Home > Continuing gold backwardation may cause a new financial crisis

Continuing gold backwardation may cause a new financial crisis

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This article discusses the meaning of gold backwardation and its relationship with the global economy.

Antal Fekete {1} warned many years ago that a “permanent gold backwardation” would act as a financial black hole that would consume the entire global financial system. Subsequent “scholars” [2} found (minor) flaws in his argument. However (I believe) Fekete was right and that his warning is particularly pertinent today - as gold now enters its fourth year in (or near) backwardation.

First - some definitions. The GOFO (gold forward rate) measures the difference between the spot gold price and the forward (futures) price, measured as a percentage, quoted individually over 1, 2, 3, 6 and 12 months. GOFO is (a swap rate) paid by the gold owner, who puts up his gold as collateral to borrow dollars. If GOFO is positive (negative) respectively, then he will pay (receive) interest to get dollars and have his gold stored. Now if the owner of the gold immediately invested those dollars at the risk free rate LIBOR, he would have a total return of GLR = (LIBOR – GOFO) at the end of the lease period. The (implied) GLR stands for the Gold Lease Rate, which is the theoretical risk free return paid to the owner of physical gold for leasing it into the market. For later reference, I write this simple formula here in all its variations:


Now if GOFO is positive (negative) respectively, the market is said to be in contango (backwardation). The normal market state is contango (GOFO > 0 or GLR < LIBOR), because there are costs associated in holding gold over any period of time (storage, insurance, lost interest). Backwardation (GOFO < 0 or GLR > LIBOR) is (or rather once was) very rare and indicates that the market will pay a higher rate of interest to borrow gold than to borrow cash, despite the associated costs of holding gold. It usually indicates (short term) supply issues and a strong demand for physical gold for immediate delivery. However, when this demand cannot be met over a long time period, we get a “semi-permanent backwardation”, which the world has already experienced during the 1970’s after Nixon took us off the gold standard - and gold rose from $35 to over $800 before the backwardation could be broken. But if ever we get a “permanent backwardation”, then the demand for gold can never be satisfied and the value of gold tends towards the infinite, consuming the entire financial system (a black hole, as Fekete describes it). This means the total collapse of fiat currency, as has occurred previously in the Weimar Republic and Zimbabwe.

Now some “financial experts” (who have called Fekete a “pseudo-expert”) including Dr Tom Fischer with help from Bron Suchecki (Perth Mint) [2] , have claimed that backwardation represents nothing special and that it creates no arbitrage opportunity and so it has NO effect on the economy. However, their argument fails to understand the nuance of “fractional reserve bullion banking” whereby (in addition to buying and leasing physical gold) a bullion bank can create (out of thin air) and sell into the market gold certificates which carry none of the costs of holding physical gold The extra saving results in the arbitrage. To prove my point, I will consider three cases calling them Bullion Banks A (Fekete), B (Fischer) and C (Real World).

Bullion Bank A has physical gold stored and insured at an annual cost of X% and they enter a lease whereby the gold is physically transferred out and returned a year later at the lease rate GLR. They would therefore have a cash return of GLR on the lease plus the unpaid costs of X%, for a total profit of GLR + X% - which money they would not have received had they not leased the gold. Fekete claimed that this was an “arbitrage” profit, but Fischer correctly pointed out that because the gold is leased for that year, the owner has given up his right to sell that gold during the year (equivalent to an additional sale of a put option) which explains the extra amount received. However, Fischer then fails in logic by arguing from his own (special) case to a (general) conclusion.

Bullion Bank B starts with zero holdings and borrows money paying LIBOR, to buy physical gold and lease it into the market to receive GLR and receive GOFO on the sale of the gold a year later, thereby returning the bank to its original position (zero) except for the profit (loss) on the arbitrage. But there is no profit (loss) because his expense (LIBOR) equals his gain (GLR + GOFO), because LIBOR = GLR + GOFO and so there is no arbitrage. However, what Fischer is missing is the fact that in the real world, bullion banks (1) don’t generally buy and sell or even lease physical gold and (2) they instead create and issue certificates as a promissory notes for gold for which they do not have to borrow money, and (3) they sell more certificates than are covered by their own physical gold holdings, and (4) they can hedge their additional risk in many ways at cheaper rates than GOFO, and (5) not all Bullion Banks are totally honest (which point I will try to ignore, no matter how interesting).

My point is this - neither case A (Fekete) nor B (Fischer) accurately represent the real world and in any case you cannot prove a general principle from a specific example. That said, I will now show that the bullion banks can indeed create an arbitrage and then go on to discuss the implications of what it means if this arbitrage remains open indefinitely – which (I think) helps explains how the bullion banks have gotten us to where we are and what happens next..

