Let Normandy know it''s rude; and Josh Wright helps gold


9:30p EDT Friday, May 26, 2000

Dear Friend of GATA and Gold:

Having gone through the data posted by the Bank for
International Settlements, Reginald H. Howe of
www.GoldenSextant.com has concluded that, far
from not being money anymore, gold was so tempting
as money to central banks and bullion banks that
they couldn't help but spend it as recklessly as they
could, putting themselves in an impossible situation
as to recovering it.

Please post this as seems useful.

CHRIS POWELL, Secretary/Treasurer
Gold Anti-Trust Action Committee Inc.

* * *

Gold: Can't Bank With It,
And Can't Bank Without It!

By Reginald H. Howe
May 26, 2000

The huge jump in the gold derivatives of Deutsche Bank
and Dresdner Bank in the last half of 1999 invites all
sorts of speculation, particularly when coupled with
similar increases at Morgan Guaranty Trust Co. and
Citibank. But as intriguing as such speculation is, it
should not be allowed to obscure the more important as
well as more factual story that resides in the larger
Bank for International Settlements numbers, of which
the figures for these four banks are only a part.

Much has been written recently about the short position
in gold. In its narrowest sense, this short position is
the accumulated physical gold transferred by deposit
(loan) from central banks and others to bullion banks.
This gold creates deposit liabilities on the balance
sheets of the bullion banks. It must be repaid in gold.
Virtually all of it has been sold by the bullion banks
into the market, creating various paper assets on their
books. Besides central bank deposits, gold deposit
liabilities of bullion banks include unallocated gold,
often in certificate form, of private parties. But the
key point is that this physical gold has left the
vaults of the banks and the control of the bankers. It
can be replaced only by new production or market
purchases, and thus constitutes a net short physical
position of the bullion banks.

The total net short physical position of the bullion
banks is reliably estimated at between 7,000 and 10,000
tonnes, though it could be higher. Ultimately its size
is limited by the willingness of gold owners to lend
and of gold users (e.g., producers, fabricators,
bullion banks, speculators) to borrow. Prudence
dictates that the net short physical position be quite
reliably hedged -- e.g., delta hedging in physical
bullion, contracts for forward delivery from gold
mining companies, call options on central banks with
large gold reserves, or other instruments where the
risk of counterparty default on the obligation to
deliver physical gold appears minimal.

In a perfectly prudent world, the net short physical
position would roughly correspond with the net short
gold derivatives position. But in the absence of such a
world, the net short gold derivatives position tends to
be larger than the net short physical position. This
phenomenon results because while part of the gold
derivatives position may be hedged in the physical
market or reliable substitutes, other parts may be
hedged in less reliable forms of paper gold or even
unhedged, such as naked calls.

As discussed in an earlier commentary, writing naked
call options can be a very effective means of adding
gold to the derivatives market, thereby putting
downward pressure on the gold price. Of course writing
naked calls is also a very risky activity. But it
demonstrates a key point: The net short gold
derivatives position is ultimately limited only by the
prudence of the least cautious players and, if
applicable, the willingness of governments or other
official agencies to back them.

As summarized in tabular form in my prior commentary,
the recent figures from the BIS on the size of the gold
derivatives market are important because they suggest:
1) that the central banks may have loaned much more
gold into the market than previously thought; and/or 2)
that the net short gold derivative position is far
larger than suspected or than anyone would deem

Before addressing these two alternatives, three points
about the BIS figures should be emphasized.

First, under the Basle Capital Accord, all off-balance-
sheet exposures, specifically including gold
derivatives, are subject to the capital adequacy

Second, the Basle Committee on Banking Supervision has
adopted a number of recommendations "to encourage banks
and securities firms to provide market participants
with sufficient information to understand the risks
inherent in their trading and derivatives activities."

And third, the statistics released semi-annually by the
BIS on the global OTC derivatives market are an
integral part of this risk assessment and disclosure

A wealth of further information on all these subjects
is available at the BIS website (www.bis.org).

Turning specifically to the derivatives market
statistics, the consolidation of notional value at the
BIS level is intended to eliminate double-counting
between reporting banks and dealers so that the total
notional figure is in effect a measure of market size
at a point in time. It is not turnover such as reported
by the LBMA. For commodities and gold, the closest
analogue would appear to be open interest on a
commodities exchange. But OTC contracts being non-
standard, counting the number of contracts obviously
does not work. Accordingly, the best way to measure
them is by underlying contract amounts or face values,
halving those between reporting parties and taking
other steps, as the BIS does, to avoid double-counting.

At the end of 1999, the BIS put the total notional
amount of gold derivatives at US$243 billion, up from
$189 billion at the end of June. Converting the year-
end notional amount to tonnes at the year-end gold
price ($290/oz.) gives just over 26,000 tonnes. Using a
$300 gold price gives around 25,200 tonnes. But these
1999 figures are only for major banks and dealers with
their head offices in the G-10 countries.

On a more irregular basis, the BIS collects similar
information for as close to the whole world as it can.
Its last larger survey as of the end of June 1998
showed a total global figure for gold derivatives of
$228 billion compared to a G-10 figure on the same date
of $193 billion, indicating that at that time there was
an additional $35 billion (or 3,629 tonnes @ $300/oz.)
in gold derivatives outside banks and dealers
headquartered in G-10 countries. Accordingly, assuming
a continuing difference of around the same magnitude,
the total global gold derivatives market is on the
order of 26,000 to 28,000 tonnes, more than twice the
higher estimates of the net short physical position,
and almost as large as the stated gold reserves of all
the world's central banks put together.

What does this number mean? How should it be
interpreted? Is it really as large as it looks?

Analysts are unlikely to agree.

