China's Gilded Age Is Over

By John Mauldin

Historical comparisons are always risky. 

This is particularly so when comparing different eras in vastly different countries like the US and China. 

Similarities can actually obscure more important differences.

Nevertheless, familiar knowledge can help build a framework for understanding. 

Obviously, present-day China is radically unlike any point in US history. 

But with that caveat, it bears some striking similarities to one part of our past. 

Today we’ll look at that period and see what it can tell us about China under Xi Jinping.

As I mentioned last week in Xi’s Changing Plan, China could be an economic partner as well as competitor, cooperating in ways that benefit its own people and the entire world. 

And while both our economies are bound together, that doesn’t seem to be the Chinese goal anymore, if it ever was. 

The US side clearly thought China would become more capitalistic and open as it became more prosperous and entrepreneurial.

This has important investment consequences you need to understand. 

We’ll start with some US history and the see how China’s course may be both similar and sharply different.

Pendulum Swing

The US hasn’t always been the world’s dominant economy. Our first step in that direction may have been after the Civil War in what is now called the “Gilded Age.” Here is how Wikipedia describes that time.

In United States history, the Gilded Age was an era that occurred during the late 19th century, from the 1870s to about 1900. The Gilded Age was an era of rapid economic growth, especially in the Northern and Western United States.

As American wages grew much higher than those in Europe, especially for skilled workers, and industrialization demanded an ever-increasing unskilled labor force, the period saw an influx of millions of European immigrants. The rapid expansion of industrialization led to a real wage growth of 60% [JM comment: this period was one of the longest periods of outright deflation in US history, thus the emphasis in this article on “real” wage growth], between 1860 and 1890, and spread across the ever-increasing labor force. The average annual wage per industrial worker (including men, women, and children) rose from $380 in 1880, to $564 in 1890, a gain of 48%.

Conversely, the Gilded Age was also an era of abject poverty and inequality, as millions of immigrants—many from impoverished regions—poured into the United States, and the high concentration of wealth became more visible and contentious.

Thirty or so years of rapid economic growth brought many changes to the US. You could say the same of the last 30 or so years in China. In both cases, occasional crises popped up but subsided. The growth was uneven, too.

In the US example, large monopolistic trusts developed in railroads, steel, oil, and other key industries, facilitated by corrupt politics. Wealthy tycoons built giant mansions and summer homes in Newport, Rhode Island, to popular acclaim as well as criticism. Again, we see similarities in China’s recent past.

The pendulum eventually swings to correct such excesses. Around 1900, the Gilded Age gave way to a “Progressive Era.” 

From the Wikipedia entry…

The Progressive Era (1896–1932) was a period of widespread social activism and political reform across the United States of America that spanned the 1890s to the 1920s. 

Progressive reformers were typically middle-class society women or Christian ministers.

The main objectives of the Progressive movement were addressing problems caused by industrialization, urbanization, immigration, and political corruption. 

Social reformers were primarily middle-class citizens who targeted political machines and their bosses. 

By taking down these corrupt representatives in office, a further means of direct democracy would be established.

They also sought regulation of monopolies through methods such as trustbusting and corporations through antitrust laws, which were seen as a way to promote equal competition for the advantage of legitimate competitors. 

They also advocated for new government roles and regulations, and new agencies to carry out those roles, such as the FDA.

The president most associated with that time is Theodore Roosevelt, who took office in 1901 following the McKinley assassination. 

His domestic agenda promised a “Square Deal” for average citizens, breakup of the powerful business trusts, environmental conservation and safe food and drugs—all understandably popular policies, given the prevailing mood. 

(What is it with politicians and “deals?” FDR’s New Deal? The Green New Deal?)

Xi Jinping is certainly no Roosevelt (though they seemingly share a similar resolve when facing problems), but he’s facing a similar time in China. 

His country had its own kind of Gilded Age, beginning back in the 1980s and extending into the 2010s and 2020, until Xi began to crack down.

In hindsight, the images we saw in those years—futuristic cities, gleaming railways, giant IPOs, and all the rest—now look like “Peak China.” 

That period’s excesses set up an inevitable backlash. 

I don’t think Xi caused this frustration. 

Like all national leaders, he is largely captive to circumstances. 

But he can control the response, and it looks more than passingly similar to the US Progressive Era: anti-corruption, anti-corporate, and pro-consumer.

You can try to achieve those through gentle persuasion or autocratic decrees. 

Xi is choosing the latter, so I suspect it won’t go as smoothly or end as well as it did in the US a century ago. 

And our own transition was more than a little bumpy, even if voters fueled it.

Xi’s crackdown on successful technology and other companies is basically telling entrepreneurs to be careful about getting too big. 

This is a monster experiment in changing the human entrepreneurial equation. 

Xi needs entrepreneurs to drive the Chinese economy forward. 

But moving away from Deng Xiaoping’s “Some must get rich first” will certainly change how entrepreneurs run their businesses. 

Maybe it will work but it does give credence to the concept of “Peak China.”

Falling Dominoes

As investors, we have to consider both what will happen and when it will happen. 

Long-term benefits won’t matter if short-term risks take you out of the game first. 

But taking steps to endure the short-term can help you stay around long enough to reap bigger rewards. 

So let’s consider the near future, then come back to the longer-range outlook.

Property developer Evergrande is the top-of-mind concern right now. 

