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The Gold Business

December 7, 2016

Chapter 36 in the exclusive series for Dynamic Commodities- becoming a commodities trader

A trading job was my dream from the day I delivered my first telex to a trader’s desk at Philipp Brothers. It was the summer of my senior year in high school. I never imagined that I would wind up trading complicated derivatives on the commodities I had come to know. Sid and Ralph would teach me all about the world of options. However, I knew that an understanding of the underlying businesses would be an invaluable skill.

In Precious Metals traffic, I settled the trades in all precious metals. The gold business was the most active of all. Gold was a multifaceted business for Philipp Brothers. The heart of the physical business was in London. Buying and selling gold was volatile and active. Although, borrowing and lending of gold was the heart of a bullion dealer’s business. This is where the bulk of profits came. Central banks around the world hold gold as part of their foreign currency reserves. In fact, governments hold more than 30% of all of the gold ever produced in the history of humanity. Bullion dealers like Philipp Brothers sought to borrow central bank gold for a fee. The business made sense, as the central bank gold sat dormant in vaults around the world earning no rate of return. Lending their gold to merchants produced income.

Philipp Brothers would then use the borrowed gold to create profits through a variety of trades. The company would buy future production from producers. They would then lock in the price by selling the central bank gold and funding the producer hedge in a match-book. However, the trade was not a perfect match. The typical central bank loan was for three to six months but the producer hedge could be one year or further into the future. The gold trader would take the risk of the mismatch between the producer sale and the central bank loan.

Borrowing central bank gold at 30 basis points and lending it to a producer at 1% or more was a very profitable trade. The trader took on the credit and performance risk from the producer. In addition, the funding risk or the ability to renew central bank deposits was also the responsibility of the trader.

Central bank gold loans to Philipp Brothers also gave the trader the ability to arbitrage versus the futures exchange. The gold borrowing turned into profits. This happened when a trader could sell the active month future and buy a deferred contract. The contract had to be at a gold loan rate higher than the amount paid to the central bank. London is the hub of international gold trading.

In the London market, bullion banks like Philipp Brothers, traded in two types of accounts, allocated and unallocated. In an allocated account, the gold traded represented actual physical bars with numbers, specific quality or fineness, and specific weights. The unallocated trading was a book entry, a debit or credit. While physical gold in a bullion bank was behind the unallocated transactions, specific bars were not involved. There is a fee for turning an unallocated balance to an allocated one. Nevertheless, the bulk of trading in the OTC market was unallocated.

The gold traders also made money in other ways. They were market-makers. They provided a constant bid-offer price on unallocated London gold. This was to the market, which included competitors of the firm. The width of the spread in the over-the-counter market, created the opportunity to buy and sell futures. It also allowed the locking in of profits via spreading positions. At times, the traders would go long or short the price of gold to profit from market moves higher or lower. As a market-maker, a gold trader has a front seat when it comes to watching the flow of buying or selling that occurs in the market each day. This amounts to the pulse of the market. The flow often puts a trader in a good position to predict the price direction for the yellow metal.

There were other ways that gold traders made money for the company. However, in those days, the bulk of profits came from the borrowing and lending of the metal. Gold trading, from my perspective, was the sexiest and most glamorous part of the precious metals business. To understand options on gold, understanding the gold business first was an imperative. Besides, the gold business was the closest and most complimentary when it came to the ruling class at Salomon Brothers.

Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities

Post Series: Origin Of A Commodities Trader

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