27 July 2008

Aussie Govt Bullion Snooping

Australia, like most countries, has money laundering legislation and a regulator to go with it. AUSTRAC (Australian Transaction Reports and Analysis Centre) administers the Financial Transaction Reports Act 1988 (FTR Act). They also now administer the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 (AML/CTF Act). Similar legislation has been enacted in many other countries.

A lot of the new AML/CTF laws around the world are a result of the Financial Action Task Force (FATF). Created in 1989, it "is an inter-governmental body whose purpose is the development and promotion of national and international policies to combat money laundering and terrorist financing". Note that Australia's FTR Act came into being before FATF, and for a while Australia's AUSTRAC was "state of the art" in anti-money laundering in the world. It was admired for its data collection and matching system but in recent years had fallen behind.

One of FATF's self appointed roles is to report on the robustness of a country's money laundering systems and its noting that Australia's system had weaknesses is what prompted the Government to instigate a review of the FTR Act, resulting in the new AML/CTF Act. I suspect that FATF's assessments of other countries' system also resulted in similar changes to their legislation.

So if you are looking for someone to blame for new "know your customer" rules, FATF is up there. But you also have to blame 911, because this also revitalised FATF as Governments looked for expertise on how to tighten up on money flows. While I certainly think that there is a need to close off terrorism's money supply, I cannot help but think that Governments' new found interest in "fixing" their systems was more about the AML part rather than the CTF part. In other words, use terrorism to tighten up on tax evasion, and don't worry about privacy while you do it.

In Australia the old (although it is still in force) FTR Act basically had two key reporting mechanisms in respect of bullion: cash transactions report and suspicious transactions report. The first had to be filled out for any transaction involving more than $10,000 cash. Note that this $10,000 level has not changed in my understanding since the Act came into being in 1988. Funny how Government's never index anything to inflation, except maybe fines!

The second one had/has to be filled out if the business suspected the transaction was for or involved a criminal purpose. There is not real guidance given on this but in practise the rule is if in doubt, fill one out. This is because it acts sort of like a get out of jail card - if the transaction ended up being criminal and you hadn't filled out a suspect transaction report, the police may consider you in on the transaction (especially if is was really sus). Filling one out is then just a real cover your arse exercise.

The AML/CTF Act has given this reporting a makeover. Of particular interest to buyers of physical precious metal should be the changes to the cash transactions report. I understand this will now be called the transactions report, ie the word "cash" is dropped. I also understand that this means that anything that is a designated service (check out the link for a big list of what this covers, bullion gets its own special table #2) over $1,000 has to be reported. This is a big change because prior to this, only cash transactions above $10,000 had to be reported.

My advice to anyone who wishes to accumulate physical metal and as a result values their privacy should do so before the end of this year when the new report comes into play. I don't condone criminal activity, but I also believe that if you are buying physical precious metal you rightly don't want any records that you have done so as this opens you up for theft (either from your fellow man - eg criminal breaks into coin dealer and steals customer list - or from the Government itself at some future time when fiat currencies collapse). The ability to buy small amounts of metal from your local coin/bullion dealer in cash was the only way to do this and it looks like this door will soon close.

UPDATE 11 August - it appears that advice from AUSTRAC was wrong, we have alternative adivce that only cash transactions of bullion above $10,000 will need to be reported. It is also possible that the limit above which identification is required will be above $1,000, but not sure what it will be at this stage. Will keep you informed.

UPDATE 1 July 2009 - Perth Mint has received approval to set the limit above which some form of identification for a bullion transaction is required from $1,000 to $5,000.

25 July 2008


I understand Deniece has been referring Depository clients to my blog. I usually post something up once a week, on the weekend. I have a list of things to cover, but if you have any questions or things you want explained or expanded upon, just leave a comment. Blogs are interactive, unlike most of the other commentators out there where you can only read what they say instead of being able to discuss it.

Coming up this weekend, how the Aussie Government will be increasing in snooping into your bullion dealings!

18 July 2008

The 1974 Liquidity Squeeze in Australia

Googling for background on the Banking Act for a future blog, I found a paper titled "A History of Last-Resort Lending and Other Support for Troubled Financial Institutions in Australia" (http://www.rba.gov.au/rdp/RDP2001-07.pdf).

I had an unnerving déjà vu experience when reading Section 10 (except the bank run part, maybe that is next). Below are some extracts.

