The London Bullion Market Association (LBMA) has reportedly offered support to American derivatives company CME Group after it allegedly faced difficulties sourcing sufficient gold bullion to physically settle its expiring futures contracts.
This sparked fear in the bullion market, resulting in a four percent divergence in the spot and futures prices of gold. As a result, the precious metal’s status as a safe-haven asset has come under heavy scrutiny of late.
On March 11, 2020, the LBMA reported an all-time high in daily volumes as it sold gold futures contracts worth almost $100 billion. Two weeks later, however, the CME Group is struggling to deliver physical gold at the time of settlement. Now, according to experts like Roy Sebag, there is a strong possibility that banks sold futures contracts without having sufficient reserves of the asset and are now struggling at the time of delivery.
Gold Spot Prices Fall Below US Futures
On March 24, 2020, the London Bullion Market Association (LBMA) and other financial organizations across the UK involved in the trade of gold asked US-based CME Group to allow a different unit of gold bars to be used for physical settlement of futures contracts. 400-ounce gold bars are commonly used in London for bullion trading, while the generally accepted norm across New York is gold bars of 100-ounces. The futures contracts traded on CME Group’s New York-based exchange naturally involve this 100-ounce standard.
Traders feared that transporting bullion from London to New York would be impossible due to the travel embargo imposed by governments in the wake of the COVID-19 pandemic. This caused panic to set in on the bullion market as news spread that London-based banks were failing to deliver gold at the time of settlement and went on to result in a four percent divergence between the gold futures contracts traded in New York and the price of spot gold traded in London.
Under normal market conditions, the two prices move in the same direction with very little divergence.
Signs of Crisis in the Bullion Market?
Roy Sebag, the founder of Goldmoney, tweeted Tuesday that some banks had decided to exit the bullion trading market after they failed to deliver physical gold at the time of settlement, which caused them to face heavy fines and financial losses. As a result, there is an acute shortage of physical gold in the American bullion market. He believes that banks were involved in an excessive short-selling of gold futures contracts, all without even possessing the underlying asset.
On March 11, 2020, Bloomberg reported a sharp rise in purchases of gold futures contracts. The LBMA, meanwhile, reported its highest ever daily trading volume as future contracts worth almost $100 billion were bought in a single day, presumably to save their capital from inflation. This shows that there is no liquidity problem in London as it is a major storage center for the precious metal.
American banks offering CME’s Comex contracts, however, likely oversold futures contracts without actually having the requisite physical gold in hand. Ownership of the underlying asset could be easily transferred if the New York-based exchange allows settlement using 400-ounce gold bars. The change in delivery terms would negate the need to melt the gold bars into 100-ounce bars.
On March 24, 2020, CME announced the launch of a new gold futures contract with delivery in 100-ounce, 400-ounce and 1-kilogram gold bars. The newly announced futures contract has its first expiry in April but it is not clear whether the change in delivery terms will be permitted for older contracts.
Cryptocurrency Market Offers Ray of Hopefor Distressed Investors
The latest series of events in London raise questions over gold’s status as a safe-haven asset during economic crises. For years, it was wrongly believed that the total supply of currency in a country’s banking system was directly proportional to its gold reserves.
The global recession of 2008 proved that the notion to be false as central banks engaged in unlimited printing of currency to combat any long-term slowdown, resulting in lower purchasing power and other detrimental side effects. This is because the total value of currency in circulation remains constant but the number of banknotes in circulation rises. As a result, inflation rises and prices of goods increase.
Cryptocurrencies are built on the principle of decentralization, which means that traders do not have to rely on an authority or third-party decision-maker. The public nature of blockchain technology, coupled with the presence of honest nodes, ensures no market manipulation takes place in the network. Unlike fiat currency, Bitcoin has a fixed supply and an inflation rate which will eventually go down to zero. There will never be more than 21 million bitcoins in circulation after the last unit is mined.
Futures contracts, on the other hand, are built on trust between two parties, while the liquidity is guaranteed by an exchange. If banks engage in selling of futures contracts without having the underlying asset, the bullion market could be decimated overnight. Equity markets have already witnessed sharp selling as the global economy is forecast to slide into another recession.
Precious metals and digital currencies are two assets that are limited in nature and their mining cannot be continued forever. Goods that are limited in nature command a premium over other assets and are considered as safe-haven in periods during economic contraction. However, unlike futures contracts, overselling can be eliminated in the cryptocurrency market.
Smart contracts built on blockchains such as Ethereum ensure that all parties own the underlying asset before initiating a trade. Every asset bought through such a smart contract is linked to the blockchain using a digital token and the ownership of such a token is enough to prove ownership of the underlying asset.
Traditionally, gold was considered to be the safest asset during times of economic upheaval. However, cryptocurrencies are legitimately scarce and traceable due to the public nature of their networks.
Institutional investors do not buy physical gold directly. Instead, they are dependent on custodians to handle their gold which could make the asset a risky proposition. Bitcoin and other digital currencies, however, do not require third party custodians and can be safely stored in a digital wallet. As a result, digital tokens make a more compelling case than even gold.