Guest Post: The Gold Market, Part 2

You can read part one here. Eventually all five parts can be found in the side bar of this website under the header “Online Education"

Written by James Orlin Grabbe in the late nineties.

Part 2

How Foreign Exchange Intervention Affects the Money Supply

In order to succeed, a regime of fixed exchange rates (and under Bretton Woods, rates for the major currencies were fixed in terms of their par values, which could not be casually altered) requires coordinated economic policies, particularly monetary policies. If two different currencies trade at a fixed exchange rate and one currency is undervalued with respect to the other, the undervalued currency will be in excess demand. By the end of the 1960s both the deutschemark and the yen had become undervalued with respect to the U.S. dollar. Therefore the countries concerned (Germany and Japan) had two choices: either increase the supplies of their currencies to meet the excess demand or adjust the par values of their currencies upward enough to eliminate the excess demand.

As long as either country intervened in the market to maintain the par value of its currency with respect to the U.S. dollar, an increased supply of the domestic currency would take place automatically. To see why this is so, take the case of Germany. In order to keep the DM from increasing in value with respect to the U.S. dollar, the Bundesbank would have to intervene in the foreign exchange market to buy dollars. It would buy dollars by selling DM. The operation would increase the supply of DM in the market, driving down DM’s relative value, and increase the demand for the dollar, driving up the dollar’s relative value.

Any time the central bank intervenes in any market to buy or sell something, it potentially changes the domestic money supply. If the central bank buys foreign exchange, it does so by writing a check on itself–by giving credit to the seller. Central bank assets go up: the central bank now owns the foreign exchange. But central bank liabilities go up also, since the check represents a central bank liability. The seller of the foreign exchange or other asset will deposit the central bank’s check, in payment for the value of the assets, in an account at a commercial bank. The commercial bank will in turn deposit the check in its account at the central bank. The commercial bank will now have more reserves, in the form of a deposit at the central bank. The bank can use the reserves to make more loans, and the money supply will expand by a multiple of the initial reserve increase.

Is there anything the German authorities can do to prevent the money- supply increase? Essentially not, as long as they attempt to maintain the fixed exchange rate. There is, however, an operation referred to as sterilization. Sterilization refers to the practice of offsetting any impact on the monetary base caused by foreign exchange intervention, by making reverse transactions in terms of domestic assets (such as government bonds). For example, if the money base went up by DM4 billion because the central bank bought dollars in the foreign exchange market, a sterilization operation would involve selling DM4 billion worth of domestic assets to reduce central bank liabilities by an equal and offsetting amount. If the Bundesbank sold domestic assets, these would be paid for by checks drawn on the commercial banking system and reserves would disappear as the commercial banks’ checking accounts were debited at the central bank.

However, the Bundesbank could not simultaneously engage in complete sterilization (a complete offset) and also maintain the fixed exchange rate. If there was no change in the supply of DM, the DM would continue to be undervalued with respect to the dollar, and foreign exchange traders would continue to exchange dollars for DM. During the course of 1971, the Bundesbank intervened so much that the German high-powered money base would have increased by 42 percent from foreign exchange intervention alone. About half this increase was offset by sterilization, but, even so, the increase in the money base–and eventually the money supply–by more than 20 percent in one year was enormous by German standards. The breakdown of the Bretton Woods system began that year.

The Breakdown of Bretton Woods

It came about this way. From the end of World War II to about 1965, U.S. domestic monetary and fiscal policies were conducted in such a way as to be noninflationary. As world trade expanded during this period, the relative importance of Germany and Japan grew, so that by the end of the 1960s it was unreasonable to expect any system of international finance to endure without a consensus at least among the United States, Germany, and Japan. But after 1965, U.S. economic policy began to conflict with policies desired by Germany and Japan. In particular, the United States began a strong expansion, and moderate inflation, as a result of the Vietnam War and the Great Society program.

When it became obvious that the DM and yen were undervalued with respect to the dollar, the United States urged these two nations to revalue their currencies upward. Germany and Japan argued that the United States should revise its economic policy to be consistent with those in Germany and Japan as well as with previous U.S. policy. They wanted the United States to curb money- supply growth, tighten credit, and cut government spending. In the ensuing stalemate, the U.S. policy essentially followed the recommendations of a task force chaired by Gottfried Haberler. This was a policy of officially doing nothing and was commonly referred to as a policy of “benign neglect." If Germany and Japan chose to intervene to maintain their chosen par values, so be it. They would be allowed to accumulate dollar reserves until such time as they decided to change the par values of their currencies. That was the only alternative if the United States would not willingly change its policy. It was clearly understood at the time that a unilateral action on the part of the United States to devalue the dollar by increasing the dollar price of gold would be matched by similar European devaluations.

