|
What is precious metals leasing, and why is it done...?
LEASING is an integral part of the precious metals market, writes
Miguel Perez-Santalla at BullionVault.
Why is it
necessary? For a diverse number of reasons, the first is the need for industry
to borrow instead of buying outright the metal. This enables them to avoid owning
the metal at a fixed price if they have not yet contracted to sell their product.
Other companies
want to borrow rather than buying gold or silver, to keep their cash consumption down. Leasing gives their
business greater flexibility in money management. Still others choose to
borrow to free up cash. Finally, there are those in a bridge lease, commonly used
in the oil refining and pharmaceutical fields.
These companies
already own all the precious metal that is needed, inside their pipeline. And
as that platinum, palladium, gold or silver does its job, of cleaning out impurities
from their end product (petroleum, drugs or other chemicals) it simply needs to
be extracted from the waste byproduct and re-introduced to the process. But leasing
gives the producer a little headroom while this goes on. They don't need to own
any more metal than they use, because it always comes back to them.
On the flip
side there are financial, trading and metal refining companies who own gold, silver
or platinum-group metals, or have metal on account, which they need to put to
work. The metal which they have on account is held as a debt to their customers,
rather than being physically allocated to the client. That is what enables them
to turn their liability into an asset by putting it to good use, leasing gold
out to earn them money.
The reason
you want to know about precious metals leasing is to understand what this function
represents, how it actually affects the market place, and its relationship to
the price. This little exposé will in no way be exhaustive about all the
different uses and functions of leasing. But it will serve as a primer for understanding
a market product and service that seems to be a mystery for many commentators.
First, the
pricing: Just as with anything you might pay to borrow, longer-term leases typically
cost more – per annum – than short-term arrangements. See this table
of indicative lease rates for instance.
 
Another
very important point you should remember is that the ability to borrow gold or
silver through leasing is not a simple process. In fact, most businesses involved
have very stringent credit practices, and depending on the entity may entail quite
lengthy processes and documentation at the front end before you can effectively
become a user of this type of service. So moving forward, let's assume for practical
purposes that all parties to a transaction have met the highest credit standards.
We must
also remember that the movement of valuables and precious metals is time consuming
and expensive. Because of this, the marketplace created the ability to swap metals
from one location – or from one period of time – with someone else
that has it in another. Now, this is not something that is done for free. There
is a charge which is determined by supply and demand for the specific location.
Of course this is the kind of thing that can only be done if the two parties share
the same interest. It is incumbent on anyone in the precious metals industry to
establish trade relationships in the major markets that enable them to participate.
What does
a swap have to do with leasing? If you are asking then I still have your interest!
The reason is that location swap transactions happen to be a major part of the
ability of institutions to lease or lend their metal to another party is because
it increases the size of the available market.
So how does
someone end up in the gold leasing business? For most, it's because they have
active business in the metal from the get go. In this case we can say a bank involved
in precious metals, a trading company or precious metals refining business would
have natural flow of business that would enable them to be in a position where
they could offer leasing. In the first example we will call this primary entity
Company A.
Company
A has customers who hold metals on deposit. They're not charged anything for this service,
on the condition that Company A can use it in the meantime. Those clients have
given their asset and accepted Company A's good credit that they will deliver
it back when needed. It is in reality no different that when you leave your money
with a banking institution. The only difference is that the gold does not multiply
through the banking system as money does. Because the sum total of physical metal
does not change.
Let us make
believe you are Company A and you have 10,000 ounces of gold deposited by your
customers. Of those, you are able to lend out 8,000 ounces easily. But now you
have an excess. So you calculate the earnings if you sell the gold outright in
the market, and deposit or lend the cash to another borrower. To make sure you
can give your clients the metal they're owed, you also need to hedge yourself
by buying gold back at a later date against a forward or gold futures contract (often referred to lately as paper gold) to avoid price risk.
In the current
market environment, this could be profitable. Because the near term price is higher
than the forward or future price (the market is in what's called backwardation).
You would pocket the premium for selling immediate gold, and buy the future delivery
cheaper. Over that time period, you also lend the cash raised from the sale as
well. It is a bonanza!
But it does
not happen like this most of the time, and besides – Company A has multiple
transactions and commitments in gold. So the picture I projected, though nice,
is not always that simple.
Let's make
believe the market is in full contango. This is the typical state of the gold and other
precious metals markets. It means that the future or forward price is higher than
the near term. So if you were Company A, then the spread would cost you money
to hedge your position, and it would cost you more than you would earn, too.
What to
do? You contact other people in the market place – outside your own circle
of gold borrowing clients – and it happens that you can lend it to another
party that has need for the gold in New York. He will pay you a premium, because
he doesn't have any there and needs to deliver to a manufacturer. But instead of just outright borrowing,
he wants to give you gold in London – the most liquid physical gold market
in the world – at the end of the term, which may be for 3 months. This sounds
good. You can earn the premium for New York because he needs it there, and you
have no price exposure. That is the simplest route from the point of view for
company A.
Now let's
look at the different reasons to lease gold. Let's take a jeweler. A jeweler needs
to produce 10,000 gold rings for Macy's (or whoever). But he does not want to
buy the gold and take the price risk. Because the jewelry outlet does not want
to price it until the goods are ready, especially if they expect the gold price
to be lower.
