Indian monsoon & 12.5% interest gold loans

<div dir="rtl" style="text-align: right;" trbidi="on"> <div class="separator" style="clear: both; text-align: center;"> <br /> <script async src="//pagead2.googlesyndication.com/pagead/js/adsbygoogle.js"></script> <script async src="//pagead2.googlesyndication.com/pagead/js/adsbygoogle.js"></script> <!-- مكعب2 --> <ins class="adsbygoogle" style="display:inline-block;width:300px;height:250px" data-ad-client="ca-pub-2756270525492930" data-ad-slot="5903208204"></ins> <script> (adsbygoogle = window.adsbygoogle || []).push({}); </script> <!-- مستطيل1 --> <ins class="adsbygoogle" style="display:inline-block;width:336px;height:280px" data-ad-client="ca-pub-2756270525492930" data-ad-slot="6868376600"></ins> <script> (adsbygoogle = window.adsbygoogle || []).push({}); </script><br /> <br /> <br /> <br /> <br /> While writing this article came up which is mildly negative for Indian gold demand (as it is only talking 80 tonnes) as it seems the jewellery industry is going to be further crimped by a new rule limiting their gold deposit schemes (ie people lend gold to jewellers to fund their business) to 25% of their assets. The really interesting thing is that the new law also prevents the jewellers from paying more than 12.5 per cent annual returns on those gold loans! Talk about using gold as money. I suppose they have to pay those rates due to the risk of them running off with the gold or going bankrupt.<br /> Just wait to Wall Street finds out about these yields - beats current junk bond rates. With investors desperate for yields in ZIRP environment will we see Wall Street selling Indian Jeweller bonds at 10% (yep 10%, where do you think those bankers bonus come from)?<br /> <div class="separator" style="clear: both; text-align: center;"> </div> </div>

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Indian monsoon & 12.5% interest gold loans

<div dir="rtl" style="text-align: right;" trbidi="on"> <br /> <div class="separator" style="clear: both; text-align: center;"> </div> <div class="separator" style="clear: both; text-align: center;"> </div> <div class="separator" style="clear: both; text-align: center;"> </div> <br /> <br /> <br /> <br /> <br /> <br /> While writing this article came up which is mildly negative for Indian gold demand (as it is only talking 80 tonnes) as it seems the jewellery industry is going to be further crimped by a new rule limiting their gold deposit schemes (ie people lend gold to jewellers to fund their business) to 25% of their assets. The really interesting thing is that the new law also prevents the jewellers from paying more than 12.5 per cent annual returns on those gold loans! Talk about using gold as money. I suppose they have to pay those rates due to the risk of them running off with the gold or going bankrupt.<br /> Just wait to Wall Street finds out about these yields - beats current junk bond rates. With investors desperate for yields in ZIRP environment will we see Wall Street selling Indian Jeweller bonds at 10% (yep 10%, where do you think those bankers bonus come from)?<br /> <div class="separator" style="clear: both; text-align: center;"> </div> </div>

While writing this article came up which is mildly negative for Indian gold demand (as it is only talking 80 tonnes) as it seems the jewellery industry is going to be further crimped by a new rule limiting their gold deposit schemes (ie people lend gold to jewellers to fund their business) to 25% o…

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GLD amendment refers to "unforeseen reasons" for unallocated failure

<br /> <br /> <br /> <br /> <br /> <br /> GLD has some amendments to its terms up for vote, one of which is <i>"that creations may only be made after the required gold deposit has been allocated to the Trust Allocated Account from the Trust Unallocated Account"</i> (hat tip I Shrugged; see here for an explanation of the existing creation process). What is interesting is the explanation of why they are making this amendment:<br /> <br /> <i>"This amendment provides additional security for Shareholders by eliminating potential risks related to issuing baskets of Shares against unallocated gold if the Custodian was to become insolvent or <b>if the unallocated gold was otherwise not allocated for some other unforeseen reason</b>."</i><br /> <br /> My emphasis on the bold bid. The risk they are referring to here is because the Authorised Participants only deliver unallocated to the Custodian and it is up to the Custodian to find the physical to allocate. This puts all the pressure on the Custodian. The amendment does raise the following questions:<br /> <ul> <li>Why the need to clarify this now, is there something the World Gold Council (who sponsors GLD) knows about the state of the market that didn't exist before?</li> <li>Why would unallocated gold now have a risk of not being allocated?</li> <li>Is there an increased risk of intra-day failures for large unallocated allocations?</li> <li>What are these unforeseen reasons?</li> <li>And why are none of the more excitable gold commentators hyping this up as more proof of the end of the London bullion banking system? :)(Probably because they didn't get the letter as they are smart enough not to hold GLD, which has numerous other issues which only make it suitable for short term trading IMO).</li> </ul> I don't think this is a case of the WGC responding to public criticism, as I haven't seen any commentary on this detail/technical matter of ETF operation. Maybe they just thought they would close up this risk point while they were making changes to the management fee revenue. However, that would beg the question of when did they become aware of the "potential risks" in the creation process and why didn't they fix it earlier?<br /> <br /> At this point I would just note it as a data point, rather than a sign of "an imminent LBMA default", which was first predicted by one commentator in April 2013, which, even by the lax standards of internet accountability, is a fail (don't shoot the messenger, but clearly the fractional reserve bullion banking system is more robust than many give it credit for).<br /> <br /> For the Perth Mint at the moment wholesale and retail demand are weak at best. Kilobar demand was so low we were considering shipping gold TO London but there has been a little pick up in kilobar interest this week. The recent GLD additions are positive but other ETFs have had liquidations so this indicator is unclear. All considered I don't see this as a situation where London is under pressure.<br /> <br /> The other amendment to GLD is a rejig of who pays its costs and gets its management fee. Currently the Trustee pays (by selling gold behind the ETF):<br /> <ul> <li>Sponsor (ie WGC): 0.15%</li> <li>Marketing Agent: 0.15% </li> <li>Custodian: approximately 0.066%</li> <li>Administration Fees: approximately 0.03% to 0.04%</li> <li>Trustee: $2 million</li> </ul> The proposal is that the WGC will take on all costs and only charge the Trust 0.40%. It just formalises the existing "Fee Reduction Agreement" by which the WGC was absorbing any costs above 0.40% so that GLD holders only paid 0.40%.<br /> <br /> I can't see any material change here. Possibly the WGC feels they may be able to control or reduce costs better now that GLD is established and hence it sees an opportunity to make a bit more profit out of GLD beyond the current arrangement, as noted in the amendment letter <em>"the net amount earned by the Sponsor could be greater or smaller than the fee of 0.15% of the daily ANAV of the Trust it currently earns, depending on the actual expenses of the Trust."</em><br /> <br /> Coincidental this happens when two large South African miners (Gold Fields and AngloGold Ashanti) dropped out of the WGC and thus the WGC lost a big revenue source? While that announcement happened after the amendment letter, the WGC would have know about this move by the miners for some time. Just another move towards the WGC becoming more self funded.</div> </div>

GLD has some amendments to its terms up for vote, one of which is "that creations may only be made after the required gold deposit has been allocated to the Trust Allocated Account from the Trust Unallocated Account" (hat tip I Shrugged; see here for an explanation of the existing creation process)…

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No Indian gold import policy change explains RBI gold swap

