Golden Jackass Tobacco Shop

[Mr. Ed]

http://www.goldensextant.com/commentary23.html
December 4, 2002. Gold Derivatives: Moving towards Checkmate

"L'État, c'est moi," famously proclaimed Louis XIV. Recently knighted by the Queen, Sir Alan is the U.S. dollar. When the ancien régime finally fell, the Sun King had been in his grave for almost a century. New statistics on gold derivatives together with other recent anomalies in the gold market suggest that Sir Alan may not be so fortunate, and that gold is close to pushing today's dollar-based international monetary regime into checkmate.

Gold Derivatives in a Nutshell. For reporting purposes, over-the-counter derivatives are generally grouped into two categories: forwards and swaps on the one hand and options on the other. Before trying to make sense of the most recently reported data on gold derivatives, a short (and simplified) review of their relationship to the short physical gold position of the bullion banks may be helpful.

Central banks, or at least some of them, lend or lease gold from their vaults to bullion banks at relatively low interest rates -- say 1% to 2% -- known as lease rates, ostensibly to earn a small return on an otherwise "sterile" asset. The bullion banks, which have no direct use for the metal, function as intermediaries, seeking to earn a small profit on the spread between the lease rates and higher returns available elsewhere while curtailing their own risk. Accordingly, they sell the leased gold into the spot market and invest the proceeds from the sales at a higher rate -- say 5% to 7%. As a consequence, they are short the physical gold that they must later return or repay to the central banks, and therefore exposed to the risk of higher gold prices when they have to cover.

To hedge this risk, the bullion banks go long in the forward market, where they exchange part (usually most) of the higher returns on the proceeds from the sales of the leased gold for agreements to deliver physical gold to them in the future. In the case of gold producers, these transactions include forward sales of future production and gold loans to fund new production. The premium or "contango" that the producer receives over the spot price for a forward sale represents the difference between the interest rate available on the proceeds from sale of the leased gold (e.g., LIBOR or the U.S. T-bill rate) and the lease rate, less of course a fee for the bank.

In the case of transactions with non-producers or the gold carry trade, the banks' counterparties have no obvious source of future gold for repayment other than what they can purchase in the market. Like the bullion banks, they are exposed to the risk of higher gold prices when the time arrives for repayment of the physical gold. Accordingly, non-producers typically try to hedge their risk with options, also purchased from the bullion banks and in turn delta hedged by them. (Delta hedging is described in a prior commentary, The New Dimension: Running for Cover).

Looking at just gold derivatives, including both forwards and options, there are two sides to every contract, a buyer for every seller and a seller for every buyer. Of course, taking all the gold derivatives of any particular bullion bank, it might be net long, net short or market neutral. But looking at the gold lending by the central banks to the bullion banks, there is a short physical gold position. It consists of all the gold that has been leased (or swapped) from the vaults of the central banks, sold into the market by the bullion banks, and is now owed by their customers to them under derivatives contracts, and by them directly in physical form to the central banks.

Short Physical Gold Position of the Bullion Banks. What is the size of the total short physical gold position, or put another way, how much gold from their vaults have the central banks as a group leased, swapped or deposited into the market through the bullion banks? In round numbers, the answer from conventional industry sources such as Gold Fields Minerals Services and the World Gold Council is 5000 metric tonnes, including 3000 tonnes for producer hedging, which leaves some 2000 tonnes for other purposes, e.g., the gold carry trade and inventory borrowing by gold fabricators.

Although 3000 tonnes of producer hedging appears reasonable based on the published financial reports of gold producers, the total of 5000 tonnes cannot be confirmed from the published financial reports of the central banks, the International Monetary Fund, the Bank for International Settlements or the bullion banks. Indeed, the IMF expressly authorizes central banks to report their gold holdings as a single entry without separately identifying gold in the vault from gold receivables, including both leased gold and gold swaps. See, e.g., "The Macroeconomic Statistical Treatment of Securities Repurchase Agreements, Securities Lending, Gold Swaps and Gold Loans," www.imf.org/external/bopage/pdf/99-10.pdf; see also www.gata.org/bofi.html. Accordingly, while the IMF reports that official gold reserves total some 33,000 tonnes, it purposefully hides the amount held in physical bullion as opposed to paper claims on gold.

