Central Banks and the Paper Gold Market

Via Forexop

Last updated on May 25th, 2020

With gold seen once more as a strategic asset, central bank buying has been steadily on the rise. One obvious reason is to diversify foreign exchange reserves away from US dollars. In an unstable world, this makes perfect sense.

Central banks gold purchasing

Central banks gold purchasing © forexop

It is no secret that this has been a strategic aim of both China and Russia for some time now.

For example, as well as central bank buying, China openly encourages its own citizens to buy gold.

These private holdings serve as additional reserves to the already large holdings of various state bodies.

When central banks buy, in the volume they do, it of course has a tendency to push up the gold price. Likewise, when they are net sellers, as they were in the 1990s and early 2000s, it has the opposite effect. Therefore, we should all take notice of what they are doing.

Monetary system reset

Central banks naturally want to support their own paper currency and therefore they publicly dismiss gold as a relic of the past. So why do they still hold it?

There is an unlimited supply of paper fiat currency and it is essentially no more than a counting device for a country’s citizens to carry out trade and commerce. It is a way for governments to collect tax and redistribute wealth.

At the international negotiating table, the golden rule applies: “He who owns the gold, makes the rules”.

In the event of a new global monetary system, nations with little or no supplies of gold are likely to see their negotiating power severely diminished. Those with large amounts of gold will have the most influence. Is this then why central banks in emerging nations have been quietly stacking as much gold as they can afford to do? It certainly seems plausible.

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The last decade saw one of the biggest central bank gold buying sprees on record. However, the trend wasn’t even. Developing nations are accumulating at a much faster rate than developed nations.

Where is the gold?

Once a central bank owns gold, what then does it do with it? Not all central banks store their own gold. For example, the Bank of England holds custody of around $240 billion worth of gold bullion. Much of this is in custody for central banks of other nations.

However, as well as buying it, there’s been a growing movement of nations wanting to repatriate their own gold and keep it in their own custody.

Lack of recent independent audits has led to speculation that some central banks no longer have any bullion in their vaults. Not the amount of that they claim to own, anyhow.

Bullion bank gold leasing

One way that central banks can get a return on gold is through gold leasing into the bullion market. Gold leasing works a bit like shorting a stock. Consider this as a simplified example. A bullion bank leases an amount of gold from a central bank vault. That makes the bank net long gold and short an IOU to the central bank. The bank can sell the gold on the London Bullion Market (LBM) for spot delivery.

However, just like when shorting a stock, the bank must buy that gold back to return it to the lease owner, namely the central bank, at some point. This means the bank needs to hedge its position in the futures market to cover its risk of the gold price rising.

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In effect then, it needs an IOU from someone else, to cover its own IOU to the central bank.

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You might ask what the point is. Why bother leasing the gold in the first place? This is where things get murky. The central bank gains from this operation because it receives a leasing fee from the bullion bank. The bullion bank wins as well because it can claim that it legitimately “owns” the gold that it is selling, rather than being a naked short speculator.

In addition, the bullion bank can invest the cash from the gold sale into a higher yielding asset for the duration of the lease, and pocket the difference.

This is a gold carry trade. The main risk to the bank is if the asset in which it invests the difference loses money. However if that asset is government bonds, for which we know central banks are providing a floor as buyer of last resort, that reduces the risk to the bank substantially. This is another advantage for the central bank as well because the bullion bank adds another layer of liquidity to the bond market.

What about the buyer of gold in the spot market? Most likely, the buyer will only have a paper claim on the gold as well. In addition, that may be in the form of an allocated or unallocated storage account within the bullion bank. When the position is closed, the bank must close the futures contract and close the lease on the gold with the central bank.

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This money-go-round between bullion banks and central banks is a perpetual cycle, with IOUs on gold moving around from one party to the other, but with most physical metal never leaving the vault.

What does this mean for the rest of us? With all of this trade relying on paper claims, essentially IOUs, the risk is of a counterparty default somewhere in the chain. For example, what if there was a default in a futures contract held by a bullion bank? The bank would then not be covered, and had the price of gold made a significant rise they’d have to buy back at a much higher price.

Credibility of the paper gold market

There’s been suspicion of manipulation in bullion markets for years, mainly due to its dominance by a small cartel of bullion banks and their privileged relationship with the central banks.

Certainly, some cases have substance. One of these was the practice of spoofing. With spoofing, false bids or offers are put on the market with the intent of moving the price to favor the spoofer. This happens before a large real order is made.

With this in mind and the current backdrop of financial instability, an increasing number of investors are shunning the paper market and turning to physical bullion vaulted outside of the banking system.