A note on the LBMA, Gold Futures and forwards, and "100-to-1
leverage" in London gold...
SOME COMMENTATORS are alarmed that the amount of
'physical' gold in London is not sufficient to meet the immediate demands of
the market, writes Paul Tustain, founder and CEO of BullionVault.
This concern is based on a simple misunderstanding. Read what follows and
you will have a much better idea of how futures, forwards, the spot and
physical markets interact.
Professionals who trade gold over the counter use a convenient standard
for specifying the form of the gold they will deliver between each other. The
standard is written and maintained by the London Bullion Market Association
(LBMA).
This standard is the Good Delivery bar which weighs about 400 troy ounces,
and is traded 100% fine (i.e. gross bar weight * purity). A Good Delivery bar
must have been manufactured by a recognized refiner which subjects itself to
rigorous and ongoing scrutiny by LBMA referees. All their output is carefully
assayed.
Professional gold dealers, and they are mostly banks, trade both these
bars, and notional contracts which are underpinned by these bars, i.e.
'derivatives' of the bars. These are things like futures, forwards and
options.
Gold Forwards
The demand for forwards comes from volume buyers of physical metal – like
gold dealers who wish to operate in the cash market and supply jewelry
manufacturers – while the volume sellers are often gold mines and refiners.
Both will make very specific forward dates and conditions for the bullion
delivery on a forward trade.
Private individuals would struggle to trade on their own account on the
forward market, because they lack the settlement facilities – like vaulting
accounts at the accredited vaults – which enable them to take and make
delivery of Good Delivery bars. But a miner might go to an LBMA bullion bank
and open a forward sale, and then arrange its gold to be shipped from a
registered refiner direct to the buying bank.
So forwards are deals in physical gold, but not necessarily for immediate
settlement.
Gold Future Contracts
Futures are different. Everyone – including private investors – can speculate
on Gold Futures very easily. So is there physical gold
behind futures trades?
A few Clearing Members of futures exchange will have a depository account
with some real gold in it, though Ordinary Members would be unlikely to, and
therefore cannot usually settle with their customers in gold.
Clearing Members' gold sits in the depository vaults, and title to it
rests with warrants which are passed between Clearing Members on the
occasions there is a net settlement of gold between them. (Several years ago BullionVault
spent quite a while trying to find a way of owning gold in a Comex Depository
Vault, through a Clearing Member, but we never found a satisfactory way.
Perhaps someone else has been more successful. If they have we'd be happy to
learn how, and publish the details.)
Because there is not ordinarily access to gold via futures markets the
huge majority of Ordinary Members of the futures exchanges, and their
customers, settle cash, not gold. The cash amount they settle is calculated
by reference to a specific price formula which becomes very relevant when a
future contract expires.
Futures & Forwards Together
Futures and forwards work hand-in-hand. Futures give the bank the opportunity
to approximately hedge out any price risk they have taken on a specific
forward trade. Futures are standardized, highly liquid and easily traded in
volume. The beauty of futures is that all the gradual liquidity of three
months of forward deliveries on specific dates can be concentrated in a
standardized futures contract which you can deal with any trader, because all
the contracts expire on the same day and with the same terms, regardless of
which trader your choose. This exchangeability is the source of their
liquidity.
Forwards, on the other hand, are hopelessly illiquid. Each was custom
built 'over the counter' for a specific settlement day. But forwards really
are deals in physical gold – which will settle as Good Delivery bars, on
almost every day of the year. So the flow of forwards through the vaulting
system is smoother than the flow of futures through a futures exchange, which
rush to close en-masse at expiry.
Adrian Douglas' Misunderstanding
The key concern that Adrian Douglas (a director of the Gold Anti-Trust Action
Committee (GATA), who attended the recent CFTC hearing) seems to have is that
there is a giant physical exposure which remains undelivered. Let me explain
why that is confused, while granting that there was no good explanation given
by Jeffrey Christian (managing director of CPM Group, a New York
commodities-market consultancy), who was in the hot-seat of a CFTC hearing.
It is easier for me with the written word.
Forward contracts are priced according to two things: the price of gold,
and the cost of money to the forward date of settlement (i.e. interest
rates). Forward prices of gold stretch out into the future for months and
years, forming what's called the forward curve.
The entire length of that forward curve is what the LBMA member's trader
calls 'physical'. For them this differentiates it from the
cash-only-equivalent of a futures contract. So, when they talk about
'physical' or about the open 'physical' position they are talking about a
whole lot of forward deliveries which sellers are under no obligation to
deliver today, and which the buyers neither immediately want nor can demand.
Those forwards will fall due for delivery a day at a time without causing
more than a ripple in the market. But being extended into a series of
physical settlements stretching out on that curve for years, the open
physical position is of course much, much larger than the amount of gold
which happens to be in the various London vaults today. That's no big deal,
it's where gold mines and aeroplanes come in.
So when a professional market analyst like Mr Christian says the open
physical position exceeds the amount of gold in the vaults all he is saying
is that the gold which is due for physical settlement next week or next month
has not necessarily been shipped in yet. But he knows (even if he does not
express it very clearly) that the seller of a forward is on the hook for
making the gold available on the appointed settlement date. And of course the
seller will incur a severe financial penalty for failing to settle, which is
why forward sellers don't sell gold without being very sure they can deliver
it.
Mr Douglas seems to have made an understandable and honest mistake caused
by the slightly confusing language which is used by traders. I hope you now
see that the LBMA's open physical position on its forward curve – far from
being a risk – is a genuine benefit to the gold market's smooth operation. It
defines the daily rate at which real bars are needed into the future, and
firmly places responsibility on the seller to make sure the gold arrives in
good time. This helps keep the world of real bars settling efficiently.
