The large bullion banks have enjoyed a sustained and generally profitable position at the fulcrum of the gold supply chain. Bullion banks are the traditional middlemen of the gold marketplace. Production from mines and refiners may not arrive at the loading dock on the same schedule by which consumers are demanding the precious metal. Work stoppages at key mines or force majeure events such as regional wars can cause interruptions in the flow of raw materials. Consequently, the bullion banks serve a vital market-clearing role, buying when the producers wish to sell, and selling to consumers whenever demand is strong. They smooth that process by means of their large inventories from varied refiners to be matched in this anonymous process with a range of demands from their wide array of customers.

The bullion banks do many traditional things other banks do, and much more. At a substantial markup over cost of the bullion, they serve the wholesale gold industry. These large buyers include the big miners, major consumers such as the jewelry and industrial businesses, central banks, and investors in securitized gold such as State Street’s GLD. And they wholesale precious metal to the enormous consumer markets of China, Southeast Asia, India, the Middle East, and Turkey. The bullion banks provide various trading services as well: spot trading, forwards, options, vaulting, etc.

However, in recent years there has been a desire for more efficient and responsive ways for institutional investors to secure positions in precious metals. Too often in the past the smaller institutions were unable to gain access to physical gold through the bullion banks, for the dominant giants in the bullion world curried favor with only the largest and most powerful clients.

Over the years, a handful of global bullion banks consolidated their power by buying up numerous merchant banks and thereby came to dominate and rationalize the cumbersome distribution process. The absence of vertical integration means that the mining companies do not control the refining, and the refiners usually reach the ultimate consumers of gold via bullion banks rather than selling directly to the buyers. This put the oligopolistic tendencies of the largest bullion banks squarely astride the supply chain of gold, and conferred upon them unusual control of the price. Higher than competitive rates for buying and storing gold were the predictable result. This opened the gates for alternative ways to bring the refiners and ultimate investors together. Now the bullion banks are focusing more than ever on the more profitable investment banking portion of their activities. But due to a paucity of appealing outlets and options, the miners and refiners must continue to rely on the considerable financial resources of the bullion banks that have in many cases funded their operations.

The accounts of the customers of bullion banks are unallocated, meaning that individual bars are neither segregated nor physically distinctive, so the client owns only a generic entitlement to the precious metal. This common practice is inexpensive and convenient, but it unfortunately paves the way to the imposition of fractional reserve banking using that limited amount of gold, for the bullion banks only keep some small fraction of the physical metal in their vaults at any one time. The bold assumption that underpins this fractional reserve practice is of course the belief that not all depositors will show up simultaneously to redeem their holdings. The potential shortfall of physical gold, or one might argue, the creation of surplus slips of paper, often means that the bullion banks have a pressing need to lease gold from the central banks. When they do so, the lease functions like a collateralized loan from the central bank with interest paid to the bullion bank. The central bank receives cash in exchange for their reserves of gold. This financial practice of leasing gold in exchange for cash is known as a “swap”. The rate of interest the central bank pays to the bullion bank for loaning out the gold is called the GOFO (gold forward offered rates), while the central bank can put the cash to work at the usually somewhat higher LIBOR (London Interbank Offered Rate). The difference in rates between the LIBOR and the GOFO is called the Lease Rate. Most often the lease rate is positive, giving the central bank an incentive to lease their gold.

But the pattern of cause and effect does not stop there, for the bullion bank has the incentive to sell the borrowed gold on the spot market, an action that boosts market supply and therefore slightly depresses the price. And it means that the bullion bank does much better at the end of the month when the loan comes due if the price of gold has actually declined. So the bullion banks have an incentive to be “bearish” on physical gold. The institutional investor in gold at the bullion bank is typically unaware of this thinly-disguised conflict of interest. The investor who holds physical gold in their account at the bullion bank seeks stability, risk mitigation, or when possible, actual appreciation of the asset. However, the bullion bank is positioned to benefit from a decline in the value of the asset. This poses a problem to the unwitting investor.

