On stabilising the gold price Almost a year ago the Telegraph's Thomas Pascoe put out an interesting piece on gold. We've decided to reprise it this Friday because we think it offers an interesting and useful perspective on current developments in the gold market: One of the most popular trading plays of the late 1990s was the carry trade, particularly the gold carry trade. In this a bank would borrow gold from another financial institution for a set period, and pay a token sum relative to the overall value of that gold for the privilege. Once control of the gold had been passed over, the bank would then immediately sell it for its full market value. The proceeds would be invested in an alternative product which was predicted to generate a better return over the period than gold which was enduring a spell of relative price stability, even decline. At the end of the allotted period, the bank would sell its investment and use the proceeds to buy back the amount of gold it had originally borrowed. This gold would be returned to the lender. The borrowing bank would trouser the difference between the two prices. This plan worked brilliantly when gold fell and the other asset - for the bank at the heart of this case, yen-backed securities - rose. When the prices moved the other way, the banks were in trouble. This is what had happened on an enormous scale by early 1999. One globally significant US bank in particular is understood to have been heavily short on two tonnes of gold, enough to call into question its solvency if redemption occurred at the prevailing price. Goldman Sachs, which is not understood to have been significantly short on gold itself, is rumoured to have approached the Treasury to explain the situation.... Pascoe goes on to quote Peter Hambro to legitimise the story: Faced with the prospect of a global collapse in the banking system, the Chancellor took the decision to bail out the banks by dumping Britain's gold, forcing the price down and allowing the banks to buy back gold at a profit, thus meeting their borrowing obligations. I spoke with Peter Hambro, chairman of Petroplavosk and a leading figure in the London gold market, late last year and asked him about the rumours above. "I think that Mr Brown found himself in a terrible position," he said. He was facing a problem that was a world scale problem where a number of financial institutions had become voluntarily short of gold to the extent that it was threatening the stability of the financial system and it was obvious that something had to be done. While the market manipulation which occurred when the gold reserves were sold was not illegal... Lessons from Libor aside, the story does bring some credibility to Gold Anti-Trust Action Committee's long standing claim that central banks were possibly suppressing the gold price through coordinated lending or sales for most of the last decade. Yet if that was then, the story now is very different. As we have previously pointed out, central banks are once again becoming net buyers and/or "absorbers" of gold. In fact, some analysts suggest the prospect of more central bank purchases may even become the key "bullish" signal for gold prices (if not the only one). And in many respects they've already become the marginal support factor. Which means if central banks did once have the tendency to suppress prices, that is definitely no longer the case. In fact, if anything, the opposite is now true, with many central banks actively working to support the gold price, rather than depress it. As to their motives for doing so, we can only speculate. Though ensuring financial stability by avoiding another bubble collapse does sound a reasonable explanation to us. Incidentally, the gold carry trade referenced by Pascoe came to an end in 2008 because gold producers" hedging books started bleeding ever greater losses as prices rose. As the GFMS gold survey reported, this then turned to a period of de-hedging, with only "small discrete amounts of project hedging as part of risk management connected to the securing of project finance agreements and credit facilities." What's really interesting is that even now after a few years of gold price stability, gold miners have still not been tempted back into hedging on a significant level. As analysts at Nomura noted this week, with reference to the gold miners: We expect that producer hedging remains limited. The lack of new mine development and limited new mine financing means there are less construction / financing hedges being put in place as compared with previous phases in the market. Yet it was producer hedging which supposedly spawned the gold carry trade to begin with. So yes, bullion banks borrowed gold, shorted it into the market and then put the proceeds into higher yielding assets. But they also sold derivatives to gold producers which not only hedged their future sales, but covered their own short positions. Thus, for a gold short position to have gone bad as claimed, it was either the case that banks had been running naked shorts (not impossible) or that producers somehow failed to deliver on their derivative obligations. Looking to the archives you certainly do find evidence for the latter. As spot prices rose in 1999, peaking in September after a bunch of European central banks announced a moratorium on gold sales, gold producers found themselves weathering ever larger opportunity losses linked to hedging books, which were all subject to margin calls. Margin calls, which in many cases, producers simply couldn't afford to make. A trawl through the 1999 news archive, courtesy of Factiva, reminds us of the nature of the situation. As the Independent On Sunday, reported in October 1999: THE BANK of England has intervened on behalf of gold producers threatened by enormous losses in the derivatives markets. The Bank is said to have asked several banks to give more time to those mining