Among the major central banks, only the Swiss National Bank and the BIS, which operates the central bank for central banks, provide any figures on the amount of their gold lending. The BIS offers its member central banks (and certain other international financial institutions such as the IMF) a traditional gold banking facility, which is depicted graphically in the chart below by Mike Bolser.



In sum, the picture at the BIS since 1995 is more lending with less gold. Two points to note: (1) as of March 31, 2002, the BIS had loaned out approximately half the total gold on deposit with it by central banks; and (2) the BIS holds physical gold reserves that exceed its gold liabilities (deposits) by nearly 200 tonnes (about the amount of gold held for its own account). Gold lending on this scale by the central banks themselves would imply a short physical position in excess of 15,000 tonnes, but one against which the bullion banks hold virtually no physical reserves.

A total short physical position of 5000 tonnes also appears insufficient to fill the gap that has existed for several years between physical demand or offtake and new mine supply, official sales and scrap recovery. In an analysis presented to the GATA conference in Durban, South Africa, in May 2001 (alternate URL: http://www.gata.org/veneroso_pdf.html), Frank Veneroso estimated that this net physical deficit amounted to at least 10,000, and possibly as much as 16,000 tonnes, implying a short physical position of equal size.

Much of Mr. Veneroso's demand analysis consisted of filling in lacunae in otherwise apparently reliable statistics from the WGC. In the second quarter of this year, the WGC changed its system for reporting physical demand (www.gold.org/value/markets/Gdt/index.php), and in connection therewith transferred much of the responsibility for data collection to GFMS. That firm's close ties to the bullion banks have undermined confidence in its estimates of total gold lending by central banks, and the same concerns now infect the WGC's new demand figures.

Estimates of the total short physical position by GFMS and Mr. Veneroso disagree by as much as 10,000 tonnes, or four years of new mine production. Both estimates rely in large measure on non-public information gathered from industry contacts. Neither, for the reasons already stated, can be confirmed or rebutted on the basis of published balance sheet or official reserve figures from the central banks or the IMF. However, published data on gold derivatives is available from several sources, including the BIS. On analysis, it undercuts the estimate by GFMS and tends to confirm Mr. Veneroso's.

Statistics on Gold Derivatives. In addition to its regular semi-annual statistics on the OTC derivatives of major banks and dealers in the G-10 countries, the BIS publishes triennial surveys of derivatives on the books of banks and dealers in almost 50 countries. Mike Bolser's side-by-side charts below summarize the gold derivatives data contained in the three triennial surveys to date, the most recent being as of June 30, 2001 (www.bis.org/press/p020318.htm). (Note: Options sold and options bought are reported in gross numbers but total options are adjusted for double-counting, i.e., where reporting banks or dealers are both seller (writer) and buyer on the same option.)



The BIS reports end-of-period position data, not turnover data for a period as some used to argue. Even so, interpreting the BIS data leaves considerable room for questions, debate and disagreement, especially when the data is used to work backwards to an estimate of total gold lending by central banks. Just converting dollar notional value figures into tonnes requires an assumed gold price. While the BIS tries to eliminate the double-counting of contracts where reporting banks or dealers are on both sides of the same instrument, the process is unlikely to be error free, and other forms of double-counting may exist. What is the reporting, for example, if gold swapped by a central bank with one bullion bank is loaned by that bank to another, which then sells the gold in connection with a forward contract?