These multi-trillion dollar bullion banks, as measured by their total reported assets, are buyers of gold and silver worldwide, serving as the clearers and distributors of metal in the market. They are traders and market makers, always prepared to make and deal on the price. They create consignment stocks in regional markets so that gold is easily accessible to consumers and producers in jewelry or industry. This is an essential function, for the supply and demand for bullion are not always in harmony, and the bullion banks are vital in smoothing out the supply chain. These banks also provide finance for those various demanders of gold and play a role in project finance for the gold mining industry. Their commitment to deal is on a continuous basis, whatever the spread. But over recent decades as the old merchant banks have fallen by the wayside, they have acted increasingly as intermediaries in the mobilization of central bank reserves, whether for leasing, swaps or sales. There is no question that such bank-enabled storage solutions have passed the test of time in some respects, providing safety and other features at more than adequate levels. But the time for constructive change is overdue.

The Ten Largest International Banks: (in trillions of dollars worth assets as of 2017) Industrial & Commercial Bank of China ($3.47T) China Construction Bank ($3.02T) Agricultural Bank of China ($2.84T) Bank of China ($2.60T) Mitsubishi UFJ Financial, Japan ($2.59T) JPMorgan Chase, US ($2.49T) HSBC, UK ($2.37T) BNP Paribas, France ($2.19T) Bank of America, US ($2.19T) Wells Fargo, US ($1.93T) But not all of them are LBMA Market making members.  See list at end of this entry.*

New vaulting firms have developed a more flexible and viable procurement and redemption solution for gold that is superior technologically to the older methods. Institutional investors would be well advised to weigh carefully the multiple advantages of holding physical gold in the form of allocated and segregated bullion rather than in accounts at bullion banks. Such clients can gain in several meaningful respects from patronizing the much larger institutions. Many smaller specialized firms now enable investors to hold and redeem in a secure ecosystem at low cost, using a simple and liquid approach.

The advantages to an investor of holding allocated and segregated Bullion compared to holding gold at bullion banks include the following seven points of interest to institutional investors:

Accessibility: UHNW and institutional investors can now attain far easier access to their positions in gold than the bullion banks ever encouraged. The KYC process is straightforward and responsive to investor timelines, the platform is easily understood, the storage partners these firms partner with have extraordinary infrastructure and are globally esteemed, and the liquidity of positions in physical precious metals is excellent. Without the delays, rationing, and high price of entry tightly controlled by the bullion banks, a direct link is established between the specific products of the refiners and the unique needs of the ultimate investors. The bullion banks will maintain most of their traditional roles within the broader gold marketplace, but in the supply chain of physical gold for investment purposes, there are these agile portals available for accessing precious metals. The needs of the clients are a primary focus at any specialized firm, unlike at huge bullion banks where gold is a minor fraction of their business.

Title and Insurance: Second, holdings of fully allocated and segregated bullion, an asset that is insured and audited, empower each owner with the flexibility to have their gold transported, delivered and redeemed on their own terms and timelines among vaults located on multiple continents. This dynamic functionality is not as easily realized by clients at bullion banks or smaller banking entities, for they cannot offer the same level of transparency and fingertip control of the asset that precious metals platforms provide to clients with utmost security and speed. The technology of advanced messaging is automated and efficient, enabling appropriate quickness with precision, redundancies, and highest standards of security.

Gold as Commodity and Currency: Third, allocated and segregated bullion brings an active element to the otherwise immobile holdings of the vaulted gold, for someday it may be used as a currency solution, both as a hedge and an overlay. A key issue for global investors is less about the dollar value of the physical asset but more about the physical amount of metal in a portfolio and in what currency it is held. The gold could conceivably constitute a sort of hedge to the base currency of origin during the period that precious metals are vaulted. The multi-currency overlay facility for active management of currencies could use the physical gold as collateral. In a figurative sense, this process takes the friction out of gold as a commodity and a currency. The kinetic aspect of gold is usually unavailable to owners of the immobile gold bars at the bullion banks or smaller institutions. And it would, at least in theory, advance gold well beyond its traditional role as a store of value into the realm of serving as a trusted medium of exchange. This is a transformational concept worth bringing to life.

