Chapter

IV. Bullion Markets, Trading, and Price Setting

Author(s):
M. O'Callaghan
Published Date:
March 1993
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Insofar as a market for gold existed prior to the 1970s, it was essentially focused in the London bullion market, whose history can be described in terms of the activities of the five London bullion houses that are still the only participants in the London price fixings.29

Mocatta & Goldsmid were exclusive brokers to the Bank of England until 1840 and thereafter shared the tasks of channeling gold from suppliers (largely colonial) to central banks and of acting on behalf of the Bank of England to preserve the U.K. gold standard. With the outbreak of World War I and the collapse of the gold standard,30 N.M. Rothschild & Sons acted as brokers for the South African mining houses, which dominated world production. The other four dealers were invited to Rothschild’s offices to participate in one of the first price fixings when the market reopened in 1919. The fixing is still conducted at, and chaired by, Rothschild & Sons, even though the South African Reserve Bank took over the marketing of South African gold a few years later and used the Bank of England as its selling agent to channel gold to the London fix. The other three bullion houses are Mase Westpac (formerly Johnson Matthey), Samuel Montagu & Co. (which sold most of the former U.S.S.R. gold at the fixing prior to 1968), and Sharps Pixley.

In 1939 the London market was closed by the outbreak of World War II, and it did not reopen until 1954. By that time, the Bretton Woods system was in place and the Bank of England, as agent for the South African Reserve Bank and operating through the five bullion houses, was able to maintain the price of gold at £12.50 an ounce, equivalent to $35 an ounce. After the price of gold rose to $41 an ounce in late 1960, the U.S. Treasury put its stock of gold at the disposal of the Bank of England. When this amount proved insufficient to maintain the gold price at $35 an ounce, six other countries joined in the formation of a gold pool of the major central banks in 1961. The Bank of England acted on behalf of the pool on a direct line to the fix, buying and selling on the pool’s account, which totaled some 24,000 tons of gold, whenever the price deviated from $35 an ounce. During the Viet Nam conflict, the pool came under increasing pressure particularly following the Tet offensive of 1968. Between March 8 and March 15 of 1968, 1,000 tons of gold are estimated to have been moved from Fort Knox to London.31 This amount proved insufficient to alleviate the emerging market pressure to increase prices, and the London market was closed on March 15.

The London market was closed for two weeks; it reopened to a changed world of gold. The so-called Washington Agreement had instituted a two-tier market for gold, permitting a free market for private individuals, while central banks could trade only with one another and only at the official price of $35 an ounce. Because the London fix would now be free of intervention by the Bank of England, an afternoon fixing was introduced in an effort to attract investors from the United States, with both fixings conducted in terms of U.S. dollars for the same reason. However, in the two weeks that the London market was closed, it had lost its largest supplier. The three major Swiss banks—Credit Suisse, Union Bank of Switzerland, and Swiss Bank Corporation—formed the Zurich Gold Pool and approached the South African Reserve Bank to market its gold through them. Their proposal was accepted on a trial basis, because (1) they had already been buying most of South Africa’s gold through London for some years;32 (2) they could guarantee secrecy for future transactions;33 and (3) they offered a price floor of $40 an ounce (which proved costly in the short run; see Green (1985, pp. 143–44)). In November 1968 a regular agreement was reached between the South African Reserve Bank and the Zurich Gold Pool.

Tables 7 and 8 detail gold flows through the United Kingdom and Switzerland for the years 1960–90 and 1968–91, respectively. These tables show that Switzerland, in addition to becoming the largest entrepot for new gold, has also become the world’s largest storage center for new gold. In the period since 1968, an average of 15 percent of its annual imports of gold have remained in Switzerland, and imports have averaged almost 66 percent of the world’s new gold supply. This implies that, on average, some 9 percent of the world’s annual supply of new gold has flowed into vaults in Switzerland for storage and fiduciary purposes.34 Net imports for the United Kingdom, in contrast, have averaged 0.6 percent of annual imports over the period 1968–90.