<div dir="rtl" style="text-align: right;" trbidi="on">After a lot of speculation about what changes the 2014 Indian budget would bring for gold import policies, we got zip. That now supports my speculation on why the Reserve Bank of India (RBI) announced, ahead of the budget, a combined quality and loco swap of its gold: it was a temporary political fix to the problem of:<br /><br />1. Making promises to the gold industry during the election campaign that it would wind back gold import restrictions.<br />2. Reality, once in office, that such relief on gold imports would negatively affect India's current account deficit.<br /><br />Standard political MO: "Oh, it is a lot worse than we thought, we can't honour our promises, it is the previous Government's fault". Interestingly, on the eve of the budget the Indian gold industry hadn't read the warning signs and thought there would be relief, with Bachhraj Bamalwa, of All India Gems and Jewellery Trade Federation, speculating that the duty would be cut to 6% and even that <em>"the government might remove the 80:20 rule in a gradual, 'phased' manner"</em>. This view was probably helped along by statements from the Government like <em>"any action on gold should take into account the interests of the public and traders, not just economics and policy"</em>. Well it is clear they sided with economics and policy.<br /><br />There were some warning signs, with this Reuters article quoting commentators noting that the Government was <em>"moving back and dithering on their decisions, and in a sense playing politics".</em> Another sign was this Report that <em>"India risks losing its investment-grade sovereign rating if it fails to get its finances into shape"</em> with S&P warning <em>"there was a one-third chance of a downgrade </em>[of India]<em> to "junk" without a big improvement in the fiscal deficit and in implementing reforms."</em><br /><br />For me, the strongest sign the new Indian government was going to back away from its promises was the RBI gold swap announcement and the local gold industry should have paid more attention to it, because its timing was very unusual: just before the election about gold which had been sitting in RBI's vaults in India for decades. Why was this non-standard gold suddenly an issue?<br /><br />I think it is a reasonable speculation that the RBI knew in advance that the new Government could not open up the import restrictions and have a flood of gold imports affecting the current account deficit and the country's rating. This gold swap was then a planned action to placate the industry by releasing supply into the local market in a way that would not affect the current account deficit.<br /><br />The RBI is aware of the local gold supply issues, have loosened the 80:20 rule a little in March by allowing some banks without three years worth of exports to import gold, but only on the basis that they had current customers to export gold to (see this Reuters article).<br /><br />Sidebar: the clear message from the Indian session at the recent Singapore Gold Forum was that it was the 80:20 rule that halted gold imports and not the duty hikes. On that basis I was expecting some duty cut as that would have made it look like the Government had done something while not making any difference to how much gold could be imported.<br /><br />So how does this gold swap work and not impact the current account deficit? Firstly, a swap involves two legs, as explained here, in this case being:<br /><br />1. Sell non-LBMA standard gold loco India<br />2. Buy LBMA standard gold loco UK<br /><br />No doubt the RBI had some interest in upgrading its non-standard gold (as it makes it easier in the future to mobilise it in a financial crisis, like it did in 1991) but it could have just sent it to a local refinery. However, this would not have had any impact on local supplies as the gold would have just went straight back into the RBI's vault.<br /><br />The key is that the swap results in a net supply of gold into the local Indian market, but the replacement gold is supplied from London (or Switzerland, as we will see shortly). The net supply in India will result in a reduction of the local premium (which the public will welcome) but more importantly, it will give the local gold industry material to work with (of which they are starved) and this should increase employment. The reason this swap will not affect the current account deficit is because the cash legs of a swap are netted, so the RBI will only be paying a few dollars per ounce out of its offshore USD reserves.<br /><br />Regarding the swap, I had a debate with twitter based precious metals analyst Silver Watchdog who thinks the RBI swap would also involve leasing. I see this as unnecessarily complex, which his diagram indicates. The leasing angle only makes sense if you believe that there is a shortage of gold in London (as the second leg of the swap pulls physical out of the London market), so only if the RBI subsequently leases their newly acquired London gold will this take pressure off the London market. Apart from there being no indication that the RBI was intending to do this, Perth Mint does not see any such shortages in London at this time.<br /><br />I would note here that while bullion banks will probably quote on this swap, the advantage is with the refiners given the quality upgrade required. The one in the box seat is the local Indian refinery PAMP-MMTC who, through PAMP's parent MKS, is capable without bullion bank help to do <em>"options, hedging and EFP’s; location, purity and quality swaps; forward leasing arrangements</em>". PAMP would have no problem refining the gold locally and supplying 400oz bars into London out of its Switzerland operations.<br /><br />While India has 557 tonnes of gold reserves, there is no indication of how much non-standard gold they hold or are looking to swap. This Reuters article notes that the RBI <em>"would decide further in regard to quantity, swap-ratio </em>[i.e. swap fee]<em>, timing etc. of the gold to be swapped"</em>. The reference to "timing" implies that the RBI is looking to supply their gold over a period of time, which would make sense if you want to alleviate local gold industry supply problems and help them out for as long as possible.<br /><br />Whatever amount is involved it will only last for a limited time, in the order of months, not years, given India's appetite for gold. So this is just a short term fix to a political problem and ultimately shortages will resume due to the 80:20 rule.<br /><br />Of course, it is entirely possible that the RBI's swap is solely about upgrading its gold reserves and the timing is purely coincidental. That would clearly be the case if the replacement gold was going back into the RBI's vaults in India, rather than with the Bank of England as reported by Reuters. However, as we are dealing with central banks, where transparency even on simple matters is rare to come by, we just don't know what the real motivation is and thus have to resort to speculation. I hope you got some value, in terms of how the industry works, out of my speculations even if they turn out to be wrong.</div>

After a lot of speculation about what changes the 2014 Indian budget would bring for gold import policies, we got zip. That now supports my speculation on why the Reserve Bank of India (RBI) announced, ahead of the budget, a combined quality and loco swap of its gold: it was a temporary political fi…

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Allocated Gold at Bank of England declines 755 tonnes

<div dir="rtl" style="text-align: right;" trbidi="on">The Bank of England's just released 2014 Annual Report discloses that it was holding 5,485 tonnes of gold as a custodian, down 755 tonnes to around the level it was in 2011 and 2012. Below is a chart of the data against the average gold price over the Bank's financial year ending February, which shows that the amount of gold has basically followed the gold price, very much like the behaviour of the gold ETFs.<br /><div class="separator" style="clear: both; text-align: center;"><span style="margin-left: 1em; margin-right: 1em;"><img border="0" height="446" src="http://lh4.googleusercontent.com/-YnisdIFWxfk/U6EdLny4r-I/AAAAAAAAAPE/ucoJXoyUUPE/w426-h272/BoEGold.PNG" width="640" /></span></div><br /><br />The table below details the figures and calculations back to 2005, when the Bank first started reporting its custodial activities.<br /><br /><br /><table border="1"><tbody><tr> <td>As at Date</td> <td>Allocated Gold (GBP billions)</td> <td>London PM Fix (GBP)</td> <td>Allocated Gold (tonnes)</td> <td>Year on Year Change (tonnes)</td></tr><tr> <td>28/02/2005</td> <td>29</td> <td>226.514</td> <td>3,982</td> <td></td></tr><tr> <td>28/02/2006</td> <td>36</td> <td>318.078</td> <td>3,520</td> <td>-462</td></tr><tr> <td>28/02/2007</td> <td>43</td> <td>338.964</td> <td>3,946</td> <td>+425</td></tr><tr> <td>28/02/2008</td> <td>72</td> <td>488.854</td> <td>4,581</td> <td>+635</td></tr><tr> <td>28/02/2009</td> <td>102</td> <td>669.809</td> <td>4,737</td> <td>+155</td></tr><tr> <td>28/02/2010</td> <td>125</td> <td>746.149</td> <td>5,211</td> <td>+474</td></tr><tr> <td>28/02/2011</td> <td>156</td> <td>868.682</td> <td>5,586</td> <td>+375</td></tr><tr> <td>28/02/2012</td> <td>197</td> <td>1110.484</td> <td>5,518</td> <td>-68</td></tr><tr> <td>28/02/2013</td> <td>210</td> <td>1046.719</td> <td>6,240</td> <td>+722</td></tr><tr> <td>28/02/2014</td> <td>140</td> <td>793.931</td> <td>5,485</td> <td>-755</td></tr></tbody></table><br /><br />In this June 2014 Quarterly Bulletin, the Bank reports on page 134 that 72 central banks hold gold with them (which is 65% of the 113 central banks that the World Gold Council records as having gold reserves). It also noted that the <i>"Bank also acts as a bank to certain other financial institutions. One example is central counterparties"</i>. Included in that the latter group would be the six London bullion market clearing banks. As it is unlikely that the Bank runs allocated gold accounts for banks that are not central to the gold market, it would be fair to conclude that the majority of the allocated gold it holds is for central banks.<br /><br /><br />Given there was nowhere near 755 tonnes of central bank selling in the year ending February 2014 it would therefore be fair to conclude that this gold outflow was from the allocated accounts that bullion banks had with the Bank of England. This is not surprising considering that the major gold ETFs lost in excess of 600 tonnes over that same period.<br /><br /><br />Just one final observation from World Gold Council central bank holdings data: it wasn't until the year ending Q1 2010 that central banks were net buyers. Prior to that they were net sellers (1,011t for 4 years to March 2009), yet the table above shows customers of the Bank of England adding to their holdings (753t for 4 years to February 2009). Now if we remove central banks that most likely don't store with the Bank, this 1,011t net sell figure may change, but I doubt enough to turn it around to anywhere near 753t of net buying. Tentative conclusion is that bullion banks were accumulating a lot of allocated gold with the Bank of England.<br /><br /><br />Combining the above figures with detailed LBMA turnover figures, UK gold import/exports, London ETF flows, and central bank activity is more work than I have time for at the moment, but it certainly would give us a better picture of the London gold market.</div>

The Bank of England's just released 2014 Annual Report discloses that it was holding 5,485 tonnes of gold as a custodian, down 755 tonnes to around the level it was in 2011 and 2012. Below is a chart of the data against the average gold price over the Bank's financial year ending February, which sho…

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Why no direct relationship between price and stocks

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">A great article by Keith Weiner explaining why open interest in gold has fallen but in silver it has increased - hint: to do with profit from carrying gold. Apart from that, it is also useful for those who falsely think that if the price goes up (or down) then open interest should increase (or fall), and also that ETF holdings should increase (or decrease).</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">It does puzzle me why people think there should be a direct relationship between open interest or ETF stocks and price, given that they don't have any problem understanding that the price of a company's shares can go up and down while the number of shares on issues doesn't change.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">For a company ownership of shares is just transfered between buyer and seller and that doesn't drive price. Price is a function of there being more buying pressure resulting in buyers not being willing to sit around waiting for people to accept their bids and instead accepting seller's offers (and vice versa).</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The same can happen with precious metal ETFs. ETFs shares are only created or redeemed if the person on the other side of the trade is someone with no interest in the ETF (ie a market maker). Where existing holders sell to new buyers no new shares need to be created, yet the price can still go up if the buyers are willing to accept the seller's offers (and the non-market maker sellers are adjusting their offers to match gold prices on Comex or the spot market.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Also, check out Warren's latest bullion bars project post, where he notes that 70% of bars added to GLD during 2013 where previously in the GLD list, demonstrating that <em>"there is a really large stock of gold in London and that it doesn't necessarily all vanish instantly to China".</em> He also predicts the return of <b>specific</b> bar numbers by July 30th - now that's a real forecast, no vague hedged cop out wording.</div></div>

A great article by Keith Weiner explaining why open interest in gold has fallen but in silver it has increased - hint: to do with profit from carrying gold. Apart from that, it is also useful for those who falsely think that if the price goes up (or down) then open interest should increase (or fall)…

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Gold forecaster with 100% accuracy says gold to remain weak