"Section 10 The 1970s

Following the comparative calm of the 1950s and 1960s, the growth of non-bank financial institutions fuelled a property boom in the early 1970s. The 1974 liquidity squeeze brought the boom to an abrupt end. The failure of a number of property financiers precipitated runs on building societies in several states, particularly South Australia and Queensland. Building societies in Queensland also experienced difficulties in 1976 and 1977. Weakness in the property market brought down the Bank of Adelaide later in the decade. The Reserve Bank provided some liquidity support in each of these cases, although it did not lend directly to non-banks.

10.1 The 1974 Liquidity Squeeze

Following a boom in lending by banks and non-bank financial institutions, the Reserve Bank tightened monetary policy in 1973. This was accompanied by a drain in liquidity resulting from a deterioration of the balance of payments and a government budget surplus. As interest rates soared, property prices began to collapse triggering the failure of several property development companies.

On 30 September 1974, the property financier Cambridge Credit went into liquidation. The failure of two other substantial property developers (Home Units Australia in July and Mainline Corporation in August) preceded Cambridge Credit’s closure. While those failures prompted sharp falls in the share prices of other property developers, finance companies and banks, Cambridge Credit’s failure saw public nervousness spread directly to other financial intermediaries. The following day, runs developed on building societies in NSW, Victoria, Queensland and South Australia. While the runs in NSW and Victoria were comparatively small, the runs in Queensland and South Australia were far more severe.


Although the Hindmarsh Building Society in South Australia was financially sound, it was subject to the most severe run. The run, based on rumours the society had lent to failed property companies, continued, little affected by the Acting Treasurer’s statement. The run exhausted the society’s cash reserves. The National Australia Bank lent the society cash until the National also ran low. On 3 October, the South Australian Premier, Don Dunstan, addressed customers queuing outside the Hindmarsh’s offices, assuring them that their funds were safe. The run subsided the next day."

For "youngsters" like me (I was only 5 years old when this liquidity squeeze occurred) I would also recommend reading "Appendix A: Financial Disturbances in Australia – A Chronology". Runs happen. Interesting question is whether the public these days would be comforted by a statement by a politician that all is OK. Maybe they will be, is there any proof that society has gotten any smarter? If anything one could argue they have gotten stupider and more greedy and are just as invested in keeping the system going so will want to believe there isn't any fundamental problem with the system. Coming soon to a theater near you: The F-Files: I Want to Believe in Fiat Currencies.

I also found some other interesting comments about legal tender gold backed notes in the paper:

“High-powered money consists of those forms of money that are directly exchangeable for real goods (i.e. commodity money, such as gold coin, and instruments declared to be legal tender). While, up until 1910 the notes issued by banks and backed by gold were also highly liquid, the fact that their widespread acceptance relied on public confidence in the banks that issued those notes indicated that they were one step removed from high-powered money.”

“In 1910, the Federal Government’s legal-tender note issue was introduced. Initially, it was required that the government’s gold reserve cover one-quarter of the value of notes issued up to £7 million. For any note issuance above £7 million, one-for-one backing was required. In 1914, however, the gold reserve provision was relaxed so that the required gold reserve was one-quarter of the value of notes on issue regardless of the size of the total note issue.”

“The bank [Commonwealth Bank] was required to maintain a minimum gold reserve of 25 per cent of the notes on issue (although the required gold reserve was reduced to 15 per cent in June 1931). Although Australia went off the gold standard at the end of 1929, it was not until the introduction of new banking legislation in 1945 that the gold reserve requirement was completely abandoned.”

I like the term "high-powered money". I wonder if this is some defined academic term or just made up by the authors? History lesson for today - get hold of some high-powered money!

12 July 2008

The Gold Value Chain Part V – Trading & Loco

Loco is short for Location. Location is relevant for gold because it is a physical commodity and it costs money to move it between locations. People new to gold, who have been used to trading shares and bonds and other “virtual” products, can sometimes not consider the implications and risks of dealing in something that is physical.

I am sure most people would appreciate that buying physical gold involves freight costs – even if you are personally going to pick up some coins or bars from your local bullion dealer, you would still appreciate that there was some cost paid by the dealer in getting the gold shipped to them in the first place. This is one of the many costs associated with dealing in physical gold (another is insurance) and they are usually embedded in the margin the dealer charges, either added to the fabrication price or the spot price. I talked about spreads last week and the reason for focussing on that was that dealers can play around with how their prices are perceived by either adding parts of their margin to the spot price or fabrication charge. The spread is the only way to get to the bottom of this.

