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Bullion Banks' $190 Billion Derivatives Position

June 12, 2000

Gold bulls have been thwarted again!

An extensive $20 short covering rally by commodity funds and market participants failed to drive the price decisively through a critical resistance of $295 an ounce.

Physical demand, which was buoyant when bullion traded between $270 and $280, faltered and yet again gold appears to be stuck in a narrow trading band.

Unexpected dollar weakness contributed to the rally. But the Gold Anti-trust Action Committee (GATA), a gold bug pressure group, is also claiming credit for the spurt. A week ago it presented a document to John Silvia, chief economist of the Senate Banking Committee; U.S. Rep. Spencer Bachus, chairman of the Subcommittee on Domestic and International Monetary Policy; and other Washington politicians. The document, "Gold Derivative Banking Crisis," published on the web at the same time, claims that a "cabal of bullion banks, with the probable assistance of the New York Fed" and other official bodies, are "repressing the true equilibrium price of gold by hundreds of dollars."

There's little point in wasting space on the allegation of central bank collusion. For a start it doesn't wash with last September's Washington central bank accord to cut gold loans and supplies. But is there any truth in the claim that bullion banks have a massive bear position which they will cover and drive the price into orbit?

GATA has extracted March 2000 figures from the U.S. Office of the Controller of Currency and estimates that derivatives positions of U.S. bullion banks amount to $91 billion, equivalent to 319 million ounces or several years' production. Bank of International Settlements figures, which are dated, estimate that total global over-the-counter gold derivatives positions were unchanged at $190 billion (667 million ounces) in the past three years.

So what do these figures mean? Jessica Cross, Johannesburg based head of Virtual Metals Research and Consulting, is skeptical. She received a doctorate for a thesis on derivatives and wrote an excellent book on the subject for the lay person, "The Derivatives Revolution" (Rosendale Press).

She confirms what bullion managers, analysts, and World Gold Council executives report. She is married to a deputy governor of the South African Reserve bank and is objective and analytical.

Jessica's comment about the GATA thesis is: "One plus one equals 20." Say a mining company sells 10 tons forward on the derivatives market. The counterparty (i.e., bank) takes on to its book a long position of 10 tons, which it immediately offsets by selling forward 10 tons. The net position of the bank is zero, but the turnover is 20 tons and is reflected in the OCC numbers. A few weeks later the mining company elects to buy back 5 tons of its forward sale and the bank, which now has a 5-ton short position, offsets it by purchasing 5 tons from another bullion bank. The commercial bank's derivatives exposure is zero, but the OCC position is 30 tons and so on. Options deals result in even more paper trading, which clocks up OCC and BIS turnover.

Let's also put the bullion derivatives position in perspective. According to the BIS, gold bullion's $190 billion notional global outstanding derivatives position compares with foreign exchange contracts of $15 trillion, interest rate contracts $54 trillion, and equity-linked contracts of $1.5 trillion. Examining "gross market values" that take into account bilateral netting agreements, the BIS estimates that global gold open positions doubled to $22 billion in June 1999 from $13 billion in June 1998. Gold, in the financial scheme of things, is a small market, illustrating the paranoia of conspiracy theories. It is way down on the international financial and economic agenda.

This doesn't mean that banks don't get overexposed from time to time. That's precisely what happened in the third quarter of last year. Although the World Gold Council and African producers are claiming credit for the Washington Accord, it is more likely that the Fed and other central banks shortened the lending book to control excess bear positions in the market, says an experienced derivatives trader. There was the inevitable market spike and several bullion banks and producers (like Ashanti) were badly burnt.

The derivatives market does accentuate moves, especially when the price breaks through trigger points. Options traders through software programmes known as "delta hedging" buy or sell gold to cover short or long positions. Longer term, it is physical demand and supply that matters. Gold is cheap, and if producers spend more on marketing, they should raise demand and hence the price.

* * *

This kind of a story is no surprise to GATA, as it is exactly what we said would happen. It is a pretty weak response by the disinformation camp, and when the price of gold soars, they are going to have to try to explain their lack of forthrightness.

