Gold: How The Spot Price is Determined, Part II

In Part 1, I explained some basic facts about the bullion banking system and the exchanges that determine the spot price of gold over the short-run.

In this post, I’ll go into more detail and provide an example of how the system works.

To begin with, let’s imagine a situation where the basis is high and the gold-lease rate is low or negative.

I’ll use the numbers from July of 2016 as an example. At that time, the 3-month gold lease rate was -0.45%, the 3-month basis was 1.1% and 3-month LIBOR was 0.65%.

So let’s assume that Bullion Bank 1 has a dollar-denominated loan coming due that it doesn’t have enough cash to cover. However, BB1 does have some gold on hand that it hasn’t lent out. And, let’s assume also that there is a second bank, Bullion Bank 2. BB2 has some gold that it has lent out and will be getting back within the next three months. However, it does not have any gold to spare currently.

In this circumstance, BB1 can lease its gold to BB2 and BB2 can sell that gold into the spot market for delivery within 48 hours. Doing so allows BB2 to get cash, which it can then use to loan money at a profit to BB1, allowing BB1 to get the cash it needs and BB2 to get income from the interest rate on the loan.

If this sounds confusing, bear with me, I’m about to show you a table that will hopefully explain it better.

But first, we have to answer the question “who would buy the gold in the spot market”? The answer is that anyone could buy it: a jewelry fabricator, coin mint, cell phone manufacturer, whoever. But for the purposes of this example, I’m going to assume that it’s a swap dealer that buys.

So what does the swap dealer get out of this? He buys the gold in the spot market and simultaneously sells a futures contract to deliver that same gold to a buyer three months from now. Since the basis is 1.1%, this is what he will make as profit on the transaction. Meanwhile, he holds the gold in a vault until it is time to fulfill the contract.

So who would buy the futures contract from him? Again, this could be anybody. Maybe GoldMoney is expecting to need gold for its customers in the next three months, for example. But for the purposes of this example, I’m going to assume that it is bought by a speculator who thinks the price of gold is going to go up within the next three months.

If the price does go up, the speculator will profit the difference between the current spot price of gold and the future spot price of gold after subtracting the basis. For the speculator, the basis is the charge he/she must pay in order to “carry” the gold contract. This carry cost eats into the trader’s profits, so it’s a cost that must be taken into account by him/her when considering a trade.

Here is a table that explains the relationship between these four parties, along with their effect upon the spot price of gold

Basis is High and Gold Lease Rate is Negative.

Bullion Bank 1

Bullion Bank 2

Swap dealer

“earns the negative gold lease rate” (pays to lend/have stored). Keeps gold on books.

“Pays” negative gold lease rate (gets paid to borrow/hold in storage). Sells spot to swap dealer. Is not allowed to hold the gold on its books.

“Earned” -0.45% from leasing gold. In other words, paid 0.45% to have BB2 store its gold while still being able to claim the gold on its own books.

Loans cash to BB1. Gets paid Libor (0.65% in July, 2016). Profits 1.1% (negative lease rate paid of 0.45% plus positive interest on cash loan of 0.65%). Will pay back the gold lease with gold from loans coming due within three months and will keep the cash it receives when the cash loan is repaid.

Buys spot from BB2 and takes delivery. Sells three month future to a speculator. In three months, delivers the gold, getting back the cash he paid for it and profiting the basis (1.1%).

Borrows cash from BB2. Uses cash to pay off loans coming due immediately. Pays 0.65% interest for this privilege. Ends up with total payment of 0.45 + 0.65 = 1.1%

Pushes down the spot price of gold. Has no effect on the price of futures.

Pushes up the spot price of gold. Pushes down the futures price of gold.

Speculator

Buys gold futures from swap dealer. If price rises, profits the difference minus the basis. If price stays the same, loses the basis. If price falls, loses the difference plus the basis. Pushes up the futures price of gold. Net result: The spot price is unaffected.

As you can see, the transaction has no net effect on the spot price.

But what happens if the speculator refuses to buy futures? After all, isn’t he getting a raw deal having to pay 1.1% just to carry the trade? The answer is simple: if the swap dealer can’t find anyone willing to pay 1.1% to carry a long trade, the swap dealer won’t be able to hedge the swap. As a result, he’ll have to offer the future at a lower price in order to get the speculator to buy. This will tend to lower the basis and increase the lease rate.

Because of this reason, a high and rising basis can only continue for so long before it collapses under its own weight and pushes down the spot price of gold.

Now let’s consider a totally opposite example. Let’s say that the gold lease rate is high and the basis is low or negative. For example, this was the case in December of 2015, right before gold made it’s huge run up in the first half of the year. At that time, the 3-month gold lease rate was 1.26%, the 3-month basis was -0.7% and 3-month LIBOR was 0.61%.

So how do these relationships work in an example like this one? Here’s another table to explain.

Basis is Low/Negative and Gold Lease Rate is High.

Bullion Bank 1

Bullion Bank 2

Swap Dealer

Earns the lease rate (1.26%). Gets to keep the gold on its books.

Pays the lease rate (1.26%)

Sells spot to swap dealer. Is not allowed to keep the gold on its books.

Pays 0.61%, earning a total profit of 1.26 – 0.61 = 0.65%

“Pays” the basis (-0.7%). “Earns” Libor (0.61%) for a total profit of 1.26%.

Buys spot from BB2. Sells 3 month future to a speculator. In three months, delivers the gold and “profits” the -0.7% basis. In other words, takes a loss on the trade.

Pushes down spot.

Pushes up spot, lowers future.

Speculator

If the price stays the same, “pays” the negative basis (-0.7%, so he earns +0.7%). If the price rises, earns the difference between the two prices minus the negative basis (or the difference plus the absolute value of the basis). If the price falls, pays the difference minus the negative basis (or the difference plus the absolute value of the basis). Pushes up future. Net result is that the spot price doesn’t change.

Once again, this trade doesn’t immediately affect the spot price.

Obviously, this is a very bad deal for the swap dealer, as it is a losing trade. So what happens if the swap dealer doesn’t sell the future? What if he wants to hold the gold and wait for the price to go up instead? Then the speculator must offer to pay a higher price for the future in order to entice the swap dealer to sell. This pushes up the futures price, increases the basis, and lowers the gold lease rate.

Because of this reason, a low and falling basis can only continue for so long before it rebounds and pushes up the spot price of gold.

In the long-run, “paper” gold doesn’t affect the spot price. In the short-run, it only affects the spot price because of changes to the various interest rates in the system. These interest rates, in turn, change because of market conditions in the “real” gold economy. They change because more people are buying gold, less people are buying gold, more gold is being mined, more gold is being recycled, or whatever.

There is no conspiracy to suppress the price of gold. So we should all be paying attention to supply and demand fundamentals instead.



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