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Gold In London & Hong Kong Is Used To Settle COMEX Futures

Physical gold located in Hong Kong and London is used to settle COMEX gold futures contracts through “Exchange For Physical” trading in the over-the-counter market.

This post is a sequel to Understanding GOFO And The Gold Wholesale Market and COMEX Gold Futures Can Be Settled Directly With Eligible Inventory – in which Exchange For Physical (EFP) trading is explained and how it can increase or decrease open interest at the COMEX. If you’re new to this subject it’s advised to first read my previous posts.

Most gold analysts surmise COMEX 100-ounce gold futures contracts (GC) can only be physically settled through taking and making delivery. This is technically true when excluding the possibility of EFP trading in GC through the over-the-counter (OTC) market. While on Exchange trading in GC is “executed openly and competitively”, trading GC in the OTC realm (and thus the price of the gold, its form and location) is a “privately negotiated transaction” between buyer and seller. The COMEX is a subsidiary of CME Group, which offers its clients OTC trading on a platform called ClearPort.

Because the COMEX in New York is the most liquid gold futures exchange globally – offering precious metals futures denominated in the world most used currency the US dollar, gold industry participants use GC for a variety of reasons, including hedging metal held outside the contract’s deliverable geography. Subsequently, the contracts can be physically “settled” anywhere at any price through EFP.

In EFP two parties sign a futures contract (short and long) and simultaneously execute a reverse spot transaction (buy and sell). One side sells short the futures contract and buys spot gold (the spot leg is referred to as the related position by CME), while the other buys long the futures contract and sells the related position. EFP trading can increase the open interest, decrease the open interest, or not change it, depending on the existing positions held by both parties before they enter into an EFP transaction. When EFP decreases the open interest the phrase “settle positions” is applicable. Another way of saying it would be “offsetting positions” or “netting out positions”.

Let us have a look at a real life example. The next picture was sent to me by data wrangler and gold specialist Nick Laird (website Goldchartsrus.com). It’s taken from the book The Prospect for Gold: The View to the Year 2000 by Timothy Green. In the excerpt the author describes how the Russians sold their gold in Switzerland during the eighties.

screen-shot-2016-12-05-at-12-59-56-pm
Exhibit 1.

This example matches my previous one regarding EFP (hedging metal held outside the contract’s deliverable geography). Any bullion bank, miner or refinery can sell short on COMEX and when the gold needs to be physically “settled”, for example in Switzerland, the short position can be unwound through EFP. The only requirement is that “the quantity of the related position component … must be approximately equivalent to the quantity of the Exchange component” – meaning the spot leg must be more or less 100-ounces of gold, which is the underlying asset of GC. In this example the GC short holder connects through CME ClearPort to Exchange For Physical. In the EFP transaction he will buy long a futures contract and simultaneously sell spot. His long and short will then be netted out while he sells spot the physical in Switzerland. Effectively, a COMEX short has been physically settled outside the contract’s deliverable geography. Naturally, a long position can also be unwound in Switzerland, which is then the other side of the trade.

EFP Moves Kilobars Through CME’s Hong Kong Vaults

In March 2015 CME launched a Gold Kilo Futures contract (GCK) physically deliverable in Hong Kong, but ever since implementation there has been poor participation in this instrument. From the start GCK trading volume has been close to nothing and deliveries rarely occur. Notwithstanding, there are massive volumes of kilobar gold flowing through the CME approved warehouse in Hong Kong owned by Brink’s, Inc.. On average 3.9 tonnes per day are withdrawn from this vault, but sometimes daily withdrawals are as high as 20 tonnes.

cme-gold-kilo-hong-kong-data
Exhibit 2. CME Kilobar delivery volume is so low it’s not visible.

Because volume and delivery for GCK on Exchange is so low, the withdraws must be explained by OTC trades. A CME representative actaully confirmed this to me; the physical movement through the Hong Kong vaults is caused by EFP transactions.

But if we look at the GCK volume page we can never observe any EFP trades being disclosed. In contrast, EFP volume of GC is substantial. Can it be gold kilobars in CME’s approved warehouses in Hong Kong are used to settle the 100-ounce futures contracts? Yes.

