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A note on the
LBMA, gold futures and forwards, and "100-to-1 leverage" in London's
wholesale gold bullion market...
SOME COMMENTATORS are
alarmed that the amount of 'physical' gold in London
is not sufficient to meet the immediate demands of the market.
This concern is
based on a simple misunderstanding. Read what follows and you will have a
much better idea of how gold futures, forwards, the spot and physical markets
interact.
Professionals who
trade gold over the counter use a convenient standard for specifying the form
of the gold they will deliver between each other. The standard is written and
maintained by the London Bullion Market Association (LBMA).
This standard is
the Good Delivery bar which weighs about 400 troy ounces, and is traded 100%
fine (i.e. gross bar weight * purity). A Good Delivery bar must have been
manufactured by a recognized refiner which subjects itself to rigorous and
ongoing scrutiny by LBMA referees. All their output is carefully assayed.
Professional gold
dealers, and they are mostly banks, trade both these bars, and notional
contracts which are underpinned by these bars, i.e. 'derivatives' of the
bars. These are things like gold futures, forwards and options.
Gold Forwards
The demand for
forwards comes from volume buyers of physical metal – like gold dealers
who wish to supply jewelry manufacturers – while the volume sellers are
often gold mines and refiners. Both will make very specific forward
settlement dates and conditions for the bullion delivery on a forward trade.
Private
individuals would struggle to trade on their own account on the forward
market, because they lack the settlement facilities – like vaulting
accounts at the accredited vaults – which enable them to take and make
delivery of Good Delivery bars. But a miner might go to an LBMA bullion bank
and open a forward sale, and then arrange its gold to be shipped from a
registered refiner direct to the buying bank.
So forwards are
deals in physical gold, but not necessarily for immediate settlement.
Gold Future
Contracts
Futures are
different. Everyone – including private investors – can speculate
on gold futures very easily. So is there physical gold behind futures trades?
A few Clearing
Members of futures exchange will have a depository account with some real
gold in it, though Ordinary Members would be unlikely to, and therefore
cannot usually settle with their customers in gold.
Clearing Members'
gold sits in the depository vaults, and title to it rests with warrants which
are passed between Clearing Members on the occasions there is a net
settlement of gold between them. (Several years ago BullionVault spent quite
a while trying to find a way of owning gold in a Comex Depository Vault,
through a Clearing Member, but we never found a satisfactory way. Perhaps
someone else has been more successful. If they have we'd be happy to learn
how, and publish the details.)
Because there is
not ordinarily access to gold via futures markets the huge majority of Ordinary
Members of the futures exchanges, and their customers, settle cash, not gold.
The cash amount they settle is calculated by reference to a specific price
formula which becomes very relevant when a future contract expires.
Futures &
Forwards Together
Futures and
forwards work hand-in-hand. Futures give the bank the opportunity to
approximately hedge out any price risk they have taken on a specific forward
trade. Futures are standardized, highly liquid and easily traded in volume.
The beauty of futures is that all the gradual liquidity of three months of
forward deliveries on specific dates can be concentrated in a standardized
futures contract which you can deal with any trader, because all the
contracts expire on the same day and with the same terms, regardless of which
trader you choose. This exchangeability is the source of their liquidity.
Forwards, on the
other hand, are hopelessly illiquid. Each was custom built 'over the counter'
for a specific settlement day. But forwards really are deals in physical gold
– which will settle as Good Delivery bars, on almost every day of the
year. So the flow of forwards through the vaulting system is smoother than
the flow of futures through a futures exchange, which rush to close en-masse
at expiry.
Adrian Douglas'
Misunderstanding
The key concern
that Adrian Douglas (a director of the Gold Anti-Trust Action Committee
(GATA), who attended the recent CFTC hearing) seems to have is that there is
a giant physical exposure which remains undelivered. Let me explain why that
is confused, while granting that there was no good explanation given by
Jeffrey Christian (managing director of CPM Group, a New York
commodities-market consultancy), who was in the hot-seat of a CFTC hearing.
It is easier for me with the written word.
Forward contracts
are priced according to two things: the price of gold, and the cost of money
to the forward date of settlement (i.e. interest rates). Forward prices of
gold stretch out into the future for months and years, forming what's called
the forward curve.