Bullion Bank C holds an unknown amount of physical gold and engages in the normal business practice of “fractional reserve bullion banking” - whereby they create (out of thin air) certificates, sell (or lease) them as gold and hedge their exposure in the futures markets and elsewhere, using all sorts of fancy techniques. As a base case, the profit comes from creating the certificates and either (1) selling them receiving LIBOR and hedging the risk by paying GOFO for a total return of (LIBOR – GOFO) = GLR, or (2) by leasing them out at GLR and hence the return is exactly the same. Thus to make a guaranteed arbitrage profit, they do not even need gold backwardation (GOFO < 0) all they need is for (GOFO < LIBOR). Thus the lower GOFO goes, the greater the arbitrage and if gold goes into backwardation (GOFO negative), the arbitrage remains open for so long as LIBOR remains positive (perhaps indefinitely).

The next question is can and under what conditions do bullion banks make arbitrage profits in the opposite direction? Fischer correctly points out that if the banks buy physical gold, there can be no arbitrage, but if the banks buy back there own certificates, they need only pay what the sold them for (large joke just made) which is GLR = (LIBOR – GOFO). However this cost becomes an arbitrage profit when GOFO > LIBOR. Thus there exists an arbitrage whenever GOFO is either sufficiently large or small relative to the risk free rate LIBOR – and only when LIBOR = GOFO does there not exist any gold arbitrage at all.

Summary of Conditions for Bullion Bank Arbitrage

  • Selling gold certificates GOFO < LIBOR
  • No arbitrage GOFO = LIBOR
  • Buying back gold certificates GOFO > LIBOR

For reference, you can view the GOFO and LIBOR rates and charts here:



Now all this makes perfect sense because (1) when there is high market demand for physical relative to future gold, the bullion banks can arbitrage by selling (expensive) spot certificates and buying (cheap) futures, and (2) when there is high market demand for future gold relative to spot gold, the bullion banks can arbitrage by buying back (cheap) certificates and selling (expensive) futures.

There is however one obvious risk in this business, namely that they get stuck with a full arbitrage book in a permanent backwardation – whereby they have sold (unbacked) gold certificates and the market never swings back into a contango to let them out. Indeed their worst nightmare would be if they sold a great number of certificates and a determined buyer (such as the Hunt brothers, or China) stood for and demanded physical delivery. Bear Stearns is rumoured to have collapsed in 2008 due to their massive short position in the silver. But since that time the banks have written themselves an escape clause, allowing (among other things) cash settlement upon default - thus reducing the need to chase physical metal to cover paper contracts. Today all they have to do is drop the price and then default on all outstanding contracts, thus escaping and making money at the same time! However the resulting scandal would probably close the market.

All of that said, my actual proof for the existence of an arbitrage rest with the fact that without a guaranteed return, the banks would not be in the business in the first place and would not have subsequently made profits every day for years on end without a single loss. And yet they are and they do, so QED – there is an arbitrage! Admittedly, the arbitrage comes from investor’s mistaken belief that “paper gold” is the same as “physical gold”, but because the banks have mitigated their risks, an arbitrage does in fact exist (at least for them). Having finally established this (important) fact, what then are the ramifications of it?

Firstly, there is incentive for the banks to run the gold price (or rather GOFO) up and down as often as possible so as to regularly open and close arbitrages and make profits on each swing. With this knowledge one can then predict which way the bullion banks will be trading because as a general rule, when they are selling (buying back) gold certificates the gold price will go down (up) respectively. But this subject is off topic and so I leave it to you to look at the charts, crunch the numbers and see what I am talking about.

Secondly, it appears that movements in GOFO and the actions of the bullion banks have a significant effect on the global economy. To understand this consider the size of the gold market. Each day (on Comex alone) around 500,000 contracts are traded, there being 100 oz per contract, with each ounce valued around $1,200. So there is around $60 billion of gold traded per day or around $15 trillion per year. I do not have the figures for all the other markets (London, Shanghai, Hong Kong, Singapore, etc), but when you add it all up, it should be obvious that the global gold market is big enough to influence (and perhaps dominate) any other market on planet earth.

Now look again at the GOFO and LIBOR charts and notice that GOFO leads LIBOR (by around three months) and not the other way around !!! Furthermore the sudden withdrawal of gold from the markets in Sep 2007, resulting in a plunge in the GOFO rates from over 5% down to zero (being caused by the unwinding of a massive gold arbitrage and the establishment of another arbitrage in the opposite direction) was probably responsible for the plunge in LIBOR rates from over 5% down to zero three months later, resulting in the current ZIRP (zero interest rate policy) worldwide. One can argue “chicken and egg” and more research is always needed, but it certainly appears that gold and its GOFO rate (backwardation or contango) lead global interest rate markets and thereby directly influence (or dominate) the global economy.

Thirdly, while geo-politics are beyond the scope of this note, there are reports of large and ongoing buying (by China and others) of physical gold and there are suspicions that this demand has been offset by both a reduction in the physical gold holdings of the bullion banks and by the selling of additional “paper gold” into the market. Although such market conditions (backwardation) encourage the selling gold certificates, there is always the danger of over-extension. Indeed, some reports suggest that there are now over 100 paper claims for every physical ounce of gold held. Furthermore, because a large proportion of the physical gold that backs the markets has been moved offshore (with cash used as collateral instead), the market has become ever more unstable and vulnerable to sudden collapse. Chaos theory tells us that “you never know which snowflake will cause the avalanche, the important thing is the degree of instability of the underlying state” and I would argue that the gold market is in fact unstable and moving ever closer to its “snowflake moment”.

