As a division of the Bank of England, the Prudential Regulation Authority recognises the importance of gold trading in London and has inserted a clause into the new rules (Article 428f) which will allow the LBMA’s centralised settlement system to continue to function. But in line with Basel 3’s apparent determination to get banking’s exposure to uneven derivative positions substantially reduced, net positions in precious metal derivatives in the form of forwards and swaps will be penalised through their inefficient use of balance sheet resources and will likely be replaced by transactions fully backed by physical gold.
The LBMA has been thrown a lifeline but will likely have to refocus from forward derivatives to physical bullion backed trading. By responding positively to these developments, the LBMA and its membership can retain and build on their pre-eminent position in global precious metals markets.
This article points out that the market value of forward derivatives in gold is currently the equivalent of 8,675 tonnes. While it would be incorrect to think it will all translate into new bullion demand, there is little doubt that if Basel 3 leads to the demise of the London forwards market, it will lead in turn to a significant replacement in the form of physical demand.
This article also looks at the broader picture for banking in the light of the PRA’s new regulations as well as the specifics for precious metal derivatives.
The background to Basel 3Investors are increasingly aware that in all international financial centres, banks are now being required to run their businesses differently under the new Basel 3 regulations. For the first time, regulators are now telling banks how they must fund their assets out of their liabilities. This is a major change, which from the beginning of this month is being applied in the US and the EU. It is scheduled to be introduced in the UK from 1 January 2022.
The introduction of Basel 3 bank regulations follows an agreement at G20 level for the Basel Committee on Banking Supervision to draw up new regulations to address the systemic risk issues exposed by the Lehman failure in 2008. The new regulations proved controversial, delaying their introduction, having been finalised as long ago as October 2014. But, unlike rules originating from national regulators Basel 3 was not easily spiked by lawyers representing the banking industry’s interests.
The changes, particularly those that disqualify unstable short-term funding on the liability side of a bank’s balance sheet from providing cover for anything on the asset side, are intended to reform banking practices from the ground up. Since the 1980s, after the repeal of the US’s Glass-Stegall Act which separated commercial from investment banking, banks have grown their balance sheets into purely financial activities and proportionately away from the creation of bank credit to finance non-financial businesses. Non-financial businesses have been increasingly directed into bond and equity markets, where banks can charge large fees without having to worry about counterparty risk.
There are worrying signs that commercial banking for the big international banks has gone about as far as it can with financialisation and has become increasingly reliant on higher gearing for diminishing margins. Consequently, many aspects of financial activity are targeted and adversely affected by the new Basel rules. A bank like Goldman Sachs with its reliance on large customer deposits is treated unfavourably compared with a bank substantially funded by retail deposits and deposits of small businesses. And Goldman reportedly has very recently reduced its holdings of equity investments, treated unfavourably with a required stable funding factor set at 85%, the same as gold. While market traders might observe these moves as indicating Goldman has turned bearish on equities, it may have more to do with responding to the US regulator’s version of Basel 3.[i] If so, it could be a warning of a similar effect on trading in precious metals
As well as uneven trading books and related liabilities being penalised, derivatives appear to be a target for containment, with a global notional value of over-the-counter (OTC) contracts of $582 trillion recorded by the Bank for International Settlements last December. And this is after the introduction of counterparty netting agreements following the Lehman failure, whereby multiple transactions between pairs of counterparties in the same contracts were reduced to a far lower net figure by mutual written agreements.
Last December, these OTC contracts had a gross market value of $15.8 trillion, indicating a 36:1 gearing relationship with their notional value. And that is on top of bank balance sheets which are in turn geared, with assets anything up to 30 times balance sheet equity in the case of Eurozone banks. Not much has to go wrong for the BIS and its Basel Committee to have failed in their quest to make banks systemically safe.
How derivatives are financed is a key focus of the new regulations. The Basel 3 approach is to disqualify their financing with ephemeral deposits. But it goes much further. Short-term funding, other than from smaller deposits, is penalised. It would appear that unallocated precious metal customer accounts, because of their nature being a bank’s liability not valued in its accounting currency and by not being specifically mentioned as an allowable exception, default to an ASF of zero.
