14 December 2011

Negative Gold Lease Rates (again)

If Tom from Metal Augmentor keeps on putting out great stuff like this post on negative lease rates, then I'll be out of a (blogging) job.

It is heavy going but a comprehensive discussion of the issue with a dramatic speculation that "The selective collateral nature of the tri-party format may force bullion banks to eventually declare their unallocated LBMA gold accounts as backed by 100% physical bullion." Other key points if you don't have the time to read the 8500 word article:

"leasing is probably done directly by the bullion banks on behalf of commercial banks for a fee. Instead of pledging the assets acquired with the sale proceeds of gold leased pursuant to a carry trade, the borrower of gold now pledges existing collateral that it could not otherwise sell without incurring a loss. The central bank accommodates the gold leasing by accepting a wide range of collateral that would be otherwise prohibited in conventional funding schemes"

"An outright sale of gold could always be hedged by acquiring a gold forward contract. Therefore, even if gold leasing has not experienced a recent resurgence, the increase in the gold forward rate indicates that owners selling gold to generate liquidity still want their gold back once the funding need has abated. The combination of a falling gold price and rising forward rate is quite a bullish feature of the gold market that is lost in the reporting on negative gold lease rates."

"the persistence of negative lease rates could be accompanied by the emergence of something entirely new: The result could be negative gold “lease rates” as gold price expectations may create an entirely new phenomenon: cash borrowed to buy gold for future delivery (what I call “gold bonds”). In effect, this is the equivalent of gold owners forward selling their gold at higher and higher prices, and receiving cash up front to be used for current liquidity needs. The above scenario may appear a lot like the current futures market because it involves leverage but the difference is that “gold bond” transactions are 100% backed by metal."

A few of comments:

Tom: "From the perspective of the borrower (typically a bullion bank or its customer, a hedge fund), gold was historically leased as a way to fund a gold carry trade under which excess returns could be earned by using the sales proceeds from leased gold to purchase highly-rated securities meeting the central bank’s collateral requirements."

Bron: This is by far the major use of leased gold, but gold can also be leased by users/manufacturers of gold products to provide physical funding of their work in progress inventories, which does not involve any sale of the leased gold.

Tom: "As just mentioned, the gold (or silver) lease rate does not represent the actual rate at which lease transactions are being done in the market. The published lease rate is simply an indicated value derived from two related variables, the gold forward rate and LIBOR."

Bron: In support I would say that the Perth Mint has always paid positive lease rates when borrowing gold, although it does so for inventory funding rather than carry trade etc reasons. Note Perth Mint borrows without posting ANY collateral because of the West Australian Government's AAA rating.

Tom: "a customer may execute a gold swap with a bullion bank pursuant to which the customer’s physical gold is initially stored in an unallocated account and used as the collateral for dollars loaned to the customer. The bullion bank then sells the gold from the unallocated account to replenish its funds and concurrently enters into a gold forward contract with a gold refinery. The forward contract is then used to back the gold liability to the customer."

Bron: My emphasis on "physical" in that. This sequence of transactions is what fractional bullion banking is. In this case the customer's metal is "lent" to the refiner.

Tom: "sane market participants will naturally demand that gold as a financial instrument retain its utility as the ultimate collateral for non-recourse funding. Under these circumstances, the appearance of 100% physical backed LBMA unallocated bullion accounts seems like a very good possibility"

Bron: I note that some years ago balances in LBMA unallocated accounts attracted no fee, whereas now there is a very small account fee as % of value. Indication perhaps that bullion banks have had to increase the percentage of physical backing unallocated (and thus need to recover that cost) due to an increase in physical redemption/turnover on those accounts.


  1. "A gold lease, by contrast, can be treated for accounting purposes as a “non-event” under lenient guidance promulgated by the IMF and BIS."

    Ok, but this is just a fudge. Tom is saying that central banks are 'leasing' gold (via already highly leveraged) unallocated which is being sold by commercial banks bidding for dollars - 'backdoor liquidity' - so depressing the gold price.

    BUT "The central bank accommodates the gold leasing by accepting a wide range of collateral that would be otherwise prohibited in conventional funding schemes."

    The central bank is utilising accounting fudges & accepting collateral which is mostly likely worthless (only enhancing the leverage of unallocated), in exchange for its highest quality asset, the ONLY asset whose quality endures no matter what.

    It seems to me that the financial system's grip on reality is completely unhinged. The gold price should be screaming upwards. The value of a banks' credit, including central bank credit, is given by the quality of its assets.

    Should the Perth Mint really be accepting dollars for gold Bron?

  2. The price of allocated gold I should say, the price of allocated gold should be screaming upwards.

    As I read it, by accepting worthless collateral for gold loans, central banks are effectively demonetising their balance sheets as well as leveraging the gold banking system.

    It seems extraordinary to me that gold is not already backwardated. Maybe we're just living in extraordinary times.

  3. Keep in mind Justin that we don't really accept dollars for gold, as we just buy replacement gold with those dollars straight away. Any dollars left from the premium we exchange back to AUD.

    It will only end when investors holding London unallocated move to physical.

  4. Fair enough Bron but I don't see that the 'assets' of the RBA or the Australian banking system in general are of enduring quality.

    In fact going on 2008, I'd say they are the equivalent of a heap of shit, a cargo of rotten fish, a pile of spoiled wheat... you're not eliminating counterparty risk by holding your margin in AUD. The bid for AUD cannot be infinite.

  5. Ha, we don't get to hold our AUD margin, we have a WA Govt mandated dividend and tax equivalent policy where we have to pay 75% of our profit!

  6. Interesting. Thanks for that, learnt quite a bit.

    I would say that Szabo is focusing on just one component of the gold lending market, although probably the largest component: central banks, commercial banks, and bullion banks.

    But as you point out, there is also the jewelery component. A gold loan by a bullion bank to a jeweler does not involve the sale of leased gold. So here, surely, is an exception to Szabo's point that "the gold lease isn’t about the gold but rather the cash that selling it can generate".

    I think Szabo is also omitting the retail end of the gold lending market. This market involves small institutions and individuals who lend their gold (unallocated) to bullion banks at some negative lease rate. The bullion bank can then on-lend this gold to another bank, refiner, or jeweler at some slightly less negative lease rate.

    So thus when Szabo says: "So, is anybody else lending gold other than central banks? Probably very little since the derived negative lease rate does make it difficult for non-central banks to earn much of a premium in excess of LIBOR."

    ... I would say that bullion banks can profitably on-lend borrowed gold even when they receive a negative lease rate since, after all, they are earning an even larger negative lease rate from retail depositors.

    Which leads to why would retail depositors pay negative lease rates? I think you pointed out last month that it could be higher storage costs. I think that makes a lot of sense. By leasing gold to a bullion bank, a retail investor can avoid high allocated storage costs while still continuing to enjoy exposure to a potentially higher gold price.

  7. Agreed, the question is how big are each of those markets and thus which drives price (of leasing). I think Tom focused where he did because that is the main market, which I think is right.