Forecasts, Commentary & Analysis on the Economy and Precious Metals
Celebrating our 48th year in the gold business

May 2021

Many thanks to Numismatic News for its kind permission to reprint this article in full.


Editor’s note: Several clients have contacted us with questions on the new Basel 3 accords implementation. This analysis from Patrick Heller, published originally at Numismatic News, is a compelling and very readable interpretation of Basel 3’s potential impact on the precious metals market – in fact, the most clearly written we have seen thus far on this complicated subject matter. It is difficult to know if the Basel Committee on Banking Supervision will implement the accord, particularly when one considers, as Heller points out, the negative impact it is likely to have on some large and influential international financial institutions. At the same time, one would think that by now, its net effects on the banking industry would be well understood and factored into the equation. We are still a month away from implementation, we caution, and anything could happen. Heller, as you are about to read, believes that its implementation would have a significant impact on gold and silver prices. We recall the signing of the Central Bank Agreement in 1999 and the subsequent impact it had on the market. Many analysts credit the signing of that agreement, which limited central banks’ sales and leasing of gold, with laying the groundwork for its secular bull market beginning a few years later. Whether or not Basel 3 will have the same impact remains to be seen, but the implications, as Heller describes them, are intriguing.

Guest opinion

graphic image of gold and silver stored in vault

Will Basel 3 boost gold and silver prices?
Coming changes could have ‘enormous’ impact on precious metals markets

by Patrick Heller

The Basel 3 accord is a set of global financial reforms developed by the Basel Committee on Banking Supervision under the domain of the Bank for International Settlements, an organization headquartered in Basel, Switzerland. These coming changes in bank system operations are to strengthen regulation, supervision and risk management within the worldwide banking industry.

Work on the Basel 3 changes began in 2008, after the onset of the Great Recession. The original version was adopted in 2010, to be implemented from 2013 to 2015.

Some changes called for in Basel 3 were so extreme that some revisions were made and implementation was repeatedly delayed. As it now stands, some of the impact of Basel 3 takes effect at the end of June this year, while all changes become effective on Jan. 1, 2023.

The goal of the forthcoming Basel regulations is to limit the levels of risk that banks take on in the pursuit of profits, which would hopefully prevent a major worldwide financial crisis if markets turn negative. It’s a wonderful idea in theory. However, in practice, some changes could be so disruptive to the actions of some governments, central banks and financial institutions that there is already pushback.

Part of the Basel 3 regulations that could be especially disruptive are those involving bank trading of precious metals.

Many of the world’s largest banks trade them for customers and for their own account. In trading these metals, they are handled as either allocated or unallocated assets.

With allocated precious metals, the customer is the owner of specifically identified and segregated coins or bars. The brand name, weight, purity and serial numbers of bars are recorded. The bank merely provides storage services. When a customer withdraws or sells these assets, the bank releases these exact same assets. Because these assets are property of the customer, the bank does not own them and they are not listed as assets of the bank or as liabilities that the bank owes to its customers.

Institutions may have sold as much as 100 times metal actually owned

It is an entirely different matter with unallocated storage of precious metals.

In unallocated storage, the bank’s customer does not own specifically identified coins or bars. Instead, the customer is an unsecured creditor of the bank, who has a claim against some of the assets owned by the bank. For example, a customer may have a 1,000-ounce silver bar in unallocated storage. The bank may be holding hundreds or thousands of these bars in unallocated storage, any one of which would be available to deliver on behalf of a customer if requested for withdrawal or sale.

In unallocated storage, that thousand-ounce silver bar would be owned by the bank and listed as part of its assets. To offset that, the bank would also record a liability to the customer for the same value as it uses for the asset. So long as banks actually hold sufficient assets to cover these liabilities, there is no problem.

When banks trade precious metals, the use of unallocated storage has a lot of advantages. Banks don’t have to keep track of each bar and coin by individual owner, which saves a lot of paperwork and shuffling of assets when they change hands.

However, there is a problem with unallocated storage.

Since the everyday turnover of precious metals involves only a relatively small percentage of the assets a bank may hold, the bank can fulfill the delivery needs even if it does not have physical custody and title to all of the precious metals it owes to customers.

You can think of this circumstance as similar to a bank’s cash customers. On a day-to-day basis, banks do not face a high percentage of their customers showing up to withdraw all of their funds. Therefore, the banks are able to hold only a small percentage of their assets in the form of coins and currency when compared to their liability to customers who have checking or savings accounts or certificates of deposit.

This lack of need to have title and custody to a high percentage of physical precious metals in their vaults compared to what their liabilities to customers has resulted in massive trading volumes in what I call paper assets.

So, many banks today engage in what could be called fractional precious metals trading. They hold only a small percentage of their liability to their customers in physical metals in their vaults. They theoretically cover the rest of their precious metals liabilities by leasing gold from central banks, trading derivatives contracts or using other paper forms.

Investment bank Morgan Stanley was caught in such a scam where it sold physical precious metals to customers and collected storage fees to hold them, but did not purchase the actual assets. Instead, this bank used customer funds to purchase other assets, many of them in paper form. Morgan Stanley settled a multi-million-dollar class action lawsuit on this issue in 2007 without agreeing with the charges.

