Interest in gold, silver and other precious metals has soared during the financial crisis – and with it their prices. The boom has been great for derivatives exchanges – many have enjoyed growing volumes and a rash of new contracts has been launched. But is this just a speculative craze that will vanish as quickly as it came? Or is it the start of something bigger? Owen Sanderson reports.
Nobody who has been watching the commodities markets can fail to be impressed by the rise and rise of the precious metals.
Gold bulls are fond of quoting the statistic that their metal has been the best-performing asset over the last 10 years. The performance of the other precious metals has been similar, despite their greater range of useful applications, and hence keener vulnerability to fluctuations in industrial activity.
With rising prices have come more volatility and higher trading volumes – although the play of cause and effect among these three indicators is hard to determine.
Institutional investors have scrambled to gain exposure to precious metals, and they have been followed by retail investors worried about future inflation and dismayed by low interest rates.
Concerns this year about the solidity of sovereign debt and fears of a double dip recession have only increased the attraction of precious metals as ‘insurance’ in a portfolio.
But how long can this continue? The gold price’s wide fluctuations in recent decades show that it can go out of fashion as easily as it came in. Is that going to happen this time, when the economy recovers and more conventional investments regain their shine?
No one, of course, can say for sure. Those involved in precious metals trading understandably tend towards bullishness, while bears are more likely just to avoid this market and devote their attentions to something else.
Yet things are changing in the precious metals markets – things that just might be taking it to a higher level of investor involvement and sophistication.
ETFs: Easy To Find
The shocks suffered by equity and bond portfolios since 2008 are one of the main reasons why during the last two years, a time of retrenchment in many financial sectors, instruments that help investors access precious metals have continued to proliferate.
The most important has been the growth of exchange-traded funds specialising in precious metals, which are now estimated to hold around 1% of all gold ever mined.
Through their handy format as lookalike equities, ETFs bring precious metals exposure within easy reach of pension and mutual funds, many of which are prevented from buying commodities or derivatives directly.
Retail investors can also buy precious metals in ETF form without special arrangements or market access. All they need is a standard brokerage account.
State Street Global Advisors’ SPDR Gold Shares, the largest gold ETF, grew by 38.8 tonnes of gold in the fourth quarter last year, so that it now owns 1,116 tonnes, worth $39.6bn at today’s spot price of $1,113.
“Tonnages are soaring,” says Robin Bhar, senior metals analyst at Crédit Agricole in London. “ETFs are bringing precious metals to the man in the street.”
Other commentators sound a note of caution, however. Stephan Mueller, executive director of the Julius Bär Physical Gold Fund in Zurich, says that many precious metals ETFs (though not Julius Bär’s) are not hedged against currency risk, and commented that “Unhedged gold positions are really for the professionals.”
A precious metals portfolio is traditionally seen as a bet against paper currency, but as all precious metals are quoted in dollars, non-dollar investors lose out when the dollar slips.
Show me the bars
For the truly risk-averse, a straightforward gold ETF may not offer enough security. Most metal ETFs hold unallocated gold, kept in a vault to which other funds or gold investors have access. The gold is usually leased out by the custodian to generate a return, which means that storage fees can be reduced or waived.
‘Physical’ ETFs, on the other hand, have allocated stores of gold, to which only they have access.
David Baker of the institutional sales group at Sprott Asset Management in Toronto says this was an attractive feature for some investors in Sprott’s newly launched Sprott Physical Gold Trust.
He also believes some US investors liked the fact that the gold was stored in Canada, given the United States’ history of gold confiscation. (In 1933 President Roosevelt issued an executive order obliging everyone to sell nearly all their gold to the Federal Reserve. Owning more than a small quantity of gold was banned until 1974.)
However, SDPR Gold Trust remains by far the largest and most heavily traded gold ETF (see chart), which suggests that liquidity and tracking error are the most important concerns for investors.