The underlying asset of GC is “either one (1) 100 troy ounce bar, or three (3) one (1) kilo bars, … with a weight tolerance of 5% either higher or lower, … [assaying] to a minimum of 995 fineness”, the underlying asset of GCK is “one kilogram bar (32.15 troy ounces) … [and] shall assay to a minimum .9999 fineness”. It’s thus within the indicated confinements on EFP trading that the 100-ounce gold futures contract is physically settled with three kilobars in Hong Kong.

My theory is that kilobars bought by bullion banks in the West, for example at Swiss refineries, to be consigned to China are hedged on the COMEX and once the gold arrives is Hong Kong the shorts are unwound through EFP. From there the gold is transported by armored truck to Shanghai Gold Exchange designated warehouses in Shenzhen by Brink’s that has a cross-border logistics license from the Chinese government. Supportive to my theory, see exhibit 3 below. Notice the strong correlation between “gold import into Hong Kong versus kilobars received in CME’s vaults” and “re-export from Hong Kong versus kilobars withdrawn from CME’s vaults”.

hong-kong-monthly-gold-trade-vs-cme-hong-kong-kilobar-vault-activity
Exhibit 3.

The correlation points out most gold moving through Hong Kong, which is headed for China, is in kilobar form and moves through CME’s vaults. And because most of this throughput is EFP related, I assume the kilobars are used to settle COMEX futures.

It’s hard to test if my theory is accurate because EFP transactions are executed in the OTC realm and little information is available. Possibly, al throughput in Hong Kong is EFP related but doesn’t impact the GS open interest. If anyone has a different theory please comment below.

London Gold Offsets COMEX Futures

We’ve established gold in Switzerland and Hong Kong is used to “settle” gold futures. But there is also proof gold in London is used to phase out positions on the COMEX. When researching this topic I reached out to William Purpura who is, inter alia, Chairman at Northport Commodities, member of the COMEX Governors Committee, and previously traded on the COMEX floor from 1982 to 2007. I asked Purpura for an example of how EFPs are used. He replied [brackets added by me]:

Most of it [EFP] is done by bullion banks. … It’s mainly for netting out. Lot’s of times London versus New York. You see lots of EFPs posted around 8am in New York on COMEX.

There it is, “London versus New York”, and, “netting out”. From this quote we learn loco London gold is used to execute EFPs to wash out New York futures positions. One can argue the related position in London is “unallocated” – I’m not sure. In the latest formulation by CME on EFP (Market Regulation Advisory Notice RA1311-5R) it’s stated:

Where the related position component … is a physical transaction … the transaction should be submitted for clearing as an EFP transaction type.

Often in wholesale gold market parlance physical is also used for “unallocated gold”, which is not exactly physical in my opinion.

I’m sure there are many more methods than I’ve mentioned to use EFP, or any other privately negotiated transaction (PNT) available on ClearPort, that influences the open interest at the COMEX. One thing is for sure, conventional delivery is not the only way to terminate futures positions. In the gold futures rulebook this is explicitly noted by CME Group. The excerpt below is about terminating a gold futures contracts [brackets added by me].

113102.E. Termination of Trading

No trades in Gold futures deliverable in the current month shall be made after the third last business day of that month. Any contracts remaining open after the last trade date must be either:

(A) Settled by delivery which shall take place on any business day beginning on the first business day of the delivery month or any subsequent business day of the delivery month, but no later than the last business day of the delivery month.

(B) Liquidated by means of a bona fide Exchange for Related Position [/EFP] … .

This is important for our comprhension of the global paper and physical gold market. COMEX gold futures delivery statistics are not all there is to it.

H/t Ronan Manly, Bron Suchecki, Nick Laird from Goldchartsrus.com

COMEX Gold Futures Can Be Settled Directly With Eligible Inventory

The 100-ounce Gold futures contract listed on the COMEX in New York can be traded in OTC market through which the contract can be “settled” with anything that resembles the underlying asset, for example gold recorded as eligible inventory in COMEX approved depositories.

Make sure you’ve read GOFO And The Gold Wholesale Market before continuing.

