LBMA Gets A Lifeline

Discouraging derivative exposure

The task set for Basel 3 was to de-risk the global banking system, with a significant danger detected in uneven derivative positions. When Basel 3 was being formulated, uppermost in regulators’ minds would have been the failure of AIG and the potential domino effect on the global banking system. What would have concerned the Basel Committee was the possibility that a deteriorating derivative position in the future could recur, and large corporate deposits flee from affected banks in search of safety. Clearly, the issue of systemic risk demanded separate treatment for derivative positions, and it is this that, among other funding issues, the net stable funding ratio addresses (NSFR).

The NSFR is available stable funding (ASF) divided by required stable funding (RSF) and must always be maintained at one or more. ASF is applied to a bank’s liabilities (i.e., its sources of funding) and different categories of liability have different ASF factors. Under Article 428k, unless specified otherwise in Articles 428l to 428o, all liabilities without a stated maturity are assigned a 0% ASF factor, which means they cannot be used for funding any of a bank’s assets. For bullion banks, this refers to customers’ unallocated metal deposit accounts. There is no mention in Articles 428l to 428o of customer accounts tied to precious metal or commodity prices, so we must assume that the intention is for them to have a zero ASF.

Now we must consider the RSF, which is the denominator in the NSFR equation. It determines how much ASF is needed to fund different categories of banking assets.

Under Article 428ag (g), an 85% RSF, the apportionment of ASF, is required for “physically traded commodities, including gold but excluding commodity derivatives.” The exception is for physical metal held specifically to hedge customer unallocated accounts in their entirety under Article 428f covering interdependent assets, referred to above, in which case both sides come out of the NSFR calculation.

Otherwise, physically traded gold and other commodities require 85% RSF, it appears without any matching deposit funding from the ASF side. And as discussed above, other than for central clearing purposes, commodity derivatives require a 100% RSF.

To summarise so far, this means that 85% of the funding for gold and commodity contracts, including other precious metals, is to be allocated from unrelated but more stable liabilities, and for derivatives, 100% of stable funding is required. The issue that now needs clarification is whether the PRA regards a forward contract with a settlement date to deliver gold or silver beyond a normal settlement cycle as a derivative. The Basel Committee includes forward contracts and swaps in its derivative statistics, so despite the LBMA’s misleading representations to the contrary, we can safely assume that the PRA will take them to be derivatives as well.[vi]

Further implications for banks and precious metals

By the addition of Article 428f, the LBMA in London has a future, albeit a different one. In effect, the Bank of England is saying, “You can have your settlement engine and your banking members can continue to trade precious metals, instead of derivatives” It is the best result the LBMA could hope for, and it is a more stable future from which it will ultimately benefit.

There can be little doubt that in the general retreat out of derivatives some banking members will throw in the towel on precious metals trading. But there is still a market for gold dealing, which is to be satisfied by banks holding physical bullion to cover unallocated customer accounts. The potential size of this market is difficult to assess, but we can make a provisional estimate.

We know from a previous attempt to quantify trading between LBMA members and non-members, which we can take as public demand for loco-London trading, that it was in the region of five times daily settlements between LBMA members. But we need to know the value of outstanding forward settlement contracts, for which figures are not available from the LBMA. But the BIS estimate of gold forwards and swaps, the large majority of which is LBMA transactions, was $530bn at end-December 2020, a relatively stable figure similarly recorded at preceding half years. At current prices, that is the equivalent of 8,675 tonnes. How much of that will emigrate from forwards and swaps to physical bullion is difficult to estimate, but it can be expected to be determined by the following factors:

  • The number of LBMA banks and non-banks offering physically-backed gold and silver account facilities, and therefore the competition to market new bullion-based services.
  • The availability of physical bullion to satisfy extra demand resulting from rule changes.
  • The price effect of extra bullion demand, and whether a rising price creates a bandwagon effect.
  • The expense of maintaining physically-backed customer accounts, and therefore the likely charges, compared with generally charge-free unallocated accounts and allocated custodial services.
  • The outlook for the gold price relative to the dollar and other major fiat currencies.

That there will be a market for a bullion-based service we can be sure. It probably explains why Chinese-owned ICBC Standard Bank, one of the four LPMCL shareholders, acquired Barclay’s new mega-vault in mid-2016, having taken a lease on Deutsche Bank’s London vault six months earlier. Even without knowledge of the new PRA rules, the bank would have been able to work out the consequences of Basel 3 for the London forward market and anticipated its replacement with dealing in physical bullion.

The broader implications of the PRA’s rule changes

Both Basel 3 and the PRA’s interpretation of the role of commercial banks are consistent with the view that banks operate as intermediaries between depositors and their operations. This is not, in fact, the case. As I explained in last week’s Goldmoney Insight, through the process of double-entry book-keeping bank deposits are created as a direct consequence of the expansion of bank credit. And while some deposits are added to by customers transferring credits from other banks, these nearly always owe their origin to bank credit creation as well.

By permitting banks to manage the relationship between assets and liabilities before Basel 3, bank regulation has not usually challenged established banking law and practice. The NSFR regime might seem to ensure funding mismatches are lessened, but the reality is new mismatches are created because the funding of an asset can no longer be tied to an offsetting deposit. The double-entry system will continue, that is for sure.

But on the face of it, having expanded balance sheet capacity almost to its limits, the global banking system will now be in retreat. Derivatives and commodity trading positions are discouraged and are set to decline. Even market-making in equities will be hampered. It means that for banks their time horizons will contract because the risks they are accustomed to offsetting with derivatives can no longer be hedged as efficiently. It will affect all aspects of banking business, potentially drawing a close to fixed long-term low-interest loans, such as mortgages and car finance.

It is tempting to think that the Basel Committee has an ulterior motive behind driving banks out of financial activities. Perhaps the BIS’s role in coordinating central banking development of cryptocurrencies satisfies an ambition to side-line commercial banks entirely, and Basel 3’s introduction is a step in that common direction. But we have little evidence of this joined-up thinking.

Nevertheless, commercial banks are being side-lined in some jurisdictions. In the EU we see the global systemically important banks — the G-SIBs, now as primarily tools for absorbing government debt. In the US and UK they have become intermediaries for distributing QE to investing institutions because the investing institutions do not have accounts with the central bank. It will be a small step for them to do so, as is already the case in the US reverse repo market with money funds. The same appears to be true of the Japanese banking system, and China’s banks under government ownership are slavishly carrying out government monetary and economic policies.

Only the smaller banks seem to have a focus on banking’s traditional business, the financing of local non-financial businesses, the SMEs that make up the bulk of any country’s GDP. Networks of smaller banks and credit unions with their fingers on the local business pulse go along with economic success, for example in Germany. But national regulators seem keen for them to be merged out of existence. These are all straws in the wind, which individually seem unimportant, but can easily lead to the impression that for banks the best times are now over.

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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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