Supply chain issues add to stagflationary winds

Waves of disruptions suggest that longer-term forces are in play

Mohamed El-Erian

Disrupted supply chains and labour shortages have resulted in empty shelves in some supermarkets in the UK © Bloomberg


Hearing that I was flying to the UK, a friend of mine sent me a picture of a partially empty supermarket shelf with a simple message: “You’ll be coming back to Soviet-era shelves.”

Unlike that era, however, this is not happening in a closed economy with inefficient state-run production protected by high tariff and quota walls. Nor is it UK specific.

It is due to supply disruptions faced by many countries. 

They will be with us for a while, complicating corporate and policy plans, and could undermine investments based on the ample liquidity injections from central banks that have pushed many markets ever higher.

The phenomenon in play is evident in macroeconomic data and corporate signals. Producer price inflation is soaring around the world.

Sizeable gaps have emerged between factory orders and output. 

Transportation costs from China to Europe and the US have risen seven to 10 times in the past year. 

More companies in more sectors are supply-constrained.

The culprit is some mix of disrupted supply chains, high transportation costs, container scarcity and congested ports. 

Labour shortages are also an issue, forcing companies in manufacturing and services to operate below capacity and with constant wage pressures. 

In the UK, the CBI has warned labour shortages may last up to two years.

Fewer chief executives have confidence that such disruptions are temporary and quickly reversible. 

This will restrain growth plans despite robust demand, and increase pressure to raise prices to offset higher costs.

Rather than a one-off dynamic, the global economy is experiencing waves of supply disruptions suggesting that longer-term forces are also in play. 

Yet some policymakers and market participants continue to assert that supply-demand imbalances are transitory, soon to be resolved by market forces. 

For support, they point to how lumber has reversed its big price rise.

Some reversible factors are indeed in play. 

Already, time has helped overcome some of the initial Covid-19 shock to the economy — a “sudden stop” more generalised than under the 2008 financial crisis. 

It is also not to deny that the latest Covid wave fuelled by the Delta coronavirus variant has temporary and reversible elements, such as the shutdown of ports in China and Vietnam. 

The same is true for destination ports, such as California’s Long Beach, where one chief executive characterised the bottleneck to me as being worse than last March’s Suez Canal blockage.

The key point is that such reversible factors are accompanied by supply side troubles that could last for one to two years, if not more. 

Already, their persistence is leading more companies to revise their supply chain management with a view to enhancing resilience, even at the cost of efficiency. 

But the beneficial longer-term mitigation effects of vendor/country diversification have short-term disruptions.

Labour market rigidities are also unlikely to pass anytime soon. 

Recent indicators suggest that the reopening of schools and, in the US, the termination of supplementary unemployment support are unlikely to lead to an immediate jump in labour force participation. 

This is despite record job openings. 

The longer this continues, the more companies adapt.

Added to inflation already in the pipeline, all this translates into stagflationary winds for the global economy that are unfamiliar to those that did not live through the 1970s. 

It is a scenario that more companies are putting front and centre in their planning. 

Yet too many policymakers and, therefore, market participants lag behind realities on the ground.

Having missed the window at the start of summer to taper the massive asset purchases implemented at the height of last year’s Covid shock, the Federal Reserve now risks a particularly difficult policy dilemma: having to lessen stimulus because of inflation consistently well above its target but hesitant to do so because of lower growth.

This could become an issue for many asset classes where valuations embody a considerable bet on the predictability and effectiveness of central bank support, including a monetary policy soft-landing in a Goldilocks economy that is not too hot or too cold.

The dominant structural theme post the financial crisis — that of deficient aggregate demand — has given way to frustrating supply rigidities. 

They are not going away any time soon. 

It is so much better for companies and policymakers to adjust now. 

Containing further disruptions is cheaper and easier than having to clean up the damage.


The writer is president of Queens’ College, Cambridge and an adviser to Allianz and Gramercy

Fed should prepare for autumn financial plumbing problem

Collateral chains are key to market liquidity, but credit conditions could tighten

John Dizard 

If any serious market instability does occur this autumn, the Federal Reserve will be in the spotlight © Bloomberg


Normally, if you are a senior Federal Reserve official, in past years you could look forward to the Kansas City Fed’s late August monetary symposium in Jackson Hole, Wyoming. 

There you could enjoy unbuttoned chats with peers while basking in the mountain air of the richest town in America.

Instead, this weekend’s Jackson Hole symposium will be a virtual affair partly due to the nasty effects of the Delta coronavirus variant causing a surge in Covid-19 cases.

The bankers might miss those mountainside moments of relaxation. 

Fed board members have plenty to worry about given that US stock prices are touching historical highs, just as inflationary pressures course through the economy. 

If any serious market instability does occur this autumn, the traditional season for financial disasters, the Fed will be in the spotlight.

I think the Jackson Hole party planners should have focused this meeting on some immediate monetary stability issues. 

Frankly, few will remember any worthy Fed comments about battling climate change. 

But what will the Fed do should the world’s financial plumbing start to rattle?

Already, there are some worrisome gurgles in the system. 

The Fed has concentrated on making sure US banks have lots of reserves on deposit in their accounts. 

Yet there are trillions of outstanding transactions around the world that are not, directly, funded by US bank lending. 

And these have been getting more expensive and uncertain in recent months.

The international monetary system increasingly depends upon the availability of collateral to back trillions of dollars in foreign exchange swaps or interest rate swap agreements. 

These support trade and investment. Regulators want any participants to guarantee their contract performance by pledging “pristine” assets, cash or equivalents not used elsewhere as collateral. 

Very often US Treasury bills are required, but also European governments’ short-term debt instruments or, occasionally, gold.

For the Fed, the most important source of liquidity are those reserves it has on deposit, or the nearly $1.4tn it holds in overnight reverse repurchase (reverse repo) agreements with, say, money market funds or banks. 

Reverse repos allow institutions to borrow using high-quality collateral, like US Treasury bills.

However, those reserves and reverse repos require an account at the Fed. 

They cannot be re-lent prior to maturity to earn fees and attract other business. 

That requires collateral such as Treasury bills.