Table 7.Financial Gold Flows Through the United Kingdom, 1960–90(In metric tons)
Refined in BarsOther Forms
YearImportsExportsImportsExportsNet ImportsStocks Accumulated
1960776.0526.848.8127.8170.2170.2
19611,531.8572.947.9192.4814.5984.7
19621,006.3710.453.7190.5159.11,143.8
19631,014.2410.152.6180.4476.41,620.1
19641,222.1344.948.5202.3723.42,343.5
19651,177.32,078.747.5301.3–1,155.11,188.4
1966802.7865.324.8284.0–321.8866.6
19671,047.41,579.127.4302.1–806.560.1
19681,385.41,428.127.8281.8–296.7–236.6
1969395.9184.428.4164.675.3–161.4
1970911.1313.036.1261.4372.8211.4
1971969.0490.932.4140.1370.4581.8
1972585.9398.819.558.6148.0729.8
1973667.7475.216.052.0156.5886.3
1974548.6626.412.644.6–109.8776.5
1975477.4440.89.568.4–22.3754.2
1976599.9440.88.2136.930.4784.6
1977625.8537.622.6122.3–11.5773.1
1978508.3516.25.1124.4–127.2645.9
1979775.4381.821.5110.4304.7950.6
1980516.4286.495.348.9276.41,227.0
1981553.0479.438.2190.5–78.71,148.3
1982512.6370.718.8216.0–55.31,093.0
1983482.5602.26.5118.6–231.8861.2
1984431.7311.84.5209.9–85.5775.7
1985345.2242.92.6182.3–77.4698.3
1986458.2364.53.6105.0–7.7690.6
1987348.1286.426.181.16.7697.3
1988582.2462.413.4159.0–25.8671.5
1989621.4615.511.9203.0–185.2486.3
1990645.9469.49.7173.312.9499.2
Source: Overseas Trade Statistics of the United Kingdom, as reported by Samuel Montagu & Co. in Annual Bullion Review (various years). See also Appendix.
Source: Overseas Trade Statistics of the United Kingdom, as reported by Samuel Montagu & Co. in Annual Bullion Review (various years). See also Appendix.
Table 8.Gold Flows Through Switzerland, 1968–91(In metric tons)
YearImportsExportsNet

Imports
Stocks

Accumulated
Imports

(In percent)1
1968773.1295.4477.7477.763.6
1969904.5666.0238.5716.273.1
1970786.4843.0–56.6659.661.9
1971634.3776.3–142.0517.649.3
1972655.0801.0–146.0371.647.1
1973958.9591.1367.8739.469.2
19741,076.4462.7613.71,353.188.5
1975926.7584.7342.01,695.194.6
19761,151.0895.6255.41,950.583.6
19771,053.0738.6314.42,264.977.3
19781,190.3822.2368.12,633.086.1
1979955.4686.2269.22,902.282.5
1980593.1603.3–10.22,892.056.4
1981806.0840.1–34.12,857.963.7
1982901.8781.4120.42,978.373.1
1983774.5582.9191.63,169.994.1
1984747.3884.7–137.43,032.554.5
1985836.4921.1–84.72,947.857.8
19861,094.4905.5188.93,136.764.4
1987758.3666.591.83,228.545.0
1988846.0823.822.23,250.746.6
19891,011.81,080.4–68.63,182.151.9
19901,202.31,031.8170.43,352.555.4
19911,019.1965.653.53,406.150.8
Sources: Swiss Federal Bureau of Statistics, Annuarie Statistique de la Suisse (various years), and staff calculations. See also Appendix II on the official reporting of gold flows.

As a percent of global new mine production and sales of nonmarket economies.

Sources: Swiss Federal Bureau of Statistics, Annuarie Statistique de la Suisse (various years), and staff calculations. See also Appendix II on the official reporting of gold flows.

As a percent of global new mine production and sales of nonmarket economies.

Zurich has also been the dominant entrepot for physical gold since 1968. The former U.S.S.R. had begun to channel its gold through Zurich in 1966, following its formation of the Wozchod Handelsbank there as a conduit, and the Zurich Gold Pool is still thought to handle most new gold sold on the world market from South Africa and the former U.S.S.R. (some 970 tons combined in 1989). Hong Kong now rivals New York as the third largest trading center for physical gold by virtue of the growing importance of the Far East as a destination for gold. Singapore has also grown as a trading center for this reason. New York remains an important primary-market, with large supplies both produced and demanded domestically in the United States. Also, as described in Section V, New York dominates the market in paper gold instruments.

