Market infrastructure ►
A central bank that wishes to buy gold can do so locally, by purchasing domestically-mined or recycled gold. Alternatively, gold bars can be bought directly from a bullion bank in the global over-the-counter, or OTC, market.
The majority of OTC gold is settled via gold bars stored in London, or ‘loco London’. Twice daily during London trading hours there is an ‘auction’, which provides reference gold prices for the day’s trading.
Either the morning (AM) or afternoon (PM) LBMA gold price auctions form the pricing basis for many long-term contracts. Market participants will usually refer to one or other of these prices when seeking a basis for valuation.
This short film explains the settlement process for a bank buying gold in the London OTC market.
Buying gold in the London OTC Market
The gold market has a series of committed ‘market makers’. In London, the market makers are represented by the London Bullion Market Association (LBMA) and commit to offering minimum volumes in spot gold and, in cases, forwards and options.
A list of market-making bullion banks can be found on the LBMA’s website. Market makers typically deal in a minimum size of 1,000 ounces. A market maker’s standard quote will be for ‘loco-London’ gold, which can be delivered to a nominated vault in London, but some bullion banks will also arrange for the gold to be shipped to another location for an additional fee.
Clearing and settlement
Some members of the LBMA are also members of London Precious Metals Clearing (LPMCL). The LPMCL members serve two functions: they settle gold transactions between buying banks and selling banks and they facilitate the physical flow of gold between market participants. There are currently five members: HSBC, ICBC Standard Bank, JPMorgan, Scotiabank and UBS.
If a central bank wants to buy gold in the London OTC market the first thing it must do is to have access to an account with one of the LPMCL members. Each LPMCL member has access to London vaulting facilities, including at the Bank of England, for the storage of gold. This enables the LPMCL member to receive loco-London gold on behalf of the buying bullion bank.
Most gold trades are conducted in dollars, but gold can also be bought in other major currencies. For a dollar transaction, the currency leg of the trade will frequently be settled two days after the trade was agreed (T+2), at close of business New York time with a New York-based bank.
Bars and vaults►
‘Good Delivery Bars’
The standard unit of account for central banks buying gold in the OTC market is the ‘Good Delivery Bar’, although central banks often hold other types of gold bars and coins that were dominant in the past, or that they have inherited.
Sometimes central banks will seek to refine other bars up to Good Delivery Bar standard to ensure the maximum liquidity. This can be carried out through a refinery that is on the London Bullion Market Association’s (LBMA) ‘Good Delivery List’.
Amongst other criteria, the bars must be ingot-shaped, be of good appearance, weigh between 350-430 fine troy ounces and have a minimum fineness of 995 parts per thousand.
A full list of the criteria that Good Delivery Bars must meet and the ‘Good Delivery List’ can be found on the LBMA’s website.
Vaulting: allocated versus unallocated gold
A central bank can either hold gold in its own vault, with another central bank or even at a commercial bank. Many central banks choose to vault some of their gold with the Bank of England or the Federal Reserve Bank of New York in the United States. If a central bank chooses to hold gold outside of its own vault it must decide whether to hold it on an ‘allocated’ or ‘unallocated’ basis.
In an allocated account, the gold is physically segregated from all other gold stored in the vault, the client has full title to the metal in the account and the client’s holdings are identified by bar number, size, fineness and weight.
In an unallocated account, the client has a general entitlement to a portion of a pool of gold, which allows the bullion bank to lease the gold for a small yield.
For gold held by central banks to qualify as a ‘Reserve Asset’ in the International Monetary Fund’s Official Reserve Statistics, it must adhere to strict standards of purity and convertibility.
However, there is no agreed international approach on how to value gold reserves. Different central banks use different valuation methods. Some central banks value their gold reserves at ‘Fixed Value’ while others value at ‘Market Value’ of ‘Fair Value’.
The United States, for example, still values gold at US$42.22 per ounce, the fixed exchange rate between dollars and gold that was set after the Second World War, while the Eurosystem revalues gold at market price at the end of each quarter.