These collateral chains provide a critical source of liquidity in international markets. 

Manmohan Singh, a financial collateral expert at the IMF, has researched this subject. 

The international liquidity provided by the relending of these pristine assets shrank dramatically after the 2008 financial crisis.

How much collateral is re-used within the system provides a measure. 

The world’s largest dealer-banks held $10tn of pledged collateral in 2007, while sourcing just $3.8tn from hedge funds and securities lending, for a re-use ratio of 3.0 times, according to Singh.

By 2016, that pledged figure had fallen to just $6.1tn compared with $3.3tn of collateral sourced, dropping the re-use ratio to 1.8 times. 

Fewer institutions trusted their counterparts to return this collateral, contributing to financial system deleveraging. 

Effectively, less credit was available.

Eventually, the mutual confidence returned. 

By the end of 2020 this re-use ratio had risen to 2.5 times, still below the heady days of 2007.

Unfortunately, we only get this trend data retrospectively. 

So we must infer what is going on today from market prices for Treasury bills and other popular sources of collateral.

But there is another complication. 

The publicly available supply of Treasury bills has declined. 

A debt ceiling imposed by the US Congress has limited issuance. 

Moreover, the Fed’s asset purchases and demand from major banks have also reduced supply. 

As an indication, yields on one-month Treasury bills have fallen this year.

This suggests more demand for pristine collateral. 

Though we do not have the data yet, the relending ratio may be contracting again as institutions worry more about counterparties, suggesting tightening credit conditions.

Market oddities, such as the August 10 gold price plunge, hint at system tension. 

Some gold market and central bank experts believe a sudden liquidation of gold collateral occurred when an institution could not provide enough Treasury bills.

I would suggest an extra agenda item for Jackson Hole. 

The Fed should commit to lending the market some of its holdings of $326bn of Treasury bills in the event of an autumn collateral shortage. 

That would provide some extra liquidity for the world’s financial plumbing. 

Life, the universe and everything

Physics seeks the future

Bye, bye, little Susy


A wise proverb suggests not putting all your eggs in one basket. 

Over recent decades, however, physicists have failed to follow that wisdom. 

The 20th century—and, indeed, the 19th before it—were periods of triumph for them. 

They transformed understanding of the material universe and thus people’s ability to manipulate the world around them. 

Modernity could not exist without the knowledge won by physicists over those two centuries.

In exchange, the world has given them expensive toys to play with. 

The most recent of these, the Large Hadron Collider (lhc), which occupies a 27km-circumference tunnel near Geneva and cost $6bn, opened for business in 2008. 

It quickly found a long-predicted elementary particle, the Higgs boson, that was a hangover from calculations done in the 1960s. 

It then embarked on its real purpose, to search for a phenomenon called Supersymmetry.

This theory, devised in the 1970s and known as Susy for short, is the all-containing basket into which particle physics’s eggs have until recently been placed. 

Of itself, it would eliminate many arbitrary mathematical assumptions needed for the proper working of what is known as the Standard Model of particle physics. 

But it is also the vanguard of a deeper hypothesis, string theory, which is intended to synthesise the Standard Model with Einstein’s general theory of relativity. 

Einstein’s theory explains gravity. 

The Standard Model explains the other three fundamental forces—electromagnetism and the weak and strong nuclear forces—and their associated particles. 

Both describe their particular provinces of reality well. 

But they do not connect together. 

String theory would connect them, and thus provide a so-called “theory of everything”.

String-driven things

String theory proposes that the universe is composed of minuscule objects which vibrate in the manner of the strings of a musical instrument. 

Like such strings, they have resonant frequencies and harmonics. 

These various vibrational modes, string theorists contend, correspond to various fundamental particles. 

Such particles include all of those already observed as part of the Standard Model, the further particles predicted by Susy, which posits that the Standard Model’s mathematical fragility will go away if each of that model’s particles has a heavier “supersymmetric” partner particle, or “sparticle”, and also particles called gravitons, which are needed to tie the force of gravity into any unified theory, but are not predicted by relativity.

But, no Susy, no string theory. 

And, 13 years after the lhc opened, no sparticles have shown up. 

Even two as-yet-unexplained results announced earlier this year (one from the lhc and one from a smaller machine) offer no evidence directly supporting Susy. 

Many physicists thus worry they have been on a wild-goose chase.

They have good reason to be nervous. 

String theory already comes with a disturbing conceptual price tag—that of adding six (or in one version seven) extra dimensions to the universe, over and above the four familiar ones (three of space and one of time). 

It also describes about 10{+500} possible universes, only one of which matches the universe in which human beings live. 

Accepting all that is challenging enough. 

Without Susy, though, string theory goes bananas. 

The number of dimensions balloons to 26. 

The theory also loses the ability to describe most of the Standard Model’s particles. 

And it implies the existence of weird stuff such as particles called tachyons that move faster than light and are thus incompatible with the theory of relativity. 

Without Susy, string theory thus looks pretty-much dead as a theory of everything. 

Which, if true, clears the field for non-string theories of everything.

The names of many of these do, it must be conceded, torture the English language. 

They include “causal dynamical triangulation”, “asymptotically safe gravity”, “loop quantum gravity” and the “amplituhedron formulation of quantum theory”. 

But at the moment the bookies’ favourite for unifying relativity and the Standard Model is something called “entropic gravity”.

Here be monsters

Entropy is a measure of a system’s disorder. 

Famously, the second law of thermodynamics asserts that it increases with time (ie, things have a tendency to get messier as they get older). 

What that has to do with a theory of gravity, let alone of everything, is not, perhaps, immediately obvious. 

But the link is black holes. 

These are objects which have such strong gravitational fields that even light cannot escape from them. 

They are predicted by the mathematics of general relativity. 

And even though Einstein remained sceptical about their actual existence until the day he died in 1955, subsequent observations have shown that they are indeed real. 

But they are not black.

In 1974 Stephen Hawking, of Cambridge University, showed that quantum effects at a black hole’s boundary allow it to radiate particles—especially photons, which are the particles of electromagnetic radiation, including light. 

This has peculiar consequences. 

