The current situation has been taking a toll on financial institutions the world over. As the economy grounds to a halt, so do many of the daily transactions that keep money moving and ensure the balance of financial markets. As companies start massive layoff programs and furlough their employees, liquidity demand is rising to levels similar to those of long-forgotten bank rushes. In a bid to prevent widespread commercial bank failures and worldwide financial collapse, Central Banks are extending their liquidity facilities and slashing official interest rates. While this does help commercial banks with meeting their immediate needs for cash, it is nothing short of financial Armageddon for investment banks. However, because so many commercial and investment banks are intertwined, policy makers are faced with a situation where, no matter their decision, it will have a negative impact across the board. Whatever Central Banks do, or even if they do nothing at all, dire consequences will follow. In this scenario, their priority becomes damage control, as they try to choose the least harmful options in search of an appropriate balance. What would you do if you were a decision maker? Would you provide cash to hold off the collapse of commercial banks, or would you try to constrain money supply to save investment banks and financial markets?
The first signs of a severe banking crisis are already showing in the precious metals derivate market, and especially the gold market. As you know, a derivative is a financial instrument that derives its value from an underlying asset or group of assets. A simple example is a call option: instead of buying a stock today, you can buy the right to acquire it in the future at a set date and price. If the stock price at that date is higher than the price set in the call option, you can make a nice profit by exercising the call and then re-selling the stock at the higher market price. Of course, if the stock price at the exercise date is lower than the call price, then there is no point in exercising it and you lose the money you paid for the call option. Given that chance plays a significant role in the prices of stock and other assets, people usually compare derivatives to betting on the markets. Nonetheless, they also play a significant role in risk management by companies and, hence, are cornerstones of the financial markets.
Precious metals and their derivatives are mostly traded in New York on the Commodities Exchange, usually shortened to Comex, and in the London financial markets, with most gold traded being actually kept in the Bank of England’s vaults. Because New York and London are both major world finance centers, any negative impact on the precious metals derivatives market can quickly spread to other markets as a sort of financial virus, much like the current pandemic. This is why the oncoming collapse of gold derivatives can have disastrous consequences and, with Central Banks focused on injecting liquidity into the economy, there is nothing to stop it.
For almost a year, gold prices have been on the rise. In the past few months, this growth in prices has dramatically accelerated, mostly due to the quickly deteriorating health situation. This has created a situation in which gold has become bid-only, as professional traders say: there are many more buyers than sellers, so instead of announcing their prices, sellers simply pick the buyers who are willing to pay more. In practice, this means that the gold market is operating much like an auction house. As a consequence, competition becomes even more pronounced and leads the price further up. Additionally, as Central Banks begin massively increasing the money supply, gold will be subjected to significant inflationary pressure, adding speed to its already fast-rising price.
The problem with mounting gold prices is that bullion banks, which are banks that trade significant amounts of precious metals, have been buying derivatives that turn a profit if prices go down. In effect, these banks have been betting on the exact opposite of the current situation, through a financial operation called short selling. According to data from Comex, the net value of swap contracts has been on negative ground since 2018 and, right now, it is near historical lows. This means that not only have bullion banks been short selling, but they have been doing it to a tune never hitherto seen. As contracts start reaching their expiry date and people demand their gold, investment banks will simply not have enough money to buy all the gold that their clients are demanding.
In this situation, it seems that the only solution would be the Central Banks stepping in to bail out these failing banks. However, the problem isn’t simple and, therefore, the solution can’t be that simple either. You see, there isn’t enough gold in the world to cover all contracts made by bullion banks. That’s right: these banks have been trading gold that doesn’t really exist… and it’s all perfectly legal. This situation arises from the way that both the financial and the monetary markets operate. The financial aspect is rather easy: it has become common for gold mining corporations to sell their production before it is extracted, as a way of financing their operation. Think of it as a sort of an advance payment by the buyers. With mines stopped due to the lockdown imposed in reaction to the current pandemic, the pre-sold gold isn’t being mined, but its ownership is still being traded.
