Hedge funds scratch for gold in Switzerland


11:30p EDT Tuesday, September 21, 1999

Dear Friend of GATA and Gold:

Here are two important essays by Reginald H. Howe, a
Harvard-trained lawyer who has worked in mining and
finance and whose essay speculating that the gold of
central banks was being mobilized to bail out the
Japanese economy was posted to you here some weeks

Reg's work is posted at his web site,

The essays here examine central bank gold leasing and
conclude that this undertaking is probably coming to an
end even as central banks are trying to buy some time
for an orderly liquidation of gold derivatives. Of course
this would have huge implications for the price of gold.

Please post this as seems useful.

Gold Anti-Trust Action Committee Inc.

* * *

Bank of England's Gold Sales: To Rescue the Fed?

By Reginald H. Howe

September 20, 1999

Here is what seems clear about the Bank of England's
gold sales:

1) The stated reason -- to adjust the composition of
the bank's foreign exchange reserves -- makes no sense.

2) The decision was made at the highest political
levels, apparently against the wishes of the bank's
senior officers.

What can possibly explain and reconcile these two

There are some who say that the bullion bankers got to
the politicians. Plausible, perhaps, though I for one
consider this degree of venality at these levels to be
unlikely. What is more, if the bullion banks themselves
were in real trouble, I would expect to find the Bank
of England both more prepared and more supportive than
it appeared.

Several people with serious credentials in the gold
business have suggested that although the Federal
Reserve claims not to lease gold, it may write (sell)
call options that are used by bullion banks to hedge
their gold-leasing activities. If this assertion is
correct (something I have no way of knowing), it is
possible that not only was the Fed surprised by the
strength of the gold price last May but also that it
was caught short with a lot of call options outstanding
at around $300 per ounce. Were this the case, it is
something that would have been known only at the very
highest levels of the Fed and the U.S. Treasury. And
under these circumstances, it is not hard to imagine a
call for help going out directly to the British prime
minister. In particular, depending on the maturity
schedule of the options, holding gold in check for just
another few months could make a huge difference.

Of course if the Fed were writing call options, one
effect -- intentional or not -- would be to stimulate
gold leasing. So turning off the option spigot would
also cause the bullion banks to rein in their
activities, driving gold lease rates sharply higher.
Indeed, at this point it would be in the interest of
the Fed, the Bank of England, the other central banks,
and the bullion banks all to cooperate to keep a lid on
the gold price long enough to permit an orderly
reduction in net gold derivatives.

* * *

Gold Leasing by Central Banks: Reaching the Limits

By Reginald H. Howe

September 16, 1999

Gold lease rates are soaring. What is going on? This is
to give my best guess, which is in many respects a
refinement of certain views expressed in my last essay,
"War Against Gold: Central Banks Fight for Japan."

Were Machiavelli alive today, he might title his
seminal work The Central Banker instead of The Prince.
Figuring out what these princes of money are doing, not
to mention why they are doing it, can be difficult. But
it is not reading tea leaves. And it has a long

The original purpose of central banks was to make the
classical gold standard function more smoothly than it
did under free banking, to protect bank depositors
(i.e., the public), and to prevent or at least
ameliorate serious banking panics. Central banks,
therefore, focused on three key problem areas: (1) the
adequacy of gold reserves in a fractional reserve
banking system; (2) the quality of bank assets derived
from investing customer deposits, particularly the
mismatching of maturities (i.e., borrowing short and
lending long); and (3) international settlements,
particularly loss of national gold resulting from
imbalances in international accounts. But while central
banks tried to prevent serious problems from
developing, they almost never gave public warnings of
imminent crisis. Quite to the contrary, banking panics
and devaluations almost always took place in the wake
of repeated official pronouncements that whatever the
perceived problem, it was under control. For today, the
lessons are two: (1) central banks are no strangers to
assessing the risks in gold banking; and (2) central
bankers are masters at dissembling in the face of
potential crisis.

