At the end of June a new set of regulations, known as Basel 3, came into effect in Europe. In January the same rules will apply in England. These rules are supposed to strengthen requirements around leverage and lending for banks.
There are three parts of Basel 3 that matter to gold.
- The Available Stable Funding (ASF) factor determines how much each kind of liability can contribute as funding on a bank’s balance sheet. The most stable kinds of liabilities, like Tier I bank equity, are given a 100% factor; the least stable are given 0%. Basel 3 gives unallocated gold (paper gold) a 0% ASF, which means it has to be backed by assets.
- The Required Stable Funding (RSF) applies to bank assets. The key Basel III change is that the RSF factor for unallocated gold positions has been reduced from 100% to 85%.
- The Net Stable Funding Requirement (NSFR) is the ASF divided by the RSF and must be at least 100% at all times. This is just the math saying banks need assets to back their liabilities.
A paper gold holding is both an asset and a liability. It’s an asset in that it has value of its own; it’s a liability because it’s a contract to produce gold should the counterparty demand. Demands for physical delivery are rare but still must be part of the equation.
This new regulation saying that paper gold, which is also often called unallocated gold, cannot contribute funding to cover the liability side of things is the key here. To date, gold trading desks at banks have traded with credit pulled out of thin air. I’m a bit facetious, but only a bit.
Let me borrow the example used by Alastair Macleod at GoldMoney.com in this article on Basel III. Say a trading desk is granted a facility to trade paper gold and the bank gives the desk 10 monetary units of credit to do so. The bank records a 10-unit asset (the loan it gave its trading desk) and records a 10-unit liability (the desk’s need to repay that loan).
The trading desk can now deal with other banks in unallocated gold…via capacity created out of thin air. It’s possible because the loan and asset sides balance each other out.
That’s what Basel III changes. Reducing the RSF for unallocated gold to 85% means those two sides no longer balance. With that balance gone, banks would have to back 15% of their paper gold positions with other assets. In other words, they would have to put real money into gold trading.
Creating credit out of nothing is not particular to the world of gold. Banks create credit in many areas in the same way. But gold is not a normal thing. It’s a diversifier against a laundry list of macroeconomic trends and events. That role combined with this easy trading mechanism means the paper trading world got very large. These graphics from Visual Capitalist are a good view into the scale – and just how much paper trading overwhelms the physical gold market.
This huge market is at risk. Just how much risk is, I am not sure. There has been a longstanding argument that the ‘fake’ paper market artificially suppresses the price of gold. To the extent that this is true (certainly convictions of price-fixing against big banks in the last decade suggest it is to some extent), regulations that make it harder/more expensive for banks to trade paper gold will lessen manipulation.
What we don’t know at this point is how much banks will continue to trade gold. Will the requirement to provide those desks with 15% backstop in real assets erase gold trading desks? Or will banks provide some funding so as to maintain their ability to hedge through gold?
Certainly some people, including the gold market experts at GoldMoney, think trading will essentially cease.
Less trading, and therefore less manipulation, is likely. Whether that will necessarily increase the price of gold is another question.
The unallocated market allowed banks to buy and sell in the paper market on a large scale without anything close to the cash reserves to make good on the contracts. That isn’t a scam in and of itself. Futures markets were designed to let people sell things they didn’t yet have (like farmers pre-selling crops of wheat to get money to harvest) or lock in a price to buy things they didn’t yet have the cash to purchase or just weren’t ready to purchase yet (like large-scale bread makers contracting for wheat purchases down the road to hedge price volatility).
That’s why futures exist. And yes, when they were designed the idea was to take delivery of the ‘things’. But as soon as a mechanism existed to bet on price movements, people started buying and selling bets without any intention of taking possession of the underlying wheat or corn or pigs or gold.
Is this betting aspect inherently good? Bad? I’m not sure. Gold is a difficult thing to buy and sell, given its price (it’s simply expensive), value (gotta keep it somewhere safe and insure it), and range of forms (coins and bars all the way to jewelry and crowns!). Those are obstacles to ownership. The paper market takes those obstacles away, which I think is a good thing as it thereby gives more people a way to invest in gold.