In April 1971, the Bundesbank took in $3 billion through foreign exchange intervention. On May 4 it took in $1 billion in the course of the day. On May 5 the Bundesbank took in $1 billion during the first hour of trading, then suspended intervention in the foreign exchange market. The DM was allowed to float upward. On August 15 the U.S. president, Nixon, suspended the convertibility of the dollar into gold and announced a 10 percent tax on imports. The tax was temporary and was intended to signal the magnitude by which the United States thought the par values of the major European and Japanese currencies should be changed.

An attempt was made to keep the Bretton Woods system going by a revised agreement, the Smithsonian agreement, reached at the Smithsonian Institution in Washington on December 17-18, 1971. Called by President Nixon “the most important monetary agreement in the history of the world," it lasted only slightly more than a year, but beyond the 1972 U.S. presidential election. At the Smithsonian Institution the Group of Ten agreed on a realignment of currencies, an increase in the official price of gold to $38 per ounce, and expanded exchange rate bands of 2.25 percent around their new par values.

Over the period February 5-9, 1973, history repeated itself, with the Bundesbank taking in $5 billion in foreign exchange intervention. On February 12, exchange markets were closed in Europe and Japan, and the United States announced a 10 percent devaluation of the dollar. European countries and Japan allowed their currencies to float and, over the next month, a de facto regime of floating exchange rates began. The floating rate system has persisted to the present, with none of the five most widely traded currencies (the dollar, the DM, the British pound, the Japanese yen, the Swiss franc) in any way officially fixed in exchange value with respect to the others. (Briefly, from October 1990 to September 1992, the DM and the British pound were nominally linked in the Exchange Rate Mechanism of the European Monetary System.) With the breakdown of Bretton Woods, there began a slow dismantling of the array of controls that had been erected in its name. This included gold.

As part of the Jamaica agreement in 1976 (which ludicrously proclaimed a “New International Economic Order"), IMF members agreed to demote the role of gold. But few central banks subsequently followed up this agreement in practice. One associated change that did come about, however, affected the private gold market in the United States. On January 2, 1975, after forty years of prohibition, U.S. citizens were allowed to purchase gold bullion legally. The Comex in New York subsequently became an important center for the trading of gold futures.

A few years ago I came across a copy of a speech by a well-known economist who was purporting to advise the government of Russia what they should to do stabilize the Russian money supply. The speech recommended they should “buy and sell gold on the London Metal Exchange." Which made about as much sense as recommending that Hillary Clinton enhance her income by buying and selling cattle futures at the NYMEX.

Cattle futures aren’t traded at the NYMEX, and gold isn’t traded at the London Metal Exchange.

The London Bullion Market Association

The center of world gold trading is London, and the center of London gold and silver trading is the London Bullion Market, operated by the London Bullion Market Association (LBMA). Members are classified into market making members, which include all of the participants in the twice-daily London gold fix described in Part 1, as well as other bullion houses (for a total of 14), and ordinary members, of which there are about 50. Most bullion houses act both as brokers for customers, and as primary dealers who hold positions of their own in order to profit from the bid/asked spread or from equilibrium price movements.

Market makers are obligated to make two-way prices (that is, for both buying and selling) throughout the day. Ordinary dealers will usually quote prices to their own clients, but have no obligation to make two-way markets or to quote to other dealers.

The fixing of the gold price starts at 10:30 a.m. in the morning (and lasts until a single price representing temporary equilibrium between supply and demand is found, usually a few minutes later), and again at 3:00 p.m. in the afternoon. (A silver price fixing takes place beginning at 12 noon.) During these time periods the fix is the principal focus of trading, but trading by the same firms occurs before and after the fix, and indeed gold trades around the world for almost 24 hours a day. The time overlaps between various trading centers can be seen in the daily gold price chart above from Kitco.

Most gold trading around the world takes place “loco London", meaning the gold is sold for delivery in London.

The London Good Delivery Bar

The LMBA sets down standards for gold bars that can be accepted for “good delivery." The London good delivery bar is a benchmark standard for spot (or physical) gold transactions. The requirements are:

Weight: 350-430 fine troy ounces

Fineness: minimum 995 parts per 1000 fine gold

Assayers/Melters Stamp: any approved by the LMBA

Obligatory Marks: a serial number and fineness, along with an assayer and melter stamp of weight to within .025 troy ounces

Appearance: must be of good appearance, free from cavities, and easy to handle and stack

Delivery: usually takes place at one of the London bullion clearing houses

Price quotations in the spot market are usually expressed in U.S. dollars, and are quoted as the price per fine troy ounce, such as:

$292.50-$292.80/oz

Here the bid or buying price is $292.50 per fine troy ounce, and the asked or selling price is $292.80 per fine troy ounce. Spot delivery will take place in terms of London good delivery bars on the spot date, which is the second working day after the trade date.

