Posted On Thursday, Jul 31, 2014
"Gold price zooms on global concerns", or "gold price drops since markets are doing well" scream headlines of various business dailies...
Gold - the yellow metal, holding some sort a magnetic attraction for us Indians, be it a wedding or even investments, everyone will prefer to put their money in gold. Globally too gold is relied upon as a medium of exchange that still holds value - now and since time immemorial.
Everyone around us has a view on gold, too expensive, too cheap, too anything. As a Fund Manager in commodities and managing the Quantum Gold Fund ETF* - I often hear the lament from my friends - "Gold is too expensive, how I can afford it?" Before I launch into my spiel on the benefits of Gold ETF and trusting a fund house which has your best interests in mind... I often wonder to myself - do we really know what determines the price of gold? Thought of sharing this with you in this edition of the Golden Truth.
Read on to know!
Let me now ask you a question - What does the word "fixing" mean to you?
`To repair something that`s broken`, you reply and rightly so.
If I were to add one word - price before fixing, then what does it bring to mind?
That `fixing` immediately brings to mind the series of unfortunate `match-fixing` scandals unearthed over the last few years. A sacrilege, a blasphemy of the worst sort for millions who follow the religion of sport across the globe. Fixing has put off sport enthusiasts and thereby poses as the biggest threat to any sport.
Drawing a parallel; in Gold markets, "Gold Fixing" refers to a century old process of price discovery. Most gold market participants look forward to the "fix" - not some drug, dear reader, but the "gold fix" being the benchmark price. Since the Libor interest rate-rigging scandal that broke in 2012, most of the financial markets benchmarks have been under high scrutiny. Some observers say the Gold Fix - the system for pricing the metal leaves it equally vulnerable to manipulation.
Let us first understand "Gold Fixing" in detail
"Gold Fix" was established by a group of bullion brokers in 1919 at the request of the UK Treasury, when a handful of bankers began to meet in the wood-paneled offices of N. M. Rothschild & Sons in London. The purpose of the fix is to set a benchmark price for gold, which is subsequently used by dealers, central banks and mining firms to buy and sell the precious metal and its various derivatives. The London gold fix is currently determined twice daily, not by complex algorithms written in the backend and a veritable cricket field of servers (couldn`t resist the pun here) doing complex calculations and then throwing out a value which will be treated as gospel across gold markets. Life`s a lot simpler than that actually - the price of gold is decided - hold your breath here - via a conference call between Barclays, HSBC, Bank of Nova Scotia and Societe Generale!
Yes, a "hi - shouldn`t the price of Gold be Rs. XX,XXX per ounce, yes it should. Ok done..." is what decides the price of gold... Quite scientific isn`t it! ☺
Actually it`s not THAT simple, but almost there, here`s how the price of Gold is determined:
Process of price discovery - The Gold Fix Price.
The member banks join a secure conference call in London. The starting price is derived from the over-the-counter and futures markets. Each bank then says how many gold bars it wishes to buy or sell including on behalf of its clients, and the price is moved up or down to reflect the net interest. It is based on transactions between their clients such as central banks and mining companies. The Gold Fix is determined at an equilibrium price where the gross amount of gold placed on buy orders nearly matches the gross amount of gold on sell orders across all of these participating banks. The significance - What does this mean, anyway?
The London Gold Fix plays a central role in the world`s trade in precious metals. The fixing price is based on actually executed trades, which provide a more accurate snapshot of the market than theoretical quotes. To quantify, in 2013 around $31 bn changed hands on an average daily totaling to about $372 bn trading on an annual basis during the fix.
The fixes are important because they provide a benchmark for mining companies to settle sales contracts and, more recently, to price such derivatives as exchange-traded funds. Even most central banks rely on the fix to put a price on their stock of gold bullion. Many retail outlets, such as coin dealers and gold jewellery manufacturers, across the globe also use the London gold fix to adjust their prices once a day.
In India, many bullion dealers / traders and jewelers use the gold fix to buy the gold from the banks for onward sales to retailers, consumers. Even the Gold Exchange traded funds use the Gold Fix price for valuation and trade purpose.
The word "FIX" provides some clue doesn`t it Watson?
Gold Fixing is an important price-setting mechanism which provides market users with the opportunity to buy and sell gold at a single quoted price. Despite all the acclamations, the `great flaw` of the gold fixing process is that the member banks trade on the information exchanged during the call with a possibility to manipulate the price of gold and gold derivatives before publication of the gold fix to the wider market. Participants on the London call can tell whether the price of gold is rising or falling within a minute or so, based on whether there are a large number of net buyers or sellers after the first round. Traders involved in this price-determining process have knowledge which, even for a short time, is superior to other people`s knowledge. The participants also can trade the metal and its derivatives on the spot market and exchanges during the calls could give some traders an unfair advantage when buying and selling the precious metal. It`s this feature that could allow dealers and others in receipt of the information to bet on the direction of the market with a high degree of certainty minutes before the fix is made public.
Two main issues concerning the gold fix relates to the fact that it is unregulated and that member banks can trade gold, and gold derivatives, during the call. This clearly raises questions surrounding transparency and thereby making it vulnerable to manipulation as there lays enough room for collusion of interests. What alleviates concerns is the fact that the four most powerful banks in the gold market are involved in setting the price for an item in which they themselves (for their clients or the bank itself) trade at the same time adding to orders that can really move the market.
The way ahead.
In recent months, authorities in the U.K. and elsewhere have been reviewing the gold and silver fixes. Separately, in May 2014, Barclays was fined £ 26 million by the U.K.`s Financial Conduct Authority after one of its traders manipulated the gold benchmark at the expense of a client.
The silver fix, which used a similar methodology involving just three banks, will change forever on Aug. 15 with the start of a new, electronic system provided jointly by CME Group Inc. and Thomson Reuters Corp. It would make sense for the gold fix to evolve in a similar way to the silver fix. That seems like a logical progression. The proposed silver fix is certainly a huge improvement in terms of transparency and breadth of market participants that can come on board and if we can get the same thing for gold it can only enhance the market. Any new methodology that evolves will have to pass the test of time before it gains credibility.
Regulators have focused on the precious metal benchmarks since the Libor interest rate-rigging scandal broke in 2012. Also, in response to the sniffing around by the regulators the owners of the London Gold Market Fixing have begun consultation on how the process can be improved and perhaps more transparent. This is part of the effort to make improvements before the EU legislation regarding financial benchmarks comes into play. Even if regulators find little evidence of manipulation, the benchmark is still outdated and wide-open to abuse, particularly due to the closed-curtain nature of the actual Fix meetings.
At least there seems to be a high probability that the Gold market will evolve for the benefit of all market participants and won`t remain a powerful ploy of the biggies. Time is about to be called on the near-century-old tradition of setting gold prices and mark the beginning of a vibrant, transparent and a fair gold market.
Data Source: Bloomberg, World Gold Council
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