The Mystery Of The Missing Australian Gold?

Has the Reserve Bank of Australia lost some of its gold reserves? Martin North of Digital Finance Analytics implies as such in The Mystery Of The Missing Australian Gold where he "discuss[es] the current state of Australia’s Gold holdings, and where 11 tonnes may have gone" with economist John Adams and then raises questions about the audit of Australia's gold in a follow up YouTube.

As is the case with most clickbait type headlines, the gold isn't missing nor is it a mystery, but that doesn't mean John hasn't raised valid questions. I will first address some misconceptions raised in the videos then discuss the audit.

At 15:50 John talks about the bars having a serial number and "emblem of the nation" and that the "Australian crest" will be stamped on the bar. This is not the case. The global standard for bullion traded in the professional gold market is detailed here and requires that bars are stamped with the brand of the refinery that made the bars, a serial number, purity and year of manufacture. Bars do not have any markings indicating who owns them and indeed anyone asking for physical allocation will usually receive a mix of bars from different refineries, as long as they are on the accredited list.

At 18:28 John discusses the interest income of $710,000 the RBA received on leasing out its gold and calculates an effective rate of 0.12%. This calculation is not correct as he is using the 30 June balance when the amount leased during the year may have changed. The RBA annual report does actually provide an accurate "weighted average effective lease rate" on page 177, which for 17/18 was 0.15%.

John and Martin then go on to discuss how this rate is non-commercial and compare it to the treasury 10 year rate. In the chart below I have graphed in blue the average rate reported by the RBA in its annual reports since 1998.

While 0.15% or even 0.40% may seem low to those outside of the bullion markets, they are reflective of gold lease rates in general, which are available here. The chart below is from that link and shows the derived (ie LIBOR - GOFO) gold lease rate for a lease of 6 months duration (note that the chart stops in 2015 as GOFO benchmarks ceased that year and full lease rate data is only available on paid subscription sites with some derived data being produced by Monetary Metals for free if you sign up).

Having said that, the 0.15% in my opinion is too low notwithstanding the RBA is lending on a collaterised basis or to entities with "government support". The red line on the previous chart shows that the RBA was pretty much lending out all of Australia's gold reserves prior to 2005 but sharply pulled out of the market as its longer term (1-5yr duration) leases matured (see this post for charts on the RBA's gold lease duration mix) into a market where lease rates were sub 0.40%. It clearly didn't think the risk/return tradeoff was right at the time and that was prescient considering the GFC hit in 2008. If the RBA is willing to increase its gold leases at 0.15% it must now consider everything has been fixed and financial risks are low!

At 21:50 John talks about what he calls the linchpin question, which is whether the RBA will accept repayment of the lease in non-physical form. If yes, then he believes this means that Australia's 11 tonnes of leased gold has been melted down and this I think is where he gets the idea the gold is "missing". I was intially puzzled at John's logic until I realised that he is probably being confused by the gold industry's use of the term "lease" and naturally would assume a common meaning, that is, that leased goods shoud be returned after use.

When one sees "lease" in terms of gold that really just means "loan" and as with money (assuming someone loaned a person physical cash) the borrower does not keep the physical money but uses it for whatever purpose they sought the loan. In the case of the gold market, central banks generally do get back physical when a gold lease matures, but it isn't the same bars they lent - just as a borrower doesn't (can't) return banknotes with the same serial numbers. As discussed in this post:

"In the case of lenders supplying actual physical bars (usually only be Central Banks) because it is understood that leased metal will be "used" (be that in a physical operation like a jeweller or mint, or for sale to create a short position), the contract cannot practically require the return of the same physical bars that were lent (ie the same bar numbers). If the lease contract was worded on a secured basis (most likely where the borrower is a jeweller or mint) the security would have to be against the general gold stocks of the borrower rather than the bars originally supplied as it is understood that the original bars are melted or sold."

On this point, I think John and a lot of people leaving comments about the RBA leasing gold are like the crowd in the Simpson's take on It's a Wonderful Life.



In John's second YouTube he gets stuck into the RBA's audit of Australia's gold reserves at the Bank of England, tipped off by the work and FOIs of Bullion Baron (see this and this post for the background). John makes a number of valid points, the primary one being that it is not a real audit if the RBA is not able to randomly sample from its bar list without direction/limitations by the Bank of England.

John's issue with the Bank of England limiting the scope of the sample is that it enables them, given the 6 weeks notice the RBA gives, for the Bank to get bars manufactured with the required serial numbers (which it would only have to do if the Bank has been leasing/selling the RBA's gold without its permission).

This scenario is actually close to impossible given how the global refinery accreditation and manufacturing process works. Refineries number bars sequentially, with some numbering since they started refining while others restarting numbering each year (which is why the standard quoted earlier requires year of manufacture on the bar). The entire industry relies upon (and continually audits) refineries to ensure the integrity of the "good delivery" system, as without it global gold trade would break down. Sequential numbering is also a key internal control within a refinery.

It is impossible for the Bank of England to call up more than one refinery (as given the way vaults operate and bars allocated, bar lists usually contain bars made by many refineries) and ask for bars to be fabricated with retrospective numbers. The number of people involved in each refiner from the lowest levels plus internal audit/control to perpetuate this level of fraud makes it unlikely to occur, let alone remain a secret.

Having said that, John misses the key control breakdown identified by Bullion Baron which is that the Bank of England has it own numbering system and it is an open question from the FOI documents whether the RBA was just given this number or the actual serial number on the bar, as the RBA refused to provide this information. If the former, then this mean the Bank could just find a bar of similar weight (difficult but not impossible given the Bank stores 416,000 400 ounce bars) and say this matches their internal number. It is only the actual serial number stamped on the bar, in conjunction with year and refinery, that uniquely identifies a bar.

While the RBA is one of the most transparent central banks in respect of reporting on its gold reserves, Bullion Baron's FOIs reveal that they dropped (still drop?) the ball in respect of managing Australia's gold reserves. A case of 1900s "Mother Country" deference-type attitudes or maybe just because Bank of England is seen as one of the "central bank club" and so you can trust your "mates" to do the right thing?

Issuers can make deliveries using eligible

Focusing on registered stocks versus open interest is a favourite of many bloggers because it produces dramatic “Comex is about to fail” figures. I have written many times that one also needs to consider eligible stocks as eligible inventory can be converted to registered relatively quickly. Blogger Kid Dynamite noted in passing in an email that December was a textbook example of eligible being used by issuers to make deliveries to stoppers. Not one to take the words of a cartel apologist at face value, I contacted data wrangler Nick Laird for detailed Comex warehouse movements and issuer/stopper figures, to check the facts for myself (and you).

Read more here.

A very silly thing to think about Comex

Last month I covered Comex warehouse stocks in response to “a lot of chatter about the potential or certainty of failed settlement and Comex default”, making a number of points:

• inventory can be converted from eligible to registered relatively quickly
• including eligible inventory give a very different picture of warehouse stocks and owners per ounce
• the actual percentage that stand for delivery is only 2-4%
• current registered stocks vs open interest is well within current delivery rates

For those who focused on the registered stocks only, recent Comex deliveries have caused some disbelief. The best example of this is this piece by Zero Hedge. They way they word some statements could be misconstrued by investors new to precious metal, so as an education service below are some quotes from the article and some clarifications. [read more]

Why asian gold contracts/exchanges haven't been able to crack the London market

The idea that gold would be released from its manipulated western shackles if only a physically settled Asian gold market could be established had its fullest expression in the 2011 Pan Asian Gold Exchange (PAGE) hype/meme. PAGE failed because of the political naivety of its exponents that "there can only be one" in the Chinese gold market, namely, the Shanghai Gold Exchange (SGE).

 

In 2014 there was a flurry of activity in Asia with the SGE International Board, Singapore Exchange's (SGX) gold kilobar contact and now, the CME's announcement of a loco Hong Kong kilobar gold future contract.

