Alhambra Investment Partners CIO Jeffrey Snider returned to Erik Townsend's MacroVoices podcast this week to discuss one of his favorite topics: How central banks' use gold lending to manipulate their balance sheets, and also to manipulate the broader market for precious metals by sheer dint of their size, and willingness to buy and sell without any consideration for the price.
Their conversation begins with Snider explaining the history of "gold swaps" between central banks that helped birth the concept of fractional reserve lending.
The first "gold swap" conducted between the Federal Reserve and the Bank of England: The Fed handed the BOE $200 million in bullion through the New York Fed; in exchange, the BOE gave the Fed a "gold receivables" in the same amount. This is essentially an IOU that could (in theory, at least) be cashed in for gold, but allowed the Fed to keep the gold deep in its vaults. As Townsend explains, the gold is being taken out of the accounting for the balance sheet, but it's not being removed from the accounting.
Again, in theory, one could argue that these gold receivables were, in fact, "as good as gold" because the default risk from a counter party central bank is, effectively, zero.
Essentially, what happened was the Federal Reserve Bank of New York on behalf of the Federal Reserve system made $200 million of gold bullion available to the Bank of England for its disposal in whatever transactions it might take in defending sterling at that pre-war parity price. What’s important about that is that it aids both sides of the equation.
Because the way a gold swap works is that, essentially, the central bank agent that is providing the gold exchanges it for what’s called a gold receivable.
If you look at Slide 5, for example, I’ve sketched out roughly what this gold swap meant. $200 million in gold was made available to the Bank of England, which it would then sell in the market for sterling at the price that it wished to defend. They put the sterling currency into an account in London on behalf of the Federal Reserve Bank of New York.
So what really happened was gold disappeared from New York and ended up as cash in the UK denomination in London. But, for accounting purposes, the Federal Reserve Bank of New York showed a gold receivable where gold used to be.
Because if (for whatever reason) the Federal Reserve Bank of New York needed its gold back, there was sterling in an account where it could theoretically buy it back. So the gold receivable was taken as equivalent to actually having bullion on hand in a vault in New York City.
So both parties were satisfied. The Federal Reserve Bank of New York got to continue reporting the same amount in its possession, while the Bank of England was supplied additional metal in order to help defend the sterling at pre-war parity.
As anybody who lived through the financial crisis would remember sometimes credit-risk analysts ignore have a tendency to ignore black-swan tail risks like the prospect of a central bank default. We delved into this topic in greater detail about a year-and-a-half ago when Carmot Capital's George Sokoloff explained why even the most sophisticated hedge funds tend to get slaughtered during market shocks.
The way that the accounting works in the gold swap scenario outlined above is the central banks are basically pretending the Fed didn't give its gold to the BOE...yet, there is still only the one $200 million slug of gold...it didn't just magically double. In a way, this feat of financial engineering echoes China's massive "rehypothecation" fraud which we've critiqued time and time again...
It's also important to remember, too, that all of this was done for political purposes: In the aftermath of World War II, Winston Churchill briefly brought the UK back to the gold standard. But to prevent a destabilizing spike in volatility, the central bank needed the gold reserves to defend the peg in the open market.
Knowing the roots of fractional reserve lending will help reframe like our stories about the missing gold at the Fed. Even Snider admits there's ample room for these so-called "conspiracies" to flourish...
...Because, as he admits, we don't know the difference between gold and gold receivables - though that is something that could be determined via a simple audit..
That’s the way this works. And of course it opens the door to all sorts of conspiracy theories. Because, obviously, people have argued, and do argue still, that if there’s more receivables than gold, then there’s no gold left. And how would anybody know the difference?
And the point of fact is we don’t know the difference. We don’t know how much gold has ever been swapped out. And how much gold remains. Because nobody has ever been required to make a distinction there.
Our interest here is defining why that would be. Why are central banks interested in doing this kind of transaction? Other than the fact that they are intentionally trying to mislead the public, which I don’t think is the case.
Again, there are legitimate reasons for all of these things to happen. You may not agree with why they’re being done, or the times of when they’re being done, but there are legitimate reasons for this.
Snider goes on to explain how these gold swaps led to the creation of the gold forward rate, a strategy that many smaller central banks employ to turn their gold reserves into a profit engine. Essentially, central banks allow gold miners to hedge their exposure by fronting them the gold to sell short before they ever pull the metal out of the ground.
