(Originally published on December 19, 2016 at goldtradingmastery.wordpress.com)
In Three Tools to Understand The Price of Gold, I talked about how to distinguish between the price of gold derived from physical supply and demand vs. the price created through speculation.
However, many blogs that cater to gold savers are filled with conspiracy theories and misinformation about this very issue. For example, these blogs often claim that central banks around the world are delibrately suppressing the price of gold by flooding the market with “paper” derivatives of it. Supposedly, this system is going to collapse soon and gold will go to 10x its value or more overnight.
The problem with this narrative is that the collapse inevitably never happens…and many gold savers become discouraged as a result. Some of them even end up selling their gold because of it. And that’s a shame – because saving in gold really is a reliable strategy to build wealth over time.
So what I want to do in this two part series is to explain how the bullion banking system works – and how the spot price of gold is determined through it.
Bullion Banking Fundamentals.
The first thing to understand about the spot price of gold is that it is primarily determined through the bullion banking system. This system is made up of banks that have deposit accounts and loans, just like regular banks do. In fact, most bullion banks are also regular banks that deal in cash in addition to being bullion banks.
The spot price is also affected by trading on the exchanges, such as Comex. However, the exchanges are linked to the bullion banks. So they are ultimately all just one big system.
Two Kinds of Accounts.
There are two kinds of bullion bank accounts: allocated and unallocated.
In an allocated account, a specific set of gold bars are set aside for the client and not included on the bank’s balance sheet. The bank is merely a custodian of the gold, and the bank has no right to lend out or otherwise use the client’s gold for its own purposes.
Bullion banks charge very high storage fees for allocated accounts. And in most cases, a client could easily get a commercial storage facility to hold his/her gold for him at a much lower price. So most clients who use bullion banks are not interested in allocated accounts.
In an unallocated account, the client buys gold which is then lent to the bank. The bank now owes gold to the client, and the client is a creditor to the bank. Under this circumstance, there are no specific gold bars owned by the client. What the client owns instead is a promise to be paid a certain amount of gold on demand if he/she asks for it.
Under this circumstance, the storage fees are either waved or drastically reduced. This is why most clients who use bullion banks have unallocated accounts.
Many bloggers refer to unallocated accounts as “paper gold” accounts because of their similarity to the way paper money worked under a fractional reserve gold standard in the 19th and early 20th centuries.
What is important to understand about this system, however, is that a client can always convert an unallocated account into an allocated one, and can even demand delivery of the physical gold if he/she wishes.
This threat of withdrawing gold is always present. And for this reason, bullion banks have to be careful who they lend gold to and under what circumstances.
The Basis, The Gold Lease Rate, and LIBOR.
In order to understand how the spot price is determined, we first need to understand the three primary interest rates of the bullion banking system: the basis, the gold lease rate, and LIBOR.
The basis is the additional cost added to a transaction if a gold buyer doesn’t want to pay for the gold yet and doesn’t want to take delivery of it yet, but wants to lock in the current price right away. This kind of transaction is called a “forward order” in the over the counter (OTC) market and a “future” on the regulated exchanges. The basis is also called the “GOFO” or Gold Forward Offer Rate in the OTC market. But these are just different terms for what is essentially the same thing: an agreement to lock in the current price in a future transaction (a future) and a premium paid for the right to do so (the basis).
When the basis is low or negative, it means that physical gold is scarce within the bullion banking system. This means that banks, miners, refineries, and merchants are having trouble getting a hold of enough gold to fulfill their loans and/or orders from current customers. As a result, they would rather have gold now than in the future. So they are only willing to buy in the future if the premium is very low or (if the basis is negative) they aren’t willing to pay a premium at all to buy in the future but will instead pay a premium to get gold now.
On the other hand, when the basis is high, it means that gold is very abundant in the bullion banking system. In this case, banks, miners, refineries, and merchants have plenty of gold and are not in any rush to receive more gold right now. In such a case, they are willing to pay a slightly higher price for gold if they can wait to pay for it later and wait to take delivery later – because doing so allows them to avoid storage fees and to lend out their cash at a profit in the meantime.
The Gold Lease Rate.
The gold lease rate is the interest rate charged by one bullion bank or a central bank to loan its gold out to another bullion bank. In a gold lease, the bank that lends out its gold is allowed to keep the gold on its balance sheet even though it no longer physically has possession of it.
The gold-lease rate can be derived by subtracting the basis from LIBOR.
When the gold lease rate is high, it means that gold is scarce in the bullion banking system. When the gold lease rate is low, it means that gold is abundant within the system.
LIBOR is the London Interbank Offer Rate. It’s the interest-rate charged for cash loaned out by the biggest banks in the world to each other or to their very best customers.
There’s actually a LIBOR for every heavily traded currency. But in this series, we’ll be focusing on the U.S. Dollar LIBOR.
When LIBOR is high, bullion banks want to get a hold of cash in order to lend it out. When LIBOR is low, there is little to no incentive for them to get a hold of cash, and they are are therefore more likely to be happy holding gold instead.
Next week, in Part II, I’ll discuss an example of a typical bullion banking transaction…and how the spot price is created through such transactions.