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 (see Sarnoff (1987, chap. 7) and Jacks (1990)). Although this development 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. Because 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 these 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 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 intriguing and might also be a fruitful avenue for research.
See Gulley (1991), Kuhn (1990), and P. Moore (1990). For an opposing opinion, see Conger (1990), Chua, Sick, and Woodward (1990), G. Moore (1990), and Temple (1990).
Several proposals have been made to return to some form of gold standard, most recently in September 1987 from James A. Baker, then Secretary of the U.S. Treasury. Alan Greenspan, Chairman of the Board of Governors of the U.S. Federal Reserve System, supported the usefulness of the price of gold in a broad-based commodity index. See McNamee (1987), Baker (1987), and Greenspan (1988).
Recent studies by Followill and Helms (1990), Melvin and Sultan (1990), Ogden and Tucker (1990), and Poitras (1990) indicate that there may be some inefficiencies in paper markets. Aggarwal and Soenen (1988) found that the London Bullion Market operates efficiently.
Forward sales in the physical market, although they involve a future claim on bullion, are agreed between two principals and, as such, are not tradable.
The markets for coins and other physical forms of gold are important in the sense that demand is closely linked to bullion prices, and their supply is just one step away from becoming a supply of bullion; accordingly, their existing stocks are included in this paper with bullion stocks. However, when market flows are being considered, inclusion of flow supply and demand in the coin market would necessarily involve double counting.
The essential difference between paper futures contracts and forwards in physical gold is that transactions in futures contracts are cleared centrally through an exchange (see below), whereas with forward transactions, the counterparties are principal-to-principal, thus making for greater flexibility in these transactions. Forwards have flexible delivery dates, whereas futures have one delivery date for each contract; and forwards are financed by credit lines that allow for easier administration than those in the highly geared margin financing of futures contracts. Forwards are also confidential, whereas disclosure requirements are set by futures exchanges. Futures contracts are, however, very liquid. For all of these reasons, the futures market is dominated by speculative trading, whereas the forward market is used by large operators to hedge their positions in physical gold. For these and further details, see Shearson Lehman Hutton (1990, p. 103 ff.).
Prior to 1990, the central banks that took part in this market usually did not secure their loans. See The Economist (1990). Also, when a number of gold loans were subject to default in 1990 (as described below), the financial institution involved went bankrupt because of loans it had made to a parent company and not because of its involvement in the market for gold loans.
See Sarnoff (1987, chap. 7) and Sarnoff (1980). Other descriptions of derivative gold instruments may be found in Brody (1988), Gold (1990), Inoue (1990), and McGanty (1990).
For example, on April 24, 1991, the spot price of gold was about $356 an ounce in New York, and COMEX offered contracts on strike prices ranging from $330 to $390 in increments of $10.
In fact, gold stocks seem to be a far more important source of potential supply, in response to an increase in gold prices, than the traditionally cited increase in mine output. Following the substantial price increase of late 1979 and 1980, mine output in the western world began to increase, but it took until 1984 for production to increase by 20 percent. The increase in supply from “dormant” gold stocks, however, in particular from scrapped jewelry, was immediate and appears to have had a significant effect in restraining further price increases. This response is described below.
Unless otherwise indicated, data cited have been obtained from Gold Fields Mineral Services Ltd. (also known as Consolidated Gold Fields Ltd.) in its annual publication, Gold (hereinafter, Gold). Tons are metric tons.
Of which 90 percent was mined over that period, and the rest represented a dishoarding of stocks. The largest gold mine in the world, with an estimated average annual production of over 80 tons, is believed to be the Muruntau gold mine in the former U.S.S.R. In 1991, Uzbekistan was responsible for more than 25 percent of Soviet gold production, most of it coming from Muruntau with an estimated production of 58 tons. By 1992, annual production in the former U.S.S.R. was estimated to have fallen to about 200 tons (or by about one-third) due to severe production difficulties. See Smith (1992).