In determining the spot gold price, however, London is still considered the most liquid and influential market because of its twice-daily fixings. Smith (1981) sums it up thus:

Because of its format and the expertise of its members, and the communications from London, I believe that the fixings are truly—the truly—genuine open outcry market, where real volume can be moved at one price—a price at which anyone in the world can participate in directly, or through someone else, and it is a price that is published for all people to see (p. 77).

Price setting in Zurich is dominated by the three major Swiss banks, which are members of the Zurich Gold Pool, and there is no fixing. That the majority of the world’s supply of new gold passes through Zurich is not a major disadvantage to London as a price-setting center, because gold held in Zurich can still be sold loco-London (with a loco-swap achieving delivery, if required). It is evident from indicators of market activity that a far larger volume of gold is actually traded in London. It is more significant for London that the holding accounts of all the major traders in the world are located there, making the London price the most influential price in the world market. Almost every other market will quote a loco-London price in addition to its own local market price.

London Bullion Market and Gold Fixings

There are 14 market making members (that is, dealers) on the London bullion market, which is the largest number in any one trading center for physical gold, and these include the five dealers participating at the twice-daily fixing.35 The market has been supervised since 1986 by the Bank of England, in consultation with the London Bullion Market Association (LBMA), which was formed in 1987 and has 52 ordinary members (brokers and bankers) in addition to the market makers. The Physical Committee of the LBMA maintains a list of acceptable melters and assayers (that is, refiners) whose stamp must appear on any bar that is considered “good delivery” in London. Good delivery bars must be at least 995 fine and must weigh 400 ounces. Spot quotations are for loco-London good delivery, but the bars are often delivered to, and stored in, the vault of a Swiss bank. Delivery and payment must be made within two working days.

Official London market hours are 9 a.m. to 5 p.m., but dealers will usually trade informally from 7:15 a.m. to 7:15 p.m. Of course, dealers and brokers constantly monitor one another’s bid and offer prices, so that deviations in price are quickly arbitraged away, but the market is actually cleared at a single price at the price fixings.36 Representatives from each of the five London bullion houses meet daily in closed session at Rothschild’s Fixing Room at 10:30 a.m. and 3 p.m. A Rothschild representative chairs the meeting and begins by suggesting a starting price. All of the participants are linked to their individual trading room by telephone, over which they are advised whether the firm is a net buyer or seller at that price. The decision is communicated to the chairman, who tries to match the positions. The price is altered until each dealer is satisfied (and has signaled this by lowering a small British flag on his desk), and the fix is then declared. Because each of the dealers communicates a net position, the volume of gold transacted at the fix is impossible to determine. However, it is well known that a large proportion of the London market’s daily volume (estimated at 100–200 tons) is transacted at the fix and that the London fix provides the world’s most liquid environment in which to place large orders.

Zurich Gold Pool and Gold Price

Even though Switzerland has no indigenous gold supplies, it has retained its dominance in physical gold trading by providing specialized banking and ancillary gold services in an essentially unregulated and confidential environment.37 The members of the Zurich Gold Pool dominate the market by providing virtually all of its supplies of new gold and by operating large refineries, but many smaller banks and finance houses are also engaged in the refinement, upgrading, transportation, and brokering of gold from producer to investor or consumer. Refined gold may be returned to the producer or forwarded to a specified market without transfer of ownership to the finance house, or it may be bought for later sale to consumers or investors. Most of the contracts written in Zurich are for actual delivery, but finance houses also provide gold storage facilities for investors who do not wish to receive the physical gold. In addition, the Swiss banks operate two types of gold bullion accounts: (1) custodial accounts offering title to the account holder, in which case the gold is beyond the reach of creditors if the bank fails; and (2) claim accounts, which are the only accounts offered by the members of the Zurich Gold Pool that never transfer title. The loco-Zurich bullion specification is the same as for the London market, which allows gold situated in Zurich to be quoted loco-London, and vice versa. Delivery and payment are made within two working days, and hours are bankers’ hours (9:30 a.m. to noon and 2 p.m. to 4 p.m.).

