The main world markets for physical gold are in London and Zurich, and London is pre-eminent.
The London gold market
- The London gold market
- The Zurich Gold market
- How accessible is the London market
- Over The Counter trading [OTC]
- Comparison to Exchanges
- The 5 clearers of the London gold market
- More about clearing
- Unallocated gold at an LBMA clearer
- Allocated gold at LBMA
- The Bank of England
- The Gold Fix
- Curiosities of the Gold Fix
- The London Good Delivery Bar
- Bar size, content and purity
- Chain of Integrity
- Central Banks in the spot market
London grew to dominate the gold market at a time when gold essentially was money.
Significant finds in the Urals (Russia) had boosted global gold production in the 18th Century, and then industrialised production took off with the Californian gold discoveries.
The mid 19th century was the time of London's domination of global commerce and finance.
As the source of capital for gold mining, and because of the gold standard of the British Pound, London became the hub of bullion trading.
London still holds that position, probably thanks to a mix of flexibility, commercial freedom and historical chance, including the good fortune to have South Africa as a colony at the time of the largest finds ever - around 1900.
The Zurich Gold market
By the end of the 1960s western governments had for a long time been operating the gold market in an artificial way with a view to maintaining the fixed exchange rates of the Bretton Woods system. In November 1967 Britain was forced to devalue its currency against the US dollar. Sellers of gold bullion (like South Africa) who had accumulated any sterling reserve balance took a significant loss in US Dollar terms.
As the established but creaking mechanisms of balancing trade, currency and bullion reserve positions unwound the London gold market - known as the gold pool - ceased to fulfil a useful function. The crisis required the complete closure of the London market for 2 weeks, and when it returned to operation it had lost substantial South African business to Zurich in Switzerland.
Nowadays a significant proportion of Russian and South African gold is shipped to Switzerland. Although Swiss gold appeals to private investors - because of the relative secrecy and security of Swiss Bank Accounts and Safety Deposit Boxes - it does not nearly match the London market for professional gold investment.
How accessible is the London market?
The London market is not accessible to individuals because there are two big hurdles to overcome.
- The first is deal-size. The most liquid physical bullion form to trade is the London Good Delivery Bar. These weigh about 400 troy ounces each, which is about 12.4 kilograms. At a price of $400 an ounce each bar is worth about $160,000. In fact even one bar is not enough to attract the attention of the world's serious dealers - they prefer $500,000 as a minimum.
- The second is the setting up of a relationship. Even if you intend to buy sufficient gold most dealers will not open an account for you either quickly or easily. There are a number of logistical, regulatory and commercial reasons for this. Logistically there is the issue of what to do with your gold. It needs to be stored or delivered, and the secure infrastructure, transportation and vaulting arrangements can take quite a lot of setting up. The regulatory issues are also forbidding. Regulatory environments have placed great obligations on firms which deal with the public - and now it is much more onerous for them to deal with private individuals than to deal with a bona-fide financial institution which is considered, rightly or wrongly, to be better able to look after itself and less deserving of legislative protection. As so often with well meaning legislation the effect has been to make the protected status of individuals onerous to suppliers, and the combined effects of logistics and regulatory hurdles makes the proposition of private customers commercially unattractive for dealers. They might make a few hundred dollars of revenue out of doing a deal with you, but the cost of set-up and the perceived reputational and regulatory risk is seen as not worth the benefit.
Over The Counter trading [OTC]
The London gold market is an Over The Counter market - which means that buyers and sellers choose each other, and do not necessarily find the best price on an exchange floor purely through price competition between different players.
Buying gold is more like shopping in a rather exclusive shopping centre than trading in a modern financial marketplace. The [gold] shopkeeper tells you his price and you take it or leave it without benefiting from an immediate direct comparison with other players - which is what you would normally find on an exchange.
It has become difficult to explain the OTC nature of the gold market in the modern world. In the case of gold its existence probably derives from a simpler world of 150 years ago. If dealer A sold and delivered gold to dealer B and B's cheque failed to clear the bank then - in those days - it was a problem only for A. No-one would hear of A calling for rescue from other market participants (never mind them offering it). As a result A and B may both be lost to the world, but everyone else would be fine. The survivors would say that A should have been more careful about his counterparty's creditworthiness, and for a while the solidity of their own financial management would be their priority. These self-regulating forces provided periodic encouragement to the market to keep its house in order.