Its business risks are largely confined to China; the fear is more about possible financial contagion, which could extend outside China to foreign investors and lenders. 

Non-Chinese debt is around $20 billion and will likely be written off. 

While painful to the institutions involved, the debt is manageable.

How might a contagion unfold? 

Here’s one scenario, outlined by my friends at The London Brief, in which Evergrande is the first domino of something worse.

Domino 2: Companies Similar to Evergrande. 

A significant number of companies are borrowing above 20% rates and can no longer fund from the dollar funding market. 

These companies can either default, they can try to sell assets, they can go to government banks to borrow money (but this route is currently closed until January) or they can go to the government. 

Today there are 35 “significant” companies, as per the strategist’s definition, and 13 are saying in the dollar funding market that they should not be refinanced. 

This is like the sub-prime equivalent; one has gone down, and the others are feeling the knock-on effect. 

These companies are 12.5% of the current market cap of the property sector. 

The amount of market cap that has been lost is $250 billion and including Evergrande is $500 billion to give some scale of numbers.  

Sidebar: In the late 1970s I borrowed money at 18% to buy literal train carloads of paper. 

I could afford it because paper costs were rising faster than 18% and there were actual shortages. 

The only way to ensure I had paper for my publishing business was to store well in advance. 

When property developers are borrowing money at 20% and inflation is much less than 5% that tends to indicate the housing markets are overheated.

Note below that prior to the Great Recession, first-time homebuyers were roughly 70% of the Chinese market. 

Today it looks like 15%. 

Now 85% of homes are bought by people who already have one or more homes. 

Just like Dave Portnoy, they believe that home prices can only go in one direction: UP!!! 

This is rampant speculation and while it is not subprime in the sense that these people are actually investing their savings in the second property, it is speculation nonetheless. 

Unless the Chinese government changes its current policy, there is going to be a serious revaluation of home prices in China, as many of these homes are empty and are out of the price range for new homebuyers.

Source: Financial Times

Domino 3: Minsheng Bank. 

In 2008, Bear Stearns imploded due to subprime debt. Citigroup is watching Minsheng Bank, which has lost over half of its market cap over the last few months. 

It is currently modelling a 20% probability of default. 

It could create contagion effects within the banking system.  

Sidebar: We think of Evergrande as a large company. 

It is dwarfed by the size of Chinese banks, many of which have large loans to the real estate market as a percentage of their assets. 

Thus, we come to the next Domino.

Domino 4: Small Banks. 

There are numerous banks in China that are very similar to Northern Rock, a small bank in the UK which imploded due to its exposure to subprime debt and a balance sheet that was wrong-sized. 

These banks have low transparency but create exposure to larger banks and insurers. 

If more property developers go supernova these banks are vulnerable.  

Domino 5: Ping An. 

This is a private insurer with a lot of problems. 

They own a property company called China Fortune Land. 5% of the investment portfolio is leveraged 10X. 

The CEO and company are under regulatory investigations. 

They issued wealth management products for Hong Kong tech shares. 

These have been sold to millions of people across the investor base of Ping An. 

They could see their savings wiped out and China may force Ping An to make them whole. 

Ping An is systemically important. 

The dollar bonds only widened out 40 bps last week, but it shows the market knows there is a problem. [There is never just one cockroach.]

Domino 6: The Equity Market. 

There are $300 billion worth of margin loans. 

If an insurer like Ping An went into stress, there could be more share selling on other banks creating a cascading impact that triggers margin calls.

Domino 7: Big Banks. 

ICBC and other systemic banks interface with international markets. 

Their equity prices could plummet and their CDS [Credit Default Swaps] could widen. 

Regulators and the banks have been assessing their risk exposures optimistically much like Morgan Stanley and other large US banks did during the subprime crisis.

Domino 8: The Credit Market. 

If China bank CDS blows out everything else blows out too and credit contracts dramatically. 

With $50 trillion of bank assets, that’s a lot of contraction.  

Domino 9: The RMB Breaks. 

Chinese banks would have to go on a worldwide hunt for dollars, which would lead to pressure on RMB and volatility and potentially force China to break its peg.  

Domino 10: The Crisis Goes Global. 

European, Korean, and Indian banks with yuan exposure could collapse and start to create an international contagion impact.  

This is an extreme scenario which the authors don’t believe will happen. 

It would not be in Beijing’s interest to let events progress that far. 

But it’s also unclear at what point the Chinese government would intervene. 

That introduces uncertainty that could get out of control. 

This week another developer, Fantasia Holdings, defaulted on $206 million in dollar-denominated bonds—a small drop in the bucket, but more could follow.

Again, I think China will muddle through this immediate problem, but the risks are high enough to justify some preparation. 

Nor is financial contagion the only risk. 

Dave Rosenberg thinks Evergrande could set off a global recession.

This is really a contained financial event within China since most of the debt is held onshore, but it is also a huge negative macro event for the world’s second-largest economy and I see that Goldman Sachs is all the way down to 0% for Chinese Q3 real GDP. 

It is a huge internal deflationary shock that could easily send China into a recession and anyone who doesn’t think that will have knock-on effects on the rest of the world doesn’t obviously realize that China accounts for nearly 20% of global GDP and still consumes half of the world’s basic materials. 

This story is going to have global macro knock-on effects that we haven’t seen yet.

Now, the silver lining here is that such a recession would probably end our commodity price inflation worries. It might replace them with other, bigger problems.