The jeweler
then borrows the gold from Company A and pays a percentage just like any loan
for the term they are borrowing the metal based on the price of the day they borrow
the gold. At the end of this lease they would then buy the gold from Company A
at the same time they sell the metal to Macy's.
Another
possibility is the gold miner who needs to pay his employees and expenses. This
company expects to have one thousand gold ounces from their recent production.
The metal however will take 30 days to be available from the refiner, ready to
sell in the market. So the miner leases the gold for one month from Company A,
selling the gold for cash and paying its bills. They then deliver the refined
gold to Company A at the end of that term.
There is
also a manufacturer that uses precious metals as part of a catalyst. They already
own what they need. But because the process to reclaim the metal from the catalyst
is time consuming, and because they need a fresh catalyst immediately when they
remove the old one, they need to lease some metal for that time period.
In leasing
there are many other models and it can be used for other purposes, much like in
the stock market. To sell short is one such use. It means to sell what you don't
have because you expect you will buy it back cheaper at a later date. But in the
precious metals market, however, you don't need to do that with physical metal
if you have access to the futures market. Speculation using physical bullion –
borrowed and then sold directly into the marketplace in the hope of buying back
later at lower prices – just doesn't make any commercial sense when the
futures (aka paper gold) market enables you to do it much faster, without the
need for long and involved credit checks like we saw earlier.
There you
have the basics of precious metals and gold leasing. Just like anything in the
world, what should always be simple is complicated by some to create some advantage
in most cases. If you understand the basics you can work make your way through
any other related concepts.
So what
kind of effect can the leasing market have on pricing? It really all depends on
liquidity. Unlike currency – where the Fed can come in and inject more money
into the system – this is not possible in a truly finite market like precious
metals. But thanks to the available supply above-ground, some precious metals
markets are more susceptible to a liquidity crunch than others. For the next example
I will use a true to life market occurrence.
In November
2006, I remember like it was yesterday, I walked into my office on a Monday morning
and platinum was up $200. It had jumped from the $1200 level to over $1400 dollars.
This was more than a 16% move from one day to the next. The chatter and market
reports back then were that a bank trader was short a large amount of platinum,
and was being forced to deliver on his short position on that Monday by other
players who had got wind of his problems, and took the opportunity to profit from
it.
Because
his short position was so large, and because the platinum market is so small,
his covering drove the price up. This
happened because typically in the platinum market, much of the metal is out on
leases. It would take some time to get all the metal back to make the delivery.
In this
circumstance there were industrial users who knew their leases were coming due
at that specific time period too. Because of this large short covering in platinum, the price shot up not just on the commodity but
on the platinum lease rate as well. That day in fact, the industrial customer
that was expecting to pay 3% to 4% for a 1-year lease was being offered at between 100% to 120% per annum! The consumer had no choice
but either to return the platinum they'd leased, buy it outright, or accept the
new rate.
In this
instance, the best way to manage the situation was to lease day by day. As it
worked out, the market calmed down and three days later the lease rates were essentially
back to normal. But if the industrial consumer had decided to buy it at that elevated
price level, he would have suffered a major – and unnecessary – rise
to his costs. By the end of that week, the platinum price had also retreated.
Take note:
the platinum market is far less liquid than gold or silver, meaning that there
is less supply and demand. So its wild gyrations would not be probable in gold
or silver markets. However, there is still a possibility of a similar circumstance.
It's just less likely that moves of that size would occur, because they are very
much larger markets. And in the end it is not the lease rates that affect the
market price, but immediate physical demand and price which affect the lease rates.
Leasing
is a tool just like any other. It has its proper function, just like a knife for
cooking, a rifle for hunting, or a gun for self-defense. That does not mean they
are not misused, and often intentionally. But this does not negate their purpose
and need in the market.
Some decry
that the ability to lease metals enables the multiplication of the metal. However
this is not true. It may multiply the commitments, but physical leasing is unlike
money – which is multiplied by the ability of financial institutions to
hold only a minimal part of the reserve as cash on hand.
With the
precious metals market, in contrast, the commitments are for physical metal and
delivery is always necessary at some point. Hence it is not a stroke of a pen,
but the blood, sweat and tears of miners, refiners and logistics companies that
produces or brings gold back into the market.
Yes, leasing
might invite poor judgment on the part of a lender, or borrower. But the contrast
that to the lack of metals industry failure with the repeated and increasingly
common failure of financial and banking entities. Having to deliver rare, physical
metals keeps errant trading to a minimum in a way which Fed-guaranteed bail outs
of banking and financial brokerages does not.
Miguel Perez-Santalla
BullionVault
Miguel Perez-Santalla is vice president of business development
for BullionVault, the physical
gold and silver exchange founded a decade ago and now the world's #1 provider
of physical bullion ownership online. A fierce advocate for retail investors, and a regular speaker at industry and media events,
Miguel has over 30 years' experience in the precious metals business, previously
working at the United States' top coin dealerships, as well as international refining
group Heraeus.
(c) BullionVault 2013
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.
|
