We drew attention to Professor Antal Fekete’s concerns over the spate of ‘ongoing’ backwardation in the the gold physical market on Monday.
The backwardation apparently has much to do with a decline in the activity of those eager to sell physical gold in the market. Professor Fekete’s methodology for identifying backwardation, however, does not rest upon looking at the exchange-listed futures curve. As he explained on the 14th December:
Most analysts calculate the basis as the difference between February and December futures prices which gives them a positive reading. They use the December futures price as proxy for the spot price. This is clearly wrong. The December futures price is not the same as the spot price, even though we are in December.
My methodology is to calculate the basis as the difference between the asked price for the December futures and the bid price for spot gold. The logic behind this is that if you wanted to transfer your costs of carrying gold to the futures market, then you would have to sell physical at the bid price of spot gold and buy it back at the asked price of the December futures.
This is almost tantamount to the forward rate.
The forward rate, as the London Bullion Market Association’s website explains, is derived as follows:
Calculating Forward Premiums Market convention is for forward prices in precious metals to be quoted in interest rate terms on the basis of which a dealer will borrow or lend metal on the swap against currency. It is also market convention to calculate the forward premium or discount to spot on the basis of the actual days involved/360 — even if the period is for longer than one year.
It is the appearance of negative rates here, therefore, that is presenting Antal Fekete with the notion of backwardation.
As the LBMA explains:
For example, a dealer might quote three months forward gold at 5.00 to 5.15 This means that he will lend on the swap — sell spot and buy forward — and pay on the basis of 5.00 per cent per annum over the spot price for the forward leg, or borrow on the swap — buy spot and sell forward — and charge on the basis of 5.15 per cent per annum over the spot for the forward.
In this scenario, were the dealer to be asked to lend on the swap at 5.00% and the spot price were $695.50 to $696.00, the dealer would, in accordance with market practice, base the deal at the middle of the spread. He would therefore sell the spot at $695.75 and buy the forward at a premium calculated as: $695.75 x 90 x 5.00 360 100 = $8.70
Which means if this rate is negative, you are in effect borrowing spot for higher than you are selling the forward on for.
This is aptly explained here, when describing the basis of swap trades:
The basis of swap trades
These are derived from the cost to the dealer of providing the basic transaction as illustrated in the diagrams above [below]. Where for example the client is a buyer of the forward, it is the cost to the dealer of borrowing currency to the forward date to finance a spot metal purchase, less an interest rate to reflect the rate at which the metal can be lent out until maturity of the forward. The major determinant in the calculation of this rate is the availability, or ‘liquidity’, of gold, silver, platinum or palladium to fund metal in the case of forward sales.
Forward rate = Dollar interest rate — metal lease rate.
Furthermore, the LBMA admits it is very rare for forward rates to turn negative as they did back in November 2008:
Traditionally gold interest rates are lower than dollar interest rates. This gives a positive figure for the forward rate, meaning that forward rates are at a premium to spot. This condition is often referred to as contango. On very rare occasions when there is a shortage of metal liquidity for leasing, the cost of borrowing metal may exceed the cost of borrowing dollars. In this scenario, the forward differential becomes a negative figure, producing a forward price lower than, or at a discount to, the spot price. This condition is known as backwardation.
Currently, however, it is leasing rates that are negative, not forward rates. This is therefore not quite the imminent monetary collapse scenario that has been made out by some gold bugs.
Leasing rates have certainly declined substantially since the beginning of the year, even turning negative at the one-month rate. But this is not– as has been interpreted by some — a symptom of central banks trying to incentivise gold-leasing for sale to keep prices artificially low.
As we have shown lease rates are highly synced with short-term rates, they are in effect a function of them. That is largely because those borrowing gold, want to make a return by selling the gold in the spot market and then parking the money, which is not used for hedging the trade via the futures market, in interest-bearing low-risk instruments. The lease rate is the effective return a bullion bank would make from that arrangement on any given day. With short-term rates at historic lows leasing rates simply have to follow suit.
Back on November 21st when forward rates were the most negative, this had much to do with still very elevated Libor levels, relatively unchanged leasing rates and a falling interest rate environment. The leasing rate as determined by Libor-Gofo (1.39500- [-0.11667]) at 1.51167 was therefore higher than the dollar interest rate leading to backwardation.
On July 14th, however, Libor was 0.28813, Gofo was 0.31000 and Libor-Gofo (leasing rate) was -0.02187. The leasing rate in effect having been forced into negativity to prevent backwardation from taking place.
This is counter-intuitive to the concept that some sort of short squeeze is going on, as usually higher leasing rates suggest gold shortages via additional demand for leased gold — although some analysts question any sort of correlation at all. Here, however, we would be talking about a shortage brought on by rates that are too low to incentivise lending and reselling of gold in the first place. While it’s possible in theory, it’s very unlikely in practice.
This is especially so given reports of more than enough gold being available for borrowing in the market. In fact the impression is that parties who are long gold desperately want you to borrow their gold.