The central bank receives a small interest rate, the miners are hedged and capitalized - everybody is happy - or at least that's what one might suspect at first brush.
In reality, the central banks' involvement in the gold market is considerably more fraught - in ways that many mainstream analysts aren't yet ready to consider.
For instance, as Townsend points out, gold bugs have for years expounded to anybody who would listen their theory about how central banks surreptitiously intervene in the gold market to suppress the price of the precious metal. As anybody who trades gold has also undoubtedly noticed that often we get what traders call "gold pukes" - sudden, sharp declines in the price of gold - often around 8 am.
Because central banks are the largest logical price-insensitive participants, many have blamed them for this phenomenon.
Snider said that, while he agrees that central banks are, in effect, manipulating the price of gold when they intervene in the market, there are more plausible explanations for why central banks might do this - aside from being motivated to manipulate the price of gold.
And there’s no legitimate reason for them to actually take an interest in price, because the gold leasing arrangement is, by its very nature, negative in price. For reasons that have nothing to do with monetary policy of any central bank around the world. Because it’s dislodging previously off-market stored gold onto the marketplace. That’s a key point to remember moving forward.
When this stuff happens, when there’s an uptick in lending and leasing for whatever reason, it is price negative. It has nothing to do with manipulation. It’s just the natural supply and demand mechanics of the way these things are set up.
In short, central banks are doing this not because they're intentionally manipulating the price of gold. Rather, the manipulation is an unavoidable side effect of their gold leasing arrangements...
Finally, Townsend and Snider discuss the latter's theory about how major turning points in gold's long-term price trajectory have been influenced by anomalies in the eurodollar market, as depicted in the chart above...
There are a couple of anomalies – or aberrations, whatever you want to call them – in
the gold market that popped up in especially 2010. Remember, 2010 is supposed to be a year of recovery. Not just in the economy, but in the financial markets. We had ZIRP (zero interest rate policy) in the US, we had ZIRP in Europe. We had QE in the US. We had all of these positive monetary factors.
And yet, in the middle of 2017, it came to light that the Bank For International Settlement, which is the central bankers’ central bank, had swapped 346 tons of gold with ten European banks in December of 2009 and January of 2010. And people couldn’t figure out why that was.
Because, again, things are supposed to be recovering. Why the hell are they taking gold out of the hands of European banks? And the reason was, of course, continued funding anomalies in dollar markets. What was reported along the way, as these things became more and more investigated, was: What had happened during the bull market in the 2000s was that people – European customers in particular – who were interested in buying gold because gold was in a bull market, may not have intentionally been buying gold for gold property. They had been buying gold – physical metal – and depositing it with their local bank for custody.
But an unallocated account was a very big difference in terms of legalities and who actually owns the metal. An unallocated account means that you’re just depositing the gold with the bank. The gold then becomes a liability with the bank. And what they give you back in return is essentially a warehouse receipt. Not actual title to the metal.
All the bank is saying is that if you ever ask for your metal, we’ll give you metal back. Not necessarily the specific bars or the specific whatever that you deposited.
And what that allowed was, in times of stress and strain, because that metal became a liability at the bank and not a separate constructive bailment as an allocated account would be, these European banks, including Swiss banks, found that they had a deep pool of unallocated gold that was their own liability that they couldn’t realize.
Again, their only liability was that they would have to put the same kind of metal or the same amount of metal back if their customers ever asked for it back.
What happened in 2010, as the European crisis wore on and got worse, was that these
European banks started to appeal to those stores of unallocated gold. They started to motivate them into the lending and leasing arrangements, which tended to be negative in price the more that happened.
Where that really broke out was in later 2011 as the dollar crisis worsened that year.
September 6, 2011, the Swiss National Bank shocked the markets by pegging the franc to the Euro, essentially trying to get away from the dollar balance. Which triggered all sorts of responses across US dollar funding markets.
And you could see, once again, another big, massive gold puke.
In summary, once again, bank's forward-lending agreements had a massive impact on the gold market because of the price insensitive nature of the transactions...
...But, of course, that's totally different from banks "intentionally" dumping on the price of gold.
Listen to the whole interview below: