07 December 2012

Freebanking and bullion banking

These comments on Freebanking and how bullion banking works come from FOFOA's blog. I've assembled them here for my future reference convenience. If you are interested in this topic you'll find them useful. If this discussion thread starts up again, I'll append them to this post.


I've been reading the freebanking work recommended by Bron, and I found an interesting passage referring to monetary equilibrium vs. price stability:

George A. Selgin,
The Theory of Free Banking: Money Supply under Competitive Note Issue [1988]

Most of these authors explicitly distinguish the goal of accommodating changes in the demand for money through changes in nominal supply from that of stabilizing an index of prices. The two goals differ because general price movements may be caused by changes in productive efficiency, and not just by changes in the demand for money balances relative to nominal income. Offsetting price changes due to changes in productive efficiency would not preserve monetary equilibrium.

...

Many past and present American monetarists would probably agree with the theoretical views of the European writers discussed above. Their preference for other policies—for price-level stabilization or a fixed money growth rate rule—stems, not from any theoretical disagreement, but from their view that these policies provide the best achievable approximation to the ideal of a truly demand-elastic money supply.


Also a passage on Say's law:

The view of monetary equilibrium presented here should not be controversial, and has been upheld by many economists. ... . Most of these writers link the concept of monetary equilibrium to that of “neutral” money. According to Koopmans (1933, 257), who has developed this approach most thoroughly, monetary policy should have the goal of “compensating for any deflation, due to hoarding, by creating a corresponding amount of new money, or of compensating for any inflation, due to dishoarding, by destroying money in like measure.” When this goal is achieved “the money outlay stream should remain constant.” In other words, money is neutral as long as Say’s Law remains valid (that is, as long as excess demand for money is zero). Conversely, monetary disequilibrium occurs and money is non-neutral whenever Say’s Law is violated:

(quote)
Hoarding and money destruction cause a leakage in the circular flow of income; dishoarding and money creation make, so to speak, new purchasing power spring from nowhere. In the first case, that of pure supply [of non-money goods], the situation is deflationary, in the second, where pure demand occurs, it is inflationary; in neither case does Say’s Law apply. If net pure demand is nil, monetary equilibrium prevails . . . the monetary equilibrium situation corresponds to Say’s Law [De Jong 1973, 24].
(end quote)

Machlup has the same view in mind when he writes (1940, 291 and 184-89) that “credit inflation is ‘healthy’ if it compensates for deflation through current net hoarding, or for an increase in the number of cash balances or in the number of ‘stopping stations’ in the money flow” and that credit contraction is healthy if it compensates for dishoarding (“a decrease in idle balances”).


Good to see you are getting some use from my free banking link. I have a theory that the bullion banking system operates very much like free banking, considering they don't have a central bank who can print gold.


I don't think there is much room for doubt that the clearing members operate on a free banking model. From a bullion bank's perspective this is the next best option to having a central bank. IMO it would be a big stretch to think they invented something totally new in banking when the free banking model was available "off the shelf".

Factor GLD into the picture and you have the emergency liquidity function of a central bank as well. GLD ensures that they can always get gold at some price provided they can get their hands on GLD shares. Folks who have brokerage accounts with these banks in which they hold GLD shares which are registered to the brokerage would make this easy to do without tipping their hand.

Obviously they could still be exposed to a cash loss if the price of gold moves against them but, as you know, they have plenty of ways to hedge. Under normal conditions this overall structure should be low risk for the BBs.


As I said in my article, I don't see a lot of borrowing going on in GLD so it doesn't seem like bullion banks are using it as a source of liquidity.

However, pre-ETFs retail investment would have went into coins/bars and thus would not have been accessible. With ETFs and street name registration, you are correct that now this metal can be borrowed directly from investors' brokers. So it has increased potential liquidity I suppose.

I don't really think much of the "get physical by buying GLD shares" theory as raising the price to induce sellers works just as well in the OTC market - that strategy is nothing special to ETFs. Secondly, if they are going to hedge it then they just create an arbitrage for someone else to take advantage of, which negates the strategy.

