So Who Actually Affects the Gold Price the Most?
In order to explain the concept of bullion banking it is useful to first identify who the major players are in gold financial markets. The Commodity Futures Trading Commission (CFTC) is the designated regulator for US derivative markets. It publishes weekly data regarding the breakdown of trading activities in many derivative markets. One of these markets is the gold futures market on the COMEX. Through their weekly breakdown, one can see how many futures contracts are being traded, and very broadly, who is trading them.
Looking at the CFTC data, some interesting observations can be made in relation to the COMEX gold futures market:
The number of short gold futures contracts held by swap dealers is at an all-time record high. These swap dealers include the large bullion banks (JP Morgan, Goldman Sachs, Citi Bank etc). Thus, the gold futures market has never before been so dominated by banking or financial firms in the history of the COMEX;
The number of short contracts held by gold producers/refiners/users (76,077) is dwarfed by the number of contracts held by swap dealers (230,869), who have no direct ties to the physical demand or supply of gold. Short contracts are used by gold producers to hedge the price of gold. Under these short contracts gold producers secure a fixed price at which they are able to sell future production, thereby protecting profit margins. Large volumes of short trades however, may have the effect of depressing the price of the underlying asset. Due to the large disconnect between the physical gold market and the paper gold market (see my previous post - https://lnkd.in/gAVtr__9), these short positions may have the effect of causing a disconnect between supply and demand dynamics of gold and gold prices;
The parties on the other sides of the short contracts (long parties) are predominantly financial firms too. These firms are somewhat removed from the demand and supply dynamics of physical gold as well;
The conclusion from this graphic is that the actions of financial firms in theory would affect the gold price far more than the hedging operations of actual gold users or producers.
What do Bullion Banks Do?
The most important players in the non-physical or "paper gold" market are the 35 or so large international bullion banks. Some prominent names include: BNP Paribas, Citibank, Goldman Sachs, and JP Morgan Chase et al.
These banks are involved in banking services involving gold, which almost exactly mirror the banking services they undertake in fiat currency. New gold deposits can be created by bullion banks, without necessarily having to reference new physical production of gold from mines. This is similar to the way that banks can create new money without having to rely on central banks to issue new physical currency.
Since the paper gold market considerably dwarfs the physical gold market, the actions of bullion banks may have a considerably larger influence on gold prices than the actions of physical gold producers and users, e.g. miners and refiners, investors in physical bars, or jewellery and electronics manufacturers who create actual supply and demand for physical gold.
It is interesting to see how the gold banking market so closely mirrors the fiat currency banking market, with regards to fractional reserve lending, trading, and hedging. These are explained in the figure below:
Fractional Reserve Lending in Gold
In order to explain how fractional reserve lending in the gold market works, it is necessary to first define what allocated and unallocated gold accounts are. Holders of physical or paper gold may deposit their gold holdings with bullion banks in either allocated or unallocated accounts:
Allocated Gold Accounts
These are deposit accounts held with bullion banks, where the bullion bank would hold the physical gold that has been specifically identified and set aside for each gold owner separately. Only physical gold would be able to be deposited in an allocated account, not paper gold. The owner of the physical gold would have full legal title to the gold held in their allocated account. This gold would be documented and tracked, and the bullion bank would merely act as a custodian for the gold. In a bankruptcy scenario, the bank’s creditors would not have a claim to this gold since it would always remain in the ownership of the gold depositor. Gold in allocated accounts cannot be created unless account holders increase their gold deposits or transfer physical gold from one allocated account to another. This will become an important distinguishing characteristic of allocated accounts, as we will soon see that for unallocated accounts “paper gold” would be able to be created through a fractional reserve system, even if there would be no corresponding increase in physical gold to match the paper gold increase.
Unallocated Gold Accounts
For an unallocated account a depositor would deposit gold with a bullion bank (either physical gold or gold represented by an electronic ledger entry i.e. paper gold), and would then be granted a claim against the bullion bank for the amount of gold deposited. The deposited gold would then form part of a fungible central pool of gold combining all the other gold held by other unallocated account holders of the bullion bank.
