Trades in unallocated gold are basically monetary loans (derived from the
transactional price of gold) from buyers to the gold dealer since physical gold
delivery is not required or expected in gold trades. Sellers in unallocated
gold accounts are merely calling
back monetary loans (derived from the transactional price of gold) previously
extended to the gold dealer. The gold dealer uses unallocated gold that its
clients bought from it as part of the dealer's liquid reserve, while paying off
the monetary loan previously extended by some sellers derived from the price of
gold, as a seller must have been a buyer previously in order to have the gold
to sell currently.
When the gold price rises after a buyer bought the gold, the buyer makes a
profit on paper until he sells; when the gold price falls after a buyer bought
the gold, the buyer suffers a loss if he needs to sell. Theoretically, the gold
dealer's solvency is not affected by volatility in gold price, provided the
dealer does not operate a proprietary gold trading desk, and provided its
clients do not default in their financial obligations to it.
A gold dealer can fail financially if it suffers unsustainable loss from its
own proprietary trading account, or the market value of its gold reserve falls
below what the dealer paid earlier on credit and the dealer is unable to meet
margin calls, or because new buyers are paying a lower price than old buyers
previous paid to buy the gold and the dealer does not have enough money to pay
new sellers because there are more sellers than buyers.
A dealer caught in a work-out resolution must pay first, from its allocated
holdings, the allocated account clients as secured creditors. The unallocated
account clients, being unsecured creditors with only unsecured claim on the
unallocated gold pool held by the gold dealer, will get paid last, provided
there is enough unallocated gold left in the dealer's reserve to pay all of
them. If not, under a bankruptcy regime, all unallocated accounts will only
receive a pro-rated amount among other unallocated accounts.
Similarly to a bank run on fiat money that can quickly deplete a bank's
fractional reserve, LBMA unallocated gold account holders are susceptible to
financial loss caused by the depletion of unallocated gold reserve if a
sufficiently large number of market participants with unallocated accounts
suddenly request delivery of physical bullion they own. In normal times, this
is considered unlikely as much gold trading is part of hedging strategies that
place claims and counter-claims on the same physical gold many times over
without demanding actual delivery. But the operative emphasis of this logic is
on "normal times".
The London over-the-counter (OTC) gold market
The London gold market is an over-the-counter (OTC) market - which means that
buyers and sellers trade directly with each other bilaterally, arranged by the
gold dealer, and not on an exchange floor through open price competition among
all other market participants operating under the same exchange rules and
governmental regulatory regimes. The surviving one of the two bilateral parties
in an OTC bilateral trade carries the entire risk burden of counterparty
default, unlike trades in an central exchange, where the counterparty risk of
default is assumed by the exchange as a financial intermediary.
Bilateral counterparty risk includes the effects of other counterparty risks
knowingly or unknowingly assumed separately by the initial bilateral counter
parties in a daisy chain of risks. A central exchange mitigates counterparty
risk by enforcing strict membership and trading rules and by requiring solid
financial qualifications for membership. The rules and practices of the central
exchange offer more protection to exchange trading members than OTC traders
enjoy bilaterally.
Outside of London, only a small limited amount of gold trading takes place on
the New York Mercantile Exchange (NYMEX) or the Tokyo Commodity Exchange
(TOCOM). Gold forward contracts, known also as gold futures contracts, are
non-standardized contracts between two parties to buy or sell gold at a
specified future time at a price agreed to on the trade day.
A gold forward contract is a transaction in which two parties bilaterally agree
on the purchase and sale of gold at a future date, commonly one, three or six
months or one year hence, but any specifically structured dates may be traded
by any two parties in the OTC market. These bilateral forward contracts often
contain terms that are party specific, that are difficult to transfer readily
to other third parties, making them less liquid in the open market. Such
illiquidity is compensated by a larger premium on the transaction.
Gold option premiums
The premium on a gold forward transaction in US dollars will reflect current
euro-dollar interest rates less an allowance for current gold leasing rates.