Note the above strategy works if only one or two are doing it for little volume - it doesn't work if they are all desperate for physical, which is the situation I think we are all interested in.


I don't see a lot of borrowing going on in GLD so it doesn't seem like bullion banks are using it as a source of liquidity.

Noted. It makes sense that the BBs will source from the best option under normal conditions. The key phrase in my comment on GLD-as-CB is "emergency liquidity". And that doesn't preclude using GLD shares creatively as part of their overall book management and client servicing.

..the "get physical by buying GLD shares" theory as raising the price to induce sellers works just as well in the OTC market..

Agreed. All of these theories based on what the punters can see are doubtful to say the least. This market is mostly opaque.

...it doesn't work if they are all desperate for physical..

Again this is where I'm also 180 degrees opposite the goldbug and silverbug pundits who scream about how much pressure the BBs are under for X reason or Y reason.

The "spiders" have this game sewn up for now. It will take a crisis of some kind to change that and I think Jim Sinclair is dead right FWIW. The BBs will make out like bandits on the upside as well.


I don't think there is much room for doubt that the clearing members operate on a free banking model. From a bullion bank's perspective this is the next best option to having a central bank. IMO it would be a big stretch to think they invented something totally new in banking when the free banking model was available "off the shelf".

To clarify, I think the free-banking model is an 'analytical model', not a 'business model'.

The question would be whether the conditions of bullion banking fit the conditions of the free-banking model, and thus whether the free-banking conclusions are applicable.


On free banking:

I have a few more comments to make regarding the free banking publication suggested by Bron. To repeat the link:

George A. Selgin,

The Theory of Free Banking: Money Supply under Competitive Note Issue [1988]


First, free banking defined: free banking occurs when there is little bank regulation and no central bank to monopolize note (paper money) issue. Each bank issues its own notes as part of their liabilities. The author assumes a base of commodity money, by which I think he means precious metal coins minted by the sovereign.

The conclusions appear to be:

1. Under free banking, the commodity base money would form the banking system reserves. Each bank would manage its own reserve ratio to maximize its profit (by profitably expanding the credit volume) while a) keeping in balance with the rest of the banking system and thus preventing its reserves from being drained by its competitors and b) keeping an emergency reserve in case random fluctuations in redemptions of its liabilities stack up against it.

2. The free banking system would be able to adjust to changes in demand for credit money, and should always keep the supply of credit in balance with its demand.

3. These conclusions do not hold when a central bank monopolized note (paper money) issue, since in that case the CB notes tend to become the reserves of the banking system, and the CB must manage the reserves to manage the credit volume.

4. It is assumed that the public holds bank liabilities and the banks hold commodity money as the reserves; so far I have not seen discussion about the possibility of bank runs.

I have read about half of it so far, so I’m sure there’s more I’m missing, but I see two angles from which to view this work:

The first is, as Bron suggests, that the bullion bank operations can be described by this model. I think he is correct. While the BBs do not issue ‘gold notes’ that circulate, I do not think that is the key to the model. The key, rather, is that there are no CB notes to use as a reserve upon which to expand credit.

Interestingly, perhaps leased CB gold, i.e. ‘the CB’s good name on paper’, could have been a type of ‘reserve note’ used by the BBs before the launch of the Euro, so that the BBs transitioned from an informally-CB-backed system of sorts, to a completely free bank system.

When I finish reading the book perhaps I will find some more insights into BB operations.

In the meantime, some more thoughts regarding bullion banking:

1. Who is transacting in all that gold that the LBMA clears? I previously had pictured paper gold as being something that you trade back and forth from within your own holdings, like switching your cash between currencies. But the LBMA clearing between members means that account holders are writing ‘unallocated gold checks’ to each other, and in very large amounts. I suppose this all goes back to the original ‘Red Baron’ question.

2. How do these gold transactions fit into a transition to freegold? How would they fit into a post-transition system?

3. How did bullion banking come about? Did it start with the closing of the Dollar gold window, or does it go back further? On the face of it, bullion banking is a strange concept.

The second angle from which to view free banking is as a clue to how things might work after a transition to freegold.