Options on SPDR GLD were launched in June 2008, and proved popular, trading on seven US exchanges with volume totalling 34.32m contracts in 2009.
Some investors, however, have been put off by the fees associated with precious metal ETFs. The fees for SPDR GLD are 0.4% a year.
Neil Meader of GFMS, a precious metals consultancy based in London, says: “A few people are understood to have shifted from ETFs to allocated metal accounts to minimise fees. These were typically players relatively new to the gold market, although quite how much shifted is hard to say.”
Allocated accounts are the accounts that physical ETFs use to back their shares, so this step is in a sense cutting out the middleman. Paying management fees for a precious metals ETF can seem like a poor bargain when all you want is exposure to a metal. On the other hand, many are happy to pay for the convenience, currency hedging and other services that ETFs offer.
OTC: Off The Charts
While ETFs have been an important new feature in the precious metals markets, gold and silver are among the most ancient traded commodities in the world.
The London Bullion Market Association (whose members trade physical bullion, spot and forward) fondly relishes its title of ‘oldest bullion market in the world’, and it remains “the market for physical gold, a very deep, very liquid market”, in the words of Robin Bhar of Crédit Agricole.
The LBMA sets the world benchmark prices for gold and silver in its morning and afternoon fixings, and establishes the international standard for quality, called London Good Delivery.
It is certainly the world’s largest gold and silver market, though no one knows quite how large. Some $22bn of gold is transferred between market makers of London Precious Metals Clearing Ltd every day – but these only represent required transfers once transactions are netted out internally.
One gold trader at a major investment bank says: “London is the centre of the world’s finance. There’s a vibrant forward market in London because of the vast liquidity pool underlying it.”
He estimates that around 250m troy ounces of gold are present in London – just under 5% of all gold ever mined. Of the LBMA clearing members, only JP Morgan and HSBC have their own vaults.
Clearers are coming
Though the LBMA’s over the counter market has been the centre of the precious metals trade for more than 200 years, there have been several developments recently in the way LBMA participants conduct business.
Most significant has been the introduction of central counterparty (CCP) clearing for gold forward contracts.
James Oliver of CME Group, which is offering the clearing through its ClearPort system for OTC derivatives, said that “several attempts have been made to introduce centralised clearing for gold forwards, but we are the first to manage it”.
Since this service began in September 2009, customers have spent time working with Ion and SunGard, which supply STP solutions, and some test trades have been conducted.
The reaction from the market has been cool. One trader comments that, with CCP, “risk mitigation more than outweighs the loss of business, but major financial institutions do not feel any urgency about this. CCP takes things away from the existing clearing arrangements between the major banks.”
As FOW reported in January, the London Metal Exchange is also in talks with some LBMA members to offer OTC clearing services, but has met a similarly lukewarm reception.
Much of the interest in CCP is driven by possible regulation. Since the financial crisis, regulators have shown keen interest in CCP as a possible way to reduce the systemic risk in financial markets.
Gavin Lavelle, CEO of Brady, a trading technology provider specialising in commodities, says: “There was talk of increased regulation and compliance even before the last two years, but obviously now things will be even stricter.”
However, CME’s ClearPort offering is criticised by one trader for multiplying the regulatory burden by exposing the London market to US regulation.
A CME Group spokesperson said that in the exchange’s view, customers saw the strong US regulatory environment as a plus, for example in the way it ensures customer funds are segregated.
The trend, then, in the OTC market, is to embrace risk mitigation techniques cautiously. But participants believe there is unlikely to be any substantial move away from physical delivery or towards exchange listing.
Futures face the regulator
New York’s Comex, now owned by Nymex and hence by CME Group, is the futures and options counterpart to the spot and forward business done in London.
Like the London OTC market, it is the largest and most liquid market in its field, and holds a pre-eminent position in price discovery for precious metal futures.
Comex and other US exchanges face a challenge from the Commodity Futures Trading Commission’s deliberations on whether to impose national position limits for metals trading, following its decision to do so for some key energy futures.
