactions are in unallocated metal: therefore, because they are treated as services, the location of the underlying metal is not relevant.”

Given this 95% of unallocated trading, the wholesale London precious metals market run by the bullion banks is nearly entirely a fractional reserve system with a very small backing of physical precious metal. The memorandum also stated that:

“Spot and forward trades are predominantly in respect of unallocated metals and can be closed out before the contract maturity date – they can be cash-settled, rather than the underlying metal being physical delivered”

Interpreting this 95% of transactions in unallocated gold, the London gold market is primarily a fractional reserve gold banking system, with a limited underpinning of physical gold underneath it, and with hedge funds and other speculators trading huge volumes of paper gold. The scale of unallocated precious metals holdings in the London wholesale market was starkly confirmed by then LBMA CEO Stewart Murray in May 2011 to a gathering at the LBMA Bullion Market Forum in Shanghai, when he stated that:

“Various investors hold very substantial amounts of unallocated gold and silver in the London vaults.”

What Murray meant is that various investors held substantial claims against bullion banks for whatever gold and silver was in the London vault pool that was not allocated.

Credit Risk and Counterparty Risk

Since an unallocated gold account with a bullion bank merely represents a claim against that bank, a buyer of unallocated gold is merely an unsecured creditor of that bank and is taking on credit risk against the particular bullion banking institution that they enter the unallocated account agreement with. The unallocated account agreement also entails general counterparty risk since the bullion bank is the other side of the agreement. Such credit risk and counterparty risk would not arise if a customer was holding fully allocated and segregated precious metals.

Template for an Unallocated precious metals account in the London market

LBMA Clearing Data hides leveraged Spec Trading and rolling of Gold Deposits

In 2003, the then chairman of LPMCL, Peter Fava, provided a once-off glimpse into some of the trade types that were behind the huge clearing volumes in the London Gold Market[11]. Fava’s list of such trades included the following:

  • Central bank gold deposits, rolling over monthly, and the hedging transactions connected to that borrowing
  • Interest rate swaps and longer-term collateralised agreements
  • Speculative trading activity on a leveraged, forward basis that is closed out before maturity
  • Investment fund participation via spot transactions * (generally netted by the counterparty banks against EFPs – exchange for physicals) but if not netted would show up in clearing
  • Interbank market trading (multiple times per day)
  • Consignment accounts in physical markets, notably Istanbul, Dubai and India, with purchases out of the consignment account hedged loco London
  • Gold-backed Exchange Traded Fund (ETF) creation and redemption trades using unallocated

You can see from the above list that very little of the trade types have anything to do with real transactions for physical gold or real physical demand for gold. The leveraged speculative trading and the investment fund activity underscore the disconnect between the physical gold market and paper gold trading which is in essence just a form of betting on “the gold price”. The bullion banks benefit in commissions and fees from the very high trading volumes of paper gold, without having to hold physical gold in reserve.

Gold Backed-ETFs Prop Up and Support the Unallocated Account System

The April 2013, the HMRC / LBMA / LPPM document on value added tax (referred to above) also stated the HRMC’s opinion on gold-backed ETFs and highlighted that ETFs perpetuate the unallocated gold account system while sourcing their metal holdings from the general London pool of metal that backs this system:

“The deposit and withdrawal of metal related to the issuing and redemption of securities is predominantly on an unallocated basis and therefore via book entries. Generally, the metal is already within the wholesale market.

As stated in the [ETF mechanics article], this is concerning because:

“Investment flows into gold-backed ETFs channel gold demand that might otherwise have gone into physical gold into products whose supply is met by tapping the pool of LBMA bank controlled gold inventories and even central bank gold lending.”

Importantly, there is zero transparency into where the large gold-backed ETF custodians, i.e. HSBC and JP Morgan, actually source gold ETF inflows from. It appears that they source this metal from an opaque pool of wholesale gold that is held in the London market.

The London Gold Market continues to Extend its Unallocated System Infrastructure

Every new product and process that have been recently developed for the London Gold Market makes use of and perpetuates the London Gold Market’s fractional reserve / unallocated paper gold infrastructure. The LBMA gold price auction, which in March 2015 replaced the London Gold Fixing, and which is now administrated by ICE Benchmark Administration (IBA) on behalf of the LBMA, still uses unallocated gold as the settlement asset in the auction. According to the IBA Gold Auction Specification document, the “underlying asset is “Spot Loco London Gold (unallocated)”.