I do not thing central banks are going away any time soon, since, as the author notes, most central banks were chartered for the purpose of securing favorable borrowing terms for the government.

However, perhaps what we would see is a system of ‘free central banks’, where gold is the underlying commodity money reserve that is used for clearing between the CBs (I assume the clearinghouse for these transactions would be the aptly-named Bank of International Settlements – the ‘central bank of central banks’ nickname being a misnomer). The differences between this arrangement and the standard free banking arrangement would be:

1. The commodity reserve floats in value.

2. The notes issues by the CBs float in exchange rates against each other.

3. Credit is issues into the economy by commercial banks which use the CB notes as a reserve, and thus credit volume is a step removed from reserve management.

I think for this arrangement to work properly, clearings between CBs would have to happen quite often.


A further implication of the 'CBs acting as free banks with gold reserves' system would be that the CBs gold would truly be the reserves of the banking system in that CBs zone. The amount of gold held would be proportional to how much credit gets cleared between a zone and the rest of the world.


To clarify, I think the free-banking model is an 'analytical model', not a 'business model'.

It's not an "analytical model" it's an operational model for a banking system without a CB. This kind of system operated at various times in various places. One of the most often cited examples operated in Scotland until around 1845 (if memory serves me).

Google 'free banking school' and 'modern free banking school'. The philosophy of the advocates in this school has, IMO, morphed into an anti-CB movement. This is hardly surprising given its roots in the "School of Salamanca" which opposed the regulation of prices and, de facto, interference in markets by a central authority. The "moderns" take this perspective a step further:

The most beautiful justification of the free market that I know of is theological in nature. In his Disputationes de justitia et jure, published in 1642 in Lyon, the Spanish cardinal Juan de Lugo (1583–1660) wrote that the "just price" depends on so many factors that it can be known only to God.....

.... The arguments of both schools of thought — the School of Salamanca on the one hand and the Austrian school of economics on the other — are powerful critiques against the central banks' role in regulating interest rates (the price of the product) and money supply (the quantity of the product).

For the priests writing in Spain, to regulate the interest rate through a centralized authority would be to presume that one man could know that of which only God has certain knowledge....


http://mises.org/daily/3607

The LBMA clearing members appear to have taken the free banking model a step further by forming a jointly owned clearing company which settles transactions at the end of each trading day. From my reading, the gold which supports the paper they are issuing is held by this jointly owned company as an unallocated pool of around 700 m/t. (And I think that it would be a big mistake to assume this is client-gold as opposed to bank-owned gold.)

It appears to be a fractional reserve system based on gold but instead of issuing notes (currency) like those Scottish banks they are writing other types of 'paper' contracts and settling in gold.

The key feature of a free banking system is that the participating banks guarrantee to accept each others paper from clients on presentation. The banks then (as a group) settle those transactions among themselves. Instead of just relying on the good reputation of the participants the LBMA clearing members appear to have pooled their gold to underwrite the system.

Looks like the BBs 'got religion' after their near death experience in the late 1990s. LOL


costata: "the gold which supports the paper they are issuing is held by this jointly owned company as an unallocated pool of around 700 m/t"

My understanding is that the http://www.lpmcl.com/ does not hold physical or run accounts, it is just a system for clearing. From their website:

"... settlement instructions through an electronic settlement system hub called “AURUM” run by the not for profit company LPMCL. ... Each bullion clearing member uses their respective banks’ bullion operations group to control the clearing function."

It is like a SWIFT for the six clearing bullion banks.


Thanks for the correction. So let me see if I have this straight now. For the sake of simplicity let's ignore any other users of this system except the clearing members.

Each clearing member has their own stock of bullion. After netting out the daily transactions conducted in-house by each clearing member they supply the data to the LPMCL AURUM system used to determine the external transfers required for physical settlement.

LPMCL isn't involved in physical transfers. The clearing members arrange any inward or outward transfers of bullion from their stock required to settle with another clearing member. Does this describe the process as you understand it?


