12 February 2014

Fractional reserve bullion banking and gold bank runs: the role of central banks

Yesterday I finished with the statement that central bank lending of gold allows the bullion banking system to expand gold credit and this extra supply suppresses the price. I think a simple example may be useful. Let us consider a market with a BB with the following balance sheet:

The Books of BB#1
Assets – 100 oz of Loans
Liabilities – 10 oz of Unallocated to Ms Strong Hands
Liabilities – 90 oz of Borrowings

Let us say no physical holders or Ms Strong Hands are interested in selling at the current price but we have a Mr Naive with an account at BB#2 who wants to buy. Mr Naive would have to increase his bid to induce someone to sell. If a Mr Short Seller approached BB#1 wanting to borrow 5oz of gold to sell to Mr Naive, BB#1 would be unable to lend gold as they have no reserves with which to settle any unallocated transfers. However BB#1 can approach a CB to borrow gold. This would give BB#1 some unallocated with the CB:

The Books of BB#1
Assets – 100 oz of Loans
Assets – 5 oz of Unallocated with CB
Liabilities – 10 oz of Unallocated to Ms Strong Hands
Liabilities – 95 oz of Borrowings

The Books of CB
Assets – 5 oz Loan to BB#1
Liabilities – 5 oz of Unallocated to BB#1

BB#1 can then lend Mr Short Seller the 5oz:

The Books of BB#1
Assets – 105 oz of Loans
Assets – 5 oz of Unallocated with CB
Liabilities – 15 oz of Unallocated to Ms Strong Hands and Mr Short Seller
Liabilities – 95 oz of Borrowings

Mr Short Seller can then sell the 5oz to Mr Naive. On settlement of that trade, BB#2 would require BB#1 to settle with it, which BB#1 can do by asking CB to transfer 5oz to BB#2. The end result is:

The Books of BB#1
Assets – 105 oz of Loans
Liabilities – 10 oz of Unallocated to Ms Strong Hands
Liabilities – 95 oz of Borrowings

The Books of CB
Assets – 5 oz Loan to BB#1
Liabilities – 5 oz of Unallocated to BB#2

The Books of BB#2
Assets – 5 oz of Unallocated with CB
Liabilities – 5 oz of Unallocated to Mr Naive

Some observations:
  • BB#1 was able to expand their loan book by 5oz, earning more interest;
  • Mr Naive did not need to bid up the gold price as Mr Short Seller arrived into the market with "gold" at the current price;
  • The CB did not need to sell any physical gold;
  • While BB#2 wasn't willing to extend credit to BB#1 and hold its unallocated, it was willing to hold the CB's unallocated;
  • The CB's unallocated was really just backed by a loan to BB#1;
  • Therefore, system wide BB#2 was really extending credit to BB#1, the CB was just acting as a guarantor in the middle.
The role of the CB here is to plug the gap in any lack of trust between BBs, in other words, if inter-BB lending broke down. That should sound familiar, as it is exactly what CBs did in the financial crisis regarding the fiat banking system.
 
I don't want to get sidetracked in this series of posts into manipulation theories (that is worth its own posts) but for now note that as long as Mr Naive is willing to hold BB unallocated and Mr Short Seller is willing to take price exposure, neither the BBs or CBs need to sell physical or go short themselves. It is the Mr Naives themselves who facilitate the price suppression. Only if the Mr Naives preferred physical would the CBs need to actually sell their gold if they wanted to suppress the price.
 
Back on topic. In normal markets the fractional reserve banking system is highly flexible and stable. The LPMCL provides an efficient inter-BB clearing system and if any bank experiences a maturity mismatch liquidity problem, other BBs can extend it temporary credit and can make a nice profit charging higher than normal lease rates for such emergency funding, or if required, lend against cash or other collateral. In the case of a lack of trust and collateral shortage, CBs can step in to mediate any inter-BB "friction". One may be able to infer this market action via changes in reported GOFO and lease rates.
 
One of the reasons I think so many gold commentators have been wrong on calls that the bullion banking system is about to fail is that they are not aware of the market structures I have been discussing in these posts, and thus do not appreciate how much stress the gold market can withstand. Because they are not aware of the role of BBs and CBs in the facilitation between  paper gold longs AND shorts, they think that price suppression can only have been achieved via physical sales and thus naturally when they run the numbers on that, they conclude that the CBs have run out of physical gold. But surprise, the game continues! I would suggest such commentators should reconsider their theory and recast it based on a more sophisticated understanding of the market.
 
Let me put it another way. On Comex it is clear from the very low percentage of physical deliveries versus open interest that Comex is primarily a market where leveraged paper longs (who don't have the cash) trade against leveraged paper shorts (who don't have the gold). The BB-LPMCL-CB system described in these posts is just an OTC version of this Comex structure, with BB unallocated account credits taking the place of futures contracts. Any look at the London OTC clearing statistics should tell you there is a lot of BB unallocated paper being held.
 
To the extent that people are willing to hold this paper, be it futures or BB unallocated, then those longs facilitate and support the game. The question then is when (if?) will they "run", which I will discuss tomorrow.

6 comments:

  1. Here is why the gold commentators consistently make these mistakes:

    http://4.bp.blogspot.com/-BplS4WaaOaI/T1a-y17WOlI/AAAAAAAAAXU/_Ari5fdIPOM/s320/Blind.jpg

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  2. Bron, this is an awesome, informative series of articles. Thanks so much for posting them.

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  3. Good post. This is where game theory needs to be mentioned. With too many greedy paper bulls trying to ride the back of too few physical accumulaters, trading positions (including ETF’s and unallocated physical) get slowly milked and PM share portfolios get trashed by falling prices and gradually diluting holdings. Physical ounces remain their unproductive same.

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  4. At DH. Yes, second that. So much more useful than this type of cheesey, wishful, disinformative recycled trash from a copout lazarus:

    http://www.roadtoroota.com/public/254.cfm?awt_l=61.TA&awt_m=3f0HrlRom0AZ85B

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  5. Bron, thanks again for the insight explanations.

    What I wonder is, that so many people are so focused about BB and assume that if a BB defaults, magically the price of gold would rise.

    Look, let's say a BB closes their doors, just like MFGlobal, why do some people think that magically people would buy more Kr├╝gerrands and yellow jewellery at a higher price, which they have not done before? At least I wouldnt. This assumption makes absolutely no sense to me.

    Okay I might see the point about a short squeeze when BB might try to cover (but who says they will, rather than just closing their doors?), but we all know, short squeeze comes and short squeeze goes, does not change the fundamentals in the long run at all. And IMHO long run is what physical gold is about.
    Greets, AD

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  6. Bretton Woods??????????????????

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