The Zurich gold market has no formal organizational structure. Except for the members of the Gold Pool, dealers quote bid and ask positions independently of one another (but in close competition). Prices are usually quoted in U.S. dollars, but are also quoted in most other currencies on request. The Gold Pool exists on the basis of an informal agreement among the three large banks (still the original members) and is free of official regulation.

Each participant in the Pool conducts trades that do not directly affect its own stock of gold; its stock is affected only via the effect on its contribution to the Pool.38 The Pool consists of a combination of these stocks, but no gold is vested in the Pool itself. Instead, the Pool operates as a mix between a consortium of dealers and a clearing system. Each member combines its external dealings into lots of 250 kilos (0.25 tons) and offsets them through an opposite transaction between it and the Pool. External sales are bought from the Pool; external purchases are sold to the Pool. In effect, the members “commit themselves to go long or short for the Pool’s account, subject to certain (undisclosed) limits” (Green (1987, pp. 145–46)).

The positions of the individual banks are not disclosed to one another, thereby keeping secret the source of any large order, and a joint clearing system totals the anonymous positions of the banks and sets a price each day “according to changes in these positions” (Schriber (1981, p. 82)). This jointly fixed price is regarded as the official Zurich price and is binding for Pool members. It also provides a guideline for the other banks that are active in the market. A net excess demand by (supply from) the market is then met (absorbed) in equal proportions from (into) the members’ own stocks. In 1982 the Gold Pool established PREMEX AG as a high-technology market intermediary that acts on behalf of other dealers on a commission basis.

The Swiss authorities do not publish statistics on the sources and destinations of gold flows through Switzerland. However, the principal export destinations for loco-Zurich gold are thought to be the Italian jewelry industry, which used 360 tons in 1989, and other fabrication centers in Europe (excluding the United Kingdom), which used 200 tons, and in the Middle East and Far East, where Switzerland supplied some 38 percent (350 tons) of total demand in 1989.

Hong Kong Bullion Market and Price Fixing

The Hong Kong gold market began operation informally in 1910 and has expanded rapidly since January 1974, when government restrictions on the importation of bullion were lifted (see Roethenmund (1987, p. 77), Green (1985, chap. 12), and Tan (1981, chap. 7)). It is now the principal distribution and clearing center for the Far East. Furthermore, when the New York market has closed and the London and Zurich markets have not yet opened, Hong Kong is the only significant physical gold market available to Middle Eastern and Far Eastern traders. Accordingly, Europe’s opening quotations are based on Hong Kong prices. Hong Kong is estimated to have imported 430 tons of gold in 1989, of which 330 tons were re-exported to other countries in the region in bullion form and 65 tons were used in the fabrication of jewelry destined for mainland China.39 The main export destination is thought to be Taiwan Province of China, which is estimated to have absorbed 240 tons from all sources in 1989, but Thailand, China, and the Indian subcontinent are also substantial customers.

Trading is between principals and takes place at the Kam Dgan, which is the Chinese Gold and Silver Society. The exchange has a fixed number of 195 members, all of whom must be Chinese, and it also includes a “bullion group” of 33 members who smelt and manufacture standard bars. Trading hours are 9:30 a.m. to 12:30 p.m. and 2 p.m. to 4 p.m. on weekdays, and 10:30 a.m. to noon on Saturdays (Hong Kong is the only gold market open on Saturdays).

Two types of contracts are traded on the Hong Kong spot market: loco-Hong Kong and loco-London. Both operate as undated futures contracts, with all trades made for an unspecified forward date (that is, contracts are open ended). Neither party is under obligation to settle the contract (that is, to make or take delivery) on any particular date, and traders may roll the contracts over indefinitely, on a daily basis, subject to provision and maintenance of a margin requirement, which is assessed with respect to market conditions (see Gehr (1988)). Although some loco-Hong Kong contracts are actually completed, most positions (and all loco-London contracts) are eventually canceled by an equal offsetting transaction between the parties involved.

Loco-Hong Kong Fixing

Spot prices are quoted in units of 1 Hong Kong dollar per tael (the Chinese measure of weight, which is equivalent to about 1.1914 ounces), and the lot size is 100 taels. Gold bars weigh 5 taels each and are of not less than 99 percent fineness (that is, slightly inferior to those in other loco-markets).