A confusing response from the LBMAOn the asset side of bank balance sheets, according to Article 428az derivatives net short or long require a 100% RSF. However, in a statement released yesterday, the LBMA claimed that gross derivative liabilities attract a 5% RSF, which seems bizarre because if that was true physical gold would be rated substantially riskier than its derivatives[ii]. Furthermore, a derivative liability is a derivative that is sold. A buyer, who records it as an asset at fair value, under the new regulations would have to treat it as subject to a 100% RSF, resulting in two different treatments, rendering this interpretation appear illogical.
According to Article 428at, what the LBMA actually refers to applies to a collateralised derivative position where the value of the derivative is negative, and being subject to Article $428da, relates to positions of qualifying central counterparties as opposed to a bank’s on-balance sheet derivatives.
This confusion followed the LBMA’s letter to the PRA during the latter’s consultation period on the new Basel 3 regulations, where the LBMA omitted to mention anywhere that unallocated gold was not physical gold but an OTC derivative of it, as defined by the Bank for International Settlements itself. By claiming that “gross derivative liabilities will also attract a 5% RSF”, perhaps it is now hoping an escape from the 85% RSF accorded to physical precious metals in an admission that forwards beyond a normal settlement cycle are in fact derivatives.
Discounting the LBMA’s initial take on the PRA rules, it was up against this unyielding brick wall that, with its unallocated gold market masquerading as bullion, the London Bullion Market Association found itself trapped.
Within precious metals markets there have been numerous comments and opinions as to the likely consequences of Basel 3. But there is general agreement that any discouragement given to bullion banks with respect to their position-taking would make precious metals prices more volatile. Subject to how these regulations would be treated by the UK bank regulator (the PRA), it was clear that the LBMA was extremely concerned for its future, and particularly for its settlement system.
With the publication of draft rules to be implemented next January, most of that uncertainly is now lifted, but clearly there are differences of opinion remaining. In an attempt to narrow these down, we shall now turn to the relevant passages in the new PRA rules
The new rulebookThe Prudential Regulatory Authority released its new draft rulebook last week, updated for Basel 3, which will become effective in January 2022.[iii] It is over-stamped by the PRA as near final, so we can assume that it will be the final version for all intents and purposes. It has been released at this time so that banks know in advance what changes to their treasury management and regulatory reporting will be required in six months’ time.
The application of Basel 3’s net stable funding ratio method to gold and other commodities generally accords with the Basel regulations, with one important addition. Article 428f concerns interdependent assets and liabilities, introduced so that the current and future owners of the London Precious Metal Clearing Limited (LPMCL) can continue to operate without having to suffer the penalties of the net stable funding ratio (NSFR). It also allows banks to use physical gold in a bank’s possession to offset customer liabilities (Paragraph 2).
The full rule, which is central to the LBMA’s future, is as follows:
“1. An institution may apply to the competent authority for permission to treat an asset and a liability as interdependent. For the purpose of this Article, an asset and a liability are interdependent where either conditions (a) to (f) below are met or where paragraph 2 applies:
(a) the institution acts solely as a pass-through unit to channel the funding from the liability into the corresponding interdependent asset;
(b) the individual interdependent assets and liabilities are clearly identifiable and have the same principal amount;
(c) the asset and interdependent liability have matched maturities;
(d) the interdependent liability has been requested pursuant to a legal, regulatory or contractual commitment and is not used to fund other assets;
(e) the principal payment flows from the asset are not used for other purposes than repaying the interdependent liability; and
(f) the counterparties for each pair of interdependent assets and liabilities are not the same.”
[Article 428f (1) above permits the operation of LPMCL and its owners to continue as before after the introduction of Basel 3’s NSFR rules, subject to the PRA granting permission to each of the owner banks.]
