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'Central banks aren't trading the gold market the way they used to'

Section: Daily Dispatches

Traders Warn on Gold Liquidity

By Henry Sanderson
Financial Times, London
Monday, May 18, 2015

A few years ago London's precious metals traders would arrive at their desks to find the phones flashing. On the other end of the line were rival banks looking to buy and sell gold. Today the trading floors are a lot quieter.

Not only is most trading screen-based but there has been a decline in bank-to-bank activity -- the anchor of the over-the-counter (OTC) billion market -- as many institutions have scaled back or exited commodities.

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This has made the gold market more frenetic and pushed up the costs of hedging and doing larger trades, according to market participants.

"If you're just transacting in small sizes then probably you have benefited from the changes as you can transact directly through a bank's electronic platform," says one veteran trader.

"The issue is if you want to transact in a decent size, which used to be 100,000 to 200,000 ounces. That has become harder to get away with without influencing the price unduly."

The decline in interbank trading has prompted a debate about the most appropriate structure for the bullion market, with some people suggesting physical gold should be traded on an exchange.

In April, the London Bullion Market Association (LBMA), an industry trade body, launched a strategic review of the bullion market with the aim of enhancing liquidity and improving transparency.

The review comes as the UK government examines the functioning of the City's fixed income, commodity and foreign markets and prepares to regulate financial benchmarks including the LBMA's Gold and Silver Prices.

While algorithm-based hedge funds are more active that has created a "frenetic liquidity," market participants say, causing choppiness in the market. That exacerbates any price moves on lower volumes but also means liquidity can disappear just when it is most needed, for example in the event of a market rout.

"The algos use similar sorts of momentum-driven models -- it can all be liquidity in the same way, particularly around economic data releases or when gold prices are at well-identified technical levels," one gold market participant says.

At the same time, banks have scaled back their operations in the gold market, in the face of greater regulatory costs. Last year Deutsche Bank said it would exit precious metals trading after it withdrew from participating in the gold fix.

Banks are also less willing to take the risk on their books for gold options further into the future, according to market participants.

The notional outstanding amount of OTC gold derivatives held by banks fell to $300bn at the end of 2014 -- the lowest level since June 2005, according to data from the Bank for International Settlements.

"Real money funds investment people just aren't playing the gold market, central banks, the whole lot of them aren't trading the gold market the way they used to," David Govett, head of precious metals at trader Marex Spectron, says.

"They've pulled back from investing in gold and trading in gold -- and because of the heat the volumes have lessened. It's created thin nervous markets -- the algos can jump in and push it around and make a mess of it."

Liquidity now is more centred around the new electronic fix as run by ICE, as well as the gold futures run by Comex in New York, analysts say.

"A lot of the trading centres around the fixing and the futures market. London has already seen that massive decline in trading liquidity and volumes," Ross Norman, head of broker Sharps Pixley, says, referring to the twice daily gold auction used to set a price. "The fix has more prominence than ever given the spot rate has less of a role."

Data on the OTC gold market in London is difficult to obtain. But February's clearing statistics for gold -- collected by the LBMA -- showed the volume of ounces transferred between banks dropped to a 12-month low of 17.8m tonnes.

The LBMA says it would like to see greater liquidity when it comes to the forward market. That has suffered since the forward rate, known as the Gofo rate, was discontinued in January. The rate was used by miners to use gold to borrow US dollars from banks.

Getting it right is crucial if London's role as the centre for the world's gold trading is to be maintained, and in order to satisfy regulators looking at OTC markets.

London faces competition from China's Shanghai Gold Exchange after it launched an international trading board in the city's free trade zone, which allows for freer flow of capital than in the rest of the country.

In September, HSBC, one of the world's largest bullion banks, said it was approved to be a member of the board.

That could fracture the global gold market, given that China is the largest producer and consumer of gold.

"We will undoubtedly have a Chinese fixing price before the end of the year and we will see a rapid development of a Chinese gold options market -- they've got a very deep liquid lending market and so the idea that liquidity is moving east is correct," one market participant says. "They do need to take stock of where the London market is going and what role it's got to play going forward."

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