Ken Gooding
The World Gold Council (WGC) can’t be particularly pleased with the findings of the report it commissioned from the London Business School (LBS) on the impact of
derivatives on the gold market.
For the study flies in the face of perceived wisdom and shows that hedging had only a marginal impact on the dollar-gold price “a few per cent”, in the words of Professor
Anthony Neuberger, who led the LBS team.
Even though the rapid growth in gold derivatives has accelerated physical supply and added an average of 400 tonnes a year since 1990, the report argues that this alone cannot explain the whole of the steep fall in the dollar price in the past decade.
This view that hedging played a relatively small part in gold’s decline is challenged by some WGC executives. One of them, Rob Weinberg, said after Neuberger’s briefing: “If the South African government announced it was closing all the country’s gold mines which would take about 400 tonnes out of annual supply do you think the impact on the gold price would be only marginal?”
The LBS report, claimed to be the first systematic study of the subject, also suggests that the rapid expansion in gold derivatives is now over and the derivatives market should stabilise.
In that case, any impact the rapid surge had on the market should now be reversed. In theory, the gold price should return to where it would have been without that extra activity.
Unfortunately, Neuberger could offer no observations about the “proper” price of gold. Although the report is an independent study, the WGC specifically asked the LBS not to do any work on that topic because of the anti-trust implications. Nevertheless, if the report is correct and the impact on the price was only marginal say a 5% extra fall then any recovery would still leave gold languishing below $300 an ounce.
One analysis carried out by the LBS team suggested that the derivatives surge could have depressed the gold price by 10% to 15% but Neuberger said that particular exercise had serious flaws and he had “little faith in that estimate”.
In fact, there is very little for the gold bulls to get excited about in the report. For example, Neuberger dismissed as unlikely the idea that central banks might stop lending gold to the market to provide liquidity. This would certainly create a serious squeeze and drive up lease rates and the spot price.
Neuberger said: “It is hard to visualise circumstances under which several lenders decide to withdraw their gold from the market simultaneously. Credit risk is not a major concern since most of the borrowers are major commercial banks for whom gold is only a small part of their portfolio.”
While the report itself does not touch on the idea that some central banks in the past have helped to drive down the gold price at critical moments to bale out some commercial banks that had heavily sold short and were caught by a rapidly rising price, Neuberger dismissed the concept completely.
“While I could see central banks providing extra liquidity if there was a crisis in the gold- leasing market, I can see no reason why they should bail out a commercial bank in trouble with bullion shorts.”
Central banks would get involved only if the total financial system was likely to suffer and gold was not a big enough element in the total to destabilise the financial markets.
In conclusion, the report says that the growth in derivatives has been broadly beneficial to the gold community.
It is playing an important part in reducing the cost of capital for producers, as well as helping to finance large stocks held by jewellery manufacturers and other downstream
businesses.
At the same time it is giving holders of gold in the private sector as well as the central banks the possibility of earning income on their gold holdings and of managing them more flexibly.
ENDS