Any interpretation of the BIS data must recognize the different financial mechanics of forwards and swaps as compared to with those of options. Forwards imply a sale of borrowed gold by a bullion bank in order to raise funds that can be invested to earn a spread. Similarly, swaps are spot sales of gold combined with simultaneous forward purchases of equal weight. The proceeds from sale of the leased or swapped gold are essential to earning a return on the transaction. Options, at least from the perspective of a sophisticated writer like a bullion bank, are normally an attempt to capture the premium paid by the buyer while eliminating adverse price risk through delta hedging. Option writers do not require leased or swapped gold to earn a return. What is more, in many cases purchasers of call options are hedging future repayment obligations arising from forwards or swaps.

The options data reported by the BIS almost certainly reflects much of the same borrowed gold that is covered by its data on forwards and swaps. However, not all the options data can be dismissed as mere double-counting of the short physical position implied by the figures on forwards and swaps. In addition to leasing gold, some central banks also write call options as a method of earning a return on their gold. Before hedging became a dirty word, gold mining companies frequently wrote call options, and in many cases applied premiums earned on the calls to purchases of put options for downside price protection. Call writing by central banks or producers, while not immediately adding to the short physical position, creates further contingent liabilities against both the gold supplies that have funded it and those being looked to for repayment.

Taking the gold derivatives data reported by the BIS as as whole, the totals for forwards and swaps when converted to tonnes at some reasonable price appear to offer a pretty good proxy -- admittedly imprecise -- for the total short physical position. Viewed in this light, these figures align quite closely with Mr. Veneroso's estimate of a total short physical position in the range of 10,000 to 15,000 tonnes. So far as I am aware, except for the discredited argument in a WGC study addressed in a prior commentary that the BIS figures represent turnover rather than position data, no one has undertaken in print to reconcile or explain the 5000 tonnes of total gold lending estimated by GFMS with the gold derivatives figures reported by the BIS.

Some have pointed out that forwards and swaps include gold borrowed into inventory by jewelry manufacturers and other gold fabricators which has not yet been sold into the market. In The Gold Book Annual 1998, Mr. Veneroso estimated that total fabricator borrowings might reach 2000 tonnes. Whatever the amount, borrowed gold in fabricator inventories is destined to be sold. What is more, it is an amount that should tend more to roll over than to rise, and could well fall with a shrinking spread between interest rates and lease rates as has occurred over the past year.

If producers only account for around 3000 tonnes and fabricators for not more than 2000 tonnes of a short physical position exceeding 10,000 tonnes, who accounts for the remainder? To quote The Gold Book (at 51): "Given the many instances of gold borrowings for non-gold purposes that have come to our attention, it does not seem implausible that many bullion dealers with access to official gold borrowings have used these low cost gold loans for general corporate purposes or have lent this gold to borrowers for non-gold uses." In other words, the biggest borrowers of gold are likely the bullion banks themselves, not for their gold banking operations but for purposes of general corporate funding.

Recent Data on Gold Derivatives. The semi-annual statistics on gold derivatives from the BIS are significant not only for the absolute values reported but also for the trends disclosed. The most recent report in this series, released on November 8, 2002, covers the period ending June 30, 2002 (www.bis.org/publ/otc_hy0211.htm). Total gold derivatives rose 21% in the first half of 2002, from a notional $231 billion at the end of December 2001 to $279 billion at the end of June 2002. These figures together with those from earlier reports are shown in the chart below by Mike Bolser. Separate figures for forwards and swaps and for options as of June 30, 2002, will not be available until the derivatives figures are republished in the December edition of the BIS Quarterly Review, at which time the chart below will be updated.

Like the increases in gold derivatives at J.P. Morgan Chase and Citibank during this year's first quarter (see commentary at GOLD MARKET REGRESSION CHARTS), the first half increases reported by the BIS are rather surprising given the many reports of gold mining companies aggressively trimming their hedgebooks combined with historically low interest rates reducing the lure of both producer forward selling and the gold carry trade. However, these increases do repeat the pattern that followed the Washington Agreement in the fall of 1999, i.e., heavy use of derivatives, especially options, to try to contain rising gold prices. As explained in The New Dimension: Running for Cover, purchased call options provide traders with ammunition for shorting gold.



