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THE GOLD CARRY TRADE - A HARBINGER OF TROUBLE

There is another risk to this derivative strategy which is even more ominous  ¾ the gold carry trade conducted by our financial institutions. As shown in the table below, the gold derivative position of our banks is a small fraction of their total derivative position. However, the position is much larger when compared to the actual gold physical market. Gold miners around the globe only produce about 2,500 metric tonnes of gold per year.

NY Bullion Banks Playing With Fire

The real story behind this explosion in gold derivatives is the gold carry trade The central banks have deposited or loaned gold to the bullion banks at a very low interest rate. The rate at which banks borrow from the central banks is called the gold lease rate which is currently 1.46%(1 yr.). The gold that banks borrow is immediately sold into the market at the prevailing rate for gold. The banks then invest the proceeds into investments paying a higher rate of return. This has become a very cheap source of capital for New York bullion banks like Chase, Morgan, and Goldman Sachs.

Gold & Silver Lease Rates as of 10/26/2000

Maturity	Gold	Silver
1 Month	.6400%	.5700%
2 Months	.6900%	.6300%
3 Months	.9587%	.8587%
6 Months	1.0000%	1.0500%
12 Months	1.4599%	1.9500%
Source: Bloomberg

Paying the Piper Poses Problems

However, a problem develops when the gold deposit is called or the gold loan comes due. When the bullion banks sold the gold short, that gold entered the physical market of gold. Today that gold is probably resting on the necks, ears and arms of women around the world as bracelets, earrings or necklaces. If those loans are ever called or the price of gold moves up, the bullion banks have a big problem on their hands. It is unlikely to be resolved by appealing to the good nature of women around the world to relinquish their jewelry for paper certificates of deposit.

Veneroso Associates estimates that official-sector gold loans stood at 9,000 to 10,000 tonnes at the end of 1999. Most of this gold has been converted into jewelry so it can’t be retrieved. These figures could be even higher this year since the gold derivative book at bullion banks has increased. With demand for gold far exceeding supply, inflation on the rise, oil prices exploding, tensions rising in the Middle East, the price of gold should be exploding. It hasn’t. Why not? The only plausible explanation is that "someone" wants to keep the price of gold artificially suppressed. The culprit can be found in the gold derivatives market. [ vi ]

It is beyond the scope of this Perspectives series to cover all of the reasons why the price of gold is being suppressed. For readers wishing to know more about this situation, an excellent source of information and detail can be found at www.gata.org under the “Gold Derivatives Banking Crisis." It is a long document, 118 pages, but well worth the read for the curious. (The author, Bill Murphy, was a guest on my program. His interview is available in real audio.)

Currently, annual demand for gold is estimated to be running around 4,000 tonnes per year. World gold demand exceeds supply by roughly 1,500 tonnes per year. The selling of gold by central banks and the leasing of gold from central banks by New York bullion banks such as J.P. Morgan, Chase, and Citibank, are alleviating the supply deficit. Another major player in this market is Goldman Sachs, which doesn’t report its position to the OCC (Office of the Comptroller of the Currency) because it is an investment bank. The total gold derivative position is $92.1 billion as of the end of the second quarter of this year. The top seven commercial banks make up $76.5 billion (83%) of that amount. The total above-ground supply of gold is only 120,000 tonnes, of which 33,000 is held as official central bank reserves. The total market value of gold in this world was worth $1.1 trillion as of the end of 1999 when the price of gold was $290. Since then, the price of gold has fallen to its recent price of $268.20.

Don't get lost in the numbers. The important point is that the total value of gold derivatives at the end of the year amounted to 26,000 tonnes. This represents ten times the annual production coming from the world’s gold mines! Even more important is the fact that the gold derivative position is only 6-7,000 tonnes short of the entire gold holdings of the world’s central banks. The remaining portion of the 120,000 tonnes is made up of scrap and jewelry.

The problem with the gold derivative holdings in bullion banks is that they far exceed the physical market for gold. If the price of gold were to move up, as in the case of a financial crisis or geo-political event such as presently occurring in the Middle East, this large short position could act as a NASA space launch for the price of gold. A financial crisis or war could breed a panic exit out of paper assets into real assets.

The Problem With Golden Paper

In the potential meltdown of LTCM, whose derivative book consisted mainly of interest rate, foreign exchange, equity, and credit derivatives, there was a ready supply of the paper assets such as bonds, equities, and currencies in relation to their derivative book. In the case of the bullion banks, the world of physical gold is far smaller than the world of gold derivatives. The annual production of the world's gold mines is roughly 2,500 tonnes. The total supply of gold in the vaults of the world's central banks is only 33,000 tonnes.[ vii ] The problem becomes apparent when a financial or geo-political crisis erupts as to where the gold exists in the vaults of central banks or in the form of jewelry. This problem of paper gold and physical gold could become the central banker's worst nightmare.

As if anticipating that problems are afoot, Treasury Secretary, Lawrence Summers and Federal Reserve Chairman, Alan Greenspan, have been lobbying Congress to approve legislation dealing with a potential derivatives crisis before they adjour. As a result of those efforts, the House passed HR4541. The bill is designed to reduce risk to the nation's banking system should a major financial institution experience a derivative explosion. This piece of legislation being promoted by the Clinton Administration would allow a bank or investment firm that becomes insolvent due to derivatives to use the net value of its losses rather than the gross value. The purpose of which would be to avoid tying up trading contracts in bankruptcy proceedings.

The New York Mercantile Exchange found the bill's passage appalling. In effect, HR4541 removes the energy and metals markets from public scrutiny and regulatory oversight. Could the Administration know something that the financial markets don't yet know? Usually, where there is smoke, there is fire. With tensions in the Middle East rising, oil prices escalating, inflation on the move and the stock market in turmoil, the price of gold is going down as a result of the bullion banks and their derivative book. Maybe Washington and Wall Street are preparing for the next bailout.

The price of gold is declining along with silver, at a time when they are both in short supply. World crises abound every which way you look. Our financial markets remain shaky, and John Q. Public is waking up to the fact that inflation is becoming real as he pays his bills the first of every month. Washington is intervening in the oil markets, the stock market, the bond market and the currency markets. The moral hazard argument is now at work. We know about bank deposit guarantees. Now it looks like we'll have financial market guarantees. Hold on to your wallets ¾ this is going to get interesting.

If you don't want to be struck by lightning, you don't stand under a tall tree in an open field during a lightning storm. The same wisdom can be applied to the world of derivatives. Our financial markets hang on a thin thread of probability and belief in a bell-shaped curve that such an event will never occur. Yet history reveals otherwise. The lesson of this last decade tell us that rogue waves and rogue traders do hit the financial markets. So far we've managed to survive them. The academics will tell us that their models will help us to avoid them. They have endeavored to convince the financial world of their mathematical certainty. But the real world isn't full of certainty.

There will come a day without warning, at a time when nobody expects, when that rogue wave will appear. It will be a day when events overwhelm the financial markets... when the house of paper will fall... when our financial institutions will be put to the supreme test... when the mettle of a man is tested... when faith in our institutions will be called into question. It will only be on that day and in that hour, that we will know if the Holy Grail of Finance truly exists.

April 28, 2001

© 2001 James J. Puplava
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