One reason the BIS gold-swap story has courted some controversy is because, on the face of it, the Bank of International Settlements — being the central bankers’ central bank– is not supposed to lend to commercial banks.
A quick read through the BIS statutes confirms as much.
However, via its gold-swap the Bank has clearly found a way around this.
One explanation for how it may have overcome the restrictions could be connected to the following point in Article 21 (a)– which states:
The Board shall determine the nature of the operations to be undertaken by the Bank. The Bank may in particular: (a) buy and sell gold coin or bullion for its own account or for the account of central banks;
So essentially the bank is free to buy and sell to whomever it wants in connection with its own bullion account. That is to say as part of its own market operations.
But should we really be surprised that the BIS has begun to engage in such a deal considering it too, like any other bank, simply wants to make a good return on its assets?
Might it be plausible that the BIS went to the commercial swap dealer banks, rather than the other way around?
Gold carry-trade effect
First off, central banks have always lent out their gold to bullion banks to make their assets work for them (so they don’t just sit idly on their balance sheets). This was particularly the case when gold prices were stagnant, with little scope for asset appreciation.
What you got, therefore, was a scenario in which central banks lent their gold to the bullion banks for a price just less than the going interbank market rate — or what they perceived covered their credit risk, so x amount of basis points.
To make money themselves — and to protect against falling gold prices –the bullion banks, acting as market makers, would lease the gold forward at a higher price and invest the proceeds at the official market rate, hence capturing the so-called implied lease rate (equal to Libor minus the gold forward rate).
Their own position was then market neutral to the effects of gold price rises or falls, and they lived on a healthy spread.
All of which went swimmingly for years — especially since producers like Ashanti and Barrick were keen on the other side of the trade to hedge their future sales or to help finance production. They did this by taking advantage of the gold contango carry trade, much like in oil today. For those still confused, see the below two diagrams courtesy of Barrick:
But as the above diagram shows, the cost of financing and sound credit relationships was critical to sustaining the strategy.
Everything changed with the Lehman crisis.
As credit risk rose, the central banks pulled out of the gold lending market substantially – since there was no incentive for them to lend their gold. Credit risk had simply got too high.
That would have put downward pressure on gold forward rates. However, because their presence was replaced by bids from the private sector (which had higher finance costs) the effect saw gold forwards rise relative to Libor. As one gold expert explained it to us:
They (the central banks) stopped doing that when lease rates went below 10 basis points, as it didn’t cover their credit risk. Meanwhile the reason lease rates went negative was because investors were lending gold against borrowing dollars through their forward purchases. And they were doing so on leverage, for forward delivery. Which had the effect of pushing up gold forwards. Libor was falling.. and GoFo (gold forwads) fell but not so much as Libor.
With so many long investors (with more expensive financing costs than the highly rated bullion banks) already long in the market and looking for a return via the contango trade, often financed with leverage — lease rates ultimately turned negative.
As our helpful gold market expert explains:
Where do you borrow money from? A bank gives you a leverage facility… and for a hedge fund that margin is quite large. Up to libor +200 basis outright just to leverage that long gold position. This is much higher than for a central bank. For a central bank it suddenly makes sense to lend dollars and get the gold as the security. Everyone is long and their marginal cost to borrow is much higher than Libor, which pushes gold forwards up.
The central bank arbitrage therefore it seems has simply been reversed, largely because the amount of gold that is in the system is more than the market can finance.
In other words, from the BIS perspective, gold forward rates may have finally become steep enough for it to arbitrage the market.
In which case the eurozone institutions dealt with could simply be nothing more than plain old intermediaries — matching BIS cash with the gold length that’s already in the market, which happens to be in need of financing.
(The effects of the trend, by the way, can clearly be seen in the changing shape of the gold futures curve, note the gold curve today versus three years ago below:)
Gold backwardation fears revisited, uh oh! – FT Alphaville
Libor is useless – FT Alphaville
The gold backwardation theory – FT Alphaville
Getting to the bottom of negative gold-leasing rates – FT Alphaville