However, although the notional value of OTC gold options has moved back toward the peak levels reached in the fall of 1999, open interest on COMEX gold options, as shown in the chart below, has traced an opposite route, declining to 1995 levels that are far from the highs of 1999.



Similarly, turnover on the London gold market has been in steady decline, as shown in the chart below that Mike Bolser updates monthly in GOLD MARKET REGRESSION CHARTS. Since the LBMA is presumably where a lot of the delta hedging on gold options is effected, this decline seems inconsistent with the growth of OTC gold options assuming they are properly hedged.



Gilding Producer Hedgebooks. In part at least, the recent increases in OTC gold derivatives appear to reflect a new phenomenon in producer hedgebooks. Call it gilding: the practice of not closing hedges but rather of trying to offset them with other hedges. For example, forward sales are not unwound or delivered into but rather offset with forward purchases, or call options sold are offset with call options purchased or other negotiated arrangements.

As Bob Landis noted in the recent update of his commentary on Barrick's hedgebook, the king of hedgers is now reporting spot deferred forward contracts on 16.9 million ounces “net of 300,000 ounces of gold contracts purchased.” Footnote 23 to Harmony's annual report for the year ending June 30, 2001, discloses forward purchase contracts on almost 800,000 ounces and calls purchased on another 100,000 ounces as against gross forward sales of just over 1 million ounces and calls sold on almost 1.5 million ounces. Similarly, footnote 9 to Newmont's annual report for 2001 discloses that in September 2001 it entered into transactions closing out certain written call options with a series of forward sales contracts calling for physical deliveries at future dates and prices ranging from $350/oz. in 2005 to $392/oz. in 2011. The same footnote also describes a forward sale contract on 483,000 ounces entered into in July 1999, adding: "Newmont entered into forward purchase contracts at prices increasing from $263 per ounce in 2000 to $354 per ounce in 2007 to coincide with these semi-annual delivery commitments."

Whatever its other failings, Jessica Cross's study, Gold Derivatives: The market view, sponsored and published in August 2000 by the WGC, contains a useful stand-alone section (chapter 5) describing the principal derivative products then in use by the gold mining industry. She identifies not less than seven types of forward contract, in each case stating: (1) that its impact on the gold price is immediate because "the executing bank borrows the equivalent amount of gold and sells it immediately into the market"; and (2) that among the "advantages to the user" is that it "can be unwound before delivery." Nowhere does she identify forward purchase contracts either as the means for unwinding forward sales or as a product in use by the producers.

Unlike standardized exchange-traded gold futures and options, OTC gold derivatives are bilateral contracts -- frequently containing quite complex provisions -- tailored to the specific requirements of the parties. Thus, unlike exchange-traded futures and options which can be unwound by closing or offsetting market transactions, OTC derivatives can be unwound only pursuant to applicable contractual provisions, if any, or by mutual agreement between the parties. Failing that, a producer can try to purchase an offsetting contract of some variety from a different bullion bank, but in that event incurs additional credit risk.

In a liquid market with prices set by unfettered market forces, reaching agreements to unwind or offset forward contracts or written calls ought to be relatively simple. However, in a tight physical gold market characterized by capped prices and a mammoth short physical position, it is unlikely that bullion banks would willingly let producers escape their forward delivery commitments except perhaps on payment of very steep premiums. Rob McEwen, the irrepressible CEO of Goldcorp, a producer that proudly eschews hedging, recently tested the liquidity of the spot market by placing an order to purchase 40,000 ounces and encountered significant constraints in availability (www.goldcorp.com/investor/pdf/11-08-02.pdf). Considerable anecdotal evidence of like import exists notwithstanding the WGC's recent report of slower physical demand.

