Bullion Banking with Alice and Bob

We are not long. We are not short. We just borrow and lend.

This is a sketch of how a bank might lend against a reserve of physical bullion. We look at a number of simplified balance sheets that illustrate the changes in the reserve ratio, and we point out the two main risks: bad loans and a run on the bank. This article contains nothing new. There are just a number of examples to illustrate the common transactions.

In future articles, we will ask what an owner of physical bullion can do in order to earn interest using his or her bullion, and how a bullion bank might try to defend against a run on their physical reserve.

The Balance Sheet

In order to understand how a bullion bank operates, let us open one. We put down 1 US$.

Balance Sheet No. 1

Assets		Liabilities and Equity
Cash	1 US$	Shareholders’ Equity	1 US$

Our first happy customer Alice walks in and deposits her 10 oz. Our balance sheet expands.

Balance Sheet No. 2

Assets		Liabilities and Equity
Cash	1 US$	Shareholders’ Equity		1 US$
Physical Bullion	10 oz	Unallocated Bullion Accounts
			Alice	10 oz

Note that we have neither credit risk nor exchange rate risk, i.e. we are neither short nor long bullion versus US$.

Our simplified balance sheets are drastically different from the balance sheets of actual banks with a bullion trading department. Their official balance sheets are always denominated in the official currency, say US$, and all bullion positions are converted to US$ – using either the price when the position was opened or using mark-to-market valuation.

The purpose of our bank is to lend. Luckily, our second customer Bob walks in and asks us for a loan of 5 oz. Our balance sheet expands again.

Balance Sheet No. 3

Assets			Liabilities and Equity
Cash		1 US$	Shareholders’ Equity		1 US$
Physical Bullion		10 oz	Unallocated Bullion Accounts
Accounts Receivable				Alice	10 oz
	Loan to Bob	5 oz		Bob	5 oz

We still have neither credit nor exchange rate risk.

Bob needs most of this bullion to purchase a new motor bike. He withdraws 4 oz, i.e. he has 4 oz allocated and then shows up at the vault and takes them home. Our balance sheet shrinks.

Balance Sheet No. 4

Assets			Liabilities and Equity
Cash		1 US$	Shareholders’ Equity		1 US$
Physical Bullion		6 oz	Unallocated Bullion Accounts
Accounts Receivable				Alice	10 oz
	Loan to Bob	5 oz		Bob	1 oz

Still, we do not have any exchange rate risk, i.e. we are neither long nor short bullion versus US$. Our balance sheet is balanced in each of the two currencies US$ and bullion independently. But we do have credit risk because Bob might not return the bullion.

Now Alice wants to go shopping for furniture and withdraws 5 oz.

Balance Sheet No. 5

Assets			Liabilities and Equity
Cash		1 US$	Shareholders’ Equity		1 US$
Physical Bullion		1 oz	Unallocated Bullion Accounts
Accounts Receivable				Alice	5 oz
	Loan to Bob	5 oz		Bob	1 oz

Again, there is no exchange rate risk, and the credit risk is unchanged. Note that our reserve ratio has become a bit stretched. Our customers have a balance of 6 oz in their accounts, but we have just 1 oz of physical bullion left in our vault.

What can go wrong

There are two ways in which we might get into trouble.

Bad loans

If Bob defaults, we lose 5 oz of equity. Since the loss is in bullion, our owners need to raise the equity in bullion. If our owners report in US$, they have exchange rate risk until the additional bullion equity has been paid in.

Run on our bank

If Alice shows up again and wants to withdraw another 2 oz, we have a liquidity problem. This liquidity problem is the consequence of a mismatch of maturities.

We are not short of capital because we still have the accounts receivable that correspond to the loan to Bob, but Alice wants to withdraw physical bullion and, according to our contract with Bob, he is required to return the borrowed physical bullion only at some point in the future. We cannot instantly recall the loan to Bob.

Paper versus Paper

If we were a bank based in the eurozone and Alice wanted to withdraw euros, we would borrow from our central bank, the ECB, and make use of their short term liquidity facilities, and we would be able to pay Alice. As soon as Bob pays back the principal of his loan, we would close the loan from the ECB. Obtaining the notes or coins to give to Alice, is just a technical detail.

Eurodollars

If we were a bank based in the eurozone and Alice had a US$ account (so-called eurodollars) from which she wanted to withdraw, we would of course not be able to borrow US$ from the ECB. So we would borrow euros from the ECB and swap them for US$ in the market. Essentially, we would need to buy US$ in the spot market and at the same time forward-sell these US$ in the futures market. This way, we would eliminate the exchange rate risk and obtain the required US$ precisely for the period until Bob is scheduled to pay back his principal. The
difference between the spot price for US$ minus the price of the future we sell, is the fee we have to pay for this swap. It may be positive or negative, depending on the term structure of the euro versus US$ futures market.

The fact that we have to borrow US$ in the market, need not be a problem, but if several banks have the same liquidity problem at the same time, it may cause the US$ to sharply increase against the euro. Precisely this situation occurred in 2008. In order to stop the US$ from rising that sharply, the Federal Reserve made a huge sum of US$ available for swapping against euros.

Paper versus Bullion

But in our example, Alice wants to withdraw bullion. We cannot borrow bullion from our central bank, and so we borrow US$ and swap them for bullion in the market. For example, we can purchase physical bullion in the spot market and at the same time forward-sell it, eliminating the exchange rate risk. If the bullion market is in contango, i.e. the futures contract we sell is more expensive than the spot price for which we buy, we even receive an income on this transaction.

