The Heart of the Gold Price - The "Fix"

The London Gold Fixing, the twice daily gold pricing mechanism at which the bulk of physical gold transactions take place is changing dramatically. In the past five London Based gold bullion banks on a direct telephone link to their clients established a price at which these transactions took place. This was an efficient way to establish an accurate price for gold deals done outside of the contracts used to supply the bulk of gold deals.

It is in this market that physical gold traders and speculators [we view the COMEX market as a financial market as around only 5% of its deals involve the movement of physical gold] also participated. By trading the marginal supplies of gold [outside of contracted sales of the bulk of gold supplies] a much smaller total, the influence of traders and speculators has had a disproportionate impact on the moment-to-moment gold prices. While the developed world received 80% of global cash flow [up to the year 2000] it also held power over the global gold market.

London - the Heart of the Gold Market

For centuries London has been the global hub of the gold market particularly during the Gold Standard, when London was importing South Africa's over 1,000 tonnes of newly mined gold a year. London has been able to maintain its position as the world's leading financial market and in particular its gold market. The high standards of gold and people involved in that market allow it to still dominate the physical gold market,

In the last few years there have been charges that the "Gold Fixing" system was outdated and the gold price manipulated by the gold bullion banks, often with government influence. While this had a large element of truth in it, it was not true of the overall London gold market's individual professional operators.

The main gold price manipulation in the past came from 1933 [when the dollar was devalued against gold] and after 1985, when central banks encouraged the acceleration of gold production to swamp the gold market, while implying that they were willing to sell of their over 30,000 tonnes of gold into the gold market. Such manipulation came to a halt in 2009. Since then individual traders have manipulated prices not only in the gold market but interest rate markets and remain under investigation for other incidents of manipulation in financial markets. But the perception has been that the gold market has been operated by professional, capable men and women, in general.

The main bullion banks that operated the gold markets have also been responsible for shipping gold bought there, to the global markets. As we have seen in the recent past, the banks can enjoy larger incomes from the inefficiencies of the distribution chains, which invite the establishment of premiums in markets such as Shanghai and India. These premiums accrued to the banks, so did not encourage an improvement in the distribution system or the lowering of such premiums.

The rise of the Emerging World

By 2020, at the latest the emerging world will enjoy 65% of global cash flow and the developed world 35% of it. The shift of wealth and power eastwards has led to a very different global gold market. In the developed world the dollar based currency system has sought to wean the developed world off gold and onto national currencies and has succeeded to date. The gold market appears to therefore have less relevance to financial life than it has had throughout history. With the development of markets trading in gold shares or other gold derivatives [futures and options] the bulk of the demand for actual gold has shrunk to very low levels in the west. This has made it far easier to influence gold prices more directly as new supplies have hit the ceiling they have now.

The result has been that the dominance of the major western banks over the gold markets and participants is almost complete. The sheer power of the volumes of money they can wield over all financial markets has allowed them and their traders to 'make' prices.

But as emerging markets have risen in wealth and power and gold production, the ability to 'make' prices should have moved away from the developed world eastwards reflecting the percentage of global gold demand China and India represent, alongside the Middle East, if markets had been efficient. But they haven't as the institutions that operated the gold markets retained their power over distribution and markets.

Add demand from the Middle East to China and India and their demand represents around 75% of global gold demand. On top of that China at an annual production level or around 430 tonnes is now the largest gold producer on the planet. So why doesn't the gold market reflect the fundamental changes in supply and demand? It's all about presence in the global gold market and the products on offer and the ease that they move across the different markets. China's gold market is still developing on the pricing front. It has developed strongly in terms of gold used in its financial system and continues to expand its distribution system westwards in China, but has a long way to go to reach all corners of China. More importantly, its absence from the London gold market, in terms of participating directly in it, has prevented its gold market presence being felt. The same applies in India, where western banks continue to dominate distribution to the country.

It is apparent that China is no longer content to use London's banks as its only source of foreign supplied gold. To that end it welcomes the redesign of the London Gold Fixing process and wants to join in. On March 20th the London Gold Fix changes to a new mechanism involving global banks as well as the London Bullion Market banks that operate the Gold Fixing now. It is hoped that the new electronic mechanism will, hopefully, operate more efficiently and smooth out global prices as well as lower the influence of the current London banks on the gold price.

At the moment there is a $5 premium over and above the London gold price in Chinese gold markets. With the following Chinese banks; Bank of China Ltd, China Construction Bank Corp and ICBC now set to join in the London Fixing, the pricing power of the Chinese gold market will hopefully, directly impact the gold price thereafter.

If we see the premium over the gold price, in China, disappear, this will have happened. Bear in mind that Industrial and Commercial Bank of China Ltd. has become the world's largest gold retail bank already and will bring to bear their significant number of clients in China. Not only do we expect these banks to operate in a way that they will try to remove the gold price premium in China [which at the moment increases the profitability of the selling [mainly foreign] banks in China] but make the gold market more globally efficient.

With the Chinese gold market being a one-way street [no export of gold is permitted] we expect the Chinese banks to create a 'pool of liquidity' where selling orders from China can take place in London without Chinese gold leaving China. We note that sales of gold in China are extremely small anyway. Nevertheless, that 'pool' of gold liquidity in London that we expect to see, will facilitate arbitrage operations that smooth out global prices and make the Chinese gold market the two-way street it needs to be to reflect global demand and supply. In turn we will see a 24-hour gold market.

The swing to 1 kg bars from the 400 ounce 'good delivery' bars in London we are now seeing from the vast tonnages of gold being re-refined in Switzerland and elsewhere, will hopefully increase the fluidity of market products, globally. The presence of Chinese banks in London may well speed that process up.

Yuan Gold Fix this Year

The Chinese have announced that they will set up a Gold Fix in the Yuan in Shanghai, later this year. We believe that, alongside the developments we described above, such a Fix will be taken to heart by the global gold market both in the developed emerging and developed world. The fact that the price will only be in Yuan, will ensure that the gold world will get used to the Chinese currency and be in a position to trade in the Yuan without having to go through the Dollar, the Euro and the Pound Sterling, which carry separate risks.

With the Chinese government encouraging the international use of the Yuan in global trade and financing, it will be a small step for foreign entities, including central banks, to hold Yuan in their reserves in the future. But this will not affect the gold market, simply the global currency markets. After all, gold is considered an alternative to all currencies.

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