So on the face of it a big advantage with an OTC structure is that each participant is sufficiently isolated from the infrastructure of the market that a serious financial problem at one member is unlikely catastrophically to infect the rest of the marketplace.
Comparison to Exchanges
In a modern exchange based system there is far more interdependency. An exchange centres on a clearer which usually has regulatory and credit responsibility for the exchange's members. The clearer itself is a key point of systemic weakness in an exchange based system, and it would in most cases destroy the market and the livelihoods of all its participants were a clearer to fail.
It feels impossible to most modern investors that the central clearing infrastructure of an exchange could be at risk, but it most certainly is. Modern exchange clearers all over the world suffer from the accumulation of inefficiencies which go with their own monopolistic power and the pressure they come under from regulators. It leads to exchanges with high complexity and large overheads, and they struggle whenever market volumes contract.
So one advantage in an OTC market structure might be that it is more likely to survive dreadful financial market conditions, under which circumstances it will probably lose just a few of its weaker members.
The 5 clearers of the London gold market
But this theory really doesn't stand up to scrutiny. Because in fact the London gold marketplace has a clearing mechanism too - it's just instead of there being only one, there are five, and each is interconnected with the others.
The five (listed on the LBMA website) are:
- The Bank of Nova Scotia - ScotiaMocatta
- Deutsche Bank AG
- HSBC Bank USA London Branch
- JP Morgan Chase Bank
These clearers manage vaults, into which gold is shipped from all over the world, and from which it is mostly transferred on to the world's jewellery manufacturers - eventually. Clearers also have investment customers, who trust them with taking delivery of the gold which they buy from the LBMA's market making members; a group which includes all of the clearers themselves and one or two specialists (who don't clear their own business).
More about clearing
London receives a substantial fraction of the world's gold production of 10 tonnes per working day, but London's daily clearing throughput is very much larger, so there's plenty of scope for each tonne to be passed around before sending it on to a jeweller to be made into something.
Yet you will not see armour plated lorries shipping bullion bars all round the city of London at this rate. Instead clearers retain accounts with each other, which protects the industry from the risk of needlessly shipping bars of gold from A to B only to ship it back again the next day - all of which would be expensive and risky.
So clearers also maintain a system of book entry ownership. This system is split into a two tier system of allocated and unallocated gold. The LBMA's website describes this system:
These accounts are opened when a customer requires metal to be physically segregated and needs a detailed list of weights and assays. The client has full title to the metal in the account, with the dealer holding it on the client's behalf as a custodian. Clients' holdings are identified in a weight list of bars showing the unique bar number, gross weight, the assay or fineness of each bar and its fine weight. Credits or debits to the holding will be effected by physical movements of bars to or from the client's physical holding.
An account where specific bars are not set aside and the customer has a general entitlement to the metal. It is the most convenient, cheapest and most commonly used method of holding metal. The units of these accounts are one fine ounce of gold and one ounce of silver based upon a 995 LGD (London Good Delivery) gold bar and a 999 fine LGD silver bar respectively. Transactions may be settled by credits or debits to the account while the balance represents the indebtedness between the two parties.Credit balances on the account do not entitle the creditor to specific bars of gold or silver, but are backed by the general stock of the bullion dealer with whom the account is held: the client is an unsecured creditor.Should the client wish to receive actual metal, this is done by 'allocating' specific bars or equivalent bullion product, the fine gold content of which is then debited from the allocated account.
This explanation benefits from an important clarification. Unallocated gold does not need to exist physically at the clearer. In legal terms it exists as a liability on the clearer's balance sheet. This means that although the clearer recognises the obligation to deliver gold - its liability - it does not need either to have it or own it.
Put another way unallocated gold can be in one of a number of forms which it is difficult for the outsider to differentiate between:
- The gold might be in a form of real gold - unspecifically held as assorted material in an LBMA member's vault.
- It might not exist at all - in which case the clearer would be running a short position in gold. This would be the case if the clearer anticipated a falling price, and expected to profit from covering the short later by buying it at a lower price.
