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A Closer Look at the Question of LBMA Turnover

February 1, 1999

It is an attempt to make sense of the announced 900+ ton daily turnover in gold on the London Bullion Marketing Association (LBMA), as recounted in the archive series of discussions that was triggered by the LBMA announcement of their turnover figures in mid 1997. The archive series was compiled by Red Baron, and is available on this site. As a new visitor to GOLD-EAGLE, I stumbled across the archive on the LBMA and read it with great interest and have spent some time thinking about the problem of 900 tons/day gold turnover in a commodity that has a total pool of about 130,000 metric tons available above ground.

Much of the discussion in the archive hinges on the question whether it is real gold that gets sold, bought an delivered as hard metal, or whether it is merely paper trade with a cash settlement, with apparently the balance of opinion swaying to a true market.

It is interesting to examine various extreme alternatives to get an idea of the boundaries of the true situation. Awareness of the boundaries of a possible explanation for what is happening then enables further speculation on what could be the true state of affairs on the LBMA.

Firstly there is the question whether the turnover represents the actual transfer and delivery of the metal itself or whether it is merely a massive cash settlement similar to trade in index futures, such as the S&P.

If it were merely based on cash settlement, then the turnover actually does not mean all that much in terms of the real world , unless someone with a large exposed position – probably a long – hedges the paper position through the purchase of real gold. Buying and selling a ton of gold, the reputed average trade, would then result in a profit or loss of $32,150 for each dollar movement in the gold price – not very much at all for large players.

In this case the LBMA would resemble a derivatives market that can be many times larger than the underlying physical market. While derivatives can drive the smaller physical market on occasion, over the longer term there is an elastic force that sooner or later drags the physical market closer to realistic levels and, with it, prices on the derivatives market as well. While it is not stated that the LBMA really is a derivatives market, if settlement is in cash and no significant delivery of the volume of gold that is traded takes place, it would resemble a derivatives market for all practical purposes.

If the turnover of 900+ tons/day represented actual delivery, then certain extremes can be defined for the nature of the trade that takes place. For example, if all the gold that is above ground, about 120,000 tons, passed through the LBMA in turn, this would imply that each particular ton of gold is sold for delivery to a new owner every 27 weeks or so. If this were true, it is strange that the convoys of trucks ferrying gold to and from between sellers and buyers has never attracted any attention!

The other extreme is that just one ton of gold is being bought and then sold again 900 times a day. At the end of the day only one ton of gold is actually transferred to the last buyer. It seems likely that the gold would be stored permanently in one place as it would make no sense to shift it around 900 times a day!

Neither alternative appears remotely realistic, but the true situation should lie somewhere in between – if, of course the 900 tons/day is correct and if none or very little of it is paper trade.

A question of course is whether their charters would allow Central Bank's to be active players in this particular market. On the assumption that they cannot freely sell their gold through the LBMA, only to buy it all back 7 months later, it seems as if Central Bank's are responsible for only a fraction of the turnover, if any at all. If we also exclude that portion of the 80,000 tons in private hands that people wear around their necks and arms or keep in a strongbox at the bank, and also the minted gold coins, it is doubtful whether much more that say 10,000 tons are in the hands of the punters who use the LBMA as their playground – if it can be that much bullion. While it would not be a very large physical quantity, its mass and the need for security would place constraints on where it is stored and how it is transported.

A repeat of the previous calculation now using a quantity of 10,000 tons available to the LBMA market, still shows extreme boundaries of one ton being traded 900 times a day or, if the CB gold, jewelry and coins are excluded, a complete turnover of the say 10,000 tons available gold about every two weeks. It could of course imply that say half of this gold could be held for much longer than two weeks before being traded again, while the average turnover of the other 5,000 tons is much more frequent than two weeks. Or some other ratio that would give the same average trading turnover per day.

Some conclusions can be drawn from this, still on the assumption that the LBMA trade results in actual delivery of the metal.

It firstly means that nobody – either one entity or a large group of independent individuals – can hoard any substantial amount of the gold that has been bought on the LBMA for even as little as 2-3 weeks. After even such a short time, the withdrawal of any significant amount of gold from the available pool – as well as lack of further activity by those traders – should result in daily turnover on the LBMA falling to some noticeable degree. Over time, if hoarding continues, turnover should display a declining trend, unless new gold flows onto the LBMA in quantity – which seems unlikely in view of the rather limited amount of 'free' bullion that could be available. Trends actually seem to show that turnover is increasing all the time – either because the available pool has grown substantially, or because of higher velocity of the gold, or both.