The CFTC is holding a public meeting on March 25 to discuss this step. OTC trades cleared through ClearPort might also be subject to Comex rules.
The dynamics of the position limits debate as they affect precious metals are somewhat different from those in energy.
In energy, there had been an unprecedented price spike that peaked in July 2008 before crashing as the world economy turned sour that autumn. Broadly speaking, public opinion and energy consumers saw market speculators as partly to blame for this extreme price swing, and wanted something done about it.
Nearly all the energy trading professionals, all of whom had a vested interest in keeping trading volumes high, resisted position limits, and many claimed that fundamental factors were entirely responsible for the price volatility.
In precious metals, prices have soared, but few dispute that speculators or “investors” have caused the change. And there are few voices calling for cheaper gold.
A touch of discontent
Rather than concerns about a herd of speculators ramping prices, more controversy surrounds fears that the precious metals markets may be too concentrated in a few hands.
Some market participants mistrust the strong presence on Comex of the major investment banks with large physical holdings of precious metals.
These commentators see the big firms’ involvement in creating the large open interest in precious metals derivatives on Comex as flawed and dangerous.
They believe that if too many market participants were to demand physical delivery (to which they are entitled), there would be too little gold and silver available to meet demand.
At the end of February 2010, total open interest in Comex Gold Futures was 475,000 contracts, with 719,000 contracts of open interest in Gold Options. Each contract is for 100 troy ounces, so the total open interest is for 119.4m ounces – or about half the estimated holdings in London.
Ben Davies, of the gold-focused hedge fund Hinde Capital in London, takes this critical view. He considers that Comex futures contracts are in oversupply because of naked short selling of precious metal futures by “four or five large investment banks, which would certainly be considered market manipulation if they were long positions”.
Davies calls Comex “a farce of a market” and considers what he calls the dominance of a few major players on the short side a “structural short in the market” – meaning that their activities are artificially depressing the price of the precious metals.
Proponents of this view fear that the CFTC’s position limits, if they are imposed, may be deeply unfair, because they might include an exemption from limits for ‘bona fide hedgers’. This, they believe, would favour the big dealers with large gold stores.
These claims are disputed by other participants. Pat Hendry, a broker at GFI Group in London, points out that fractional reserve systems – where a smaller quantity of the underlying commodity is held than the paper that backs it – are common elsewhere, and are not inherently unstable.
CME Group itself also rejects these criticisms of Comex. “The activities of the big banks on Comex are legitimate,” says a CME spokesperson in London. “They may be on the short side, and this may not suit participants who would benefit from a higher price for gold, but the dealers are using the market in the way it was intended, to hedge their holdings of gold. They are also contributing to price discovery and providing liquidity to the market. It is not in our interest to see the market manipulated.”
The spokesperson added that market participants should not be concerned about the balance between open interest and deliverable supplies of gold, as this pattern was common to many commodities markets.
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Not just a pretty metal: platinum and palladium
Platininum and palladium (together with rhodium, iridium, osmium and ruthenium) are collectively known as the platinum group metals (PGMs).
Although they are valuable and scarce enough to warrant the title ‘precious’, experts disagree on the extent to which they are used as stores of value or inflation hedges (like gold and silver bullion).
Only platinum and palladium have active exchange-traded markets, and of these, platinum is the larger. The other metals have various industrial uses, but “much thinner markets, and no real fixing mechanism” as one metals trader put it, adding: “if you’re looking for a large amount of rhodium, you’re going to get stung on price”. The main industrial applications of platinum and palladium relate to clean technologies – around 37% of world platinum production goes into catalytic converters, which are fitted to vehicle exhausts to reduce toxic emissions.