In a “short term backwardation”, the mathematics clearly dictates that the bullion banks should arbitrage by selling certificates. But as the backwardation becomes “semi-permanent” - as it has been since 2011 - the market risks entering a negative feedback loop, causing the backwardation to become ever deeper. This is caused by investors stubbornly buying physical gold thereby removing the backing for the market itself. Announcements by the US Mint of “record sales” and “shortages” do not help.

One solution to breaking such a backwardation is to take LIBOR negative, which seems impossible, but this is strangely happening in Europe where banks are now charging customers interest to safely store their money. Other solutions are (1) to drive the spot gold price ever lower, in the HOPE of getting the spot price to stay below the futures price and thereby create a positive GOFO, and (2) to drive the gold price so high that investors stop buying and the gold hoarders start selling (or leasing), all with sufficient quantity so as to create a lasting contango.

This problem should be well understood by both the bullion banks and the Governments because they have already seen it once before in the 1970s. When Nixon ended the “gold standard” in 1971, there was a massive flight to gold and a “semi permanent” backwardation resulted. The gold price rose from $35 to $200 in 1974 and then the price was taken back down to $100 in 1976 (presumably in the hope of ending the backwardation). But this only caused a surge in demand which eventually took the gold price back over $800 in 1980. Inflation skyrocketed, requiring interest rates to be raised to around 20%. Finally, some sellers and leasers of gold appeared and the backwardation was broken, allowing for the normalization of interest rates and the economy.

But the same problem is repeating today and so far the response has been the same. From 2008 to 2011 the gold price tripled from $650 to $1,900. Over the last three years the bullion banks and Governments have tried to break the backwardation and normalize the economy by dumping huge amounts of physical gold and “paper gold” at the gold spot price. But they have failed, because although they have reduced the gold price from $1,900 back down to $1,200, they have not been able to create a lasting contango. Instead, the gold buyers and hoarders have dug in, bought everything and demanded more – which has only strengthened the backwardation.

Sooner or later, the bullion banks and Governments will run out of ammunition and they will be forced to step back and allow the market to do its thing. Which is to repeat of the 1970s – the worst of all economic outcomes – stagflation. Unfortunately, this is the consequence of all the money printing and while it can be delayed – it cannot be stopped. The gold price will eventually peak in the tens of thousands of dollars and unless the bullion banks unwind their short positions, they will either default or go bankrupt.

But the most serious outcome is Fekete’s vision of a “permanent backwardation” whence, unlike the 1970’s, the gold backwardation can NEVER be broken. In this case, the gold price tends towards the infinite, taking inflation with it. The gold lease rate GLR is also driven to infinity (by the market seeking gold) and LIBOR is dragged up with it under the relationship LIBOR = GLR – GOFO. But in this case there is no end - confidence in dollars is completely lost and gold goes into deep hiding (bid no offer). Under these circumstances we get a hyper-inflation and a total collapse of the fiat money system. Just like the Weimar Republic and Zimbabwe. Gold will then have (once again) reasserted its supremacy.

The world will then be divided between those who have gold and those who do not. War and chaos will reign until the poor countries accept the terms of the rich countries under a new world order using gold as currency. Somewhat ironically, this scenario was originally dictated in the US Constitution - but as Winston Churchill famously said “you can rely on Americans to do the right thing AFTER they have exhausted all other possibilities”. And so I think history will judge the period from 1971 (Nixon) to 2014 (?) as the era of American economic insanity.

Professor Antal Fekete is the pioneer of this argument, although his “colourful style” has often left him open to criticism. I would also like to thank Dr Tom Fischer whose criticism has got me to rethink the problem and then add support to Fekete’s work.

References: [1] Prof Antal Fekete - http://www.professorfekete.com/

{2} Dr Tom Fischer “gofo – real explanations vs pseudo experts” http://www.safehaven.com/article/32250/gofo-real-explanations-vs-pseudo-experts

For the time poor amongst you:

(1) Basically, there exists a gold arbitrage for the bullion banks.
(2) During periods of high physical gold demand (backwardation) – the arbitrage creates ever more “paper gold"
(3) But the longer the backwardation continues, the more the market gets drained of physical gold and filled up with paper gold.
(4) This can continue for a few years, but eventually the market becomes too unstable and the price soars looking for some physical gold.
(5) But if physical gold never returns to the market, regardless of the price, it means that confidence has been lost in fiat currency - and the dollar collapses.
(6) The bullion banks can delay this outcome, but they cannot stop it.

*Fraser Murrell is a mathematician and quantitative analyst with experience in the financial sector as an analyst, broker and trader, and currently works at the University of Melbourne.

This article  appears courtesy of Mine Web. To read more daily international and financial mining news click here.

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