Tag Archives: gold lease rate

GOFO And The Gold Wholesale Market

An essay on the relationship between GOFO, gold forwards, the gold lease rate and the US dollar interest rate.

In order to continue to reveal essential information about the physical and paper gold markets around the world, first I would like to expand on the inner workings of the gold wholesale market. In this post we’ll use the Gold Forward Offered Rates, in short GOFO, as an excuse to illuminate the most vital gears that drive the gold market engine. For, if we truly understand GOFO we also understand gold leasing, forwards and swaps, which are the building blocks of the gold wholesale market. Therefor, the goal of this post is to achieve a thorough understanding of  GOFO.

GOFO officially “represents rates at which the market making members will lend gold on swap against US dollars”, but GOFO also resembles the gold forward rate and the difference between the US dollar interest rate and the gold lease rate. The purpose of this post is to explain all this in a simplified way.

Let us start discussing gold forward contracts and work our way through this. Please be aware this post requires some studying and is not an easy read.

Gold Forward Contracts

In the gold market there are several possibilities to enter into contracts for buying or selling gold at a future date. These contracts can be used by gold market participants to lock in a future gold price or for speculation. The most common contracts are forwards and futures. On exchanges (organized markets) such as the COMEX gold futures contracts are traded, in the over the counter (OTC) market gold forwards are traded. For this post we’ll mainly focus on forwards.

Below is a chart in which I’ve plotted an exemplar gold forward curve based on mid market rates. In addition, I’ve added a table in the chart with the the bid and ask quotes (that set the mid market rates). The bid quotes represent the prices at which market making members are willing to buy gold at a pre-determined date in the future. These are the same prices at which we the market takers are willing to sell gold at a corresponding date in the future. The ask, or offer, quotes represent the prices at which market making members are willing to sell gold at a pre-determined date in the future (market takers buy at these prices). The mid market rate is the mid-point between the bid and ask price. Have a look at the chart and the table.

Forward curve gold price
Chart 1. Gold forward curve. The slippage is $0.15.

Please note, forward prices reflect what the market expects now about the future based on present circumstances. Forward prices do not determine what the actual spot price in the future will be.

We can see the bid-ask spread in this example is a constant $0.3 for every gold forward contract. In reality these spreads can vary and are determined by the liquidity of the forward contract. For liquid contracts, which are traded in high volumes, the spread is thin (meaning the spread between the bid and ask quotes is small). For illiquid contracts the spread is wide.

Furthermore, the difference between the mid market rate and the bid (or ask) is called the slippage.

Let’s have a look at a simplified example how a gold forward contract can be used. Say, a gold mining company anticipates the gold price will decline in the future. The miner has a steady output of 1,000,000 fine ounces a year and his annual expenses are 1.3 billion dollars, all to be paid at the end of the year. His business is viable starting at a gold price of $1,300 dollars an ounce. To ascertain to stay in business over one year’s time the miner can choose to enter into a 12 months forward contract in order to sell gold for $1,310.74.

The seller of a forward contract is said to be short, the buyer of the contract is said to be long. The total amount of shorts and the total amount of longs are always equal with respect to forward and futures contracts. The total amount of outstanding contracts is what is referred to as the open interest.

The long, in example, is a jewelry company that in turn seeks to lock in a future price for the well being of his enterprise. Perhaps it makes economic sense for the jeweler to borrow gold for the fabrication of gold ornaments, in the now, a loan he’s required to repay in one year’s time. Not to be exposed to future swings in the gold price he can choose to buy 12 months gold forward, assuring him to be able to repay the gold loan when it comes due.

Let us move on to the workings of the gold lending (/lease) market.

The Gold Lease Market

In a free market any currency can be lent out. Whether it’s the US dollar, euro, Norwegian krone or gold. Interest is paid from the borrower to the lender to stimulate supply, compensate for the risk of defaulting on the loan and postponement of using the currency. It’s true precious metals safely stored in a vault do not yield, however, when metal is lent out it will accrue interest. Gold lending in the gold wholesale market is referred to as gold leasing, and the acronym for the gold lease rate is GLR.