“2. This paragraph applies to an institution's unencumbered physical stock of precious metals and customer deposit accounts in precious metals where all of the following conditions are met:
(a) the institution’s unencumbered physical stock of each precious metal is used to cover customer deposit accounts in the same precious metal;
(b) the institution is not exposed to liquidity or market risk resulting from either the sale of precious metals by the customer or the physical settlement of customer transactions in precious metals; and
(c) the precious metals assets and liabilities are on the balance sheet of the institution.
- For the purpose of paragraph 2:
(b) the interdependent asset and liability treatment shall only be available to the extent that the institution's unencumbered physical stock of each precious metal is matched by customer deposits of the same precious metal. Any excess physical stock or customer deposits in a precious metal shall not be treated as an interdependent asset or liability for the purpose of paragraph 1;
(c) an institution’s precious metals accounts at any other institution shall not be considered a part of the institution’s physical stock of precious metals.”
[Paragraph 2&3 allows any bank to offset an unallocated customer liability with physical bullion, so long as it is in that bank’s allocated possession and on its balance sheet]
It will assist the reader to understand Article 428f (1) if the function of the LPMCL is briefly explained. LPMCL is a not-for-profit entity acting as a central clearing system for LBMA members. It is owned and operated by four London-based clearing LBMA members: HSBC, ICBC Standard Bank, JPMorgan and UBS, settling loco-London allocated and unallocated metal trades.
Unallocated trades, forming a large majority of settlements, are netted off, first by individual LPMCL members on behalf of their clients, other LBMA members and on their own books, and then the centralised LPMCL settlement system (AURUM) settles the remaining differences between the four LPMCL members. Deliveries of physical metal occur within the system but form a small minority of transactions. Except where an unallocated trade is settled by delivery, all unallocated trades naturally cancel each other out.
The four LBMA members owning LPMCL operate a physical float as part of their management of these trades. It can therefore be appreciated that unless Article 428f (1) had been added to the PRA regulations the LPMCL clearing system would have almost certainly ceased to function.
Paragraphs 2 and 3 of this Article are also important, permitting banks to offer unallocated accounts without a balance sheet penalty so long as they are fully covered by deliverable physical bullion on the bank’s balance sheet. It allows a bank to continue to offer the considerable convenience of an unallocated account without balance sheet penalties. Rather than withdrawing from offering customers any gold market facilities other than pure custody, it will permit LBMA members to continue to offer precious metal accounts on a pooled basis.
But instead of matching unallocated client accounts with unallocated or other derivative assets, banks will be encouraged through balance sheet incentives to acquire physical bullion to provide the service. While it should make bullion banks a safer systemic proposition for their customers — the objective of the Basel 3 exercise — it should be noted that unallocated accounts will continue to bear counterparty risk.
This could have a significant impact on the prices of precious metals because LBMA statistics show that the combined weekly turnover in gold, silver, platinum, and palladium totals $357bn between members alone. But from an attempt in 2011 by the LBMA to collect turnover statistics (which was abandoned) it appears that transactions between LBMA members and their non-member customers could be about five times greater. This must represent an ongoing and significant line of business interest, unlikely to be simply abandoned.[iv]
Article 428f (2 and 3) referred to above appears to offer a lifeline to the LBMA, which can continue to have an important and active role in precious metal markets. However, the market for forward transactions beyond a normal settlement cycle is likely to become significantly restricted or even end because of the balance sheet penalties of running uneven derivative positions. With bullion banks likely to restrict taking uneven trading positions for their own accounts, derivative supply will be withdrawn from the market and replaced by physical demand instead.
The interest cost penalty for buying physical bullion to replace unallocated derivatives is for the moment minimal because of current interest rate levels for reporting currencies. Instead of unallocated customer accounts being offered for free, they might suffer a small charge, perhaps 10—20 basis points, an annual maintenance cost that might drive some marginal trading business away. But London should continue to see good demand, some of which might even be diverted from ETFs whose expense ratios are considerably higher.[v]
By significantly reducing counterparty risk for bullion bank customers while giving them a continuing facility, the PRA’s inclusion of Article 428f is a sensible addition to the proposed regulations.
