The Mystery of BIS Gold Swaps

London, UK - 8th July 2010, 12:25 GMT

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Central banks have started using their gold reserves to raise cash -- a record USD 14bn worth -- from the Bank for International Settlements (BIS), the central bankers’ bank based in Basel, Switzerland. BIS co-ordinates financial co-operation amongst its 57 member countries, that include most of the G20. The BIS, took 346 tonnes of gold -- a record volume of gold reserves -- in exchange for foreign currency in "swap operations" in the financial year ending March 31st, according to a note in its latest annual report. The increase in the use of gold swaps is particularly surprising because central banks have rarely used them for decades, and as a result, the amount of gold at the BIS has remained stable for years. These are the first major BIS gold swaps since the 1970s. Based on the latest data, BIS would be executing the biggest gold swaps in history in 2010. In a gold swap, one counterparty, in this case a bank, sells its gold to the other, in this case BIS, with an agreement to buy it back at a later date. In return the bank get the money and pays some interest to the BIS. The BIS has the ability to serve as a glorified global "pawn shop" for central bankers.

Gold Bars For Cash

Timing

Such gold swaps in 2009 were "nil", the BIS annual report states. According to monthly data from the International Monetary Fund (IMF), the gold swaps have surged since January, when the Greek debt crisis erupted with cascading effects across the Eurozone and world equity markets. Such swaps might yet place the entire gold-buying spree among central banks in 2009 in a very different light. What was the motivation in buying the gold in the first place?

1. Gold is a very effective means of raising cash;
2. Gold has been trading at record levels; and
3. Cash was -- and is still -- needed by central banks.

A gold swap with the BIS allows a bank to raise the cash and buy the bullion back later, presumably after the prices decline. This is probably not the best timing for such news, given that the World Gold Council has just sent out a massive report arguing in favour of central bank purchases of gold. What if they all get the same idea of pawning their gold? Wouldn't that distort the global gold market significantly?

Signs of Distress

Gold swaps could suggest a last-resort measure because they are, after all, the equivalent of 'pawning' family treasure with the BIS. Central banks having to resort to swap their best performing monetary asset, ie, gold in order to raise funds is a further sign of the distressed state of the international financial and monetary system. If central banks -- widely assumed to be from troubled Eurozone states -- have had to resort to gold swaps and they may have been used by one or a combination of three of the PIIGS -- Portugal, Greece and/or Spain -- then the lack of clarification of the news may lead to weakness in the gold market as this creates uncertainty. Jittery traders may sell until clarity is gained. It is now clear that the gold bars which were supposed to have been taken off the market -- perhaps for good -- to gather dust in secure central bank basements, are instead gathering foreign exchange from the BIS. This is a new twist in the gold tale. What this tells us is that central banks are in need of additional cash for their commercial banks or in desperate need to settle emergency bills incurred by their governments.

Psychology of Surprise

The gold market continues to digest the surprising news of the 346 tonne gold swap with the BIS. The quantum surprised the market, which had assumed most central banks wished to retain their gold holdings. News of the swaps seems to have initially spooked gold markets, as some participants thought it could mean BIS might sell -- or might have already sold -- those 346 shiny tonnes. As a result, the yellow metal has touched price levels significantly below USD 1,200 per troy ounce in a continuation of its decline to new six-week lows.

For now, the BIS reports, the 346 tonnes of gold it holds via the swaps remains at the central banks. But the BIS has more ability to liquidate those holdings than the central-bank owners post the gold swap arrangements. However, under the terms of the BIS gold swaps, "The Bank has an obligation to return the gold at the end of the contract." So the metal would only be sold outright if the cash borrower -- the central-bank pledging gold bullion as collateral -- went bankrupt, and the BIS sought to cover its loss. What happens if the BIS decides to liquidate such collateral on the open market if the need arises due to a sovereign default? That could create a situation where investors would suddenly see an unanticipated glut of gold and a subsequently depressed gold valuation on the global market.

Uncertainty

There is a lot of uncertainty regarding the gold swap news which has not been confirmed or clarified by the BIS or the IMF. The Wall Street Journal said the swap was made by central banks while another respected financial newspaper said the sale was by commercial banks. If so, have European commercial banks begun using their holdings of gold to raise cash with the BIS via their central banks, in a further sign of strains in the money markets on which many rely for funding? Euribor, the rate at which Eurozone banks lend to each other has risen for 27 successive days, suggesting growing interbank lending stress.

China

In parallel, China's State Administration of Foreign Exchange (SAFE) currency-reserve managers have repeated their view that gold cannot replace US Treasury bonds as the "main channel" for holding Beijing's massive foreign exchange reserves estimated at USD 2.4 trillion. This statement has added to the downward pressure on gold pricing. The reasons for SAFE's view are obvious. They are the same reasons we have highlighted before:

1. Small market;
2. Limited availability of large amounts of gold to buy; and
3. Liquidity problems related to large scale disposals of gold.

An Enigma

Rudi Bogni, former chief executive of UBS private banking, who sits on the board of several financial institutions, said, "The truth is that we know absolutely nothing about the reasons for these swaps. There may be good technical or legal reasons why central banks refinanced themselves this way. As to distorting the gold market, I suspect that swapping gold rather than selling it was a more neutral way to refinance themselves, unless you mean that by not causing a further spike, distortion ensued."

Conclusion

Pawning gold with the BIS, usually rare, is occurring at a record rate in 2010. The central banks plan to buy the gold back later in swap agreements, but if they don't, the BIS would need to sell the gold, which could then flood the market. This flies in the face of conventional market wisdom that the gold rush has been a "flight to safety" by governments: their central bankers considered gold more trustworthy than holding foreign currencies. Yet, we have central banks offloading their gold, right in the middle of a sovereign debt crisis, to pay their governments' bills or prop up their commercial banks. Is gold losing its charm given the dire necessity of possessing hard cash to pay for emergencies? If central banks are trading their gold in, it might be bad news for the price of gold, but looking deeper, it may be even worse news for the world banking system. For one, it means that central banks are actually having trouble paying their governments' bills and are finding it difficult to raise sovereign debt by issuing IOU paper. For another, gold is well-known as a fallback in times of extreme crisis -- and if central banks are selling gold, could they be leaving themselves and their national banking system wide open to an even more severe liquidity crisis?

Key Question

If some central banks are trading their gold for cash, what are those central bankers thinking? What do they know, that we don't know yet?

[ENDS]

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