Synthetic supply of gold?
23 April 2011 10 Comments
In the comment section at FOFOA’s blog (see the messages by DP and Jeff), we had a discussion about whether you can create synthetic supply, i.e. a form of paper gold, using the futures markets such as the New York Commodities Exchange (COMEX).
In the following, I explain why I think the answer is no.
What exactly is meant by synthetic supply? Let us interpret this term in a broad sense as any measure which makes the market for gold look bigger than the market for physical gold actually is, or any measure which tempts people to trade a substitute for physical gold instead of the real thing, a substitute which can be supplied in larger quantities.
Let us assume we are a large financial institution, we have some physical gold, but we wish to create a much bigger such synthetic supply. Which choices do we have?
1. The brute force method. We sell short more gold than we own
If we wish to do this with physical gold, we can use the commodities exchanges and sell futures contracts, write call options or purchase put options. We would sell short more gold than we have actual physical. If we have gold in an unallocated account with a bullion bank, we can also use this strategy and sell more forward contracts than we have unallocated gold.
This strategy is profitable if the price of gold is in a downward trend such as the period from 1995 to 1999. In fact, it is very likely that this was indeed done as part of the so-called gold carry trade. The gold carry trade consists of borrowing gold, selling it for US$ in the spot market and investing the proceeds elsewhere. The position is closed by buying back the gold in the spot market. This strategy has a positive carry as long as the forward or futures market is in contango and borrowing gold is cheaper than borrowing US$, but it has the obvious exchange rate risk if the price of gold in US$ rises while the carry trader is short gold.
When the downward trend in the price of gold stops and reverses such as it did between 1999 and 2001, however, the carry trade starts losing money and we will have to unwind it. Depending on how crowded the trade was, this may become difficult because everyone will run for the same exit. In fact, it is very likely that some of these carry trades indeed ‘blew up’. The signature of such an event is a sudden drop in the Gold Forward Offered Rate (GOFO) a few of which can indeed be found in the historical data as we have seen in a previous article.
Since 2001, the price of gold in US$ has been in a strong and steady upward trend. Shorting gold against such a trend, except perhaps as a technical trade for a very short period, would be financial suicide. We would probably not even find any bullion bank who would enter such a forward contract with us, simply because they know we would blow up. Of course, we can still sell futures contracts at the COMEX, but we would keep getting margin calls and would burn more and more capital.
So is it plausible that any significant synthetic supply is being created by systematically shorting the forward or the futures market? If anyone has been doing this, they must have lost hundreds of billions over the previous ten years. Very unlikely.
2. The elegant method. Unallocated accounts
If we are a member of the LBMA and if we offer unallocated gold accounts to our customers, then creating synthetic supply is straightforward. We just need to find somebody who is willing to borrow gold, and we are in business. For example balances sheets of how this works, please refer to this previous article. Update (20 March 2012): For further examples on how synthetic supply is obtained by creating credit, we refer to How Credit Suppresses The Gold Price.
The only limitation is our reserve ratio, i.e. the ratio of gold we lend per physical bullion in our vaults. If this ratio is stretched too far, we risk a run on the bank.
The beauty of lending gold to unallocated account holders is its simplicity. It works just like conventional commercial banking in US$, except that we are not required to hold a banking license (because we do not create credit in a legal tender currency that is regulated by a government. In legal terns, unallocated gold accounts are just derivatives on a commodity). The downside is that there is no guarantee that one of the central banks helps us out when our customers run on the bank and try to withdraw physical gold.
3. Other ways of lending gold
In addition to lending gold to an unallocated account holder, we can also lend gold to the general market. With physical gold, we would sell physical gold for US$ and purchase a futures contract in order to buy it back at some point in the future. But we can lend physical gold only if we have some. With unallocated gold that we hold in our account, we can enter the analogous transaction. We sell it in the spot market and purchase a forward contract. Again, we can lend only what we own, but not create any new supply.
Apart from entering a high risk naked short position, the only way of creating synthetic supply is the lending of unallocated gold while we hold a physical gold reserve only for a fraction of the amount that we lend. This is completely analogous to the creation of US$ in the commercial banking system.