Category: Financial Markets Commentary

Monthly financial markets commentary from Sabino Investment Management, LLC

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Basel III and Its Impact on Bullion Pricing

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 4th weekend.  If you have any questions or comments, please contact me.

Robert G. Kahl
CFA, CPA, MBA

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Bonds, the Dollar, and Leverage – 4/6/2021

In the title of his latest commentary, Ray Dalio, Founder of Bridgewater Associates, asks “Why in the World Would You Own Dollar Debt?”  He argues that the current dynamic is “typical of the late stage of the long-term debt cycle.”

The world is a) substantially overweighted in bonds (and other financial assets, especially US bonds) at the same time that b) governments (especially the US) are producing enormous amounts more debt and bonds and other debt assets. This is particularly true for US bonds. US bond holdings are over a third of global bond holdings held by central banks, sovereign wealth funds, and international investors with the next largest country/currency bond being euro bonds at only roughly 60% of US bond holdings.  Their overweighted position in US bonds is largely because of the “exorbitant privilege” the US has had being the world’s leading reserve currency, which has allowed the US to overborrow for decades.  The cycle of becoming a reserve currency, overborrowing, and being overindebted threatening the reserve currency status is classic.

Some international investors are shifting a portion of their fixed income allocation from US$ bonds to Chinese bonds, which now account for about 6% of global portfolios.  Given the low interest rates in many countries, investors have also been willing to invest more in common stocks and precious metals.  However, bonds still have a place in portfolios for now, given valuation levels in the stock market that have already priced in a strong recovery.

The recent disclosure of some large bank losses due to business with Bill Hwang’s Archegos Capital raises some questions about derivatives and capital markets.  A record level of margin debt has contributed to higher prices in the stock market, but derivatives have added another source of leverage for speculators.

Bloomberg estimates that derivative contracts with Archegos caused the forced liquidation of more than $20 billion in holdings.  Much of the leverage used by Archegos was provided by Nomura Holdings Inc. and Credit Suisse Group AG via equity swaps and a type of derivative contract called contracts for difference.  Archegos may never actually have owned most of the underlying securities, preferring to bet on the highly levered derivatives contracts instead.  Among the stocks impacted by the forced liquidations was ViacomCBS which has dropped nearly 60% since March 22.  The prime brokerage losses have not been fully disclosed yet, but Credit Suisse has reported a loss of $4.7 billion so far due to their business relationship with Archegos.  Total losses for all banks are likely to exceed $10 billion.

Some of the large banks also have exposure in the precious metals markets with large short positions in silver, platinum, and gold.  Futures contracts for these three metals have a higher level of contractual open interest relative to global production than other commodities.  The short positions are highly concentrated among among eight large bank trading groups.  For example, the eight largest traders are net short silver an amount that would require 180 days of global mine production.  They are also net short platinum by 117 days and gold by 86 days of global mine production.

Investment demand for bullion and coins has picked up considerably from prior years.  Sprott Asset Management compared the total demand for coins and bars at three government mints: the US Mint, Perth (Australia) Mint, and Royal Canadian Mint.  For 2020, sales of gold coins and bars at the three mints was 157% higher than 2019, while the sale of silver coins and bars was 54% higher.  Gold and silver bullion ETFs have increased their inventories of bars.  Buyers of COMEX contracts are also requiring delivery of physical metal at higher levels than they did in past years.  Given government and central bank policies around the world, investment demand for precious metals is likely to continue or rise from current levels.  Higher prices should follow.

If you have any questions or comments, please contact me.

Robert G. Kahl
CFA, CPA, MBA

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The Short Game – 2/3/2021

There has been much in the news about the Reddit crowd beating the hedge funds at their own game.  GameStop Corp (GME), the retailer of video games and consumer electronics received the most attention.  For the most recent twelve months that were reported ending in October 2020, the company had revenue of $5.16 billion and a net loss of $274.8 million.  Revenue for the October quarter had declined by 30.2% from the prior year’s comparable quarter and the company had $446 million of cash and short-term investments.  The declining fundamentals attracted short sellers.  GME has a 52-week low price of $2.57 per share and a 52-week high of $483.00, achieved during its spectacular run-up last week.  As recently as January 12, GME closed at $19.95 per share.