Photons carry radiant heat, so something which emits them has a temperature. 

And, from its temperature and mass, it is possible to calculate a black hole’s entropy. 

This matters because, when all these variables are plugged into the first law of thermodynamics, which states that energy can be neither created nor destroyed, only transformed from one form (say, heat) into another (say, mechanical work), what pops out are Einstein’s equations of general relativity.

That relationship was discovered in 2010 by Erik Verlinde of Amsterdam University. 

It has serious implications. 

The laws of thermodynamics rely on statistical mechanics. 

They involve properties (temperature, entropy and so on) which emerge from probabilistic descriptions of the behaviour of the underlying particles involved. 

These are also the particles described by quantum mechanics, the mathematical theory which underpins the Standard Model. 

That Einstein’s equations can be rewritten thermodynamically implies that space and time are also emergent properties of this deeper microscopic picture. 

The existing forms of quantum mechanics and relativity thus do indeed both seem derivable in principle from some deeper theory that describes the underlying fabric of the universe.

String theory is not so derivable. Strings are not fundamental enough entities. 

But entropic gravity claims to describe the very nature of space and time—or, to use Einsteinian terminology, “spacetime”. 

It asserts this is woven from filaments of “quantum entanglement” linking every particle in the cosmos.

The idea of quantum entanglement, another phenomenon pooh-poohed by Einstein that turned out to be true, goes back to 1935. 

It is that the properties of two or more objects can be correlated (“entangled”) in a way which means they cannot be described independently. 

This leads to weird effects. 

In particular, it means that two entangled particles can appear to influence each other’s behaviour instantaneously even when they are far apart. 

Einstein dubbed this “spooky action at a distance”, because it seems to violate the premise of relativity theory that, in the speed of light, the universe has a speed limit.



As with black holes, Einstein did not live long enough to see himself proved wrong. 

Experiments have nevertheless shown he was. 

Entanglement is real, and does not violate relativity because although the influence of one particle on another can be instantaneous there is no way to use the effect to pass information faster than light-speed. 

And, in the past five years, Brian Swingle of Harvard University and Sean Carroll of the California Institute of Technology have begun building models of what Dr Verlinde’s ideas might mean in practice, using ideas from quantum information theory. 

Their approach employs bits of quantum information (so-called “qubits”) to stand in for the entangled particles. 

The result is a simple but informative analogue of spacetime.

Qubits, the quantum equivalent of classical bits—the ones and zeros on which regular computing is built—will be familiar to those who follow the field of quantum computing. 

They are the basis of quantum information theory. 

Two properties distinguish qubits from the regular sort. 

First, they can be placed in a state of “superposition”, representing both a one and a zero at the same time. 

Second, several qubits can become entangled. 

Together, these properties let quantum computers accomplish feats such as performing multiple calculations at once, or completing certain classes of calculation in a sensible amount of time, that are difficult or impossible for a regular computer.

And because of their entanglement qubits can also, according to Dr Swingle and Dr Carroll, be used as stand-ins for how reality works. 

More closely entangled qubits represent particles at points in spacetime that are closer together. 

So far, quantum computers being a work in progress, this modelling can be done only with mathematical representations of qubits. 

These do, though, seem to obey the equations of general relativity. 

That supports entropic-gravity-theory’s claims.

Put your analyst on danger money

All of this modelling puts entropic gravity in poll position to replace strings as the long-sought theory of everything. 

But the idea that spacetime is an emergent property of the universe rather than being fundamental to it has a disturbing consequence. 

It blurs the nature of causality.

In the picture built by entropic gravity, spacetime is a superposition of multiple states. 

It is this which muddies causality. 

The branch of maths that best describes spacetime is a form of geometry that has four axes at right angles to each other instead of the more familiar three. 

The fourth represents time, so, like the position of objects, the order of events in spacetime is determined geometrically. 

If different geometric arrangements are superposed, as entropic gravity requires, it can therefore sometimes happen that the statements “A causes B” and “B causes A” are both true.

This is not mere speculation. 

In 2016 Giulia Rubino of the University of Bristol, in England, constructed an experiment involving polarised photons and prisms which achieved exactly that. 

This spells trouble for those who have old-fashioned notions about causality’s nature.

However, Lucien Hardy of the Perimeter Institute, in Canada, has discovered a way to reformulate the laws of quantum mechanics to get around this. 

In his view, causality as commonly perceived is like data compression in computing: it is a concept that gives you more bang for your buck. 

With a little bit of information about the present, causality can infer a lot about the future—compressing the amount of information needed to capture the details of a physical system in time.

But causality, Dr Hardy thinks, may not be the only way to describe such correlations. 

Instead, he has invented a general method for building descriptions of the patterns in correlations from scratch. 

This method, which he calls “the causaloid framework”, tends to reproduce causality but it does not assume it, and he has used it to reformulate both quantum theory (in 2005) and general relativity (in 2016). 

Causaloid maths is not a theory of everything. But there is a good chance that if and when such a theory is found, causaloid principles will be needed to describe it, just as general relativity needed a geometry of four dimensions to describe spacetime.

Amplitude modulation

Entropic gravity has, then, a lot of heavy-duty conceptual work to back it up. 

But it is not the only candidate to replace string theory. 

Others jostling for attention include an old competitor called loop quantum gravity, originally proposed in 1994 by Carlo Rovelli, then at the University of Pittsburgh, and Lee Smolin, of the Perimeter Institute. 

This, and causal dynamical triangulation, a more recent but similar idea, suggest that spacetime is not the smooth fabric asserted by general relativity, but, rather, has a structure—either elementary loops or triangles, according to which of the two theories you support.

A third option, asymptotically safe gravity, goes back still further, to 1976. 

It was suggested by Steven Weinberg, one of the Standard Model’s chief architects. 

A natural way to develop a theory of quantum gravity is to add gravitons to the model. 

Unfortunately, this approach got nowhere, because when the interactions of these putative particles were calculated at higher energies, the maths seemed to become nonsensical. 

However, Weinberg, who died in July, argued that this apparent breakdown would go away (in maths speak, the calculations would be “asymptotically safe”) if sufficiently powerful machines were used to do the calculating. 