On the other hand, the monetary aspect is a bit more complex. Bullion banks are usually members of the LBMA, short for London Bullion Market Association, and have regular banking licenses. They take in gold deposits from their clients, like commercial banks take in cash deposits, and typically place them in unallocated accounts. For bullion banks, an unallocated account is great, because it means that they don’t have to actually keep the gold there. Exactly like regular accounts in commercial banks, these accounts operate under the fractional reserve system, which means that LBMA member banks only have to keep a small fraction of the deposited gold as reserves. The remaining gold can be invested and lent out, so that the bank can make a profit and expand its operations. Much of this gold is then traded and derivatives are created based on it, effectively multiplying the amount of gold that is nominally available. However, the real quantity of gold remains the same, as no financial operation can create real gold out of thin air. Sometimes, economics might sound like magic, but it isn’t THAT powerful. Let us know in the comments what you think about the fractional reserve system!
Under regular circumstances, neither the gold “created” by mining companies pre-selling their production nor the gold “created” by fractional reserve banking pose a threat to financial markets, because investors don’t frequently demand that the gold be delivered to them. It is much cheaper to leave it guarded in a bank’s vault than it is paying to have it secure at home. Consequently, it doesn’t really matter if the gold exists or not, because investors will just keep on trading it. The problem is that now, because of the current health situation, investors do want their gold. Even worse, many bullion banks kept their reserves as gold derivatives instead of keeping them as real gold. As their clients come knocking for their gold, the banks will be in a hurry to exchange their derivatives for the underlying real gold.
Both Comex and LBMA have been desperately trying to calm down the market, by releasing a series of reassuring statements and even announcing a new derivative financial instrument to meet rising prices. Jeff Christian, who leads the CPM Group, even gave what appears to be a staged interview in which he tries to assure investors that bullion traders have covered their positions. This means that different derivatives should cancel out, thus securing the bullion banks. While this is what should always be done in theory, in practice traders don’t do it. Thus, banks are fully exposed to the risks of a rush on gold by investors.
While the first troubles in the gold derivatives market were already showing up in the last quarter of 2019, the current pandemic created the perfect storm. Whereas in the past Central Banks were willing to lease their own gold reserves as a means of stabilizing the market, nowadays the leasing rate for gold is strongly negative, which means that they would have to pay the lessor to lease the gold. While some Central Banks have implemented negative official interest rates, they were very close to 0% and so were easily supported, but no institution could ever deal with rates of almost -4%. Meanwhile, most banks in the bullion business also have significant commercial operations. As governments start putting pressure on them to ease credit restrictions and help failing enterprises, they will be more than willing to part with speculative business like derivative trading. This adds further pressure to the gold derivatives market, to the point that the collapse of some banks’ gold trading desks might be so spectacular that it will result in the bankruptcy of the whole bank.
However, all of this will seem insignificant when the domino effect starts operating. As the gold market collapses and a few financial institutions start going bankrupt, the central role played by London and New York in the global economic system will spread the panic like a virus, bringing all derivatives markets to their knees. All around the world, markets will be plagued by defaults on derivatives contracts and a crisis of confidence will arise. As investors start demanding their money, a liquidity crisis will ensue and the already overstretched Central Banks won’t be able to provide much help. Further defaults will happen and a vicious circle will develop.
The final pieces of this falling set of dominoes are most commercial banks. All of them are exposed, one way or another, to the derivatives market. In fact, most of them are significantly exposed, though they try to conceal it as best as it is legally possible. For example, Deutsche Bank’s 2019 balance sheet reports a net value of derivatives of around a billion euros. In a balance sheet of €777 billion this seems like a grain of sand, but if we read the notes we find that the gross exposure is upwards of €37 trillion. This translates to a leverage of gross to net exposure of around 35,000:1. When the derivatives market collapses, an intervention to save Deutsche Bank would cost more than double what the entire economy of the United States can produce in a year.
In fact, according to the Bank for International Settlements, the sum of all over-the-counter derivative contracts outstanding in June 2019 amounted to a whopping $640 trillion, and this doesn’t even include derivatives traded on exchanges. For perspective, according to the International Monetary Fund, the world’s total GDP in 2019 amounted to $87 trillion. Therefore, a severe crisis of the derivatives market, if not its outright collapse, can lead to economic losses equal to more than 7 years of the world’s output at current levels. The impact of such an event would, quite simply, raze all the world’s economies to the ground. It becomes hard to make economic predictions when dealing with an event of this magnitude. Most economic theory just goes through the roof. Indeed, an economic loss of $640 trillion is so astronomically catastrophic that it is, in a word, unimaginable. Utterly unimaginable.
As this new threat to worldwide financial stability looms ever closer, what do you think should be done to avoid it?