It’s widely discussed COMEX gold futures contracts (GC) can only be physically delivered with gold recorded as registered inventory in COMEX approved depositories, which currently stands at multi year lows. In the same spirit it’s discussed the ratio between the open interest and registered inventory is at an all time high. I would say this is technically true. However, essential to mention is that the COMEX facilitates a mechanism through which trading in GC does not have to be “executed openly and competitively on the Exchange”. Effectively, “settlement” of gold futures contracts can be negotiated in the Over The Counter (OTC) market, at a different price than floats on the Exchange, and executed with anything that resembles the underlying asset; example given, eligible inventory. This settlement in the OTC market then circumvents normal physical delivery. In my opinion this insight is significant for our approach to COMEX trading.

Conventionally COMEX gold futures contracts are traded “on the Exchange” through CME’s electronic trading platform Globex or through the old fashion way of Open Outcry. Roughly 95 % of total GC trading volume is executed on the Exchange. Market takers can choose to sell short (or respectively buy long) GC contracts by submitting bid (ask) quotes at the Exchange, in order to make physical delivery (take delivery) of gold at a fixed date in the future, or for hedging or speculative purposes. If one has no interest in making (taking) delivery the short (long) position must be closed or rolled before delivery date is reached. When traders open new positions (short or long) the open interest is increased, when traders take opposite positions to existing positions they hold, or when physical delivery is made, positions are closed and the open interest is decreased.

The mechanism through which GC contracts can be traded in the OTC market is called Exchange For Physical (EFP). EFP can be seen as a forward swap whereby a futures contract is opened combined with the reverse spot trade. I will try to describe this phenomenon supported by quotes taken from official documents by CME Group (of which the COMEX is a subsidiary). The sources that I used for this post are The CME Group Risk Management Handbook, CME’s Market Regulation Advisory Notice RA1311-5R, The CME website, CME’s helpdesk (phone and email), the LBMA OTC Guide and The Gold Market by Grabbe.

To understand EFP trading in the OTC market and how it can increase or decrease the open interest we must start by establishing some nomenclature. All off-exchange (OTC) negotiated trading in CME’s contracts is what is referred to as Ex-Pit trading or Privately Negotiated Transactions (PNT). Ex-pit trades and PNTs can be subdivided in more specific types of which we will only discuss Exchange Of Futures For Related positions (EFRP) and EFP, as the rest is irrelevant for now. From The CME Group Risk Management Handbook we can read:

EX-PIT TRADING

… there are some circumstances in which a privately negotiated or ‘‘ex-pit’’ trade may be warranted. The term ex-pit trade refers to any transaction that is executed on a noncompetitive basis and outside of a traditional open outcry or electronic trading environment. The several varieties of ex-pit transactions serve slightly different purposes and may be subject to somewhat different rules. These transactions are known by a variety of names including exchange for physicals (EFPs), exchange for risk (EFRs), block trades, and cleared-only, or ClearPort, contracts. Whatever the nomenclature, they may collectively be referred to as ‘‘ex-pit’’ transactions.

…Although traditionalists in the futures industry are accustomed to referring to EFPs, … Over the years, these practices have been adopted in the context of futures markets and generalized as exchange of futures for related positions (EFRPs).

Let’s say EFP is a form of an EFRP (which both are types of ex-pit/PNTs).

On the homepage of GC at the CME website we can see it’s disclosed this contract can be traded off-exchange (OTC) through CME ClearPort.

Screen Shot 2016-02-04 at 5.25.10 pm
Courtesy CME Group

What is ClearPort? Again, we’ll read a little in The CME Group Risk Management Handbook to understand: 

CME ClearPort should not be thought of as a trading platform or as a clearing service. Rather it is best understood as an Internet or web-based gateway. The CME ClearPort system currently provides traders a wide degree of latitude to conduct transactions in literally hundreds of energy, metals, and other contracts. These transactions are executed off exchange in a bilateral transaction directly between buyer and seller. This is much like the execution of any other OTC derivatives contract.

… By submitting OTC transactions to the CME ClearPort process, one enjoys the financial sureties afforded by the Clearing House.

So ClearPort is a gateway through which market participants can use EFP to trade GC contracts OTC style.

For an overview of what was just discussed,  let’s head over to CME’s website and look at the volume page of GC. We can see PNT/ClearPort volume (framed in red in the screen shot below) is the sum of block trades, EFP, EFR, EFS and TAS, and Total Volume (framed in green in the screen shot below) is the sum of Globex, Open Outcry and PNT/ ClearPort volume. Have a look at the headers and the numbers below.