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">I have found a gold forecaster with a 100% accuracy rate. Below is a chart of two of his recent predictions.</div><br /><div class="separator" style="clear: both; text-align: center;"><span style="margin-left: 1em; margin-right: 1em;"><img border="0" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiyKiXcFS3mFiMmSyCLJ8GHDe-6VbqGw_QUp7vXlQVhKjT3d7aIrOVgLX-tcCPumXYPCtTQCsc2SU1CcBaP0DVxMblA52B7p4zYriA2NMl-R9B2_7c3RYqjo9b6daxMXYndxtRkR8Z7ppJL/s1600/forecast1.png" width="640" /></span></div><br /><div style="text-align: justify;">The first arrow marks the 15th of January when he said to <em>"use narratives, not just charts, to tell if gold's bottom may be near"</em>, noting that mainstream commentary was a <em>"precursor to more bullish narratives. It also gives confidence to smart money to start to get into the market"</em></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The second arrow marks the 15th of March when he said that he <em>"would not be surprised to see it correct down"</em> and that <em>"there will be corrections on the climb back up"</em> during the rest of 2014.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Of course the forecaster is me, and the 100% accuracy rate is misleading as I've only made these two calls in the entire time I've blogged (here and here), but hey, since when does the full truth matter in click baiting headlines?</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Now given that my sample size is only two forecasts, you can probably bet <strong>against</strong> my next call as there is no way I can maintain a 100% accuracy rate. I'm not ready to make a call for a bottom in this correction so at this time will just expand on the March 15 comments I made in an interview with Al Korelin.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In that interview I noted negative premiums on the SGE were possibly indicative of bullion banks having overestimated Chinese New Year demand (BBs stockpile ahead of these high demand periods, see here for some evidence of this). Perth Mint has seen some on and off weakness in kilobar premiums recently and this was confirmed by Ed Steer noting that JP Morgan received exactly 160,750.000oz of eligible gold into their Comex warehouse on March 20. This is exactly 5 tonnes, which readers of this blog know is indicative of kilobars. If the Chinese are so hot for gold right now, why is JPM putting kilobars into a NY warehouse?</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">For a current read on the market I think you have to take a narrative approach I discussed in that January 15 article - and that is mainstream financial markets narratives, not goldbug narratives, as that is where the big money is. Where is that narrative now? First this Business Insider article quoting Goldman:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><em>"we see potential for a meaningful decline in gold prices towards the level implied by 10-year TIPS yields, which our rates strategists expect to rise further this year, and reiterate our year-end $US1,050/toz gold price forecast. More broadly, we believe that with tapering of the Fed’s QE, US economic releases are back to being a key driving force behind gold prices"</em></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">And this from the Australian Financial Review via Macro Business, quoting some nobody and SocGen:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><em>"Gold is going to be somewhat problematic from an investment standpoint over the next six to 12 months. We’re probably looking to a relatively higher and quicker increase on rates, which is a headwind for precious metals."</em></div><div style="text-align: justify;"><em></em><br /></div><div style="text-align: justify;"><em>"We continue to believe that the economic momentum in the US shows further improvement, we reiterate our very bearish outlook for this year. Prices could drop below $US1,000. I would not rule that out."</em></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The important thing is these people believe this stuff, that the US is "improving" and they will trade gold accordingly. I think it is also worth noting Dan Norcini's repeated comments that this price run up was more about short covering than new longs, and he is representative of the Comex floor "narrative".</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">I also note the Zero Hedge article on China Commodity Funding Deals regarding gold, which has some potential to be negative for gold, despite what some may say. Most likely their "don't worry, it is bullish for gold" interpretation comes from a lack of understanding of the deals as they probably haven't got access to the professional market commentary on that topic. That is for another post, but I will note I brought this issue to your attention in September 2012 and ZH and others who are now jumping on it could have found out a lot earlier from these articles (good background reading if you're keen) June 2013, August 2013, September 2013, December 2013 and finally from Koos Jansen, who you'd think gold bloggers would read, with this quote indicating the risk: <em>"some enterprises in China use gold leasing from banks to solve their short-term funding problems in the hope of buying back the gold at lower levels to repay the lease. However they can be short-squeezed when gold moves higher"</em></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">So at this stage I think the risk is to the downside but will hold off on a bottom call until I can see some shift in the mainstream narrative.</div></div>

I have found a gold forecaster with a 100% accuracy rate. Below is a chart of two of his recent predictions.The first arrow marks the 15th of January when he said to "use narratives, not just charts, to tell if gold's bottom may be near", noting that mainstream commentary was a "precursor to more bu…

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GLD vault defragmentation

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">Warren has a cool animation showing the addition and redemption of pallets of gold bars out of GLD's vault, done in the style of the old PC disk defrag programs, at the screwtapefiles blog.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">A few comments on the 5 minute animation (see screenshot below):</div><ul><li><div style="text-align: justify;">During the redemptions in 2013, most of the bars are taken from the bottom, that is, the recently added stuff. Makes sense, this stuff is easier to access.</div></li><div style="text-align: justify;"></div><li><div style="text-align: justify;">But note much of the redemptions are from all over the place. Some of that is explained by them "hunting" for 9999 bars as Warren discussed in emails. He will have a follow up post taking this animation analysis into more detail showing this.</div></li><li><div style="text-align: justify;">In the pic below the area just above the empty bottom area is really stubborn, something about those bars they don't redeem from, even though they are more recently added than the bars in the first half of the pic above that section.</div></li></ul>Snapshot of GLD defrag youtube:<br /><div class="separator" style="clear: both; text-align: center;"><span style="margin-left: 1em; margin-right: 1em;"><img border="0" height="446" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgv1eOCyhzgPR3wlwe7NZEb7EiNR3xaolNGWBybS8BCcF9_vDMWoMQYO66D0dSYrZIGcvlj-Bf1JTuXJtwjU8QIrdHHAahSHlT_9vhYWxv6HdO1ZHKpjn_z22WLTSDLWsC0AEQKAMEQBjQD/s1600/glddefrag.PNG" width="640" /></span></div></div>

Warren has a cool animation showing the addition and redemption of pallets of gold bars out of GLD's vault, done in the style of the old PC disk defrag programs, at the screwtapefiles blog.A few comments on the 5 minute animation (see screenshot below):During the redemptions in 2013, most of the bar…

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How ETFs Haven't Altered The Dynamics Of Gold

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">Have a post up on the corporate blog How ETFs Haven't Altered The Dynamics Of Gold where I have a go at the mainstream finanical narrative that gold ETFs were a “game changer for the gold industry”, making it easier for investors to buy gold and having a positive impact on the gold price. If you properly classify bar/coin and jewellery bought for investment reasons then that accounts for over 11,400 tonnes of physical gold compared to only 2,600 tonnes of ETF investment between 2004 and 2012. More at the link.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Still snowed under with work so fustrated at limited blogging capacity. Just one quick FYI from a contact Ronan on a soon to be launched gold ETF from Axel Merk:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><em>This Trust seems to follow the standard format, a trust backed by allocated physical 400oz bars. JP Morgan will be custodian. The differentiating factor in this trust will be that it holds other types of gold in addition to 400oz bars, such as smaller bars and even coins, and small investors will be able (if they want) to redeem shares for gold bullion, which is a new angle.</em></div><div style="text-align: justify;"><em></em><br /></div><div style="text-align: justify;"><em>There is a web site which seems to be on hold </em><em>www.merkgold.com</em><em> until after the IPO. See </em><em>link</em><em> for one of the filings.</em></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">I'm surprised anyone would think more gold ETFs are needed, but maybe they think the redeemability in small sizes will be attractive. I would note that redeemability at any size into any coin or bar was a feature of Perth Mint's ASX listed gold product PMGOLD when launched in 2003. Ten years later they are catching up. The holding of smaller bars will just add to costs, but as they don't have a Mint out the back, I suppose there is no other way for them to offer than redeemability.<br /><br />Merk has some good articles on gold here, quote: <em>"I am an optimist. I’m no conspiracist. I just happen to think the road to hell is paved with good intentions. As a result, I own gold"</em>. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">FYI, you may also find this paper by CME Group having a go at gold ETFs versus Comex futures of interest/amusement, quote:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><em>"While there is a place for ETFs in any investment portfolio, there are several drawbacks that do not make them the first choice for individuals wishing to invest in gold.</em></div><div style="text-align: justify;"><em></em><br /></div><div style="text-align: justify;"><em>When the goal is to simply benefit from a rise or fall of the price of gold, COMEX Gold futures are the logical choice. COMEX Gold futures offer the investor a fast and accurate pricing mechanism, the ability to leverage their trading strategies and the security of doing business on an exchange that has guaranteed the performance of each of its transactions for over 100 years."</em></div></div>

Have a post up on the corporate blog How ETFs Haven't Altered The Dynamics Of Gold where I have a go at the mainstream finanical narrative that gold ETFs were a “game changer for the gold industry”, making it easier for investors to buy gold and having a positive impact on the gold price. If you pro…

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Sprott PHYS redemptions arbitrage driven

