Central bank leasing — yet to be resolved In 2002, Frank Veneroso, a respected analyst, concluded that central banks had leased anything between 10,000—16,000 tonnes of gold at that time — the upper figure being about half of global central bank gold reserves at that time. He gave his reasoning at a speech in Lima on 17 May that year. Central bank leased gold was being sold into the market for dollars, which as part of a carry trade were being reinvested by banks in US Treasury bills and the like, the cost of finance being a gold lease rate of one or two per cent, for a yield of six or seven. Veneroso concluded that much of the gold was repurposed into jewellery and had effectively disappeared from the market.
Between the 1980s and the turn of the millennium, gold had been in a bear market, so the general public, including investing institutions, were either genuine sellers (which was in limited physical quantities) or hedging and speculating on the short side using derivatives. This enabled the bullion banks to hedge out the price risk on gold that would have to be eventually returned to central banks by going long for forward delivery relatively cheaply. But at the time of Veneroso’s speech, gold was $325, having risen from about $255 over the previous fourteen months.
Conditions were changing from a long-established bear market, which favoured gold leasing activity, into the beginning of a new bullish phase. Leasing and even undeclared sales then became a tool for central banks to supply physical liquidity to the gold market, either to rescue bullion banks from being badly squeezed or simply to suppress the price.
The leased gold might not have always left the vaults of central banks in the main gold dealing centres, as Veneroso assumed. However, during the period covered by Veneroso’s analysis, I regularly lunched at The Banker’s Club opposite the Bank of England’s rear entrance in Lothbury. On most days, security vans could be observed entering and leaving the Bank’s premises, transporting physical gold to and from the Bank’s vaults. So perhaps Veneroso was right about physical being sold and delivered into the market, at least to some degree.
In March 2008 gold breached $1,000 for the first time. It would have been impossible for central banks to recover their leased gold by then, because Chinese and Indian demand was beginning to suck physical gold out of Western markets at an alarming rate, in any case significantly faster than any replacement by available mine and scrap supplies. It might appear that leased gold could then have been returned to central banks during the 2012—2015 bear market, but again, Chinese and Indian demand continued to absorb most of the available physical released by any ETF sales and other sources of physical supply.
Alternatively, there would have to have been substantial selling of Western-owned stockpiles, and there is no evidence of that. The best one can say is that in some years, notably 2013, there was some ETF liquidation, but not in the quantities required to resolve the leasing problem. By way of confirmation, in 2014 I was told by one of the large Swiss refiners that they were working double shifts seven days a week turning 400-ounce LBMA bars into 1 kilo 9999 bars, the new Chinese standard. Some of the LBMA bars arrived in a poor condition and obviously had not been touched for decades, scraped out from the darkest recesses in deep-storage vaults. Furthermore, customers from the Middle East were submitting LBMA bars for refining into the new 1 kilo standard and taking them back to be re-vaulted in that form. Not only did this indicate that they were aligning themselves with China’s growing gold presence, but they were definitely not selling. Clearly, the 40% decline in the gold price between September 2011 and December 2015 led to substantial unrecorded increases in physical demand, cleaning out Western vaults. It would not have been possible for central banks to regain their leased gold.
There was, perhaps, further circumstantial evidence of the leasing problem, when Germany decided to withdraw her earmarked gold from the New York Fed’s vaults. The desire to do so was publicly justified on the basis that Germany’s gold no longer needed to be stored abroad, because the threat of a Soviet invasion had been removed by the collapse of communism. But given that the suppression of gold involved leasing and gold swaps in significant quantities in order to maintain the dollar’s credibility, was the true reason nothing to do with Soviet presence but that the Bundesbank suspected its gold was being used for this purpose without its permission?
The Bundesbank’s first action was to request to inspect its gold, a request that was flatly refused. Following that refusal, the decision was taken to begin a process of repatriation. Why it was partial is not entirely clear but could be explained if the Bundesbank suspected it wasn’t actually there. There would be nothing to be gained by demanding the return of all of it, but a partial return might at least enable the New York Fed to find some gold from elsewhere and avoid a public crisis. It turned out that after a series of meetings it was agreed to repatriate only 300 tonnes of Germany’s gold over a period of seven years. In fact, it was returned three years early. The Netherlands also sought, and obtained, 122.5 tonnes of her gold repatriated from New York. Austria arranged for the repatriation of some of its gold from London. While some of these repatriations were in the wake of public demands, they were never important enough to trigger them on their own. But they are consistent with substantial quantities being leased and assessments by the central banks repatriating national gold stocks that they are better secured on their own territory.