 

The future for CME's new contract doesn't look bright, with Reuters noting that the "25 kg contract on the Singapore Exchange and the three new international contracts on the Shanghai Gold Exchange have failed to garner significant trading volumes." As Silver Watchdog tweeted, SGE announced they would be exempting international members and customers from all fees for six months "with a view to encouraging international members and customers’ participation in trading and delivery activities on the International Board". Not exactly something you need to do if your contract is successful.

 

The CME's new contact seems pitched a little better than the SGX's, being in lots of one kilo (versus SGX's 25 kilos) and in USD per ounce (vs USD per gram). I would note that CME's Comex contract, while for 100oz, can be settled in three kilobars (although it is a 99.5% purity contact compared to 99.99%) and this similarity would be behind the CME's promoting of it "providing spreading and arbitrage opportunities with other world gold markets virtually 24 hours a day", which seems a pitch directly targeted towards traders, not physical users.

 

However, no matter how well the contract specifications are designed, I think CME's new contract will go the same way as SGE and SGX and the reason is hinted at in the blurbs for the two contacts:

• SGE: "there is an increasingly compelling need for a transparent and centralized Asian price discovery platform for the kilobar gold market"
• CME: "will offer a liquid and cost-effective price discovery tool and a precise risk management instrument that accurately reflects the underlying kilo gold market in Asia"

A compelling need for price discovery by whom? The problem is that these exchanges are only looking at one side of the market - the demand side. Certainly importers, distributors and manufacturers large enough to trade a kilo contract would want more transparency on kilobar premiums. But it takes two to tango and these new contracts have little appeal to the supply side (which is not miners, BTW).

 

The mistake of the exchanges I think is that they thought that if they created a contract which appealed to the demand side, which is composed of many firms, that the supply side, which is composed of refiners but primarily bullion banks, would follow. The problem is that the supply side is dominated by a handful of firms and the banks, who intermediate most of the supply to consumers, are quite happy with an opaque kilobar premium market. Why would the banks want to disintermediate themselves out of this position?

 

The only way to break this would be for an exchange to get all of the demand side to insist on only buying via the exchange. Given the large number of participants, this is next to impossible as the bullion banks would hold out until defectors looked to get a jump on their competitors. I would note here that many of the consumers are also looking for finance/delay settlement with their purchases, something the exchanges don't offer. Bullion banks advantage is they can provide both physical and finance in one deal.

 

If we ignore the asymmetry of the number and size of the suppliers versus the consumers, there is also the practical realities of the kilobar market where demand at the various locations changes frequently. After doing a deal with a consumer, bullion banks can ship the physical from a refinery direct to the consumer. The exchange contracts however require physical to be shipped to their warehouses for settlement, and from there we have another shipment leg to the end consumer. This is not as efficient as an over the counter (OTC) trade where metal can be directed quickly to where it is needed. It is funny that in the CME's new contract FAQs that they acknowledge this sort of market structure when they say that "with OTC clearing through CME ClearPort, you can continue to negotiate your own prices privately and conduct business off exchange" yet the contract they propose works against the current kilobar market structure.

 

The exchanges were given a hint of the problem by this comment made at the LBMA Singapore conference (I didn't catch the person making it) "whether a benchmark can compete or become established depends not just on its volume but also whether there a big enough premium/discount due to fundamental difference between the location and existing benchmark locations from a physical point of view". The brilliance of this comment is that the person making it knew that the loco difference between London and these Asian markets just isn't big enough to suck liquidity to the new venues - and knew that the exchanges didn't know.

 

The current OTC kilobar market is highly efficient with the spot price being traded basis the liquidity and depth of the London market and just the kilobar premium being negotiated separately on a client by client basis based on location/shipment cost, finance and purity (99.50% and 99.99%). Trying to compete against that while imposing a need to ship into a warehouse instead of directly to client, and require exchange settlement and clearing (with margin), while the client still has to deal with the bank anyway for finance, is a hard ask.

 

In the end China is probably best placed to win this game as they can force all of their consumers to trade through the SGE but as Adrian Ash at BullionVault noted "only a truly liberalized gold trade, with foreign cash and gold flowing in...and out...right alongside China's domestic flows will challenge London's 300-year old dominance." And that is still some way off.

Why WGC's India gold policy won't make much impact on import "problem"

For all the laudable recommendations (yes, Indians using their own gold to fund their own gold jewellery industry is OK) in the WGC & FICCI's Why India needs a gold policy, I think it fails to articulate a compelling case for the only thing that matters to the Indian Government - reducing gold imports (ie currency leaving the country).

 

Stating it simply, imports will only be reduced by the amount of gold tied up in manufacturing inventories, thereafter Indian's net accumulation urges will have to be satisfied by imports again. The failure of the report to identify the size of manufacturing inventories means the size of import substitution cannot be quantified, denying the report the sort of hard numbers that could attract policy makers' attention.

 

First some facts. The report mentions 22,000 tonnes of gold held in India. Yearly consumer demand is around 800t and WGC's global stock estimates put industrial/manufacturing inventories at around 10% of total gold stock. So that would work out to:

 

Physical Gold held by Indians - 22,000t
Physical Gold held by Manufacturers as work in progress - 2,400t
Yearly demand/addition to stock - 800t

 

Note that Indians are net accumulators of gold (the report notes they spend 8% of their income on jewellery and coins). This means any mobilisation of the 22,000t into bank gold savings schemes does not mean that those people will not buy more gold. All they are doing is changing the way they hold their existing gold savings; they will still want to add to their existing savings (in aggregate). Any mobilised/recycled gold is just sold back to others who don't want a bank gold savings scheme - the total amount of physical gold in the country stays the same, it is just that some are now holding bank gold savings schemes.

 

Lets say the WGC's proposals are so successful that they manage to mobilise 800t a year. So Indian banks don't have to import gold and can instead loan the mobilised gold to manufacturers who then transform it and sell it (their total holdings stay the same). This is how the gold "balance sheet" of India looks after this first year:

 

Indian Physical Gold asset - 22,000t
Indian Gold Savings Schemes asset  - 800t
Bank gold liabilities to Indians - 800t
Bank gold asset (loans) to Manufacturers -  800t
Manufacturer liability (borrowings) to Bank - 800t
Manufacturer Physical Gold asset - 2,400t

 

After three years of this we would have this situation:

 

Indian Physical Gold asset - 22,000t
Indian Gold Savings Schemes asset  - 2,400t
Bank gold liabilities to Indians - 2,400t
Bank gold asset (loans) to Manufacturers -  2,400t
Manufacturer liability (borrowings) to Bank - 2,400t
Manufacturer Physical Gold asset - 2,400t

 

Now what happens in year 4? The banks get another 800t from Indians but they can't loan it to manufacturers as the manufacturers have all the gold financing they need. The manufacturers would be happy to buy the gold from the banks but this would leave the bank with short gold position. If the bank sold the mobilised gold they would have to use the cash to buy replacement gold. As Indians are not net sellers (in aggregate) the banks' only option is to buy gold overseas, but in doing so they send currency out of the country, which is what the Government is trying to prevent.

 

So gold mobilisation is probably only good for a few years worth of gold import substitution and thereafter the Indian Government is back to its "problem". One could add another year or two if the Indian export jewellery industry expanded based on the other recommendations (WGC estimates exports could increase five-fold - but that doesn't translated to work in progress inventory increase of the same size as manufacturers would just increase their inventory turnover). But in the end mobilisation is a temporary solution. Maybe that explains the lack of hard numbers in the report.

 

It is not like the WGC and FICCI could not have worked out the amount of gold tied up in manufacturing - a November 2013 FICCI report in conjunction with AT Kearney (All that glitters is Gold: India Jewellery Review 2013) has a lot of very detailed numbers on the jewellery industry and so working inventory estimates obviously would not be difficult to obtain. My only conclusion is that it was a deliberate strategy of the WGC to avoid putting numbers to the real import substitution potential.