Screen Shot 2016-02-05 at 5.51.32 pm
EFP participants are required to submit their trading volume to CME, not settlement prices or the offsetting positions. (Green and red frames added by Koos Jansen.)

Again, Total Volume of GC consist of Globex, Open Outcry and PNT/ ClearPort trading.

The next step is to understand what EFP is. According to the most recent formulation by CME Group (Market Regulation Advisory Notice RA1311-5R, 2014):

An Exchange for Related Position (“EFRP”) transaction involves a privately negotiated off-exchange execution of an Exchange futures … contract and, on the opposite side of the market, the simultaneous execution of an equivalent quantity of the … related product … corresponding to the asset underlying the Exchange contract.

One party to the EFRP must be the buyer of the Exchange contract and the seller of (or the holder of the short market exposure associated with) the related position; the other party to the EFRP must be the seller of the Exchange contract and the buyer of (or the holder of the long market exposure associated with) the related position. …

(I will quote from the above paragraph later on.) 

The related position component of an EFRP must be the cash commodity underlying the Exchange contract or a by-product, a related product or an OTC derivative instrument of such commodity that has a reasonable degree of price correlation to the commodity underlying the Exchange contract. The related position component of an EFRP may not be a futures contract or an option on a futures contract.

Where the related position component of an EFRP is a physical transaction … the transaction should be submitted for clearing as an EFP transaction type.

For the sake of simplicity we won’t discuss all varieties of EFP described by CME Group in the Market Regulation Advisory Notice RA1311-5R, but only what I believe is the common denominator: a forward swap. In a previous post I described what a forward swap is, how it’s executed in the London Bullion Market and that it’s usually referred to in short as a swap. When a (forward) swap is executed in the futures realm this is done through EFP, as James Orlin Grabbe wrote in the late nineties:

While forward gold is traded in the form of swaps, which combines a spot trade (buy or sell) with the reverse forward trade (sell or buy), gold futures can be traded in the form of EFPs (exchange for physicals), which combine a futures trade with the reverse spot trade.

The CME Group Risk Management Handbook (2010) also describes EFP to be a swap:

Technically, an EFP refers to a transaction in which a futures position is assumed in juxtaposition to an offsetting … spot transaction.

So, we’ll focus on the swap characteristics of EFP.

In EFP two parties sign a futures contract (short and long) and simultaneously make a spot transaction (buy and sell). One party sells short the futures contract and buys spot gold (the spot leg is referred to as the related position by CME), while the other party buys long the futures contract and sells the spot related position. EFP trading can increase the open interest, decrease the open interest or not change it, depending on the existing GC positions held by both parties before they enter into an EFP transaction.

Example given how EFP can increase the GC open interest: Suppose two traders, Mister A and Mister B, have no existing GC positions. Mister A and B connect through CME ClearPort and privately negotiate to enter into an EFP transaction. Through EFP Mister A buys long 1 GC (the buyer of the Exchange contract) and simultaneously sells spot gold (the seller of … the related position). Mister B sells short the corresponding GC (the seller of the Exchange contract) and simultaneously buys the corresponding spot gold (the buyer of … the related position). In this example the open interest is increased by 1, counted unilaterally, as both Mister A and B open a new GC position (1 short, 1 long). The movement in the related position (the spot leg) is irrelevant to the open interest.

Example given how EFP can decrease the GC open interest: Suppose, Mister A is short 1 GC to be delivered in December 2016 and Mister B is long 1 GC to be delivered in December 2016. Mister A and B connect through CME ClearPort and privately negotiate to enter into an EFP transaction. Through EFP Mister A buys long 1 GC December 2016 (the buyer of the Exchange contract) and simultaneously sells spot gold (the seller of … the related position). Mister B sells short 1 GC December 2016 (the seller of the Exchange contract) and simultaneously buys the spot gold (the buyer of … the related position). In this example the open interest is decreased by 1, as the existing positions by Mister A and B before entering into the EFP transaction have been offset by both taking an opposite futures position through EFP and simultaneously exchanging spot gold. What happened is that Mister A and B settled their existing GC December 2016 position (short and long) through EFP. This settlement can only be performed if both parties agree in EFP. No short or long GC position can be forced to settle through EFP.

