Precious Metals Dealing— An Ecosystem Set For Change
There is a lot of interest around modernizing custody models and settlement infrastructure in a variety of different asset classes right now. The industry dialogue does not always appreciate the differences between securities and less standardized hard asset markets. In order to improve transparency, better manage settlement risk, and build confidence across investors, improvements in hard asset and commodities market settlement should recognize how the markets differ so that solutions can be tailored. This is intended to be a straightforward piece outlining the challenges and opportunities surrounding dealing in precious metals. In the future I intend to write similar pieces covering financing and hedging functions.
Since its inception, Tradewind has been focused on understanding the precious metals ecosystem and, in particular, the gold market starting with North America. With this understanding and input from key players in the industry, we have developed a toolset, along with legal, operational and technical frameworks, that aim to add efficiency to trading and settlement in the physical, not paper, precious metals market. The focus here will be giving some context around where we believe there is real change occurring in the market, and my experience in that evolution.
Gold
In its most basic form, gold is a thing that exists in a place and is used to make stuff. It requires everything that any high value thing in a place needs, i.e. security, insurance and so on.
Dealing is a term used in many Over-The-Counter (OTC) markets, it means the same as trading, buying and selling of gold. Here I am focusing mainly on the buying of gold at refineries that ranges between unrefined dore bars and refined bars.
Globally, the throughput at refineries is about 4000 tonnes. A tonne is worth about $40M at today’s price. This leaves roughly $160B in gold going in one end and out the other of refineries around the world. In my estimation, those dropping off material at the front door of a refiner are rarely the same as those picking up the new bars or grain on the other side.
What struck me most when beginning to speak with gold traders about their business is the realization that vast majority of traders I have spoken to did not actually trade physical gold. They were trading futures, London unallocated credits, and Exchange-Traded Funds (ETFs) like GLD, the SPDR Gold Shares ETF. Very few traders transacted in real physical, gold bars, coins, grain, dore and so on, and understood the complexities and nuances of the global supply chain. To be clear, there are a few key industry players that know the physical market really well and have carved out a great business for themselves, but increasing regulatory obligations have put tremendous pressure on this business model.
Trading gold
“Gold trading” can mean many things. It can be a hedge fund trading futures, as easily as it could imply a gold producer selling unrefined dore to a refinery in Switzerland. It’s nothing like a stock or bond market. Bespoke, several geographic considerations, many different client profiles. Complicated.
China is the largest buyer of physical bars which purchase about 25% of the global production each year. The vast majority of physical gold today is traded on the London OTC market, with ‘clearing’ managed through a five-member consortium of banks forming the London Precious Metal Clearing Limited organization.
What initially interested me about the precious metals market was the high value of settlements needing to occur, and additionally that the majority of precious metals settlements that do occur are conducted with a degree of open settlement risk. Open settlement risk being that one party doesn’t deliver to the other, and causes some degree of loss.
In most securities markets, this is the time when central counterparties would step in. First, bonds are paper, or electronic entries held in highly centralized depositories. Second, the financing structures the banks use in the market are pretty similar to what an investor like a hedge fund would use. In essence there exists a market construct that is much more advanced and adaptable to moving around the players.
In the gold and silver markets, this is not the case. It takes a deep expertise to manage the acquisition of gold from a mine site in Mexico, ship it to Salt Lake City, refine it, and all the while matching billions of dollars of this material against buyers globally who at the end of the cycle need the material.This is the definition of a high touch business model.
Unlike the securities markets, the physical precious metals market presents a number of challenges. First, the ‘market’ involves buying and selling material at various stages of throughout the supply chain: from dore coming off a mine site, to refined gold in a standardized bar, to minted products such as small bars and coins. Add to this, the complexity of securing title to material that is not clean due to commingling of material throughout the manufacturing process (i.e. it is often difficult to point to a gold or a specific bar at a refiner and say, “that’s the gold I own!”). Because of this, there are few third parties willing to provide guarantees to buyers and sellers that their trades will settle for this type of a market construct.
Meeting my first real physical gold trader
Currently, there are five banks that manage settlement in the London market on behalf of hundreds of customers, netting obligations internally and moving metal between the member banks as required.
In 2015, before Tradewind was its own entity and I was very much in the learning phase, the first group I met was the physical trading team at a large Canadian bank in New York. They were the largest player in the North American physical market, but have since almost entirely exited the business of physical gold trading, which I touch on later.
When I first met the bank, they had the edge on what we would call physical trading at least in North America, if not globally. They had a three pronged structure: NY, Hong Kong and London. The physical business, in terms of what a bank would say, is exactly that. They buy, sell and finance bars, coins, grain for making jewelry, dore, and pretty much anything else you can name — at refineries, vaults, factories around the world. They buy gold in Switzerland and sell it in China; they buy mined gold from Mexico and take it to refiners in the USA. Again, it is the definition of a high touch business. To conduct this business the bank has a need for a large global staff maintaining relationships on the ground with all the aforementioned parties. It also requires sophisticated trade hedging and lots of cash to lend with low borrowing rates on the other side, two topics I will cover in later articles.
Many mainstay banks have distanced themselves from the world of physical metal. This could be seen as disruptive to the fluidity of the markets from a financing and dealing perspective. It is, however, nothing new. In the wake of Dodd-Frank, many banks were essentially forced to jettison their proprietary trading divisions, the largest market makers to issuers and investors in many asset classes, including the the US corporate bond market. I would be willing to bet that a large scale corporate issuer would have more paper turning over in a year, on a notional basis, than the entirety of the physical gold market. So was it a complete catastrophe? Nuances aside, 99.999% of the population would not have noticed.
Due to a lack of comfort with the risks associated with buying and selling material from hundreds of global sources, the increasing balance sheet costs associated with the bank’s business, they decided to exit the business formally in 2018. Although they are the marquee example, there is definitely a predisposition for banks to be moving away, rather than toward providing the role of market maker to the industry.
The industry players
When breaking down the players who would be interested in bringing gold to a refiner, you have two primary categories. The first category is comprised of primary gold producers. These are companies that specialize in mining gold and silver, or receive it as a by-product of mining other materials. This community accounts for roughly 50% of the 4000 tonnes delivered to refineries annually. The other is, you guessed it, everything else. From scrap, to recycling, to unwanted jewelry from a pawn shop, any physical material that would benefit from being repurposed.
The majority of those bringing gold to the refinery do not want to collect it on the other side. This brings us back to the team at the physical bank. The vast majority of this material is, or in the case of our physical bank, was, purchased by these institutions. In many cases they buy it before it’s turned into bars, in a business knows as “dore financing”. This is a fancy name banks use for buying stock at refineries while it goes through the plant.
The team at a physical bank maintains relationships with producers, scrap dealers, and refiners all over the world. They are the largest buyers of material, asking for it to be made into bars and grain. The group second largest to the banks is up for debate. Options include, the refiners themselves, who purchase a fairly large chunk of the material to produce high margin gold products, or independent bullion dealers.
Contrary to childhood fantasy, physical banks don’t ship all the gold into a Scrooge McDuck style Swiss vault and seal the door. They maintain relationships with jewelry companies, industrial users and investors all over the world. When the refined product is complete, the banks manage shipments to the end buyer. A high volume of which is routed to India and China.
As with most businesses, this model is profitable when the intermediary can purchase the gold from the producer, refiner, scrap dealer at a lower price than they can sell it after accounting for the cost of transport, financing, compliance, staff. In their role the bullion bank does many things, as you can see above, making scale an important characteristic of the business model.
In addition, a large physical bank holds billions in inventory at a network of refineries and vaults, which presents its own risks for loss as a result of fraud, negligence or other operational issues. As it stands, I am not aware of a good solution.
This role the banks play is critical, however the result is that the buyers and sellers of physical gold are unknown to each other. Thus, gold producers have little visibility into how much the end buyer pays.
A critical question would be, do the buyers and sellers want to interact? The answer is sort of. Many would be interested to see the value of their material at market, but they also have a lack of interest in performing many of the functions banks currently handle. Well, you can’t have your cake and eat it to. So, I believe this is going to incentivize new players to enter the market and take up the slack. There is much more to say about how transparency, operational efficiency, and client relationships can be enhanced in the physical gold market. We will go more deeply into these topics in my next post.