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">Sprott PHYS fund redemptions show up in the first few days of a month, and for March there were no redemptions. This lack of news is actually news as it confirms for me that the redemptions we have seen in the past (see here) were driven by an arbitrage opportunity.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Below is a graph that demonstrates this. First I took the reported premium/discount to Net Asset Value (NAV) and subtracted the $5 per ounce redemption cost. This is graphed in green (for a profit) and red (for a loss) in percentage terms on the right hand scale. When it is green, you can make a profit buying PHYS shares at a discount to NAV, redeeming, and then selling the physical gold at the higher spot market price.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Second, I graphed the amount redeemed on the left hand scale and shaded the months during which the shares would have been accumulated to do the redemption. You'll note that the shaded periods run from the 16th of a month to the 15th of the next month. This is because you have to submit your redemption request to the fund by the 15th of each month to give the fund 2 weeks to process and get your gold ready for delivery by the end of the month.</div><br /><div class="separator" style="clear: both; text-align: center;"><span style="margin-left: 1em; margin-right: 1em;"><img border="0" height="417" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwztM7dau9_2gYPWHPhYa4EZlVU-lpP9tw6zLO2nc5wFcV7VK8kIbkXI2bQeP6F1iB3IvYu7_NXtgnKyscqSNwgXdKA7F7cZhsZ5q_dQdruqDvjC2cDpab6TEWYY_MpAxd0sZ1IEBg7qxY/s1600/sprott3.png" width="640" /></span></div><br /><div style="text-align: justify;">You can see from the chart that the redemption accumulations only occur when there is an arbitrage profit to be had and cease when there is no profit.</div><div style="text-align: justify;"></div><div style="text-align: justify;">PHYS first started to go into discount during April 2013 (prior to that it had always traded at a premium). However, while there was some arbitrage profit in May/June, that month only showed a redemption for 400oz. I think this is explained by the fact that PHYS was only showing small discounts to NAV and a trader or bullion bank first wanted to test the redemption process before redeeming in bulk. Hence they redeemed exactly one LBMA bar - not coincidental I think and strongly suggestive of a test transaction.</div><div style="text-align: justify;"></div><div style="text-align: justify;">As the discount persists into the Jun/July and July/August periods we see the trader ramp up the redemption quantities. I note that as a percentage of PHYS' trading volume for those months, the units redeemed were only 0.6% and 1.6% respectively. That is quite low. August/September presented no arbitrage opportunity so we don't see any redemptions.</div><div style="text-align: justify;"></div><div style="text-align: justify;">But in September/October and subsequent periods, the discount (and arbitrage profit) reappears and we see the redemptions increase. Note that while the next two redemptions are similar in ounces to Jun/July and July/August periods, due to lower trading in PHYS they represented 12.1% and 16.5% of trading volume respectively. This is getting quite high but the buying of PHYS did not drive PHYS back into a premium, so in the next two months the traders must have felt more confident and really ramped up their buying to the 3 tonne level, and at 28.9% and 30.1% of PHYS' trading volume in November/December and December/January respectively.</div><div style="text-align: justify;"></div><div style="text-align: justify;">I am wary of ascribing causality here, but do wonder if this high level of buying relative to the number of shares of PHYS that normally trade did result in the fund returning back into a premium to NAV from January onwards. That is what arbitrage in theory should do.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">I would note that the redemption activity we see may not be an arbitrage trade (that is, someone just looking to pocket the different in prices) but also a physical investor who is not interested in holding a fund and just sees PHYS as offering a cheaper way of getting physical. In either case the result is the same.</div><div style="text-align: justify;"></div><div style="text-align: justify;">I'll keep track of this data and post if there is any action that further confirms, or contradicts, the theory that a trader or investor is opportunistically taking advantage of PHYS trading at a discount to NAV.</div></div>

Sprott PHYS fund redemptions show up in the first few days of a month, and for March there were no redemptions. This lack of news is actually news as it confirms for me that the redemptions we have seen in the past (see here) were driven by an arbitrage opportunity.Below is a graph that demonstrates…

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US deep storage gold - weights

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">Still catching up after my two week holiday, have many posts planned including finishing the fractional bullion banking, the London fix manipulation and legal case, Sprott PHYS redemptions, bitcoin. In the meantime, the table from the last post but by ounces of fine gold:</div><br /><div class="separator" style="clear: both; text-align: center;"><span style="margin-left: 1em; margin-right: 1em;"><img border="0" height="178" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhoVXH9X5K77JbIeOD_WBA1VGo3fp8sJSuP8okoGEDjOB8ySAdDm3SrcCuYqrisSmD2s1rjv0TaJ6bP0OweDd54f2UxCfW1UU0iJzPJP6LvLICIpakoV7lssMM3dEyWHN1qFkBsaB1hb7u/s1600/usdeep3.png" width="320" /></span></div><br /><div style="text-align: justify;">Similar percentages to the one by number of bars. As Golden Nugget commented, I should note that the spreadsheet is only for US Mint held gold, which is 95% of the total, with the other 5% held at the US Fed. Unfortunately the bar list for that is only supplied as a pdf of a scan so impossible to analyse in Excel.</div><div style="text-align: justify;"></div><div style="text-align: justify;">Anyone interested in the reality of the US gold reserves really should read the pdf of hearing 112-41 (see link) as this bascially busts many of the memes around the US gold reserves. I will do a post on that hearing as there is a lot of detail supplied and suprising that I've never seen much commentary around it.</div></div>

Still catching up after my two week holiday, have many posts planned including finishing the fractional bullion banking, the London fix manipulation and legal case, Sprott PHYS redemptions, bitcoin. In the meantime, the table from the last post but by ounces of fine gold:Similar percentages to the o…

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US deep storage gold reserves bar list made public

<div dir="rtl" style="text-align: right;" trbidi="on">Warren James (the guru of ETF bar list analysis) was tipped off by a reader that the US government had a bar list of its deep storage gold reserves on its website, see Victor's tweets here for details and links. Warren's initial comments are:<br /><br /><em>"Have already perused the bar numbers - a stack of Rand/Matthey/Rothschild bars there but no match (obviously) for the bar signatures we have in ETF data and happy to say that the sequences are consistent with the data we have. They are (again as you might expect) really old bar sequence numbers. Talking, early Rand number sequences. I gave them both the observation that the spreadsheet seems to have been built up from some older documents - there seem to be some OCR errors, which I assume were from earlier typewritten lists."</em><br /><br />He will no doubt come out with a full analysis in due time assessing its internal consistency (as he has done for the ETF bar lists). In the meantime below is a quick analysis of the type of bars. I'm just looking here at the number of bars but have identified clear groupings of bar types. First the raw data:<br /><br /><div class="separator" style="clear: both; text-align: center;"><span style="margin-left: 1em; margin-right: 1em;"><img border="0" height="158" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgPGIauH9QlpATntmnkzqk16LlN4jelm7azWJllfZbfL32-UEk42vLZwW4DMcPXkL255UANcBg9_33axZ_EX8Ds9fzrhdSt571kWlK8HaGCjiF5y-pTiynMp7Wyg-o5PovBB7EJb3sHLGFd/s1600/usdeep.png" width="640" /></span></div><br /><div style="text-align: justify;">My choice of purity and bar size categories was driven by clear clusterings in the data. The key categories are:</div><br /><div class="separator" style="clear: both; text-align: center;"><span style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh3Wjz3LFeNuN24Mqy4mhRUuBWthZfpf0bTcAeAr_6N2wE-6XHu57Reu_pwBkc4_LPenowTAnnBR0ZGrx9XuwHfkerbp9SKIIOpv_SfyOhDAJDGB4iQqfrZgdVvs_LIPTAuGZZIo3MPTEGt/s1600/usdeep2.png" /></span></div><br /><div style="text-align: justify;">So 8 bar types account for 85% of the bars. No suprise that few meet the LBMA standards for weight and purity, given the source (1930s confiscation, ie coin melt) of most of the gold.</div><div style="text-align: justify;"></div><div style="text-align: justify;">Not suprised to see 100oz bars given that is Comex futures standard, but the 36% is not standard and clearly coin melt source.<br /><br />Significant is the fact that 55% of all the bars are 90% (+/- .1%) purity and 13% are 22ct (current US Eagle purity). Unusual is the circa 840oz and 1070oz bar sizes, very heavy.</div><div style="text-align: justify;"></div><div style="text-align: justify;">Note that the LBMA standards are post 1987, hence the bars which are close to LBMA weight and/or under purity are reflective of a general industry standard to 90%+ purity circa 350oz size bars prior to 1987, but this was later firmed up later by the LBMA to the currently 350oz-430oz 99.5%+ standard.</div><div style="text-align: justify;"><br />I think that the sub 2 percent purity cateory is an error. There are 714,993oz of gross weight recorded for this category and if we assume the purity is more likely around 90%, then this spreadsheet understates US gold reserves by 640,000oz!<br /></div><div style="text-align: justify;">A lot more to come from this data but just wanted to draw attention to this data ASAP and look forward to further analysis and comment by Warren and others.</div></div>

Warren James (the guru of ETF bar list analysis) was tipped off by a reader that the US government had a bar list of its deep storage gold reserves on its website, see Victor's tweets here for details and links. Warren's initial comments are:"Have already perused the bar numbers - a stack of Rand/Ma…

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Service interruption annoucement

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">Your goldchat blogging service will have intermittent service interruptions over the next two weeks due to the fact that I'm in Singapore/Malaysia for holidays and my other half has this crazy view that gold blogging is not an authorised holiday/relaxation activity.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">I was aiming to get the series of fractional bullion banking posts completed before I left for holidays but it didn't work out. If it is not clear, I did not start this series with any idea of how it would end up or how long it would take. I had some general ideas on the topic but have just been exploring them as I go. That is why they don't seem clearly structured and I think it will be worth putting them altogether into one article and fixing them up into a more coherent whole.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">As an FYI, most of the posts in this series have only been getting around 1000 views with the "how can I default on thee" one getting 3600, due to a GATA referral. This is not surprising as the material is technical in nature. I'm consoling (deluding?) myself that it is the quality of the readers, not the quantity, that matters.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">I will do my best to try and sneak in a final (or two) posts in the fraction/run series. Now off to get some congee for breakfast - yum.</div></div>

Your goldchat blogging service will have intermittent service interruptions over the next two weeks due to the fact that I'm in Singapore/Malaysia for holidays and my other half has this crazy view that gold blogging is not an authorised holiday/relaxation activity.I was aiming to get the series of …

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Fractional reserve bullion banking and gold bank runs: a run or stroll?