Bain Macro Trends Group offers us this simple chart. 

A slowing Chinese housing market will reduce demand for materials across the board. 

Note that property construction accounts for one-third of the Chinese economy. 

As pointed out above, that large proportion is now being fueled at least in part by speculation and not actual demand. 

I expect any day now that we will hear the Chinese equivalent of Ben Bernanke saying, “Subprime is contained.”

Source: Bain Macro Trends Group

Nearly every major country has what is called a PMI index, or Purchasing Managers’ Index. 

When the number slips below 50, it indicates that the manufacturing portion of the country is not growing. 

That is the case in China. 

Let’s look at the US, Europe, and China courtesy of Bain:

Source: Bain Macro Trends Group

This is compounded by a serious energy crisis in China. 

My friend Bill Bishop writes:

They [the power shortages] appear to be a result of a witch’s brew of partially and poorly implemented power market reforms, surging coal costs that have led power generators to operate at a loss, and the political commands in some provinces leading to campaign-style efforts to reduce energy consumption and intensity to meet targets set by the central government. 

Something is going to have to give, and quickly, as winter is approaching.

We are all familiar with rising natural gas prices in Europe and the US. 

And while China does use a great deal of LNG, they are most dependent on coal. 

And coal prices have risen over 150% in the last year in Chinese currency:

Source: Bain Macro Trends Group

Even high-priority industries like technology and semiconductors are subject to rolling blackouts. 

While we might see relief in commodity prices, energy shortages could aggravate supply chain problems. 

Many US and European industries still depend heavily on Chinese components.

Wounded Regime

Many in the West view China as a rival power, fearing its size and ambitions will lead it to eventual domination. 

The real danger, though, may arrive when Chinese leaders conclude their power has peaked.

A recent historical analysis in Foreign Policy described how growing wealth motivates leaders to act boldly, shrugging off minor annoyances. 

Fear of decline does the opposite. 

Leaders try to hide their weakness, which becomes increasingly difficult.

Eras of rapid growth supercharge a country’s ambitions, raise its people’s expectations, and make its rivals nervous. 

During a sustained economic boom, businesses enjoy rising profits and citizens get used to living large. 

The country becomes a bigger player on the global stage. 

Then stagnation strikes.

Slowing growth makes it harder for leaders to keep the public happy. 

Economic underperformance weakens the country against its rivals. 

Fearing upheaval, leaders crack down on dissent. 

They maneuver desperately to keep geopolitical enemies at bay. 

Expansion seems like a solution—a way of grabbing economic resources and markets, making nationalism a crutch for a wounded regime, and beating back foreign threats.

It goes on to show how many of China’s previous advantages disappeared in the last decade or so. 

A once self-sufficient country now depends on imported energy and food, is approaching a demographic precipice, and is ideologically centralizing power at the expense of economic prosperity, all while external pressure grows more intense.

That’s not to say war or economic collapse is inevitable. 

I think both are very unlikely. 

But it does serious damage to the idea of China as a “state capitalist” economy that can work with Western businesses and governments. 

Companies in the US and Europe who have made large investments in China will increasingly find their deals come with unacceptable “new” conditions, especially technology sharing. 

Chinese companies exporting to the West will encounter more barriers. 

US consumers who have grown accustomed to low-priced Chinese goods may see higher prices, if they can get those goods at all.

This isn’t catastrophic, but it will certainly be different. 

Many US companies are at high valuations because investors think they will keep growing in new markets like China. 

That now looks like a pipe dream. Whatever you have to sell, a Chinese company probably has a home-grown version and will beat you to market, with the government’s enthusiastic help.

That’s the best case. 

It’s also possible someone (not necessarily in China) will trigger events that make a bad situation worse. 

China is now so interwoven into the global economy, problems could start anywhere.

I’ve been saying for some time the 2030s will be a bright time, but we have to get through the 2020s first. 

China is one reason the next decade could be tough.

New York, Energy Costs, and Thanksgiving

My current intention is to be in New York from October 27 through November 2. Not sure what to do on Halloween in NYC. I’m sure we will have at least one client (and possible new clients) dinner. I’ll spend Thanksgiving with family in Dallas.

I got into a bit of a debate on Twitter last week about energy. I said that to a climate warrior, high fossil fuel prices are a feature, not a bug. They make solar and wind more competitive. That started a back-and-forth that was quite fun. You should follow me on Twitter.

We really do try to keep this letter to around 3,000 words. 

Honestly, there is so much to say about China it could easily have gone 12,000 words. 

And of course, I said nothing about Friday’s jobs report, which was strong enough in the current environment that the Fed should seriously begin to taper in December. 

Unless Biden appoints a serious dove.

And with that I will hit the send button. 

Have a great week and spend more time with friends and family.

Your happy to be mostly hedged analyst,

John Mauldin
Co-Founder, Mauldin Economics

The extinction of gold derivatives

By Alasdair Macleod

This month is the fiftieth anniversary of the Nixon shock, when the Bretton Woods agreement was suspended. 

And the expansion of commercial banking into credit for purely financial activities became central to the promotion of the dollar as the international replacement for gold.

With the introduction of Basel 3, commercial banking enters a new era of diminishing involvement in derivatives. 

The nominal value of all derivatives at the end of last year amounted to seven times world GDP. 