At BullionVault
we and all our customers benefit from this, because it means we can buy real
bullion a few thousand ounces at a time from an LBMA dealer who keeps bars on
hand to satisfy our modest demands. We don't have to organize the shipments.
We settle 48 hours after dealing, by sending a bank transfer and getting
ViaMat (our recognized vault operator) to collect the bars. This is called
spot trading, which is, in effect, the nearest 2 days of that long forward
curve.
How Banks Use the Forward Curve
When novices jump into the spot market and buy up all the immediately
available stock (and this happens from time to time) the result is a spike in
spot prices which reflects a lack of sellers capable of making immediate
delivery. It may not represent a fundamental shift in the value of gold;
there might – for example – be plenty of gold arriving next week.
What a trader will do is look at the shape of the forward curve. If he
sees that the curve has developed a lump at 48 hours, caused by that
aggressive novice's buying, it will be profitable for him to sell his spare
gold at spot, and buy forward by a week. He can deliver his bullion bank's
on-hand gold which will be replenished next week when the aeroplane arrives.
And he will make money from the aggressive buyer who has paid a premium price
for urgent settlement.
Meanwhile, as that bank buys one week forward in anticipation of the
aeroplane's arrival the effect is to distribute the novice's order along the
curve, and to smooth it out again.
BullionVault
Gold
So where does this leave your BullionVault gold? On BullionVault.com
you are buying 'Good Delivery' gold from stock which is already in the vault.
You are not even waiting for spot markets to settle.
The unusual rule on BullionVault is that a seller's gold must be on-hand, in
the vault, for settlement; and the buyer's cash must be cleared in the bank.
That's why BullionVault
is the only gold market in the world which offers instantaneous settlement at
the point of trade, and on a 24/7 basis. Thereafter BullionVault
simply looks after your gold. It's your property. It isn't available for any
selling when the spot market goes to a premium, and we have neither the right
nor the wish to play the curve the way a bullion bank does.
You can see this proven, each day. If we were delivering gold out to make
a few dollars on the forward curve our bar lists would show we were short of
physical gold in our vault. This is why we regard it as so important to
publish our bar lists, and reconcile them to all customers' holdings on a
daily basis. So far as we know we are the only gold business in the world
which does this.
We hope this has cleared up any confusion about the amount of gold in
London vaults. Now we'd like to finish with a quick look at who is
manipulating the futures market, and how.
Gold: Futures Price Manipulation
Futures brokers here in the UK routinely tell their new customers that 9 out
of 10 private customers lose money by dealing in futures. We understand the
regulators require this as part of the necessary risk warning.
Part of the reason – which has recently been alleged by GATA – is that it
is quite likely that there is some price 'manipulation' of futures contracts
at expiry. This sort of thing is not a gold problem. It is a problem relating
to futures markets in general.
Imagine you are a large futures market seller – not necessarily of gold,
but of anything – and you have the ability to settle the underlying
commodity, while your buyers do not. You sell the futures whenever they
appear to be at a premium over your forward curve, which will happen as the
speculators get into a buying frenzy on the futures market.
Suppose that at expiry the futures price is low against the forward curve,
which is quite likely if lots of private investors are on the long side and
are rushing to close out their near contract. You – the professional – will
be perfectly happy to buy the future back, so long as the discount to
forwards remains worth it, because then your physical stock won't have to be
delivered out, and you won't need to buy a new forward to arrange a
relatively expensive new delivery of physical stock into your depository
account. So you see you'll only find buyers for your urgent sales if they are
given a discount to fair value. Because they can settle they are in the box
seat.
Now suppose the opposite: that at expiry, the future is at a premium over
the forward curve (which is what happens when lots of short sellers who can't
settle have been dominating the speculator's market, and are now rushing in
to buy to close before expiry). Now the professional will act as the seller,
but only if the future is offering him a premium over the forward curve,
otherwise he'll run his open long to settlement. So once again the
professional has the whip hand over a crowd all trying to do the same thing
to avoid settlement. Whichever way the market moves the professional is in
the driving seat if he can sort out settlements, which is the position few
(if any) private investors are in.
Regardless of the commodity this will always be the case where most people
cannot settle. It is where the artificiality of futures, being compacted into
a single settlement date, wrings profit out of un-sophisticated investors who
wish to speculate. Who's to blame? It's hard to accuse a seller who ran his
two month old trade to settlement to be guilty of price manipulation, and
it's very hard to blame the opportunist professional buyer for buying at a
discounted price at expiry! The only people who can really be blamed for the
expiry volatility are the people who bought futures without both the money
and the storage facilities to settle, and that's usually those private
investors who are its victims, which is ironic.
That's futures, and it's ultimately each investor's own choice. If you
choose to play you are dealing in a marketplace which may force you to trade
at the time of your maximum disadvantage.
At BullionVault
our position is that you might cautiously use futures for short term
speculation. But we think you'd do better to avoid them for long term capital
preservation, which for many is what buying gold is about.
Instead, you should choose Physical
Gold through services like ours, where there are no artificial barriers
placed in the way of smoothly continuous trading and settlement. All you need
to do to avoid an unfair price dip in futures at expiry is buy the real thing,
and although that's difficult with pork-bellies, with gold it's easy.
Buying Gold made simple, secure and cost-efficient! Start with a
complimentary gram of gold now at BullionVault...