The Bank for International Settlements (BIS), in estimating market sources and uses of gold, measures supply as western world production, sales by nonmarket economies, and changes in official gold stocks. Changes in the reserves of the South African Reserve Bank are excluded, however, because they are generally believed to represent the execution or unwinding of gold swaps with commercial banks in other countries, and such swaps do not appear on the market. Total supply from these sources is assumed to be equal to annual “nonmonetary absorption” of gold, averaging 1,886 tons for 1985–91. (See Bank for International Settlements (1990 and 1992, pp. 197–208 and 153–57)). The BIS estimate therefore essentially ignores the supply from gold swaps.
Fabrication includes the use of gold in electronics and dentistry, and the manufacture of jewelry, medals, and coins. Of total fabrication demand, jewelry accounts for an average of 78 percent, on the basis of 1985–91 data. Italy has the world’s largest gold fabrication industry, accounting for over 17 percent of the total in 1991.
The IMF’s Balance of Payments Statistics Yearbook does report “nonmonetary gold” flows, as variously defined, for the United States, Canada, Austria, France, Italy, Sweden, and Switzerland. See the appendix for further details on reporting.
Imports and exports for the United Kingdom and Switzerland are available, however, and are presented in Tables 7 and 8.
Of the countries listed in Table 2, only France, Italy, and the Netherlands value gold at near market prices.
Prior to the formation of the central bank gold pool in 1961, gold accounted for 64 percent of total central bank reserves.
For descriptions of activity by the former U.S.S.R. in gold production and sales, see Green (1985, chap. 3) and (1987, chap. 9), Euromoney (1987, suppl., p. 12), Mining Journal (1988, p. 334), and Craig (1982, chap. 6).
See Gooding (1991c). In January 1988, apparently inadvertently, the Bank for Foreign Economic Affairs in Moscow revealed production figures for six of the years between 1970 and 1985 (Mining Journal (1988)). These figures, and those revealed in 1991, have largely conformed to prior estimates by market analysts. For these estimates, see Gold (1990) and, in particular, CPM Group (1990).
Green (1981, p. 29). Total new gold supply from Western world mining and net sales by nonmarket economies in 1980 was 1,036 tons. See Gold (1982).
This problem is somewhat similar to the problem of asymmetry in the world current account, which, in theory, should be zero but is not.
Switzerland is estimated to have an annual refining capacity of 600–700 tons; the United Kingdom also has substantial refining facilities.
See Green (1985, chap. 3), Green (1987, chap. 9), Euromoney (1987, suppl. p. 12), Mining Journal (1988, p. 334), and Craig’(1982, chap. 6).
In 1980, Swiss customs figures on Soviet gold exports to Switzerland over a 20-month period were published by the Financial Times (see Kettell (1982, p. 214)), which may have caused Soviet officials to redirect some of their sales to London. However, the Swiss authorities have reportedly been careful to avoid a repetition of this situation. More recently, the former U.S.S.R. has sold some gold directly in Middle Eastern markets, according to market analysts.
Similarly, the net decrease in imports mainly by the Asian countries and the Indian subcontinent, of about 71 tons, is attributed to a reduction in net exports from the United Kingdom.
Increased imports of refined gold (of 179 tons largely derived from the former U.S.S.R. and the nonmarket economies); a decrease in refined exports (of 26 tons); and increases in scrap (6 tons) and unrefined imports (11 tons).
Similarly, there must have been increased disinvestment of some 84 tons in the United Kingdom when the other supply-side factors are considered.
Section IV draws heavily on Green (1985, chap. 9), Kettell (1982, pp. 203–208), and Roethenmund (1987). For articles describing developments in the gold market from 1968 to 1980, see Williams (1972) and Martin (1978 and 1980).
The United Kingdom was forced to abandon its gold standard by the huge debts it incurred in the operation of the war. The gold standard was re-established in 1919.
As Green (1985, p. 130) relates, the floor of the Bank of England’s weighing room actually collapsed.
During and immediately following World War II, while the London market was closed, the major banks in Zurich had established Zurich as the major world retail trading center for gold and were well connected to subsidiary markets worldwide. At the first London fixing in 1954, the Swiss banks immediately became the biggest buyers and they maintained their dominance in retail trading while London acted as a wholesale center.