 

Given that many of the recommendations would make it easier to invest in gold both in jewellery and coin/bar, once the mobilisation import substitution ran its course the result would actually be increased Indian gold demand compared to doing nothing and leaving the industry in its current less than optimal state. Maybe I'm too cynical thinking that the WGC knows this and deliberately allows the report to imply to less savvy policy makers that it solves the "gold problem", in which case you certainly don't want to have any hard numbers focusing on real physical gold and currency flows.

 

In my opinion the report does spin the 5006 person (not much in a country that size) survey results quite hard. The survey seems heavily skewed to urban (only 2.44% employed in agriculture), but I don't know what the general population distribution is, and nor does the report indicate if their sample is representative of India in general. The report notes that "more than 49 per cent of respondents said they would be willing to deposit their gold to earn interest while a further 12 per cent said they might do so. Moreover, 72 per cent said they were happy to receive different gold from their initial deposit." OK, so (49 +12) x 72 = only 44% who would actually go with a mobilisation scheme that could recycle gold.

 

The report also noted that "more than a third of respondents would be willing to deposit 25-50 per cent of gold in their possession" (didn't indicate the other respondents % they would deposit). Once you get the 44% then apply a third then apply 25% it would look to me that we are talking about a much smaller amount of the 22,000t that would actually be mobilised, certainly less than the report implies (note that the report says that Turkey only "monetised around 300 tonnes of gold").

 

How much gold Indians would be willing to mobilise is questionable, especially considering the following from the November 2013 FICCI report: "Unlike other financial investment options, many retail transactions in gold can still be done in cash without any documentation. This provides an easy route for investing unaccounted (black) money."

 

Probably the best source of mobilised gold would be the temple trusts, which the earlier FICCI report says "it is estimated by various sources that about 1800-2000 tons of gold is present with the temple trusts in the country" That would probably fund the gold jewellery industry.

Chinese regulations: rule of law or rule by law?

Following on from yesterday's post on the Chinese leasing market, there was a small amount of back and forth on Twitter between Koos, DP and myself (see here). While nothing was resolved in respect of the double counting and fractional issues I raised, I mention the discussion because Koos made a few references to SGE rules and I sense that from his other writings he relies on these and other (interpreted) documents heavily. That is fine but given Chinese is a reader responsible language, I think one has to be careful not to read such documents in a Western black and white manner.

 

Until recently, I had no idea there was a difference between communication approach in Chinese and English that could result in misunderstandings. My first inkling of this was a comment to an October 2013 Koos post to Andrew Maguire (comments seem to have been lost in moving them all over to Bullion Star) which read in part (original link):

 

"In Chinese, the "delivery" word is translated into 交割(jiao ge). And this is what the "Delivery Volume" in the daily price table means. "Moving the physical out of registered depositories" should be translated into "出库“(chu ku). The number you have in the SGE weekly report is the number of "出库”. It is the SGE that causes the confusion. It refuses to use the generally accepted terms. Instead, it uses 交收(jiao shou) to mean 交割. And the SGE uses 交割 to mean 出库. Then the SGE uses the same English word "delivery" to translate both 交收 and 交割. That makes you confused."

 

At the time I passed this off as an interpretation technicality, but later I came across this article which said that:

 

English is a writer-responsible language. That means it is the responsibility of the writer to make sure the message is understood. Writing is clear, direct and unambiguous. Schools teach from early on the importance of structure, thesis statement and topic sentences when writing in English. A good writer assumes no or little background knowledge on the part of the reader.

 

Korean, Chinese, and Japanese are reader-responsible languages. That means the reader is responsible for deciphering the message, which is often not stated explicitly. For an American who is expecting direct and explicit information, this style can be very confusing.

 

These style differences can create cross cultural misunderstandings in emails, job applicant cover letters, and even technical writing.

 

This attracted my attention given our reliance (via Koos) on mostly formal Chinese documents and speeches etc on their gold market. It raises a number of issues:

• We cannot read Chinese documents in a Western black and white manner, and must be aware of context and what is being said between the lines.
• We are reliant on interpreters deciphering the message correctly, getting the context right.
• For technical gold market matters (see the comment above about delivery vs settlement), interpretation by non-gold market specialists may result in an incorrect translation.

So when it comes to SGE regulations or even official statements, this passage from a language blog is always uppermost in my mind:

 

Good speakers in the West see it as their responsibility for the audience to understand them. In contrast, Dave says that when he has heard a regulatory official in China give a less-than-captivating talk (i.e., reading from a script), Chinese colleagues have explained, “he’s important, we need to listen and understand what he says.”

 

In his daily work, Dave says that he often gets involved in discussions with colleagues from Europe and elsewhere about how to interpret Chinese regulations and how to deal with confusion about the law’s requirements. There is an issue with ambiguity in how Chinese regulations are written and this can make compliance difficult.

 

To further emphasise the point, see this from the same blog:

 

When fǎzhì 法治 is being used to designate the application of law as it is conceived of by the Chinese Communist Party, I would be very careful always to translate it as "rule by law".  When we are referring to the application of law as it is conceived of in the West, then I would be careful to translate it as "rule of law".

 

And even more blunt in a comment to that blog post:

 

The way my Chinese law professor explained it to me was the same way it's been explained above: 依法治国 (rule of law) indicates that the government creates laws that explain how things are going to work and then follows those laws; 以法治国 (rule by law) indicates that the government first makes an arbitrary decision about the outcome it desires and then finds/interprets/creates/ignores laws as expedient to achieve that interpretation — i.e. the law exists as a tool for the government to enact its will.

 

So that is why I'm not so convinced by statements by Chinese officials or formal Chinese rules - I don't discount them, but nor do I accept them as a black and white fact. Just another case of ambiguity.

 

In case you think I'm exaggerating, Perth Mint has experienced this first hand. I can't get specific, as it would give away which entity I'm talking about and Perth Mint runs under some pretty hard confidentiality rules (Section 74 of Gold Corporation Act 1987 is black and white rule of law that sends me to jail), but Perth Mint investigated and found that there was no rule against doing X in China but when we attempted X we were not able to do it.

 

On yesterday's post, Nutster noted the "black hat/white hat" narrative of the West vs China. If indeed China is a "white hat" and SGE rules mean what they say and everybody follows them properly and it is such a transparent market, isn't it a bit odd that SGE only reports gold withdrawals and doesn't report deposits into SGE warehouses nor warehouse stocks? I mean, this is less transparent than those black hats at Comex! Such reporting would help a lot in resolving Koos' debate with WGC on what is China's real demand. The fact that they don't tells us that China is as much into perception management (in this case how big the Chinese gold market is to help along their ambitions re pricing power as well as attracting foreign traders to their market) and use of ambiguity in regulations as the West is with their MOPE and lawyers.

 

Since we are on the topic of interpretation of language and rules, that leads perfectly on to accounting standards and double counting. In yesterday's post, "Out of the woodwork" asked the following question:

 

"Are commercial banks in China free to record a transaction on their balance sheet in a misleading way when it is recorded in an unambiguous, non-misleading way in their SGE account?"

 

Now I used to think as a lay person (pre university) that the words "accounting standards" mean, well, that there is a standard accountants follow and given they deal in hard numbers that what they do is all black and white. Those who have studied accounting, as I have unfortunately done, know that "accounting standards" just means standards for how to make a judgement call on which of X number of authorised ways you can treat a "number".