The unallocated gold held by each account holder would be referenced by a book-keeping entry of the bullion bank as opposed to a specific inventory list of gold bars. This book-keeping entry would record the deposited gold as an asset to the unallocated account holder, and a liability to the bullion bank. The account holder would then hold an unsecured claim against the bullion bank for the gold they deposited. Gold deposited in an unallocated account would become the property of the bullion bank, exactly in the same manner as which cash deposited with a bank would become the property of the bank, with the depositor then being granted an unsecured claim against the bank for the cash deposited.
Gold held in unallocated accounts can then be traded by the bullion bank, repurposed for investment products issued by the bank, or loaned-out further in the same manner as cash would be under a fractional reserve system.
A highly beneficial use of unallocated accounts would be for the provision of location swaps. Here a mine or a refiner would deposit gold in one location with a bullion bank, and then withdraw an equivalent amount of gold in another location to settle a delivery obligation. In this way, the mine or refiner would save significant transportation and storage costs.
The Creation of Paper Gold
Bullion banks are also able to grant gold loans of unallocated gold on a fractional reserve basis. For example, suppose a gold producer wished to borrow gold from a bullion bank to terminate a short position in a hedge contract, or borrow a certain amount of gold to sell into the market today, to raise additional liquidity. The gold producer would do so if the terms on which it could borrow gold would be more advantageous than the terms on which it could borrow fiat currency. The gold producer would then repay this gold loan from future production of gold. The bullion bank could grant this gold loan by crediting the gold producer’s unallocated account with additional gold in deposits. In this moment, paper gold would have been created, much in the same manner as fiat money supply is created when banks issue new loans (see article: https://www.linkedin.com/pulse/understanding-money-creation-qe-perry-fisher/).
Credit Risk
The mechanism of unallocated accounts introduces credit risk for depositors, since bullion banks can engage in fractional reserve lending in their unallocated gold holdings. Credit risk is the risk of a party to a transaction not being able to repay their obligations as and when they become due. The obligation of the bullion bank to the gold depositor is the gold held in the unallocated account on behalf of the depositor. Recall, this gold is an unsecured claim against the bullion bank, since the depositor can demand a withdrawal from the bank at anytime, and the bank would need to honour this withdrawal request.
In the event of bankruptcy the unsecured claims represented by unallocated gold deposits would be preferred to other subordinated claims of the bank. However unlike with gold held in allocated accounts, unallocated gold would not be physically set-apart for each depositor at all times. Thus a situation could arise where the assets of the bank would not be sufficient to settle all of the claims of the unallocated gold deposit holders at once. This introduces credit risk to account holders of unallocated gold accounts.
Rehypothecation of Gold
Rehypothecation entails the pledging of assets as collateral, where those same assets had previously been pledged by others as collateral in different transactions. This creates a situation where two or more unrelated parties have claims to the same assets in completely unrelated transactions, whether knowingly or unknowingly.
The consequence of this is would be a misrepresentation of risk in investments involving duplicated collateral. In a worst-case-scenario the situation could become like a game of musical chairs, where multiple funders would scramble to lay claim on the same physical assets each of them thought they owned outright.
Rehypothecation is commonly seen in bullion banking. Gold held in unallocated accounts may be rehypothecated by bullion banks. A bullion bank could borrow gold from a central bank (these gold loans are typically short-term and are allowed to roll over on a month-to-month basis). The bullion bank could then further loan this gold out to a gold producer in order for that gold producer to settle a hedge contract, for example. If the hedge contract provider was another bullion bank, the gold producer would sell their borrowed gold to the hedge-providing bullion bank to settle the hedge, and then this hedge-providing bank could then issue further loans on the gold received. This gold could be further loaned out to hedge funds or pension funds, or used in other gold-backed derivative contracts, repeating the process over and over again on the same gold bars initially owned by the central bank.
Worst-case Scenario
What if the central bank decided not to roll-over a gold loan, and instead take repayment of their gold? What if, simultaneously, many long positions under derivative contracts actually took physical delivery of gold held in unallocated accounts? What if gold producers failed to deliver physical production to settle their gold loans?
The answer in one word: Chaos! Also known as a potential short squeeze.
The shortage of physical gold to fulfil all claims above would lead to loss of confidence in the gold sector, and perhaps the financial sector at large.