Tuesday, November 8, 2011

IMF - The Structure and Operation of the World Gold Market

The Structure and Operation of the World Gold Market
Gary O`Callaghan
December 1991

IMF Working Paper No. 91/120

"In spite of gold's historical monetary significance, a freely functioning world market for gold has just recently come of age. The gold market had functioned more as a distribution mechanism than as a price setting device when the price of gold was maintained by monetary authorities at a predetermined level. However, market forces assumed a driving role on March 15, 1968, when a two-tier market for gold was established. For a time, central banks refrained from dealing in gold on the new free market, but agreed to transact in gold among themselves at the then official price of $35 per fine ounce. However, the two-tier market came to an end when the U.S. dollar's convertibility into gold was formally suspended in August 1971, and this effectively took away gold's pivotal role in the international monetary system. Since then, a global market for gold as an asset in its own right has developed, remaining open around the clock and using a full range of derivative paper instruments..."


"...II. Market Agents and Instruments
The market for gold consists of (1) a physical gold market, in which gold bullion or coin is transferred between market agents, and (2) a paper gold market, which involves trading in claims to physical stocks rather than in the stocks themselves. 1/ Both markets are closely linked by arbitrage and the possibility of participants being forced to satisfy the claims of paper gold physically, and paper gold prices are keenly affected by developments in the market for physical gold, where unanticipated changes in fundamental demand and supply are first detected..."

[Mrt: Freegold is just a next stage looking at it from the historical context.]

"...Gold loans are a phenomenon of the 1980s. The market for gold loans developed quickly in 1987, when the October stock market crash left many mining companies with reduced access to new capital. The market is typified by large (usually syndicated) loans to mining companies that want to finance excavation and further exploration and at the same time obtain a hedge against adverse price movements. The lending banks obtain gold either by borrowing from large investors and central banks or by buying on the spot market and simultaneously selling gold forward. By the end of 1986, only 38 loans, representing some 60 tons, had been negotiated; but by the end of 1989, an additional 159 contracts were in place and loans representing some 320 tons were outstanding.  Prior to 1990, lending rates for gold never exceeded 3 percent (of the physical stock involved) on an annualized basis and were normally well below 2 percent, providing a cheap source of finance for mining companies. Banks could simultaneously compensate the central banks that had long held barren gold assets, 2/ even if they included a substantial profit margin, and this generated a rapidly growing market. In 1988, however, after the Bank of England issued a public warning about banks that lacked expertise in the market, many participants withdrew, leaving a somewhat compressed market in the hands of the major bullion banks. 3/ Then, in 1990, the Drexel Burnham Lambert financial services group collapsed, with large outstanding gold liabilities to many central banks. 4/ As a consequence of the increased wariness after the collapse, the market supply of loans from central banks has been substantially reduced.

(The major arrangers and providers of gold loans have been the Chase Manhattan Bank, the Bank of Nova Scotia, the Union Bank of Switzerland, Westpac, the Reserve Bank of Australia, Barclays Bank, the Kleinwort Benson Bank, and the Bank of New York.)..."


"...The U.S.S.R. and the South African Reserve Bank are the major providers of gold swaps, which are attractive because they do not directly depress gold prices. However, swaps can provide liquidity to the market for gold loans if they are converted into loans by the dealers concerned, and they can subsequently affect supply to bullion markets if the loans are drawn down and sold by producers. The U.S.S.R-, for example, is estimated to have swapped some 300 tons for foreign currency in the first half of 1990, 6/ providing temporary liquidity to the market for gold loans when interest rates fell to 0,5 percent (annualized). These swaps werethought to have been unwound when the gold price reached $400 in August, however, and the gold sold directly onto the market, with a consequent reduction in gold prices and an increase in the gold lending rate..."

[Mrt: No comment. Means comments all between the lines. :o)]

"...Since 1968, the world gold market has developed into a fully-fledged global market, complete with a full range of derivative financial instruments that allow the adoption of hedging and options strategies. While this conforms to the trend toward rapid financial innovation in other international commodity and asset markets, a number of features of the gold market appear to have evolved in response to some of gold's unique characteristics both as a commodity and a financial asset. As such features might provide avenues for further research, they are at least worth a brief mention here.
Because gold cannot be consumed and can easily be transformed, a large existing stock constantly overhangs the market, and market participants are particularly sensitive to any changes in its distribution. Perhaps, for this reason, large gold holders are very secretive about their positions,and market placements are conducted with the utmost confidentiality. However, it is difficult to place a large sell order without its being detected by other market participants. The gold market appears to have discovered a unique solution to this set of problems, and this solution may explain the division of market functions between Zurich and London. The Zurich banks operate a pool that can absorb (and therefore disguise) large sales, so that Zurich has retained its dominance as the entrepot for new gold supplies. The London fixing allows the rest of the world to absorb any net supply (or demand) and is regarded as the true market price by virtue of its market-clearing mechanism.
Exchange-traded derivative financial instruments are essentially located in the New York market. Exchange trading, because of its disclosure requirements, does not promote confidentiality and therefore attracts a type of market participant different from those who hold large positions in physical gold. The market is largely confined to speculative interest. Although futures contracts do provide adequate hedging facilities, most large positions in physical gold are hedged through forward dealer contracts or swaps, and these are likely to remain an integral part of the market. Finally, gold's historical role as a monetary anchor has led to large stocks that have been accumulated as reserves at central banks, which in turn has facilitated the development of a market in gold loans. Although the market for large syndicated loans has now been substantially diminished, an inter-dealer market lending rate is quoted. From this market the possibility of discovering a "real" interest rate (which is not related to a particular currency), without recourse to derivation from a nominal (currency specific) rate, is somewhat intriguing, and might also be a fruitful avenue for research..."

Source: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=885158

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