CURRENT COMMENTARIES March 24, 2006. Now They Tell Us: BIS Confirms Rigging Gold Prices
William R. White, Economic Adviser and Head of Monetary and Economic Department at the Bank for International Settlements, has confirmed the central allegation of the Complaint in the Gold Price Fixing Case: that the BIS is the principal hub through which the major central banks organize their price fixing activities in the gold market. In February 2006, the Bank published the proceedings of its fourth annual conference held in Basel on June 27-29, 2005, as BIS Paper No. 27, Past and Future of Central Bank Cooperation. In his opening remarks to the conference and based on his eleven years of service at the Bank, Mr. White stated in part:
Before turning briefly to an assessment of past efforts and likely future challenges, it is perhaps worth spending a minute on what is meant by central bank cooperation (emphasis in original). I think that the terminology developed for domestic monetary policy might have some uses here; namely, the ultimate objectives, the intermediate objectives and the operational instruments. The ultimate objectives have always been monetary and financial stability, though clearly the focus of attention has often shifted over the years. The intermediate objectives of central bank cooperation are more varied. First, better joint decisions, in the relatively rare circumstances where such coordinated action is called for. Second, a clear understanding of the policy issues as they affect central banks. Hopefully, this would reflect common beliefs, but even a clear understanding of differences of views can sometimes be useful. Third, the development of robust and effective networks of contacts. Fourth, the efficient international dissemination of both ideas and information that can improve national policymaking. And last, the provision of international credits and joint efforts to influence asset prices (especially gold and foreign exchange) in circumstances where this might be thought useful. [Emphasis supplied.]
Why Mr. White chose this particular occasion to boast about the central banks' price fixing activities in the supposedly free market for gold and, incidentally, to equate gold with foreign exchange is not clear. But three points are:
First, the BIS regards itself as effectively above and outside the reach of U.S. law regarding the trading of commodities. What is more, the Bank takes this position notwithstanding its trading activities on the COMEX, which at its annual gold dinner in 2000 honored the Bank's manager responsible for gold and foreign exchange with a "Man of the Year Award" apparently for his work in turning back the rally in gold prices precipitated by announcement of the Washington Agreement on Gold in September 1999. See Complaint, ¶¶ 4, 55.
Second, neither the BIS nor its member central banks adhere to the principle of a free gold market enshrined in the Second Amendment to the Articles of Agreement of the International Monetary Fund, which rewrote Article V, Section 12(a) to commit the Fund to "the objective of avoiding the management of the price, or the establishment of a fixed price, in the gold market." [Emphasis supplied.]
Third, as worldwide purveyors of unlimited paper money, the BIS and its member central banks both recognize and continue to struggle against their most dangerous enemy: gold. Put directly, gold is money, and they know it whatever others may think, including most mainstream economists.
Issuers Take Note: Time To Tell It Like It Is
But while the BIS and its member central banks may operate with little or no regard for U.S. law, gold producers are not so fortunate, especially with regard to new issues of securities marketed to U.S. investors. After Mr. White's candid confession, it may not be so easy for these companies and their investment bankers to continue to pretend that the blatant market rigging of the recent past is a figment of the imagination of "conspiracy theorists" or cranks. Future prospectuses that do not fully and fairly disclose the inarguably material fact of regular and coordinated official suppression of gold prices threaten to hand plaintiffs' attorneys a rather powerful weapon. Consider:
Risk Disclosures. Because their share prices generally move in tandem with those for their product, gold producers typically issue new securities during periods of relative strength in gold prices. Not uncommonly, investors who purchase these securities suffer early losses as gold prices retreat, not infrequently due to official intervention in a market widely assumed by many to be free from this particular risk. Thanks to Mr. White, prospectuses for new issues of gold-related securities can no longer safely ignore this risk under cover of the fiction of a free gold market.
Conflict of Interest Disclosures. New issues by significant gold producers are generally underwritten by the same large bullion banks through which the central banks conduct their own gold trading activities. Chinese walls may provide a certain amount of separation between the underwriting and trading departments of a bullion bank, but they cannot isolate top management from overall knowledge of, and responsibility for, the bank's operations.