While we can obsess about the effects on precious metals markets, they are just a very small part of the big Basel 3 picture.

However, gold remains central to global money and credit and the impact on gold markets should concern us all. 

In this article I quantify gold forwards and futures derivatives to estimate the impact of reversing anti-gold policies that date back to the Nixon shock in 1971.

We are considering nothing less than the effects of ending fifty years of gold price suppression. 

Through leases, swaps, and loans central banks have fed physical bullion into derivative markets from time to time to keep prices from rising and breaking the banks who are always short of synthetic gold to their customers.

To summarise, bullion banks withdrawing from derivative markets is bound to create replacement demand for physical gold that can only drive up the price and further undermine fragile confidence in fiat currencies at a time of rapidly increasing monetary inflation.


The introduction of the net stable funding ratio (NSFR) as a central feature of Basel 3 regulations will have a major impact on derivative markets. 

For the purposes of this article, we are interested in how it will affect the exchange value for gold.

Derivatives break down into two broad categories. 

There are derivatives traded on regulated exchanges, for which there are publicly available data, principally futures contracts and options on futures. 

But these are the tip of an iceberg that consists of over-the-counter derivatives, multiples larger in outstanding obligations. They consist of forwards, swaps, loans, leases, and options, for which collective data is scarce.

Officially, the purpose of derivatives is to hedge risk. 

And since we turn to banks to finance our activities either by drawing down on our deposits or obtaining bank credit, they are the usual originators of derivatives, expanding their quantity as the demand for underlying assets, such as gold, increases. 

Consequently, they have become primarily a source of paper equivalents, because banks rarely deal in physical commodities.

While risk management was the original function, banks have turned trading in derivatives to lucrative profit centres. 

The banks have evolved products that permit speculators and investors to acquire exposure without having to access underlying products. 

It is a sophisticated version of betting, whereby you can buy and sell paper from a computer terminal without having to touch the referenced asset. 

And when you have markets populated by punters fuelled by growing quantities of paper currencies which in turn fuel financial asset values, it is natural that banks increasingly operate as their bookies.

For this and other reasons in recent decades the world of OTC derivatives has exploded in size, as banks have diversified from expanding credit for manufacturing and non-financial service businesses into expanding credit for purely financial activities. 

Consequently, at the end of last year, according to the Bank for International Settlements notional amounts of paper derivatives outstanding were $582 trillion with a gross value of $15.8 trillion.[i] 

That represents gearing between notional amounts and their value of over 36 times, and nearly seven times the World Bank’s estimate of global GDP.

As the chart from The Bank for International Settlements above shows, total derivatives expanded rapidly ahead of the Lehman crisis in August 2008. 

After a brief wobble they continued expanding into 2014 before declining into 2016, since when the uptrend has been gently rising.

Following the Lehman crisis and while admitting the usefulness of derivatives for the purpose of risk management, as part of their overhaul of banking regulations the BIS would have been concerned at the systemic risks to commercial banks from increased position taking. 

This has led to two new definitions: high quality liquid assets, which can be readily realised in a crisis; and the net stable funding ratio, which ensures that a bank’s assets are suitably funded by its liabilities.

The Basel Committee on Bank Regulation finalised its NSFR rules in October 2014, coinciding with peak derivatives in the BIS chart above. 

The publication of these future regulations might have been one reason behind the subsequent 2014-16 decline. 

But another factor was the introduction of written bilateral agreements between counterparties netting off common derivatives into one position. 

This has the effect of reducing apparent outstanding derivatives, which had hit record levels in 2008 before netting agreements were in place.

In the NSFR equation[ii], derivative liabilities net of matching derivative assets, if their liabilities exceed their asset values have an available stable funding (ASF) of zero. 

In other words, unlike more stable categories of balance sheet liability a bank cannot use them to fund balance sheet assets. 

And if derivative assets exceed associated derivative liabilities, they require an ASF of 100% to be applied as required stable funding; in other words, they must be funded totally by liabilities that qualify as available stable funding.

At the banks’ treasury level, net long and short derivative positions are an inefficient use of the balance sheet by curtailing more efficient uses. 

The same applies to uneven positions in equities and commodities, though different ASFs and RSFs may apply. 

Furthermore, note that no distinction is made between regulated and OTC derivatives. 

The overall effect is likely to stem and reverse the tide of bank credit expansion into purely financial activities. 

And given that banks have already reduced their lending to non-financial activities relative to their total lending, by hampering further expansion into financial activities Basel 3 appears to mark the peak of commercial banking.

It is against this background that we approach our examination of gold derivatives. 

At $834bn, gold OTC derivatives are too small to register on the BIS chart above. 

This article drills down into what is essentially a minor element of the Basel 3 revolution, making bullion banking the subject of far larger derivative issues.

Gold derivatives

There are two classes of gold derivative commonly dealt with, forwards and futures as well as options in both categories. 

The legal difference is that forward contracts are bilateral bespoke agreements, while future contracts are standardised and traded on registered exchanges.

Essentially, they serve two different markets. 

Futures are classified as regulated investments while forward contracts are not. 

As regulated investments, investing institutions have limitless access to futures contracts, whereas their access to unregulated OTC forwards is strictly limited, if permitted at all. 

Therefore, the speculating traders in Comex futures, for example, can be anyone. 

Traders in forward contracts in the London market are predominantly acting as principals not requiring regulation, which therefore excludes nearly all collective investment schemes and investment managers. 