Hence the question Bob Landis posed is a good one: Who sold Barrick (and the other producers) their forward purchases? And why? Other than gold producers, the usual sellers of forward contracts on gold are central banks, which sometimes implement official gold sales in this manner. Some past spikes in lease rates have been attributed to one central bank or another calling in or failing to roll over a lease in order to meet delivery on a forward sale. But to sell gold forward, especially where physical delivery is contemplated, is a risky business absent assured availability of the metal when delivery must be made. Accordingly, with producers as a group reducing their forward sales and assuming that the bullion banks are not taking on unprecedented levels of naked risk, it appears that the central banks themselves must -- in one way or another -- be standing behind the forward purchases of the producers.

In this event, several important questions about the Washington Agreement and its anticipated renewal are presented. Why are total gold derivatives rising if the central banks are observing their undertaking not to increase gold lending? How are forward sales handled? Are they counted as sales on the date of the contract, the date of delivery, or not at all if the contract is unwound before delivery? What happens if a lease is converted to a sale, as for example because the lessor cannot obtain gold for repayment, or cannot do so without driving up prices? Do written calls only become sales when delivery is demanded, or should they be treated as sales if and when they go in the money? As it is, compliance with the Washington Agreement is impossible to verify, and its renewal is unlikely to benefit anyone except the central banks.

In the absence of any contractual means for unwinding or offsetting their forward sales or written calls, producers have only two ways to reduce their hedgebooks. First, they can accelerate deliveries from their own production. Second, they can purchase bullion at spot and deliver it or hold it for delivery into their forward commitments. But producer purchasing that pushes gold prices higher also increases the mark-to-market losses on the remaining portions of their hedgebooks. Some have argued that the recent strength in gold prices is largely attributable to producer buying in the physical market, and that gold prices are likely to weaken once producers have completed their hedgebook reductions. This argument loses much of its force, however, if producers are mostly gilding their hedgebooks, as their own financial reports and the recent increases in gold derivatives suggest.

Conundrum of Current Lease Rates. Currrent low lease rates are in apparent conflict with the reports of tightness in the physical gold market. Before addressing this conundrum, another short and simple review may be helpful.

Currencies and gold have two sets of prices: the prices at which they are exchanged for each other, i.e., the exchange rate or the gold price; and the prices at which they are loaned or borrowed, i.e., the interest rate or the lease rate. These prices all interact on each other in complex and sometimes quite unpredictable ways. Despite the best efforts of governments (and the WGC) to turn gold into an ordinary commodity, it continues to be treated as a currency by the markets, where forward gold prices like forward currency rates are determined and arbitraged on the basis of relative interest rates, all as explained in much more detail in The Golden Sextant, the essay from which this website draws its name.

The basic formula governing forward gold prices in a given currency is IR (interest rate, typically LIBOR) - LR (gold lease rate) = FR (gold forward rate, often referred to as GOFO). GOFO is normally positive and thus in contango, meaning that gold prices for forward delivery exceed current prices for spot delivery. But when the forward rate turns negative, as when interest rates fall below lease rates or lease rates rise above interest rates, gold goes into backwardation, meaning that spot prices exceed forward prices.

The following chart by Mike Bolser shows 6-month lease rates since January 1998 (yellow line) calculated as the difference between 6-month dollar LIBOR and 6-month dollar GOFO as reported by the LBMA (www.lbma.org.uk). When lease rates spiked in September 1999 following announcement of the Washington Agreement, which included limitations not only on sales but also on lending, gold went into backwardation but just briefly. Otherwise, the forward rate or GOFO (blue line) has remained in positive territory, but has declined with U.S. interest rates so that for the past year the contango on 6-month forward sales has rested at five-year lows.

Significantly, from the Washington Agreement until the Federal Reserve started cutting interest rates sharply in 2001, GOFO remained at relatively high levels, apparently helping to pressure gold prices (red line) lower. As U.S. rates declined, both gold prices and lease rates rose until GOFO dropped below 3%. Since then, lease rates have followed U.S rates lower, maintaining GOFO at between 1% and 2%, and gold prices have continued to show relative strength.