As Evgeny Serdyukov, head of Futures and Options on Russian Trading System, the derivatives arm of the RTS stockmarket, notes: “Other precious metals – silver, platinum and palladium – have now become largely industrial metals and these will be dependent on underlying economic activity. PGMs in particular have a very important long term role to play in combating greenhouse gas emissions and this is an increasing trend globally.”
For this reason, Stephan Mueller, executive director of the Julius Bär Physical Gold Fund, considers these other metals valuable balances to gold in a portfolio of precious metals. “Gold traditionally attracts the risk-averse,” he says, “but as economic activity picks up, it will drive the demand for the white metals.” |
“In 2009, deliveries of gold against open interest on Comex were the smallest since 2006, despite the large amounts of physical metal purchased by investors last year,” he said. “This shows that despite the vast quantity of metal purchased, including coins and small bars, the exchange was not used as a source of physical supply, as some might suppose.”
Furthermore, the small size of Comex, relative to the physical OTC market, means that arguments made on the basis of net short positions on exchanges are far from conclusive.
In fact, the gold market demonstrates particularly clearly the impotence of position limits that are imposed only on regulated futures markets, and not on OTC trading, as a way of controlling behaviour in a commodity market.
To judge by its approach in the energy sector, the CFTC is unlikely to impose any limits that are draconian. Even if it did, much of the activity on Comex would surely just migrate elsewhere, either off exchanges entirely, or to an exchange with a more benign regulatory environment.
Exchanges pile in
There is no shortage of aspirational exchanges that would be glad to receive more international interest in their precious metal derivatives.
Exchanges in Japan, South Africa, Russia, Taiwan and Thailand launched precious metal contracts in 2009; the Singapore Commodity Exchange has just announced that its Gold Deferred Settlement contract will be listed on March 30.
Recent price rises for precious metals have caused some of this interest, but particular local circumstances have also played a part.
“We’re just following market demand here,” says Chris Sturgess, general manager of commodity derivatives at Johannesburg Stock Exchange. “South Africa has exchange control, so South Africans are limited in the international exposure they can pick up.”
JSE’s product is quoted in rand, but references the Comex price to prevent market abuse in such a small market.
In other financial centres without exchange controls, it is harder to understand the rationale for exchanges to offer thinly traded precious metals contracts.
One senior trader says: “I don’t understand what these exchanges are doing. They don’t add new liquidity, nobody is adding anything, they are hoping to take business away from other exchanges. There is no advantage to the big international players, because the cake doesn’t get any bigger.”
Compared with that view, James Oliver of CME Group is surprisingly generous: “There are lots of other exchanges whose USP is capturing local interest, plus trading hours are important… they can find local time zone niches.”
Smaller exchanges can profit even from small trading volumes, but will always struggle to provide the benchmark price discovery and small spreads that come with high volumes and deep pools of liquidity.
For this reason, Robin Bhar of Crédit Agricole believes that: “With time, some may close, some will merge. It’s a natural way for exchanges to develop, it happened in Europe and America.”
Perhaps the most ambitious precious metals derivative project is that of Hong Kong Mercantile Exchange, a new exchange which plans to launch this year with a 32 oz gold future.
Its CEO, Albert Helmig, says: “There is no commodity exchange in our time zone that brings together global and local market participants in the way that New York and London have. We see that as a market failure that’s going to be rectified sooner rather than later.”
Shiny future
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How big is the gold market?
Answering this question is harder than it might seem, as Jon Hay discovers.
Despite the long-established importance of gold, it is surprisingly hard to know how much is actually traded.
All agree that the London Bullion Market Association is the biggest venue for trading, with one estimate putting its share of the market at 90%. But as this is an over the counter market, no one knows how much value or how many tonnes of gold are traded every day.
What is known is the net positions between LBMA dealers, which are paid out each day. These average about $22bn a day, which at $1,000 an ounce is 22m ounces of gold. The total amount of value that changes hands must be much greater, however.
One banker estimates that vaults in London hold about 250m ounces altogether, or some 5% of the world’s total stocks.