 

The result is that, yes, banks are free within bounds to record transactions differently, which can result in double counting, no matter what SGE rules says. In a lot of cases I'd guess this would happen due to accountant interpretation of what is "material". Case in point, see Scotiabank's annual report, a reasonable player in the bullion market. They explicitly report precious metal assets at $7,286m because it is material compared to their total cash and other deposits of $64,000m but when it comes to derivative financial instruments, they report foreign exchange and gold contracts as one line item and don't break it down.

 

Contrast this to JPMorgan's 344 page annual report. The word "gold" is not mentioned at all and the word "precious" is only mentioned twice in text commentary. Nowhere in their financial numbers is gold or precious metals reported. Heck, not even in their detailed "major product category and fair value hierarchy" assets and liabilities table do they show it. And this from a bank which is one of the biggest players in the bullion market. The reason? As big as it is in bullion, it is just not material on their $2.4 trillion balance sheet.

JPM's 18 tonne Comex fat finger

In Ed Steer's August 7th Gold & Silver Daily, he commented that:

"Ted pointed out something that I'd missed in Tuesday's column on Comex gold inventories---and that was the fact that the 595,102 troy ounces that the report showed withdrawn from JPMorgan on Friday was, with the exception of a few ounces, totally reversed in Monday's report from the Comex."

This big adjustment was also noted by "Pirocco" on the SilverStacker forum here. When questioned by Pirocco, Comex’s response was that "the adjustment column allows the depository or warehouse to make changes to their inventory in either of the categories for various circumstances as needed", which as Pirocco notes, just avoids answering the question because "various circumstances" says nothing.

Well I’ve worked out what one of those "various circumstances" is. If you subtract the 594,506.898 Monday adjustment from the Friday figure of 595,102.000 you get 595.102. That is not a coincidence. In other words, the Friday figure was a fat finger keying error, where someone at JPM keyed in "595 comma 102" instead of "595 point 102"! Hence JPM had to do an adjustment of 594,506.898 to turn 595,102.000 into the correct figure of 595.102.

I do wonder if the fat finger extended to the paperwork sent to the receiver of the erroneous 595,102 ounce withdrawal - perhaps a temporary bit of excitement that they were getting an unexpected 18+ tonnes?

What is surprising is that this sort of data transfer between warehouses and the CFTC isn't automated. Worryingly, this is not an isolated incident:

• CFTC charging JP Morgan $650k for repeatedly submitting "large trader reports that contained hundreds of errors"
• Screwtapefile's Warren finding discrepancies between the numbers in the GLD trade settlement spreadsheet and the GLD bar list
• Rand Refinery losing 87,000 ounces ($113 million) of gold
• Canadian Mint's 2009 $15 million gold inventory "discrepancy"

It makes you wonder if the whole gold industry is held together with spreadsheets. Be afraid, be very afraid.

No Indian gold import policy change explains RBI gold swap

After a lot of speculation about what changes the 2014 Indian budget would bring for gold import policies, we got zip. That now supports my speculation on why the Reserve Bank of India (RBI) announced, ahead of the budget, a combined quality and loco swap of its gold: it was a temporary political fix to the problem of:

1. Making promises to the gold industry during the election campaign that it would wind back gold import restrictions.
2. Reality, once in office, that such relief on gold imports would negatively affect India's current account deficit.

Standard political MO: "Oh, it is a lot worse than we thought, we can't honour our promises, it is the previous Government's fault". Interestingly, on the eve of the budget the Indian gold industry hadn't read the warning signs and thought there would be relief, with Bachhraj Bamalwa, of All India Gems and Jewellery Trade Federation, speculating that the duty would be cut to 6% and even that "the government might remove the 80:20 rule in a gradual, 'phased' manner". This view was probably helped along by statements from the Government like "any action on gold should take into account the interests of the public and traders, not just economics and policy". Well it is clear they sided with economics and policy.

There were some warning signs, with this Reuters article quoting commentators noting that the Government was "moving back and dithering on their decisions, and in a sense playing politics". Another sign was this Report that "India risks losing its investment-grade sovereign rating if it fails to get its finances into shape" with S&P warning "there was a one-third chance of a downgrade [of India] to "junk" without a big improvement in the fiscal deficit and in implementing reforms."

For me, the strongest sign the new Indian government was going to back away from its promises was the RBI gold swap announcement and the local gold industry should have paid more attention to it, because its timing was very unusual: just before the election about gold which had been sitting in RBI's vaults in India for decades. Why was this non-standard gold suddenly an issue?

I think it is a reasonable speculation that the RBI knew in advance that the new Government could not open up the import restrictions and have a flood of gold imports affecting the current account deficit and the country's rating. This gold swap was then a planned action to placate the industry by releasing supply into the local market in a way that would not affect the current account deficit.

The RBI is aware of the local gold supply issues, have loosened the 80:20 rule a little in March by allowing some banks without three years worth of exports to import gold, but only on the basis that they had current customers to export gold to (see this Reuters article).

Sidebar: the clear message from the Indian session at the recent Singapore Gold Forum was that it was the 80:20 rule that halted gold imports and not the duty hikes. On that basis I was expecting some duty cut as that would have made it look like the Government had done something while not making any difference to how much gold could be imported.

So how does this gold swap work and not impact the current account deficit? Firstly, a swap involves two legs, as explained here, in this case being:

1. Sell non-LBMA standard gold loco India
2. Buy LBMA standard gold loco UK

No doubt the RBI had some interest in upgrading its non-standard gold (as it makes it easier in the future to mobilise it in a financial crisis, like it did in 1991) but it could have just sent it to a local refinery. However, this would not have had any impact on local supplies as the gold would have just went straight back into the RBI's vault.

The key is that the swap results in a net supply of gold into the local Indian market, but the replacement gold is supplied from London (or Switzerland, as we will see shortly). The net supply in India will result in a reduction of the local premium (which the public will welcome) but more importantly, it will give the local gold industry material to work with (of which they are starved) and this should increase employment. The reason this swap will not affect the current account deficit is because the cash legs of a swap are netted, so the RBI will only be paying a few dollars per ounce out of its offshore USD reserves.

Regarding the swap, I had a debate with twitter based precious metals analyst Silver Watchdog who thinks the RBI swap would also involve leasing. I see this as unnecessarily complex, which his diagram indicates. The leasing angle only makes sense if you believe that there is a shortage of gold in London (as the second leg of the swap pulls physical out of the London market), so only if the RBI subsequently leases their newly acquired London gold will this take pressure off the London market. Apart from there being no indication that the RBI was intending to do this, Perth Mint does not see any such shortages in London at this time.

I would note here that while bullion banks will probably quote on this swap, the advantage is with the refiners given the quality upgrade required. The one in the box seat is the local Indian refinery PAMP-MMTC who, through PAMP's parent MKS, is capable without bullion bank help to do "options, hedging and EFP’s; location, purity and quality swaps; forward leasing arrangements". PAMP would have no problem refining the gold locally and supplying 400oz bars into London out of its Switzerland operations.

While India has 557 tonnes of gold reserves, there is no indication of how much non-standard gold they hold or are looking to swap. This Reuters article notes that the RBI "would decide further in regard to quantity, swap-ratio [i.e. swap fee], timing etc. of the gold to be swapped". The reference to "timing" implies that the RBI is looking to supply their gold over a period of time, which would make sense if you want to alleviate local gold industry supply problems and help them out for as long as possible.

Whatever amount is involved it will only last for a limited time, in the order of months, not years, given India's appetite for gold. So this is just a short term fix to a political problem and ultimately shortages will resume due to the 80:20 rule.

Of course, it is entirely possible that the RBI's swap is solely about upgrading its gold reserves and the timing is purely coincidental. That would clearly be the case if the replacement gold was going back into the RBI's vaults in India, rather than with the Bank of England as reported by Reuters. However, as we are dealing with central banks, where transparency even on simple matters is rare to come by, we just don't know what the real motivation is and thus have to resort to speculation. I hope you got some value, in terms of how the industry works, out of my speculations even if they turn out to be wrong.