These principals include banks, family offices and their ultra-rich principals, privately-owned corporations, sovereign wealth funds and central banks.

We shall start by examining the OTC market, whose forwards and swaps are predominantly dealt in by the members of the London Bullion Market Association (LBMA) for settlement either in London (loco London) or in Switzerland (loco Zurich).[iii]

Figure 2 shows that since gold bottomed against the dollar in December 2015 outstanding forwards and swaps had more than doubled from $351bn to $834bn and OTC options had tripled from $101bn to $304bn by December 2020. 

And while the multiyear shifts appear to be greater in percentage terms than for the whole OTC universe, the expansion of outstanding obligations before the Lehman crisis shared with the general trend, and the expansion from late 2015 does as well.

According to Dr Fergal O’Connor writing in Issue 99 of The Alchemist, about 60% of daily settlement volume in gold in London’s bullion market is for spot settlement, while swaps and forwards accounted for about 30% of the total. 

Bear in mind that these figures cannot be compared with those of the BIS derivatives, which are of outstanding positions, including those of non-LBMA members. 

O’Connor’s figures appear to be of settlement between LBMA members only and exclude trades with non-members.[iv] 

This point was brought out in research by Paul Mylchreest for Hardman & Co, where he points out that turnover volumes reported in 2011 were approximately five times higher than in 2018.[v] 

However, it seems likely that O’Connor’s figures, which is of LBMA members’ transactions only and provided by the LBMA itself, formed the basis of the LBMA’s assumption in evidence to the PRA consultation earlier this year that unallocated gold is spot physical by another name.

With LBMA customer transactions now excluded from the LBMA’s turnover figures, we can therefore ignore the apparent mismatch between the proportions that are shown as spot transactions and forward trades which seems to suggest that physical settlements dominate the market. 

And we know from the BIS figures that at the end of last year swaps and forwards totalling $530bn existed. 

In practice, forwards will be reflected on bank balance sheets as liabilities in the form of unallocated gold accounts (where in normal banking parlance there would be customer deposits) while swaps are almost certainly off-balance sheet leading to on-balance sheet transactions. 

We do not know the split between swaps and forwards, but that does not matter.

We can get a feel for the use of gold derivatives by looking at the BIS’s OTC Derivatives by Maturity tables (Table D9).[vi] 

Of the $834bn gold derivatives outstanding, $757bn matured in one year or less, $62bn between one and five years, and $20bn in five years or more. 

The remaining $5bn error may be due to rounding or different data reporting methods.

Under the new British regulatory interpretation of the Basel 3 NSFR, either customer unallocated gold accounts will end up being closed, or alternatively banks will have to acquire unencumbered physical gold to back them to avoid financing disadvantages for their balance sheets. 

The alternative of banks imposing charges on unallocated accounts to offset the regulatory burden seems unlikely to happen, because bank customers are likely to demand off-balance sheet custodial ownership instead, costing as little as 8 basis points for the largest accounts. 

We must therefore conclude that as the bullion banks rearrange their affairs ahead of the year-end, demand for physical gold among LBMA customers is likely to increase substantially, as precious metals business movers towards custody arrangements.

Availability of physical gold in London

At end-December 2020, $530bn —the total of forwards and swaps mostly between members of the LBMA — was the equivalent of 8,676 tonnes of gold. 

Total holdings of vaulted gold reported by the LBMA at end-June was 9,587 tonnes, which at first sight and as promoted by the LBMA’s reporting might be taken for the market’s underlying liquidity. 

But more than half of it is the Bank of England’s 5,756 tonnes, which is not a LBMA member and nearly all its gold is earmarked for central banks. 

The true figure for LBMA member vaults is therefore 3,831 tonnes. 

And of that, approximately 1,500 tonnes are custodial gold for ETFs, leaving 2,331 tonnes. 

This balance is held between allocated accounts on behalf of large investors around the world and as backing for unallocated accounts on bank balance sheets including the four owners of the LBMA’s settlement system. 

The LBMA and vault operators do not provide breakdowns of these categories but given that allocated bullion can be stored and insured for less than ten basis points annually, custodial gold could easily exceed 1,500 tonnes, leaving a pool of physical gold of under 1,000 tonnes.

From the bullion banks’ point of view, preserving physical liquidity is vital to their operations. 

And the obvious variable is ETF custodial gold. 

It explains why discouraging the wider public from becoming bullish is paramount, and in times of illiquidity the best policy is to just tough it out, knowing that investors always turn sellers when the panic of the day subsides, thereby releasing LBMA-vaulted bullion. 

And the LBMA trumpeting headline vaulting figures ten times the true liquidity adds to the deception. 

Let us not forget that the LBMA primarily represents the interests of the ringmasters in this market.

Basle 3 will fundamentally change the London market, removing lucrative gold trading under strictly managed conditions from the bullion banking cartel. 

This is why the LBMA vociferously opposed its introduction. 

They were relying on an approach of calling out the regulators for not recognising that gold is a High Quality Liquid Asset as defined in Basel 3: on this point they are certainly correct. 

But they then appear to have relied on the preponderance of spot transactions between settling LBMA members, published in The Alchemist Issue 99 and referenced in footnote iv to this article, to claim that unallocated is simply a convenient form of physical gold.[vii]

The PRA was not taken in by the LBMA’s lobbying efforts and would have looked at the underlying contract templates between LBMA banks and their customers and decided that these accounts were backed by derivatives as defined by Basel 3 and correctly recorded in the BIS’s derivative statistics. 