Gold forward contracts are the basic modules of many gold-related swap
arrangements. For example, a central bank would sell gold at spot price while
simultaneously entering into a forward contract to buy the gold back at the
same price or a lower price by a future date if such contracts are available at
a reasonable premium.
Gold mining companies have also made extensive use of the gold forward market
in recent years as part of their more sophisticated hedging programs designed
to mitigate gold price volatility over specific periods. Gold miners would pay
a premium to enter into forward contract at a strike price to ensure them a
desired profit margin over the current or estimated future cost of production.
In the options market, the right, but not the obligation, to buy is referred to
as a call option ("call"); and the right, but not the obligation, to sell is
referred to as a put option ("put"). The pre-agreed price of the transaction is
known as the strike price or exercise price. The pre-agreed strike price is not
the price of the option because the transaction is designed to be
self-neutralizing in value. The price of an option is the premium on the
price-neutral transaction based on currently known market implications.
Options have become the third dimension of the gold market, beside physical
gold and gold futures transactions. The gold option market has expanded at a
fast pace since the 1980s, along with other structured finance markets such as
debt securitization and derivatives markets. The options market has generated a
lexicon of specialized terminology that forms its own nomenclature to
accommodate the great variety of trading and hedging strategies with increasing
esoteric complexity.
A premium (basic price of the option) is the compensation the grantor of the
option receives from the buyer for providing the opportunity of meeting the
buyer's expected transaction aims. The premium for an option is calculated
based on a combination of the current gold price, the strike price, current
interest rates, the time to expiration and the anticipated gold price
volatility during the period of the option contract.
The premium in an option is the logical mathematical product of market
implications. It is not based on the hunch of a gambler. The risk in option
transactions lies in paradigm shifts in the market that renders the logic
behind market implications inoperative, such as an unexpected external
perturbation. One example is the Russian sovereign debt default in 1998 and its
adverse impact on the high-leveraged trading strategies of Long Term Capital
Management (LTCM), a spectacularly successful hedge fund before its sudden
demise from an unexpected shift in market paradigm, causing its over-leveraged
positions to turn bad, after losing $4.6 billion in less than four months,
Black-Scholes formula and credit default swaps
In pricing options, the premium is the amount required to compensate for the
specific amount at risk to the issuer. The premium can be precisely calculated
electronically using the Black-Scholes model.
In their 1973 paper, "The Pricing of Options and Corporate Liabilities",
Fischer Black (1938-95) at the University of Chicago and MIT, and later a
partner in Goldman Sachs before falling victim to cancer, and Myron Scholes
(1941-present) at MIT and later in 1994 one of the founding partners of LTCM,
published an option valuation formula which has since come to be accepted by
the market as the standard method of pricing options.
Black and Scholes derived a stochastic partial differential equation governing
the price of an asset on which an option is based, and then solved it to obtain
their formula for the price of the option. Robert C Merton, (1944-present),
also of MIT, published a paper expanding the mathematical understanding of the
options pricing model and coined the term "Black-Scholes" option pricing model.
Merton and Scholes received the 1997 Noble Prize for Economics for this and
related work.
Black and Scholes made a path-breaking contribution to the growth of the option
market by providing a mathematical calculation for precise pricing of an
option, changing it from mysterious intuitive guesses to measurable rational
market implications. The formula was the intellectual godfather of the
conceptual logic behind credit default swaps (CDS), a pivotal financial product
that helped enable the spectacular growth of structured finance, and as it
turned out, one of the prime causes of the global financial crisis in
deregulated globalized markets that broke out in mid 2007. (See
The Folly of Deregulation, Asia Times Online, December 3, 2009.)
As I pointed out in May, 2009 (see
Mark-to-Market vs Mark-to-Model, May 25, 2009), a $10,000 bet on a CDS
failure could stand to win $100,000,000 in insurance payments within a year.
That was exactly what many hedge funds did because they could recoup all their
lost bets even if they only won once in 10,000 years.
As it turned out, many only had to wait a couple of years before winning a huge
windfall. But until AIG was bailed out by the Federal Reserve, these hedge
funds were not sure they could collect their winnings from AIG, their insurer
of choice.