- It might exist as a clearer's bull position on its Bank of England clearing account - in which case only the Bank of England knows how much bullion stands behind it.
- It might have been put to work - for example by being lent. In this circumstance it would not be at the clearer, but would match the clearer's gold liability with an asset; a sum of gold due back to the clearer from one of its borrowing customers. The asset could take many forms incorporating gold loans, futures, options, swaps, and all other types of derivative construct.
Unallocated gold at an LBMA clearer
The main advantage of unallocated gold held at an LBMA clearer is that it is cheaper to manage and trade. Without physical movements or custody to worry about, ownership can be transferred by book entries, which costs almost nothing.
So you can buy gold from an LBMA market maker, who through his clearer (possibly themselves) causes your asset to be recognised as a liability on the clearer's balance sheet. It might be lent or otherwise re-used via derivatives for the clearer's gain.
This leads to the disadvantage. A clearer can get into trouble, either through the default of one of its borrowers, or through volatile gold prices.
In the early 1980s (to be scrupulously fair this was before the existence of the LBMA) a bullion market with declining volume encouraged one of London's main participants - Johnson Matthey Bank - to put its gold stock into financial use. In 1984 their auditors uncovered a severe concentration of the bank's asset exposure arising from these transactions, and decided the company was insolvent. Either directly or indirectly the other London clearers were exposed to JMB through clearing member balances, and the result was that without rescue the entire London market would have collapsed domino-style. Fortunately the Bank of England came to the rescue, but it was a close run thing.
The LBMA itself grew out of this financial collapse. One result is that now there is a much larger degree of collective supervision. But there is still a significant use of unallocated gold, as is evidenced by the large daily volume reflecting book entry transfers of gold between clearers. Historically it is debatable whether official supervision has been materially more reliable as a means of policing the extension of book entry liabilities than the self-interest of participants. Time has a habit of catching out both.
Allocated gold at LBMA
Unlike unallocated gold the legal title of gold owned at LBMA in allocated form rests with the owner. Allocated gold is not a legal liability of the clearer; it is the property of the owner and has been identified as such - bar by bar. Allocated gold is not ordinarily lent or put to use - it is physical material sitting there, doing nothing, and costing its owner a storage charge.
That is just about all that needs to be said about allocated gold, but not quite. A surprising feature is that even this gold might not be where you might suppose it to be.
As well as unallocated accounts with each other the LBMA clearers have allocated holdings with each other - with each effectively operating as a sub-custodian for the other. This means that although the property will exist, and not as a liability, its location is a bit of a secret. One clearer's allocated collection - comprising individually identified 400 oz bullion bars - might actually be distributed across multiple vaults.
Again this device reduces the shipment of gold between parties in settlement of their gold trades. Whether or not it imposes or spreads risk is difficult to say.
The Bank of England
In addition to the 5 clearers there is the Bank of England, which clears the net gold positions between the 5 clearers each day by making book entry transfers into unallocated accounts in respect of each clearers' trades. So the balances of the clearers at the Bank of England represents their entitlement to the Bank's bullion, and within the rules of the LBMA the clearers can treat it is if it were physical reserve - even though nobody outside the bank ever gets to look at the actual metal itself.
The Bank of England is not an LBMA member, but it is - in effect - the LBMA's central bullion clearer. If it chooses to it can expand the supply of bullion in the clearing market by the creation of notional bullion as unallocated liabilities on its own balance sheet, and it can shorten the supply by buying back from the clearers and reducing the bullion - notional or otherwise - in market circulation.
The Gold Fix
A major consequence of the OTC structure of the gold bullion market is the gold "fix". This is an alternate mechanism of price discovery which is designed to allow gold traders to trade at a fair market price.
Twice a day the members of the 'fix' in London conduct what amounts to an elegant private auction which establishes the price at which the number of buy orders matches the number of sell orders. The fixers will be acting both on their own behalf and for those customers of theirs who have issued orders for them to trade at the 'fix'.
The result is the gold fix price which comes out once in the morning and once in the afternoon. The fix price is published widely in newspapers, on the internet and on teletext services, and is a good guide to the value of gold at that instant. It is the widely used method by which traders establish a fair price for a physical gold transaction. On the internet you can see it at www.lbma.org.uk and at www.wgc.net.
