The end of the LBMA is nigh

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by Alasdair Macleod, GoldMoney:

Basel 3 is on course to regulate the LBMA out of existence. And with it will go all the associated arbitrage business and position-taking on Comex, because most bullion bank trading desks will cease to exist. The only supply to buy-side speculators of gold and silver contracts will be producer hedging.

In recent months there has been some limited commentary concerning the introduction of Basel 3 regulations and the implications for precious metals trading. These new regulations are scheduled to be introduced for European banks at the end of June — only seven weeks’ time — and in the UK from 1 January next, affecting all LBMA member banks.

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This article explains the new regulations and concludes that the recent joint LBMA/WGC consultation paper addressed to the British regulator is unlikely to save London’s unallocated gold trading market. And because Basel 3 regulations are scheduled to be introduced into the UK at the year-end all banks in the London gold market can be expected to wind down their exposure well ahead of the deadline.

The unallocated forward settlement market will effectively be shut down. Hedging into Comex futures from this source will also cease. As it is unwound, the withdrawal of synthetic supply has enormous implications for future precious metals prices by transferring pricing power to physical markets, now dominated by China.

Abbreviations in this article

PRA      Prudential Regulation Authority, the UK financial sector and banking regulator.

EBA      European Banking Authority, the EU banking regulator.

LBMA  London Bullion Market Association, the trade body for forward dealings in unregulated, unallocated precious metals in London.

WGC    The World Gold Council, a trade body based in London which researches and quantifies global gold supply and demand.

CME    Chicago Metal Exchange, the US-based regulated futures market used by bullion banks around the world.

BIS       Bank for International Settlements, a sub-committee of which devises the Basel series of rule-based banking regulations. In the wake of the financial crisis of 2007—2009, Basel 3 is being implemented to ensure that banks are adequately capitalised globally to undertake their various lines of business without imparting systemic risk to other banks.

RSF      Required stable funding, introduced by Basel 3 and is applied to banking assets.

ASF      Available stable funding, introduced by Basel 3 and is applied to banking liabilities.

NSFR    Net stable funding ratio, the ratio between ASF and RSF, introduced by Basel 3 and never to fall below 100%.

Introduction

On 4 May, the London Bullion Market Association in conjunction with the World Gold Council submitted a paper to the Prudential Regulation Authority making the case for unallocated gold to be spared a required stable funding factor (RSF) of 85% under new Basel 3 regulations. The new regulations are due to be implemented in Europe by the European Banking Authority at the end of June, to be followed in the UK on 1 January 2022.[i] The paper claims that if the proposed RSF of 85% is imposed on gold and other precious metals it would undermine clearing and settlement, drain liquidity, dramatically increase financing costs and curtail central bank operations.

These are very serious statements to the effect that unless the London bullion market gets a waiver on the net stable funding ratio calculation (NSFR), it may as well shut up shop. And with the LBMA severely curtailed, the CME’s gold and silver futures contracts would lose out badly on both volumes and liquidity as well, with the number of active bullion bank trading desks (the Swaps) reduced to very few at the least.

At first sight it seems crazy that the impact of Basel 3 regulations will be permitted to radically undermine forwards and futures markets, which have been so instrumental to deflecting hoarding demand from physical bullion. It is through paper derivatives that the gold price in particular has been kept suppressed in conjunction with central bank leasing, and therefore prevented from challenging the US dollar’s credibility, following gold’s replacement as the world’s reserve currency fifty years ago.

The disruption to forwards and futures markets from Basel 3 will be a major shock, yet wider markets appear to be blithely ignoring the problem. When it goes ahead, Basel 3 will mean that banks will be forced to wind down their positions in unallocated precious metals, almost certainly causing massive disruption to physical bullion markets as well. If the expansion of paper markets has suppressed the prices of gold and silver for the last fifty years, then a severe contraction of paper equivalents at a time of escalating fiat money inflation could send prices to the moon.

In order to understand the proposed regulations, we need to look at them while taking into account the standard accounting practice of double entry bookkeeping as it is applied to bank balance sheets. There are three new Basel 3 definitions that matter in this regard:

  • The Available Stable Funding factor (ASF) is applied to the sources of a bank’s funding on the liability side of its balance sheet. Depending on the liability (shareholders’ equity, customer deposits, interbank loans etc.) they are multiplied by a factor, from 100% for the most stable forms of funding, such as Tier 1 bank equity, to 0% for the least stable. Being on their balance sheets, unallocated gold owed to a bank’s depositing customers is to be given a Basel III ASF of 0%, which means it will not be permitted to be a source of funding for any balance sheet assets, which must therefore be funded from other liabilities.
  • The Required stable funding (RSF) is to be applied to a bank’s assets. Unallocated gold positions are to be valued at 85% of their market value. Note that allocated gold, being held in custody, is not on bank balance sheets (except where the bank actually owns physical gold in its own right) and is therefore not involved in the calculation.
  • The Net stable funding requirement (NSFR) is the ASF divided by the RSF and must be at least 100% at all times.

The LBMA’s problem with Basel III becomes obvious. Unallocated gold liabilities cannot be used for funding the bank’s assets, and unallocated gold assets take a valuation haircut of 15% of market value as well. In future, the former cannot be simply offset against the latter, but bullion banks in London naturally run unallocated positions on both sides of their balance sheets. Whether the bank owns vaulted allocated gold to offset some of the price risk is immaterial. If this Basel 3 proposal goes through without modification, it will effectively be the end of the LBMA’s forward settlement business, and the end of arbitrage and hedging between LBMA members and the CME’s Comex futures contracts. And the Swaps on Comex, which are the bullion bank trading desks, could be regulated out of existence.

We cannot be sure yet that this will definitely happen, because it was put out for consultation in the UK by the PRA until 3 May. The end-June deadline after which Basel III applies in Europe might be extended again — which seems increasingly unlikely. In a patched-up compromise, unallocated gold could be rescheduled for a higher ASF and/or RSF, though again, that seems unlikely. Furthermore, the LBMA’s plea to the PRA, if successful, would only apply to UK regulated banks, not those in other jurisdictions, unless they set up full-blown London subsidiaries. And even that is unlikely to be acceptable to European and other regulators regulating their parents, because it is normal practice for regulators to look through such arrangements.

The LBMA paper suggests a compromise, that London could follow Switzerland which intends to rely on a clause in the European Banking Authority’s rule book allowing banks to make returns to the regulator instead, and for the regulator to decide stable funding matters.[ii] For this to work, the PRA would have to obtain agreement on a common approach with banking regulators in Europe and elsewhere. If that is to be the case, time is running out rapidly.

But the Swiss option only works on the basis that unallocated positions on both sides of the balance sheet are classified as interdependent. Any mismatch between unallocated gold liabilities and assets would not be covered. One assumes that hedging through Comex futures could resolve this issue partially, but that is only an assumption. And even if this get-out is adopted, liquidity will still dry up, because bullion bank trading desks will be given minimal trading discretion, limited to maintaining even books across the markets because of the NSFR issue.

The Swaps category on Comex (the bullion bank trading desks) is currently net short of about $24bn in the GC gold futures contract and $1.6bn in silver futures. Pressure to pare back ownership of these positions to a few genuine market makers and American bank trading desks is bound to increase, because the short positions held by European bullion banks would have to be covered in the next six weeks. And in London, all LBMA banking members will similarly reduce their unallocated activities because unbalanced books would be heavily penalised by the rule changes when they come in for the UK as well. That would make Comex gold and silver contracts entirely dependent on producer hedging.

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