Allocated Gold at Bank of England declines 755 tonnes

The Bank of England's just released 2014 Annual Report discloses that it was holding 5,485 tonnes of gold as a custodian, down 755 tonnes to around the level it was in 2011 and 2012. Below is a chart of the data against the average gold price over the Bank's financial year ending February, which shows that the amount of gold has basically followed the gold price, very much like the behaviour of the gold ETFs.

The table below details the figures and calculations back to 2005, when the Bank first started reporting its custodial activities.

As at Date	Allocated Gold (GBP billions)	London PM Fix (GBP)	Allocated Gold (tonnes)	Year on Year Change (tonnes)
28/02/2005	29	226.514	3,982
28/02/2006	36	318.078	3,520	-462
28/02/2007	43	338.964	3,946	+425
28/02/2008	72	488.854	4,581	+635
28/02/2009	102	669.809	4,737	+155
28/02/2010	125	746.149	5,211	+474
28/02/2011	156	868.682	5,586	+375
28/02/2012	197	1110.484	5,518	-68
28/02/2013	210	1046.719	6,240	+722
28/02/2014	140	793.931	5,485	-755

In this June 2014 Quarterly Bulletin, the Bank reports on page 134 that 72 central banks hold gold with them (which is 65% of the 113 central banks that the World Gold Council records as having gold reserves). It also noted that the "Bank also acts as a bank to certain other financial institutions. One example is central counterparties". Included in that the latter group would be the six London bullion market clearing banks. As it is unlikely that the Bank runs allocated gold accounts for banks that are not central to the gold market, it would be fair to conclude that the majority of the allocated gold it holds is for central banks.


Given there was nowhere near 755 tonnes of central bank selling in the year ending February 2014 it would therefore be fair to conclude that this gold outflow was from the allocated accounts that bullion banks had with the Bank of England. This is not surprising considering that the major gold ETFs lost in excess of 600 tonnes over that same period.


Just one final observation from World Gold Council central bank holdings data: it wasn't until the year ending Q1 2010 that central banks were net buyers. Prior to that they were net sellers (1,011t for 4 years to March 2009), yet the table above shows customers of the Bank of England adding to their holdings (753t for 4 years to February 2009). Now if we remove central banks that most likely don't store with the Bank, this 1,011t net sell figure may change, but I doubt enough to turn it around to anywhere near 753t of net buying. Tentative conclusion is that bullion banks were accumulating a lot of allocated gold with the Bank of England.


Combining the above figures with detailed LBMA turnover figures, UK gold import/exports, London ETF flows, and central bank activity is more work than I have time for at the moment, but it certainly would give us a better picture of the London gold market.

Fixing the Fixed Fix - Barclays Case

The gold blogosphere is generally not known for its nuance - its a you're with us or against us black and white world. I suppose this is a result of the need for click baiting headlines to drive traffic to your site and I'm sure ambiguity doesn't survive the brutal A/B testing Darwinian selection process that is modern social media (and something I'll probably find out for myself when the Perth Mint gets some proper website software in a year's time and I select myself out of job if I persist with my current ways, such as not getting to the point quickly in the first filled-with-SEO-friendly-words paragraph).

So it is with the two silver Fix stories, being its closure and Barclay's manipulation of. The main example of nuancelessness was confusing manipulation with suppression and thus seeing Barclay's actions as proof of the latter. There is a big difference between the two, as I discussed here:

"I believe in manipulation but not suppression. One is short term, the other long term. Many of the manipulation and suppression theories are simplistic comic book stuff."

The fact that the manipulation in this case was downward fed the confirmation bias. It will be interesting to see the response if the next case (I would not be surprised to see another) has a bullion bank trader manipulating upwards, which, if you don't look at charts with one eye, you would have to say is equally probable given the evidence.

Anyway, below I quote from the Final Notice for Barclays and Daniel James Plunkett which can be found here and make comments after each bit I find interesting. The one good thing about this case is it gives us an insight into the fix which we have never seen before.

"Gold Fixing Members are required to declare their interest in increments of five bars, but there is no such requirement in relation to their underlying customers, i.e. their underlying customers can place their orders for any amount, not only in increments of five. ... At any time a Gold Fixing Member, or their underlying customers, may increase, decrease or withdraw a previously-declared selling or buying order or place a completely new order."

This is one aspect of the fix that very few understand - that the customers (big ones dealing direct with a bullion bank) can also change their orders during the fix. Even someone like Matt Levine in this article falls into the trap of seeing the fix as "five banks, getting on the phone, talking about what the price will be, and adjusting their trading based on that information".

Now I'm not saying that the current fix process is perfect (as the buy/sell balance I believe is not communicated and a bank can change its position in response to customer changes) but the fact that a bank's customers can change their orders as the fixing price changes means that manipulating the fix is uncertain as you don't know beforehand what customers will do, making it a risky proposition (even if you can collude beforehand with traders from other banks). Whatever the fix's problems, it is not some market where the banks just set the price amongst themselves, as Matt and others portray.

"On 28 June 2011, Barclays entered into the Digital with Customer A ... The Digital had a notional amount of approximately USD43m ... customer A paid a premium of 8.18% of the notional value, USD4.4m, to Barclays ... if the price fixed in the 28 June 2012 Gold Fixing at 3:00 pm exceeded USD1,558.96 (the Barrier), a payment of 9% of the notional amount, or approximately USD3.9m, would accrue to Customer A"

Based on PM fix of $1499 on 20/6/11, that puts the notional as around 29,000oz, or nearly a tonne of gold. This is no small customer. What I find interesting is that a client of this size could have "listened in" to the fix on the 28/6/12 and put its own orders in to influence the price. Of course it would have to have done that with another bullion bank, not Barclays.

Given the money on the table, the customer could have justified losing money on a large fix trade, just as Plunkett did (which was only USD 114,000). It certainly would have been an interesting fix, with the customer countering each of Plunkett's orders. Given that Plunkett would not earn all the $3.9m ("Mr Plunkett’s book thereby profited by USD1.75m (excluding hedging") it could be argued that the customer would have won out as it would be prepared to lose more than the $1.75m that Plunkett would have earned (assuming Plunkett would not have included his share of the initial $4.4m).

It may not necessarily have been naivety on the part of the customer to not protect its interests and maybe more to do with the fact it was already down $4.4m and didn't want to reduce its profit on the first option date given the gold market had peaked and it was unlikely to make a profit on the second date.

The above does raise the question I tweeted, namely: "Would it have been OK for client on other side of Barclay's digital gold option to manipulate gold price up by buying on the Fix?"

People's views on this matter differ, as I noted in this blog post:

"Manipulation is a continuum with differing views on what constitutes unlawful or unethical behaviour. Traders I’ve spoken to see most of it as just part of the “game”, like a boxing match to see who is stronger. I tend more towards the ethical end but not naive to think that you can walk in and put all your (price) cards on the table and not get screwed."

What I find interesting about this case is the assumption that their was a principal-agent relationship. It is not like the customer was asking Barclays to broker an order on Comex - a digital option is a pure OTC product and thus clearly for me if I was the customer I would know the bank was taking the other side, and thus we has a principal to principal relationship. That view is what is behind the comments from traders in this FT article quoted at GATA.

"There's a fundamental belief that both parties can aggress or defend their book, and I would have expected my traders to do so."
"If you have Goldman Sachs on one side and JPMorgan on the other, the gloves are off"

For example, when you go to a car dealer, you know they are lying to you about how desperate they are to sell the car and what their lowest price is, just as you are lying about how desperate you are to buy it and your maximum price. If you subsequently found out that the dealer would have sold it for $1000 less, you wouldn't have any cause of action against them. Indeed, you know that the dealer made a profit on the deal. They are not acting as a broker, selling to you at their cost plus and agreed upfront fee.