The entire length
of that forward curve is what the LBMA member's trader calls 'physical'. For
them this differentiates it from the cash-only-equivalent of a futures
contract. So, when they talk about 'physical' or about the open 'physical'
position they are talking about a whole lot of forward deliveries which
sellers are under no obligation to deliver today, and which the buyers
neither immediately want nor can demand.
Those forwards
will fall due for delivery a day at a time without causing more than a ripple
in the market. But being extended into a series of physical settlements
stretching out on that curve for years, the open physical position is of
course much, much larger than the amount of gold which happens to be in the
various London vaults today. That's no big deal, it's where gold mines and
aeroplanes come in.
So when a
professional market analyst like Mr. Christian says the open physical
position exceeds the amount of gold in the vaults all he is saying is that the
gold which is due for physical settlement next week or next month has not
necessarily been shipped in yet. But he knows (even if he does not express it
very clearly) that the seller of a forward is on the hook for making the gold
available on the appointed settlement date. And of course the seller will
incur a severe financial penalty for failing to settle, which is why forward
sellers don't sell gold without being very sure they can deliver it.
Mr. Douglas seems
to have made an understandable and honest mistake caused by the slightly
confusing language which is used by traders. I hope you now see that the
LBMA's open physical position on its forward curve – far from being a
risk – is a genuine benefit to the gold market's smooth operation. It
defines the daily rate at which real bars are needed into the future, and
firmly places responsibility on the seller to make sure the gold arrives in
good time. This helps keep the world of real bars settling efficiently.
At BullionVault
we and all our customers benefit from this, because it means we can buy real
bullion a few thousand ounces at a time from an LBMA dealer who keeps bars on
hand to satisfy our modest demands. We don't have to organize the shipments.
We settle 48 hours after dealing, by sending a bank transfer and getting
ViaMat (our recognized vault operator) to collect the bars. This is called
spot trading, which is, in effect, the nearest 2 days of that long forward
curve.
How Banks Use the
Forward Curve
When novices jump
into the spot market and buy up all the immediately available stock (and this
happens from time to time) the result is a spike in spot prices which
reflects a lack of sellers capable of making immediate delivery. It may not
represent a fundamental shift in the value of gold; there might – for
example – be plenty of gold arriving next week, and all of it available
at a cheaper price.
What a trader
will do is look at the shape of the forward curve. If he sees that the curve
has developed a lump at 48 hours, caused by that aggressive novice's buying,
it will be profitable for him to sell his spare gold at spot, and buy forward
by a week. He can deliver his bullion bank's on-hand gold which will be
replenished next week when the aeroplane arrives. And he will make money from
the aggressive buyer who has paid a premium price for urgent settlement.
Meanwhile, as he
buys one week forward in anticipation of the aeroplane's arrival the effect
is to distribute the novice's order along the curve, and to smooth it out
again. You may have read of gold bugs who put huge orders into the spot
market to prove the gold is not there. Well now you understand why no-one
sells it to them! Selling physical gold which you cannot deliver on time is a
big mistake which professionals don't make. If the gold bugs ordered 2 months
forward – allowing time for sourcing and shipments – there would
be plenty of sellers happy to take their business.
BullionVault Gold
So where does
this leave the private investor? Using BullionVault, you can buy 'Good
Delivery' gold from stock which is already in the vault. You are not even
waiting for spot markets to settle.
The unusual rule
on BullionVault is that a seller's gold must be on-hand, in the vault, for
settlement; and the buyer's cash must be cleared in the bank. That's why we
host the only gold market in the world which offers instantaneous settlement
at the point of trade, and on a 24/7 basis. Thereafter, BullionVault simply
looks after your gold. It's your property. It isn't available for any selling
when the spot market goes to a premium, and we have neither the right nor the
wish to play the curve the way a bullion bank does.
You can see this
proven, each day, on our Daily Audit. If we were delivering gold out to make
a few dollars on the forward curve our bar lists would show we were short of
physical gold in our vault. This is why we regard it as so important to
publish our bar lists, and their reconciliation to all customers' holdings,
on a daily basis. So far as we know we are the only gold business in the
world which does this.