What I will focus on here is the spot price. A lot of times people think of the spot price like an exchange rate, a “base” price on top of which fabrication, freight and profit are added. Exchange rates are for fiat currencies, something as virtual as you can get. The spot price, by contrast, is for something that is ultimately physical. As a result, the spot price has a location cost embedded into it (or should have). One of the biggest misrepresentations by dealers is not really making this clear to investors and the risks associated with it.

In the industry “spot price” is really shorthand for “the price of gold located in London”. Why London? Because that is where, historically, gold was traded. It is where the major bullion banks have head offices and where some pretty big vaults are located and a fair amount of physical gold is located. Thus the price quoted on Reuters is for gold located in London, or in industry jargon, “loco London”. If you are dealing with a dealer who has trading accounts with bullion banks, the spot price they are quoting is effectively a loco London price. This is effectively gold’s “base” price.

If you deal in gold in other locations, e.g. loco Perth, the price has to be different to gold’s price loco London. Sure, you say, it costs money to freight gold between locations so I can understand that the spot price for the basic wholesale form (400oz bars) is different between locations. But the question is, who pays this difference? Answer is, supply and demand.

I’m sure everyone understands supply, demand and price. More supply than demand and price drops, other way around and price goes up. Same applies to gold in each location. For example, Australia produces way more gold than it needs domestically, so loco Perth supply is higher than demand. Thus miners can’t sell it all to Perth buyers and will therefore have to freight it to London first to get the loco London spot price. There is a cost associated with this, let’s say $1.00 for simplicity. In practise the miners don’t ship it and instead AGR Matthey does a loco swap (see Value Chain Part II blog below for details). However AGR says to the miner “since it would cost you $1.00 to ship the gold to London, I will only give you the loco London spot price less $1.00”. The miner in retort may say “yes, but you want the gold to make into bars to sell to Indians, so it would cost you $1.00 to ship gold from London to Perth”. In the end there is a bit of horse trading and they settle on a price, the most fair one being the mid-point, say $0.50. As a result, in this example gold loco Perth would trade at a discount to loco London gold, or in industry jargon, the loco discount for Perth gold would be $0.50.

This little game is played all over the world and each location trades at a premium or discount to London depending upon local supply and demand at that time and the relative bargaining power of the players. As a result, loco discounts/premiums are not fixed and change over time as supply/demand changes. Normally the supply/demand situation is stable, which is another way of saying that the physical flows around the globe are stable. However, this can change. For example, one major flow of physical gold is from Australia to India. But what happens when the gold price rises and Indian demand dries up. Then the gold flow is from Australia to London, or wherever the demand is. This changes the loco discount of Perth.

When a dealer sells to you, they quote the loco London price because they are backing this deal by buying gold loco London. They then want to swap this for, say, loco Perth gold. In this case, because loco London trades at a premium to loco Perth, AGR Matthey will pay the dealer $0.50 for the London gold in exchange for Perth gold. When a dealer buys back from you, the process is reversed. The dealer sells gold in London, but has your physical in Perth. They need to swap this for London gold so they can settle their sale trade in London. AGR will do a swap but the dealer is now in a similar situation to the miner, so they have to pay $0.50 to AGR. In the end the dealer gets $0.50 on the sale to you and then pays $0.50 when buying back, so it netts out. In normal markets (where the loco discount is constant) a dealer can therefore make their loco price the same as the loco London price.

This can therefore give investors the impression that there is one global spot price for gold. I think this is misleading because when markets change and there is sustained buying or selling imbalances in a location, the discount can start to become quite large and netting not possible, resulting in investors getting a price much lower than they expect. That’s why I am writing this, so you know the risks involved. You may not be able to do anything about it at the time, but at least you are aware. You also want to consider where you are storing your gold, because if it is in a location with low volumes/low liquidity or far away from London, the discount could become quite large. To understand these risks you need to understand how loco discounts are priced.

The main issue for investors is what price are you going to get when you sell. I am assuming that you are accumulating gold at these low low prices on the expectation that gold is going to go much higher. Hopefully you will time it right and sell before the peak, but what happens when the price starts dropping and all the people who rushed in at the end try and sell at the same time? In that situation you will have a glut of physical gold in that location for sale but few buyers. Technically the price could diverge from the loco London price by quite a bit as no one is buying. But then arbitragers will step in to buy loco Perth, ship it to London, and sell loco London.