GME has 69.7 million shares outstanding.  The float, which excludes restricted stock that cannot be sold to the public, is 49.3 million shares.  In mid-January, there were 71.2 million shares of GME that had been sold short, or 144.3% of the float.  Technically, shares which are sold short must be borrowed from a brokerage firm that holds the shares in the margin account of customers.  Short sales generate additional business for brokerage firms.  The cost of borrowing shares of GME stock exceeded 20%.  When a brokerage firm lends shares that it does not hold in a customer margin account, it is called a “naked short” and the brokerage firm is taking a financial risk.

Call options contributed to the price action in GME stock.  Some speculators buy options instead of the stock to get more leverage.  Options dealers who sell the call options usually purchase the stock to hedge their exposure on the call options.  So, the options dealers become another source of demand for the stock.

The large GME short position attracted some attention and the Reddit/WallStreetBets crowd, with over 8 million members, pushed the idea of buying GME stock and its call options en masse to force additional buying by the shorts to cover their losses.  It worked!  According to some traders, as older shorts incurred large mark-to-market losses and were forced to buy shares to meet margin calls during the last week of January, new shorts who were able to find shares to borrow established new short positions.  The shorts were then aided by several brokerage firms who forbid the purchase of GME shares by retail investors late last week.  The hedge funds and other short sellers were able to cover their short positions (buy shares) without competition from the Reddit crowd, many of whom were unable to buy shares but were allowed to sell shares.  By Monday, February 1, the GME short interest had declined to 39% of the float.

Other heavily shorted stocks benefitted from the market action.  AMC Entertainment (AMC), BlackBerry (BB), and Nokia (NOK) all had similar but less exaggerated price action.  AMC and American Airlines (AAL) used the price spike to sell additional shares to the public to raise some cash for their businesses.

Some media commentators, professional investors, and politicians have called for a Congressional investigation and additional regulatory intervention.  Jack Inglis, CEO of the Alternative Investment Management Association (AIMA), said, “What is dangerous, amid this trading frenzy, is that retail investors have been chasing prices so far above any sane valuation and that many well end up nursing losses.”  True, but many are skeptical that an organization that includes many hedge fund managers is concerned about small investors.

Hedge funds that shorted Gamestop and other companies with poor fundamentals have large losses for the month of January.  ZeroHedge.com estimates that one hedge fund, Melvin Capital, lost over $7 billion or 53% of its capital in the month of January.  The Wall Street Journal reported that another smaller hedge fund, Maplelane Capital, started the year with $3.5 billion and had a loss of 45% by the end of January.

Regarding potential changes in the regulatory environment to rein in the Reddit crowd, Ryan McMaken, senior editor at the Mises Institute wrote this:

This “exemption from free market discipline” is what Wall Street is all about these days.  The financial sector has become accustomed to enjoying bailouts, easy money, and the resulting financialization which puts ever greater amounts of the US economy into the hands of Wall Street money managers. The sector is now built on corporate welfare, not “free markets.” No matter what happens, Wall Street expects the deck to be stacked in its favor.

One question that has not been addressed in all the media coverage of the GME saga is the function of short sales in the financial markets.  It generates more commissions and fees for brokerage firms, and the hedge funds claim that it is a strategy that justifies their generous fees.  But short sales shift capital from a productive economy that produces goods and services to a speculative economy that does not provide capital to produce anything but has a lot of activity to support a zero-sum game where market participants place bets against each other.  Is it any wonder that the US now has large trade deficits every month?  For the last reported month of November 2020, the US trade deficit was $68.1 billion.  Maybe our financial markets should put a greater emphasis on providing capital to companies that can provide goods and services at a profit.

If you have any questions or comments, please contact me.

Robert G. Kahl
CFA, CPA, MBA