Michael H: “BBs do not issue ‘gold notes’ that circulate”

But they do “issue” unallocated account credits that are used within the industry to settle transactions, that is, “account holders are writing ‘unallocated gold checks’ to each other”

Michael H: “perhaps leased CB gold, i.e. ‘the CB’s good name on paper’, could have been a type of ‘reserve note’”

Michael H: “How would they fit into a post-transition system?”

Pretty well I think. In Selgin’s paper he does assume gold as the unprintable thing that the banks agree is the reserve which clears imbalances, that is, extinguishes liabilities between them.

The key difference between freebanking and banking is that the reserve medium cannot be printed, it is fixed. I think this is needed otherwise there would not be a control over credit issuance by the banks in an environment where the amount of reserves changed/could be manipulated.

Note that the paper was written in the late 80s, so the idea of bitcoins was not envisaged. Bitcoins would probably work fine as the reserve medium and maybe better than gold because with gold there is a small increase in its stocks every year.

Selgin’s paper does not envisage gold circulating as money as that would not be practical. I think the idea that the gold is “still” in the banks’ reserves is compatible with the idea of gold as a store of value only. In essence freebanks are using gold purely as a SoV with bank paper circulating as the money.

Michael H: “On the face of it, bullion banking is a strange concept.”

Only if you haven’t shifted your frame of reference to consider gold as an accounting unit. Perth Mint runs accounting books in gold and silver alongside our AUD accounts. Banks pay for our coins with unallocated gold, which we use to pay miners for their physical to make more coins. It is all very natural.


costata, That is how I understand it. Keep in mind that one of the transactions is metal account transfers (no trade for cash). For example, Perth Mint requests JPM to transfer unallocated from the Perth Mint's account with JPM to Miner's account with HSBC.

Clearing is a system by which HSBC will give the Miner unallocated and recognise a claim on JPM and JPM extingusih a liability to Perth Mint and recognise it has a liability to HSBC.


Thanks again. So each of the clearing members maintains an unallocated pool held with other members. From the LBMA website:

Members offering clearing services utilise the unallocated gold and silver accounts they maintain between each other for the settlement of mutual trades as well as third party transfers.

These transfers are conducted on behalf of clients and other members of the London bullion market in settlement of their own loco London bullion activities.

This system avoids the security risks and costs that would be involved in the physical movement of bullion.


So from an overall market perspective this network of BB owned unallocated pools (in aggregate) functions like a single virtual unallocated pool that provides the liquidity to the whole market and it's also the capital of the bullion bank clearing members.


Yes, and the point of the clearing process is when those unallocated account balances between a pair of clearing banks gets too big for the sort of risk they are prepared to take against each other (they would take some credit risk), then that is settled by either:

1. the owing bank allocating the unallocated account of the owed bank into physical with the owing bank (allocated is not a credit risk); or

2. the owing bank transferring physical from its allocated account to the owed bank's allocated account with Bank of England (with whom all clearers would have an account); or

3. the owing bank shipping physical to the owed bank's vaults.

The above is probably in order of preference, so as to minimise physical movements.

To the extent that the clearing banks have the same mix of clients there would probably never be any sustained/ongoing movement of physical from one to another as over time a bank's flows would net.

However if the mix of clients is not even (eg one bank predominantly has mining/selling clients and another has jewellers/buying clients) then there would be ongoing movement of physical from one clearer to another.

This was a debate I was having with FOFOA around the LBMA survey imbalance as if the mix of clients between banks is not symmetric then you will have an imbalance in the trading reported (yes, I have not forgotten, it is still on my to-do FOFOA). FOFOA doesn't think so, I do, but maybe I need more time to get to where he is.


In response to my statement that “On the face of it, bullion banking is a strange concept,” you responded:

Only if you haven’t shifted your frame of reference to consider gold as an accounting unit. Perth Mint runs accounting books in gold and silver alongside our AUD accounts. Banks pay for our coins with unallocated gold, which we use to pay miners for their physical to make more coins. It is all very natural.

It may seem natural, but does the fabricator of copper pipe pay the smelter in unallocated copper, and does the copper miner sell in exchange for unallocated copper?

Do cereal makers pay with unallocated Corn, and the grain elevators pay the farmers in same unallocated corn?