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">The fact that Australia's Prime Minister referred to the global financial crisis as a "shitstorm" will probably just reinforce Americans' Paul Hogan/Steve Irwin view of Australians. Shitstorm is also the title of a book about that Prime Minister's first term and how close Australia came to financial disaster. In that book they cover the bank run that was developing at the time:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>"It was a silent run, unnoticed by the media. Across the country, at least tens and possibly hundreds of thousands of depositors were withdrawing their funds. Left unchecked, there would soon be queues in the street with police managing crowd control ... It's a long time since Australia has had a serious run on a financial institution, but it's all about confidence, and you cannot allow an impression to develop generally in the public that there is any risk."</i></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">So how did the Australian government stop this bank run? Simples, they just told people they would guarantee bank deposits. End of run. I think it worked because the average Westerner can't conceive of a government becoming bankrupt. If pushed, the government would just print physical cash and send it to bank branches and take on the bank's assets and the average person would feel safe as long as they had that physical cash in their hands.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Now the holders of BB-unallocated are a step ahead of the average person because they hold gold, but the fact that they hold it with a bank tells you they still trust the system. Certainly if there was a fiat bank run, these BB-unallocated holders would request physical gold, but our focus here is if/when and how would a gold run occur, independent of a fiat run.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">As I said in yesterday's post, the opacity of the gold market works to suppress run dynamics but paradoxically, that lack of information also means that if a credible rumour can gain hold (ie a narrative develops) then the run will be fast and thus the BB system is more unstable than the fiat banking system in this respect, particularly as even the most naive investors knows you can't print gold.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">My best guess as to what could cause these BB-unallocated holders to begin redeeming in large numbers would be multiple reports of failures to deliver. If that coincided with reports of coin shortages it would help. But it has to be multiple reports - this bank, that bank - around the same time. The one off reports/events we have had are not enough to trigger a mass redemption. The fact is people rationalise away such single events. I mean, look at MF Global - people are still trading futures and there has not been any uptick in deliveries vs open interest. I think it needs a clustering of multiple events, and it would help if some of those were picked up by more mainstream news/blogs.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Also, it would be necessary for a large number of people to redeem at the same time. I believe that the gold market is already experiencing a slow gold run, more of a gold walk or stroll. The fact that Perth Mint clients have been increasingly preferring allocated, that non-bank storage services are growing, and other anecdotal stories I've heard (plus a soon to be launched product we are working on with a big bank) show that more and more clients are withdrawing away from BB-style unallocated and becoming risk adverse.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">However, the reason I spent so many posts on the structure of the BB system was to show that this slow shift is not a problem for the BBs as they can handle such a move between themselves and central banks - it gives them time to let their gold assets mature into physical.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">It is important to note at this point that while BB engages in maturity transformation just like fiat banking, it is mostly short term in nature - BBs don't lend gold out for 30 year mortgages. Even at the height of the miner short selling, a WGC August 2000 report on gold derivatives stated that most of the global mine hedge book was concentrated in the first 4 years and did not extend past 10 years. Today we have hardly any mine hedging, as this chart from Sharelynx.com shows:</div><br /><div class="separator" style="clear: both; text-align: center;"><span style="margin-left: 1em; margin-right: 1em;"><img border="0" height="244" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEikMg2OAdpgEMrJrS4tVNVm_1ncnd8vHbe6a-bvxrHvOPOM_O_HEnflMqOvJekR2WYNjATzNBTul8_ctx0oru-izPqW_EOsmi4nWNWZ7B2abkzXgt-1FOgUtiH54zc5JPJfRw_4I2vdT2oh/s1600/occbook.png" width="320" /></span></div><br /><div style="text-align: justify;">Note that the the blue line representing miner hedging is a delta hedged figure where as the OCC figures are notional. The notional miner hedging figure would be much more but I don't have any figures on it. Even so, it would not account for all of the OCC notional figure. The balance would be other short positions (eg Comex hedges, OTC forwards and options, etc) as well as gold lent to industry for inventory funding purposes.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">So in a slow burn scenario, BBs can just let their gold leases mature. Indeed, the chart above shows that this is exactly what has been happening, with gold derivatives declining from 10,000t in 2000 to 2,500t today. If miner hedging is basically nil at the moment, what makes up the 2,500t and more importantly, how long is it lent out?</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Obviously, part of those OCC figures would reflect Comex and other futures. But note the open interest in futures - there is hardly any volume outside the current contract. This indicates that most speculators are playing short term. As far as the OTC markets are concerned, note that GOFO rates are only quoted up to terms of 1 year. Again an indicator of where most of the volume is, in the short stuff. Finally, the Perth Mint's understanding of the extent of central bank leasing is that the majority, if not all, of it is for terms of one year or less.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The other significant part of the 2,500t figure would be lending to industry for inventory and consignment funding/hedging purposes. The WGC derivatives report estimated this at 1465t as at December 1999. Demand for gold is much higher today so, say, 2000t of gold tied up in refiners/mints/coin dealers (plus jewellery distribution and retailing) is highly realistic.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">So my reading of the BB assets is that most of the short selling lending is very short term in nature and thus can mature quite quickly, in months. However, that which is lent to industry, even if terms are less than one year, are more ongoing in nature. While industry could liquidate inventory if lease rates rose (which they would if BBs were desperate for physical), that would not be overly quick, particularly as it would bump up against refinery capacity limitations and in any case, the industry needs a base amount of gold in process to function. So industry inventories can mostly be considered locked out in respect of meeting any BB-unallocated redemptions.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">What the OCC chart does not tell us is the size of the unallocated pool and how much of it is backed by physical. In the WGC report, they estimate the total gold lending supply at 5,230t as at December 1999. Whether the OCC notional 10,000t would delta hedge down to 5,230t I don't know, but for our purposes whether the WGC estimate is understated is not as relevant as the estimate that only 520t of that lending came from non-central bank sources - 10%.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">With the gold bull market there is no doubt that unallocated balances have increased but if this ratio of central bank to investor lenders then BBs don't have much risk of a run as private investor are only a small part of their borrowings and may be able to be met by repayments from their short term gold loans.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The other interesting data point is the red star in the chart above. That marks the date when BBs started to charge professional investors for holding unallocated. It is not coincidental I think that this happened after the amount of derivatives and mining hedging peaked and started to decline. I also coincides with the beginning of the gold bull market. Why would BBs start to charge a small fee on unallocated, thereby discouraging it? They would if they were facing two trends:</div><ol><li>A decline in the demand for borrowing gold, which means they don't need as much unallocated (particularly as they can get what they need from central banks).</li><li>More investors starting to buy gold, of which some would be doing by holding unallocated.</li></ol><div style="text-align: justify;">The result of these two trends would be increasing amounts of physical gold that the BBs had to hold against their unallocated. If you had OCC derivatives declining by 7,500t but as the same time increasing unallocated balances, then there is no one to lend that unallocated to and the only way to cover it is to hold gold. This increases your costs and thus the need to start recovering some of that by fees. I would note that the fees are in basis points and quite small, so this whole thesis is speculative and possibly overstated. Nevertheless, beginning to charge for unallocated is an interesting data point that should be considered.</div><div style="text-align: justify;"></div><div style="text-align: justify;">Now the picture painted so far is not one which leads to much chance of the BB system being caught out by a slow run. It is possible as well that BBs may be running a much higher amount of reserves against unallocated than many would consider possible. However, I think that this series of post has shown that the BB system is still quite vulnerable. We will discuss that further tomorrow and how central banks may respond to a gold run.</div></div>

The fact that Australia's Prime Minister referred to the global financial crisis as a "shitstorm" will probably just reinforce Americans' Paul Hogan/Steve Irwin view of Australians. Shitstorm is also the title of a book about that Prime Minister's first term and how close Australia came to financial…

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Fractional reserve bullion banking and gold bank runs: bank run theory