Adrian Douglas, a commentator who belongs to the Gold Anti-Trust Action Committee, a body that believes the gold market is unfairly organised, argued recently that gold was the biggest physical commodity market – bigger even than oil.
It is certainly widely overlooked that gold flows are immense – but bigger than oil may be too long a stretch.
On a typical day, a total of about 1.18bn barrels of oil are traded through the three most active futures contracts: WTI at Nymex and Brent and WTI at ICE Futures Europe. Open interest for the three is about 340m barrels. At $75 for a barrel of oil, that trading is worth $89bn and the open interest $26bn.
Then there are all the other ways in which oil is traded, not to mention all the refined oil products.
A different way of comparing the two commodities is to consider the total value of all gold that has ever been mined. This is reckoned at a little over 5bn troy ounces, which at $1,000 are worth $5tr.
World oil consumption is about 85m barrels a day, which at $75 a barrel costs $6.4bn. That means all the gold above ground would buy about two years’ worth of global oil production.
Annual gold production is small by comparison – only about 2,400 tonnes or 77m ounces, worth about $77bn – as much as 1bn barrels of oil, or 12 days’ supply.
Perhaps the most interesting fact is the absence of one – the lack of transparency that means no one really knows whether the gross amount of gold trading is three times the net value or 10 times.
This opacity is not just a nuisance for lovers of trivia. It means serious gold professionals who have spent years working in the market can disagree widely over such basic questions as whether there is enough gold to back all the trades that are made. |
So with precious metal prices at historic highs, where next for precious metals trading? Is it likely to slump when the economy returns to normal and – presumably – prices cycle back downwards again?
Only time will tell, but the infrastructure devoted to precious metals investing is much more developed than it was even a few years ago – and commodity investing in general has become more popular.
ETFs are widely available; so are futures contracts on many exchanges. The futures are not all widely traded now, but may develop greater depth and maturity as international players come in seeking fresh liquidity pools, and as local funds and even retail investors start to play in the market.
There are promising indications in other areas too. Since October 2009, CME Group has accepted physical gold as collateral for dealings in its products, covering up to $200m of required margin.
Neither Comex gold nor gold ETFs are included in the scheme, but CME has had favourable feedback on the subject, and has been asked to consider raising the limit.
This makes gold more attractive as a financial asset, and may prompt other exchange groups to do the same.
More importantly, CME believes the move towards centralised clearing of OTC gold trading is likely to stick. The exchange’s James Oliver says that “as the credit situation unfurls, we can expect to see more OTC business going through clearing”. He adds: “Anecdotally, clearing was seen as a cost, but not any more, it’s given a much greater priority.”
CME may have a long struggle if it wishes to persuade the members of the LBMA to adopt ClearPort for all their precious metals business, but it has made some progress in convincing them that CCP might be beneficial.
“CCP has yet to get off the ground,” says one commodities broker. “It should become more attractive, but it’s difficult to break the structures that have been around 200 years. However, the young bloods are very much up for it.”
So precious metals trading is likely to continue at high volumes, though in different forms. Exchanges and clearing groups are poised to pick up more of the business, especially if regulatory requirements change.
As long as gold and silver remain virtually indestructible commodities in limited supply (all the gold ever mined would fit in a cube with sides a little shorter than a tennis court), both will continue to be useful hedges against inflation.
As the world’s economic centre of gravity shifts eastwards, this will also boost gold demand in the long term. Gavin Lavelle of Brady points out: “It’s really a Western thing about paper investment. In Asia, a principal investment has always been gold.”
Platinum and palladium (see box) have followed similar trajectories to gold and silver over the course of the past two years, but many commentators see future opportunities based on their role in clean technologies.
Gold will remain most important, as one senior gold trader notes, “because my mother knows what I do for a living, and because 7 billion other people know what gold is and understand it. It hasn’t gone away since the Pharaohs, and it won’t go away now.”