Don Lindley has approached backwardation in a different manner. Beginning in 1985, he has identified some 56 days, or 20 events counting consecutive days as one event, when settlement prices on the front two COMEX gold contracts were in backwardation. He found no instances in which the backwardation extended into further out contracts, indicating that these COMEX events are more related to transitory imbalances in the physical market than to lease rates per se. Don's chart below shows the days and events of COMEX backwardation from January 1998 to the present, the same period covered by Mike's chart above. Don reports that the three events of COMEX backwardation this year, including a major one of six days at the end of July (identified by its flat top), have coincided with the expiration of European options (second business day before the end of the month). He interprets them as bullish indicators reflecting European physical demand hitting a tight market.



Veteran gold analyst Martin Murenbeeld, whose list of clients (www.murenbeeld.com/clients.htm) includes producers on both sides of the hedging debate, has published a strong defense of Barrick's hedging program in which he argues (emphasis in original): "There should be an 'economic' cost to hedging, insofar as 'risk takers' need to be compensated for accepting a risk the producer does not want to bear." Stating an opinion shared by many opponents of hedging, he adds: "I am inclined to say that because central banks have lent their gold at too low lease rates however, there has been a definite advantage to hedging gold -- the contango has been higher than it should have been in a perfectly competitive market these last 15 or so years."

Why have the central banks subsidized through low lease rates not only producer hedging but also fabricator borrowing and the gold carry trade? Dr. Murenbeeld does not address this question, but fundamentally there are only two possibilities (not necessarily mutually exclusive): (1) stupidity, or at least a cavalier and amateurish assessment of risk; or (2) an intent and purpose to drive gold prices lower by adding to current supply.

In discussing the specifics of Barrick's hedgebook, Dr. Murenbeeld makes another important point: "Barrick does face a potential problem however in the event the contango turns negative. ... Backwardation represents the biggest threat to the Barrick Program [of spot deferreds] because the new contract price declines on each re-pricing date when there is backwardation." But because "the gold market is almost never in backwardation," he concludes: "It is therefore safe to assume that the contango will be positive on re-pricing dates."

Safe as this assumption may be under normal free market conditions, does it remain safe after years of central bank manipulation of gold prices and lease rates? And in the event gold goes into backwardation, what would be the consequences not just for Barrick but for others in the gold market as well?

The essay that introduced this website, War against Gold: Central Banks Fight for Japan, addressed the consequences of yen gold prices going into backwardation when yen interest rates were dramatically lowered in 1995, and further speculated that this development may well have triggered the continuing manipulation of gold prices that began in earnest at about that time. But gold is typically priced in dollars worldwide, and dollar gold prices in backwardation would present a far more serious problem, particularly under current circumstances.

Falling U.S. interest rates have already reduced the contango to the point where there is little incentive for producers to engage in forward sales, for fabricators to borrow, or for anyone to borrow gold instead of dollars. However, backwardation of dollar gold prices would reverse the incentives, putting pressure on the spot market as producers, fabricators and other gold borrowers closed gold loans and moved to cheaper dollar financing. This surge in demand would likely operate on the short physical position to send gold prices and lease rates skyrocketing just as happened after the Washington Agreement, and in the process unmask the fundamental weakness in the structure of modern gold banking.

In the currency markets, rising interest rates are a two-edged sword, penalizing borrowers but rewarding lenders. Move rates high enough, and hard cash migrates out from under mattresses and into bank deposits. Currencies, at least until they descend to the status of party favors or wallpaper, never stray too far from the banking system. In his presentation at the GATA summit in Durban, Frank Veneroso made this key point about gold:

Now, almost all commodities have an income elasticity of less than unity; in other words, they almost all have a declining intensity of use over the long run, at least in modern economies. BUT NOT GOLD. Excluding the monetary use of gold and focusing only on jewelry, on electronics, and the like, if you look at 200 years of data until 1997 what you find is that gold has an income elasticity in excess of unity. That is, demand rises more rapidly than global income over periods in which the gold price is constant in real terms.