And, with the recent advent of supercomputers of such power, it looks, from early results, as if he might have been right.

One of the most intriguing competitors of entropic gravity, though, is the amplituhedron formulation of quantum theory. This was introduced in 2013 by Nima Arkani-Hamed of the Institute of Advanced Study at Princeton and Jaroslav Trnka of the University of California, Davis. They have found a class of geometric structures dubbed amplituhedrons, each of which encodes the details of a possible quantum interaction. These, in turn, are facets of a “master” amplituhedron that encodes every possible type of physical process. It is thus possible to reformulate all of quantum theory in terms of the amplituhedron.

Most attempts at a theory of everything try to fit gravity, which Einstein describes geometrically, into quantum theory, which does not rely on geometry in this way. 

The amplituhedron approach does the opposite, by suggesting that quantum theory is actually deeply geometric after all.

Better yet, the amplituhedron is not founded on notions of spacetime, or even statistical mechanics. 

Instead, these ideas emerge naturally from it. 

So, while the amplituhedron approach does not as yet offer a full theory of quantum gravity, it has opened up an intriguing path that may lead to one.


That space, time and even causality are emergent rather than fundamental properties of the cosmos are radical ideas. 

But this is the point. 

General relativity and quantum mechanics, the physics revolutions of the 20th century, were viewed as profound precisely because they overthrew common sense. 

To accept relativity meant abandoning a universal notion of time and space. 

To take quantum mechanics seriously meant getting comfortable with ideas like entanglement and superposition. 

Embracing entropic gravity or its alternatives will require similar feats of the imagination.

No theory, though, is worth a damn without data. 

That, after all, is the problem with Supersymmetry. 

Work like Dr Rubino’s points the way. 

But something out of a particle-physics laboratory would also be welcome. 

And, though their meaning is obscure, the past few months have indeed seen two experimentally induced cracks in the Standard Model.

On March 23rd a team from cern, the organisation that runs the lhc, reported an unexpected difference in behaviour between electrons and their heavier cousins, muons. 

These particles differ from one another in no known properties but their masses, so the Standard Model predicts that when other particles decay into them, the two should each be produced in equal numbers. 

But this appears not to be true. 

Interim results from the lhc suggest that a type of particle called a b-meson is more likely to decay into an electron than a muon. 

That suggests an as-yet-undescribed fundamental force is missing from the Standard Model. 

Then, on April 7th, Fermilab, America’s biggest particle-physics facility, announced the interim results of its own muon experiment, Muon g-2.

In the quantum world, there is no such thing as a perfect vacuum. 

Instead, a froth of particles constantly pops in and out of existence everywhere in spacetime. 

These are “virtual” rather than “real” particles—that is, they are transient fluctuations which emerge straight out of quantum uncertainty. 

But, although they are short-lived, during the brief periods of their existence they still have time to interact with more permanent sorts of matter. 

They are, for example, the source of the black-hole radiation predicted by Hawking.

The strengths of their interactions with types of matter more conventional than black holes are predicted by the Standard Model, and to test these predictions, Muon g-2 shoots muons in circles around a powerful superconducting magnetic-storage ring. 

The quantum froth changes the way the muons wobble, which detectors can pick up with incredible precision. 

The Muon g-2 experiment suggests that the interactions causing these wobbles are slightly stronger than the Standard Model predicts. 

If confirmed, this would mean the model is missing one or more elementary particles.

Cracks of dawn

There is a slim chance that these are the absent sparticles. 

If so, it is the supporters of supersymmetry who will have the last laugh. 

But nothing points in this direction and, having failed thus far to stand their ideas up, they are keeping sensibly quiet.

Whatever the causes of these two results, they do show that there is something out there which established explanations cannot account for. 

Similarly unexplained anomalies were starting points for both quantum theory and relativity. 

It looks possible, therefore, that what has seemed one of physics’s darkest periods is about to brighten into a new morning.

LBMA gets a lifeline

 By Alasdair Macleod


The draft PRA rules complying with Basel 3 regulations have now been issued six months ahead of their implementation to allow banks to adjust for them in time. 

From now, senior bankers, their lawyers and bank treasury managers will be planning amendments to their business strategies accordingly.

As a division of the Bank of England, the Prudential Regulation Authority recognises the importance of gold trading in London and has inserted a clause into the new rules (Article 428f) which will allow the LBMA’s centralised settlement system to continue to function. 

But in line with Basel 3’s apparent determination to get banking’s exposure to uneven derivative positions substantially reduced, net positions in precious metal derivatives in the form of forwards and swaps will be penalised through their inefficient use of balance sheet resources and will likely be replaced by transactions fully backed by physical gold.

The LBMA has been thrown a lifeline but will likely have to refocus from forward derivatives to physical bullion backed trading. 

By responding positively to these developments, the LBMA and its membership can retain and build on their pre-eminent position in global precious metals markets.

This article points out that the market value of forward derivatives in gold is currently the equivalent of 8,675 tonnes. 

While it would be incorrect to think it will all translate into new bullion demand, there is little doubt that if Basel 3 leads to the demise of the London forwards market, it will lead in turn to a significant replacement in the form of physical demand.

This article also looks at the broader picture for banking in the light of the PRA’s new regulations as well as the specifics for precious metal derivatives.

The background to Basel 3

Investors are increasingly aware that in all international financial centres, banks are now being required to run their businesses differently under the new Basel 3 regulations. 

For the first time, regulators are now telling banks how they must fund their assets out of their liabilities. 

This is a major change, which from the beginning of this month is being applied in the US and the EU. 

It is scheduled to be introduced in the UK from 1 January 2022.

The introduction of Basel 3 bank regulations follows an agreement at G20 level for the Basel Committee on Banking Supervision to draw up new regulations to address the systemic risk issues exposed by the Lehman failure in 2008. 

The new regulations proved controversial, delaying their introduction, having been finalised as long ago as October 2014. 

But, unlike rules originating from national regulators Basel 3 was not easily spiked by lawyers representing the banking industry’s interests.