Now clearly the FCA investigation found that there was a principal-agent relationship but it seems somewhat naïve of the customer to just hope that the bank would say that "pushing around a benchmark is 'not quite cricket'" (as Mr Klapwijk was quoted) when the other side of trade is not a market professional, ignore the fact that practically it was a principal-principal arrangement, and not look to protect themselves from the conflict of interest. Then again, they did in the end protect themselves and were aware of the conflict of interest in querying the trade with Barclays, so maybe that was the most ethical way to address it.

"If the price fixed during the 20 June 2013 Gold Fixing exceeded USD1633.91, a payment of 18% of the notional amount would accrue to Customer A, less any accrued percentage payment related to the 28 June 2012 Gold Fixing."

I note that the PM fixed at $1292.50 on 20/6/13, so the customer net lost $500,000 on this trade.

"the proposed price quickly dropped to USD1,556.00, following a drop in the price of August COMEX Gold Futures (which was caused by significant selling in the August COMEX Gold Futures market, independent of Barclays and Mr Plunkett"

As Nanex ask, "How does the FCA know the drop at 10:00:23 was unrelated to Barclays or Mr. Plunkett? Do they have access to COMEX audit trail data? If so, why was there no mention of cooperation with the exchange or the CFTC?"

That early Comex move doesn't look like a coincidence. I don't read "independent of" as implying that the FCA actually investigated Comex trading, just that the price move occurred before Plunkett's actions. If you look at it from FCA's point of view, they already have a closed case, with Barclays having voluntarily done an internal investigation and bringing it to FCA's attention. Once they had their man on the illegal trading done 6 minutes later, what's the point of spending more time and money looking into trading on an exchange in another country before that?

I would also note here this quote from a Bloomberg article: "While commodity derivatives are regulated by the FCA, the London gold fixing isn’t. As a result, the trader’s actions fell outside the regulator’s criminal jurisdiction" so the FCA doesn't even have oversight over OTC gold trading, let alone US exchanges, and they only got him on "breaching the regulator’s principles of integrity".

What I think is interesting is that the CFTC should be looking into the 10:00:23 Comex trading, which we don't hear anything about. Seems like a good chance it will payout (in fines) for CFTC, certainly more of a sure thing than some other investigations they could spend their limited time on. Maybe it is because Plunkett contacted the Fed's go-to gold man who all the bullion bank traders have on speed dial to front their manipulative trades (sarcasm). Seriously, the CFTC should be looking into trading at this time.

While we are on Nanex, I would note that the timing of this case shows that Comex trading influenced the Fix, not the other way around as it is often presented, and as it was misinterpreted in this case. This is not surprising as an LBMA Alchemist article showed that price influence worked both ways between London and New York, shifting over time.

Indeed, the other observation is that Plunkett's subsequent Fix actions 6 minutes does not seem to have had much impact on Comex, which is not surprising considering how small it was relative to Comex volumes in this case.

Nanex also asked a few questions in their article, which I will have a stab at answering:

1. "Do poker players show everyone their hand at the beginning of a round?" Did Nanex actually read the FCA document, Plunkett was emailing internally, he wasn't showing his hand.
2. "Is Mr. Plunkett really that lucky?" Not sure why Nanex asks this, the whole case proves he wasn't and manipulated it down.
3. "Mr. Plunkett made no attempt to manipulate prices during the crucial first 6 minutes" He waited because he had the luxury of doing so as he could see how the fix was progressing. They normally take a couple of minutes, so 23 seconds in he had plenty of time to step in, but why do so and risk losing (as he did) on your fix trade if you don't have to and the market moves your way?
4/5/6. "How does the FCA know the drop at 10:00:23 was unrelated to Barclays or Mr. Plunkett?" Agreed, CFTC needs to look further into this.

"placed a large sell order of between 40,000 oz. (100 bars) and 60,000 oz. (150 bars) ... which led to Barclays declaring itself to be a seller of 52,000 oz. (130 bars)."

Not sure why it says "between", I mean don't they know exactly? Anyway, I love all this detailed stuff, which while only showing one day and not representative of all Fix trading, is interesting for me as to what it says about the volume of trading done on the Fix.

The key is the statement that after Plunkett's first order, the Fix was at "155 bars buying/345 bars selling", which is 2 tonnes buying, 4.3 tonnes selling. That selling is only $200m or so, which doesn't seem like a lot.

Subsequent Fix positions were "155 bars buying/215 bars selling" and finally "155 buying/145 selling". That is only two tonnes or $100m worth of trades. Not a lot and thus easy for a bullion bank or hedge fund to influence, which is probably why Plunkett was successful.

"before the price was fixed, there were a number of further changes in the levels of buying and selling in the 28 June 2012 Gold Fixing, which coincided with an increase in the price of August COMEX Gold Futures."

This bit is important because there are those that don't know the Fix is constantly being arbitraged to OTC and other market exchanges (which is obvious to any professional) like academics Caminschi and Heaney who "found" that "information from the fixing is leaking into markets prior the fixing results being published, and there exist economic returns for trading on these information leaks". Wow, you don't say, and given that customers can also adjust their fix orders during the process, they too can get economic returns, but if any serious player can do it, is it really an unfair leakage (as their work was presented in the blogosphere)? Caminschi and Heaney - you are just observing arbitrage here.

"After the weekend, on the morning of Monday 2 July 2012, Mr Plunkett sought out his line manager and informed him that he had traded during the 28 June 2012 Gold Fixing. He also subsequently reported his trading to Barclays’ Compliance. During Barclays’ internal investigation, Mr Plunkett provided an account of his trading during the Gold Fixing that was untruthful, in that he did not disclose the true rationale for his trading, or the reasons why he failed to disclose his trading to the Sales Desk on 28 June 2012. In giving this account, Mr Plunkett intended to give the impression that he placed orders in the 28 June 2012 Gold Fixing for reasons other than to increase the likelihood that the price of gold would fix below the Barrier."

So it wasn't a case of the FCA uncovering the illegal behaviour, it was only because the client complained, that set off a chain of events. It does make you wonder how many other derivatives that were close to the Fix which did not pay out will have customers reviewing and complaining. I do find it surprising that Plunkett, after realising that his trading on the Fix would be found out, then persisted it lying about why, given that surely Barclay's investigators would look at his whole book and find the digital option.

Next post I'll have a look at the closure of the silver Fix, and all whether that will fix the fixed Fix.

Why no direct relationship between price and stocks

A great article by Keith Weiner explaining why open interest in gold has fallen but in silver it has increased - hint: to do with profit from carrying gold. Apart from that, it is also useful for those who falsely think that if the price goes up (or down) then open interest should increase (or fall), and also that ETF holdings should increase (or decrease).

It does puzzle me why people think there should be a direct relationship between open interest or ETF stocks and price, given that they don't have any problem understanding that the price of a company's shares can go up and down while the number of shares on issues doesn't change.

For a company ownership of shares is just transfered between buyer and seller and that doesn't drive price. Price is a function of there being more buying pressure resulting in buyers not being willing to sit around waiting for people to accept their bids and instead accepting seller's offers (and vice versa).

The same can happen with precious metal ETFs. ETFs shares are only created or redeemed if the person on the other side of the trade is someone with no interest in the ETF (ie a market maker). Where existing holders sell to new buyers no new shares need to be created, yet the price can still go up if the buyers are willing to accept the seller's offers (and the non-market maker sellers are adjusting their offers to match gold prices on Comex or the spot market.

Also, check out Warren's latest bullion bars project post, where he notes that 70% of bars added to GLD during 2013 where previously in the GLD list, demonstrating that "there is a really large stock of gold in London and that it doesn't necessarily all vanish instantly to China". He also predicts the return of specific bar numbers by July 30th - now that's a real forecast, no vague hedged cop out wording.

