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The London Bullion Market

February 7, 2017

Chapter 78 in the exclusive series for Dynamic Commodities- becoming a commodities trader

The London Bullion Market is the hub for gold and silver trading around the world. While many in the United States look to the COMEX futures market when it comes to trading or investing in precious metals, it is in London where huge volumes traditionally trade in the physical bullion market. A COMEX contract represents a 100 ounce gold bar while the standard of trade in London is a 400 ounce bar. In silver the standard is the 1,000 bar for both COMEX and London.

In the gold market, central banks around the world hold over 30% of all of the yellow metal ever produced in the history of the world. The International Monetary Fund classifies those holding as foreign exchange holdings. The nation with the largest gold reserves is the United States that holds over 8,000 tons of the yellow metal. 8,000 tons amounts to around 260,000,000 ounces at a price of $1220 per ounce, the value of the U.S. gold in around $320 billion. Almost all nations hold gold as part of their reserves.

Many investors and traders think of the financial institutions that are bullion dealers as traders who just buy and sell the metal. The major focus of those dealers is not buying and selling but the borrowing and lending of gold bullion and that is where the lion’s share of profits come from in the gold business.

The gold held by central banks just sits in vaults around the world. Bullion dealers borrow central bank gold for a fee, which is the gold lease rate. The gold loans tend to be for short maturities, three to six month periods. The dealers then lend that bullion to producers looking to hedge future output. When a gold producer sells forward to lock in a price, the dealer that takes the other side of the trade takes on two risks. First, the dealer assumes to credit risk of the producer or the risk of future delivery. Secondly, and this is where the profits comes from, gold producers tend to sell for longer periods than central banks lend. Therefore, the dealers take a “match book” risk. In the London market, dealer borrow short-term and lend long-term and that is the essence of the bullion banking business. A gold dealer that borrows gold for three months from a central bank for a fee of 30 basis points often turns around and buys one year (or further) gold from a producer who is hedging. The discount on the future price, compared to prevailing interest rates, represents the gold loan rate. If the deal prices the future transaction at 1.3% below the price of gold plus the interest rate for the period, they profit by 1% if they can roll the central bank gold deposit for the entire period of the hedge. A 1% profit on one million ounces of gold yields a profit of $12.20 per ounce (at a price of $1220) or $12,200,000 each year. The match books of the major dealers in the gold business tend to be a lot bigger than one million ounces. As you can see, the bullion banking business is a very profitable venture that requires the institution to maintain a strong balance sheet and credit rating. Central banks will only lend their gold reserves to the dealers with the strongest balance sheets.

Silver is a more speculative business and there are few central banks that hold stockpiles like in gold. Moreover, as a byproduct of other metals, the producer hedging business in silver is less active. For the bullion dealers in London, silver is a buying, selling and arbitrage business.

Philipp Brothers was a member of the London Bullion Market. The company was an associate member meaning that it did not have vaults and did not participate in the daily fixings for the prices of gold and silver. Philipp Brothers stored its gold with other bullion banking institutions. However, the business I ran in London was an active bullion banking enterprise borrowing gold from central banks and lending that bullion to the producers of the world.

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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