The changes, particularly those that disqualify unstable short-term funding on the liability side of a bank’s balance sheet from providing cover for anything on the asset side, are intended to reform banking practices from the ground up. 

Since the 1980s, after the repeal of the US’s Glass-Stegall Act which separated commercial from investment banking, banks have grown their balance sheets into purely financial activities and proportionately away from the creation of bank credit to finance non-financial businesses. 

Non-financial businesses have been increasingly directed into bond and equity markets, where banks can charge large fees without having to worry about counterparty risk.

There are worrying signs that commercial banking for the big international banks has gone about as far as it can with financialisation and has become increasingly reliant on higher gearing for diminishing margins. 

Consequently, many aspects of financial activity are targeted and adversely affected by the new Basel rules. 

A bank like Goldman Sachs with its reliance on large customer deposits is treated unfavourably compared with a bank substantially funded by retail deposits and deposits of small businesses. 

And Goldman reportedly has very recently reduced its holdings of equity investments, treated unfavourably with a required stable funding factor set at 85%, the same as gold. 

While market traders might observe these moves as indicating Goldman has turned bearish on equities, it may have more to do with responding to the US regulator’s version of Basel 3.[i] 

If so, it could be a warning of a similar effect on trading in precious metals

As well as uneven trading books and related liabilities being penalised, derivatives appear to be a target for containment, with a global notional value of over-the-counter (OTC) contracts of $582 trillion recorded by the Bank for International Settlements last December. 

And this is after the introduction of counterparty netting agreements following the Lehman failure, whereby multiple transactions between pairs of counterparties in the same contracts were reduced to a far lower net figure by mutual written agreements.

Last December, these OTC contracts had a gross market value of $15.8 trillion, indicating a 36:1 gearing relationship with their notional value. 

And that is on top of bank balance sheets which are in turn geared, with assets anything up to 30 times balance sheet equity in the case of Eurozone banks. 

Not much has to go wrong for the BIS and its Basel Committee to have failed in their quest to make banks systemically safe.

How derivatives are financed is a key focus of the new regulations. 

The Basel 3 approach is to disqualify their financing with ephemeral deposits. 

But it goes much further. Short-term funding, other than from smaller deposits, is penalised. 

It would appear that unallocated precious metal customer accounts, because of their nature being a bank’s liability not valued in its accounting currency and by not being specifically mentioned as an allowable exception, default to an ASF of zero.

A confusing response from the LBMA

On the asset side of bank balance sheets, according to Article 428az derivatives net short or long require a 100% RSF. 

However, in a statement released yesterday, the LBMA claimed that gross derivative liabilities attract a 5% RSF, which seems bizarre because if that was true physical gold would be rated substantially riskier than its derivatives[ii]. 

Furthermore, a derivative liability is a derivative that is sold. 

A buyer, who records it as an asset at fair value, under the new regulations would have to treat it as subject to a 100% RSF, resulting in two different treatments, rendering this interpretation appear illogical.

According to Article 428at, what the LBMA actually refers to applies to a collateralised derivative position where the value of the derivative is negative, and being subject to Article $428da, relates to positions of qualifying central counterparties as opposed to a bank’s on-balance sheet derivatives.

This confusion followed the LBMA’s letter to the PRA during the latter’s consultation period on the new Basel 3 regulations, where the LBMA omitted to mention anywhere that unallocated gold was not physical gold but an OTC derivative of it, as defined by the Bank for International Settlements itself. 

By claiming that “gross derivative liabilities will also attract a 5% RSF”, perhaps it is now hoping an escape from the 85% RSF accorded to physical precious metals in an admission that forwards beyond a normal settlement cycle are in fact derivatives.

Discounting the LBMA’s initial take on the PRA rules, it was up against this unyielding brick wall that, with its unallocated gold market masquerading as bullion, the London Bullion Market Association found itself trapped.

Within precious metals markets there have been numerous comments and opinions as to the likely consequences of Basel 3. 

But there is general agreement that any discouragement given to bullion banks with respect to their position-taking would make precious metals prices more volatile. 

Subject to how these regulations would be treated by the UK bank regulator (the PRA), it was clear that the LBMA was extremely concerned for its future, and particularly for its settlement system.

With the publication of draft rules to be implemented next January, most of that uncertainly is now lifted, but clearly there are differences of opinion remaining. In an attempt to narrow these down, we shall now turn to the relevant passages in the new PRA rules

The new rulebook

The Prudential Regulatory Authority released its new draft rulebook last week, updated for Basel 3, which will become effective in January 2022.[iii] 

It is over-stamped by the PRA as near final, so we can assume that it will be the final version for all intents and purposes. 

It has been released at this time so that banks know in advance what changes to their treasury management and regulatory reporting will be required in six months’ time.

The application of Basel 3’s net stable funding ratio method to gold and other commodities generally accords with the Basel regulations, with one important addition. 

Article 428f concerns interdependent assets and liabilities, introduced so that the current and future owners of the London Precious Metal Clearing Limited (LPMCL) can continue to operate without having to suffer the penalties of the net stable funding ratio (NSFR). 

It also allows banks to use physical gold in a bank’s possession to offset customer liabilities (Paragraph 2).

The full rule, which is central to the LBMA’s future, is as follows:

“1. An institution may apply to the competent authority for permission to treat an asset and a liability as interdependent. 

For the purpose of this Article, an asset and a liability are interdependent where either conditions (a) to (f) below are met or where paragraph 2 applies:

(a) the institution acts solely as a pass-through unit to channel the funding from the liability into the corresponding interdependent asset;

(b) the individual interdependent assets and liabilities are clearly identifiable and have the same principal amount;

(c) the asset and interdependent liability have matched maturities;

(d) the interdependent liability has been requested pursuant to a legal, regulatory or contractual commitment and is not used to fund other assets;

(e) the principal payment flows from the asset are not used for other purposes than repaying the interdependent liability; and

(f) the counterparties for each pair of interdependent assets and liabilities are not the same.”

[Article 428f (1) above permits the operation of LPMCL and its owners to continue as before after the introduction of Basel 3’s NSFR rules, subject to the PRA granting permission to each of the owner banks.]