Note that ultimately anyone can get the loco London price; they just have to ship their gold to London and sell it to a dealer there. Of course in reality small investors can’t do this. They won’t be able to arrange insured freight for small amounts, and have the risk that when the dealer gets the gold they just don’t pay on the basis that you aren’t going to spend thousands to fly over there. So this does present a great business opportunity to buy gold from all the idiots lemmings at a discount, aggregate it, ship it, and sell it in London at a higher price. So what is involved in arbitraging physical gold?

Firstly, your idiots are going to be so desperate with the gold price tanking that they will want their cash straight away. They aren’t going to want to wait for you to ship it to London. So what you have to do is lease gold loco London, sell that gold at the London spot price and use the cash to pay your idiots. Fine, but you now have to get that gold to London to pay back the lease. The longer you wait, the longer the lease runs for and the more your lease cost is. But you can’t ship the gold straight away, you have to wait for some more idiots to come along and buy gold from them until you eventually have a large enough pile of gold to get a good bulk freight deal. This means the all up cost to you to buy loco Perth is composed of:

1. Freight cost, which is dependent upon the size of the shipment
2. Lease cost, which is dependent upon the lease rate and the time it takes to accumulate your shipment size plus the time to ship to London

There is a bit of a balancing act here, because the longer you wait the bigger your shipment size and therefore the lower your per ounce freight cost, but the greater your lease cost. Depending upon the variables there will be an optimal point at which you should ship. Let’s do some numbers.

Let’s assume lease rates are 0.2%, price $1000 per ounce, freight time is about 3 days and let’s say it takes you about 12 days to accumulate your shipment. This means your per ounce lease cost is $1000 x 0.2% x 15 days / 365 days = $0.08 per ounce. Not a lot. What is the freight cost? Hard to say given it is highly volume related, but you can consider it to be around the tens of cents per ounce for shipments in the tonnes.

There are two important risks to be aware of here. Firstly, the lease rate. If you look at lease rates over the last two decades, it has averaged 1%, spiked above 3% for durations of months on 5 occasions and has got as high as 6-7%. If we plugged 3% into our model, the lease cost becomes $1.23, still lowish considering a spot price of $1000, but a big jump from $0.08.

Secondly, we are assuming we can actually freight it out when we want. There is only limited air freight capacity out of any location, and combined with the fact that insurers are probably not going to be happy covering a whole plane load of gold (lest the pilot decides to divert the flight), you could find yourself having to sit on gold loco Perth for a while until freight capacity becomes available. Alternatively, you could bid the freight price up to get earlier flights. Either way your costs are going to go up. With the price falling, you could have a fair amount of selling going on so could build up your loco Perth stock pretty quickly. Let say the lease rate was still 3% but you had to wait 2 months before you could get flights out of Perth. That is now a lease cost of $5 per ounce.

Now you might say what is the chance of that happening? Well consider that if the price is tanking then miners are going to start to want to hedge (or alternatively, miners decide it is wise to start hedging at these high prices before anyone else does, and then the price starts to tank). This means they need to borrow gold, which will push up the lease rate. Oil isn’t getting any cheaper, so freight costs will also be up.

Where it gets really scary is with silver. This is because it is bulky. At a ratio of 50:1, you simply cannot fly silver to London, it has to be shipped. How long does that take? Well, 2-3 months. Currently lease rates for that time period are say 0-0.1%. At a spot price of $18, this equals $0.005 per ounce. However, there was a time in early 2002 when the 2 month silver lease rate exceeded 15%. This would result in a lease cost of $0.68. Hopefully there is more capacity to take big tonnages and frequent shipments when you are dealing with ships as opposed to planes, so you may not have to hold on to your silver buybacks for too long.

Therefore, the smaller the local market for gold and silver, the fewer flights/ships, the further away from London you are the more exposed you are to a big discount in the selling price occurring during abnormal market situations. This explains why the big ETFs hold their metal in London. It lowers the risk as that is the biggest physical spot market. I trust this also gives an insight into the sort of issues and factors that a dealer has to work with when setting their trading prices.

06 July 2008

The Gold Value Chain Part IV - Trading & Prices

In the past few blogs you’ll have noticed that I focus on the use of leasing. This is because this is what I have experience in. Central banks and bullion banks look at The Perth Mint’s enabling legislation (the Gold Corporation Act 1987) and particularly the Government Guarantee in Section 22 and realise this means that the West Australian Government is 100% on the hook for what the Mint does. As a result of the Government’s AAA rating, they are happy to therefore extend substantial credit limits to the Mint and therefore lend it precious metal.