No Chinese wall can hide the fundamental conflict between underwriting activities that benefit from higher gold prices and trading activities that frequently profit from suppressing gold prices at the behest of central banks. Nor can a Chinese wall hide the profitable opportunities inherent in the proprietary trading of gold when carried out with knowledge of the thrust and direction of any official interventions. Nor is it likely that any major bullion bank conducting operations for a central bank would do so without the knowledge, if not direct involvement, of its senior managers.
New Legal Calculus. The Private Securities Litigation Reform Act (1995) imposed heightened pleading requirements in actions for securities fraud based on issuers' misstatements or omissions of material facts in their communications with investors. It provides in relevant part:
In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged ... state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.
This standard has proven difficult to meet. But Mr. White may have considerably eased the burden for future plaintiffs in cases where gold producers tap the equities markets during periods of strong gold prices without disclosing the elephant in the wings: official intervention implemented through the bullion banks to suppress gold prices should that "be thought useful" by the BIS and its member central banks.
December 12, 2005 (RHH). Gold Derivatives: Footprints of Retreat
On November 17, 2005, the Bank for International Settlements released its regular semi-annual report on the over-the-counter derivatives of major banks and dealers in the G-10 countries for the period ending June 30, 2005. The total notional value of all gold derivatives fell to $288 billion from $369 billion at year-end 2004, a decline of more than 20% and the first time since June 2002 that total gold derivatives have failed to top $300 billion. As subsequently detailed in table 22A of the December issue of the BIS Quarterly Review, forwards and swaps fell by 17% from $132 to $109 billion while options fell by 25% from $237 to $178 billion, more than reversing the $48 billion increase in options reported for the last half of 2004.
Translated into estimated tonnes, these figures are shown below in an updated version of the chart by Mike Bolser that has illustrated past commentaries on this data. Also shown in estimated tonnes are the gold derivatives held by U.S. commercial banks (principally J.P. Morgan Chase, HSBC USA and Citibank) as reported through June 30, 2005, by the Office of the Comptroller of the Currency (www.occ.treas.gov/deriv/deriv.htm).
Prior commentaries have argued that the total notional value of forwards and swaps as reported by the BIS and converted into tonnes is a pretty good proxy for the total net short physical position in gold arising largely as the result of gold lending in one form or another by central banks. See, e.g., Hard Money Markets: Climbing a Chinese Wall of Worry (6/28/2004) and Gold Derivatives: Hitting the Iceberg (12/20/2003). As the above chart indicates, continuing a decline that began in the first half of 2003, total forwards and swaps fell sharply during the first half of 2005 to under 8000 tonnes, a level not seen since 1998.
Howevcr, neither the timing nor the relative size of this decline has correlated closely with reductions of well over half in total producer hedge books over the same period. Indeed, while total forwards and swaps fell by some 1900 tonnes during the first half of this year, Gold Fields Minerals Services reported that the delta-adjusted forwards portion of the global producer hedge book declined by less than 100 tonnes to well under 1400 tonnes. GFMS, Global Hedge Book Analysis (quarterly, editions 10 through 12, May, Aug. & Nov. 2005). See also R. O'Connell, The Global Hedge Book, two authoritative surveys for the third quarter, Mineweb (Nov. 14, 2005).
On the most generous estimates, the global producer hedge book, including options, never exceeded 4500 to 5000 tonnes. Accordingly, most of the total gold derivatives reported by the BIS cannot be attributed to producer hedging but instead appear to have been generated by bullion banks funding themselves through the gold carry trade while assisting the central banks to suppress gold prices. See Déjà Vu: Central Banks at the Abyss (12/7/04).