Fast forward to late 1995. My contention that the
central banks decided to mobilize their gold as
necessary in support of an effort to prevent a complete
financial and banking collapse in Japan is really no
more than an educated guess -- a deduction made after
the fact on the evidence available. It rests on my view
that nations, no matter what officials may say, do not
part with gold absent very good reason, usually
touching issues of national survival or monetary
sovereignty. The claim that a government is selling
gold merely to adjust the composition or yield of its
foreign exchange reserves strikes me as deeply suspect.
The Dutch and Belgian sales are far better understood
as measures taken in preparation for the Euro. My guess
is that Canadian sales were not unrelated to the Quebec
issue, but that is a subject for another time. The Bank
of England's current sales are quite simply
inexplicable on this ground. And in time, if the
proposed Swiss sales ever do occur, we will probably
learn that they involved some sort of calculation or
quid pro quo having to do with the protection of Swiss
banking or Switzerland's uniquely independent status
within an integrated Europe. In any event, the Swiss,
who actually can make a reasonable claim to having
excess gold, are unlikely to hold a fire sale like the

By 1997, with the amount of gold reserves on lease
having risen sharply since 1995, two events suggest the
first signs of central bank alarm. First, the London
Bullion Market Association (LBMA) disclosed for the
first time ever the volume of its gold trading
activities and promised to release average daily
clearance figures every month in the interest of
greater market transparency. Second, the Federal
Reserve commissioned and made public an internal study
on government gold policies.

The LBMA disclosure was announced under the headline
"Gold global market revealed" in The Financial Times on
January 30, 1997. At the time the daily volume of gold
trading by the 14 market-making members of the LBMA was
about 30 million ounces or 930 metric tons. Some
traders said that the number was misleadingly low
because matched orders were not included. More
recently, the LBMA has reported average daily clearing
numbers closer to 40 million ounces (1240 tons). For
purposes of comparison, 50,000 contracts or 5 million
ounces, is a busy day on the COMEX, and 100,000
contracts or 100 tons a very busy day on the TOCOM. In
short, the over-the-counter London gold market dwarfs
the public gold markets in New York or Tokyo. More
importantly, it is where most transactions that involve
gold leased from central banks are conducted. Not
surprisingly, therefore, the LBMA's disclosure received
prominent attention in the BIS's 67th annual report
released in June 1997. There, as part of an extended
discussion of gold leasing (pp. 95-96; see my earlier
essay), the BIS noted that the amount of daily gold
turnover in London "rivals that of London trading of
sterling against the Deutsche mark." It added:
"According to a Bank of England survey, most of the
trading was spot -- both physical and book entry --
with a significant forward market and an active option
market." Exactly why in January 1997 the LBMA broke
with a tradition of secrecy going back hundreds of
years has never been fully explained. My opinion: the
central bankers were demanding a better picture of what
was happening with their leased gold.

The Fed study can be read at
This study contains the usual disclaimer that it
presents the views of its authors, not the Fed or other
staff, and could be dissected endlessly for obvious
errors and omissions. It purports to analyze the costs
and benefits of various courses of action, including
immediate sale of all government gold and no sale of
government gold. A startling feature of the
presentation is the treatment of gold to be mined as
part of the available gold stock. The final paragraph
suggests a compromise policy (p. 26 text; p. 45 pdf):

Of course, any benefits of government ownership of gold
are lost at once under a policy that involves selling
all government gold immediately. However, any such
benefits are lost much later under a policy that
involves leasing out all government gold immediately
and selling it gradually after some date in the future.
It is clear that if governments lent out all their gold
but wanted to keep open the possibility of using it in
a crisis, they would have to structure their loan
contracts so that they could get their gold back
immediately in a crisis.

This study appears more an effort to rationalize a
policy after the fact than to develop a new, well-
thought out one. It is the sort of memo a bureaucrat
might wave in explanation of a failed policy, but it
could hardly persuade a smart central banker to adopt
the policy in the first place. Why? The authors fail to
appreciate what central bankers know too well: leased
gold does not stay in the possession of the lessor.

The term "lease" is a misnomer, confusing the basic
difference between banking on the one hand and
bailments and leases on the other. A bank deposit of
currency or gold creates a liability for repayment in
currency or gold, but the money actually deposited
passes to the bank for use in its business as it sees
fit. The depositor necessarily becomes a creditor of
the bank. A bailment creates an obligation to return
the item bailed and gives no right to use it. A lease
creates an obligation to surrender the item leased at
the end of the lease term, during which period the
lessor has the right to use but not to convert or sell
the leased property. A lessor does not become a
creditor of the lessee except as he may agree to accept
rent in arrears. A gold loan by a central bank is a
deposit in a bullion bank, not a lease in the ordinary
sense of that word. The gold "leased" is effectively
put out for immediate sale into the physical market,
where ultimately the gold for repayment will have to be
purchased. The basic point: gold leasing is not leasing
at all; it is banking. The great irony of gold banking
as practiced today is that the central banks are the
principal depositors. Like private depositors before
the era of central banking, they must protect