A unique daily fixing is conducted at 11:30 a.m. on weekdays and an hour earlier on Saturdays, and trading stops temporarily while this process is carried out. First, those who wish to make and take delivery are listed on opposite sides of a blackboard. Then, supply and demand are matched—not by altering the spot price, but by the variation of a daily interest factor, which is expressed in terms of Hong Kong dollars per 10 taels of gold a day, and which is actually a financing charge or premium on open positions maintained until the next day. The charge may be positive or negative, depending on the positions to be squared. When the shorts are originally in excess, the interest factor is positive and the shorts make payment to the longs; when the longs are in excess, the interest factor is negative, and the longs make payment to the shorts. This unique procedure allows the market to clear without requiring that the (undated) contracts be fulfilled. If there is an excess of long positions (for example), this is equivalent to excess demand at the prevailing spot price, and the “price” rises by imposing a cost on the longs for maintaining their long positions. The shorts also maintain their positions, but receive a payment to do so.

Loco-London Pricing

Loco-London contracts are also undated and are rolled over indefinitely until a position is closed by an equal opposite transaction. The market is purely speculative, with no delivery effected. Price quotations are based on spot rates for standard good delivery bars in London, and trading is performed on the basis of the payment of a margin. A daily interest charge based on the LIBOR (London interbank offered rate) is levied on any open positions financed by the broker or is credited to the accounts of those in profit.

New York Bullion Market

The physical gold market in New York developed after U.S. restrictions on holding gold were lifted in 1975 (see Kettell (1982, pp. 212–14), Roethenmund (1987), and Green (1987, pp. 151–52)). Investors and speculators became interested principally in trading in coins (especially South African Krugerrands) and derivative gold instruments. Except for some interest in the South and West, bullion never became a major target of investment funds. However, the United States was considered in 1990 and 1991 to be the second-largest producer of mined gold in the world, having produced 294 and 300 tons, respectively, in these two years, and the New York bullion market serves as a conduit between this mined gold and the U.S. gold fabrication industry, which was the third largest in the world in 1990 (after Italy and India) and the fourth largest in 1991 (after Italy, India, and Japan). In 1990 and 1991, totals of 216 and 202 tons of new gold, including coins, are estimated to have been demanded in the United States (see Gold (1992)).

The New York bullion market has no formal structure and no open-outcry meeting place. It consists of a number of market makers who operate an over-the-counter bullion trade.40 Any quantity may be traded, but most transactions are in multiples of 100 ounces and the most common units are 400-ounce and 100-ounce bars of 999 fine (that is, American gold). Trading is not restricted to any exchange hours, and delivery may be made on any date mutually agreed upon, with payment due on receipt.

Singapore Bullion Market

The Singapore bullion market serves principally as an entrepot between London and other countries in the Far East (in particular, Indonesia).41 Of the 227 tons imported by Singapore in 1989, only an estimated 28 tons were retained to satisfy domestic demand (see Samuel Montagu & Co. (1990, p. 12)). The market, which was formed in 1969, has no formal organizational structure and no open-outcry meeting place. It is primarily made up of brokers who charge an over-the-counter premium on the price quoted (on an overnight basis) by their European consignors. However, some of the larger bullion houses do act as principals, taking positions on their own account, and most of the large overseas gold houses are well represented.42

Gold bars of many sizes are traded, but the most popular unit is the kilobar (32.151 ounces) of 999 fineness, and all physical gold is traded loco-Singapore and in Singapore dollars. Settlement is effected by full payment of cash on delivery, which is usually within a week of the date of contract. An undated futures market also operates in Singapore, trading loco-London and loco-Hong Kong paper gold on a rollover basis; this procedure permits margin speculation on overseas spot prices, with interest on outstanding balances being charged daily on the basis of LIBOR. Banks have also developed gold certificates and gold savings pass-book programs that are denominated and accumulated in units as small as a gram.

Other Bullion Markets

In addition to the major bullion markets, a number of minor markets operate throughout the world.

