The gold market and the BIS

Alasdair Macleod – 3 August 2010

The Financial Times published a story on 29 July to clarify the gold transaction hidden at the back of the Bank for International Settlements’ latest annual report. This clarification is about as effective as headlights in thick fog and has set off a fair amount of speculation in the gold blog-o-sphere. The FT article is important, because it is a fair assumption that the journalists who wrote it will have cleared its factual basis with the BIS so far as the BIS is concerned.

The hard facts are few. We know that the BIS entered into a gold swap agreement with several commercial banks involving 346 tonnes of gold, worth about $14bn at current prices: that much has been reluctantly revealed in a statement by BIS. However, the BIS does not possess 346 tonnes of gold; the official figure as declared in the World Gold Council statistics at the end of 2009 showed the BIS holding less than 120 tonnes. Either the BIS has more gold than it is letting on (highly unlikely), or most if not all of it has come from somewhere else.

It is worth pointing out that the BIS does not usually deal with commercial banks, restricting its activities to central banks, which is why it is known as the “central banks’ bank”. Furthermore, this transaction, which is dismissed by the BIS as routine, is probably the largest gold swap in history. Bizarrely, it even dismissed the transaction as “normal” and in line with its policy of “obtaining a return on its US dollar denominated holdings”. But some or all of this gold does not even belong to it.

So, what did the FT story add to our knowledge?

The story is interesting for what it said as much as the way it said it. The transaction was initiated by the BIS, not by the commercial banks. Given that the BIS has no direct relationship with the commercial banks, this suggests that the BIS was acting on behalf of one or more unidentified central banks, probably as guarantor. This is contrary to the impression the BIS has given.

There are two possible reasons for this action. Firstly, a central bank may have wished to swap gold for funds, with a view to reversing the transaction at a later date. The central bank would prefer the BIS as counterparty rather than one or more bullion banks for risk purposes; and the benefit of a swap is that ownership of the gold does not change hands, so for reporting purposes there is nothing to declare. Coincidently the size of the swap roughly matches Portugal’s gold reserves, fuelling suggestions that they may be involved.

The second possibility is the BIS may be acting for the central banking community in trying to suppress the gold price. Essentially, the BIS makes central bank gold temporarily available to the bullion banks to cover their shortages, normally on lease. The FT article actually suggests it is the other way round by stating: “The BIS asked the commercial banks to pledge a gold swap as guarantee for the dollar deposits they were taking from the Basel-based institution”. The BIS omits to say who does what. But it is perfectly possible to rephrase this as, “The BIS loaned gold swapped from unnamed central banks to a number of commercial banks in return for a payment of its value in dollars.” The statements agree, but the seems to be designed to give a misleading impression.

Both the reasons for the transaction outlined above might be true. It is known that several governments in the euro bloc with central banks that are unable to issue fiat currency have gold to swap and a need for money to cover spending deficits. While $14bn is not sufficient for a country like Spain or Italy, it is for Portugal; and Portugal officially has 382.5 tonnes of gold. We know also that there has been substantial physical demand for gold bullion and coins from citizens in Euroland and elsewhere, which could easily amount to over 300 tonnes. And we know that the bullion banks are short of gold in large, undeclared quantities on their unallocated accounts with their customers, and that some of the bullion banks are also short of a net 700 tonnes on Comex. A crisis has developed out of demand for bullion that threatens to break the bullion banks, with disastrous consequences for the wider financial community and the central banks themselves – who are probably the biggest creditors.

If such a crisis got out of hand, it would be a nuclear event. And if this is the reasoning behind the BIS swap, it makes sense to deflect all attention from the problem. But it was admitted in the FT article that more than 10 commercial banks were involved, confirming the swap was addressing a market-wide, rather than an isolated problem. The timing certainly confirms a European angle, given the known demand for gold on the back of the Euroland crisis. Furthermore, two of the three banks actually named are major French banks, and it should be remembered that French citizens through bitter experience are natural hoarders of gold in uncertain times. This is particularly interesting, since there have been virtually no reports in the international press of French citizens’ demand for gold, yet here we have two major French banks apparently being bailed out of their unallocated account liabilities.

There is further evidence of a European footprint in a somewhat confused passage in the penultimate paragraph of the FT article:

The gold used in the swaps came mainly from investors’ deposit accounts at the European commercial banks. Some investors prefer to deposit their gold in so-called “allocated accounts”, which restrict the custodian banks’ ability to use the gold in their market operations by assigning them specific bullion bars. But other investors prefer cheaper “unallocated accounts”, which give banks access to their bullion for their day-to-day operations.

The gold cannot have come from allocated accounts, since that is a custodial function. The banks operate a fractional reserve banking system on unallocated accounts and this ratio of bullion held to bullion liabilities is most probably giving cause for alarm. So the fractional relationship with unallocated accounts suggests that the gold cannot have come from them either, without making the position worse. The gold must have been supplied by central banks to the commercial banks under the agreement with the BIS. For these to be described as “investors” is simply misleading.

The last paragraph of the article is obfuscating: “Officials said other commercial banks obtained the gold from the lending market, borrowing bullion from emerging countries’ central banks.” It is almost certain that emerging markets are routinely tapped for deliverable bullion, and so the statement is obviously correct. Its relevance to the BIS deal is not clear and may be there just to confuse us; the alternative, that the European central banks do not have sufficient gold to come up with for this operation without bamboozling the likes of India, Lebanon and Algeria we can perhaps discount for the moment.

It is almost certain that the panjandrums at the ECB and the BIS have discussed this problem at their fortnightly BIS meetings, which are held in secret. A true un-spun press statement issued by this committee might have summed up the position as follows:

“The Committee is aware of a general increase in the bullion liabilities of banks in the Euro Area and is working with the ECB and relevant European central banks to ease market shortages.”

The reason we will never get the truth this plainly is that any such admission would be rocket fuel to the gold price, bring on the bankruptcy of the bullion banks, and the concomitant collapse of all paper currencies.

But to take this gold, when China, Russia, India and other nations are aggressively accumulating it, and the ability of the bullion banks to return swapped or leased gold to its actual owners is one hell of a gamble. We have probably just witnessed the last throw of the dice in the European central banks’ attempts to suppress the gold price.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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