We hope this has
cleared up any confusion about the amount of gold in London vaults. Now we'd
like to finish with a quick look at who is manipulating the futures market,
and how.
Gold Futures
Manipulation
Futures brokers
here in the UK routinely tell their new customers that 9 out of 10 private
customers lose money by dealing in futures. We understand the regulators
require this as part of the necessary risk warning.
Part of the
reason – which has recently been alleged by GATA – is that it is
quite likely that there is some price 'manipulation' of futures contracts at
expiry. This sort of thing is not a gold problem. It is a problem relating to
futures markets in general.
Imagine you are a
professional futures market seller – not necessarily of gold, but of
anything – and you have the ability to settle the underlying commodity,
while private investors do not. You sell the futures whenever they appear to
be at a premium over your forward curve, which will happen as the speculators
get into a buying frenzy on the futures market.
Suppose that at
expiry the futures price is low against the forward curve, which is quite
likely if lots of private investors are on the long side and are rushing to
close out their near contract. You – the professional – will be
perfectly happy to buy the future back, so long as the discount to forwards
remains worth it, because then your physical stock won't have to be delivered
out, and you won't need to buy a new forward to arrange a relatively
expensive new delivery of physical stock into your depository account. So you
see private investors will only find buyers for their urgent sales if the
buyers get a discount to fair value. The professionals are in the box seat
because they can settle.
Now suppose the
opposite: that at expiry, the future is at a premium over the forward curve
(which is what happens when lots of short sellers who can't settle have been
dominating the speculator's market, and are now rushing in to buy to close
before expiry). Now the professional will act as the seller, but only if the
future is offering him a premium over the forward curve, otherwise he'll run
his open long to settlement. So once again the professional has the whip hand
over a crowd all trying to do the same thing to avoid settlement. Whichever
way the market moves the professional is in the driving seat if he can sort
out settlements, which is the position few (if any) private investors are in.
It gets worse.
Rolling over to the new futures contract doubles the opportunity for the
professionals to profit. If, having just sold at a discount, lots of private
investors are rolling forward to buy the new futures contract for the next
quarter then that future will offer the professionals a premium over the
smooth forward curve, and the professional will willingly sell it to them as
soon as the premium is sufficient to make it profitable.
So you see even
when private investors are offered rollover at apparently attractive terms
(e.g. at middle prices and half the commission) the reality is that they are
selling the old at a discount and buying the new at a premium. Wherever your
trade is in the same direction as a large number of market participants who
lack the ability to run their position until settlement you will probably
lose out in this subtle way.
This is where the
artificiality of futures wrings profit out of un-sophisticated investors who
wish to speculate. Who's to blame? It's hard to accuse a seller of price
manipulation when he runs his two month old trade to settlement, and it's
very hard to blame the opportunist professional buyer for supporting a low
price by buying at a discount at expiry! The only people who can really be
blamed for the expiry and rollover costs are the people who bought futures
without both the money and the storage facilities to settle, and that's
usually those private investors who are its victims; which is ironic.
That's futures,
and it's ultimately each investor's own choice. If you choose to play you are
dealing in a marketplace which may force you to trade at the time of your
maximum disadvantage.
At BullionVault
our position is that you might cautiously use futures for short term
speculation. But we think you'd do better to avoid them for long term capital
preservation, which for many is what buying gold is about.
Instead, you
should choose physical gold through services like ours, where there are no
artificial barriers placed in the way of smoothly continuous trading and
settlement. All you need to do to avoid an unfair price dip in futures at
expiry is buy the real thing, and although that's difficult with
pork-bellies, with gold it's easy.
Paul Tustain
Director
and Founder
Bullionvault
Paul Tustain is director and founder of Bullionvault
- the world's
fastest-growing gold ownership service, where you can buy gold today vaulted in Zurich on $3 spreads and 0.8% dealing fees.
Please
Note: This article
is to inform your thinking, not lead it. Only you can decide the best place for
your money, and any decision you make will put your money at risk.
Information or data included here may have already been overtaken by events
– and must be verified elsewhere – should you choose to act on
it.
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