Risk Reduction: Fourth, by enabling the physical holding and exclusive ownership of precious metals in a choice among many vaults in global financial centers, the physical investment gold firms minimize the systemic risk to the value of client holdings. Systemic risk is the chance that a disruption at a firm, in a market segment, to a settlement system, or in a similar setting will cause widespread difficulties at other firms, in other market segments, or in the financial system as a whole. One can think of it as the tumbling of dominoes. With the bullion bank approach to physical gold storage, there are problems associated with dependence on the established banking structure, including daunting concerns about counterparty risk and systemic risk. Direct physical ownership of gold removes those worries. By working through a secure ecosystem and storing the client’s bullion at a comfortable distance from the traditional banking system, the owner of the metal is no longer subject to the risk of failure of the banking institution. The risk that the counterparty will not live up to contractual obligations is minimized or entirely eliminated. Recent financial history provides a cautionary tale in that regard, and investors and institutions of substantial means around the world are paying closer attention than ever to this unsettling source of uncertainty. Many investors today explicitly prefer fully allocated and segregated accounts over the shared or unallocated accounts featured by bullion banks. In the event of a financial crisis that triggers systemic risk and potential failure of the bullion bank, the customer is only a secured creditor and not a specially designated “Authorized Person”, as bullion banks tend to label their important clients. In that case the owner may not be able to recover the gold immediately or even at all, at anywhere close to the equivalent value. There is no justification for burdening clients with such a daunting barrier to their peace of mind.

Cost Efficiency: Fifth, there is the matter of cost of the vaulting service. Allocated and segregated bullion consisting of assured premier quality metal within the “Good Delivery” system can be stored and fully insured at lower total cost of ownership than customarily charged by the bullion banks, assuming the client could even qualify to be a customer at those very large institutions. Completely insured delivery or prompt transfers among vaults of these physical gold investment firms utilize the most reliable and experienced logistics companies, at reasonable market rates. The gold ownership enablers maintain its exclusive focus on the precious metals market as their reason for existence, so there is no risk of cross-subsidization of one division with the excess profits earned from another. And there is no benefit to the firm if the price of gold declines. Therefore rates and fees are kept as low as feasible. Within the complex structure of huge bullion banks or even less powerful banks, there is no guarantee that fees in each segment are set equitably in that manner.

Quality Assurance: Sixth, allocated and segregated bars of physical gold have every bit of the quality, security, and gold marketplace expertise behind it that the bullion banks provide. All the bullion is of the same Good Delivery purity as the metal from the bullion banks. This is established and maintained strictly at the highest standard set by the London Bullion Market Association that represents the wholesale over-the-counter market for gold and silver. The LBMA undertakes ongoing work encompassing many areas, including refining standards, good trading practices and standard documentation. Indeed, the bullion banks themselves, along with the best refiners and well-established dealers, are among the prime sources of bullion to these firms that have made ownership of gold so much safer and more convenient than ever before.

Industry Expertise: Seventh, the technology bringing customers access to allocated and segregated holdings of physical gold is built upon a more effective, transparent, flexible, secure, and liquid process for the procurement, ownership, trading, and redemption of gold bullion. The technology expedites the widespread procurement and global exchange of physical precious metals. making physical gold function as both a store of value and a medium of exchange.

Roy Van Til, Ph.D. Vienna ME royvantil@mac.com 207-500-9604

*The 13 Market Making members of the LBMA that provide two-way pricing in gold are: Citibank NA, Goldman Sachs International, HSBC, JP Morgan Chase, UBS AG, Bank of Nova Scotia-ScotiaMocatta, BNP Paribas SA, ICBC Standard Bank, Merrill Lynch International, Morgan Stanley & Co International Plc, Societe Generale, and Standard Chartered Bank.