Discouraging derivative exposureThe task set for Basel 3 was to de-risk the global banking system, with a significant danger detected in uneven derivative positions. When Basel 3 was being formulated, uppermost in regulators’ minds would have been the failure of AIG and the potential domino effect on the global banking system. What would have concerned the Basel Committee was the possibility that a deteriorating derivative position in the future could recur, and large corporate deposits flee from affected banks in search of safety. Clearly, the issue of systemic risk demanded separate treatment for derivative positions, and it is this that, among other funding issues, the net stable funding ratio addresses (NSFR).
The NSFR is available stable funding (ASF) divided by required stable funding (RSF) and must always be maintained at one or more. ASF is applied to a bank’s liabilities (i.e., its sources of funding) and different categories of liability have different ASF factors. Under Article 428k, unless specified otherwise in Articles 428l to 428o, all liabilities without a stated maturity are assigned a 0% ASF factor, which means they cannot be used for funding any of a bank’s assets. For bullion banks, this refers to customers’ unallocated metal deposit accounts. There is no mention in Articles 428l to 428o of customer accounts tied to precious metal or commodity prices, so we must assume that the intention is for them to have a zero ASF.
Now we must consider the RSF, which is the denominator in the NSFR equation. It determines how much ASF is needed to fund different categories of banking assets.
Under Article 428ag (g), an 85% RSF, the apportionment of ASF, is required for “physically traded commodities, including gold but excluding commodity derivatives.” The exception is for physical metal held specifically to hedge customer unallocated accounts in their entirety under Article 428f covering interdependent assets, referred to above, in which case both sides come out of the NSFR calculation.
Otherwise, physically traded gold and other commodities require 85% RSF, it appears without any matching deposit funding from the ASF side. And as discussed above, other than for central clearing purposes, commodity derivatives require a 100% RSF.
To summarise so far, this means that 85% of the funding for gold and commodity contracts, including other precious metals, is to be allocated from unrelated but more stable liabilities, and for derivatives 100% of stable funding is required. The issue that now needs clarification is whether the PRA regards a forward contract with a settlement date to deliver gold or silver beyond a normal settlement cycle as a derivative. The Basel Committee includes forward contracts and swaps in its derivative statistics, so despite the LBMA’s misleading representations to the contrary, we can safely assume that the PRA will take them to be derivatives as well.[vi]
Further implications for banks and precious metalsBy the addition of Article 428f, the LBMA in London has a future, albeit a different one. In effect, the Bank of England is saying, “You can have your settlement engine and your banking members can continue to trade precious metals, instead of derivatives” It is the best result the LBMA could hope for, and it is a more stable future from which it will ultimately benefit.
There can be little doubt that in the general retreat out of derivatives some banking members will throw in the towel on precious metals trading. But there is still a market for gold dealing, which is to be satisfied by banks holding physical bullion to cover unallocated customer accounts. The potential size of this market is difficult to assess, but we can make a provisional estimate.
We know from a previous attempt to quantify trading between LBMA members and non-members, which we can take as public demand for loco-London trading, that it was in the region of five times daily settlements between LBMA members. But we need to know the value of outstanding forward settlement contracts, for which figures are not available from the LBMA. But the BIS estimate of gold forwards and swaps, the large majority of which is LBMA transactions, was $530bn at end-December 2020, a relatively stable figure similarly recorded at preceding half years. At current prices, that is the equivalent of 8,675 tonnes. How much of that will emigrate from forwards and swaps to physical bullion is difficult to estimate, but it can be expected to be determined by the following factors:
- The number of LBMA banks and non-banks offering physically backed gold and silver account facilities, and therefore the competition to market new bullion-based services.
- The availability of physical bullion to satisfy extra demand resulting from rule changes.
- The price effect of extra bullion demand, and whether a rising price creates a bandwagon effect.
- The expense of maintaining physically backed customer accounts, and therefore the likely charges, compared with generally charge-free unallocated accounts and allocated custodial services.
- The outlook for the gold price relative to the dollar and other major fiat currencies.