An extremely knowledgeable African in the gold industry had the following to say:

"Did you read the section headed 'The Peculiar Views Of Jessica Cross'? In your 'Gold Derivative Banking Crisis" report, Page 22, Paragraph 2, you made mention of Jessica Cross and a survey she is conducting for the World Gold Council. I wish to reiterate that she earns her living from persuading mines to hedge. It is in her absolute interest to underplay the effects of hedging on prices and set low estimates for the open short position in gold. To emphasize where she is coming from I have pasted below an e-mail sent from a friend in which a London-based commentator called Neil Behrman uses the views of Cross to trash your GATA report. The World Gold Council would be well-advised to employ a different consultant. I trust this helps you."

This African is right. That is very good advice for the World Gold Council. This is the same Jessica Cross who commented publicly to the media last year that the $84 gold runup last September was one of the worst events in the history of the gold market.

Behrman also does not report that he spoke with gold dealer honcho Martin Stokes of J.P. Morgan in London. "Martin was very cool to me," Behrman told me on the phone. Stokes is the same bullion dealer who would make no comment when an industry pro confronted him after the recent World Gold Council meeting about the disclosure of Morgan's $38 billion off-balance-sheet derivative position.

Who is right about the gold derivative explosion?

For an answer, why not try using some common sense. We know there is record gold demand, the CRB is making new highs all the time, the oil price has gone up 250 percent in 16 months, and gold producers such as Normandy are delivering into their hedges, which is restricting heretofore gold supply that was hitting the market.

Yet the price of gold is beaten down below $290 every times it makes a run above that.

While all these bullish factors for the price of gold are kicking in, the number of gold derivatives just happens to explode on the books of bullion banks that MUST disclose their positions. J.P. Morgan went from $18 billion to $38 billion the last half of 1999 alone.

The gold derivative numbers on the books of Deutsche Bank have gone bonkers too.

From's Reg Howe and his May essay, "Deutsche Bank: Sabotaging the Washington Agreement?"

"This table portrays a very disturbing picture. Deutsche Bank, the largest German bank, which had precious metals derivatives at the end of 1996 with a total notional value under US$5 billion, by the end of 1999 had grown this business to a total notional value in excess of $50 billion, or by more than 10 times in three years. What is more, a huge amount of this growth came in 1999, especially in the last half, as can be seen by comparing the average notional value for 1999 ($37.7 billion) with the year-end notional value ($51.2 billion). Note also that this growth was almost all in the longer maturities."

It took Chase Bank 14 years to get to $22 billion. It was just disclosed the other day in the new OCC gold derivative numbers that Chase's gold derivative position exploded up to $31 billion -- a $9 billion increase in only three months. Chase: What gives? Is this just another meaningless number on your books?

How can the bullion dealer camp get away with saying this does not mean anything, that is just a bunch of double counting? That just not hold up. The numbers affect the banks' capital requirements.

Regarding the BIS numbers derivative numbers, Reg Howe had this to say in May in his essay, "Gold: Can't Bank With It, And Can't Bank Without It":

"Three points about the BIS figures should be emphasized. First, under the Basel Capital Accord, all off-balance-sheet exposures, specifically including gold derivatives, are subject to the capital adequacy standards. Second, the Basel Committee on Banking Supervision has adopted a number of recommendations "to encourage banks and securities firms to provide market participants with sufficient information to understand the risks inherent in their trading and derivatives activities." And third, the statistics released semi- annually by the BIS on the global OTC derivatives market are an integral part of this risk assessment and disclosure process.

"Turning specifically to the derivatives market statistics, the consolidation of notional value at the BIS level is intended to eliminate double-counting between reporting banks and dealers so that the total notional figure is in effect a measure of market size at a point in time. It is not turnover such as reported by the LBMA. For commodities and gold, the closest analogue would appear to be open interest on a commodities exchange. But OTC contracts being non-standard, counting the number of contracts obviously does not work. Accordingly, the best way to measure them is by underlying contract amounts or face values, halving those between reporting parties and taking other steps, as the BIS does, to avoid double-counting."

It is too bad that Behrman did not take the time to carefully read the "Gold Derivative Banking Crisis" report. Everyone I know who has done so is just stunned and has acknowledged that the gold market is a ticking time bomb that could explode at any time. Regardless of the exact details of the meaning of the gold derivative numbers, it is a FACT that they have increased dramatically over the past year. It is very clear that the bullion banking camp has taken to gold derivatives (or paper gold) to try and hold down the gold price. They are being found out.

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