<div dir="rtl" style="text-align: right;" trbidi="on">A key question in bank run dynamics is whether the information/event points to one specific bank. George Kaufman notes that if people just <em>"switch their deposits to other banks [and] their concerns about the bank’s solvency are unjustified, other banks in the same market area will generally gain from recycling funds they receive back to the bank experiencing the run." </em>As we have seen with the interconnectedness between the key BBs via the LPMCL and also the role of the central banks who can step in between the BBs, such <em>"a run is highly unlikely to make a solvent bank insolvent."</em><br /><br />System wide bank runs are therefore not going to occur from a rumor believed to be about just one bank. However, an academic paper on bank runs by Diamond and Dybvig concludes that all depositors have the incentive to withdraw immediately as the early movers get all their money back, the later ones part or none. The result is that bank runs can be self-fulfilling.<br /><br />This BIS paper by Haibin Zhu notes that Diamond and Dybvig assume that people don't know whether other people are withdrawing their money. One does not have to be a master of game theory to realise that if you come across some information about the solvency of a bank that you <strong>don't</strong> think is true, if you can't tell whether other people don't think it is true, then you're best precautionary action is to take your money out anyway.<br /><br />Zhu considers this assumption is unrealistic, saying that in the real world people <i>"are able to observe partial or complete information about those that make decisions before them"</i>. Selgin also notes that <em>"panics happen because liability holders lack bank-specific information about changes in the banking systems’ total net worth"</em> but that this would not occur in a true free banking system <em>"where bank liabilities are competitively bought and sold there would not be any risk-information externality"</em> - depositors would be able to see current market discount rates for each bank's banknotes.<br /><br />Opacity, however, is a defining feature of the gold market and the quality of information about whether a gold BB run is in play is poor given that:<br /><ul><li>Bullion banking is not a true free banking system;</li><li>BBs don't have physical branches where people can see people taking physical gold out;</li><li>Initial liquidity problems would result in increasing inter-BB gold borrowing rates, but GOFO/lease rates are LIBOR style estimates by the BBs themselves rather than actual market/executed rates on an exchange, so subject to conflict of interest;</li><li>Continuing liquidity problems would result in increasing premiums on wholesale bars, as BBs compete to acquire physical, but this information is restricted to the professional markets and when revealed to the retail market by people like myself, it will be largely ignored anyway (see why here and here);</li><li>Anecdotal stories about "I couldn't get my gold" are likely to be ignored by mainstream gold investors due to a "cry wolf" effect, given past reports of such events have been pushed by websites as "this it is" yet no run eventuated and the BB system continued to operate.</li></ul>Zhu notes that "<em>when information becomes noisy, the banking sector is more vulnerable to runs and the probability of [panic] bank runs increases."</em> Now while the BB system may have a higher risk to a run, how would one start if holders of BB-unallocated lack information on the solvency of a BB's gold balance sheet or whether a run is starting?<br /><br />One may argue that there are no standalone BBs, BBs are just divisions within a larger fiat bank, and as such a trigger may come from a concern about the parent bank's solvency. However, with "too big to fail", and the ability and demonstrated willingness of central bankers to print money to back up the banking system, I would consider it doubtful that a gold run would start this way.<br /><br />So for a gold run to occur, there would need to be a non-bank specific piece of information/event which gains the attention of <strong>mainstream</strong> gold investors (not goldbugs, by definition, goldbugs don't hold BB-unallocated) who still have some faith in banks.<br /><br />Many goldbugs are going to have a problem with that last sentence but I ask you to cast your mind back to before you became aware of gold and fiat fractional reserve banking etc and remember that you once believed in "the system". You also have to consider that there are investors out there who hold gold for portfolio diversification reasons, or as a hedge against non-catastrophic financial problems but who do not want to see themselves, or be seen, as one of those "crazy goldbugs" as the mainstream financial media paint it. This image is reinforced by gold websites which hype up stories that play well to a goldbug audience (and drive clicks), but these just create a "cry wolf" effect to mainstream investors when the claims of "imminent failure" never eventuate and make them see much of the gold internet as inaccurate and sensationalised claims.<br /><br />Such websites may well have desensitised mainstream investors to the really important information when it comes out, and thus be indirectly helping to support the BB-unallocated system. Indeed one of the key motivations for my blogging activities is to pull up such inaccuracies and exaggeration for this very reason, but the need for fact based professionalism in gold commentary is lost on them and I'm accused of being a shill if I dare to critique any meme.<br /><br />Tomorrow: what could cause a run to start, and how vulnerable is the system-wide gold balance sheet to a run.</div>

A key question in bank run dynamics is whether the information/event points to one specific bank. George Kaufman notes that if people just "switch their deposits to other banks [and] their concerns about the bank’s solvency are unjustified, other banks in the same market area will generally gain fro…

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Fractional reserve bullion banking and gold bank runs: the role of central banks

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">Yesterday I finished with the statement that central bank lending of gold allows the bullion banking system to expand gold credit and this extra supply suppresses the price. I think a simple example may be useful. Let us consider a market with a BB with the following balance sheet:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><strong>The Books of BB#1</strong></div><div style="text-align: justify;">Assets – 100 oz of Loans</div><div style="text-align: justify;">Liabilities – 10 oz of Unallocated to Ms Strong Hands</div><div style="text-align: justify;">Liabilities – 90 oz of Borrowings</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Let us say no physical holders or Ms Strong Hands are interested in selling at the current price but we have a Mr Naive with an account at BB#2 who wants to buy. Mr Naive would have to increase his bid to induce someone to sell. If a Mr Short Seller approached BB#1 wanting to borrow 5oz of gold to sell to Mr Naive, BB#1 would be unable to lend gold as they have no reserves with which to settle any unallocated transfers. However BB#1 can approach a CB to borrow gold. This would give BB#1 some unallocated with the CB:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><strong>The Books of BB#1</strong></div><div style="text-align: justify;">Assets – 100 oz of Loans</div><div style="text-align: justify;">Assets – 5 oz of Unallocated with CB</div><div style="text-align: justify;">Liabilities – 10 oz of Unallocated to Ms Strong Hands</div><div style="text-align: justify;">Liabilities – 95 oz of Borrowings</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><strong>The Books of CB</strong></div><div style="text-align: justify;">Assets – 5 oz Loan to BB#1</div><div style="text-align: justify;">Liabilities – 5 oz of Unallocated to BB#1</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">BB#1 can then lend Mr Short Seller the 5oz:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><strong>The Books of BB#1</strong></div><div style="text-align: justify;">Assets – 105 oz of Loans </div><div style="text-align: justify;">Assets – 5 oz of Unallocated with CB</div><div style="text-align: justify;">Liabilities – 15 oz of Unallocated to Ms Strong Hands and Mr Short Seller</div><div style="text-align: justify;">Liabilities – 95 oz of Borrowings</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Mr Short Seller can then sell the 5oz to Mr Naive. On settlement of that trade, BB#2 would require BB#1 to settle with it, which BB#1 can do by asking CB to transfer 5oz to BB#2. The end result is:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><strong>The Books of BB#1</strong></div><div style="text-align: justify;">Assets – 105 oz of Loans </div><div style="text-align: justify;">Liabilities – 10 oz of Unallocated to Ms Strong Hands</div><div style="text-align: justify;">Liabilities – 95 oz of Borrowings </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><strong>The Books of CB</strong></div><div style="text-align: justify;">Assets – 5 oz Loan to BB#1</div><div style="text-align: justify;">Liabilities – 5 oz of Unallocated to BB#2</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><strong>The Books of BB#2</strong></div><div style="text-align: justify;">Assets – 5 oz of Unallocated with CB</div><div style="text-align: justify;">Liabilities – 5 oz of Unallocated to Mr Naive</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Some observations:</div><ul><li><div style="text-align: justify;">BB#1 was able to expand their loan book by 5oz, earning more interest;</div></li><div style="text-align: justify;"></div><li><div style="text-align: justify;">Mr Naive did not need to bid up the gold price as Mr Short Seller arrived into the market with "gold" at the current price;</div></li><div style="text-align: justify;"></div><li><div style="text-align: justify;">The CB did not need to sell any physical gold;</div></li><div style="text-align: justify;"></div><li><div style="text-align: justify;">While BB#2 wasn't willing to extend credit to BB#1 and hold its unallocated, it was willing to hold the CB's unallocated;</div></li><div style="text-align: justify;"></div><li><div style="text-align: justify;">The CB's unallocated was really just backed by a loan to BB#1;</div></li><div style="text-align: justify;"></div><li><div style="text-align: justify;">Therefore, system wide BB#2 was really extending credit to BB#1, the CB was just acting as a guarantor in the middle.</div></li><div style="text-align: justify;"></div></ul><div style="text-align: justify;">The role of the CB here is to plug the gap in any lack of trust between BBs, in other words, if inter-BB lending broke down. That should sound familiar, as it is exactly what CBs did in the financial crisis regarding the fiat banking system.</div><div style="text-align: justify;"></div><div style="text-align: justify;">I don't want to get sidetracked in this series of posts into manipulation theories (that is worth its own posts) but for now note that as long as Mr Naive is willing to hold BB unallocated and Mr Short Seller is willing to take price exposure, neither the BBs or CBs need to sell physical or go short themselves. It is the Mr Naives themselves who facilitate the price suppression. Only if the Mr Naives preferred physical would the CBs need to actually sell their gold if they wanted to suppress the price.</div><div style="text-align: justify;"></div><div style="text-align: justify;">Back on topic. In normal markets the fractional reserve banking system is highly flexible and stable. The LPMCL provides an efficient inter-BB clearing system and if any bank experiences a maturity mismatch liquidity problem, other BBs can extend it temporary credit and can make a nice profit charging higher than normal lease rates for such emergency funding, or if required, lend against cash or other collateral. In the case of a lack of trust and collateral shortage, CBs can step in to mediate any inter-BB "friction". One may be able to infer this market action via changes in reported GOFO and lease rates.</div><div style="text-align: justify;"></div><div style="text-align: justify;">One of the reasons I think so many gold commentators have been wrong on calls that the bullion banking system is about to fail is that they are not aware of the market structures I have been discussing in these posts, and thus do not appreciate how much stress the gold market can withstand. Because they are not aware of the role of BBs and CBs in the facilitation between  paper gold longs AND shorts, they think that price suppression can only have been achieved via physical sales and thus naturally when they run the numbers on that, they conclude that the CBs have run out of physical gold. But surprise, the game continues! I would suggest such commentators should reconsider their theory and recast it based on a more sophisticated understanding of the market.</div><div style="text-align: justify;"></div><div style="text-align: justify;">Let me put it another way. On Comex it is clear from the very low percentage of physical deliveries versus open interest that Comex is primarily a market where leveraged paper longs (who don't have the cash) trade against leveraged paper shorts (who don't have the gold). The BB-LPMCL-CB system described in these posts is just an OTC version of this Comex structure, with BB unallocated account credits taking the place of futures contracts. Any look at the London OTC clearing statistics should tell you there is a lot of BB unallocated paper being held.</div><div style="text-align: justify;"></div><div style="text-align: justify;">To the extent that people are willing to hold this paper, be it futures or BB unallocated, then those longs facilitate and support the game. The question then is when (if?) will they "run", which I will discuss tomorrow.</div></div>