companies that owe them large sums. A number of banks, notably Goldman Sachs and UBS, are thought to have put pressure on their creditors to pay up. The Bank is also thought to be lobbying Lonmin, the British miner, encouraging it to pursue its planned takeover of Ashanti, the Ghanian group worst hit by derivatives losses. "The Bank of England is taking a considerable interest because the gold market is based here," one gold analyst said. It's all part of their quiet, behind-the-scenes manipulation. The Bank is keen for stability to return to the gold market as it continues the sale of Britain's gold reserves. It is anxious that the volatility in the gold market does not put excessive strain on the balance sheets of either the banks or the miners. At least one investment bank is said to have an exposure to the bullion market which runs into billions of pounds. Cambior, a Canadian miner, is also thought to have incurred heavy losses. Like several other miners, Ashanti has been caught out by the recent sharp increase in gold prices, which was sparked by last month's decision by European central banks to declare a moratorium on their gold sales - an agreement from which Britain is exempt. From Global Finance, December 1999 (via Factiva): Ashanti Goldfields, Africa's third-largest gold producer, secured a three-year reprieve from its 15 gold-hedging counterparties in November. The troubled gold miner, based in Accra, Ghana, won an exemption from its obligation to post collateral against margin calls on hedging contracts in return for issuing the counterparties with warrants convertible into Ashanti shares. If fully exercised, the warrants would give them a stake of about 15% in Ashanti. Ashanti racked up losses of about $570 million when a sharp rise in gold prices left its hedging program at a severe loss. Now the company can wait until December 31 2002 before it must post any margin on its hedge contracts. And lastly the AFP, December 1999 (via Factiva): LONDON, Dec 1 (AFP) - The gold price continued to fall on Wednesday ahead of an announcement on Ashanti Goldfields financing and in continued reaction to the latest official sale from Britain. The gold spot price fell to 289.90 dollars an ounce in afternoon trading on the London Bullion Market, from 291.60 dollars late on Tuesday. Prices had fallen as low as 289 dollars earlier in the session. The Ghanaian gold producer, Ashanti, was due to say on Thursday if it had secured additional funding of 100 million dollars and formally secured a freeze on potentially crippling exposure to derivative contracts from its creditors. The African producer was badly caught out by a rise in gold prices in September. It was reported at the time that Ashanti, in which the Ghanaian government holds a 20-percent stake and a golden share, faced calls for about 270 million dollars after betting the wrong way on price movements. And so on. Not so much Gordon Brown doing a deal for the banks, but acting to mitigate the damage being caused to African gold producers due to European central banks deciding to suspend gold sales. As for that European bank moratorium decision, that was largely prompted by a desire to stabilise the gold price from market fears that central banks had the power to collapse the price at any time by shedding reserves. Fears which existed because gold's role as a store of value and reserve asset had started to be questioned, making it an ever less logical asset to hold. Indeed as the WSJ reported in September, 1999: It has been a long time since the phrase "good as gold" has had a ring of truth. But yesterday came close. The metal's value skyrocketed $14 an ounce to $281.80, hitting a five-month high on news that 15 European central banks won't unload extra gold onto the market for the next five years. Analysts said the unexpected move virtually erased the biggest specter that has been scaring investors away from gold for more than a year - a seemingly endless string of rumors or announcements that government gold sales could flood the market. The interesting thing, of course, is that according to Pascoe, Brown's original decision to start selling gold dates back to May, 1999 - so before the moratorium was even known about. He also says it came in the interests of stabilising the short exposure of the banks - shorts which should, theoretically, have been performing perfectly well at that point. The account also runs contrary to press reports which linked the decision to gold's growing irrelevance to the monetary world, and years of downward price moves in the wake of Richard Nixon's decision in 1971 to suspend gold convertibility. If Pascoe is right on the real motivation of the original Brown gold sales, however, the implication is that banks were possibly being provided an opportunity to cover any remaining naked shorts ahead of the moratorium's announcement. And if that is true, that is pretty interesting- especially if you look at the gold price trend running up to the moratorium: So were Brown's much criticised gold sales really that ill-advised? Perhaps, they represent the first time Brown "saved the world" by helping banks cover shorts, which would otherwise have been severely hit by the European-wide moratorium. Which does make us wonder about the current spate of central bank gold purchases. To what degree is this trend really about market stabilisation rather than an appetite for gold? How is a central bank gold purchase different to a QE-motivated bond purchase anyway? More so, what does this story foretell about central bank intervention in commodities more generally, especially now that oil companies have started behaving like the old gold producers? Related links: Propping up the gold price - FT Alphaville The end of the gold carry trade - Seeking Alpha Chinese demand brings new luster to yellow metal - China Daily Gold hedging now just for project finance - GFMS - MineWeb