One wonders at the damage that the World Gold Council, which is meant to represent the wider case for gold while relying on its income from a physical gold ETF, would have done to its own reputation at the BoE by being sucked in to support the LBMA’s self-interested lobbying.

Obviously, the Bank of England (which hosts the PRA) was looking at gold trading in a wider context. 

The unallocated jig was up, and the Chinese were making a good fist of gaining control over global physical trading. 

That had to be countered. 

And in the near-final version of the PRA’s article 428f, not only was the London Precious Metals Clearing Limited put onto a proper clearing house footing (#1), but bullion banks were told that unallocated accounts must become pooled accounts backed entirely by unencumbered physical gold (#s 2 and 3).[vii]

Clearly, the BoE and its regulator desire a future for gold trading in London. 

It is likely that the UK’s Treasury and even the US authorities might have been consulted, given the US’s financial interest in curbing China’s strategic expansion into physical gold. 

The wider strategic implications of creating a rival to China’s growing global dominance of physical gold trading will not have been lost on the highest levels of government.

For gold trading, this is the other bookend to London’s big bang of the mid-1980s, which gave birth to the banking industry’s love affair with derivatives. 

That episode is now ending with Basel 3. 

London must adjust to predominantly physical trading. 

And the demand for physical gold is growing, not only as implied by Basel 3 regulatory changes, but more obviously driven by the increasing inflation of fiat currencies. 

It is no wonder that the most active Chinese bank in London’s gold market, ICBI Standard Bank, one of the four owners of London Precious Metals Clearing Limited, recently bought Barclay’s 2,000 tonne vault, because vaulting capacity for London’s physical demand in the wake of Basel 3 and considering current monetary developments will be extremely scarce.

Regulated gold futures contracts

Statistics on regulated gold futures are freely available, and fortunately for analysts, Comex’s regular gold futures GC contract dwarfs all others, allowing them to confine their comments to this one market.

It is far smaller than OTC forwards. 

At the end of 2020, outstanding futures contracts were for 1,739 tonnes equivalent, which compares with the 8,676 tonnes equivalent for forwards and swaps in the BIS’s statistics. 

The relationship between the two major gold markets has usually been described as Comex providing a hedging facility for dealers in London. 

This is meant to occur through two mechanisms. 

The first is that net short positions on Comex hedge net long positions in London, where there is a drip-feed of global mine supply of about 70 tonnes a week. 

And the second is the exchange for physical facility which allows for positions to be transferred between markets.

Besides the EFP facility (a misnomer because it is an exchange between futures and forwards — no physical is involved), the relationship between the two markets is very different from the conventional story. 

If anything, the hedging requirements out of London are for LBMA member banks to access net longs on Comex, because the bullion banks are short to their depositor customers’ unallocated gold accounts to a far larger extent than the drip-feed of physical bullion coming into the market. 

In London, banks job on the short tack, just as they do on Comex.

Bullion bank trading desks are included in the Swaps category, which is defined by the CFTC as, “an entity that deals primarily in swaps for a commodity and uses the futures markets to manage or hedge the risk associated with those swap transactions”. 

In other words, not exclusively the Swaps category includes to bullion bank trading desks. 

Referring to the CFTC’s Bank Participation Report, we see that on 6 July (the last report available) banks accounted for 59% of the Swaps category longs, and 73% of the Swap’s shorts. 

Of these, 31 are foreign, likely to be LBMA members.

Together with the Producer/Merchant/Processor/User category, swap dealers on Comex are designated as non-speculators, while Money Managers and Other Reportables are designated as speculators. 

And finally, there are a minority classified as Non-Reportables included in the speculator category.

In effect, the two non-speculator categories provide market liquidity, and they record both long and short positions, almost always being net short. 

The table below shows the recent position in Comex, excluding spreads, which are matching contracts arbitraging price differentials.

Based on the weekly Commitment of Traders Report issued by the CFTC, the table is arranged to show the non-speculator categories separated from the speculator categories, along with the position changes from the previous week (the panel to the right). 

Of the 500,187 contracts of open interest on 27 July, 403,286 were not spreads (81,518 + 321,768). 

Of these, the Swaps were liable for 77% of the net short position, representing 536.6 tonnes equivalent.

For the purposes of Basel 3 and its NSFR, regulated derivatives are little different from OTC derivatives, so we can expect banks dealing on Comex to reduce their involvement as soon as they can practicably exit, especially as the same banks run books in London as well. 

But the overall Swap category’s position is proving difficult to reduce, as Figure 3 illustrates.

Total swap net shorts stand at $31bn. 

According to the most recent Bank Participation Report, the banks share of this works out at $24.4bn. 

There are two problems standing in the way of these banks eliminating their short futures position. 

The first is growing interest from the speculator managed money category in selling dollars for gold futures, and the second is a new trend whereby the Producer/Merchant category is reducing its net short position, increasingly throwing the onus for supplying longs to speculators onto the swaps.

Furthermore, the shortage of physical liquidity combined with the increase in monetary inflation for all the major currencies and the dollar especially is turning Comex into a physical delivery market. 

