A New Driving Force Behind the Gold Price?

How regulations prevent banks from benefiting from gold's full value...

WHEN the 2007 credit crunch hit, the loss in value of so many paper assets forced the sale even of those assets that did manage to retain both value and liquidity, writes Julian Phillips at GoldForecaster.com.

Individual investors often sold gold, silver, and the like to cover margin requirements that screamed to be topped up in the hope of retaining assets that were losing value. That's why asset values on so many fronts declined so markedly. Even assets whose market fundamentals remained solid were sold down only to recover when the storm passed. Gold and silver were among those.

At banking level, the pressure to go against investor logic was due to the regulations of the system. With gold only valued at 50% of its value when held by banks as part of their reserves, it could be credited on the balance sheet at half its actual value. So its real market value could only be given meaning when it was sold. 

By selling gold and using the proceeds to buy Tier I assets, such as Treasuries, the bank ensured that their balance sheets benefitted fully from the value of their gold. Even when the Gold Price fell 20% it was worth selling, so that at least 80% of its former value could be credited to the bank's balance sheet instead of just 50%.

As the value of assets of various governments and potentially US bonds are threatened by over-indebtedness, commercial banks are left little recourse except changing the situation by changing the rules for the banks. Hence, the current discussions on its definition in banks' balance sheets. If gold is redefined as a Tier I asset, then when any future loss of asset value of paper assets occurs, there will be no need for banks to sell gold to compensate for such falls. And, as gold has amply demonstrated, the Gold Price is more than likely to rise in such situations, proving to be a 'counter to all paper assets' on the bank's balance sheets. 

Such a change will do a great deal to remove the shock to the solvency of so many commercial banks in credit crunches and the like. Will the change happen? We at GoldForecaster believe so and expect this to take effect on January 1st 2013.

LCH.Clearnet is a clearing house for major international exchanges and platforms, as well as a range of OTC markets. As recently as 9 months ago, figures showed that they clear approximately 50% of the $348 trillion global interest rate swap market and are the second largest clearer of bonds and repos in the world. In addition, they clear a broad range of asset classes including commodities, securities, exchange traded derivatives, CDS, energy and freight. The development follows the same significant policy change from CME Clearing Europe, the London-based clearinghouse of CME Group Inc., announced recently that it planned to accept gold bullion as collateral for margin requirements on over-the-counter commodities derivatives. 

Both CME and now LCH.Clearnet Group have decided to allow use of gold as collateral. It is likely that they too have the same concerns about the possibility of another 'credit crunch' and the danger forced asset sales can have on liquidity. They too see the benefits of treating gold as money and collateral. 

LCH.Clearnet Group Ltd. said it will accept 'loco London' gold [0.999 or 0.995 quality gold] as collateral for margin-cover requirements on OTC precious-metals forward contracts and on Hong Kong Mercantile Exchange precious-metals contracts starting Aug. 28. 'Loco London' gold is London 'Good Delivery' Bars (roughly 400-ounce or 12.5 kilograms gold bar) held with LBMA members within the London bullion clearing system. The clearing house has already been using gold bullion as collateral since 2011 but now will accept 'loco London' gold as collateral. 

Additionally, Intercontinental Exchange Inc. too has allowed the use of gold as collateral. LCH.Clearnet limited the amount of gold that could be used as collateral to no more than 40% of the total margin cover requirement for a member across all products and at a maximum of $200 million, or roughly 130,000 troy ounces, per member group. David Farrar, Director, LCH.Clearnet said at the time that "market participants want greater choice when it comes to assets that can be used as collateral. Gold is ideal; as an asset it typically performs well in times of financial stress, remains liquid and has a well-established pricing mechanism."

Thus the commercial banking system is and has prepared to treat gold as full-bloodied money because of its invaluable liquidity virtues and its acceptability even under pressure. 

We believe that the markets have yet to catch up to what's going to happen. But the current Gold Price breakout is not because of this aspect of gold; it's because of both technical and seasonal factors. When gold is a Tier I asset and commercial banks appear in the market place, then the gold market will also see a new driving force behind the Gold Price. There is still a considerable distance to go before the Gold Price really does discount these potential changes.

In summary, the banking system, overall, is moving toward where gold will be an active, confidence-building monetary asset.

With gold moving back to such a pivotal position in the monetary system, won't the private sector interfere with the 'stability' of the gold market, chasing its price up just as the Hunt Brothers tried to do in the days of yesteryear? This is possible, but this time the Gold Price will not be at a fixed price as it was under the gold standard. By 'floating' the Gold Price, every time it rises in price, it will benefit bank's balance sheets and liquidity levels, countering volatile markets. The reverse is true if the Gold Price falls and other assets rise in value as the markets seems to believe will be the case. 

Overall there will be a 'value anchor' as Mr. Zoellick, the last head of the World Bank, advocated last year.

If these changes are instituted, there is a danger of interference in the gold market price by the public, but on the upside not the downside. After all, it will be in the interests of the monetary system to see higher Gold Prices rather than lower prices that the powers-that-be appeared to want between 1985 and 2005. But they will want to see a level of stability consistent with that of currencies and other monetary assets in that situation. 

Their desire for this can be overwhelming, as we saw in 1933 when US citizens were banned from holding most forms of gold in the interest of the nation's monetary system. It was not until 1974 that they were again permitted to do so; however, this permission came with the proviso that owning gold from then on was a "privilege, not a right" as though to warn us all that things could change again. Even though governments attempted to write gold out of the system, they made it clear that they considered gold as part of their domain.

This is a real danger and one that should not be overlooked by us all in all the nations of the world. Any government that feels it is in their interests to take their citizen's gold will do so even if it means changing their laws.

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