Yesterday I finished with the statement that central bank lending of gold allows the bullion banking system to expand gold credit and this extra supply suppresses the price. I think a simple example may be useful. Let us consider a market with a BB with the following balance sheet:The Books of BB#1A…

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Fractional reserve bullion banking and gold bank runs – Frankenstein Free Banking

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">The bullion banking and inter-BB clearing system described yesterday has a lot in common with free banking, which is <i>"the competitive issue of money by private banks as opposed to the centralised and monopolised issuance of currency under a system of central banking."</i></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">That quote comes from George Selgin's 1988 paper The Theory of Free Banking: Money Supply under Competitive Note Issue, which provide 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 our topic.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The key features of a free banking system as described in Selgin's paper include:</div><ul><li>no central bank, ie no monopoly of currency issue</li><li>each bank issues its own branded bank notes</li><li>banks compete against each other for deposits and loans</li><li>banks hold physical gold as reserves (not government fiat)</li><li>people are paid in different branded bank notes and deposit these with their bank</li><li>banks settle/clear the notes of other banks deposited with them by their clients with gold</li><li>banks establish a clearinghouse to facilitate inter-bank settlements</li></ul><div style="text-align: justify;">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 BB with whom you hold it. The BBs do compete with each other in a light touch regulatory environment, depending on the jurisdiction., and the BBs hold physical gold reserves and settle in physical gold via a clearinghouse.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Note: I'm going to refer to a number of conclusions Selgin comes to in his paper, which he bases on logic and historical evidence of episodes of free banking. I am not a monetary expert but to this lay reader his conclusions seem well argued. Happy for people to disagree with his conclusions but if you haven't bothered to engage with Selgin's work, don't expect me to engage, particularly if you are rasing criticisms he addresses in his paper.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">One of the key conclusions that Selgin comes to in his paper is that under free banking 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 <em>"the value of the monetary unit is stabilized, and events in the money market do not disturb the normal course of production and exchange."</em></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">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 (eg if there was 10oz vs $10 then the price is $1 per oz; if you double the ounces, then 20oz chases $10, price becomes $0.5 per oz).</div><div style="text-align: justify;"></div><div style="text-align: justify;">The reason for this is that if an individual BB creates/lends too much gold credit (unallocated) then when its clients use/transfer that unallocated to clients with accounts at other BBs, it will result in that BB owing gold to its competitor BBs and they will request physical to settle the growing LPMCL imbalance resulting from that BBs over lending. So all BBs are restricted in their unallocated gold lending to the extent of their physical reserves.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">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. 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:</div><ol><li>The growth in money supply will result in a grow in clearings, which will bring with it a growth in the <strong>variability</strong> of clearing debits and credit. This will require banks to increase their precautionary reserves, and this increase in reserves constrains money creation.</li><li>The redemption of physical gold by the public (ie, the reduction in bank reserves).</li></ol><div style="text-align: justify;">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 BBs that do not follow their competitors. If not, and all BBs increase at the same rate, there will be inflationary gold credit but it will stabilise at some higher level (than than required by legitimate gold credit demand) due to the variability of clearing issue.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">However, we know that central bankers hold gold and lend it to BBs, so we do not have a true free banking system. However, it is also not like a fiat system as gold can't be printed, so it is a half way house with bits from both, or a Frankenstein Free Bullion Banking system.</div><div style="text-align: justify;"></div><div style="text-align: justify;">Selgin notes that with a monopolised currency supply, central banks can create more reserves and <em>"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".</em></div><div style="text-align: justify;"></div><div style="text-align: justify;">So in our Frankenstein Free Bullion Banking system, the lending of gold to the BBs by a central bank increases the BBs reserves and thus increases the BBs' 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.</div></div>

The bullion banking and inter-BB clearing system described yesterday 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 Sel…

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Fractional reserve bullion banking and gold bank runs – inter-bank buddies business

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">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 BBs. If our Refiner banked with BB#1 and our Miner banked with BB#2, this is what would happen if the Refiner requested a transfer to the Miner’s account:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><strong>The Books of BB#1</strong></div><div style="text-align: justify;">Asset – 10 oz Loan to Refiner</div><div style="text-align: justify;">Liabilities – 10 oz of Unallocated to BB#2</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><strong>The Books of BB#2</strong></div><div style="text-align: justify;">Asset – 10 oz of Unallocated with BB#1</div><div style="text-align: justify;">Liabilities – 10 oz of Unallocated to Miner</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">There would be many of these transfers during the day, including clients of BB#2 wanting to transfer to clients of BB#1. At the end of the day a BB would net out its transfers with other BBs leaving it either owing gold to each BB or being owed gold from each BB.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Now while BBs are likely to be willing to extend credit to other BBs, that is, hold unallocated balances with them, each BB has an internally set credit limit given to the other BBs beyond which it will not want to hold unallocated. For example, if BB#1 only had refining clients, and BB# only had mining clients, we would expect BB#1 to owe BB#2 an ever growing large amount of gold.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Once a BB reaches this limit, if it wants to request any more transfers to the accounts of clients of another BB, it would have to ship physical gold to that other BB in settlement. Once you start adding more and more BBs, it would result in a lot of gold moving between vaults.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">To the make the settlement of these positions between many BBs more efficient, the six major BBs formed a not for profit organisation called London Precious Metals Clearing Limited (LPMCL), which is a daily electronic settlements matching system that <em>“avoids the security risks and costs inherent in the physical movement of metal.”</em></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Each member of the LPMCL has the right <em>“to call for any one, or a combination of the following actions:</em></div><div style="text-align: justify;"><em></em><br /></div><div style="text-align: justify;"><em>a) Physical delivery of metal.</em></div><div style="text-align: justify;"><em>b) Transfer of all or part of a credit balance to another member where the caller has a debit balance.</em></div><div style="text-align: justify;"><em>c) Allocation of metal.”</em></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The innocuous quote above actually gives us a lot of insights:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">1) If a BB has requests for physical delivery from its clients and not much physical reserves of its own, it would choose a).</div><div style="text-align: justify;">2) If a BB owes other BBs (ie it has debit balances) <strong>and</strong> other BBs owe it (ie it has credit balances), it would choose b) to minimise being called upon by the other BBs for physical delivery or allocation.</div><div style="text-align: justify;">3) If a BB has too much unallocated (credit balance) with another BB (that is, it is exceeding the internal credit limit it set on the other BB), then it would choose:</div><div style="text-align: justify;">3.1) Action b) if it had debit balances to minimise</div><div style="text-align: justify;">3.2) Action c) if it did not have any debit balances.</div><div style="text-align: justify;">4) In the case of 3.2), a BB could also reduce credit limit exposure by choosing a). Whether it did so would depend upon balancing out the shipment costs of a delivery versus the storage cost charged to the BB for allocated. Action a) would only be chosen if the BB expected to continue to accumulate credit balances with the other BB such that storage fees would accumulate and exceed any shipment cost.</div><div style="text-align: justify;">5) There is no “cash settlement” option, only net out or cough up physical.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The LPMCL notes that the key purpose of the system is <em>“to ensure that excessive exposures are minimised”;</em> for BBs to <em>“to minimise their credit risk exposures”</em> to other BBs. This is reinforced by the fact that a LPMCL BB member must provide <em>“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.”</em></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The <strong>same-day</strong> allocation within <strong>one hour</strong> requirement means that when the clients of a BB request the transfer of unallocated gold to accounts at other BBs, then that request will require the BB to have physical gold if:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">a) it expects on a net basis across all the other LPMCL BBs to have a debit balance (ie it net owes other BBs); <strong>and</strong></div><div style="text-align: justify;">b) it expects that the amount it will end up owing to the other BB(s) will exceed the credit limit that the other BB(s) have given it.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Note that Action b), the transferring credit balances, allows a BB 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 BB with whom it expects it still has credit with. Ultimately, the total extent to which all other BB’s are willing to extend credit to a BB will impact on how much physical reserves that BB needs to keep. It will also determine how much of a BB’s unallocated liabilities end up being “backed” by unallocated claims on other BBs, which just means it is “backed” by the quality of the gold assets held by those other BBs.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">One final observation. Each of the six major BBs also hold accounts with the Bank of England, with the LPMCL noting that being a BB clearing members involves <em>“close liaison with the Bank of England”</em>. The Bank of England acts as a bullion banker to the bullion bankers, a neutral counterparty, but is not part of the LPMCL itself. So allocations could also occur by a BB requesting transfer of its allocated with the Bank of England to another BB’s account with the Bank of England.</div></div>

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 BBs. If our Refiner banked with BB#1 and our Miner banked with BB#2, this is what would happen if the Refiner requested a transfer to…

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Fractional reserve bullion banking and gold bank runs - how can I default on thee? let me count the ways

