by Paul Tustain
Wednesday, 21 April 2010
A note on the LBMA, gold futures and forwards, and “100-to-1 leverage” in London’s wholesale gold bullion market…
SOME COMMENTATORS are alarmed that the amount of ‘physical’ gold in London is not sufficient to meet the immediate demands of the market.
This concern is based on a simple misunderstanding. Read what follows and you will have a much better idea of how gold 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 gold futures, forwards and options.
The demand for forwards comes from volume buyers of physical metal – like gold dealers who wish to supply jewelry manufacturers – while the volume sellers are often gold mines and refiners. Both will make very specific forward settlement 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 you 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, and all of it available at a cheaper price.
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 he 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. You may have read of gold bugs who put huge orders into the spot market to prove the gold is not there. Well now you understand why no-one sells it to them!Selling physical gold which you cannot deliver on time is a big mistake which professionals don’t make. If the gold bugs ordered 2 months forward – allowing time for sourcing and shipments – there would be plenty of sellers happy to take their business.
So where does this leave the private investor? Using BullionVault, you can buy ‘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 we host 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, on our Daily Audit. 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 their reconciliation 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 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 professional futures market seller – not necessarily of gold, but of anything – and you have the ability to settle the underlying commodity, while private investors 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 private investors will only find buyers for their urgent sales if the buyers get a discount to fair value. The professionals are in the box seat because they can settle.
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.
It gets worse. Rolling over to the new futures contract doubles the opportunity for the professionals to profit.If, having just sold at a discount, lots of private investors are rolling forward to buy the new futures contract for the next quarter then that future will offer the professionals a premium over the smooth forward curve, and the professional will willingly sell it to them as soon as the premium is sufficient to make it profitable.
So you see even when private investors are offered rollover at apparently attractive terms (e.g. at middle prices and half the commission) the reality is that they are selling the old at a discount and buying the new at a premium. Wherever your trade is in the same direction as a large number of market participants who lack the ability to run their position until settlement you will probably lose out in this subtle way.
This is where the artificiality of futureswrings profit out of un-sophisticated investors who wish to speculate. Who’s to blame? It’s hard to accuse a seller of price manipulation when he runs his two month old trade to settlement, and it’s very hard to blame the opportunist professional buyer for supporting a low price by buying at a discount at expiry! The only people who can really be blamed for the expiry and rollover costs 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.
Paul Tustain is founder & CEO of BullionVault, the world’s largest store of privately-owned investment gold bullion.
(c) BullionVault 2010
Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.