Sunday Gold Fix – The Basics of Leasing
The most common question I receive about gold relates to the means through which an increase in leasing/lending activity is negative for gold prices. It appears that the mechanism by which this is accomplished is unclear and counterintuitive.
By all accounts, an increase in the demand for gold as collateral to obtain “cash” should be positive for gold since it amounts, on the surface, to a rise in demand for gold. But that is not actually what happens, and, in fact, the activity is all on the supply side.
Below is a response to a reader about the mechanics of gold monetization and how it relates to gold prices:
The mechanics of gold lending are much the same as gold leasing. In a gold lease arrangement, a miner or gold producer sells forward future production to lock in whatever price, akin to hedging. In order to sell forward, the producer has to borrow existing bullion from somewhere – and the only holders of such large stores of physical gold have been central banks and bullion banks.
So an increase in gold leasing dislodges formerly dormant stores of physical gold from central banks, acting as an added supply of gold onto the markets. That was one of the prime forces suppressing gold prices in the 1990’s – the huge rise in producer leasing with central banks, and bullion banks acting as the intermediaries, that were more than happy to “monetize” their gold stores.
The accounting rules are such that the central bank continues to hold “gold” on its books despite the leasing arrangement that moved that actual physical metal into the marketplace. Thus the market has actual gold sold into it while central banks report no loss of supply (under the accounting line “gold and gold receivables”). Since these are opaque transactions, nobody really knows what has been leased out and what actually remains.
Gold lending takes a similar form. Banks typically hold client gold in unallocated accounts – this is intentional since unallocated accounts have smaller fees and clients have not been educated as to the legal distinctions. Unallocated gold is a liability of the bank; the client continues to hold title to physical bullion, but that is in the form of a “paper” promise by the bank to deliver future gold. Often, the agreement that creates the unallocated arrangement even allows for the bank custodian to settle the client claim in cash under certain circumstances.
Therefore, the bank can use the unallocated metal toward its own purposes, in exactly the same way that prime brokers rehypothecate hedge fund credit holdings in margin accounts. In a gold lending relationship, the bank uses the unallocated gold as collateral for cash (in whichever currency is needed, which is one of the appeals of using bullion for collateral). Now, the gold is in the hands of an intermediary that, apart from any haircut set with the borrowing bank, is at price risk. The cash lending bank will either sell the gold outright, since it only has to replace metal at the end of the agreement, or hedge its collateral position (based on the cost of selling futures).
The end result is exactly the same whether lending or leasing gold. It acts as an agent to disgorge previously unmarketed supply into the physical or paper markets, or both. Gold that was until that time sitting idle in an unallocated account has now entered the market through physical (dumping by the cash lender/collateral holder) or paper (hedging the collateral holdings) markets, or some of both dependent on parameters like gold forward rates and futures curves. Any marginal increase in lending and leasing will therefore suppress both the paper and physical prices (absent any change in demand).
Going back to the gold smashes in 2008, it is easier to imagine how this might work in a very short space of time. As counterparty risk was perceived to be suddenly a large problem, banks were forced to scramble for collateral, including gold. As a large uptick in gold lending dumped supply on the market, akin to a scramble for dollars, it snowballs as other leveraged holders are forced to liquidate in the course of margin calls. For any cash borrowers with falling gold prices, their cash lending counterparties would also issue demands for additional collateral posting as the price of gold is forced still lower. That leads to even more supply being disgorged and so on until a cascade situation is reached.
Remember, the primary concern here is not the price of gold, it is the cash lending arrangement. The full object of the cash borrower is to obtain currency liquidity through any means, regardless of where the price of gold follows. So the situation in gold collateralized lending is quite different from US Treasury repos. The key difference is liquidity and volatility of price (or at least expected volatility) owing to the differences in depth of the marketplaces.
What began in the 1980’s as a means for producers to obtain lending to finance new production facilities and capabilities morphed into a financial practice that aided central banks in “monetizing” their “useless” gold stocks. The bullion banks were only too happy to lend into the market and aid their central bank counterparts.
It was only in early 2008 that gold collateralized lending took on the emergency proportions that we saw in the gold “smashes”. Given the shrinking collateral environment coupled with the effective closing of unsecured interbank lending markets (beginning in August 2007), banks are navigating a liquidity system that is nowhere near certain. Add in the pressures of QE (or LTRO’s in Europe) on collateral chains, and gold’s appeal in lending markets is more obvious.
In this way, client stores of gold were very much like central bank stores in the 1970’s and 1980’s. Banks saw a large increase in client activity in physical gold in the price run during the 2000’s, leaving them with “easy” access to an asset in which a lending market already existed. All it took (takes) was (is) circumstances to move that supply into the markets.
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