It is therefore unlikely that any substantial amount of the gold traded on the LBMA disappears into hoards that are being built up and maintained for any length of time.

Secondly, the logistics of carting the gold around, referred to above, makes it very impractical to deal constantly with the high turnover in individual gold hoards that appear to be necessary to sustain a volume of 900 tons/day. Of course, it could be that most of the available pool of gold is stored in one or a few centrally located vaults where ownership of the gold changes frequently, but only small amounts are ever transported anywhere else.

The picture that emerges from this is that of a fairly static pool of gold, probably largely contained at some central location or locations, that is being quite actively traded among a relatively small and quite stable pool of speculative traders. As knowledge of the LBMA and its activities became better known, more participants joined that market, probably bring new gold into the pool as well – but without changing the basic parameters of the market to any significant degree – thereby increasing average daily turnover during the past few years.

We are still dealing with the assumption that trade on the LBMA involves change of ownership, if not always the actual physical delivery of the gold. In this speculative trader's market, transactions would be settled by payment of the full amount of the trade, i.e. the transfer of about $300 x 32,150 or almost $10 million for each average transaction of one ton of gold. A buyer of a ton of gold must therefore have $10 million available in a liquid bank account, where it would probably attract less that maximum interest and carry the cost of the transfer to the seller's bank.

If the gold price has moved by $3 by the time the new buyer has sold the gold again, he would show a gross profit of $3 x 32,150 or almost $100,000 less the cost of the bank transfer and the lost opportunity cost of earning interest on $10 million for however long he had kept the gold before selling it again. Secondly, unless they allow short selling, a trader can only deal in gold that he actually owns – which limits actual trading to the available pool of real gold, which has an upper limit of probably 10-12 000 tons, if that.

This smacks to me as being a very ineffective and costly way to run such a market – one that would find it difficult to maintain a turnover of even 50 tons /day, let alone 900 tons and growing. My guess is that the following developed over time: initially, trades were made against delivery or at least transfer of ownership of actual gold. As the intensity of trading and thus the velocity of the gold picked up, the cost to transfer the full purchase amount between banks and the need to manage one's cash reserves, ate into profits. As time passed, more and more instances of cash settlement of the difference – almost like a derivatives market – crept in as more and more people tried to maximise profits and reduce costs.

Sooner or later the market would become a place where the majority of transactions are mere paper trades, where an elaborate system of bookkeeping settled accounts at, say, month-end on a cash basis, with relatively little real gold changing hands. The alternative – true delivery of the gold bought and sold from a limited pool of available gold – appears just too cumbersome to handle the volumes that are reported.

As such, the LBMA would seem to be just a paper tiger – of academic interest only, and with quite little effect on the real world out there. With cash settlement the effective size of the market is $1 x 900 x 32,150 for each $1 change in the gold price, or about $29 million per dollar change – the equivalent of 3 tons per day at $300/oz. Not exactly peanuts, but not nearly in the major leagues. Could it be that the LBMA announcement of turnover in tons of gold was merely an attempt to cast a giant shadow?

If the above is correct, LBMA prices would follow the proper price of gold, simply because the capital that flows through the LBMA is relatively small – settlements on fractional changes in the gold price, not funds representing the purchase of 900 tons of gold! This reasoning also implies that really large holders of gold – merchant and other banks – may use the LBMA more as a means to make speculative insider profits than as a true market.

Of course, if there is some link between LBMA trade and the real gold market, the relatively small capital requirements on the LBMA could enable a determined player to build a very large position in gold that could exercise a knock-on effect on the gold price. But surely that can already be accomplished through the options and other derivatives markets as well – probably for less capital than it would take to make a dent in a 900+ tons/day market.

My estimates are very subjective and may not be near the mark. However, I think they have to be out by orders of magnitude to have any substantial effect on the conclusions.

A last sideways remark, apropos of a contribution by 'ANOTHER' on 9 October 97 (#36 in LBMA-7): common terminology has it that 'gold is now trading at $286'. Should it not be 'the dollar is now trading at 1/286th of the worth of 1 ounce of gold'. Not a very practical system, I know, but it would get the true message across!

This does not say that the above logic is impeccable. I am not very knowledgeable about these markets and have to guess half the time. If I missed a crucial point completely somewhere in the above reasoning, I apologise for time wasted.

Any input or comment on this question and analysis and the implications for the gold market are of course welcome.

Gold's special properties mean that it has a greater variety of uses than almost any metal.
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