“2. This paragraph applies to an institution's unencumbered physical stock of precious metals and customer deposit accounts in precious metals where all of the following conditions are met:

(a) the institution’s unencumbered physical stock of each precious metal is used to cover customer deposit accounts in the same precious metal;

(b) the institution is not exposed to liquidity or market risk resulting from either the sale of precious metals by the customer or the physical settlement of customer transactions in precious metals; and

(c) the precious metals assets and liabilities are on the balance sheet of the institution.

For the purpose of paragraph 2:

(a) precious metals means gold, silver, platinum or palladium;

(b) the interdependent asset and liability treatment shall only be available to the extent that the institution's unencumbered physical stock of each precious metal is matched by customer deposits of the same precious metal.

Any excess physical stock or customer deposits in a precious metal shall not be treated as an interdependent asset or liability for the purpose of paragraph 1;

(c) an institution’s precious metals accounts at any other institution shall not be considered a part of the institution’s physical stock of precious metals.”

[Paragraph 2&3 allows any bank to offset an unallocated customer liability with physical bullion, so long as it is in that bank’s allocated possession and on its balance sheet]

It will assist the reader to understand Article 428f (1) if the function of the LPMCL is briefly explained. 

LPMCL is a not-for-profit entity acting as a central clearing system for LBMA members. 

It is owned and operated by four London-based clearing LBMA members: HSBC, ICBC Standard Bank, JPMorgan and UBS, settling loco-London allocated and unallocated metal trades.

Unallocated trades, forming a large majority of settlements, are netted off, first by individual LPMCL members on behalf of their clients, other LBMA members and on their own books, and then the centralised LPMCL settlement system (AURUM) settles the remaining differences between the four LPMCL members. 

Deliveries of physical metal occur within the system but form a small minority of transactions. 

Except where an unallocated trade is settled by delivery, all unallocated trades naturally cancel each other out.

The four LBMA members owning LPMCL operate a physical float as part of their management of these trades. 

It can therefore be appreciated that unless Article 428f (1) had been added to the PRA regulations the LPMCL clearing system would have almost certainly ceased to function.

Paragraphs 2 and 3 of this Article are also important, permitting banks to offer unallocated accounts without a balance sheet penalty so long as they are fully covered by deliverable physical bullion on the bank’s balance sheet. 

It allows a bank to continue to offer the considerable convenience of an unallocated account without balance sheet penalties. 

Rather than withdrawing from offering customers any gold market facilities other than pure custody, it will permit LBMA members to continue to offer precious metal accounts on a pooled basis.

But instead of matching unallocated client accounts with unallocated or other derivative assets, banks will be encouraged through balance sheet incentives to acquire physical bullion to provide the service. 

While it should make bullion banks a safer systemic proposition for their customers — the objective of the Basel 3 exercise — it should be noted that unallocated accounts will continue to bear counterparty risk.

This could have a significant impact on the prices of precious metals because LBMA statistics show that the combined weekly turnover in gold, silver, platinum, and palladium totals $357bn between members alone. 

But from an attempt in 2011 by the LBMA to collect turnover statistics (which was abandoned) it appears that transactions between LBMA members and their non-member customers could be about five times greater. 

This must represent an ongoing and significant line of business interest, unlikely to be simply abandoned.[iv]

Article 428f (2 and 3) referred to above appears to offer a lifeline to the LBMA, which can continue to have an important and active role in precious metal markets. 

However, the market for forward transactions beyond a normal settlement cycle is likely to become significantly restricted or even end because of the balance sheet penalties of running uneven derivative positions. 

With bullion banks likely to restrict taking uneven trading positions for their own accounts, derivative supply will be withdrawn from the market and replaced by physical demand instead.

The interest cost penalty for buying physical bullion to replace unallocated derivatives is for the moment minimal because of current interest rate levels for reporting currencies. 

Instead of unallocated customer accounts being offered for free, they might suffer a small charge, perhaps 10—20 basis points, an annual maintenance cost that might drive some marginal trading business away. 

But London should continue to see good demand, some of which might even be diverted from ETFs whose expense ratios are considerably higher.[v]

By significantly reducing counterparty risk for bullion bank customers while giving them a continuing facility, the PRA’s inclusion of Article 428f is a sensible addition to the proposed regulations.

Discouraging derivative exposure

The task set for Basel 3 was to de-risk the global banking system, with a significant danger detected in uneven derivative positions. 

When Basel 3 was being formulated, uppermost in regulators’ minds would have been the failure of AIG and the potential domino effect on the global banking system. 

What would have concerned the Basel Committee was the possibility that a deteriorating derivative position in the future could recur, and large corporate deposits flee from affected banks in search of safety. 

Clearly, the issue of systemic risk demanded separate treatment for derivative positions, and it is this that, among other funding issues, the net stable funding ratio addresses (NSFR).

The NSFR is available stable funding (ASF) divided by required stable funding (RSF) and must always be maintained at one or more. 

ASF is applied to a bank’s liabilities (i.e., its sources of funding) and different categories of liability have different ASF factors. 

Under Article 428k, unless specified otherwise in Articles 428l to 428o, all liabilities without a stated maturity are assigned a 0% ASF factor, which means they cannot be used for funding any of a bank’s assets. 

For bullion banks, this refers to customers’ unallocated metal deposit accounts. 

There is no mention in Articles 428l to 428o of customer accounts tied to precious metal or commodity prices, so we must assume that the intention is for them to have a zero ASF.

Now we must consider the RSF, which is the denominator in the NSFR equation. 

It determines how much ASF is needed to fund different categories of banking assets.

Under Article 428ag (g), an 85% RSF, the apportionment of ASF, is required for “physically traded commodities, including gold but excluding commodity derivatives.” 

The exception is for physical metal held specifically to hedge customer unallocated accounts in their entirety under Article 428f covering interdependent assets, referred to above, in which case both sides come out of the NSFR calculation.

Otherwise, physically traded gold and other commodities require 85% RSF, it appears without any matching deposit funding from the ASF side. 

And as discussed above, other than for central clearing purposes, commodity derivatives require a 100% RSF.