GLD vault defragmentation

Warren has a cool animation showing the addition and redemption of pallets of gold bars out of GLD's vault, done in the style of the old PC disk defrag programs, at the screwtapefiles blog.

A few comments on the 5 minute animation (see screenshot below):

• During the redemptions in 2013, most of the bars are taken from the bottom, that is, the recently added stuff. Makes sense, this stuff is easier to access.
• But note much of the redemptions are from all over the place. Some of that is explained by them "hunting" for 9999 bars as Warren discussed in emails. He will have a follow up post taking this animation analysis into more detail showing this.
• In the pic below the area just above the empty bottom area is really stubborn, something about those bars they don't redeem from, even though they are more recently added than the bars in the first half of the pic above that section.

Snapshot of GLD defrag youtube:

Central Bank gold reserves transparency

For a physical asset held on behalf of a country's citizens primarily for use in extremis, central bank reporting on gold holdings is woeful. It is impossible for a country's citizens to determine if their central bank is appropriately managing their (as in citizen's) gold such that it can perform its "last resort" function, if necessary, without knowing:

a) the amount of physical gold held under its control and ownership versus how much has been leased (physically, not book)

b) the amount of physical gold held domestically versus offshore

I would argue that gold has a higher standard of disclosure compared to a central bank's fiat activities because if lost, say by the bankruptcy of a lease counterparty, physical gold cannot be printed out of thin air.

Now you may argue that I am being unrealistic, pointing to GATA's freedom of information lawsuit against the US Federal Reserve, or the IMF's 1999 weakening of central bank gold reporting requirements, as examples of central bank opacity. I agree that it is a difficult ask, but in both these cases either the detail sought, or the reporting frequency, opens up lines of arguments that can be used to muddy the waters and give plausible grounds for refusal.

I would argue that one does not deal with bureaucrats as one would in a commercial negotiation, where you go in with your highest (or lowest, if buying) offer, as that just opens up many points for refusal. It is better to go in with your strongest argued case, which will often not be exactly what you want, because it give much less wriggle room, and thus the best chance of success. Secondly, bureaucrats can have an arse covering herd mentality, so appeals to precedent are always useful as no bureaucrat wants to strike out on their own lest they get it wrong.

Given the above, I would propose that the best way to approach central bank gold reporting is to simply argue that central banks follow the accounting standards, that normal commercial organisations do to, when producing their annual reports.

Simple and reasonable. It is also difficult to argue against as central banks, via their oversight and regulation of the financial system, impose those accounting standards on others. It is also hard to argue against it on the basis that it would be market sensitive, as it is only being disclosed once a year and many months after the balance date of the annual report. As a result, one could interpret a refusal to do so as hypocrisy and an indication of something to hide.

You may wonder if this will achieve anything with respect to physical versus leased gold. By way of example, I offer the Reserve Bank of Australia (RBA), which also provides you with a precedent. The RBA has, at least since 1998, been reporting physical gold, gold leases, the duration and risk profile of those leases, and average lease rates, all to accord with Australian Accounting Standards.

For example, an analysis of the RBA annual reports allows us to produce the chart below, which shows how much of Australia's meagre 80 tonnes was held as physical and how much was leased out for which terms.

It is clear that the RBA started winding back its leasing after 2004, due I would argue, to the fact that lease rates by that stage had moved below 1% (and subsequently continued to fall), providing a poor risk/return tradeoff. We can also produce a breakdown of the credit rating of who the gold was leased to.

So we can tell from the above that the RBA is now only leasing 1 tonne of gold for a duration of between 3-12 months to an AAA rated counterparty. Such information, if provided by all central banks, would provide their citizens with the ability to assess how prudently their gold was being managed. It would also provide valuable information to the gold market in general.

So if it is good enough for the Reserve Bank of Australia to report this level of detail with respect of its gold reserves, I think it is fair to say it should be good enough for other central banks.

Technical Note: In point a) I referred to "leased (physically, not book)". The reason is that there is a difference, in terms of whether gold is at risk of counterparty failure, whether a lease involved actual physical shipment to the borrower, or whether it was just leased by way of a book entry with the physical gold remaining in the possession of the central bank.

 

Thus when looking at gold reserves in terms of its last resort use, if gold is leased by book entry then it is arguable that there is no risk as, in case of a war for example, a central bank can just extinguish the paper claim by the counterparty and retain the gold.

 

The extent to which central banks have lent gold physically or only via book entry to bullion banks and the different implications of those two methods for the stability of the fractional reserve bullion banking system and its run-proofness is another topic altogether, and one I can cover in another post if anyone is interested (stupid question, of course you do).

The story behind JPM's 10 tonne gold withdrawals

What is JPM up to? A detailed look at the movements in an out of their eligible stock indicates they, or a client, is stockpiling/parking kilobars in a Comex warehouse for later withdrawal, possibly to do with Chinese new year.

Back in October, TF Metals Report noticed some "round number" Comex movements in multiple of exactly one tonne. At the time I noted that 3 kilo bars are acceptable for delivery against a Comex contract and speculated that:

"if we see 99.5 bars going into COMEX then it may be an indicator that Asian demand has eased. Maybe JPM had commitments with refiners to buy their output for a period of time, and if Asian demand had eased then they may have just asked their refineries to make 99.5 (for all we know maybe those deliveries were 99.99 kilo bars) and they are just parking them in their COMEX warehouse, waiting for Asian demand to return ... if there are movements of round ounce tonne lots, indicative of kilo bars, out of the warehouses then it may be an advance bullish signal of Asian demand returning."

Given these two large recent withdrawals, I decided to have a look at all tonne type movements in and out of JPMs eligible stock over the past two years. The first list shows the recent movements, which started in October with eight receipts totalling 20 tonnes. Coincidence that exactly 20 tonnes is then withdrawn a few days before Chinese new year on the 31st? I don't think so.

18 Oct 13 Received 6 tonnes
21 Oct 13 Received 3 tonnes
23 Oct 13 Received 1 tonne
11 Dec 13 Received 2 tonnes
12 Dec 13 Received 2 tonnes
13 Dec 13 Received 2 tonnes
16 Dec 13 Received 2 tonnes
17 Dec 13 Received 2 tonnes
24 Jan 14 Withdrawn 10 tonnes
28 Jan 14 Withdrawn 10 tonnes

The other explanation to my initial one is that JPM contracted to sell 20 tonnes to an Asian client way back in October, hedged that on Comex and then accumulated kilobars over the next 4 months from refineries. That is, the 20 tonnes that was being accumulated was already spoken for. Either way, the two 10 tonnes withdrawals do not look like they were unplanned or unexpected by JPM.

This isn't the first time JPM has done this. Consider this sequence of movements towards the end of 2012 - accumulating 18 tonnes, then 17 tonnes withdrawn:

27 Aug 12 Received 6 tonnes
19 Sep 12 Received 6 tonnes
09 Oct 12 Received 6 tonnes
13 Dec 12 Withdrawn 10 tonnes
18 Dec 12 Withdrawn 2 tonnes
26 Feb 13 Withdrawn 5 tonnes

Chinese new year in 2013 was 10 February, so the pattern is not as strong as 2013, but I would note that the 12 tonnes accumulated in September and October exactly equal the 12 tonnes taken out in December.

Here are some other tonne lot movements back to the beginning of 2012, which is as far back as I went in this quick analysis and that don't seem to be related, just for completeness.

06 Feb 12 Withdrawn 5 tonnes
09 Apr 12 Withdrawn 5 tonnes
12 Apr 12 Withdrawn 5 tonnes
20 Apr 12 Withdrawn 3 tonnes
29 Jun 12 Received 1 tonnes
02 Jul 12 Received 2 tonnes
07 Aug 12 Received 5 tonnes

It is clear from the above that tonne lot movements in Comex warehouses are certainly not unique - a quarter of all JPM eligible movements are in tonne lots over the past couple of years. Seems they use Comex for holding kilobar inventory on a semi-regular basis.