Secrecy was assured through both the lack of any official intervention and the method of operation of the gold pool, which provided anonymity.
Because of Switzerland’s stable monetary history, the Swiss have not had a tradition of investing in gold. The French, the Italians, and (to a lesser extent) the Germans do invest in gold, however, and they often place it in Switzerland.
For descriptions of the London gold market, on which much of the following is based, see Green (1985, chap. 9), Kettell (1982, pp. 203–209); Roethenmund (1987), and Craig (1982, pp. 19–24).
The actual fix price is for the sale of at least 2,000 ounces in London good delivery bars of 400 ounces. Purchasers pay the fix price, plus ¼ of 1 percent as commission.
For descriptions of the Zurich gold market, on which much of the following is based, see Schriber (1981), Green (1987, chap. 10), Kettell (1982, pp. 209–212), Roethenmund (1987), Craig (1982, pp. 24–26), and Swiss Bank Corporation (1985, pp. 50–55).
The banks act as principals and issue their own contracts, which means that they maintain their own dealing positions in gold. Traders regard the individual banks as their counterparties.
See Samuel Montagu & Co. (1990, p. 12). We do not have detailed information about these gold flows for the most recent years.
The principal market makers are J. Aron & Co. (which is allied with Goldman Sachs), Mocatta Metals Corporation (which is connected to Mocatta & Goldsmid of London), Philipp Brothers (a division of Phibro Corporation), the Republic National Bank of New York, and Sharps Pixley. Morgan Guaranty Bank is a powerful market force because it has a large number of central bank and institutional investor clients, and Drexel Trading also had an important market niche with institutional investors and central banks before it went bankrupt along with its parent company, the Drexel Burnham Lambert Group, in 1990.
Other countries include Malaysia, Thailand, Viet Nam, Taiwan Province of China, and India. For further information on the Singapore market, and as a source for much of the following text, see Roethenmund (1987), Green (1985, chap. 13), Tan (1981, chap. 8), and Hok (1981).
The market leaders have been the local representatives of Rothschild & Sons, the Republic National Bank of New York, and Credit Suisse, as well as the bullion divisions of some local banks: the United Overseas Bank, the Overseas Chinese Banking Corporation, and the Overseas Union Bank.
See Euromoney (1990). The largest single loan was to American Barrick Resources of Toronto for 1.05 million ounces (32.66 tons). The loan was led by the Union Bank of Switzerland, Westpac, and the Royal Bank of Canada, representing a syndicate of ten banks, and has a maturity of 8 years (extendable to 11 years), with a 42-month grace period. The coupon is for 1 percent over a base rate that is adjusted every 3 months by the three banks—representing a market shift toward a floating rate rather than fixed rates.
In 1992 lending rates declined gradually to an average of 2 percent from high levels in December 1991 (see World Gold Council (1992)).
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.
According to market sources, the central banks most affected were the Bank of Portugal (which is estimated to have lost almost nine tons of gold worth $100 million), the Bank of Yugoslavia (which is estimated to have lost gold worth over $70 million), the Bank Negara Malaysia (with losses of over $40 million), and the Narodowy Bank Polski (with losses of over $10 million). The State Savings Bank of Warsaw is also estimated to have lost almost $5 million. These loans were normally unsecured. See The Economist (1990) and Nathans (1990).
The contango is the positive difference between the future and spot prices (a negative difference is called backwardation), which in this case were $363.3 an ounce (on the COMEX October contract) and $357.1 an ounce, respectively. The contango can be expressed as a percentage of the spot price. In this case, it is 1.71 percent, or 3.42 percent on an annualized basis.
Of the original five exchanges, the New York Mercantile Exchange (NYMEX) contract became inactive in 1981 (NYMEX is now planning to merge with COMEX), and the International Monetary Market (IMM) contract in Chicago, having originally performed better than most, became inactive in 1986. The other three are still active (see Table 9).
The members of the Clearing House Association are the actual counterparties to these trades, and each member of the association guarantees jointly, and without limit, the contractual obligations of every other member. A “settlement price” is established at the end of each trading day, and at the start of the next day each member must furnish a maintenance margin to the Association for each adverse position carried on its books.