The gold fix is often the means by which a customer's physical gold order is filled by a gold dealer, but it means the customer has to wait until gold is next fixed to find out how much has been paid or received for bullion. This might well cause a purchaser to miss a market move (which could of course be either in his favour or against him).
On the other hand the knowledge that the price paid was the result of a substantial number of orders in perfect balance means that it is known that a fair price has been paid.
Usually a customer who buys gold at the 'fix' will pay a small premium. This will be earned by the member through whom the order has been placed. A typical premium would be 25 cents per ounce, which is about 0.06% at $400 per ounce.
More surprisingly there may even be a premium to the fix received upon selling - as selling prices seem to be 5 cents above the fix. Quite why this should be is a mystery, but it has the effect of making selling at the fix look more compelling than buying at it, as the price received tends to exceed the fixing price. Once you know about this anomaly though you will see that the fix is even more competitively priced than you realised, with a spread of only 20 cents from bid to offer, and that is a very significant plus point of the system - achieved through putting large amounts of business through a single minute in each day.
Curiosities of the Gold Fix
So is the gold fix as square as it seems at face value? It is not easy to answer, but it is easy to show the sort of thing which could happen, and which in modern trend-following marketplaces might indeed be regular.
The gold fix is dominated by four market makers:
- The Bank of Nova Scotia - ScotiaMocatta
- Deutsche Bank AG
- HSBC Bank USA London Branch
- Société Générale
Against the background of a rising market the herd mentality of modern fund managers and financial institutions tends to bring buyers or sellers into the market in waves.
Each of these four market makers operates both as a 'fixer' and as a principal, trading gold with its customers. So if one of them has 18 gold purchase orders and only 4 gold sale orders from customers it is not an unreasonable guess that the other fixers have a similar excess of buyers. Then it is likely that at the opening price of the fix - declared from the chair - the market makers will avoid rushing to declare themselves as sellers to bring the market into equilibrium. Indeed they'd be pretty daft to do so, as they'd be selling into demand at too low a price (a sure way to the poorhouse).
Far more profitable is to hold off from declaring themselves as sellers - yet it is they who will ultimately balance the demand with the supply, as they sell their own bullion into the hands of the surplus of buyers at the start. Clearly it is better for them to do this at a higher price.
So they enjoy their twice daily game of spoof. The market maker's art is to hold off declaring as a seller until the price has gone almost to the point that another fix member will sell into the available demand, which ought to be a difficult judgement. But the problem for outsiders is that the participants' mutual interest is best served by unofficial co-operation - in effect by understanding that they all have outside demand.
If - excluding the market makers themselves - there's a material balance of outside buyers all market makers benefit from spoofing high, and a high price will be fixed and enjoyed by all the market makers on the sales they make to their customers. Similarly if there's a balance of sellers they'll benefit from spoofing low. Meanwhile their trend-following customers overpay or under-receive.
So what does this mean in practical terms? Nothing new! A gold fix market-maker can improve his profits by working his book well at the fix, and by being a good 'spoofer' when he suspects that the market is awash with outside orders in a particular direction. This is the same for any financial trading principals who have won what traders call 'order-flow' from customers, and it is this which sets principals (who sell gold to you) apart from agents (who buy gold for you).
The result is that the lion's share of a market-making principal's profit is likely to be made not from the 20 cent mark-up, which is transparent to outsiders, but by buying lower and selling higher, which is not.
The London Good Delivery Bar
Allocated gold bought in the London Gold Market - usually at the fix - will need to be delivered. What characterises a spot trade is that within a short period of time one party will deliver gold to the other and take money in return.
This process is settlement, and might involve unallocated book entries (described above) or the actual allocation and possibly shipping of bullion.
The standard unit of gold bullion settlement is the London Good Delivery Bar and a spot trade assumes settlement in the form of these bars. A single bar weighs about 400 troy ounces (over 12.4 kg).
Physical settlement of a loco London gold trade requires gold bar(s) conforming to the following specifications:
- Weight: minimum gold content: 350 fine ounces (approximately 10.9 kilograms), maximum gold content:430 fine ounces (approximately 13.4 kilograms). The gross weight of a bar should be expressed in ounces troy, in multiples of 0.025, rounded down to the nearest 0.025 of an ounce troy (see LBMA paper on "Weighing, Packing and Delivery Procedures for Gold and Silver Bars").