So far this year, users of the futures market have stood for delivery for a total of 123,100 contracts, representing 383 tonnes, in a market where in previous years deliveries of physical were not common.

Central bank gold leasing could become a major issue

In 2002, Frank Veneroso, a respected analyst concluded that central banks had leased anything between 10,000—16,000 tonnes of gold. 

It is now largely forgotten, but just as there is little public evidence of continued central bank leasing there is no evidence that it has declined or been reversed. 

For a central bank the purpose of leasing was to earn interest on an otherwise non-yielding asset to pay for storage costs and to become a profit centre. 

For an arranger of leasing, such as the Bank of England, it ensures that physical bullion is available to manage markets. 

For example, last August saw the Bank of England listed as a sub-custodian for the GLD ETF. 

This was no doubt a filing disclosure of a leasing arrangement to make up for a severe bullion shortage in the markets driven by rising public demand.

Concealing arrangements whereby gold is made available by a central bank to the market has been facilitated by the IMF in its accounting treatment of central bank gold. 

It is the IMF that collects the figures. 

Gold swaps are recorded as collateralised loans, with the gold remaining on the central bank’s balance sheet. 

A gold loan, which is treated in the same manner as a repo, also remains on the central bank’s balance sheet. 

In its latest guidance, the subject of gold leasing is omitted. 

But reclassifying a lease as a loan which remains on a central bank’s balance sheet gets round the problem by simply redefining it.[ix]

There is little doubt that government-owned gold has been used to “manage” the gold price. 

In the 1970s, the US Treasury openly sold bullion by auction, but stopped doing so when they merely stimulated demand. 

Regulatory encouragement for the expansion of derivative markets has subsequently absorbed demand that would otherwise have driven bullion prices even higher. 

And there is the stubborn refusal by the US Treasury to quash rumours of missing gold by appointing an independent metal audit of monetary gold in its possession.

But perhaps the most damning evidence was the refusal of the New York Fed, responsible for storing earmarked gold for foreign central banks, to firstly let Bundesbank officials inspect its earmarked gold, and then to refuse to deliver it to Germany as requested. 

After some haggling, in 18 months the Bundesbank only managed to get back 37 tonnes of the 1,500 tonnes held in New York on its behalf. 

There should have been no argument about it: earmarked gold is gold held in custody and as custodian the New York Fed should have responded immediately to the Bundesbank’s instructions.

They didn’t. 

Did the Bundesbank suspect the US authorities were misappropriating its gold, and that was why it wanted it back? 

And why were its authorised representatives denied access? 

And the tonnage that came back from America was melted down immediately to “bring the bullion up to the current bar standard”. 

Unsurprisingly, this action stoked speculation that it was to eliminate bar details which didn’t match the Bundesbank’s records.

This treatment of Germany’s undisputed property by the US authorities sparked a similar withdrawal request from the Netherlands, which was satisfied in a timelier manner. 

And even Austria thought it wise to send a team of auditors to check on its gold in the Bank of England’s vaults.

The message seems to be that the central banks, which have between them declared ownership of 35,544 tonnes, are concealing old leases, more recent swaps and loans, and outright misappropriation of earmarked gold. 

It is a market deception that has been brewing for half a century. 

It was a problem likely to remain hidden so long as two conditions continued to be fulfilled: derivatives would continue to expand to soak up excess demand synthetically, and global money-printing would not spiral out of control. 

Even back in 2002, Frank Veneroso reckoned up to 50% of monetary gold in the central banks might have vanished in leases. 

Circumstantial evidence, such as the Bundesbank’s experience, suggests it is a trend that has continued, in which case a major portion of the West’s monetary gold has simply vanished.

At a time of mounting evidence that the destruction of purchasing power for fiat currencies is approaching, for some central banks the backstop of turning their fiat currencies into credible gold substitutes may not be available, and nowhere is this more of an issue than the future backing for the dollar itself.

A brief note on silver

So far as we are aware, central banks do not store silver. 

A possible exception is the Peoples Bank of China or through one of its agencies, which was appointed in 1983 to manage the acquisition of China’s gold and silver. 

But just as banking involvement in gold derivatives is set to eventually become little more than a topic for financial historians, the same is true for silver.

Silver was finally demonetised in the 1870s. 

Its replacement with gold in monetary standards for the few remaining European nations on silver standards led to its lower repricing as a predominantly industrial metal today, and the gold-silver ratio rose from 15—16 or so to over 70 currently.

We are so used to the state defining money for us that we forget that all theories of state money are fatally flawed, because its promoters can never resist actions that lead to its destruction. 

And when state currencies die it is the people who decide what will replace them as money, and the most reliable replacement that people have always returned to through the millennia is gold and silver. 

Following the chaos of a currency collapse the decision as to whether silver can circulate again as money is a decision for the people.

On a practical level, silver is more accessible than gold to most people. 

Today, a one ounce silver coin buys $25-worth of goods, and as fiat currencies slide, a silver ounce buying, for example, a value of one-twentieth of a gold ounce in silver is practical money for most people faced with exchanges of goods in the absence of fiat currencies.

These conditions are likely to arise following an accelerating expansion of state money and credit, such as that developing today. 

It is a separate consideration from the market changes that arise from bank regulation and the resulting diminution of paper silver. 

Suffice it to say that what applies to the effect of banks withdrawing from gold derivatives also applies to those of silver.


This month marks the fiftieth anniversary since the last vestiges of a gold standard for the US dollar were abandoned. 