Of course, nothing is ever simple. Take a look at this graph.
Thanks to Sprott for another useful chart. This one shows gold in ETFs in blue and gold in reported CFTC positions for non-commercials and managed futures in black, with the price of gold along the bottom. CFTC is Commodity Future Trading Commission. The two large players charted in black here – non-commercials and managed futures – are large funds that are not playing the future market to hedge actual metal (in other words, they are not gold producers or traders hedging their sales contracts against price volatility) but are speculators using the paper market to bet on price movements.
The chart doesn’t show commercial players but if it did the line would be much less volatile than the black line that is on the chart. That’s because hedging price exposure risk is a staid game compared to betting, usually with leveraged money, on price moves for the sake of it.
There are a few things to notice on the chart.
- The black line is jagged and volatile and only sort of correlated to the price of gold. That’s because the macro-type funds placing these bets play with a lot of capital, so when their short-term investment thesis on gold changes they move a lot of capital in or out of the space.
- These large funds also usually use leverage, which amplifies these already large moves.
- These large funds are also usually beholden to investment rules that, when they kick in, can create cascade effects. A pertinent one here is Value At Risk rules, which for large funds betting on gold futures usually involves a hard stop-loss process. Such hard lines force the fund to sell if gold falls to a certain level. Since their bets are large, those forced sales can push the price down, perhaps triggering the next stop-loss level, triggering more sales…you get the picture.
- Robotic macro funds are also part of this picture. Algorithm-driven, headline-scanning robo funds do not trade in physical; they trade in paper. It’s likely Basel III will downsize this business significantly, reducing another key source of volatility in the gold space.
- By contrast, the ETFs line has been almost stable, rising to gold’s peak in mid-2020 and then declining slightly. It’s pretty akin to gold’s 200-day moving average. And since gold in ETFs reflects mainly retail investors and smaller funds (which can’t play with much leverage and so don’t speculate via futures to a large degree), this stable – and of late slightly rising – trend is more indicative of ‘true’ investor interest in gold.
OK. So ‘true’ interest in physical gold appears to have been stable to rising while ‘speculative’ interest in paper gold has been volatile. If we really simplify this: taking the speculative side out of the equation makes for a more stable and more bullish setup.
Then there’s the question of how much of the trading that has happened in the paper space will persist. A huge part of that trading was banking desks trading to make profits for the bank but part of it is trading on behalf of customers. And should the paper market indeed shrivel, undoubtedly some bank customers will seek to replace their unallocated gold positions with physical.
This is a heck of a situation to understand, quantify, and then predict. A huge part of that challenge is that the unallocated gold market is annoyingly opaque, so there’s not a lot of data to work from.
Bottom line: Basel III limits the asset value of a bank’s paper gold position to 85%, which means banks will have to fund 15% of their gold trading desks with real capital (not credit created out of air that gets balanced by the value of paper gold contracts). This is very likely to reduce trading in paper gold.
How much the market will shrink is yet to be seen. Only about a quarter of the major gold trading banks are in Europe so despite Basel III having taken effect in Europe a few weeks ago it’s impossible as yet to see the impact. When the rules hit London, where the rest of the big banks sit, at the end of this year…the paper market could be reduced to a fraction of what it is today. Even if banks fund their gold trading desks to some extent, the paper market will still shrink notably.
What’s even harder to know is what impact this will have on pricing. The paper market is where price-fixing happens (as per convictions in recent years). It’s also where leverage is used, liberally. And it’s where algorithmic traders operate. This all means the paper market is far more volatile than the physical market. That basic foundation suggests that less paper trading should means more stability for gold, in the very least. Upside is also pretty likely, if even some of the paper trading switches to physical and if price discovery is left untampered.
All of that said, water will find a way downhill. If Basel dramatically alters this gold trading mechanism, which is what it appears will happen, traders will likely find another way to access easy credit and use it to trade gold. But it will take time for that new path to develop. And in the meantime, gold is likely to benefit.