The broader implications of the PRA’s rule changesBoth Basel 3 and the PRA’s interpretation of the role of commercial banks are consistent with the view that banks operate as intermediaries between depositors and their operations. This is not, in fact, the case. As I explained in last week’s Goldmoney Insight, through the process of double-entry book-keeping bank deposits are created as a direct consequence of the expansion of bank credit. And while some deposits are added to by customers transferring credits from other banks, these nearly always owe their origin to bank credit creation as well.
By permitting banks to manage the relationship between assets and liabilities before Basel 3, bank regulation has not usually challenged established banking law and practice. The NSFR regime might seem to ensure funding mismatches are lessened, but the reality is new mismatches are created because the funding of an asset can no longer be tied to an offsetting deposit. The double-entry system will continue, that is for sure.
But on the face of it, having expanded balance sheet capacity almost to its limits, the global banking system will now be in retreat. Derivatives and commodity trading positions are discouraged and are set to decline. Even market-making in equities will be hampered. It means that for banks their time horizons will contract because the risks they are accustomed to offsetting with derivatives can no longer be hedged as efficiently. It will affect all aspects of banking business, potentially drawing a close to fixed long-term low-interest loans, such as mortgages and car finance.
It is tempting to think that the Basel Committee has an ulterior motive behind driving banks out of financial activities. Perhaps the BIS’s role in coordinating central banking development of crypto currencies satisfies an ambition to side-line commercial banks entirely, and Basel 3’s introduction is a step in that common direction. But we have little evidence of this joined-up thinking.
Nevertheless, commercial banks are being side-lined in some jurisdictions. In the EU we see the global systemically important banks — the G-SIBs, now as primarily tools for absorbing government debt. In the US and UK they have become intermediaries for distributing QE to investing institutions, because the investing institutions do not have accounts with the central bank. It will be a small step for them to do so, as is already the case in the US reverse repo market with money funds. The same appears to be true of the Japanese banking system, and China’s banks under government ownership are slavishly carrying out government monetary and economic policies.
Only the smaller banks seem to have a focus on banking’s traditional business, the financing of local non-financial businesses, the SMEs that make up the bulk of any country’s GDP. Networks of smaller banks and credit unions with their fingers on the local business pulse go along with economic success, for example in Germany. But national regulators seem keen for them to be merged out of existence. These are all straws in the wind, which individually seem unimportant, but can easily lead to the impression that for banks the best times are now over.
[i] See https://www.zerohedge.com/markets/goldman-has-aggressively-and-quietly-liquidated-quarter-its-equity-investments
[ii] See https://www.lbma.org.uk/articles/net-stable-funding-ratio-update-1?_cldee=YWxhc2RhaXIubWFjbGVvZEBnb2xkbW9uZXkuY29t&recipientid=contact-8e7ffa95f4cae81180e3005056b11ceb-755a73fdedc34b3287ba8725b4ccde79&utm_source=ClickDimensions&utm_medium=email&utm_campaign=LBMA%20Weekly%20-%20Non%20Member&esid=294ab02b-afe4-eb11-8106-005056b11ceb
[iii] See PRA Rulebook (CRR) Instrument 2021 at https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/policy-statement/2021/july/ps1721app1.pdf?la=en&hash=4F9123529EADC488AAF6151AF453DE7D5FF3430C
[iv] See Open Letter to LBMA Board of Directors by Paul Mylchreest, Hardman & Co, January 2020, page 33.
[v] LBMA members currently offer custodial services, and I understand that for the largest customers these can be as low as 8 basis points. With LBMA banks no longer profiting from gold derivative turnover, custody rates including vaulting are likely to rise. Whether LBMA customer business remains on-balance sheet or migrates to custodial services remains to be seen.
[vi] See https://cdn.lbma.org.uk/downloads/Pages/NSFR-PRA-Letter-final_signed-20210504.pdf . In this submission jointly signed by the World Gold Council unallocated gold was presented solely as a convenient means of gold dealing, and nowhere was the reader informed that the BIS regarded forwards as derivatives. This is an important misrepresentation because gold and physical commodities outside a normal settlement cycle is covered by different rules in Basel 3.
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