Turning to the figures on options, the previous BIS report seemed to indicate a sharp increase in the use of call options written by the central banks to provide delta hedges for short sales by the bullion banks, whether of borrowed physical or paper gold. See Gold Derivatives: Skewing the World (6/15/2005). Anecdotal evidence from John Brimelow at GATA's Gold Rush 21 tended to confirm this view, at least as to the fact of heavy call writing by the central banks if not as to their purpose.
Some of the first half decline in the total notional value of gold options may well reflect falling volatility premiums arising from relatively flat gold prices during the first half of the year. However, the size of the decline also suggests a possible about-face in the attitude of the central banks toward writing call options against their own reserves. If so, official efforts to suppress gold prices have suffered another major setback.
Central Banks Selling. Pursuant to the Joint Statement on Gold (WAG II) issued by the European Central Bank and 14 other European central banks (but not the Bank of England) to replace the original Washington Agreement on Gold (WAG I) that expired at the end of September 2004, the signatories agreed to limit their gold sales to 500 metric tonnes per year over the succeeding five years. The following table, compiled from the monthly International Financial Statistics published by the International Monetary Fund, show the sales by signatory for the first year of WAG II.
WAG II Total Gold Reserves Signatories 9/30/04 9/30/05 Decline Germany 3433 3428 5 France 3024 2890 34 Italy 2452 2452 - Switzerland 1419 1290 229 Netherlands 778 723 55 ECB 767 720 47 Spain 523 493 30 Portugal 482 427 55 Austria 317 303 14 Belgium 258 228 30 Sweden 185 170 15 Greece 108 108 - Finland 49 49 - Ireland 6 6 - Luxembourg 2 2 - ---- ---- ---- 13,803 13,289 514 Sales under WAG II, unlike those under WAG I, are not for the most part being carried out pursuant to a plan of publicly announced annual quotas for each participating country. Instead, the sales appear more opportunistic, with the ECB acting as coordinator.
Although the Banque de France continues to adhere to its announced intention to sell 600 tonnes under WAG II in order to diversify into higher-yielding currencies, its first year sales of 34 tonnes were but a baby step in this direction. See M. Isa, French gold sales allows FX reserves diversification, Reuters (Nov. 15, 2005) (alternate link). However, according to the ECB's current data on official reserve assets, France sold another 33 tonnes in October and the Netherlands an additional 5.5 tonnes.
The Bundesbank, which also claims a right to sell 600 tonnes under WAG II, sold a mere five tonnes during the new agreement's first year. It also resisted pressure from the new German government for gold sales to finance an investment fund to promote research and education. See Buba's Weber to resist political pressure to sell gold reserves, Forbes (Nov. 14, 2005) (alternate link).
John Brimelow has followed gold sales by the ECB and its member banks under WAG II quite closely. As he recently noted: "It is clear the ECB is boosting sales to meet price strength, rather than selling regular amounts, weekly as the Swiss did. One wonders why." A partial explanation may be that many of these sales have been made in response to previously written calls, either as deliveries into in-the-money calls or as sales timed to push certain calls out-of-the-money.
But this explanation, while consistent with the recent BIS reports on derivatives, does not address why the central banks, presumably mostly from the euro area, wrote heavy volumes of calls in the first place, especially during the last half of 2004. Nor does it explain why the euro area central banks continue to announce gold sales at a rate that puts them on track to sell a full 500 tonnes during the current (second) year of WAG II.
What's Up? Since June 30, 2005, the price of gold has risen from $437 (London PM) to over $530 at this writing. Given the inadequacies of their reporting on transactions in gold, how the euro area central banks are handling this action cannot be known with certainty, but it seems quite possible -- indeed, likely -- that at least three distinct although related operations are at work, each focusing on a traditional central bank activity: management of exchange rates, management of gold and foreign exchange reserves, and bank supervision.
Managing the Euro Exchange Rate. The following chart by Mike Bolser plots the euro/dollar exchange rate versus the dollar gold price from January 1, 2004, to almost the current date. As is immediately apparent, the sharp ascent of the euro during the last half of 2004 took place during the same time period that the BIS reported a huge increase in OTC gold options. Similarly, the equally sharp decline of the euro during the first half of 2005 covers the recent period for which the BIS has just reported a large decline in gold options. What is more, during the latter period the ECB announced the sale of some 47 tonnes from its own gold reserves.
