Gold in the financial system

Gold relinquished its role as money after the outbreak of the Second World War, which had devastated the economies of Europe and Asia. At the end of the war, the Bretton Woods monetary system, a regime of fixed exchange rates, was created. This system broke down in 1971 when the US unilaterally ended its gold standard, which set the convertibility of gold and the dollar to US$35 per ounce.

However, while gold’s role as money has faded over time – at least in the West – its role in the financial sector has grown. Much of this stems from the changes that have been made to global banking regulations following the 2008 financial crisis. 

Gold in the IMS

For many decades, the US dollar has been the main reserve currency worldwide and it still accounts for more than 50% of international reserves. However, its share has been gradually declining, while that of other currencies, like the Chinese RMB, has grown, signalling the potential emergence of a multicurrency reserve system. 

The Gold in a multicurrency reserve system report examines recent developments in the global macroeconomic landscape and their implications for the international monetary system. We examine the tectonic shift from West to East; post-crisis slowdown in world growth; as well as macroeconomic policy challenges faced by the biggest global players, and analyse their potential consequences for reserve asset policy and allocations to gold. 

In what we believe is the first study of its kind that has been done for gold, we constructed an econometric model to explain central bank reserve asset allocation, distinguishing between developed and developing countries. We’ve also conducted a series of macroeconomic simulations, quantifying the impact of various structural and policy shocks on the structure of international reserves.

Gold as collateral

The 2008 credit crisis prompted regulators around the world to put in place new standards and rules to try to reduce systemic risks to the financial system.

Many of the new regulations are aimed at reducing counterparty risk between institutions, which was badly managed prior to 2008 and was a major contributor to the financial crisis. 

These regulations have focused on pushing for more trading to be conducted via clearing houses and, when not centrally-cleared, with enhanced margin requirements. Gold’s lack of credit risk and deep liquidity mean that it has emerged as a source of high quality collateral in many of the regulations.

On 2nd September 2013, The Basel Committee on Banking Supervision and the International Organisation of Securities Commissions (IOSCO) released its final framework for margin requirements for non-centrally cleared derivatives. The report includes guidance on the type of assets that can be used for collateral purposes, which include gold.

Similarly, in Europe, the European Market Infrastructure Regulation (EMIR) and draft Central Securities Depository Regulation include gold as a source of collateral at Central Counterparty Clearing (CCPs) Houses and Central Security Depositories respectively.

Since the adoption of EMIR on 16th August 2012, each of Europe’s large CCPs (LCH Clearnet, ICE Clear Europe and CME Europe) have started to accept gold. 

Gold in reserve requirements

The strains on the financial sector caused by huge liquidity constraints across many markets since 2008 have led to new roles being found for gold in reserve requirements.

For example, the Central Bank of Turkey (CBT) announced on 1st November 2011 that it would permit commercial banks to post up to 10 per cent of their reserve requirements maintained for Turkish lira liabilities in gold.

The CBT said the dual objective of this policy was “to strengthen the build up of gold reserves and to provide more flexibility in the banking system’s liquidity management”. On 16th August 2012, the upper limit for gold reserves that can be used to meet Turkish lira reserve requirements was raised to 30 percent.

The Turkish example demonstrates one way that gold can be used to strengthen banking systems and increase liquidity in financial markets.