It's not so strange that the gold industry pays in gold up and down the supply chain; rather, it is strange because it is the only industry to do so. Why is it special?

Bron Suchecki December 4, 2012 6:12 PM

Michael H: "It's not so strange that the gold industry pays in gold up and down the supply chain; rather, it is strange because it is the only industry to do so. Why is it special?"

Because gold was once money. Just because we went off the gold standard didn't mean the infrastructure of gold accounts and borrowing and lending gold stopped, it just continued on and then got a real boost when miner financing by forward selling gold was created.

Also, for physical gold businesses, you have to run "accounts" or inventory systems to keep track of your gold, so again the infrastructure is there on which to build (see http://goldchat.blogspot.com.au/2009/06/metal-accounting-i.html)

7 comments:

Michael H said...

Thanks for putting these together.

A few more comments on why gold is so special that it needs its own banking and accounting:

First, the value of gold as a raw material dwarfs the value added in processing and handling. For example, one can buy 1 oz gold coins online for $50 over spot -- $50 to be split between the mint, shipping, and retailing, and a 3% price move could wipe out the entire gross margin.

So it is obvious that the inventory and work-in-progress needs to be hedged, but this is also true of other low-margin commodities such as corn. Futures markets are enough for true commodities, so why not for gold?

That leads to the second characteristic that makes gold special, which is that investors want to own it, and are willing to underwrite the mining and processing to get their metal.

Still doesn't really explain the origin of gold-denominated credit, outside of historic evolution, to which I am reluctant to ascribe as 100% the origin of gold banking.

That is why I was wondering when gold banking came about. I would imagine that it would be superfluous under a gold standard, since currency credit = gold credit at that point. But it might have started before 1971, when presumably mines did not have the same capabilities as foreign CBs to convert dollars to gold.

Did gold banking exist prior to, say, 1980?

(btw the captcha is a real pita)

costata said...

Hi Bron,

The book available at this link (by Lawrence H. White) is widely considered to be an excellent exploration of Scottish free banking. There are also links at the bottom of the page to other works on the topic by Selgin, Hayek and others.

http://www.iea.org.uk/publications/research/free-banking-in-britain-theory-experience-and-debate-1800-1845

There's also a free PDF download option. If any of your readers want to explore this topic in depth the links at site would be a good starting point IMHO.

Cheers

Bron Suchecki said...

Michael H,

I have a few history of gold books in the Perth Mint, will see if I can find anything.

costata,

Thanks for the link, I'll check it out.

milamber said...

Nothing to add, just subbing so I can read what you bright people write.

Milamber

costata said...

Hi Bron,

I have been looking through the older PDF version of L. W. White's book for some quotes that highlight the similarities between Free Banking as it was practised centuries ago and the LBMA clearing members system.

I had to transcribe this so apologies in advance if there are any typos. From Page 32 of 194:

In a bi-lateral note exchange the clearing balance is computed simply between the two participants. Where third and further banks enter the arrangement, it is likely to be cheaper to conduct the exchange multilaterally than as a series of bi-lateral exchanges.

A single clearing balance is computed for each bank against all other banks, and settlement is paid into and out of a central pool.


White goes on to observe that settlement need not be in specie or by physical transfer. It could just as easily be effected by "the transfer of some other agreed-upon medium. He also specifically refers to the "side-payments to reach a loint optimum".

So the central pool concept can be virtual without invalidating the comparison between Free Banking and the LBMA clearing members system.

costata said...

Corrections:

"the transfer of some other agreed-upon medium"

"side-payments to reach a joint optimum"

I was trying to avoid having to go through the ordeal of that spam blocker.

Michael H said...

Further to my December 3, 2012 5:24 AM & December 3, 2012 5:24 AM above:

A free banking view of freegold would look like:

1. CBs clear imbalances between each other in gold.

2. CBs issue base money and currency which become the reserves of their domestic commercial banking system, and is used for settlement in said system.

3. Citizens transact in credit issued by the commercial banks (along with a much smaller amount of CB-issued currency).

4. Citizens also can buy gold with the credit issued by commercial banks, closing the currency management loop.