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">A crude view often promoted in the gold blogosphere is that a gold run will result in a default when on call depositors ask for delivery/physical. The reality is more complex. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The composition of a BB's gold balance sheet has many different assets and liabilities but when looking at a gold run our interest is only in on call (or to use accounting terms, current) assets and liabilities versus those assets and liabilities which have committed maturities or terms (non-current). As an example consider this simple setup:</div><br /><table border="1"><tbody><tr> <td width="30%"></td> <td width="35%">Assets</td> <td width="35%">Liabilities</td></tr><tr> <td>Current</td> <td>10 oz</td> <td>20 oz</td></tr><tr><td>Non-Current</td> <td>90 oz</td> <td>80 oz</td></tr></tbody></table><br /><div style="text-align: justify;">As Professor Fekete noted, what matters in fractional reserve banking is flow, so let us assume clients have been redeeming at a constant rate of 5oz.When looking at the 20oz of client on call deposits, the are a number of run scenarios:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">a) Rate of redemption increases to 11oz</div><div style="text-align: justify;">b) Rate of redemption increases to 20oz</div><div style="text-align: justify;">c) Clients redeem at the expected 5oz, but another BB with whom the BB held 2oz of unallocated fails to supply physical as it had done reliably in the past.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">So a default can occur because of a failure on the asset side, not just from a run from the liability side, of a BB's gold balance sheet. The other thing that matters is what is the current rate of redemption and how much it is increasing by. In the case of a) the BB may be able to survive that by cash settlement or just buying physical gold, as the "gap" is small. However in the case of b) the amount of the "gap" is 10% of their balance sheet and default would be probable.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">A BB manages this risk by holding physical gold. How much would depend on its assessment of the make up of its on call depositors and their historical redemption rates. Where I see the first point of risk is a BB getting too confident about the reliability of historical redemption rates. They could probably be sure that a large hedge fund is just after cash profits and unlikely to want physical, but large private investors - maybe one day they might get spooked by goldbug chatter.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Gold industry unallocated holders may also be historically reliable, as individually they would hold small balances (using them primarily for settlement purposes) but as a group there would be a fair balance held across them at any one time and redemption behaviour as a group would be consistent. However, take the example of the Perth Mint in the 2008 demand surge. The silver flow we obtained as a by-product of gold refining was enough for our normal bar and coin demand, but in 2008 we had so much demand we began to withdraw 20 tonnes of silver a week from London for months on end. This was unexpected (BTW, there was never a problem with delivery).</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Even if we assume that a BB holds all current assets as physical gold, we still have a maturity mismatch problem. On top of that, a BB has a "certainty of counterparty meeting their promises" problem. This can lead to the following scenarios:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">1) BB could have perfect maturity matching, but a counterparty fails to honor their commitments when they fall due and the BB is short gold</div><div style="text-align: justify;">2) All counterparties honor their commitments, but maturities don’t match up, leaving the BB short gold</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">What are the BB’s mitigating controls for these risks? In the case of 1) the BB needs to determine if:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">1.1) the counterparty is just having their own liquidity problems, in which case the BB can borrow gold from another BB or CB and charge their counterparty a penalty</div><div style="text-align: justify;">1.2) the counterparty is permanently defaulting (bankrupt), in which case is the counterparty:</div><div style="text-align: justify;">1.2.1) Secured – then the BB can draw on the collateral and margin and use that to purchase gold </div><div style="text-align: justify;">1.2.2) Unsecured – then the BB has to book a loss and use their own cash to purchase gold (and maybe recover some cents on the dollar later)</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In the case of 2), a maturity mismatch, the BB can:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">2.1) request an extension from their non-BB client and get charged a penalty</div><div style="text-align: justify;">2.2) borrow gold from another BB or CB</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">You'll notice a certain commonality in the mitigating controls, which gives us another two points of risk:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">i) will the BB be able to buy enough missing gold with the cash (ie, we have trading liquidity, volatility and gap risk, particularly if we are talking large amounts); or</div><div style="text-align: justify;">ii) that another BB or CB will lend the BB gold (note, depending on the type of depositor, this could just be a need for unallocated, not a physical gold loan).</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The second point ii) leads us into a discussion of inter-bank dealings and clearing, which we will cover on Monday.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Just one final point. In our example above many in the blogosphere would say that the BB is running at a 10% fractional reserve ratio. This is technically true but yet another simplification. This 10% or other claimed much lower numbers do sound very shaky and is used to scare people. What I've never seen talked about in the gold blogosphere is that the bank is only running a 20% fractional reserve <strong>liability</strong> ratio, in our example.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The correct way to look at it is that the BB is running a 50% reserve - 10oz of current assets against 20oz of current liabilities. The complete lack of any discussion of this is surprising to me, as in many cases gold commentators are financial analysts and you'd think they would be aware of a basic financial metric like the current ratio. So for analysing a gold run it is the current (I'd toughen it up to on call, not the usual 12 months) ratio that matters, not the fractional reserve ratio.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">To be fair, I have not focused on the current ratio either. I suppose this is the benefit of doing a series of posts in detail on a topic like this, as it forces you think through the topic. But thinking is a lot harder than just loosely throwing around terms like "fractional", "hypothecation", "leverage" to make it sound like you know what you are talking about and to scare goldbugs with fairy tales of an evil Blythe Masters who will trick you into an unallocated house. Don't get me wrong, fairy tales have a lesson to teach and with unallocated, for example, you do need to know what sort of risks are involved if you are not dealing with a straight up facility like the Perth Mint (and that is the point of this series of posts). However, you shouldn't think the fairy tale is an accurate representation of reality and thus a helpful tool for assessing if/when a system will blow up.</div></div>

A crude view often promoted in the gold blogosphere is that a gold run will result in a default when on call depositors ask for delivery/physical. The reality is more complex. The composition of a BB's gold balance sheet has many different assets and liabilities but when looking at a gold run our in…

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Fractional reserve bullion banking and gold bank runs - unallocated as real (gold) bills

<div dir="rtl" style="text-align: right;" trbidi="on"><div style="text-align: justify;">I must apologise for jumping around a bit with these posts on fractional reserve bullion banking. I haven’t planned this series out and each day I think of additional things worth noting if one is to have a more nuanced understanding of how a gold run would play out. I’ll get there in the end.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">So another slight diversion. I forgot to mention in this post that BBs can create gold credit (ie unallocated) just like with fiat currencies. So their gold balance sheet can consist of unallocated liabilities backed by promises to repay gold. <em>"That sounds fraudulent"</em> I hear you say. A practical example may help.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Consider a simple world with one Miner, one Refiner, one Bullion Bank, and an Investor.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">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.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">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:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Asset – 10 oz Loan to Refiner</div><div style="text-align: justify;">Liabilities – 10 oz of Unallocated to Refiner</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">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:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Asset – 10 oz Loan to Refiner</div><div style="text-align: justify;">Liabilities – 10 oz of Unallocated to Miner</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Note, while the Bullion Bank does not hold one ounce of physical (more cries of <em>"fraud"</em>), the Refiner is holding physical, making their promise to repay the gold loan credible. 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. There are cries of <i>“no”</i> from our audience, <i>“don’t you know that paper gold is evil, don’t trust that bullion banker”</i>, but our Investor ignores them and agrees a price with the Miner. The Miner instructs the Bullion Bank to transfer gold to the Investor. The Bullion Bank’s balance sheet now looks like this:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Asset – 10 oz Loan to Refiner</div><div style="text-align: justify;">Liabilities – 10 oz of Unallocated to Investor</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Meanwhile, the Refiner diligently works to turn the dore into 99.99% pure 1 oz gold bars. After one year (very inefficient), 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:</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Asset – 11 oz of physical gold bars</div><div style="text-align: justify;">Liabilities – 10 oz of Unallocated to Investor</div><div style="text-align: justify;">Equity – 1 oz of retained earnings (interest profit)</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Now many have been convinced that this is fractional fraud, but what would you say if the Refiner just issued the Miner with a real bill for 11 oz of gold and the Miner discounted that bill with the Bullion Bank for 10 oz of gold? While there are no bills issued, the process above in effect is no different to a gold real bill (see here for a discussion of real bills by Professor Fekete and I look forward to comments explaining why he is wrong). 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?</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The gold credit creation process above is in my opinion a legitimate function of bullion banking that facilitates the gold manufacturing and distribution business of 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.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">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):</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i>“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.”</i></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Before some goldbugs start having cognitive dissonance with someone as respected as Professor Fekete is endorsing that which they have been told is bad, I would direct their attention to the last sentence in that quote. Bullion banking is only legitimate <i>“as long as the bank holds only gold and self-liquidating bills </i>[ie loans to the gold industry]<i> to cover the bank note </i>[ie unallocated]<i> issue, it changes neither the supply of nor the demand for credit”</i>. The problem is that much of the assets a BB holds do not fit this definition as they are not maturing into physical gold within a few weeks or months. It is my guess that while BBs are involved in this legitimate and useful banking function for the gold industry, it is only a small part of their assets, with the bulk of unallocated on call deposits being used to fund outright speculative short selling and much longer term financing (introducing maturity risk). You can rest easy in your hate of unallocated.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">At this point I’ve learned my lesson and I am not going to commit to what I’m going to talk about tomorrow regarding fractional bullion banking and banks runs, as I’ll probably think of something else I’ve forgotten to mention. At this time, these are the topics I think I have left to cover:</div><ul><li>The dynamics of a gold run on a single bank – who are the unallocated holders an how likely are they to “run” and can the BB's assets satisfy the demand for physical</li><li>Introduce multiple banks and inter-bank account transfers, settlement and clearing - bullion banking as freebanking</li><li>The role of central banks in inter-bank clearing and liquidity provision via paper leases vs physical leases – is it still freebanking?</li><li>Central bank support of bullion banking system vs individual BB support in a run (difference between domestic BBs vs overseas BBs?); free rider problem for the US?</li></ul>Feel free to suggest any other topics for discussion around this gold bank run issue.</div>

I must apologise for jumping around a bit with these posts on fractional reserve bullion banking. I haven’t planned this series out and each day I think of additional things worth noting if one is to have a more nuanced understanding of how a gold run would play out. I’ll get there in the end.So ano…

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