Since the days, as Veneroso put it, when central bank gold ended up adorning Asian women, leasing procedures, being targeted at providing liquidity and at supressing the gold price, will have changed. Wherever possible, leased gold need not leave the Bank of England’s or the New York Fed’s vaults. A ledger entry, or book entry transfer confirming it is at the disposal of the lessee is all that’s required, and for the payment for the sale of leased gold to be arranged through the appropriate channels. And from there it can be reassigned by another book entry transfer. We saw this in action when GLD, the gold ETF, ended up with the Bank of England recorded as a sub-custodian holding some 70 tonnes of gold last August precisely in these conditions.
In a leasing contract, ownership remains with the lessor. When arranging gold leasing, we can be sure that in recent times the Bank of England will have comforted lessors that their gold never leaves the Bank of England’s vault, so there’s no need to worry about repossession. This would be an operational justification for continuing leasing activities to offset physical shortages in the market. But the question over how much leased gold that has left the Bank of England and the New York Fed in the past remains unresolved, but it is likely to be in significant quantities with Veneroso’s lower estimate perhaps a bare minimum.
The true quantity of monetary gold It is commonly stated that the above-ground gold stock is 200,000 tonnes. While that may be a reasonable approximation, most of it is not monetary gold in any sense of the definition and is not therefore its monetary supply.
The statist definition of monetary gold is physical bullion held as part of a central bank’s declared monetary reserves. According to the IMF the current total of all such monetary gold is 35,244 tonnes, though as we have seen from the foregoing paragraphs it is unlikely to be all there or unencumbered. But to this we must add gold bullion hoarded and stored by all other parties on the assumption that it is either a more stable store of monetary value than fiat or an insurance against fiat currencies losing purchasing power. It must be in a form immediately available for monetary purposes, being in bar or coin form. Of an estimated 200,000 tonnes of above ground gold, it is generally assumed that 60% is used for other purposes, mainly jewellery but also some industrial purposes, leaving 80,000 tonnes of monetary gold conforming with our definition. After subtracting official monetary gold from the total, we are left with 44,756 tonnes.
In October 2014 I published an article explaining why China had considerably more gold in storage than her declared reserves, and I estimated that by 2002, when the Chinese government removed the ban on personal ownership and opened the Shanghai Gold Exchange, the state could have acquired up to 25,000 tonnes. Much of this gold would have been leased gold sold into the London market. (Veneroso’s statement about ending up adorning Asian women could not have been true for Chinese women, because they were not permitted to own gold until 2002 and Indian imports were severely restricted for some of the relevant time).
That China had accumulated substantial undeclared bullion stocks was confirmed to me anecdotally by experienced China watchers. If we treat that as part of our estimate of monetary gold, and make an allowance for Russia, of perhaps an unrecorded 5,000 tonnes, monetary gold in the hands of everyone else appears to amount to only 15,000 tonnes.
But this figure will have been bolstered by central bank leasing activity, perhaps even doubled, with leased gold appearing to have two or even more owners, and the actual possession being in undeclared Asian hands. It is in this context that the threat to derivative trading from Basel 3 must be viewed. Not only will paper supply estimated at 11,300 tonnes equivalent in unregulated and regulated markets be threatened with removal, but there is an additional unknown figure of central bank leasing and swaps to be unwound. Obviously, there is significant guesswork involved, but if the numbers outlined herein have the slightest validity, the ending of gold derivative markets, if it is permitted to go ahead, will create a major gold crisis, of which the BIS regulators seem blissfully unaware.
Silver The mechanics behind dealing in the LBMA silver market are the same as for unallocated gold. The LPMCL settlement system is the same, providing access only to LBMA members. The basis of calculating the net stable funding requirement is the same, so silver derivatives suffer from the same balance sheet disincentives. The principal difference is no silver is vaulted at the Bank of England, nor, so far as we are aware, in the vaults of any other Western central bank.
In terms of demand, it is also primarily an industrial metal, and is mostly consumed. According to the Silver Institute, of a total annual demand of roughly a billion ounces that is forecast in the current year, 253 million ounces is identified as investment demand and a further 150 million ounces as ETF/ETP demand. Bizarrely, the report estimates there will be a fall in ETF demand, when it is already rising. And of the supply, only 18.5% is from recycling.
The BIS figure for outstanding silver OTC derivatives is included in “Other precious metals” at $64bn. The same NSFR treatment for all commodity derivatives, including energy, involves an estimated $858bn’s worth. Not only is the introduction of the NSFR disruptive of precious metal markets, but it also threatens to disrupt wider commodities at a time when their prices are already increasing rapidly as a consequence of falling purchasing powers for fiat currencies.