With access to precious metal without the need for collateral or margin, the Mint therefore has no need to use futures markets because they would cost more, not just because of low lease rates but also because it is operationally more efficient. As a result I have no practical experience in the futures markets – the Mint has never traded futures nor has any accounts with brokers in those markets – so I won’t go into them in much detail except for theoretical discussions. Considering that much of the gold commentary out there is US-centric and thus futures focused, I don’t think I’d be adding anything of interest anyway. By contrast, there isn’t much on leasing or the spot market or London, which is what I do have experience in, so hopefully that is of interest.

Having got that out of the way, let’s talk about how trading works in a bit more detail. In a prior blog I discussed the network nature of the gold market and the use of Reuters as a bulletin board for prices. I think the main lesson for anyone buying and hopefully selling back at a profit is that the only way to get a good price is to have people you can play off each other – a dealer isn’t going to give you a good price if they don’t believe you have anyone else to go to. That’s how it works at the wholesale end of the market, so it is the same at the retail end.

There is also one other rule/saying – get big or get out. By this I mean your price depends upon the size of your trade. Size is also relative to your dealer. For a small coin dealer a $10,000 deal may be big, for the Mint for example it is ho hum. Of course, as with any business, if you are a regular customer you can expect a better price than if the dealer thinks they won’t see you again.

There are two ways you can get an idea of whether the price you are being quoted is good or fair. One is to shop around and compare between dealers or better still, have a live Reuters data feed, although that can cost thousands a year. I can certainly tell you that if you have a fair amount to trade and tell the dealer “well my Reuter’s screen says $x” and the dealer can see that is the same price they see, once they know you have a Reuter’s feed they know they won’t be able to jerk you around. Having said that, if you are trading 10oz, then it won’t help because that is too small – just knowing the price doesn’t mean you can get it.

The second way is to ask for both their bid (buying back price) and ask (selling price to you), but don’t indicate whether you are buying or selling, otherwise they’ll just load up the price you need to deal at. By getting the “spread” the dealer has nowhere to hide, if they load up both sides you see that in a wide spread.

In the end though, all the above doesn’t matter if you don’t really have anyone else you can or want to buy from or sell to. So many times in my first job with the Mint in Sydney I’d have people come in, look up at the screen and say “Perth Bullion Exchange (or Jaggards or whoever) down the road has a better price on 1oz Nugget coins”. Now they didn’t realise that the spot price we used was set by the Treasury department in Perth and I had no way or authority to change it, so couldn’t really get into bargaining. I would just say “Oh well, best buy it from them, then.” In almost all cases they’d just shuffle on the spot for a bit and then buy from me anyway. It was all bluff.

Where you do have to be careful is if you are trading gold on an account basis (that is, not taking physical and selling physical back) and this covers allocated and not just unallocated or pool accounts. If you have gold with someone, even if it is allocated, you really can only sell it back to them without going into a lot of cost with taking delivery. With physical, the dealer knows you can just take it to someone else a lot easier. By accounts, I would include Perth Mint PMCP or PMDS, Kitco’s pools, GoldMoney, Bullion Vault etc, anything where you don’t hold it yourself and someone else is storing it for you.

In these situations, when choosing the “system” or service I would suggest investigating the spread they operate at. When talking to them about opening the account, ask for both their bid and ask prices over a few days or telephone calls. It should be consistent. Compare this to the other accounts you’re looking at. It probably doesn’t matter too much if you’re not planning to do much trading, but it does give you a bit of an insight into how they operate.

So what is the best price you can expect? At the bullion bank level, the true market makers (or price makers) operate with a $0.50 spread but these are at deal volumes of 1000oz or more ($1 million). However, even if you have a million to get this price you also need to have an account with a bullion bank – not easy to get, you really need to be a corporate entity with a reasonable credit rating. And note that the $0.50 spread is for normal market situations, it can widen when the market gets choppy.

Anyway, this gives you a benchmark against which to compare the prices you are being quoted. The smaller you go below 1000oz, the wider the spread. Only way to get a handle on it is to ring around or check out the prices quoted on websites. Kitco is a good place to start – they show both bid and ask for various products. For example, their pool accounts had a bid/ask spread of $3.80 just now. Not too bad actually. The spread really is your best friend as it shows what the real markup is.

Next week - understanding loco discounts. There is no such thing as a single global gold price.