Although the price is quoted in dollars per ounce, all trades must take place in terms of so many gold bars, because physical delivery must take place in whole multiples of gold bars. The standard amount for a dealer spot price quotation is ten 400 oz. bars, or 4000 ozs. of gold. Thus if one purchased the standard amount at the dealer’s asked rate listed above, one would pay:

10 x 400 x $292.80 = $1,171,200

in two working days to the seller, and receive in return 4000 ozs. of gold at one of the bullion clearing houses.

London Clearing Houses

A buillion clearing house nets out gold transactions, much as banks do in trading foreign exchange. Only the net difference between total purchases and total sales vis-a-vis a counterparty is actually transferred. But a bullion clearing bank may take physical delivery of bullion, whereas a foreign exchange clearing bank only takes delivery of foreign exchange in the form of accounting entries (a checking balance at some foreign bank).

LMBA clearing houses include the Bank of England, the five dealers at the gold fixing, and a few other houses whose identities have varied from time to time. The number of clearing members is smaller than the number of market making members (8 versus 14), because the financial and other requirements are much stricter for clearing members.

The volume of precious metals cleared by the members of the LBMA has traditionally been kept confidential, but in January 1997 the LBMA released figures for the final (December) quarter of 1996. The average daily volume cleared between the (then) 14 market making members of the LBMA was approximately 933 tons (about $10 billion at prices then current), compared with annual global mine production of approximately 2,300 tons. That is, an amount equal to total annual gold production was cleared every 2.5 days. (The total amount of silver cleared daily was approximately 7,775 tons.)

[Koos Jansen: in 2011 the LBMA did its latest survey which you read here. Volumes had increased immensely since the nineties.]

Of course, because most gold is traded loco London, these clearing figures represent the result of worldwide gold trading, not just trading in London. Of the 933 tons cleared daily, it was estimated that about 218 tons represented London trades, while of the 7,775 tons of silver cleared daily, about 3,732 tons represented London trades.

Gold accounts at a bullion house may be allocated or unallocated. The unallocated account is most typical. One holds on deposit a specific number of ounces of gold, but these ounces of gold are not identified with any individual physical gold bars. These unallocated accounts may or may not bear interest, and may or may not have insurance and storage charges. All clearing accounts are unallocated accounts, and contain identical (hypothetical) 400 oz. bars.

Most gold trading takes place by paper transfers between unallocated accounts. Bookkeeping entries avoid the transactions costs and security risks of moving the actual metal. Traders clear their trades with one another through book entry transfers in or out of accounts at one or more clearing members, while clearing members clear their net trades with one another through their gold accounts at the Bank of England, as well as by physical gold transfers.

Allocated accounts, by contrast, contain individual gold bars with given serial numbers. In effect, allocated accounts are safe-keeping or custody accounts. Such accounts do not bear interest, are normally subject to charges, and may not be used as clearing accounts.

Transactions at the Fix

The London daily price fixings allow everyone to deal on equal terms, and large volumes to be transacted at a single price. In addition, the price is widely publicized, so it is undisputed. Once a price has been found such that net gold for sale (in 5 bar denominations–i.e., units of 2000 oz.) is equal to net gold for purchase, transactions then take place according to the following formula.

A seller on the fix receives the fixing price plus $.05 per ounce of gold (fix+.05). A buyer on the fix pays the fixing price plus $.25 per ounce of gold (fix+.25). This is equivalent to a market bid price of fix+.05, and a market asked price of fix+.25, for a total spread of $.20. This spread is narrower than the normal dealing spread, which is typically $.30 or higher.

Fixing orders may be placed in various ways.

Example 1: A market order. A client leaves an order to sell 20,000 ozs. at the PM fix.

Example 2: A price limit order. The client places an order to buy 25,000 ozs. at the AM fix, if the fixing price is at or lower than $290/oz.

Example 3: An average rate order. A client places at order to buy 10,000 ozs. at the average of the AM fixing price for July 1998. (Simple question in risk management: How will the firm manage this order?)

Example 4: Dynamic order. The client stays on the horn, listening to the fixing commentary, and changes his order according to the new fixing price being tried.

James Orlin Grabbe

In Gold We Trust