- Fineness: the minimum acceptable fineness is 995 parts per thousand fine gold.
- Marks: Serial number, Assay stamp of Acceptable Refiner, Fineness, Year of manufacture (expressed in four digits). Marks should be stamped on the larger surface (normally the cast surface at the top of the mould) of the two main surfaces of the bar.
- Appearance: bars should be of good appearance, free from surface cavities and other irregularities, layering and excessive shrinkage. They must be easy to handle and convenient to stack.
Bar size, content and purity
There is something in the process of bar formation which seems to make it difficult to produce bars of consistently accurate weight, so the LBMA does not impose a narrow range of bar weights and instead specifies the 350 to 430 ounce range described above. But most bars are much closer to 400 ounces than this range implies.
The specification is very demanding on purity and actual bar weight because it is the fine gold content that is paid for - impurities come for free! So a bar's weight - however far removed from 400 oz - is multiplied by the purity to give the actual fine gold content.
Refining beyond 99.5% is quite expensive for what you get. Some specialist gold requirements need 99.99% (called "four nines") and even 99.9999% (called "six nines"). The jewellery industry on the other hand is not usually this demanding, and since it is (i) the main user of gold metal and (ii) likely to alloy the metal down to lower purities like 91.6% (22 carat) and 75% (18 carat) the extra expense of four nines and six nines refining is mostly unnecessary.
Chain of Integrity
A receiver of a bar needs to be sure that it is of acceptable quality. Virtually the only way of achieving this with certainty is to re-refine, or assay it. Dealers don't want to pay these costs on buying the material, so there is a system called the ‘Chain of Integrity’ which includes refiners and each of the LBMA's clearers' vaults.
In this chain the trusted businesses deliver individually numbered 400 oz bars to each other and each guarantees to the next that the bar is soundly refined and stamped and has never left the chain of trusted suppliers approved by the LBMA. The reliability of the chain is audited.
The audit process of the LBMA aims to ascertain, by sampling, the purity of refined batches of gold products. It involves a complicated analytical process involving checking not only samples cut from particular bars but also the homogeneity (consistency) of bars throughout a batch. A overview of the sampling and analysis process can be found here.
This chain of integrity keeps London settlement costs down by eliminating the need for repeated refining of bullion delivered from proven sources and batches. It also imposes considerable extra refining costs on outsiders - because they cannot get the same price for the bars from outside this chain when they sell back into London. This is because any bar which has left the London chain is no longer considered a London Good Delivery Bar until it has been re-proven.
This makes foreign held gold unable to benefit from London's best bullion sale prices and concentrates vaulting activity in London.
Central Banks in the spot market
Central Banks are very important operators in the physical gold market because they are the willing sellers which make up for the global production shortage described in the previous FAQs section. A central bank selling trend developed in the 1980s and accelerated in the 90s. Between 1989 and 1996 the US Federal Reserve Board records that around 2,000 tonnes were sold by various governments - mostly European. There was at that time a strong distaste for gold among central bankers who considered gold’s role as a monetary asset to be obsolete.
Facing concern that the USA would be the last gold seller, after everyone else had dumped their own at better prices, the Fed itself commissioned and published studies by economists to establish the effects of immediate gold sales versus gold loan policies, and delayed sales.
The economists told the Fed that it should sell its gold, though there is a suspicion that they simply found what they were asked to find. This recommendation was a confirmation of the policies of European central banks which had sold physical gold before, during and after this period.
It is less clear whether or not the USA sold any of its reserve as a result of the research. Nevertheless there is no question that central bank sales are a continuing phenomenon occurring with the broad approval of economically oriented civil servants.
Other ways of buying physical gold include jewellery and bullion coins and small bars
The unsatisfactory conclusion on physical gold is that there is no truly viable way for most private investors to buy, store, and sell it at competitive rates. The mechanisms which are accessible are usually expensive, and those which are not expensive only involve gold in some intangible way. Many people who have set out with the intention of buying bullion have ultimately been frustrated to find that what - to them - ought to be a simple and cost-effective transaction is rarely either.