Again, if several banks have the same liquidity problem at the same time, this may cause the bullion price to increase sharply. In contrast to the paper currency examples above, there may be no entity that is willing and able to lend huge amounts of bullion to the market in order to mitigate the increase in bullion price.

For more details on the swaps of US$ for gold, please see the article on backwardation.

Summary

Lending against a reserve of physical bullion is largely identical to commercial banking. The bank focuses on lending, but does not assume any exchange rate risk, i.e. the bank is neither long nor short gold in US$.

The risks are also analogous to commercial banking in US$ denomiation: credit risk (that a debtor defaults and fails to return the bullion) and liquidity risk (that the bullion reserve might be temporarily insufficient). The main difference is the lack of a ‘central bank of bullion banking’ that is committed to providing emergency liquidity.

Purchasing Bullion

So far, we had a customer (Alice) deposit and withdraw bullion and another customer (Bob) borrow bullion. Bob wil have to repay his loan in bullion, of course.

A new situation arises when Charlie shows up in order to purchase bullion. Let us start with Balance Sheet No. 5 above. First, Charlie pays in 71 US$.

Balance Sheet No. 6

Assets			Liabilities and Equity
Cash		72 US$	Shareholders’ Equity		1 US$
Physical Bullion		1 oz	Unallocated Bullion Accounts
Accounts Receivable				Alice	5 oz
	Loan to Bob	5 oz		Bob	1 oz
			US$ Accounts
				Charlie	71 US$

Assume 1oz of bullion costs 35 US$. Charlie calls in and asks us to exchange 70 US$ for 2 oz.

Balance Sheet No. 7

Assets			Liabilities and Equity
Cash		72 US$	Shareholders’ Equity		1 US$
Physical Bullion		1 oz	Unallocated Bullion Accounts
Accounts Receivable				Alice	5 oz
	Loan to Bob	5 oz		Bob	1 oz
				Charlie	2 oz
			US$ Accounts
				Charlie	1 US$

This balance sheet is only preliminary and the transaction not yet complete. Charlie is already long bullion as he wished, but we are now short. Since we are a bank and focus on borrowing and lending as opposed to speculating, we need to hedge our exposure.

Hedging with physical bullion

The most conservative strategy is to purchase 2 oz of physical bullion in the market.

Balance Sheet No. 8

Assets			Liabilities and Equity
Cash		2 US$	Shareholders’ Equity		1 US$
Physical Bullion		3 oz	Unallocated Bullion Accounts
Accounts Receivable				Alice	5 oz
	Loan to Bob	5 oz		Bob	1 oz
				Charlie	2 oz
			US$ Accounts
				Charlie	1 US$

Now the balance sheet is balanced in both currencies independently, and we are neither short nor long bullion versus US$.

Hedging in the futures market

If we wish to hedge our exposure to Charlie’s bullion account, we can also purchase a futures contract for 2 oz. The advantage of this strategy is that we do not need to spend all of the 70 US$, but we have to put down only a small margin, say 7 US$.

Alternatively to Balance Sheet No. 8, we would arrive at:

Balance Sheet No. 9

Assets			Liabilities and Equity
Cash		65 US$	Shareholders’ Equity		1 US$
Physical Bullion		1 oz	Unallocated Bullion Accounts
Accounts Receivable				Alice	5 oz
	Loan to Bob	5 oz		Bob	1 oz
Derivatives				Charlie	2 oz
	Bullion futures position (2oz)	7 US$	US$ Accounts
				Charlie	1 US$

The advantage is that we can still make full use of most of the cash that Charlie gave us, namely 64 US$ of the original 71 US$.

The disadvantage is that we have to keep rolling our futures position as long as Charlie has not changed back his bullion for US$. Each time we roll, say by extending the maturity by three additional months, we need to pay the corresponding contango.

If there is no particular counterparty risk priced into the bullion futures market, the contango is basically the risk-free interest rate in US$ plus the carrying charges for storing the bullion. Fair enough, this is precisely what we save by holding the futures contract as opposed to the outright purchase of bullion. Still, our advantage is that we can invest the free 63 US$ elsewhere for a yied higher than the risk-free rate.

Other hedging strategies

Rather than purchasing physical bullion ourselves, we could go to another bullion bank and ask them to exchange 70 US$ for 2 oz. We would then be to the other bullion bank what Charlie is to us, and they would have to think about hedging their exposure. In contrast to Balance Sheet No. 7, we would not have 2oz in physical bullion, but rather 2oz in bullion accounts with other banks.

Similarly, rather than offsetting our exposure to Charlie in the (physical) futures market, we could purchase a forward contract for (paper) bullion, i.e. a forward contract that is settled by transferring bullion in a bullion account with another bank.

Summary

Either way, as soon as Charlie purchases bullion with his US$, someone in the bullion banking system needs to enter an offsetting transaction. Otherwise, some bullion bank would be short bullion versus US$ and thereby speculate rather than lend. This offsetting transaction exerts the same buying pressure on the bullion market as a direct purchase by Charlie who holds a pure long position.

When a bullion bank offeres a bullion loan to Bob, however, the supply of (paper) bullion available for investment increases, i.e. the volume of bullion denominated credit increases. This does affect the price of bullion (How Credit Suppresses The Gold Price).

The difference between Bob and Charlie is that Bob has to repay his loan in bullion, regardless of price. Bob is therefore neither long nor short bullion, and so is our bank. Charlie, however, can exchange his bullion back to US$ at the prevailing spot price whenever he pleases. Therefore, our bank has to enter an offsetting transaction in order not to end up short bullion.

References

[1] Some of the examples and some of the explanations are taken from an email exchange with FOFOA.