We can surmise that it was by design that the banking reforms that followed in the 1980s contributed the suppression of gold by expanding the availability of derivatives substituting for physical bullion. 

And it became central to the promotion of the dollar as gold’s permanent monetary replacement.

Today’s policymakers repeatedly exhibit an ignorance of the underlying reasons behind the promotion of the dollar as the worlds reserve currency. 

Through the passage of time, they have probably come believe that gold has no future monetary role. 

And the few among the statists who are alarmed by their addiction to monetary inflation probably think salvation lies in technology —digital currencies issued by central banks, cutting out credit creation by commercial banks to increase central banking control over money and credit.

The escape route of digital currencies probably explains why reducing the role of commercial banks in financial markets by curtailing their derivative activities is not raising serious concerns at the central bank level, let alone over the likely impact on the gold price. 

We can only conclude that at the highest levels of government the authorities are no longer concerned that a rising gold price is a challenge to fiat currencies and can be simply dismissed — in which case they will have underestimated the likely consequences of reversing a fifty-year tide of gold suppression.

[i] See It should be noted that the gross market value is the sum of in-the-money valuations. Because for every derivative there is an equal and opposite position there are matching gross market liabilities which are not recorded in the BIS’s semi-annual surveys.

[ii] NSFR = Available Stable Funding/Required Stable Funding, and must always be greater than one

[iii] A swap contract is where two parties agree to exchange between them a variable rate for a fixed sum. It is principally a means of insuring against price volatility.


[v] See

[vi] See

[vii] See

[viii] For a detailed explanation of the relevant rules, see

[ix]See the IMF’s Monetary and Financial Statistics Manual and Compilation Guide available from 


A different approach to investing in developing countries

The concept of emerging markets is strained. Time to think about economic growth models instead

Forty years ago Antoine van Agtmael of the International Finance Corporation pitched the idea of a “Third World Equity Fund” to sceptical fund managers, and the concept of emerging markets entered global investing. 

The aim had been to offer diversified exposure to fast-growing countries outside the rich world. 

Since then emerging and developing countries have, in aggregate, gained economic and corporate clout. 

But the vast disparities between them makes lumping them all into a single category increasingly odd. 

What might a new framework for investing outside of the rich world look like?

In the early 1980s emerging and developing countries made up about 25% of global gdp, according to the imf. 

Today they account for about 40%, and more than 20% of total global market capitalisation. 

The market cap of the msci emerging-markets index, as a share of the global gauge, has risen by 13 times.

Yet countries’ economic situations vary widely. 

Consider, for instance, the msci emerging-markets index. 

In 1988, when the gauge was launched, the income per person of countries that were included ranged from $1,123 in Thailand to $7,598 in Greece. 

In 2019 the range was over four times that, stretching from India’s $2,100 to South Korea’s $31,846. 

The fortunes of some economies, such as Brazil and Russia, are tied to the vagaries of commodities markets; those of East and South-East Asia, by contrast, are powered by manufacturing.

Existing definitions of emerging markets do not capture such complexity. 

Most people, including many investors, think of the category as linked to income levels. 

But index providers also consider whether trading in markets is as frictionless as in the rich world. 

This is why, although South Korea and Taiwan are wealthy, their markets are not considered “developed”. 

The result is a grouping that is highly concentrated: the two East Asian countries together make up 27% of the msci emerging-markets index.

How then to think about gaining exposure to more than three-quarters of the world’s population, and two-fifths of the global economy? 

A framework that is organised by geography seems only slightly less arbitrary than the emerging-markets classification: the Turkish and Saudi Arabian markets, say, have little in common. 

Another approach would be to segment countries by income. 

But this too can have odd results. 

The low-income category, for instance, would combine places that have failed to develop for decades with those that could soon take off. 

The Republic of Congo and Vietnam have similar levels of income per person, but share few other economic qualities. 

Kuwait and Taiwan are broadly as rich as each other, but their stockmarkets are vastly different. 

Income levels alone do not say much about a country’s prospects.

Perhaps a more promising approach is to think of countries in terms of their growth models instead. 

This framework would apply to the familiar big emerging economies, as well as to the edgier, “frontier” markets. 

Investors who want more exposure to export-oriented powerhouses could turn not just to China, South Korea and Taiwan, but also to later adopters of the model, such as Bangladesh and Vietnam. 

These are still minnows compared with the incumbents’ market capitalisation of about $16trn. 

But adding them makes sense, since they are already beneficiaries of rising Chinese wages, and could expand into technologically advanced manufacturing.

A second category could include countries that rely instead on services-led growth, with all the promise of healthy middle-class consumption. 

Here, India and Indonesia are possible candidates; Kenya might be a frontier market worth investigating. 

And a third group could include commodity exporters, such as Brazil, Russia and South Africa. 

These have provided dismal returns over the past decade and shrunk as a proportion of emerging-market indices. 

But climate change and the green transition could create new winners and losers, as some resources, such as battery metals, become sought-after, and others fall out of favour.

Such a taxonomy is far from perfect. 

Growth models can change over time, for a start. 

Just think of China, which is seeking to become more consumption-led. 

Many smaller countries have long had hopes of boosting exports, only to be tripped up by poor policymaking. 

Still, the strategy of lumping much of the world’s population and output into one category is no longer useful. 

Time to experiment.