Naturally, EFP can leave the GC open interest unchanged if either Mister A or B has an existing position and the other one not before both enter into an EFP transaction.

Let us move further to the essence of this post. The COMEX publishes the amount of gold stock in its approved depositories in two categories: eligible and registered inventory. Factually, gold stock recorded as eligible or registered is required to respect exactly the same specifications and are both stored in vaults “within a 150-mile radius of the City of New York“. The only difference between the two is that registered gold has a warrant attached to it. From the COMEX rulebook we can read:

Eligible metal shall mean all such metal that is acceptable for delivery against the applicable metal futures contract for which a warrant has not been issued. Registered metal shall mean an eligible metal for which a warrant has been issued.

…A warrant shall mean a document of title … demonstrating that the referenced quantity of the covered metal, stored in the facility referenced thereon, meets the specifications of the applicable metal futures contract.

comexstockpileau05
Courtesy Sharelynx.com. Registered inventory has almost dried up while there is ample eligible inventory.

Through the conventional process – without OTC trading – GC is physically delivered with “either one (1) 100 troy ounce bar, or three (3) one (1) kilo bars, … with a weight tolerance of 5% either higher or lower, … [assaying] to a minimum of 995 fineness”, which is located in a COMEX approved depository in New York and has a warrant attached to the gold. On the warrant the serial numbers of the bar(s) are written, and it is this warrant that changes hands when the gold is delivered from a short to a long. Because physical delivery is done with warrants, often only registered inventory is presented by analysts when comparing COMEX gold stock to the open interest or other economic parameters.

But, as we just learned GC can also be settled through EFP. The punch line of EFP is that the related position (the spot leg) can be anything that resembles 100 ounces of gold. Through EFP “the quantity of the related position component … must be approximately equivalent to the quantity of the Exchange component”. Therefor, the related position is allowed to be gold recorded as eligible inventory in New York, but it can also be Good Delivery bars or a bag of gold coins located anywhere on this planet. Yes, CME confirmed to me in black and white the related position in EFP has no geographical limitations. The physical gold used in EFP for settlement of GC does not have to be located in New York.

Does CME generally inspect what these related positions are? Well, CME can ask EFP parties to show their offsetting (/related positions) accounts. From The CME Group Risk Management Handbook we can read [brackets added by me]:

The … spot … position that is traded opposite to the futures contract must be a product that represents a legitimate economic offset.

After the two counterparties consummate the [EFP] transaction, the futures position is reported to the CH [CME Clearing House] through a clearing member via electronic systems. The cash position [/related position] continues to be held in appropriate accounts established by the EFP counterparties and is not reported to the exchange upon execution. If called on during the course of a periodic audit, however, clearing members may be required to produce statements that show the offsetting position was transacted and meets exchange standards as a valid offsetting position.

What about the price at which EFP is executed? Again, these trades are OTC so the price is privately negotiated between the EFP participants – and are not likely to be in line with prevailing prices on CME’s Globex. A CME representative told me over the phone that EFPs are usually quoted by brokers in dollars that reflect the difference in price between the spot (related position) and the futures leg. From the Market Regulation Advisory Notice RA1311-5R we can read:

EFRPs may be transacted at such commercially reasonable prices as are mutually agreed upon by the parties to the transaction.

… The price of the Exchange leg of an EFRP transaction is not publicly reported. EFRP volumes are reported daily, by instrument, on the CME Group website.

From The CME Group Risk Management Handbook we can read:

An EFP may be transacted at any time and at any price agreed on by the two counterparties. Two customers may transact an EFRP among themselves provided that the resulting futures position is subsequently submitted to the CME Clearing House (CH) through the facilities of a clearing member.

Last but not least; below is a chart showing EFP volume, clearly this concept is not something unusual. On average 4 % of total daily trading volume in GC is performed through EFP. If EFP volume is 8,000 a day the lower bound is that the open interest is decreased by 8,000 contracts, the upper bound is that the open interest is increased by 8,000 contracts.

gc efp gold futures

This concludes the introduction of EFP. More will be discussed in forthcoming posts.

