I got this article from a source in the mainland.
In short, some enterprises in China use gold leasing from banks to solve their short-term funding problems in the hope of buying back the gold at lower levels to repay the lease. However they can be short-squeezed when gold moves higher. My source was so kind to do a quick translation for us (the west):
The Gold Bear Market Game: Spread Arbitrage Through Gold Leasing For Individuals
January 20, 2014
By Chen Zhi, Shanghai
It’s Spring Festival time again. A private business owner Chen Qian (Alias) is unhappy with her own investment impulse.
At the beginning of January, she got the 11 million RMB from a due trust product and she wanted to use it as the cushion to pay for the bills for procurement. 2 weeks later, because she couldn’t resist the temptation of a real estate trust product with an annualized rate of 11%, she put her money into this product.
To her surprise, because another sum of sales proceeds was said to be delayed, she now needed some money to pay for business procurement.
In fact, this is not her first time to be in a shortage of funds. In the past, she could pledge trust products at banks to apply for short-term bridge loans. This year, she was told banks didn’t have enough lending capacity so the bridge loan was impossible.
Therefore, she had to try the gold lease business.
Gold lease is like this: eligible businesses can lease gold from banks and pay the same quantity and grade gold when the gold lease is due and pay the relevant gold lease rate. During the lease, businesses can sell the gold to get short-term funding.
However, to her surprise, gold lease is not only a new financing tool but many business owners use it as a modern arbitrage means.
“Among my friends, there are business owners investing tens of millions of RMB and play the gold lease risk-free spread arbitrage.” Chen Qian said. But in her opinion, this kind of risk free arbitrage may have unfathomable risks.
6.7 % Funding Cost: The Involvement Of Individuals
Chen Qian’s first experience with gold lease is from the recommendation of a jewelry manufacturer.
In the past, through gold lease, this jewelry manufacturer could easily get tens of millions yuan of “cheap”funds, even in the time of credit crunch, which made her jealous.
It works like this: the jewellery manufacturer first leases 33kg of gold from a bank and then sells it through the Shanghai Gold Exchange to get around 10 million yuan (at 303 yuan/gram). Then he uses 1.5 million (15% margin rate) to buy 33 kg of gold futures contracts and use the 8.5 million left for the short-term funding of businesses.
Because the finance expenses including the gold lease expense, the brokerage fee for the futures contract are less than 0.55 million yuan, then the effective cost for the gold lease is close to 6.7 %. At the same time, the total finance expenses for bank loans (including loan rate, to cost to buy wealth management products, business audits, etc) are more than 9 %.
But not all businesses are qualified for gold lease as a means to get low rate loans. Chen Qian’s first application for gold lease was turned down. The reason is banks only lease gold to companies involved in gold market, including gold production, fabrication, sales and trade. Gold lease is not available for high net worth individuals.
Under the guide of the jewellery manufacturer, Chen Qian found that high net worth individuals can circumvent rules to get gold lease contracts. Way No. 1: set up an enterprise related to gold business. One only needs to put the phrase “gold jewellery business” into the business license to satisfy the internal compliance needs of banks. Way No 2: use the “tunnel” provided by financial lease companies and gold fabricators. One just needs to ask them to lease gold from banks to re-lease to individuals.
In her opinion, her enterprise’s internal credit rating in banks is B+ and has enough credit limit and funds so leasing gold is simple.
“Some bank insiders say, gold lease is an off-sheet lease activity. When authorities are putting tight controls on on-sheet lending, this kind of off-sheet lease business is flexible” Chen Qian said. The biggest flexibility in her opinion is lack of generalised pricing standards.
At the moment, ICBC, CCB, SPDB, BOC etc all have gold lease businesses. The 3 banks Chen met had the following rates: the lowest 3.5 %, highest 4.2 % and one is 3.8 %
“The pricing (of the lease) is related to banks’ internal pricing of risks” a person working at a Bank’s precious metals dept. This is related to the bank’s cost to deal with future gold volatility, the cost for physical delivery etc. But he emphasized that to prevent enterprises and individuals to use gold lease to get funds for speculation, most banks don’t allow non-gold related enterprises to get involved.
Every rule has loopholes. Chen found in casual chat that gold lease has become a fashionable spread arbitrage game among the enterprise owners around.
Picking Pennies In Front Of A Bulldozer Through Spread Arbitrage.
Spread arbitrage is like this: these business owners, in the background of gold’s 28% pullback in 2013, remain bearish on gold. They “borrow”gold through different ways and sell the gold on the SGE for funds. They hope to buy back the same amount of gold to repay and get the spread when gold falls further to their targets in 2014.
“A business owner signed a 3-month gold lease agreement at the end of last year and sold the gold at $1300/oz. He said he would buy back and return the gold when gold fell to $1150/oz in Q1 2014 and pocket the $150/oz difference.” Chen said. This business owner used tens of thousands of yuan. Because banks had many limitation on gold lease targets, he chose to lease physical gold from gold producers/merchants.
Gold merchants have a lot of physical gold in hand and this gold has no interest. So they would rather lease out the gold for a return.
This method is similar to banks’ gold lease. It needs business owners to put a certain percentage as margin and use real estate as pledge. During the lease, the hedge in the gold futures agreement must be done through the gold merchant’s account to control gold price volatility. But if the gold’s fall is far less than business owner’s target price to buy back the gold at the beginning of the lease, the business owner has to meet margin calls or even suffer losses.
“Gold lease is usually shorter than 1 year because the shortage the tenor, the easier to control price volatility.” The person working at the Bank’s precious metals department said. But there are some radical rich investors.
Recently, some rich people even use the funds through gold lease to invest in high yield real estate trust products to achieve “getting something from nothing”. The spread between the yield on trust products and gold lease rate is risk free in their eyes.
“Is it really risk free?” Chen was suspicious. On the one hand, many real estate investment products are facing default risks and on the other, gold lease arbitrage is facing the volatility of gold price. If these 2 risks occur at the same time, this seemingly risk-free arbitrage could be in fact “picking pennies in front of a bulldozer.”