To summarise so far, this means that 85% of the funding for gold and commodity contracts, including other precious metals, is to be allocated from unrelated but more stable liabilities, and for derivatives 100% of stable funding is required. 

The issue that now needs clarification is whether the PRA regards a forward contract with a settlement date to deliver gold or silver beyond a normal settlement cycle as a derivative. 

The Basel Committee includes forward contracts and swaps in its derivative statistics, so despite the LBMA’s misleading representations to the contrary, we can safely assume that the PRA will take them to be derivatives as well.[vi]

Further implications for banks and precious metals

By the addition of Article 428f, the LBMA in London has a future, albeit a different one. 

In effect, the Bank of England is saying, “You can have your settlement engine and your banking members can continue to trade precious metals, instead of derivatives”. 

It is the best result the LBMA could hope for, and it is a more stable future from which it will ultimately benefit.

There can be little doubt that in the general retreat out of derivatives some banking members will throw in the towel on precious metals trading. 

But there is still a market for gold dealing, which is to be satisfied by banks holding physical bullion to cover unallocated customer accounts. 

The potential size of this market is difficult to assess, but we can make a provisional estimate.

We know from a previous attempt to quantify trading between LBMA members and non-members, which we can take as public demand for loco-London trading, that it was in the region of five times daily settlements between LBMA members. 

But we need to know the value of outstanding forward settlement contracts, for which figures are not available from the LBMA. 

But the BIS estimate of gold forwards and swaps, the large majority of which is LBMA transactions, was $530bn at end-December 2020, a relatively stable figure similarly recorded at preceding half years. 

At current prices, that is the equivalent of 8,675 tonnes. 

How much of that will emigrate from forwards and swaps to physical bullion is difficult to estimate, but it can be expected to be determined by the following factors:

- The number of LBMA banks and non-banks offering physically backed gold and silver account facilities, and therefore the competition to market new bullion-based services.

- The availability of physical bullion to satisfy extra demand resulting from rule changes.

- The price effect of extra bullion demand, and whether a rising price creates a bandwagon effect.

- The expense of maintaining physically backed customer accounts, and therefore the likely charges, compared with generally charge-free unallocated accounts and allocated custodial services.

- The outlook for the gold price relative to the dollar and other major fiat currencies.

That there will be a market for a bullion-based service we can be sure. 

It probably explains why Chinese-owned ICBC Standard Bank, one of the four LPMCL shareholders, acquired Barclay’s new mega-vault in mid-2016, having taken a lease on Deutsche Bank’s London vault six months earlier. 

Even without knowledge of the new PRA rules, the bank would have been able to work out the consequences of Basel 3 for the London forward market and anticipated its replacement with dealing in physical bullion.

The broader implications of the PRA’s rule changes

Both Basel 3 and the PRA’s interpretation of the role of commercial banks are consistent with the view that banks operate as intermediaries between depositors and their operations. 

This is not, in fact, the case. 

As I explained in last week’s Goldmoney Insight, through the process of double-entry book-keeping bank deposits are created as a direct consequence of the expansion of bank credit. 

And while some deposits are added to by customers transferring credits from other banks, these nearly always owe their origin to bank credit creation as well.

By permitting banks to manage the relationship between assets and liabilities before Basel 3, bank regulation has not usually challenged established banking law and practice. 

The NSFR regime might seem to ensure funding mismatches are lessened, but the reality is new mismatches are created because the funding of an asset can no longer be tied to an offsetting deposit. 

The double-entry system will continue, that is for sure.

But on the face of it, having expanded balance sheet capacity almost to its limits, the global banking system will now be in retreat. 

Derivatives and commodity trading positions are discouraged and are set to decline. 

Even market-making in equities will be hampered. 

It means that for banks their time horizons will contract because the risks they are accustomed to offsetting with derivatives can no longer be hedged as efficiently. 

It will affect all aspects of banking business, potentially drawing a close to fixed long-term low-interest loans, such as mortgages and car finance.

It is tempting to think that the Basel Committee has an ulterior motive behind driving banks out of financial activities. 

Perhaps the BIS’s role in coordinating central banking development of crypto currencies satisfies an ambition to side-line commercial banks entirely, and Basel 3’s introduction is a step in that common direction. 

But we have little evidence of this joined-up thinking.

Nevertheless, commercial banks are being side-lined in some jurisdictions. 

In the EU we see the global systemically important banks — the G-SIBs, now as primarily tools for absorbing government debt. 

In the US and UK they have become intermediaries for distributing QE to investing institutions, because the investing institutions do not have accounts with the central bank. 

It will be a small step for them to do so, as is already the case in the US reverse repo market with money funds. 

The same appears to be true of the Japanese banking system, and China’s banks under government ownership are slavishly carrying out government monetary and economic policies.

Only the smaller banks seem to have a focus on banking’s traditional business, the financing of local non-financial businesses, the SMEs that make up the bulk of any country’s GDP. 

Networks of smaller banks and credit unions with their fingers on the local business pulse go along with economic success, for example in Germany. 

But national regulators seem keen for them to be merged out of existence. 

These are all straws in the wind, which individually seem unimportant, but can easily lead to the impression that for banks the best times are now over.


[i] See https://www.zerohedge.com/markets/goldman-has-aggressively-and-quietly-liquidated-quarter-its-equity-investments

[ii] See https://www.lbma.org.uk/articles/net-stable-funding-ratio-update-1?_cldee=YWxhc2RhaXIubWFjbGVvZEBnb2xkbW9uZXkuY29t&recipientid=contact-8e7ffa95f4cae81180e3005056b11ceb-755a73fdedc34b3287ba8725b4ccde79&utm_source=ClickDimensions&utm_medium=email&utm_campaign=LBMA%20Weekly%20-%20Non%20Member&esid=294ab02b-afe4-eb11-8106-005056b11ceb

[iii] See PRA Rulebook (CRR) Instrument 2021 at https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/policy-statement/2021/july/ps1721app1.pdf?la=en&hash=4F9123529EADC488AAF6151AF453DE7D5FF3430C

[iv] See Open Letter to LBMA Board of Directors by Paul Mylchreest, Hardman & Co, January 2020, page 33.

