In the last year The Real Asset Company has brought several pieces of research to your attention that look at the workings of the international gold market; from price discovery to the major participants within those markets.
People unfamiliar with the gold market, or even ‘markets’ in general are surprised to find that there is no single gold market, and that the price is affected by different gold products, be it physical, futures or ETFs.
But the question on so many participants’ (and observers’) lips is, ‘Who sets the gold price?’. We have previously postulated, based on research by Lucey et al (2012) that it changes between the London Gold Market and COMEX. This is despite London being significantly larger than COMEX, and that they both trade different gold products.
One step towards investigating gold price discovery is looking at how the major gold markets, London, New York, Tokyo and Shanghai, influence and spillover into one another. The paper we look at today, written by Lucey et al (2014) investigates ‘the degree to which these markets are integrated, and which are net senders or recipients of information.’
Who is the most dominant?
It will come as no surprise to anyone that, ‘the strongest and most integrated markets are the London Cash market and COMEX.’ As we mentioned earlier, there is a pull between COMEX and London as to where is the centre of price discovery, the authors state that ‘The largest pool of liquidity was and remains the London OTC market, whose benchmark price set by the London AM and PM fix is seen as the global benchmark.’
To give you an idea of just how huge the London Gold market is, Murray (2011) ‘suggests that 87% of global volume is settled in London, with just under 10% via COMEX in New York.’ Whilst the SHFE and TOCOM account for ‘approximately 1% each.’
One might ask why one would take the time to take into account of two markets whose contributions are just 10% of the second largest. On this matter, the authors state, ‘despite the much smaller size of the Far Eastern markets much speculation has emerged regarding the future role of these markets.’
Does the SHFE matter?
One of the most interesting gold markets we have looked into in the past is the Shanghai Futures Market, particularly the moves being made to open it up as a price maker, rather than a price taker. The authors of this paper find ‘Shanghai remains isolated as a market both in terms of volatility and return spillovers.’
But is the SHFE just the small event that the volume number suggest? No, referencing our work the authors draw attention to the fact that the SHFE ‘is now the second largest hub for gold futures trading worldwide, after COMEX in New York.’
Who feeds the gold price?
In order to establish a price, information must flow between markets, one would assume that this would come from COMEX ‘Given the size and overall dominance of COMEX, the general consensus [of previous research] is that COMEX dominates in terms of information flow.’
But, as we know from previous price setting research, ‘it is reasonable to assume that size alone does not imply dominance. It is well known that the transparency and ease of execution of organized derivative markets can allow (relatively) small markets to lead larger markets.’
The research shows that when it comes to which market impacts the most, New York and London ‘are the dominant markets.’
So much so that when looking at influence spillovers New York ‘contributed 26.7% of the error variance in forecasting Tokyo’s returns’ the favour was not returned as ‘Tokyo is responsible for only 3.4% of New York’s forecast error variance.’
Unsurprisingly ‘both New York and London contribute in roughly equal proportions to each other’s error variances.’ This is not a surprise as we have already found similarities between the two in terms of price influence.
Overall the authors find both Tokyo and Shanghai have very little influence on the either London or New York. However Shanghai ‘is very disconnected from the other three markets with 98.7% of its forecast error variance coming from itself.’
Spillover effects
When gold first broke through $1000/oz (a psychological barrier) New York and London were both ‘driving other markets at this time.’
Interestingly this is an ongoing pattern, ‘London is never a net recipient of spillovers,’ which suggests that volume size really does dominate and influence rather than be influenced.
And what about China? Does that ever get look in? Between March-May 2009, New York sees its ‘only significant occasion when it is a recipient…here Shanghai goes through its only sustained period of new spillover to other markets. The authors believe this is due to major economic news and data being reported during this time.
The authors conclude that ‘gold spillovers, in both return and volatility, are concentrated from London and New York.’
So, does size matter?
In the case of the gold market, yes. The authors find that ‘there is little evidence that [the SHFE] as yet has an impact on the world gold market. It rarely provides spillovers to the other market either in returns or in volatility.’
This is an important note to remember, whilst it may seem depressing to those in gold investment that the impact the paper and cash markets of New York and London may have on the gold price, it does suggest that the moves being made on the SHFE will eventually spread out the influence of each gold market.
