LBMA Gets A Lifeline

The new rulebook

The Prudential Regulatory Authority released its new draft rulebook last week, updated for Basel 3, which will become effective in January 2022.[iii] It is over-stamped by the PRA as near final, so we can assume that it will be the final version for all intents and purposes. It has been released at this time so that banks know in advance what changes to their treasury management and regulatory reporting will be required in six months’ time.

The application of Basel 3’s net stable funding ratio method to gold and other commodities generally accords with the Basel regulations, with one important addition. Article 428f concerns interdependent assets and liabilities, introduced so that the current and future owners of the London Precious Metal Clearing Limited (LPMCL) can continue to operate without having to suffer the penalties of the net stable funding ratio (NSFR). It also allows banks to use physical gold in a bank’s possession to offset customer liabilities (Paragraph 2).

The full rule, which is central to the LBMA’s future, is as follows:

“1. An institution may apply to the competent authority for permission to treat an asset and a liability as interdependent. For the purpose of this Article, an asset, and a liability are interdependent where either condition (a) to (f) below are met or where paragraph 2 applies:

(a) the institution acts solely as a pass-through unit to channel the funding from the liability into the corresponding interdependent asset;

(b) the individual interdependent assets and liabilities are clearly identifiable and have the same principal amount;

(c) the asset and interdependent liability have matched maturities;

(d) the interdependent liability has been requested pursuant to a legal, regulatory or contractual commitment and is not used to fund other assets;

(e) the principal payment flows from the asset are not used for other purposes than repaying the interdependent liability; and

(f) the counterparties for each pair of interdependent assets and liabilities are not the same.”

[Article 428f (1) above permits the operation of LPMCL and its owners to continue as before after the introduction of Basel 3’s NSFR rules, subject to the PRA granting permission to each of the owner banks.]

“2. This paragraph applies to an institution's unencumbered physical stock of precious metals and customer deposit accounts in precious metals where all of the following conditions are met:

(a) the institution’s unencumbered physical stock of each precious metal is used to cover customer deposit accounts in the same precious metal;

(b) the institution is not exposed to liquidity or market risk resulting from either the sale of precious metals by the customer or the physical settlement of customer transactions in precious metals; and

(c) the precious metals assets and liabilities are on the balance sheet of the institution.

  1. For the purpose of paragraph 2:

(a) precious metals means gold, silver, platinum, or palladium;

(b) the interdependent asset and liability treatment shall only be available to the extent that the institution's unencumbered physical stock of each precious metal is matched by customer deposits of the same precious metal. Any excess physical stock or customer deposits in a precious metal shall not be treated as an interdependent asset or liability for the purpose of paragraph 1;

(c) an institution’s precious metals accounts at any other institution shall not be considered a part of the institution’s physical stock of precious metals.”

[Paragraph 2&3 allows any bank to offset an unallocated customer liability with physical bullion, so long as it is in that bank’s allocated possession and on its balance sheet]

It will assist the reader to understand Article 428f (1) if the function of the LPMCL is briefly explained. LPMCL is a not-for-profit entity acting as a central clearing system for LBMA members. It is owned and operated by four London-based clearing LBMA members: HSBC, ICBC Standard Bank, JPMorgan, and UBS, settling loco-London allocated and unallocated metal trades.

Unallocated trades, forming a large majority of settlements, are netted off, first by individual LPMCL members on behalf of their clients, other LBMA members, and on their own books, and then the centralized LPMCL settlement system (AURUM) settles the remaining differences between the four LPMCL members. Deliveries of physical metal occur within the system but form a small minority of transactions. Except where an unallocated trade is settled by delivery, all unallocated trades naturally cancel each other out.

The four LBMA members owning LPMCL operate a physical float as part of their management of these trades. It can therefore be appreciated that unless Article 428f (1) had been added to the PRA regulations the LPMCL clearing system would have almost certainly ceased to function.

Paragraphs 2 and 3 of this Article are also important, permitting banks to offer unallocated accounts without a balance sheet penalty so long as they are fully covered by deliverable physical bullion on the bank’s balance sheet. It allows a bank to continue to offer the considerable convenience of an unallocated account without balance sheet penalties. Rather than withdrawing from offering customers any gold market facilities other than pure custody, it will permit LBMA members to continue to offer precious metal accounts on a pooled basis.

But instead of matching unallocated client accounts with unallocated or other derivative assets, banks will be encouraged through balance sheet incentives to acquire physical bullion to provide the service. While it should make bullion banks a safer systemic proposition for their customers — the objective of the Basel 3 exercise — it should be noted that unallocated accounts will continue to bear counterparty risk.

This could have a significant impact on the prices of precious metals because LBMA statistics show that the combined weekly turnover in gold, silver, platinum, and palladium totals $357bn between members alone. But from an attempt in 2011 by the LBMA to collect turnover statistics (which was abandoned) it appears that transactions between LBMA members and their non-member customers could be about five times greater. This must represent an ongoing and significant line of business interest, unlikely to be simply abandoned.[iv]

Article 428f (2 and 3) referred to above appears to offer a lifeline to the LBMA, which can continue to have an important and active role in precious metal markets. However, the market for forward transactions beyond a normal settlement cycle is likely to become significantly restricted or even end because of the balance sheet penalties of running uneven derivative positions. With bullion banks likely to restrict taking uneven trading positions for their own accounts, derivative supply will be withdrawn from the market and replaced by physical demand instead.

The interest cost penalty for buying physical bullion to replace unallocated derivatives is for the moment minimal because of current interest rate levels for reporting currencies. Instead of unallocated customer accounts being offered for free, they might suffer a small charge, perhaps 10—20 basis points, an annual maintenance cost that might drive some marginal trading business away. But London should continue to see good demand, some of which might even be diverted from ETFs whose expense ratios are considerably higher.[v]

By significantly reducing counterparty risk for bullion bank customers while giving them a continuing facility, the PRA’s inclusion of Article 428f is a sensible addition to the proposed regulations.

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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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