[v] LBMA members currently offer custodial services, and I understand that for the largest customers these can be as low as 8 basis points. With LBMA banks no longer profiting from gold derivative turnover, custody rates including vaulting are likely to rise. Whether LBMA customer business remains on-balance sheet or migrates to custodial services remains to be seen.

[vi] See https://cdn.lbma.org.uk/downloads/Pages/NSFR-PRA-Letter-final_signed-20210504.pdf . In this submission jointly signed by the World Gold Council unallocated gold was presented solely as a convenient means of gold dealing, and nowhere was the reader informed that the BIS regarded forwards as derivatives. This is an important misrepresentation because gold and physical commodities outside a normal settlement cycle is covered by different rules in Basel 3. 

A Dose of Eurorealism

Europe must not reject complacency by embracing declinism. Rather than resigning themselves to inevitable decline, Europeans should recognize and celebrate Europe's strengths, recognizing that its greatness consists in its being greater than the sum of its parts.

Javier Solana


MADRID – The narrative is becoming a trope: the United States and China are locked in a battle for global supremacy in myriad fields such as technology, commerce, defense, cyberspace, and even outer space. 

Few pundits question the general consensus that Sino-American relations will shape the history of the twenty-first century. 

But analyzing today’s geopolitical scene as a byproduct of a two-horse race is utterly simplistic and antiquated.

Our world is better described not in black and white, but as a kaleidoscope of shifting patterns. 

One key source of color is the European Union. In the current international environment, the EU is less noticed than it should be, but more noticed than it thinks.

True, Europe lags behind the US and China in developing strategic technologies such as semiconductors and quantum computing. 

When the EU addresses the rest of the world, it often sounds more like a cacophony than a symphony. The rare harmonious choruses are frequently muffled. 

And many of the bloc’s citizens, perhaps recalling a time when Europe was home to the world’s undisputed great powers, now tend to disdain the EU’s contributions and belittle its room for maneuver.

But we Europeans should give ourselves more credit. 

Even skeptics must recognize that, at the very least, we have established a single market whose regulation depends exclusively on EU institutions. 

But while the EU’s commercial impact should therefore be measured in aggregate form, traditional analytical frameworks give primacy to states. 

This approach, together with the Sino-American “trade war,” has led us to exaggerate the economic weight of the US and China, to Europe’s detriment.

So, let’s look at the facts. 

The EU is the world’s largest merchandise exporter, and the second-largest importer (slightly behind the US). 

In services, Europe leads in terms of both exports and imports. 

Furthermore, the EU rubs shoulders with the US, and is far ahead of China, as both a provider and recipient of foreign direct investment (excluding investments among member states). 

And when it comes to official development assistance, the EU has a clear lead, boasting a collective total more than double that of the US.

One common criticism of the EU is that it lacks “hard power.” 

There is some truth to this. After all, the EU was never intended to be a military alliance; it is not NATO. 

The Afghan debacle underlines the need to build up Europe’s military capabilities, which remain far too fragmented and dependent on the US. 

But they are by no means irrelevant, as evidenced by our numerous deployments abroad.

Moreover, we should not overlook the economic dimension of hard power. 

Collectively, it is the EU, not China, that has the world’s second-largest economy, in nominal terms. 

Add to that its trade and investment ties, and the EU has little to envy in its competitors.

As for the “soft power” of attraction and persuasion, it may appear too ethereal to matter in a global context marked by stark geopolitical tensions. 

But soft power reflects the political, social, and economic trends that determine the short- and long-term performance of any country or bloc. 

Here, too, the EU looks to be in good shape.

The Soft Power 30 index assesses countries according to six categories: cultural reach and appeal, digital infrastructure and capabilities in digital diplomacy, human capital and educational attractiveness, business friendliness and capacity for innovation, diplomatic network, and the quality of political institutions. 

By this measure, five of the world’s top ten countries – and 16 of the top 30 – are EU members. 

The US ranks fifth, and China 27th.

That was in 2019, when the list was last compiled. 

Today, the same index would surely assign greater weight to public health. 

And while the EU, with its first-rate health systems, has suffered more than expected from the COVID-19 pandemic, its vaccination campaign is proceeding apace.

Despite a slow start, the vaccination rate in the bloc’s four most populous countries – Germany, France, Italy, and Spain – has now surpassed that of the US. 

And Europe’s commitments to supply vaccines to the rest of the world are becoming more ambitious. 

Add to that the massive COVID-19 joint recovery fund, and the EU’s pandemic performance begins to look more respectable.

The EU is also demonstrating global leadership in other crucial areas, particularly the green transition. 

Long at the forefront of environmental regulation, the European Commission has now announced the so-called Fit for 55, a strategy for reducing greenhouse-gas emissions by 55% by 2030 (compared to 1990 levels). 

If adopted, this will most likely shape rules and standards in the rest of the world, via what Columbia University’s Anu Bradford has dubbed the “Brussels effect.”

This effect exemplifies the EU’s modus operandi: operating behind the scenes to make change that is felt, if not necessarily seen. 

Though Europe continues to occupy a vulnerable position in certain global supply chains, and though we have neglected some conflicts that affect us directly (such as in Syria and Libya), its impact is far from negligible.

The world tends to appreciate – albeit quietly – the EU’s influence, because it is generally based on incentives, rather than sanctions. 

Moreover, its influence stems from a multilateral and cooperative approach. 

And its influence breaks the Sino-American contest’s stifling grip on the global system.

Europeans must not reject complacency by embracing declinism, but rather by conducting a level-headed assessment of our strengths and weaknesses. 

As our athletes’ brilliant performance at this summer’s Tokyo Olympics should remind us, Europe remains a force to be reckoned with. 

And if we are to further secure our global standing, we must learn to live by the following maxim: the EU is greater than the sum of its parts.


Javier Solana, a former EU high representative for foreign affairs and security policy, secretary-general of NATO, and foreign minister of Spain, is President of EsadeGeo – Center for Global Economy and Geopolitics and Distinguished Fellow at the Brookings Institution.