By 1998, with net gold derivatives rising in step with
the increased leasing of gold by central banks, concern
about the risks involved were rising too. Certainly
they were on Fed Chairman Alan Greenspan's mind. On
July 28, 1998, testifying before the House Banking
Committee looking into the regulation of over-the-
counter derivatives, he distinguished financial
derivatives from agricultural derivatives, saying that
it would be impossible to corner a market in financial
futures where the underlying asset (e.g., a paper
currency) is of unlimited supply. The same point, he
continued, also applied to certain commodity
derivatives where the supply was also very large, such
as oil. And he further volunteered: "Nor can private
counterparties restrict supplies of gold, another
commodity whose derivatives are often traded over-the-
counter, where central banks stand ready to lease gold
in increasing quantities should the price rise."
Needless to say, this statement provoked considerable
comment in the gold community, much of it having to do
with a conspiracy by central banks to control the gold
price. The real question, however, is to what extent
and at what risk central banks "stand ready to lease
gold," whether into rising prices or otherwise.

The amount of gold available for this purpose is large,
but far from infinite. In the July issue of its
quarterly Gold in the Official Sector, the World Gold
Council (www.gold.org) puts total official gold
reserves at the end of 1998 at about 33,500 metric
tons, amounting to just over 15% of total world foreign
exchange reserves. Of this amount, the five largest
holders (U.S., Germany, France, Italy and Switzerland)
accounted for just over 20,000 tons. The U.S., which
holds a little over 8100 tons, claims not to lease
gold. In 1999, the numbers for Germany, France and
Italy will decline in aggregate by over 500 tons due to
transfers by them to the new European Central Bank

Because accounting for leased gold varies by
country, it is virtually impossible to tell from
official statistics how much government gold is out on
lease. What is known is that some governments withdraw
gold from the lease market near year-end to improve the
risk profile of their balance sheets. What is also
clear is that at a daily rate of 1000 tons, the LBMA's
annual turnover is around 250,000 tons, or almost eight
times total official reserves.

After excluding from world reserves the United States
and the international financial institutions (BIS, IMF and
ECB), there are some 20,000 tons theoretically
available for lease. Reasonable current estimates of
the net short position in gold derivatives run from
under 5000 to over 10,000 tons, implying that about
this same amount is out on lease from the central
banks. Why? Because, subject to the caveat discussed in
the next paragraph, it is the destiny of such leased
gold to be sold at spot into the physical market,
creating a short position of equal amount. This
position may be hedged many times over, but it remains
a net short position until the gold is repurchased and
returned to the central bank that deposited it.

An ancient rule of thumb in gold banking is that under
ordinary circumstances gold placed at sight (that is,
in demand deposits) should be backed by a reserve of 40
percent in physical gold. Indeed, as recently as 1946
the legislation governing the Federal Reserve System
required a gold cover of 35 percent against deposit
liabilities of Federal Reserve banks and 40 percent
against Federal reserve notes in circulation. Although
I have seen nothing to this effect, it is possible that
the bullion banks engaged in gold banking with deposits
from the central banks are holding some of this leased
gold in reserve. If so, the amount of central bank gold
out on lease would exceed the net short position in
gold derivatives by an amount equal to the total leased
gold held in reserve by the bullion banks.

Of course, in this event the bullion banks' rate of
return would also be less. On the other hand, if the
bullion banks are not retaining significant physical
reserves (as I rather suspect), the risk profile of the
central bank gold out on lease is increased, and at a
time when general financial conditions are far from
ordinary. Adding to the risk, the central banks by
their own leasing have driven gold prices to bargain
levels that have stimulated unprecedented physical
demand, accelerating the withdrawal of physical gold
from the reaches of western bullion bankers into India,
other parts of Asia and the Middle East.

Finally, now pressing in on the central banks is a real
wild card -- Y2K, a subject on which the BIS has issued
several far from reassuring reports. (See

By any historical or common-sense measure, and
particularly under current circumstances, a net short
gold derivatives position of anything like 10,000
metric tons is pushing the limits of any reasonable
assessment of central bank tolerance for risk. To me at
least, the message of today's high gold lease rates is
that central banks no longer "stand ready to lease gold
in increasing quantities" and are instead focusing on
the problem of recovering their gold in preparation for
Y2K and whatever other crises may lie directly ahead.

Expect them to issue reassuring statements; don't
expect them them to part with a lot more gold. No
central banker wants to be remembered in history for
losing his nation's gold, or for giving it away.