This picture suggests that at least some of the heavy option writing in gold during the last half of 2004 was designed to brake the euro's rise against the dollar. The strategy could have been as simple as providing the bullion banks with ammunition to suppress gold prices, and thereby to relieve some of the downward pressure on the dollar. Another possibility is that gold calls were offered in some way as a quid pro quo for not going long the euro, i.e., to try to lower at the margin the demand for euros, especially as an alternative to dollar reserves.
Viewed in this light, the ECB sale could easily be explained as resulting from the exercise of written calls (probably European style) sold to one or more bullion banks. (Calls written by one central bank directly to another would not turn up in the BIS reports.) Although the ECB claims generally to have refrained from significant gold lending or other active management of its gold reserves, managing the euro exchange rate would seem to present the strongest case for mobilizing these reserves.
For their part, the bullion banks would likely have been more than willing to assist the ECB and other euro-area central banks in their effort to stem the euro's ascent. Still short gold owed to euro-area central banks under loans taken down to implement the gold carry trade, the bullion banks were almost certain to be not just cooperative but also pleased to have an opportunity to go long against the central banks for whatever gold they could.
Managing Forex Reserves. Of course, with euro having returned to more normal levels against the dollar, exchange rate management cannot explain current gold sales at the maximum rate permitted under WAG II. The ECB's member banks no longer issue currencies, nor do the gold reserves remaining under their control appear subject to any common euro-area policy on gold other than the requirements of WAG II. Accordingly, the national gold and forex reserves of the ECB's member banks now operate more as a national investment fund than a currency reserve.
Under these circumstances, greater emphasis is put on yield, especially in those countries where some or all of the annual income from gold and forex reserves is paid over to the state. And even then, proposals regularly surface for gold sales to fund some activity favored by the politicians but hard to accommodate within already constrained national budgets. Indeed, it is a fair question whether a central bank that does not manage a national currency should have custody and control of any large holdings of gold and forex reserves. As what amounts to a national investment fund, perhaps in a democracy these reserves should be subject to more direct control by elected officials.
But old habits die hard. Gold and forex reserves are an investment arena traditionally viewed as falling within the special competence of the central bank. The ECB's member banks have worked hard, if not always smartly, to keep the national gold and forex reserves on their own balance sheets. Indeed, the reach for yield explains in large measure why so many of them participated so heavily in lending to the gold carry trade.
Sales of gold from official reserves are generally carried out under the supervision of the central bank. Few central bankers would wish to appear as incompetent in this regard as the United Kingdom's current Chancellor of the Exchequer, who unloaded nearly 400 tonnes of British gold at multi-year lows caused in large measure by his chosen methods of announcing and implementing the sales. See, e.g., B. Jamieson, Brown's gold sale losses pile up as bullion price surges, The Scotsman (Nov. 28, 2005).
Although the Swiss gold sales were also made during a period of generally weak prices, unlike the Bank of England, the Swiss National Bank took steps not only to minimize the market impact of its sales but also to enhance its returns. By in effect writing out-of-the-money call options, the SNB managed to realize average prices slightly over spot on a portion of its sales. See P.M. Hildebrand, SNB gold sales - lessons and experiences (May 5, 2005), noting:
Apart from spot operations, 350 tonnes were sold through option programs. In a typical program, the buyer committed to buy 50 tonnes of gold spread evenly over several months and to pay the daily average AM and PM London Fixing plus a premium. In order to increase this premium, the SNB accepted to fix a cap to the maximum selling price. In other words, the programs were based on the idea of selling gold on a spot basis and writing out-of-the-money call options. In an effort to obtain competitive premiums, each program was allotted in an auction between three major dealers. Considering the high variance of the bids we received, this auction procedure proved suitable. The realized premium varied between USD 1.4 and USD 3.5 per ounce. These modest premiums reflected the SNB’s prudence in choosing the caps. At the time of the relevant auctions, these were far above the market price. This explains why, despite an overall bullish market, the strike levels were only attained on two occasions, namely in February 2003.
