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There has been much commentary recently in the precious metals arena about Basel III bank regulations proposed by the Bank of International Settlements (BIS”) that are now in the process of being implemented and their potential impact on the price of gold and silver.

The Bank of International Settlements is a supranational organization based in Basel, Switzerland whose mission is to support central banks’ objective of monetary and financial stability through international cooperation.  It provides a forum for dialogue and cooperation to develop a common understanding and plans for common actions.  The BIS has proposed Basel III rules as a set of voluntary international financial standards agreed upon by BIS members in the aftermath of the 2008 financial crisis.

The Basel III regulations make a distinction between allocated and unallocated bullion accounts.  Allocated bullion accounts represent title and ownership of specific bars, with the dealer acting as custodian on the client’s behalf.  Similar to the contents of deposit boxes, allocated bullion deposits do not appear on a bank’s balance sheet.

Most bullion in London is traded and settled on an unallocated basis, where the customer does not own specific bars but has a paper claim to an amount of metal.  Thus, such contracts are often referred to as “paper gold.”  Unallocated gold obligations appear as a liability on a bank’s balance sheet.  The origin of all unallocated gold accounts is not the depositing of gold, but credit creation by banks.

Basel III regulations will classify banks’ actual physical gold holdings (allocated and held in their own vault) as safe, tier 1 assets along with cash.  Unallocated gold contracts will be classified as tier 3 assets against which greater reserves are required.  The new requirements became effective on June 28 for European banks.  US banks are required to comply effective July 1 and UK banks will begin compliance on January 1, 2022.  UK banks dominate bullion trading at the London Bullion Market Association (LBMA), so much of the impact may be delayed until later this year and early 2022.

The unallocated gold market in London is huge in comparison to the physical gold that is traded.  Approximately 600 metric tonnes of gold derivatives (unallocated gold) are traded daily between LBMA members.  This does not include trading between members and non-members or intraday turnover.

Alisdair Macleod, Head of Research at Goldmoney, and others believe that the introduction of Basel III regulations will have a significant impact on bullion trading by large banks and consequently the price of gold and silver.  Macleod writes:

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 the 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.

Macleod argues that Comex futures for gold and silver will also be impacted.

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…  And in London, all LBMA banking members will similarly reduce their unallocated activities because unbalanced books would be heavily penalized 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.

Price manipulation in the gold and silver market has been frequent and obvious in the past as banks were able to create more precious metals derivatives out of nowhere.  That will be more difficult in the future as the role of derivatives declines and there is a greater reliance on physical gold and silver.

The likely result of the Basel III regulations is:

• A reduction in open contracts at the LBMA and Comex for gold and silver bullion.
• For those investors who want to retain price exposure to gold and silver, a shift from unallocated bullion contracts to physical bullion in a vault.
• Higher prices for physical gold and silver bullion.

I wish all of you a Happy July 4^th weekend.  If you have any questions or comments, please contact me.

Robert G. Kahl
CFA, CPA, MBA