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Market Impact of Gold Loans and Swaps

As a point of reference, GFMS estimates that the gold lending market is currently about 2,970 tonnes and has been as high as 4,700 tonnes in the last few years. What type of market impact would 4,000 tonnes have? Huge.

“The basic problem with the People’s Bank of China increasing its gold reserves to 10 percent or 15 percent, which a lot of people talk about, is that it’s just too much gold. To get to 15 percent would take 4,000 tonnes of gold. There’s no way in the world they could come into the market and buy that amount of gold without dramatically moving the price.”

Kamal Naqvi
Precious Metals Analyst, Barclays Capital& Chairman, LBMA Public Affairs Committee; London Bullion Market Assoc. Conference Sept. 2004

GFMS makes their beliefs quite apparent in the opening paragraphs of their Gold Survey 1998:

“The apparently inexorable decline in the gold price during 1997 was the clearest sign of an oversupplied market…Turning now to the supply components that really did the damage last year, these can be summed up in one word – liquidity. The front cover of this survey attempts to represent the cardinal role played by a massive increase in market liquidity in determining the course of the gold price last year. Simply expressed, liquidity refers to the pool of gold available to the market for borrowing and lending purposes and which, in the case of gold, is largely associated with the trading of gold on a loco-London basis and the presence in London of substantial official sector gold holdings owned by many different central banks... In more concrete terms, the lending of gold to the market, in most cases by a central bank in order to generate a return on its gold holdings, results in a physical sale, either directly by the borrower, or after a series of interconnected transactions.”

Analysts who disagree with our assessment of the impact of lending and swaps on price will make the case that each of those activities has a net zero impact on the price over time. In it’s simplest explanation that is how loans and swaps should work. The gold is sold into the market and then when the loan term ends, the gold comes back off the market. In reality, this is not the case.

1. Gold loan terms are usually for 3, 6, and 12 month terms. Some central banks have publicly stated that they have made gold loans with term lengths as long as five years. When gold is sold into the market in year 1, the buy back of gold from the market won’t take place for five years. In other words, the net zero effect of that trade is so far off in the future that the loan will impact supply side pricing without a corresponding demand increase for quite a long term.
2. Even a loan of one year can significantly impact prices if put on at certain points of the year when there are seasonally either huge influxes of supply or large deficits of supply. In a market that has as many seasonal supply/demand trends as gold, making the net zero impact is a hollow argument. For example, a 100 tonne sale made in the fall when there is traditionally a great deal of demand for gold from fabricators and from seasonal influences such as the Chinese new year or Indian wedding season will have little impact on the price when compared to a traditionally thin market over the summer period from June to August. The market has the depth in the fall to easily absorb the 100 tonne sale. During the summer months, it’s entirely possible that the 100 tonne sale could have a significantly larger impact on prices. The same principles apply when gold loans are being closed out on the market. Without knowing when loans and swaps are being put on the market and removed in central bank reports, even a correct guesstimate as to the annual levels of lending information is limited in it’s usefulness without the corresponding timing information.
3. Bullion banks and central banks roll some loans forward on a continual basis. So a loan of three months could actually be rolled forward on a regular basis, in essence extending the length of time the gold supply stays on the market.
4. Finally, a certain number of gold loans are settled out via cash transactions and due to the vague accounting allowed on loans and swaps by the IMF for gold reserves, the cash settlement becomes the call on the loan instead of the return of the gold to reserves…while at the same time staying on the books as gold in reserve.

Confusing isn’t it? It’s about time some of the confusion left the marketplace.

If this is the case, who has the ability to change how central banks report to the public ending confusion on gold lending and swaps? The International Monetary Fund.

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