Continental Europe

Investors in France have long had an affinity for investment in gold. It is estimated that they had accumulated some 5,000 tons of gold for this purpose prior to 1968. Analysts speculate that this is still the largest stock of unreported gold in the Western world (Roethenmund (1987) and Green (1981)). Since 1968 the French have preferred to make and hold their gold investments in Switzerland, and the Paris gold market (the Matif) is used predominantly for domestic transactions in gold for fabrication purposes. France consumed about 39 and 38 tons of new gold in its fabrication industry in 1990 and 1991, respectively (Gold (1992)), and the importation and exportation of gold for other purposes is largely prohibited. Paris has both a midday and afternoon fixing, at which prices are set in French francs per kilobar.

Because of its reputation as a liberal international financial center, Luxembourg has become increasingly important as an international gold trading center. Gold movements are not restricted, and no tax is imposed on transactions. Since March 1981 there has been an official gold fixing at 10:30 a.m. on weekdays, under the auspices of the Luxembourg Stock Exchange, and this is the first daily official quotation in Europe (see Golddealers Luxembourg (1988)). Prices are fixed in terms of Luxembourg francs per kilobar (999 fine), and U.S. dollars an ounce for a standard (995 fine) 400-ounce bar. The fixing is open to members of the stock exchange, who act as principals for their own account. Settlement is loco-Luxembourg through a clearing intermediary that maintains a central depository at the State Bank of Luxembourg and is effected within two working days.

Brussels, which was traditionally a free market and served as an outlet for newly mined gold from Zaïre, lost much of its trade in 1981 when the Belgian government imposed a 6 percent value-added tax, which was later reduced to 1 percent. Germany has a rather small gold market in Frankfurt, but most of the former Federal Republic of Germany’s estimated net demand of 78 and 80 tons in 1990 and 1991, respectively, was met in Zurich and Luxembourg. The Frankfurt market has been unrestricted since 1959, but transactions are subject to a 12 percent value-added tax. The kilobar is the basic unit of trading (Roethenmund (1987)).

Middle East

Egypt prohibits the importation and exportation of gold, but it has two local free markets in Cairo and Alexandria. Much of the supply to these relatively active markets is reportedly smuggled into the country. Israel also severely restricts gold trading, and investment must be made through authorized dealers who retain the gold in storage. Beirut rivaled Zurich as the world’s largest trading center for gold before the London market reopened in 1954, and for many years it maintained its important role as an investment center and entrepot for gold flows to the Middle East. The market in Beirut is still free of restriction, but it was almost closed by the civil war that began in 1975. Most of its business has shifted to Kuwait and, especially, Dubai (see Roethenmund (1987), Green (1985, chap. 14), and Samuel Montagu & Co. (1990, p. 14)).

Net Middle Eastern offtake in 1989 is estimated to have reached 370 tons, of which 190 tons is estimated to have been imported into the region through Kuwait and Dubai. (In 1990 and 1991, net Middle Eastern offtake was about 380 tons and 386 tons, respectively.) Of this, most flowed through Dubai, including an entrepot trade to India estimated at 160 tons. Dubai’s extensive coastline, with a direct route to the Indian subcontinent, has made it one of the main sources of gold (in smuggled tola bars) into that region. The remainder of trade was for net regional investment purposes, and gold remains very popular with small investors who acquire low quality jewelry and other stocks of physical gold through the souks (local markets) in most Middle Eastern countries.

Ankara opened an official market in 1989, and stock building for this has combined with local fabrication demand to produce Turkey’s estimated imports of 95 tons, virtually the total remainder of Middle Eastern inflows after accounting for Kuwait and Dubai. The Central Bank of Turkey operates as the broker in the market.

India and the Far East

Restrictions on the importation of gold into India, coupled with a high demand for investment and fabrication, have produced an active trade in gold smuggled into India, and gold usually trades at a substantial local price premium over the London price (see Roethenmund (1987), Green (1985, chap. 15), and Samuel Montagu & Co. (1990, p. 14)). The unit of measurement is a tola (0.375 ounces), with bars of 1, 5, and 10 tolas being commonplace in the main local trading centers of Bombay, Madras, and Calcutta. India is estimated to have absorbed 242 and 239 tons of new gold in 1990 and 1991, respectively.

