I am going to run through this in a simple step-by-step process. Central banks don’t directly take their bullion to the market and lease it out. They use a vehicle called a bullion bank (BB).
Although bullion banks are numerous, some of the more well known are Barclays, Goldman Sachs, JP Morgan, Bank of America, UBS, and Citibank.
The central banks loan gold to the BBs at a rate of approximately 1%. The BBs take it to the LBM and sell it on the open market. The BBs take the cash from selling the bullion and in turn buy Treasuries.
So if the story were to end here, the bullion banks would just walk away with a net 4% return. But it doesn’t end, because they only have the leased gold for a certain length of time. They eventually have to give the gold back to the central banks, but now they are at risk of price swings in a very volatile market.
The answer to their problem is to go long the futures market. Essentially, they buy futures contracts to hedge their risk. In other words, they secure gold for delivery at a specific price, on a specific date in the future. Once they buy their futures contracts, it doesn’t matter what the price action of gold is.
In a perfect scenario, after the gold lease rate and price risk hedging, the bullion bank will walk with a modest 1–2% gain. The central banks will receive a return on their gold, keep the price of gold suppressed in order to keep real inflation suppressed, and get a boost in the demand for Treasuries. It’s a win-win situation for both the bullion and central banks.
Jim Sinclair’s Commentary
In our world of shameful crimes and lies hiding in plain sight there is no law that demands the funds raised by selling gold you leased has to go into US Federal Treasury instruments. You might use it to finance almost about anything. Do you think the exact people that gave you LIBOR are bastions of ethics in how the money is used from the sale of the leased gold? Clearly they are not.
As such, gold leasing has become a method of financing whatever you please without reference to having to be in the gold business or using the funds toward purchases of Treasury instruments. In fact Treasury instruments are not purchased because there is no law or regulation in the OTC derivative type business. The OTC derivative market for gold leasing is a pure Wild West. You can do anything you please with the funds derived from the sale of the gold. As far as hedging the sale by being long paper gold, few gold banks seem to recommend or participate on that side. Many of our legacy leases are made up of bankrupt gold lease specific performance agreements that are unfunded.
The typical gold lease from a central bank has a duration of only one year. So many central banks were willing to lease gold that the gold banks undertook themselves to guarantee a rollover of the leases so that the client had no concern of a short period for repayment and renewal.
As both gold banks and central banks began to experience losses and recognized their real risk of the counter party to the lease, this business began to slow down. That slow down was in the form of a growing reluctance by central banks to lease with the exception of the central bank that most wished to apply downward pressure on gold.
These transactions, which are best described as OTC special performance derivative contracts, began to go into disarray. Lease gold right now still shows as owned by the central bank regardless of the ability to financially repurchase and return the gold to the central bank via the gold bank.
Here is more disappearing gold camouflaged by useless, non functioning, OTC derivative paper.
This is another reason why the gold banks attacked the paper gold market to decrease the price. They intended to have this depreciation of price drive the buyers away from the market. They were correct butt only in paper and not in physical gold. Physical is in demand as an asset of savings brought about by the worldwide writing in of the bail-in method revealed by Ms. Lagarde of the IMF and the young Dutch Minister of Finance over the Cyprus planned bail-in and confiscation of depositor’s money.
The physical market for gold is going to become the source of price as the paper market is revealed to be the fraud that it has always been. Simply put, there is no gold whatsoever in any paper gold contract of any form. Much of the leased gold is simply gone never to be identified again.
The death of the paper gold market that cannot deliver is the both of the emancipation price of gold that will surprise even those most positive bull on the metal.