Gold and liquidity

The 2007-2009 financial crisis highlighted the challenges of running a liquidity portfolio. Many markets that reserve managers had considered to be deep and liquid proved to be the exact opposite, with assets selling only at a large discount. This was even true of some AAA-rated assets, showing that credit ratings offered no effective guide to liquidity. Many central banks had to rely on bi-lateral currency agreements with other central banks, principally the US Federal Reserve.

The gold market remained liquid throughout the financial crisis. This was the case even at the height of liquidity strains in other markets: a reflection of the size, low market concentration and flight to quality tendencies of gold. The Swedish Riksbank used its gold reserves at the height of the crisis to finance temporary liquidity assistance.
 

Size

Gold is virtually indestructible, so almost all of the gold that has ever been mined still exists. In the fixed-income market, gold would be equivalent to a bond that never matures - although there are obvious difficulties in comparing the gold and bond markets.

Perhaps the best proxy for gold to “outstanding bond issuance” is the combined value of gold in private bullion stocks and the official sector. GFMS estimated this to be 58,500 tonnes in 2009, or US$2,063 billion at the year-end close price.

The gold market is larger, on this basis, than each of the Eurozone bond markets, save Italy. It is considerably larger than the UK Gilt market, and it dwarfs smaller sovereign debt markets such as Australia and Norway, popular with reserve managers in recent years.

The same challenges apply when comparing trading volumes of gold and bonds. The numerous channels through which gold trading takes place make comparison particularly hard, though one can make general comments.

Relative Size: Gold and Selected Domestic Government Debt Issues (US$ billions) - click to enlarge

Most gold trading takes place in the global OTC market. It centres around gold stored in London. The London Bullion Market Association (LBMA) is the body that represents the bullion dealers active in the global OTC market. According to LBMA estimates, the daily net amount of gold that was transferred between loco London accounts averaged US$19.9 billion in 2009 (based on the average 2009 gold price).

As many trades are simply netted out, trading volumes among the bullion banks are much higher than they might appear. Traders estimate that actual daily turnover is a minimum of three times the estimated figure, and could be up to eight times higher. This figure would put global OTC trading volumes settled using gold stored in London vaults alone at between US$59-159 billion. Such volumes would make the gold market more liquid than the UK Gilt and German Bund market, but less liquid than JGBs and US Treasuries.

In reality, global gold trading volumes would be higher still given that considerable volumes of OTC trades are settled outside of London and as gold derivatives are traded on several exchanges around the world (this point can also be made of government bond futures).

Diverse range of buyers and sellers

Gold’s liquidity is underpinned by its diverse range of buyers and sellers. Unlike financial assets, the gold market is not solely dependent on investment as a source of demand. Gold has a wide range of buyers and sellers each of whom has different trading motivations and reacts differently to price movements.

Table: Average Daily Trading Volumes (US$ Billions) in 2009

1) Primary dealer activity
Sources: Securities Industry and Financial Markets Association, UK Debt
Management Office, Bundesrepublik Deutschland Finanzagentur GMB,
London Bullion Market Association, Japan Securities Dealers Association.

In the five years to 2009, 61% of gold demand came from the jewellery sector, 27% from investment and 12% from industrial uses. Gold has a diverse range of buyers, stretching from Indian jewellery manufacturers, to electronics producers in Asia, from worldwide dentistry and medicine, to retail investment demand.

Demand has risen among institutional investors, including pension funds, endowments and central banks. Central banks became net buyers of gold starting in the second quarter of 2009, ending two decades of annual net sales of substantial quantities of gold to the private sector.

The motivations for investment demand in gold are disparate. Some investors buy gold as a long-term strategic asset, others are seeking an inflation or dollar hedge. Some buy gold as a safe-haven, others because of their tactical view on the gold market.

The sources of supply are equally disparate, being a combination of newly-mined gold, the net mobilisation of central bank reserves and the recycling of above ground stocks.

In the five years to 2009, 59% of gold supply came from newly-mined production (net of producer de-hedging). A further 10% came from net official sector sales with 31% from the recycling of fabricated products - principally jewellery from emerging markets.

The long lags in mine production mean changes in the gold price will only influence supply after a number of years. Other factors influencing supply include the extent and success of past exploration spending, the cost of extracting gold, and various geological factors.

The gold price, price volatility and general economic conditions in the host country are the factors that most affect recycled gold supply levels. Central banks’ reserve decisions have most impact on net official transactions.

Flight-to-quality tendencies

Gold has a history of safe-haven inflows during times of financial market duress. This stems from a complete absence of credit risk and because gold’s value cannot be debased by government measures to remedy financial crises, for example quantitative easing, which can lead to inflation and erode the value of fiat currencies.

The 2007-2009 banking crisis is a good case in point. Between June 2007, when the credit crisis first began, and June 2009, when the world economy was showing signs of bottoming out, the gold price increased by 43% in dollar terms. This compares with increases of between 3% and 9% (local currency terms) in the main sovereign bonds held by central banks.

The financial crisis did have some impact on the gold price. Some investors sold gold to raise vital cash, as liquidity constraints in other markets became acute.

Between the end of Q2 2008 and 12 November that year, the gold price fell from US$925.40/oz to US$712.30/oz. This was the worst of the financial crisis, covering the period when Lehman Brothers collapsed and liquidity constraints in the wholesale market for dollars and the FX swap market were most pronounced.

3-month LIBOR rates soared as high as 366 basis points above the Overnight Swap Index. Fund managers facing large redemptions and/or margin calls turned to gold as an “asset of last resort” to stay solvent. The Swedish Riksbank also relied on its gold reserves for liquidity at the height of the crisis, using gold to finance temporary liquidity assistance.