By Reginald H. Howe
On November 12, 2009, the Bank for International Settlements released its regular semi-annual report on the over-the-counter derivatives of major banks and dealers in the G-10 countries and Switzerland for the six months ending June 30, 2009. The total notional value of all Gold derivatives rose to $425 billion from $332 billion at year-end 2008, corrected from the previously reported figure of $395 billion. Although gold prices more than recovered their decline over the prior six months to close at $935 (London PM), gross market values fell from a corrected $55 billion to $43 billion.

Forwards and swaps increased from a corrected $116 billion to $179 billion, and options from a corrected $216 billion to $246 billion. Converted to metric tonnes at period-end gold prices, total gold derivatives rose by nearly 2300 tonnes on a corrected basis (from 11,873 to 14,146), with forwards and swaps up by over 1800 tonnes (from 4148 to 5958, or almost 2.5 years of new mine production), and options by over 460 tonnes (from 7725 to 8188).

The significant increases in worldwide gold derivatives reported by the BIS for the first half of 2009 are not reflected in the figures for OTC gold derivatives of U.S. commercial banks reported by the Office of the Comptroller of the Currency, but then neither were the large declines reported by the BIS for the last half of 2008. From December 31, 2008, to June 30, 2009, the total notional amount of gold derivatives held by U.S. commercial banks actually fell from $107 billion to $99 billion, with JP Morgan Chase's almost unchanged at $81.2 billion versus the prior year-end figure of $82.5 billion.

According to GFMS, the global delta-adjusted producer hedge book continued to contract, albeit marginally, to 458 tonnes at the end of June. See GFMS & Société Générale, Global Hedge Book Analysis (Q2-2009) (August 2009), esp. chart on page 7 ("Evolution of the Global Hedge Book Volume"). Declines in forward positions more than offset increases in options as producers continued to deliver into their hedge books and AngloGold Ashanti "increased its long 2009 forward position, mathematically treated as a de-hedge." Ibid. at 5.

While the purchase of forward contracts by producers to offset their outstanding sales of forwards may properly be treated as reducing the net global producer hedge book, these purchases should ordinarily have the opposite effect on total gold derivatives reported by the BIS. However, relative to that total, the global producer hedge book accounts for only a small fraction.

Of course producers would like to reduce their hedge books in a rising gold price environment. However, when they do so by buying forwards, the question arises as to how the sellers, presumably the bullion banks, are protecting themselves, particularly with respect to being called on at some future time to deliver actual metal in a tight physical market. That question begs another: are some or all of these forwards purchased by producers written to provide for some sort of cash settlement option, thereby sheltering producers from further dollar liabilities on account of their hedge books but sparing the bullion banks from having to deliver physical?

More generally, with gold prices flirting with backwardation as abnormally low interest rates force lease rates down to derisory levels, the economics of traditional gold lending by central banks in support of forward sales by the bullion banks are more than a little problematic. What is more, central bank attitudes toward gold are changing: more are buying; fewer selling. So it stands to reason that the pool of central bank gold actually available for lending must be shrinking, probably quite sharply.

In the absence of better data, commentaries at this site have argued that total forwards and swaps as reported by the BIS are a pretty good proxy for the total short physical gold position, which largely consists of gold loans, deposits and swaps from official reserves. As explained in Gold Derivatives: Hitting the Iceberg (12/20/2003):

Unlike options, forwards and swaps are transactions which generally assume the sale of an equivalent amount of Gold into the spot market. Bullion banks borrow gold, usually from central banks, for the purpose of acting as financial intermediaries. They sell the gold acquired by deposit, loan or swap, and then invest the proceeds in an effort to earn a positive spread while at the same time hedging themselves against any unfavorable movement in gold prices as, for example, by taking the other side of a forward sale by a gold producer or by purchasing call options.

Gold loans used to fund forward sales by a gold producers are typically repaid out of future mine production, and thus are integrated with a hedging transaction that is independent of the gold market. In contrast, gold loans used to fund what for several years was a very profitable gold carry trade required forward sales by non-producers that could be hedged only in the options market. Ultimately, unless settled in cash, these gold loans must be repaid by metal acquired in the market.

In face of negligible lease rates and low spreads, the increase of 1800 tonnes in gold forwards and swaps in the first half of 2009 is hard to explain in terms of traditional gold lending, prompting another query: has the whole category of gold forwards and swaps as reported by the BIS now been severely infected by instruments that have no credible counterparty in the physical market?

Gold lending for the most part is an activity of central banks, many of which continue to hold (or manage) significant official gold reserves acquired for the most part during the gold standard, gold exchange standard and Bretton Woods eras. With the possible exception of the Chinese, none of them hold large reserves of silver. Yet the BIS reports large and growing volumes of forwards and swaps in the "other precious metals" category, the vast bulk of which are silver.

Through the Silver Looking Glass. Silver analyst Ted Butler has long argued that the extreme concentration of silver short positions on the COMEX in a handful of banks is a sure sign of market manipulation precisely because they could never deliver metal in anything close to the quantities that they are short. See collected articles at Butler Research LLC. In mid-November 2009, he calculated that the total short position in COMEX silver futures amounted to some 500 million ounces, of which JP Morgan Chase accounted for 200 million. Total mine production in 2008 was 680 million ounces. See Demand and Supply in 2008, The Silver Institute (2009).

Mr. Butler as well as others have taken their concerns about manipulation of silver prices on the COMEX to the Commodity Futures Trading Commission, which opened an investigation into the matter in 2008 but so far has not taken any action to reduce or limit the concentrated short positions, which have in fact grown. Any resemblance to the SEC's ineffective investigation of Bernard Madoff is probably not purely coincidental. Of course, as the CFTC has on occasion noted, short positions on the COMEX may be covered or hedged in other markets.

Indeed, they may. Even more problematic than the figures on OTC gold derivatives reported by the BIS are those related to other precious metals, primarily silver. In dollar terms, total derivatives on other precious metals reached a new peak at $203 billion. Expressed in ounces of silver, forwards and swaps on other precious metals increased by 2.8 billion ounces -- more than four years of annual silver production at the 2008 rate -- to 7.25 billion ounces, or over 10.5 years of new mine production.

Against these numbers, the COMEX appears as much or more of a sideshow in silver than it is in gold, where forwards and swaps are not yet quite as out-of-line with annual production and known stockpiles as they are with silver. But the same large bullion banks dominate the markets for both, and there is no obvious reason to suppose that the extremes reached in silver could not be reached in gold.

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