If sales under WAG II by the euro-area central banks appear to be driven more by price strength than those of the Swiss, the most likely explanation is that they are making even greater use of option strategies, especially the writing of out-of-the-money calls at target prices. These strategies can be quite complex, as can the terms of the more exotic options available to implement them. But in general, they would aim not only at realizing the desired target prices but also at maximizing premium income along the way, e.g., by writing calls at strike prices that remain out of the money until or at expiration, depending on whether the options are American or European style.
In this connection, relatively small price movements at certain times or from certain levels could significantly improve returns on the income side, making it unlikely that the central banks would refrain from manipulating gold prices to their advantage whenever they could. See D. Speck, Price Anomalies In The Gold Market, Gold-Eagle.com (Dec. 6, 2005). But bowing to the reality of market pressures, their basic objective seems to have shifted from simple price suppression to managing gold prices higher.
Saving the Banks. The decline in forwards and swaps reported by the BIS suggests that some progress is beginning to be made in reducing the total net short physical position in gold created by central bank lending to the gold carry trade. Taking place simultaneously with gold sales by the central banks that did much of the lending, these reductions are consistent with the bullion banks effectively settling their repayment obligations through cash payments rather than by delivery of gold bullion.
Announcement of WAG I in September 1999 caused a sharp spike in gold prices that not only caught the major bullion banks completely wrong-footed, but also resulted in a panic later described by Edward A.J. George, then Governor of the Bank of England (Complaint, ¶ 55):
We looked into the abyss if the gold price rose further. A further rise would have taken down one or several trading houses, which might have taken down all the rest in their wake. Therefore at any price, at any cost, the central banks had to quell the gold price, manage it. It was very difficult to get the gold price under control but we have now succeeded. The U.S. Fed was very active in getting the gold price down. So was the U.K.
This event was essentially the gold short-squeeze that had been predicted in GATA's Gold Derivatives Banking Crisis. "Get[ting] the gold price under control" could ease the immediate financial distress of the bullion banks, but it could not secure the gold they needed to repay their gold loans from the central banks. Most of that gold could only have been obtained by market purchases that in the quantities necessary would have blown the lid off gold prices.
A long-term plan was required, and now seems to be unfolding along the following lines. The central banks accept cash payments in lieu of metal, but not at $300 to $350 gold prices prevailing in the immediate wake of WAG I. Most of the gold loans and swaps were thus rolled over to await the arrival of higher prices. In the meantime, insofar as necessary to to meet their VAR (hedging) requirements, the bullion banks purchased call options from the central banks, the terms of which were designed to allow the central banks to attain their desired price objectives but to avoid imposing crippling losses on the bullion banks.
Under this scenario, the bulk of sales under WAG II do not represent physical gold hitting the market. What is more, assuming the use of barrier options, official selling at least on a very short-term basis probably would not display the same sort of profit-maximizing timing as more conventional sales. For example, a bullion bank holding an up-and-in call option cannot exercise it until the barrier is reached, but then, if exercising that option for the purpose of setting the price at which the sale establishing its loss will be made, would try to do so at the lowest price possible.
Central Banks Buying. Not all central banks are sellers. Indeed, it appears that they could well be turning into net buyers. Argentina reported adding 55 tonnes to its gold reserves during the last quarter of 2005. The Governor of the Reserve Bank of South Africa says it may soon add to its gold holdings. See S.Africa c.bank says might up gold reserves, Reuters (Nov. 14, 2005) (alternate link).
Recently the Russian central bank announced plans to double its gold reserves, raising them from 5% to 10% of total reserves. See V. Korchagina et al., President Supports Gold Plans, The Moscow Times.com (Nov. 23, 2005) (alternate link). Enlarging upon his support for the proposal, Russian president Vladimir Putin noted: "The reserves are after all gold and forex reserves. Let's not be too restrained here." See CB should increase gold weighting in reserves - Putin, Interfax (Nov. 22, 2005) (alternate link).