How huge is this paper market, where banks may hold paper contracts to cover their liabilities to deliver physical precious metals? In a Commodity Futures Trading Commission hearing in March 2010, precious metals consultant Jeffrey Christian testified that these institutions may have sold their physical metals as much as 100 times the quantity of metal that they actually owned. Obviously, if all these owners contacted their bank to take delivery, the paper market would crash.

Basel 3 could ‘wipe-out’ trading unallocated gold and silver in London and New York

The world’s largest trading platform for precious metals is the London Bullion Market Association. Just in gold, it trades an average of $20 billion every day, which is more than $5 trillion annually. Virtually all of this trading is in the form of unallocated precious metals.

The New York COMEX is the world’s second largest platform for trading precious metals. The COMEX trading of gold futures and options contracts began in the mid-1970s specifically as a means for the U.S. government and the primary trading partners of the Federal Reserve Bank of New York to manipulate the price of gold.

The fractional reserve method trading of unallocated precious metals is the primary means by which the U.S. government, the primary trading partners of the Federal Reserve Bank of New York, allied central banks and the Bank for International Settlements suppresses gold and silver prices.

By selling paper contracts, without having to deliver the physical metals, there is the appearance that there is a lot more gold and silver available on the market than there actually is. The result is that prices are lower than if buyers and sellers of precious metals traded on the basis of actual supply and demand information.

As I have explained in the past, the prices of gold and silver effectively serve as a report card on the U.S. government, U.S. economy and the U.S. dollar. If precious metals prices are rising, that not only reflects poorly on the government, it also forces higher interest rates that must be paid on government debt and pushes down the purchasing power of the dollar.

Back to the Basel 3 accord. The most important change for precious metals is that banks would be required to hold reserves against their assets. Under the coming regulations, banks would count unallocated precious metals at 85 percent of their value on the bank’s books in making the determination of how much it needs to hold in reserves against these assets.

However, banks would no longer be able to consider any of the liability for unallocated precious metals as part of their required reserves.

Therefore, to comply with Basel 3 regulations, banks would have to either create a huge increase in their shareholders’ equity to provide the required reserves or they will be forced to sharply reduce or completely eliminate their trading in unallocated precious metals.

Will these banks take title and custody to many times the quantity of physical precious metals that they now hold? For all practical purposes that isn’t possible because there just aren’t enough physical metals available. Another obstacle is that these banks simply do not have the storage capacity to hold sufficient inventory to provide sufficient reserves for their precious metals assets.

The practical effect of this part of the new Basel 3 regulation would be to almost completely wipe out the trading of unallocated precious metals in the London and New York markets. About the only trade that would survive would be for allocated metals.

Implementation scheduled for end of June in continental Europe and January in UK

Banks in continental Europe will implement the changes in precious metals trading as of the end of June this year. British banks will be required to adopt the new standards by Jan. 1, 2022. At least, those are the current scheduled implementation dates.

With the elimination of most trading in unallocated storage, the U.S. government could lose its primary tactic of suppressing gold and silver prices.

Between the increased demand for physical precious metals and the elimination of the use of unallocated precious metals to suppress prices, gold and silver prices might undergo huge increases.

This impact of these forthcoming market changes is so enormous that on May 4, 2021, the London Bullion Market Association and the World Gold Council submitted a paper to the Prudential Regulation Authority, the United Kingdom’s regulator of banks and the financial sector, asking for the changes in Basel 3 standards in trading unallocated precious metals be eliminated. This paper claimed that implementing the new regulations would undermine the ability of banks to clear and settle precious metals trading, drain liquidity from this market, sharply increase financing costs of such trades and would limit central bank operations with precious metals.

(Editor’s note: Please see “The Impact of the NSFR on the Precious Metals Market,” London Bullion Market Association and the World Gold Council, May 2021)

The claim that the London Bullion Market Association may be almost forced to cease operations without this waiver also means that the COMEX trading of unallocated metals would also come to a virtual standstill.

How likely is it that the near-term implementation of the Basel 3 standards for trading unallocated precious metals will occur? Not enough to eventually matter, as the most likely difference would simply be another delay in the implementation date.

But, even if the implementation dates are once more postponed, that deferral might only apply to British banks.

Another possible change suggested in the LBMA and WGC paper is to instead adopt the Swiss interpretation which considers it applicable only to unbalanced positions on both sides of a bank’s balance sheet. That might not provide much leeway.

Still, time is running out to try to change the regulations before the first of these standards applies to continental European banks at the end of June this year.

Right now, the COMEX currently has about $24 billion in short sales of gold futures contracts and another $1.6 billion in short sales of silver futures. There will almost certainly be pressures for short sellers to cover these COMEX contracts as continental European banks scramble to cover their short positions.

However this eventually turns out, the ultimate result is almost certain that gold and silver prices will climb far higher, perhaps multiples of current levels, within the next six months to two years

Patrick Heller is a frequent contributor to Numismatic News, the national weekly publication on collecting coins. He is a recipient of numerous industry awards and editor of Liberty’s Outlook, a monthly newsletter on rare coins and precious metals.


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