LBMA Gets A Lifeline

Time, Time Management, Stopwatch, Industry, Economy

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The draft PRA rules complying with Basel 3 regulations have now been issued six months ahead of their implementation to allow banks to adjust for them in time. From now, senior bankers, their lawyers, and bank treasury managers will be planning amendments to their business strategies accordingly.

As a division of the Bank of England, the Prudential Regulation Authority recognizes the importance of gold trading in London and has inserted a clause into the new rules (Article 428f) which will allow the LBMA’s centralized settlement system to continue to function. But in line with Basel 3’s apparent determination to get banking’s exposure to uneven derivative positions substantially reduced, net positions in precious metal derivatives in the form of forwards and swaps will be penalized through their inefficient use of balance sheet resources and will likely be replaced by transactions fully backed by physical gold.

The LBMA has been thrown a lifeline but will likely have to refocus from forward derivatives to physical bullion-backed trading. By responding positively to these developments, the LBMA and its membership can retain and build on their pre-eminent position in global precious metals markets.

This article points out that the market value of forward derivatives in gold is currently the equivalent of 8,675 tonnes. While it would be incorrect to think it will all translate into new bullion demand, there is little doubt that if Basel 3 leads to the demise of the London forwards market, it will lead in turn to a significant replacement in the form of physical demand.

This article also looks at the broader picture for banking in the light of the PRA’s new regulations as well as the specifics for precious metal derivatives.

The background to Basel 3

Investors are increasingly aware that in all international financial centres, banks are now being required to run their businesses differently under the new Basel 3 regulations. For the first time, regulators are now telling banks how they must fund their assets out of their liabilities. This is a major change, which from the beginning of this month is being applied in the US and the EU. It is scheduled to be introduced in the UK from 1 January 2022.

The introduction of Basel 3 bank regulations follows an agreement at G20 level for the Basel Committee on Banking Supervision to draw up new regulations to address the systemic risk issues exposed by the Lehman failure in 2008. The new regulations proved controversial, delaying their introduction, having been finalized as long ago as October 2014. But, unlike rules originating from national regulators, Basel 3 was not easily spiked by lawyers representing the banking industry’s interests.

The changes, particularly those that disqualify unstable short-term funding on the liability side of a bank’s balance sheet from providing cover for anything on the asset side, are intended to reform banking practices from the ground up. Since the 1980s, after the repeal of the US’s Glass-Stegall Act which separated commercial from investment banking, banks have grown their balance sheets into purely financial activities and proportionately away from the creation of bank credit to finance non-financial businesses. Non-financial businesses have been increasingly directed into bond and equity markets, where banks can charge large fees without having to worry about counterparty risk.

There are worrying signs that commercial banking for the big international banks has gone about as far as it can with financialization and has become increasingly reliant on higher gearing for diminishing margins. Consequently, many aspects of financial activity are targeted and adversely affected by the new Basel rules. A bank like Goldman Sachs with its reliance on large customer deposits is treated unfavorably compared with a bank substantially funded by retail deposits and deposits of small businesses. And Goldman reportedly has very recently reduced its holdings of equity investments, treated unfavorably with a required stable funding factor set at 85%, the same as gold. While market traders might observe these moves as indicating Goldman has turned bearish on equities, it may have more to do with responding to the US regulator’s version of Basel 3.[i] If so, it could be a warning of a similar effect on trading in precious metals

As well as uneven trading books and related liabilities being penalized, derivatives appear to be a target for containment, with a global notional value of over-the-counter (OTC) contracts of $582 trillion recorded by the Bank for International Settlements last December. And this is after the introduction of counterparty netting agreements following the Lehman failure, whereby multiple transactions between pairs of counterparties in the same contracts were reduced to a far lower net figure by mutual written agreements.

Last December, these OTC contracts had a gross market value of $15.8 trillion, indicating a 36:1 gearing relationship with their notional value. And that is on top of bank balance sheets which are in turn geared, with assets anything up to 30 times balance sheet equity in the case of Eurozone banks. Not much has to go wrong for the BIS and its Basel Committee to have failed in their quest to make banks systemically safe.

How derivatives are financed is a key focus of the new regulations. The Basel 3 approach is to disqualify their financing with ephemeral deposits. But it goes much further. Short-term funding, other than from smaller deposits, is penalized. It would appear that unallocated precious metal customer accounts, because of their nature being a bank’s liability not valued in its accounting currency and by not being specifically mentioned as an allowable exception, default to an ASF of zero.

A confusing response from the LBMA

On the asset side of bank balance sheets, according to Article 428az derivatives net short or long require a 100% RSF. However, in a statement released yesterday, the LBMA claimed that gross derivative liabilities attract a 5% RSF, which seems bizarre because if that was true physical gold would be rated substantially riskier than its derivatives[ii]. Furthermore, a derivative liability is a derivative that is sold. A buyer, who records it as an asset at fair value, under the new regulations would have to treat it as subject to a 100% RSF, resulting in two different treatments, rendering this interpretation appears illogical.

According to Article 428at, what the LBMA actually refers to applies to a collateralized derivative position where the value of the derivative is negative, and being subject to Article $428da, relates to positions of qualifying central counterparties as opposed to a bank’s on-balance sheet derivatives.

This confusion followed the LBMA’s letter to the PRA during the latter’s consultation period on the new Basel 3 regulations, where the LBMA omitted to mention anywhere that unallocated gold was not physical gold but an OTC derivative of it, as defined by the Bank for International Settlements itself. By claiming that “gross derivative liabilities will also attract a 5% RSF”, perhaps it is now hoping an escape from the 85% RSF accorded to physical precious metals in an admission that forwards beyond a normal settlement cycle are in fact derivatives.

Discounting the LBMA’s initial take on the PRA rules, it was up against this unyielding brick wall that, with its unallocated gold market masquerading as bullion, the London Bullion Market Association found itself trapped.

Within precious metals markets, there have been numerous comments and opinions as to the likely consequences of Basel 3. But there is general agreement that any discouragement given to bullion banks with respect to their position-taking would make precious metals prices more volatile. Subject to how these regulations would be treated by the UK bank regulator (the PRA), it was clear that the LBMA was extremely concerned for its future, and particularly for its settlement system.

With the publication of draft rules to be implemented next January, most of that uncertainly is now lifted, but clearly, there are differences of opinion remaining. In an attempt to narrow these down, we shall now turn to the relevant passages in the new PRA rules

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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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