The Mechanics of the Global Gold Market


by Jan Nieuwenhuijs, The Gold Observer Substack:

How the physical gold price is set, and how physical and derivates markets around the world are connected and interact.

Founding Members of The Gold Observer may submit a topic for an article. One of the first Founding Members was Marko Viinikka, who asked me to write an article about how the global gold market operates and how the physical gold price is set. An excellent topic! How can we ever understand gold if we don’t know how the global market functions?



The price of physical gold is set by supply and demand for physical gold. The global physical market can be divided into exchange trading and bilateral trading. In addition to the physical market there are multiple gold derivate markets that influence the physical market. To understand the entire machine, we will examine the workings of gold exchanges, bilateral trading (networks), and derivate markets separately, and finally how all derivatives are tied to the physical market. Derivatives are traded on exchanges and on a bilateral basis as well, but for the sake of clarity we will discuss them independently.

Important to mention is that there is not one physical gold price. As gold is a commodity and the forces of supply and demand for commodities are not equal at any and all locations—and energy and time are needed to transport commodities—the price of physical gold differs geographically. Moreover, physical gold comes in many shapes, weights and purities. Manufacturing costs for bars are more or less fixed, but relatively cheaper for larger bars due to their higher value.

What most people refer to as the spot gold price is the price per fine troy ounce of gold, derived from trade in large wholesale bars located in London (“loco London”). Large wholesale bars weigh roughly 400-ounces. The smaller a bar compared to “large bars,” the higher the premium it will attract. Gold coins and jewelry enjoy even higher premiums per fine weight, due to even higher manufacturing costs. The “real price of physical gold” thus depends on where you are and what type of product you are trading.

A gold product’s fine weight is calculated as:

Fine weight = gross weight * purity

Collection of large wholesale gold bars. In the wholesale market gold is always priced per fine weight. Large bars have a fineness of no less than “995.0 parts per thousand.”

Gold Exchanges

An exchange is a centralized market. On any exchange multiple gold contracts can be listed. On the Shanghai Gold Exchange, for example, spot gold contracts varying in size from 100 grams to 12.5 Kg are traded. Supply and demand on an exchange meets through the exchange’s order book. Simplified, some market participants submit limit order bids (buy) and asks (sell) in the order book, while others submit market orders (buy or sell). A matching engine connects and clears all orders and this is how the price is set.

The order book of the Shanghai Gold Exchange’s Au99.99 contract in the night trading session of March 18, 2021. Bid and ask quotes are shown in red (top righthand corner); the corresponding quantities in yellow show the depth of the market (liquidity). The highest bid in this order book is ¥365.15 yuan per gram; the lowest ask is ¥366 yuan. The market was illiquid during this trading session, as the quantities in the order book were very low.

Because the order book is visible to all traders and there is a central authority that sets the trading rules, exchange trading is more transparent than bilateral trading networks called over-the-counter (OTC) markets. Some traders prefer exchange trading, some prefer OTC trading that offers more flexibility and discretion.

Spot gold exchanges are sparse. Examples are the Shanghai Gold Exchange in China, the Borsa Istanbul in Turkey, and the Dubai Gold and Commodities Exchange in the U.A.E.

Arbitrage causes prices between different parts of the global gold market to synchronize. When gold is cheaper in Dubai than in Shanghai an arbitrager can make a risk-free profit. The classic example is that the arbitrager will lock in his profit by buying the gold where its cheap and physically transports the metal to where it’s more expensive to sell. If the trade is profitable depends not only on the price spread, but also on the costs of financing (interest), shipping, insurance, and possibly the recasting of bars. Alternatively, the arbitrager can take a long position on one exchange and a short position on the other until the spread has closed, and exit his positions.

Generally, gold trades at a discount in net exporting countries, such as South Africa, versus a premium in countries that are net importers. Gold trading hubs like the U.K. can flip from a net importer to a net exporter, which will cause the local price to trade at a premium or discount versus parts of the world that are on the other side of the trade (usually Asia).

Gold bar standards around the world. Some exchanges listed are derivate exchanges. Courtesy Gold Bars Worldwide.
Gold bar weighing 187.5 grams (five tael) traded on the Chinese Gold and Silver Exchange in Hong Kong.

Bilateral Trading

In the previous chapter we discussed that globally there are only a few physical gold exchanges. Implying, the majority of physical gold trading is done bilaterally: negotiated on a principal-to-principal basis, whether that be through an electronic trading system, by phone, or face to face.

Because gold doesn’t perish and has been highly valued for millennia, all gold that has ever been mined is still with us. This makes gold trade more like a currency than a commodity in terms of supply and demand dynamics. Physical supply and demand are anything but restricted to annual mine output and newly fabricated products.

Every day, gold is traded on a bilateral basis between thousands of companies—refineries, banks, dealers, mints, miners, jewelers, industrial fabricators, investment funds, etc.—and perhaps millions of individuals around the world. Gold can be exchanged in any form, and of course it can be altered in shape, weight and purity throughout the supply chain.

At the smallest level a bilateral trade can be a Turkish woman selling a golden bracelet to her male neighbor. By agreeing to her offer price, the neighbor affects the global price of gold, albeit extremely little. For, if the neighbor would reject the woman’s offer, she would sell the bracelet to a jewelry store that is connected to the global gold market where supply would increase. Accepting her offer causes supply not to increase. Through this example it’s clear that with every (bilateral) trade buyer and seller influence the gold price.

Gold jewelry shop in the U.A.E.

Business-to-business trading in a bilateral trading network is referred to as an OTC market. Globally, the London Bullion Market, overseen by the London Bullion Market Association (LBMA), is the most dominant gold OTC market. Another vibrant OTC market is in Switzerland, which is the gold refining capital of the world. Each year, hundreds to thousands of tonnes of gold supply are transported to Switzerland, where 400-ounce bars destined for London, 1 Kg bars destined for Asia, 100-ounce bars destined for New York, or other bars and products are manufactured depending on demand. Switzerland also accommodates many large vaults for gold investors.

The London Bullion Market has a unique framework because it’s based on bilateral trading, yet it has a centralized character. We will discuss this market in the next chapter on derivatives, because most trades in London are executed through “paper contracts.”

Derivate Markets

derivative is a “a type of financial contract whose value is dependent on an underlying asset.” In this article we discuss derivatives with physical gold as the underlying asset. The single most important difference between physical gold and a derivative of gold, is that owning physical gold doesn’t incur any counterparty risk, whereas owning a gold derivative does. For other commodities, like corn, it can be said: “you can eat corn, but you cannot eat a corn derivative.” It boils down to the same economic conclusion: physical supply can’t be increased by the creation of derivatives.

Yet derivatives have a considerable impact on the physical gold price, as they trade in large volumes and many use leverage. In my view, the most relevant derivates markets are the paper market in London, Exchange Traded Funds, and the futures market in New York.

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