F(r)actions Of Gold

The simple fact of the matter is that gold is no longer money and hasn’t been treated that way in decades. It is a frustrating and often woeful outcome, but deference isn’t a reason to color judgement. As an investment, which is more like what gold has become, it isn’t all that straight, either. Gold behaves in many circumstances erratically; often violently so. In 2008, gold crashed three times; but it also came back (and then some) three times. The metal remains stuck in some orthodox limbo of duality, sometimes acting an investment while at others, more rarely, as almost reclaiming its former status.

The junction of that dyad format is wholesale collateral. It is a difficult and dense topic because it plumbs the very depths of the wholesale arrangement – factors like leasing, swaps and collateralized lending through binary bespoke arrangements. It is there that I think it helps to form the narrative, however, starting by reviewing what the BIS was up to in late 2009 and early 2010. I am going to borrow heavily from an article I wrote in April 2013 that describes the events in question but this is one of those times when you should read the whole thing.

Back in July 2010, the Wall Street Journal caused some commotion when it happened to notice in the annual report for the Bank for International Settlements the sudden appearance of gold swap operations to the tune of 346 tons. Subsequent investigation by media outlets, including the Financial Times, reported that the BIS had indeed swapped in 346 tons of gold holdings from ten European commercial banks. That was highly unusual in that gold swaps are typically conducted between and among central banks.

Included in that list of commercial banks were, according to the Financial Times, HSBC, BNP Paribas and Société Générale. The timing of the swaps was pinned down to sometime between December 2009 and January 2010 – just as the world was getting reacquainted with the Greek Republic.

In other words, “dollar” problems had been reborn despite QE1 and ZIRP (and the follow-on programs at the ECB, SNB and elsewhere) because European banks, in particular, had swapped “toxic” MBS collateral for “toxic” PIIGS sovereigns. Now, like MBS before it, even government bonds were becoming non-negotiable in repo (haircuts) and derivative collateral. Stuck not long after the last crisis, banks were in a tight spot since no central bank appeared ready to commit to another great effort so soon risking what they found a fragile but fruitful early revival. Banks then turned to the BIS in what only can be interpreted as great desperation for survivorship.

The amount of physical bullion purchased by private investors in the decade of the 2000’s had ended at custodial accounts in various commercial banks. Some of these investors were discerning and suspicious enough to demand allocated accounts. Some were not. Unallocated gold can get pooled into a house custodial account with rights over custody being retained by the bank, not the investor. In this case, said investor owns not gold, but rather a bank liability payable in gold.

Unallocated gold in pooled accounts residing in a bank with growing funding stress makes for a rather easy liquidity target. The gold market offers depth in a broad range of currencies. Gold markets are also very well interconnected, between the physical market in London and various paper markets, particularly the CME in Chicago.

  In the case of the large gold swap in 2010, the commercial banks accessed dollar liquidity “off-market” since the BIS simply held the bullion in its custody. Being accustomed to holding physical gold, it did have $23 billion, about 1,200 tons already on account, meant no additional hassle. The BIS surely incurred storage and administrative costs, but they would easily be absorbed by the interest rate the banks would pay on this collateralized loan (essentially the gold swap in this case amounted to a dollar denominated loan with gold bullion held as collateral by the BIS).