At almost the same time, an article in the officially sponsored China Securities Journal by an economist at state-owned China Galaxy Securities argued that China should raise its gold reserves to 2500 tonnes in the near to medium term with a longer-term objective of 3000 tonnes, putting it in roughly the same league as the IMF, Germany or France. See also J.A. Nones, When Will Asian Central Banks Buy Into Gold?, Resource Investor (Dec. 2, 2005); Asian central banks likely to increase gold reserves, People's Daily Online (Dec. 1, 2005).
As reported to the IMF at the end of September, Russia's official gold reserves stood at 387 tonnes and China's at 600 tonnes, suggesting that these two countries alone could take more than the total amount of gold available for sale under WAG II over the next four years. Not surprisingly then, as gold moved over $500 to prices not seen in more than 20 years, some analysts suggested central bank buying as a likely explanation. See, e.g., K. Morrison, Gold at new 24-1/2 year highs, FT.com (Dec. 7, 2005).
For obvious reasons, prospective large buyers do not normally announce their intentions in advance, and the Russian central bank quickly indicated that its plans did not contemplate large near-term purchases. See Russian Central Bank could increase gold in reserves, RIA Novosti (Nov. 24, 2005) (alternate link); P. Lavelle, Central Bank signals gold policy to change slowly, RIA Novosti (Nov. 28, 2005) (alternate link) (claimed total gold reserves in excess of 500 tonnes (17.64 million oz.), segregated "as monetary gold, allocated gold, and term deposits worth some $6 billion").
The latter story is interesting in two respects. First, the 500 tonnes substantially exceeds the 387 tonnes reported to the IMF. Second, at $480 per ounce (roughly the level of gold prices at and immediately preceding the date of the story), $6 billion of deposits equates to almost 390 tonnes. In other words, it appears that the Russian central bank has loaned out a quantity of gold curiously close to the total gold reserves that Russia reports to the IMF.
From 1996 through 2001, Russia reported to the IMF gold reserves ranging between roughly 400 and 500 tonnes. With the gold price suppression scheme then operating in high gear, it is quite possible that the IMF aid package to address Russia's 1998 economic crisis was conditioned upon, or secured by, deposits of large amounts of its official gold. Just as weak oil and gas prices exacerbated that crisis, today's strong energy prices benefit the Russian economy and dramatically improve its international financial position.
Unlike the ECB and other euro-area central banks, the Russian central bank has no obvious interest in rescuing primarily Western bullion banks from their short gold positions, but every incentive to demand satisfaction in bullion of any gold deposits that it may have with them. No central bank could move substantial funds into physical gold today without quickly driving prices far higher. On the other hand, to demand repayment of outstanding obligations denominated in gold is quite a different matter, at least where the great weight of any adverse consequences, including sharply rising gold prices, falls on parties for which the creditor has no supervisory or other responsibility.
President Vladimir Putin at a mineral resources exhibition in Madagan in the Russian Far East, Nov. 22, 2005, Itar-Tass photo
Barbarous Relic at the Gate. What message exactly was President Putin trying to communicate in this intriguing photo op? If he were only trying to give a boost to Russian gold mining, he did something that no head of a major gold producing country has done in a long while: support gold. A more interesting possibility is that he was signaling his support for any demands by the Russian central bank that its gold deposits be returned or repaid in kind.
Whatever his motives, this former Soviet spymaster appears to have let gold out of the closet where the guardians of the Western welfare states have tried to confine it. In so doing, he may have opened the door to gold again playing an important and possibly central role in the international monetary system.
Effecting a retreat that does not turn into a rout ranks among the most difficult of military maneuvers. Napoleon learned this lesson the hard way in Russia. So did the Germans under Hitler. And so, perhaps, will the Western central banks that have for the past decade waged war on permanent, natural money -- gold.