Addendum

Btw, this is helpful as wel. From CME:

113102.E. Termination of Trading

No trades in Gold futures deliverable in the current month shall be made after the third last business day of that month. Any contracts remaining open after the last trade date must be either:

(A) Settled by delivery which shall take place on any business day beginning on the first business day of the delivery month or any subsequent business day of the delivery month, but no later than the last business day of the delivery month.

(B) Liquidated by means of a bona fide Exchange for Related Position (“EFRP”) pursuant to Rule 538. An EFRP is permitted in an expired futures contract until 12:00 p.m. on the business day following termination of trading in the expired futures contract.

Strong Withdrawals Mainland & Hong Kong Gold Vaults

From June 8 – 12 withdrawals from SGE certified vaults in China mainland and CME Kilobar vaults in Hong Kong accounted 76 for tonnes.

Withdrawals from the vaults of the Shanghai Gold Exchange (SGE) and Shanghai International Gold Exchange (SGEI) came in elevated for this time a year at 46 tonnes in week 23 (June 8 – 12), up 41 % from the previous week.

Shanghai Gold Exchange SGE withdrawals delivery 2015 week 23

Shanghai Gold Exchange SGE withdrawals delivery only 2014 - 2015 week 23

Year to date a staggering 1,061 tonnes have been withdrawn, up 20 % y/y (2014), up 7 % y/y from 2013.

SGE withdrawals have lost their accuracy since the launch of the SGEI in September 2014 – withdrawals in the Shanghai Free Trade Zone (SGEI) can distort Chinese wholesale demand measured by SGE withdrawals (SGE withdrawals disclosed in the weekly reports capture both SGE and SGEI withdrawals). From numbers available in 2014 we knew that not much of SGEI trading was withdrawn by foreign SGEI members; most of the withdrawals in the Shanghai Free Trade Zone were imported into the mainland by SGE members.

For more information please read The Mechanics Of The Chinese Domestic Gold MarketChinese Gold Trading Rules And Financing Deals ExplainedThe Workings Of The Shanghai International Gold Exchange and SGE withdrawals in perspective.

At this stage total SGE withdrawals, as disclosed by the weekly SGE reports, are difficult to analyze as we didn’t get any hints lately from the Chinese as to what is composition of the demand side of withdrawals, how much are SGEI withdrawals that are not imported into the mainland, and what is the composition of the supply side, how much gold is imported into the mainland and/or recycled to supply SGE withdrawals. Technically, all trades (volume) on the SGEI can be withdrawn and exported to, for example, India. This is not likely, but we don’t know. Attempts from my side to obtain the latest data regarding SGEI withdrawals have resulted in little intelligence.

In week 23 (June 8 -12) total SGEI volume was 35 tonnes; international gold trading in renminbi slowly comes to life.

SGE & SGEI contracts bullionstar

The iAu99.99 contract is traded on the SGEI; Au99.95, Au99.99 and Au(T+D) are traded on the SGE.

Hong Kong Kilobar Withdrawals

In March 2015 the Chicago Mercantile Exchange (CME) launched a gold kilobar futures contract, which can be physically delivered in Hong Kong. The contract can be traded over exchanges (CME Globex, CME ClearPort, CME Direct, New York open outcry) and in the Over The Counter (OTC) market.

The kilobar volume over exchanges is insignificant and I’m not aware if any delivery is made from these trades. However, if we look at the physical gold throughput of the Hong Kong vaults, we must conclude this contract is a popular trade in the OTC market. This has been confirmed to me by a CME representative. Note, withdrawals from the Hong Kong vaults transcend the volume disclosed by the Merc, so the physical settlements must happen in the  OTC market.

I would like to emphasize kilobar withdrawals do not have the same significance as SGE withdrawals. The mechanics of the gold market in Hong Kong are completely different from the market in the mainland. Hong Kong has been a trade hub for centuries; gold is imported and exported in vast amounts. Kilobar withdrawals do not reflect gold demand; it does illustrate how much is going through the Chinese Special Administrative Region (Hong Kong).

Kilobar withdrawals

In week 23 kilobar withdrawals in Hong Kong accounted for 30 tonnes. On June 8 a record 16.61 tonnes in 9999 kilobar gold was withdrawn from the Brink’s vault in Hong Kong.

Hong Kong monthly gold trade January 2013 - March 2015
This chart is an example for the amount of gold flowing through Hong Kong.