Frankfurt The global gold market is a fragile structure with a clear division of tasks: In London, the most important trading center for the precious metal, primarily physical gold is traded. In New York, trading in futures, i.e. delivery contracts, is carried out. Both markets interact – but in the corona crisis, the connection was briefly broken.
The consequences can still be felt today – and they could also have long-term effects on the gold price. During the corona crisis, gold prices on the futures exchange in New York and in physical trading in London had developed extremely sharply.
In the meantime, an ounce (around 31 grams) of gold was the next possible delivery in New York 90 dollars more expensive than in London. Price differences of one to two dollars are normal. The reason for this was the collapse of global supply chains, says Ross Norman, an independent industry analyst based in London.
The Swiss gold refineries, which produce 70 percent of the gold bars produced worldwide, had to shut down. In addition, there was hardly any air traffic, so that little gold could be transported from Zurich or London to New York. “There was enough gold, but in the wrong shape and in the wrong place,” said Norman.
The situation has now largely normalized. But the damage is huge among the banks active in gold trading. In May, the HSBC had to admit that in March it had accumulated a loss of 200 million euros in the London gold trade within a single day. This exceeds the maximum losses that were possible according to the bank’s risk models – and by far, the bank said.
At the end of April, Scotiabank announced that it would completely deal with precious metals trading in London. In the past few years, the Canadian money house had evaporated the precious metals division more and more, also because of a money laundering scandal. But the market turmoil of March is considered to be a reason for the final withdrawal of Scotiabank.
They hit the gold trading banks particularly hard, as precious metals expert Norman explains. Because as a service provider for gold refineries and mining companies on the one hand and for speculative financial investors on the other hand, the banks were in an uncomfortable situation. Mines and ingot manufacturers hedge against falling gold prices by lending and selling gold from banks in London, ie going “short”.
Now the banks bear the risk of falling gold prices, but they also protect themselves against it by going “short” on the futures exchange in New York, ie betting on falling gold prices. The risk of losses from falling gold prices is borne by speculative financial investors who are active on the New York Stock Exchange to take leverage bets on rising gold prices.
Gold is usually traded on the New York futures exchange without physical precious metal actually changing hands. Instead of insisting on the fulfillment of expiring delivery contracts, the speculative financial investors sell the future shortly before the cut-off date and replace it with a longer-running contract.
For example, the bank has to hold the gold on the opposite side of the trade – but rarely deliver it. Typically, only one to three percent of all futures in New York would actually be physically settled, says Norman.
Banks were caught cold
It was different in March: supply chain disruptions caused gold prices to rise in New York, while they rose less in London, where most gold is stored in banks’ vaults. It was extremely expensive for banks to close out short bets in New York. “The supply chain problems caught the banks cold,” explains Norman. “They had to pay high prices to get gold to New York.”
Many gold traders at banks have not yet recovered from this shock, says Wolfgang Wrzesniok-Roßbach, precious metal expert at Fragold. “That will definitely have negative effects on the gold market in the long term.”
The banks are more reluctant to take trading risks in the future. Wrzesniok-Roßbach expects that this will reduce the liquidity of the gold market and the price differences between London and New York could remain high in the long term.
John Reade, chief strategist at the World Gold Council, the most important lobby organization in the gold industry, observed: To date, the price differences between the two trading venues have not yet leveled off at the pre-crisis level. In addition, according to Reade: “The number of long positions of speculative financial investors is not as high as one might expect in the current market environment.”
Gold ETFs are booming
In the past, low interest rates in the US and an expansionary monetary policy by the US Federal Reserve would have led financial investors to bet heavily on the futures markets for rising gold prices. Instead, however, inflows into physically backed gold index funds have been rising for weeks.
From Reade’s perspective, this could be a sign that investors are turning away from futures exchanges because banks have become more reluctant to oppose these bets. Investors then switch to gold index funds, Reades said.
This is a development that could also fundamentally change the dynamics on the gold market. Because leveraged bets on the futures exchanges are usually shorter-term than investments in gold ETFs. If investor demand shifts to less volatile gold ETFs, volatility in the gold market could decrease, Reade said.
It is not yet possible to predict whether other financial institutions will withdraw from the London gold trade. Nevertheless, a process is taking place internationally that is already well advanced in Germany. “We see that there has been a paradigm shift in gold trading,” says Christian Brenner, head of the precious metals dealer Philoro. “There are fewer and fewer bank branches, so the sources of physical gold are dwindling.”
In Germany, it is the bank-independent precious metal traders that fill this gap. For international professional investors, asset managers who offer gold ETFs meet the demand for bets on rising gold prices.
More: Zero interest rates and the fear of inflation fuel the gold rally. Read more here.