For nearly a decade, by lending gold at concessionary rates and capping gold prices, the central banks have fed primarily non-monetary or commodity demand, largely from the third world, not western investment demand. In the process, the central banks have let the bullion banks engage in gold banking without maintaining prudent reserves, as for example the BIS does. Even worse, the central banks have allowed the entire gold banking system to spill a large amount of its physical reserves into non-monetary or commodity uses -- areas from which their retrieval by the banking system is far more difficult.

Outside of the central banks themselves, there is now no obvious large pool of investment gold that can readily be mobilized and quickly attracted back into the bullion banks through higher lease rates. The bullion banks could of course buy gold, but that entails using their own capital and would just add to upward pressure on prices. Sharply higher prices, even if they draw back significant tonnages of gold from price-sensitive holders in India and elsewhere, would also risk awakening previously dormant investment demand in western countries, not to mention triggering a spike in lease rates.

Current lease rates are low because they have to be. Sir Alan and his court at the BIS have built modern gold banking on Dr. Murenbeeld's assumption: dollar gold prices always in contango, which requires that lease rates be held below dollar interest rates. When dollar interest rates fell below those on euros, exchange rates for the euro expressed in dollars went into backwardation (as they typically are for the Canadian dollar and the British pound) without causing any major disturbance in the currency or financial markets. Dollar gold prices in backwardation, however, would threaten a financial Armageddon, and that is the principal difference between currencies and gold as they are traded and arbitraged today in world markets.

Checkmate. Sharply rising OTC gold derivatives in the face of reduced incentives for gold lending or borrowing, and against falling LBMA volumes and declining open interest in COMEX gold options, send an ominous message. They suggest that the bullion banks have been unable to wind down their pyramid of gold derivatives in an orderly manner as contangos have narrowed, and that the central banks are locked into rolling over (or even adding to) their gold leases at rates that no longer compensate -- if they ever did -- for the real risk assumed. It is a message that appears confirmed by recent staff cutbacks at several bullion banks and the withdrawal of others from the business completely.

The free market alternative to gold in backwardation is higher U.S. interest rates, possibly much higher if lease rates are allowed to move to levels that not only fully compensate for risk but also are sufficient to draw gold back into the banks from non-monetary uses to which so much of it has escaped. If tightness in the gold market cannot be remedied through higher lease rates because neither backwardation nor higher dollar rates are acceptable policy choices, the only means left for restoring market balance is higher prices.

Absent higher lease rates, the gold leasing market can remain functional for only so long as the central banks continue to support it at non-economic rates or until they run out of gold. Without a gold leasing market, forward and futures markets for gold could no longer operate on the basis of relative interest rates, as they have and as forward currency markets do. Instead, forward prices on gold would have to be set on the basis of external factors, just as forward prices for oil and other commodities are.

Any transition in the forward gold markets from the currency/relative interest rate model to the ordinary commodity model is difficult to envisage without an intervening period of effective closure, including a cessation of trading in the COMEX gold contract. What is more, upon reopening in commodity mode, the forward gold markets would likely be much smaller than when they were operating in banking or currency mode. Barrick concedes that its ability to roll over its spot deferreds is contingent on "the existence of a gold pricing market." According to Dr. Murenbeeld, the ability to roll terminates "if the bullion bank can't borrow any more gold anywhere." These contractual provisions deal with what are no longer remote theoretical contingencies, particularly in the event of a non-linear upward explosion in gold prices.

Non-linear events are the Achilles' heel of derivatives and not uncommonly grounds for unprecedented exercises in the arrogance of power. If gold pushes Sir Alan's dollar and interest rate policies too close to checkmate, he can upset the board and send most paper gold instruments to the nether regions. But he is not an alchemist. Perhaps that explains his recent speech to the Council on Foreign Relations acknowledging hidden dangers in derivatives (www.federalreserve.gov/boarddocs/speeches/2002/20021119/default.htm), instruments he normally praises as effective insurance against financial risk but that Warren Buffet and Charlie Munger describe as financial sewage. Mais alors, Sir Alan ne se prend jamais pour de la petite merde.