Gaming the London Fix ... Seat Price

While goldbugs are focused on whether the London Fix is gamed, the industry is watching an equally interesting and delicate game around Deutsche Bank's London Fix Seat.

If you thought that the gold market was opaque, well a seat on the London Fix would have to be a totally dark market. This creates a problem for both buyer and seller as:

1. there are no public prices for a seat
2. neither seller or buyer want to be seen as too desperate by approaching the other party directly
3. the buyer doesn't know how profitable a seat could be, as Fix volumes are not published

Given the above, it is not unreasonable to expect the seller and potential buyers to play some of their signalling/negotiating game via the media. However, to be fair the "sources" mentioned in various media reports could also be legitimate bystanders just speculating, we just don't know. Either way, no need for that to spoil the fun of looking at the various comments made in the media (here and here and here) over the past few days to see how the London Fix Seat price game is playing out.

In favour of the seller

• the last time a seat was sold in 2004, it cost around 1 million pounds ($1.6 million) [anchoring high]
• Gold traders say the benchmark still has value, helping them to hedge risk [you make money being a fix member]
• a seat at the table is prestigious; to say that they're a fixing member carries a certain kudos [the seat carries a premium above the profit made as a market maker]
• there could be quite a few contenders; Deutsche said it had already begun talks with other banks to sell its role [lots of buyers]
• a logical possibility would be for another of the London Bullion Market Association's market-making members ... not currently involved in fixing - Credit Suisse, Goldman Sachs, JPMorgan, Merrill Lynch, Mitsui Precious Metals and UBS [lots of serious buyers]
• a candidate is more likely to emerge among the Asian banks ... as these look to raise their profile in the London market ... Bank of China and Industrial and Commercial Bank of China (ICBC) are already members of the LBMA. ICBC is also about to complete the acquisition of the London commodity arm of Standard Bank [even more buyers]
• bidders ... may also include other parties with an interest in the gold market such as refiners [a lot more buyers than you think, better rush]
• The bank said it would ... resign its seat if it fails to do so [but if I can't find a buyer I'll walk away, I'm not desperate]

In favour of the buyer

• Market participants said the role as a rate setter would be worth around £200,000 and had more value as a mark of status [anchoring low]
• it's a tough sale at the moment, there's nothing really in it for the banks [there's not that much money in market making]
• who, after the Libor scandal, will want it; increased scrutiny, with regulators pushing for new rules on commodity benchmarks after the Libor scandal, threatens to outweigh that benefit; if regulators are going to say 'well the fix doesn't work as it is, and we have to find another way of doing it', nobody is going to want to buy that seat [lots of regulatory risk]
• it is a very old-style, archaic system and it is amazing that such a way of doing business has survived the modern day and age [Fix is old school and will probably fade away so not worth that much in the future]
• any interested party ... would have to weigh the price carefully against shareholder value [I'm not desperate, won't overpay]

So we have a £200,000 to £1,000,000 price range with good points made on both sides. I think there is a good chance a Chinese bank will buy a seat for the prestige as it gives them the ability to differentiate themselves from their domestic competitors - Deutsche can be expect to work the status benefits point hard to new players in the bullion market or those looking to step up.

On the negative side, Deutsche Bank's biggest problem is the risk that regulators turn the fix from, as Paul Tustain says, a place where "financial trading principals [win] what traders call 'order-flow' from customers, principals (who sell gold to you)" where you can make money working your book, into a place where the holder of a Fix Seat is just an "agents (who buy gold for you)" and who can only earn the $0.20 per ounce Fix fee spread.

Wealthy Chinese short sellers a source of future demand?

Koos Jansen latest piece on gold leasing and short selling within China is a must read. There seems to be two basic "gold trades" used by wealthy Chinese:

Finance business by Lease and Hedge

1. Lease gold from bank

2. Sell gold on SGE

3. Post 15% of cash from #2 as margin against long gold futures

4. Use remaining cash from #2 to fund your business

5. At end of lease, take delivery of futures and use physical to repay lease

The article says that the effective interest rate on the amount of cash left over from #4 works out at 6.7% compared to around 9% for a conventional loan.

Finance business by Lease and Short Sell

1. Lease gold from bank

2. Sell gold on SGE

3. Use cash to fund your business or other investment

4. At end of lease, buy back gold (which has hopefully fallen) and repay lease

Needless to say, the second method is highly risky and is more a combination of financing your business plus a speculative bet on gold prices. Here are some interesting quotes that give a different insight into the thinking of some wealthy Chinese that is at odds with the common view (narrative) about how Chinese view gold (which is that they are buy and hold investors):

• "these business owners, in the background of gold’s 28% pullback in 2013, remain bearish on gold ... hope to buy back the same amount of gold to repay and get the spread when gold falls further to their targets in 2014"
• "A business owner signed a 3-month gold lease agreement at the end of last year and sold the gold at $1300/oz. He said he would buy back and return the gold when gold fell to $1150/oz in Q1 2014 and pocket the $150/oz difference."
• "some rich people even use the funds through gold lease to invest in high yield real estate trust products to achieve “getting something from nothing”. The spread between the yield on trust products and gold lease rate is risk free in their eyes."

While banks limit gold leasing to those legitimately involved in the gold business who need to finance their physical inventory, it appears that some gold merchants have excess physical stocks. They are therefore willing to lend this out to private investors (who put up cash margin and real estate as collateral). Alternatively, it seems people can create fake gold business to access this market.

Koos' article is similar to a trade identified by FT Alphaville in August, where "Chinese firms have been able to benefit from cheaper US interest rates by using various commodities with high value-to-density ratios, such as gold, copper, nickel and “high-tech” goods, as collateral. The deals were motivated by the fact that borrowing US dollars in this collateralised fashion was cheaper than borrowing in the domestic Chinese market."

See also this GFMS note "our information collection from various trade sources indicated that these Hong Kong export numbers have been highly inflated by growing round tripping between mainland China and Hong Kong whereby local companies used gold to engage in currency and interest rate arbitrage transactions" This would make sense in light of Koos' research that says that the same bar cannot be traded back on to the SGE - maybe a way around this is to export gold out of China and reimport as "new" gold (I have been able to confirm that bars are being exported out of China as part of this trade).

There are a number of implications from this story:

1. How much of the gold that we have seen being imported into China is just tied up in these trades?
2. Has this Chinese short selling impacted negatively on the gold price?
3. When will the unwinding of these short selling deals happen?
4. What will be the impact on the gold price when these short selling deals are unwound?

The FT Alphaville article noted that the copper collateral scheme may have raised between $35-40 billion. Gold is a lot more value dense than copper, so realistic to think that the gold collateral trade is of the same or greater size?

I would also note that exports from China to Hong Kong (the round tripping trade) really began to pick up in March 2012, when it was clear that the gold price had peaked. The quotes above indicate that some wealthy Chinese took a bearish view on gold and maybe March was when this short selling trade started to pick up. It is also interesting that this chart of Koos shows big differences developing between SGE withdrawals and all known supply in April 2013, on the price smash. Did the price smash encourage more bearish bets, which would have resulted in gold within China held by industry users being released and sold on the SGE? Maybe Koos can run this chart back a few years so we can see if this gap only developed once gold peaked.

Koos article closes with the observation that "many real estate investment products are facing default risks and on the other, gold lease arbitrage is facing the volatility of gold price. If these 2 risks occur at the same time, this seemingly risk-free arbitrage could be in fact “picking pennies in front of a bulldozer.”"

I am sure that is the majority view of Chinese and this short selling is limited to a few, but China is a big market and this trade could still be significant in terms of the global gold trade. Maybe we have just found another source of potential future demand should these Chinese short sellers come to the view that gold has bottomed.