While this new auction could have been totally redesigned to use physical gold transfers, like the physical settlement system used by the Shanghai Gold Exchange (SGE), this was never going to happen since the LBMA was running the competition which chose the winning service provider to administer the new auction, and the LBMA is at pains to protect the unallocated system since this system is operated by the LBMA’s most influential members, the bullion banks.

In another development, the London Metal Exchange (LME) is planning to launch a new suite of gold and silver futures contracts for the London market in the first half of 2017. These futures, to be known as ‘LMEprecious’, will, in the words of the LME, ‘respect the London market’, i.e. they will utilize unallocated gold transfers and again perpetuate the unallocated system. Specifically, the new LME settlement procedure is as follows:

“Physical settlement one day following termination of trading. Seller transfers unallocated gold to LMEC account at any LPMCL member bank, and buyers receive unallocated gold from LMEC account at any LPMCL member bank.”

ICE (Intercontinental Exchange) has also announced competing exchange-traded gold futures which it plans to launch in February 2017. These futures will also settle via unallocated accounts. According to ICE:

“The contract will be settled through unallocated loco London gold vault accounts using LBMA Good Delivery Rules.”

The absurdity of calling something an ‘unallocated gold vault account’, when it’s merely an electronic account representing a claim against a bullion bank which holds no gold, or very little reserves of gold on a fractional basis, should be obvious to see.

CME Group has also announced that it too will launch London gold futures contracts that will deliver unallocated gold loco London.

Nearly all LBMA system Gold under Title of Central Banks and ETFs

In September 2016, BullionStar produced research into how many tonnes of physical gold were actually held in the LBMA vaulting system in London, concluding that there were 6500 tonnes of gold in the London market, 4725 tonnes of which was at the Bank of England, leaving 1775 tonnes at the other vaults.

Of the gold in the other vaults, 1679 tonnes was held in allocated form by the gold-backed ETFs, again meaning that there was a very small residual (less than 100 tonnes) to back total outstanding unallocated account claims.

Even if the bullion banks have access to borrowed central bank gold stored at the Bank of England, that gold is owed to the lending central banks, and therefore has multiple claims on it. If there was a run on the fractional reserve bullion banking system by customers wanting to convert their unallocated positions to allocated gold holdings, analogous to a bank run where all customers want to withdraw their cash at the same time, then this could lead to some serious problems in the ability of the bullion banks to provide the required gold. Such a situation would undoubtedly require cash settlement of customer positions, a move which would see the price of paper gold collapse, while the price of physical gold would skyrocket.

No Transparency in the London Gold Market

There is a total lack of transparency in the London Gold Market. There is no trade reporting and no position reporting. This means that there is no visibility into the amount of paper gold trading vs trading related to physical gold, and no visibility into the volume of outstanding unallocated positions vs the amount of physical gold backing those positions. Therefore, there are no metrics as to the size of the fractional positions, i.e. the ratio of unallocated positions to allocated positions. The bullion banks have as of yet not cooperated in releasing trade information, so it appears they are protecting the status quo. The regulators, in the form of the Bank of England and the FCA, are also compliant by not devising a mandatory system of trade reporting, which incidentally would be very easy for them to do.

Some of the other transparency deficiencies in the London Gold Market include the following:

  • The locations of the commercial gold vaults in London are not published by the LBMA. Compare this to New York, where the vault locations that are use and approved by COMEX are publicised and well-known.
  • No confirmation of the identities of central bank & bullion bank customers at the Bank of England. The Bank of England does not even say how many bullion banks hold gold accounts with it, let alone the identities of these banks.
  • There is no official data published about the London Gold Lending Market. Nothing at all.
  • The Gold offer Forward Rate (GOFO) and Forward Curve submissions were discontinued by the LBMA banks as of January 2015.

See BullionStar seminar speech “The Gold Market – Where Transparency means Secrecy” for more details about the lack of transparency in the London Gold Market.

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