With the specter of a "yes" outcome to the Swiss gold referendum finally being priced in by the market, and the frontrunning of the SNB's potential 1,500 tons of gold purchases starting to move the price of gold higher, a question has emerged: is there enough physical gold to satisfy Swiss gold demand in case of a favorable outcome to the referendum. Well, as Deutsche Bank reports, that may not even be an issue. Because as the following step by step explanation demonstrates, the SNB may simply "window dress" its balance sheet with gold swaps.
So for anyone curious how banks "represent and warrant" that they have thousands of tons of physical gold when in reality they have far less if not zero physical in storage and all in "synthetic" form, here is the blow by blow.
From Robin Winkler of Deutsche Bank
An early suggestion of the ‘gold initiative’ was to transfer Swiss gold reserves to a sovereign wealth fund to protect them from perceived mismanagement by the SNB. This idea was soon dropped. The concern behind the referendum is not the SNB’s management competence but the perceived shortage of gold reserves. Transferring the SNB’s FX reserves to a fund to avoid gold purchases would therefore be a blatant disregard of the political will and probably involve another referendum.
Gold swaps a more realistic option
Another option for the SNB would be using gold swaps to ‘window dress’ its balance sheet rather than holding physical gold or futures contracts. The SNB could borrow gold from counterparties prior to monthly balance sheet reporting dates, re-exchanging it for currency the following day.
There would be two advantages to such an approach. First, by borrowing gold to meet reserve holdings disclosure requirements for one day of the month, the SNB would be free to invest in other, higher yielding assets during the rest of it. Second, if the SNB chose to meet its gold requirements through physical or paper gold, it could still use swaps to smooth out purchases beyond the initial 5 year implementation period thereby minimizing its market footprint.
Gold swaps are politically more straightforward than the introduction of a SWF. There is a long history of monetary institutions using gold swaps dating back to the early 20th century. Indeed, in era of pre-Bretton Woods convertibility, gold swaps were frequently used to make up the gold ratio requirements of central banks. The SNB was in fact one of the most frequent users of gold swaps over the course of the 20th century (see appendix for more detail).
Second, using gold swaps to meet reserve ratio requirements would be consistent with international accounting standards. Gold swaps are recognized by the IMF as a legitimate means for managing central bank reserves.
Third, the amendment does not specify whether the gold has to be in physical or derivative form. The movement behind the gold initiative had initially demanded that all gold be held in bullion, rather than in financial derivatives such as swaps, but this is not an explicit demand of the constitutional amendment. The proposal does specify that SNB gold must be held in Switzerland. In theory, however, the SNB could meet this requirement by transacting swaps with counterparties whose gold is stored in Swiss vaults.
Is the gold swap market large enough to accommodate Swiss demand? It is unknown to what extent the major central banks engage in gold swap and repo transactions, since official statistics no longer disaggregate these. The BIS alone currently holds 236 tonnes of gold under swap agreements with banks. The IMF is prevented from entering gold swaps by its statutes. National central banks would need to step into the breach, as they did pre-Bretton Woods.
The SNB could also choose to use the market to conduct swaps. It is interesting to note that benchmark gold-dollar swap rates have recently traded negative (see chart above), meaning investors are paying to borrow gold. This is unusual as gold is traditionally used as a source of collateral for cash financing. While a number of factors may play a role, such as excess dollar liquidity or an increased demand for collateral on the back of the global regulatory developments, it is possible that anticipation of an affirmative vote in the gold referendum has played a role.
It is important to note that while gold swaps could help address concerns surrounding asset returns and the technical implementation of gold purchases, they do not solve the fundamental issue that the SNB would be obliged to commit a fixed share of its balance sheet to gold, in derivative form or otherwise. Under the terms of the proposal, these reserves would not be available for sale and therefore free to use for monetary policy. Moreover, they would be recorded in reserves, and therefore expose the SNB to balance sheet risks.
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And a brief appending on Gold swaps in monetary history
Gold swap lines are still used between central banks today, but they naturally were a more important staple of global central banking during eras when global currencies were pegged to gold. Interestingly, gold swaps are historically strongly associated with the Swiss National Bank. Although the first gold swap arrangement was made between the Fed of New York and the Bank of England in 1925, worth US$200m of US gold against sterling, the SNB was the most frequent initiator of swaps during the Bretton Woods era. Transactions were made with both the BIS and other central banks. In 1955, the BIS accepted the first US dollars from the SNB in exchange for gold in a swap arrangement with a maturity of three months. In 1959, the SNB received gold from the BIS and the Bank of England in return for US$50m and US$20m, respectively, or roughly US$700m in today’s prices. The rationale was balance sheet window-dressing. Towards the end of 1959, a number of Swiss commercial banks were short of liquidity in Swiss francs given contemporary minimum reserve requirements. They thus entered dollar/franc swaps with foreign banks. The rapid influx of francs threatened the SNB’s own note cover and it in turn had to scramble to obtain additional gold holdings over the year end. Swaps did the trick, plugging the gold gap in its balance sheet at least temporarily.
Gold swaps came to be reciprocated between central banks. In 1961, the SNB entered a large gold/sterling swap with the Bank of England after the revaluation of the German mark had put downward pressure on sterling. To support the Bank of England, a series of bilateral swap arrangements were formalized among a number of central bank and the BIS under the ‘Basle Agreement’. By mid-1961, total swaps under the Basle Agreement amounted to US$904m, with the BIS accounting for US$154m of gold swaps alone.
After currencies were unshackled from gold at the end of the Bretton Woods era, gold swaps lost their significance somewhat, but they remain a customary tool of international monetary cooperation. It was commercial banks which most recently revived the concept during the financial crisis, when they entered extensive gold swaps with the BIS. The gold collateral was provided by national central banks such as the Swedish Riksbank.