With all this in mind it is interesting to note the following announcement from the Chicago Mercantile Exchange on Tuesday:
CME Group Inc., the world’s largest and most diverse derivatives exchange, today announced the launch of clearing services for over the counter (OTC) London gold forwards. Clearing services will be available through CME ClearPort(®), a set of flexible clearing services open to OTC market participants to substantially mitigate counterparty risk and provide capital efficiencies across asset classes. Clearing services for house business will commence on August 23 for trade date August 24, with customer segregated activity following within 90 days of commencement. These contracts are made available for clearing on COMEX through CME ClearPort, and are subject to COMEX and CME rules and regulations.
They go on:
“Launching our clearing services for London gold forwards is in direct response to customers’ need for a secure way to manage counterparty credit exposure,” said Joe Raia, CME Group managing director of energy and metals products. “This post-trade service allows trades to be privately negotiated and executed off-exchange and then submitted through CME ClearPort for clearing. This allows counterparties to continue to trade as they always have while transferring credit risk to CME Group.” “Counterparty credit concerns stemming from the global credit crisis have acted as a constraining influence on financial markets,” said Barry Wainstein, Vice Chairman and Deputy Head, Global Capital Markets and Global Head of Foreign Exchange and Precious Metals at Scotia Capital. “Introducing centrally cleared products, such as the London Gold forwards, will assist in returning normalcy to the markets by mitigating counterparty credit risk.”
The CME provides this further detail:
End-of-day settlement prices are published for contracts with open positions via the CME SPAN files. In addition, aggregated trade volume, open interest and a discrete set of forward prices will be published daily on the website and in the Daily Bulletin.
This is interesting a) because it appears to have been a CME initiative prompted by an LBMA seminar looking into further clearing options for the London Bullion Market in the wake of the credit crisis and demand for counterparty risk mitigation — and b) because it will end up providing an alternative set of forward prices to those already published by the LBMA. This could be seen as adding a sliver of extra transparency into the forward rate market – which is still to all extent and purposes fairly opaque. Only 10 pricing points will be provided along the curve, but again this is better than none.
Given the uselessness of Libor as an indication of the cost of money at the moment, any additional insight into real gold lease rates — the LBMA derived rate of which is currently published in tandem with Libor at 11am daily — can in some ways be seen as a good proxy for real interbank rates. After all, if the bullion banks are prepared to lease gold for a negative return, something very strange is going on.
In this respect it’s worth remembering that the LBMA derived lease rate represents the interest rate one would earn if one were to lease gold, sell it in the spot market and invest the proceeds at Libor. But the banks are not actually obliged to invest it at Libor. Furthermore, if the need for cash on your balance sheet is greater than for gold, which cannot be pledged at the discount window as collateral, the concept of negative or close-to-zero lease rates still being traded by the banks makes even greater sense, as does backwardation itself.
In fact, as the latest edition of the LBMA’s quarterly publication the Alchemist suggests, this was very much the case back in November when the one-month Gofo (forward) rate went negative:
In spite of central banks’ actions, it is fair to assume that during this three-week period, dollar funding for non-dollar banks was difficult to get; basis swaps (LIBOR versus EURIBOR currency swaps) became increasingly expensive, and it is likely that, at that time, using gold to obtain US dollars became attractive. As a result, it appeared that market participants were ready to pay much to borrow US dollars using gold as the need for dollar funding was pressing and no other sources of funding were available. As this need diminished, GOFO-OIS began to move lower, leading to the final leg higher in lease rates as LIBOR peaked some days later.
Remember, the Libor-Gofo lease rate is only an indication as provided by the LBMA. It does not necessarily provide the real leasing rate to any specific bank. These rates are determined by banks’ own internal financing arrangements. Therefore, on the basis that a negative leasing rate makes no sense at all, negative Libor-Gofo rates might actually be insinuating that real interbank lending rates are much higher than what Libor is suggesting.
On a side note, under the current LBMA clearing mechanism only six banks make up the clearing service that covers delivery failures in the London market.
As the LBMA explains:
London Bullion Clearing is at the heart of the loco London system, supporting the most widely traded market for bullion dealing globally. It is a daily clearing system of paper transfers whereby LBMA Members offering clearing services utilise the unallocated gold and silver accounts they maintain between each other, not only for the settlement of mutual trades, but for third party transfers.
These transfers are conducted on behalf of clients and other members of the London bullion market in settlement of their own loco London bullion activities. This system avoids the security risks and costs involved in the physical movement of bullion. The bullion clearing system in the London market is overseen and managed by the London Precious Metals Clearing Limited (LPMCL), which is jointly owned and managed by those LBMA members which not only provide a comprehensive clearing service in the London market, but which also have applied for and been granted membership of LPMCL. LPMCL has in place rules that set out the framework under which its members operate the clearing system, covering two main areas:
* the right any LPMCL member has over any other LPMCL member to call on his unallocated account with any other LPMCL member and;
*the timing under which instructions for transfers and allocations may be given and effected.
The CME’s Clearport mechanism however will alleviate that burden somewhat by also guaranteeing physical deliverability as well as specific bilateral counterparty default protection, something the LBMA system currently does not offer.
If anything that should encourage more physical availability of gold via increased trading and lending, pushing the market more decisively into contango.
Related links:
Dear Paul, the greatest monetary crisis of all times is coming – FT Alphaville
Libor is useless - FT Alphaville
The gold backwardation theory – FT Alphaville
REMOBILIZE GOLD TO SAVE THE WORLD ECONOMY! – Antal Fekete