On 4th May 2021 the London Bullion Market Association (LBMA), the independent precious metals authority, issued a ‘last ditch’ 68-page document to UK regulators pleading for a concession, or nil exemption, from the forthcoming Basel 3 requirements. These banking reforms, which seek to buttress the global financial system, look set to finally go live in January 2022 despite 8 years of lobbying against them.
Within the Basel 3 framework, there are requirements that we believe will have a big impact on the Gold market. In this second instalment of Monetary Metal Matters (MMM), we will unpick the regulatory jargon, and reveal the wide-reaching implications of what appears to us to be an ending of the LBMA-led status quo.
How Basel 3 unravels the banks’ ability to issue/hold credit Gold
The first important change in the Basel 3 framework is the amount of long-term funding banks are obliged to hold against their assets. The regulatory tool for measuring this requirement is in the Net Stable Funding Ratio (NSFR). Under Basel 2 rules, the LBMA banks were obliged to hold 50% in long-term funding against gold trading, however this is set to rise to 85% under Basel 3, and is clearly the biggest sticking point for the current system of Unallocated Gold trading in London.
To quote from the LBMA’s 4/5/21 document: “An 85% RSF charge would undermine clearing and settlement. The required stable funding for short-term assets would significantly increase costs for LPMCL clearing banks to the point that some would be forced to exit the clearing and settlement system, which may even be at risk of collapsing completely.”1
As detailed in the first instalment of this series, the majority of daily trading takes place in unallocated (OTC) Gold in London. Unallocated gold, often revered to as XAU, is just digital/paper exposure to the price. There is no requirement for the banks to hold any physical bullion against these trades. As an owner of unallocated gold, you are an unsecured creditor of the bank with no legal title to physical bullion. This of course is a form of credit risk, without the unencumbered physical gold collateral being identified and ring-fenced. Basel 3 unravels the banking system’s ability to issue/hold credit Gold in this way.
The only realistic solution for the LBMA banks is to acquire (much) more physical gold to fall in line with the new requirements. However, in a physical market that is already tight (see our observations about the float in part 1 of MMM) this is potentially a big problem for the LBMA.
The language of this document is not what one would normally expect to read coming from a banking industry body. We also note that this latest 68-page lobbying attempt from the LBMA targets the UK regulator, after 5+ years of unsuccessful lobbying to the European Banking Authority (EBA). It appears the European regulators are not interested in buckling to the demands of the LBMA and indeed adds colour to why it was that Deutsche Bank left the Gold market entirely after an investigation by the German regulator BAFIN in 2013.2 This investigation saw Deutsche Bank exit their central role as clearer in the LBMA system and even sell their expensively-built new London vaulting facilities.
Head of BAFIN, Elka Koenig made the following comment at the time: “The allegations about (manipulation of) Precious Metals markets are particularly serious because such reference values are based typically on transactions in liquid markets and not on estimates of the banks.”3
Could Gold return to a physical cash market?
That quote from 8 years ago offers an insight into the why the European regulators have not buckled to LBMA’s continued attempts to lower the 85% funding requirements from Basel 3. It also seems strange that the LBMA banks have not sought to get their house in order in the interim. Perhaps the goal here of the Basel 3 committee is to cleanse the market of paper exposure, and return gold to a physical cash market. If we are correct in this assessment, then seismic changes are afoot.
Within these Basel 3 reforms are significant changes that will also upgrade physical gold from a Tier 3 to a Tier 1 asset, placing physical gold holdings on par with cash and US Treasuries from a capital risk weighting perspective. This is separate from the funding requirements from NSFR, and refer to the mark-to-market (MTM) value that can be realised when holding (physical allocated) gold on the books.
Gold being upgraded to a Tier 1 asset under Basel 3 allows banks to realise 100% of the mark-to-market value of their allocated physical Gold.4 This highlights, at an important moment in markets, the role of Gold as a risk-free monetary asset. This seems unlikely to be a coincidence, especially as the member European Central Banks hold large (and marked to market) Gold reserves. Ever since the Basel 3 reforms were first mooted (post global financial crisis), Central Banks have been net buyers of Gold, averaging net purchases of over 500 tonnes per year since 2009. Notable buyers including the People’s Bank of China and the Central Bank of Russia. Undoubtedly, central banks outside of the Federal Reserve appreciate the benefit of returning Gold to its historic role as genuine and recognised apolitical and risk-free monetary instrument of choice within the banking system.
Basel 3 / NSFR changes are a key structural event for the Gold market and potentially have wide reaching ramifications for banks beyond their Gold business. The continued lobbying from the LBMA tells us the current model of 90%+ in paper trading is genuinely under threat.
It’s possible the LBMA could receive some form of concession in the coming weeks; however with the 28th June deadline fast approaching (the date the regulators have to reply to the LBMA), a concession seems increasingly unlikely. If these changes do indeed go ahead, they will help return Gold to its natural status as risk-free instrument of choice in the global banking system. We are watching this subject very carefully and suggest others do so too.
1Source: LBMA, The Impact of the NSFR on the Precious Metals Market, 04.05.2021
2Source: Reuters, Deutsche quits gold price-setting as regulators investigate fix, 17.01.2014
3Source: Reuters, How London’s gold and silver price benchmarks are “fixed”, 17.01.2014
4Source: Bank of International Settlements: https://www.bis.org/basel_framework/
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