I look at it this way. If the net short physical
position is 10,000 tonnes, and if that position has
been fully hedged (far from certain), the total
notional value of all that business should be around
20,000 tonnes. In that event, using 26,000 tonnes as
the total notional amount for all gold derivatives, the
net short gold derivatives position -- over and above
the net short physical position -- is about 6,000
tonnes, and the bullion banks have undertaken to
deliver this amount in addition to what they must
deliver to cover the net short physical position of
10,000 tonnes.

In other words, as I define it, the net short gold
derivatives position is the amount by which the total
notional value of all gold derivatives exceeds twice
the net short physical position, and it must be added
to the net short physical position to get a total net
short position -- that is, the amount of gold that the
bullion banks are committed to deliver on their
outstanding paper. This formula effectively assumes
that the net short physical position is fully hedged
with zero risk of default but that any derivatives
position in excess of twice the net short physical
position is as a practical matter wholly unhedged in
terms of reliable physical gold.

To return to the two alternatives posed earlier, is it
possible that the physical gold borrowings underpinning
total notional gold derivatives are larger than
thought, thereby reducing, assuming they are credibly
hedged, the net short gold derivatives position?

Of course it is. Here are the obvious possibilities.

One, the central banks have on a net basis leased more
gold than thought, thereby increasing the liquidity
base of the gold derivatives market.

Two, the central banks have on a net basis sold more
gold than thought, and this gold has remained within
the gold banking system -- that is, sold to investors
or others who have deposited it in unallocated

Three, the central banks have written covered calls in
far greater volume than thought, thereby providing an
additional sound base for gold lending.

All these possibilities require that the central banks
on a net basis reduce their combined official gold
reserves by much more than they have suggested they are
willing to do or have done.

Indeed, looking at what central banks say and allowing
for significant private lending as well, it is very
hard to come up with even 7,000 tonnes as a net short
physical position. In that case, the net short gold
derivatives position would be 12,000 tonnes (26,000 - 2
x 7000), and the bullion banks are in even more parlous
condition under my rough formula.

But whatever the exact numbers, and whatever the
motives of some of the bullion banks or the officials
who have supported them, there is a far more
fundamental but apparently unrecognized problem here.
By historic standards, the bullion banks are operating
with wholly inadequate gold capital and gold reserves
for the very extensive gold banking business that they
have built.

Everyone, bankers and regulators alike, appears to have
assumed that gold derivatives are a more or less
ordinary variety of commodity derivative. However valid
this assumption may be for markets like the COMEX or
the TOCOM having open interest of only a few hundred
tonnes, or for a single bullion bank with gold
derivatives of similar size, it is dangerously false as
applied to a total gold derivatives market where
deposits or their equivalent exceed 10,000 tonnes.
Exposures that amount to but fractions of annual new
production are one thing; a total exposure equal to
several years of new production is quite something

The Basle Capital Accord provides two methods for
determining capital adequacy for off-balance-sheet gold
derivatives: the current exposure method and the
original exposure method. Without going into the
details of these formulas, which are basically the same
as for exchange rate derivatives, suffice it to say
that the capital adequacy requirements range from 1
percent of total notional value for maturities under
one year to 7.5 percent (or higher under the original
exposure method) for contracts over five years. These
percentages are less than those for equity, other
precious metals, or other commodities derivatives.
Further, there is no requirement that any of the
necessary capital be held in gold bullion.

Under this regime, largely on the basis of deposit
liabilities by the central banks and others amounting
to something like 10,000 tonnes, the bullion banks have
built a gold lending business of equal size, to which
they have added a net short derivatives position of
another 6,000 tonnes. All this has been done at gold
prices in the $300/oz. neighborhood. And so far as can
be told, almost all the gold deposited with the bullion
banks has been sold into the market and disappeared
from the gold banking system to India and other parts
of the Middle East and Asia.

Accordingly, where by traditional standards the bullion
banks should be holding in their own vaults on the
order of 5,000 to 6,000 tonnes of gold reserves, under
the new gold banking paradigm they are apparently
almost completely naked to about this same amount of
gold liabilities.

On an individual basis, perhaps, the gold derivatives
business of some bullion banks may look like
commodities trading. But taken as a whole, the gold
derivatives business of all these banks has evolved
into nothing less than full-scale gold banking, which
done prudently has always required immediately
available gold reserves equal to 35 to 40 percent of

This situation is ironic testimony to the true nature
of gold as permanent, natural money. Bankers and
governments could not abide the discipline of the gold
standard, even in watered down forms such as the gold
exchange standard or Bretton Woods. But even after
expunging from the banking system any formal role for
gold, neither the central banks nor the private banks
capable of acting as bullion banks could resist the
temptation to engage in gold banking. As money just
lying around, the allure of gold proved too strong for
the bankers, who, now calling it a commodity, proceeded
to reestablish an enormous gold banking business while
disregarding all the prudential rules that several
hundred years of gold banking experience had taught.

In the process they fostered the illusion that low gold
prices demonstrated confidence in their paper money
system whereas in fact these low gold prices reflected
only the reckless abandon with which they were creating
paper gold liabilities in lieu of physical gold.

These low gold prices had two further deleterious
effects. First, they encouraged the flow of physical
gold to parts of the world where gold's true value is
still appreciated, and from which only much higher
prices will cause it to return. Second, they decimated
the gold mining industry worldwide, all as brilliantly
set forth in John Hathaway's newest essay, "The Folly
of Hedging":


An old saying, long forgotten, is about to take on new
life: "There's no rush like a gold rush, and no run
like a bank run." In these circumstances, the safest
gold is not in bank storage of any variety. It rests in
more imaginative places: the snake pit, the closet with
the black widow spiders, or buried in the backyard near
the Doberman's bone and well within range of his leash.