What's behind the movement of Gold prices? The BIS says FT Alphaville

It’s the BIS

Posted by Izabella Kaminska on Jul 08 17:06.

One reason the BIS gold-swap story has courted some controversy is because, on the face of it, the Bank of International Settlements — being the central bankers’ central bank–  is not supposed to lend to commercial banks.

A quick read through the BIS statutes confirms as much.

However, via its gold-swap the Bank has clearly found a way around this.

One explanation for how it may have overcome the restrictions could be connected to the following point in Article 21 (a)– which states:

The Board shall determine the nature of the operations to be undertaken by the Bank. The Bank may in particular: (a) buy and sell gold coin or bullion for its own account or for the account of central banks;

So essentially the bank is free to buy and sell to whomever it wants in connection with its own bullion account. That is to say as part of its own market operations.

But should we really be surprised that the BIS has begun to engage in such a deal considering it too, like any other bank, simply wants to make a good return on its assets?

Might it be plausible that the BIS  went to the commercial swap dealer banks, rather than the other way around?

Gold carry-trade effect

First off, central banks have always lent out their gold to bullion banks to make their assets work for them (so they don’t just sit idly on their balance sheets). This was particularly the case when gold prices were stagnant, with little scope for asset appreciation.

What you got, therefore, was a scenario in which central banks lent their gold to the bullion banks for a price just less than the going interbank market rate — or what they perceived covered their credit risk, so x amount of basis points.

To make money themselves — and to protect against falling gold prices –the bullion banks, acting as market makers, would lease the gold forward at a higher price and invest the proceeds at the official market rate, hence capturing the so-called implied lease rate (equal to Libor minus the gold forward rate).

Their own position was then market neutral to the effects of gold price rises or falls, and they lived on a healthy spread.

All of which went swimmingly for years — especially since producers like Ashanti and Barrick were keen on the other side of the trade to hedge their future sales or to help finance production. They did this by taking advantage of the gold contango carry trade, much like in oil today. For those still confused, see the below two diagramscourtesy of Barrick:

But as the above diagram shows, the cost of financing and sound credit relationships was critical to sustaining the strategy.

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