Tokyo has grown significantly as a trading center for gold since restrictions on imports were lifted in 1973, and the Tokyo market is estimated to turn over 20–30 tons a day. Kobe, Osaka, and Yokohama also have gold markets. Prices are quoted in yen per nomme (3.75 grams). Japan imported some 284 tons in 1989, of which 200 tons were for fabrication purposes. Manila and Sydney also have active, but relatively small, markets in physical gold.

Other American Markets

In Brazil and Mexico, residents are allowed to hold gold for investment purposes, but exports are restricted and there is reputed to be a great deal of smuggling. Nevertheless, Sao Paulo is probably the largest market in South America; Rio de Janeiro and Mexico City are also prominent. Canada has gold markets allied with the commodity exchanges of Montreal and Winnipeg.

Markets in Derivative Physical Instruments

In addition to the continuing demand for bullion, derivative physical instruments, including loans and swaps and forward sales, have found markets in the last several years.

Gold Loans

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.43

Prior to 1990, lending rates for gold had 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.44 Banks could simultaneously compensate the central banks that had long held barren gold assets, even if they included a substantial profit margin, and this generated a rapidly growing market (in all, some 30 central banks are estimated to have engaged in gold loans (see Gooding (December 4, 1990)). 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.45 Then, in 1990 the Drexel Burnham Lambert financial services group collapsed, with large outstanding gold liabilities to many central banks.46 In consequence of the increased wariness after the collapse, the market supply of loans from central banks has been substantially reduced.

Nevertheless, there is still a substantial demand for gold loans from mining houses, and the market has been enhanced by the development of an informal, yet sophisticated, global interbank system that permits dealers to borrow gold on a short-term basis in order to fulfill delivery requirements. In mid-1991 about 500 tons of central bank gold were estimated to be on loan in the market at any point in time (see Glynn (1991)). Since December 1990, the Financial Times has reported interdealer loco-London mean lending rates for gold (denominated in U.S. dollars) for maturities of 1—12 months, which have become known as the “gold LIBOR.” Lending rates for gold rose to just over 5 percent on an annualized basis in December 1990, representing a substantial premium over the implicit cost of providing such a loan. According to market analysts, this rate reflects an increased tightness in the market after the loss of central bank suppliers (see Gooding (1990)). For example, on May 21, 1991, the six-month LIBOR was 6.25 percent, but the contango (or return) on a spot purchase and six-month forward sale of gold was 3.42 percent.47 This leaves the implicit net cost of borrowing for a hedged purchase of gold at 2.83 percent, compared with a gold lending rate of 5.16 percent. By comparison, on December 1, 1989, the LIBOR was 8.25 percent and the contango was 7.69 percent, yielding a hedged borrowing rate of 0.56 percent, which was close to the prevailing gold lending rate of about 0.7 percent.

Gold Swaps and Forward Sales

Gold swaps and forward sales by producers have become an increasingly prevalent aspect of the gold market, and forward sales have been cited as a particularly important determinant of gold prices in the last couple of years (see Gooding (1991b, 1992)). Market analysts estimate that some 249 tons in 1990 and 51 tons in 1991 were sold forward by producers, compared with Western mining production of 1,744 tons and 1,782 tons in the two respective years and equivalent sales of 65 tons in 1989 (Gold (1991)). In the third quarter of 1990 alone, 159 tons are thought to have been sold after the price of gold rose to $400 an ounce following Iraq’s invasion of Kuwait (estimate by Barclay de Zoete Wedd financial services group, quoted in Gooding (1991a)). In total, almost 10 percent of known gold reserves in the ground in South Africa, Australia, and North America were estimated to have been hedged (either through gold loans or forward sales) at the end of 1990—representing some 70 percent of their anticipated 1991 production.

The former 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 former U.S.S.R., for example, is estimated to have swapped some 300 tons for foreign currency in the first half of 1990 (see Gooding (1990)), providing temporary liquidity to the market for gold loans when interest rates fell to 0.5 percent (annualized). These swaps were thought to have been unwound when the gold price reached $400 in August, however, and the gold was sold directly onto the market, with a consequent reduction in gold prices and an increase in the gold lending rate.

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