The Extinction Of Gold Derivatives

This month is the fiftieth anniversary of the Nixon shock when the Bretton Woods agreement was suspended. And the expansion of commercial banking into credit for purely financial activities became central to the promotion of the dollar as the international replacement for gold.

With the introduction of Basel 3, commercial banking enters a new era of diminishing involvement in derivatives. The nominal value of all derivatives at the end of last year amounted to seven times world GDP. While we can obsess about the effects on precious metals markets, they are just a very small part of the big Basel 3 picture.

However, gold remains central to global money and credit and the impact on gold markets should concern us all. In this article, I quantify gold forwards and futures derivatives to estimate the impact of reversing anti-gold policies that date back to the Nixon shock in 1971.

We are considering nothing less than the effects of ending fifty years of gold price suppression. Through leases, swaps, and loans central banks have fed physical bullion into derivative markets from time to time to keep prices from rising and breaking the banks who are always short of synthetic gold to their customers.

To summarise, bullion banks withdrawing from derivative markets is bound to create replacement demand for physical gold that can only drive up the price and further undermine fragile confidence in fiat currencies at a time of rapidly increasing monetary inflation.

Introduction

The introduction of the net stable funding ratio (NSFR) as a central feature of Basel 3 regulations will have a major impact on derivative markets. For the purposes of this article, we are interested in how it will affect the exchange value for gold.

Derivatives break down into two broad categories. There are derivatives traded on regulated exchanges, for which there are publicly available data, principally futures contracts and options on futures. But these are the tip of an iceberg that consists of over-the-counter derivatives, multiples larger in outstanding obligations. They consist of forwards, swaps, loans, leases, and options, for which collective data is scarce.

Officially, the purpose of derivatives is to hedge risk. And since we turn to banks to finance our activities either by drawing down on our deposits or obtaining bank credit, they are the usual originators of derivatives, expanding their quantity as the demand for underlying assets, such as gold, increases. Consequently, they have become primarily a source of paper equivalents, because banks rarely deal in physical commodities.

While risk management was the original function, banks have turned trading in derivatives to lucrative profit centers. The banks have evolved products that permit speculators and investors to acquire exposure without having to access underlying products. It is a sophisticated version of betting, whereby you can buy and sell paper from a computer terminal without having to touch the referenced asset. And when you have markets populated by punters fuelled by growing quantities of paper currencies which in turn fuel financial asset values, it is natural that banks increasingly operate as their bookies.

For this and other reasons in recent decades the world of OTC derivatives has exploded in size, as banks have diversified from expanding credit for manufacturing and non-financial service businesses into expanding credit for purely financial activities. Consequently, at the end of last year, according to the Bank for International Settlements notional amounts of paper derivatives outstanding were $582 trillion with a gross value of $15.8 trillion.[i] That represents gearing between notional amounts and their value of over 36 times, and nearly seven times the World Bank’s estimate of global GDP.
 

As the chart from The Bank for International Settlements above shows, total derivatives expanded rapidly ahead of the Lehman crisis in August 2008. After a brief wobble, they continued expanding into 2014 before declining into 2016, since when the uptrend has been gently rising.


Following the Lehman crisis and while admitting the usefulness of derivatives for the purpose of risk management, as part of their overhaul of banking regulations the BIS would have been concerned at the systemic risks to commercial banks from increased position-taking. This has led to two new definitions: high-quality liquid assets, which can be readily realized in a crisis; and the net stable funding ratio, which ensures that a bank’s assets are suitably funded by its liabilities.

The Basel Committee on Bank Regulation finalized its NSFR rules in October 2014, coinciding with peak derivatives in the BIS chart above. The publication of these future regulations might have been one reason behind the subsequent 2014-16 decline. But another factor was the introduction of written bilateral agreements between counterparties netting off common derivatives into one position. This has the effect of reducing apparent outstanding derivatives, which had hit record levels in 2008 before netting agreements were in place.

In the NSFR equation[ii], derivative liabilities net of matching derivative assets, if their liabilities exceed their asset values have available stable funding (ASF) of zero. In other words, unlike more stable categories of balance sheet liability a bank cannot use them to fund balance sheet assets. And if derivative assets exceed associated derivative liabilities, they require an ASF of 100% to be applied as required stable funding; in other words, they must be funded totally by liabilities that qualify as available stable funding.

At the banks’ treasury level, net long and short derivative positions are an inefficient use of the balance sheet by curtailing more efficient uses. The same applies to uneven positions in equities and commodities, though different ASFs and RSFs may apply. Furthermore, note that no distinction is made between regulated and OTC derivatives. The overall effect is likely to stem and reverse the tide of bank credit expansion into purely financial activities. And given that banks have already reduced their lending to non-financial activities relative to their total lending, by hampering further expansion into financial activities Basel 3 appears to mark the peak of commercial banking.

It is against this background that we approach our examination of gold derivatives. At $834bn, gold OTC derivatives are too small to register on the BIS chart above. This article drills down into what is essentially a minor element of the Basel 3 revolution, making bullion banking the subject of far larger derivative issues.

Gold derivatives

There are two classes of gold derivative commonly dealt with, forwards and futures as well as options in both categories. The legal difference is that forward contracts are bilateral bespoke agreements, while future contracts are standardized and traded on registered exchanges.

Essentially, they serve two different markets. Futures are classified as regulated investments while forward contracts are not. As regulated investments, investing institutions have limitless access to futures contracts, whereas their access to unregulated OTC forwards is strictly limited if permitted at all. Therefore, the speculating traders in Comex futures, for example, can be anyone. Traders in forward contracts in the London market are predominantly acting as principals not requiring regulation, which therefore excludes nearly all collective investment schemes and investment managers. These principals include banks, family offices and their ultra-rich principals, privately-owned corporations, sovereign wealth funds, and central banks.

We shall start by examining the OTC market, whose forwards and swaps are predominantly dealt in by the members of the London Bullion Market Association (LBMA) for settlement either in London (loco London) or in Switzerland (loco Zurich).[iii]

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Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated. The article is for general information ...

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