06 November 2013

FOFOA - more on LBMA survey and Coatcheck

I have been tardy in responding to this FOFOA comment. For new readers, this LBMA discussion is a follow on from this and this.

FOFOA: "It is well known that banks use delta hedges or complex derivatives based on correlated assets and currencies in these high-volume markets, which provides a reasonable explanation for how and why "paper gold" could have expanded so much in one quarter."

This is the crux of our disagreement. You believe this statement is reasonable, hence it explains the LBMA survey discrepancy and you thus see no point in questioning the survey. I think the delta hedges idea doesn't hold, as I said in this post:

"My reaction is driven by a gut feeling that 7,576 tonnes paper creation hedged by some synthetic construction "using correlated asset derivatives" is just unrealistic. An oft made point about gold is that it is not correlated to other assets and indeed its correlation to them changes over time. As a result I am skeptical that one could construct an ongoing synthetic long gold position which would not blow up - just look at the problem JPM had with its CIO's synthetic credit portfolio.

The thesis is that 7,576 tonnes of paper gold was created in Q1 2011. The assumption is that this is not a one off and the outstanding paper gold position is much larger. I understand the FX and other markets are large but if the banks have been doing this for some quarters and not just Q1 2011, then we may be talking some significant positions in the "correlated assets", giving rise to the "whale" problem that JPM had/has."

As a result I believe that, just like you have shown a flaw in Sprott's analysis, that there is flaw in the LBMA methodology. Their approach may be fine for their purposes, but I cautious of reading anything more into it because I don't know the approach or assumptions they took. I was not looking for an "explanation that would better fit your narrative" but exploring how the survey was constructed to see if it had any methodological problems.

What I do not understand is why you are so sure there aren't any problems with the survey? You seem quick to accept it and don't express any caution. That is why I throw back the claim of not investigating or questioning further because it fits your bias, or at least the first explanation you came up with. Much the same as TF, who didn't bother to enquire futher as to why COMEX deliveries were not showing any fractional ounces.

FOFOA: "As far as the Trust is concerned, the bullion banks are already the owners of record of all existing shares. They don't even need to pry them out of strong hands in order to redeem. They can potentially redeem at any time they want."

Yes all GLD shares are held in street name. But this doesn't mean they are held by the few bullion banks who need to coatcheck - many of the AP's are not bullion banks. So a bullion bank facing physical redemption pressure elsewhere can only rely on the GLD shares of clients it acts as broker for.

Anyway, what you are proposing is that a bullion bank acting as broker just redeems the GLD shares backing the GLD shares they owe their clients, making them naked short GLD. While it is legal for a broker to lend out shares (which might give them counterparty exposure, but no price exposure), I'm not sure if it is illegal for a broker to just liquidate shares and go naked short (certainly naked short selling is illegal, but coatcheck is talking about going naked after selling). However, I suppose given ethics these days we would have to assume it isn't.

So the proposed coatcheck transaction results in the GLD share liability of the brokering division being backed by some gold asset held by the bullion banking division of the bank (note, the brokerage division's loss of the GLD share asset is offset by the removal of the bullion banking division's unallocated liability to the client who wanted and got the physical ex-ETF, so the banking group doe snot have any price exposure). While I consider it doubtful that within a banking group such netting would be allowed, I will concede that our creative bankers could just have the brokerage lend the GLD shares to the bullion division, with the GLD share loan collateralized by the bullion division's gold loan book or other asset, thus meeting any stock regulator requirements.

So the above is an open thought process where I'll now agree coat checking is possible.

VTC: Since serving as an extra reserve of the LBMA clearers was one of the main rationales for the creation of GLD, they are not going to change the way GLD operates.

This, however, I will dispute on two grounds. First, having being involved in discussions with the WGC and others in the early days of the creation of the ETFs, this was not the main rationale or driver of the project IMO. Second, as the marginal cost to a bullion bank to hold physical reserves is zero (vaulting is primarily a fixed cost business), there was/is no pressing need to create ETF's to save costs by parking metal in an ETF structure.

ETFs simply reflected a shift in strategy by the WGC towards investment demand and saw the ETFs as taking physical off the market. To the bullion banks they were just another way to earn brokerage and trading fees - we are talking 2002/2003 here when the ETFs were being developed, there was no belief in a gold bull market nor any chance of stress on the fractional reserve bullion banking system.


  1. there was/is no pressing need to create ETF's to save costs by parking metal in an ETF structure.

    If you hold a physical reserve, some of your capital is tied up deep down in your vault. If you sell the stuff to investors (in such a way that you can definitely buy it back later should you need it), your capital is free to be invested elsewhere.

    Isn't this what banking has always been about?

    Isn't this what you are doing at the Perth Mint, too? Sell your inventory to investors? Because this way, your business is way less capital intensive?

    If you do this (as a bullion bank), however, you need to make sure you can indeed buy the stuff back should you ever run out of reserves. And GLD is the ideal construction for this since no investor can take out any allocated gold. Allocation and deallocation are handled by HSBC only, and this is at the very core of the clearing system.


  2. yes Victor - but that (by which I mean: "Allocation and deallocation are handled by HSBC only") means that BBs can't use GLD as a coat check - only ONE firm can: HSBC...

    for the others, since redemptions are done via unallocated, there's no need to bother with GLD shenanigans...

  3. Wouldn't only one need to? Just as currency denominated banks work together when it comes to reserves and protecting against bank runs, I don't think it is far fetched to think bullion banks would work together for reserves to protect their industry

  4. Victor, I left a response to DP here http://fofoa.blogspot.com/2013/10/gold-as-forex-currency.html?showComment=1383793230528#c6038222924845246096 which I think addresses your questions.

    Sam - the problem here is that the run is on all the banks, so by helping your competitor you weaken yourself. In the case of fiat there is a CB who can print, so banks are more willing to support each other as they know the CB has their back. In gold there is no CB who can print physical, so in a gold bank run it is each bank for themselves.

  5. Bron,
    I am sorry for jumping in for it was Sam you replied to:
    ‘’ so by helping your competitor you weaken yourself..”
    If the coatcheck theory is right the bullion banks have little precious options but follow the design until some big entity calls the game off (e.g. GLD ETF tonnage falling below 600-400 tonnes range) and ensures the remaining physical goes to its most important buddies.

  6. Bron,

    Sam - the problem here is that the run is on all the banks, so by helping your competitor you weaken yourself.

    In case of a bank run on the BBs, it is the Bank of England who is going to tell them what to do. Just as in 1998/99. For this, it is perfectly enough if HSBC has the allocated.