The interest on a gold loan can be settled in gold or dollars, although most often the latter is agreed. From the London Bullion Market Association we can read:

Market convention is for the interest payable on loans of precious metals to be calculated in terms of ounces of metal. These ounces are then generally converted to US dollars, based upon a US dollar price for the metal agreed at the inception of the lease transaction.


In the past decades the most prominent gold lenders have been central banks. During perceived economic stability it was thought to be safe for central banks to lend large portions of their official gold reserves. Though, in recent years these leases have been unwound to a great extent.

A borrower in the gold market can be, in example, the jewelry company mentioned in the previous chapter. In need of funds for production goods the jeweler can borrow dollars at ie 6 % from a bank, or he could directly borrow gold at ie 2 %. Historically, the normal state of the gold market offered a lower GLR than US dollar interest rate.

Below is a chart with an exemplar gold lease curve – showing the mid market GLR for several tenors. The gold lease bid is the interest rate market making members are willing to pay for borrowing gold (and the rate market takers are willing to receive for lending gold), the gold lease ask is the interest rate market making members want for lending gold (and we the market takers are willing to pay for borrowing gold).

Gold lease rate curve
Chart 2. Gold lease rate curve. 

Usually interest rates in financial markets are calculated on a 360 days a year basis.

Let us move on to combine currency lending, spot and forward markets, and come to grips with how these are interrelated and how the wholesale market in general functions.

Interest Rate Parity

Free markets that cater liquid venues for lending currencies, spot exchange and trading in forward contracts give rise to a concept called interest rate parity. This concept can be tough to get your head around, therefor I will describe it first and then show the math to clarify it.

Let us start at the base: the interest rate of any currency affects the forward value of this currency, because loans based on the interest rate grow into more supply of the currency over time. In example, a $5,000 US dollar loan at a 6 % US dollar interest rate grows into $5,300 in 1 year.

The theory of interest rate parity suggests that the interest rates of two currencies determine the forward relationship between the values of these two currencies (/the forward price of either currency denominated in the other). As, both interest rates generate a return in the future, the volumes of which determine the forward price. With respect to gold, interest rate parity suggests the forward gold price is firmly correlated to the gold lease rate and US dollars interest rate.

We should get familiar with the math that clarifies interest rate parity. We’ll work with the following exemplar market: the spot gold price is $1,200, the US dollar interest rate is 6 % and the GLR is 2 % – we’ll ignore bid-ask spreads for now. From here it can get complicated. Suppose, a trader borrows $1,200 for 6 months (180 days) at the annual US dollar interest rate of 6 %. When the loan comes due the trader is obliged to repay the principal plus interest to the US dollar lender. In the following formula we can see the principal (1,200), the interest rate (0.06) and the tenor (180/360) going in:

$1,200(1+0.06(180/360)) = $1,200(1.03) = $1,236

With the dollars borrowed the trader can buy 1 ounce of gold on spot and lend it for 6 months. When the gold loan matures the trader will get back the principal plus interest. In the next formula we can see the principal (1 oz), the interest rate (0.02) and the tenor (180/360) going in:

1(1+0.02(180/360)) = 1(1.01) = 1.01 oz

Remarkably, as we know the spot gold price and the volumes the loans grow into, we can compute the 6 months forward gold price: the gold lend by the trader will grow into 1.01 ounces over a 6 months time horizon and his dollar loan will grow into $1,236 over the same period, so consequently the 6 months forward gold price is $1,223.76.

$1,200/1       = $1,200         = spot gold price

$1,236/1.01 = $1,223.76   = forward gold price

As mentioned above, “both interest rates generate a return in the future, the volumes of which determine the forward price”.

In one formula it will show the 6 months forward gold price is:

$1,200(1+0.06(180/360)) / (1+0.02(180/360)) = $1,223.76

We can see the forward gold price is higher than the spot gold price because the GLR is lower than the US dollar interest rate.

Interest rate parity

The market will set the 6 months forward gold price at $1,223.76, because any undervalued or overvalued forward gold price (bellow or above $1,223.76) would immediately be arbitraged (interest rate parity is said to be “a no-arbitrage condition”).

Let’s have a look at an arbitrage trade in case the forward gold price would diverge from the forward price suggested by the theory of interest rate parity. Suppose, interest rates and the spot gold price are the same as above, but now the quoted forward gold price is too low at $1,220. To arbitrage this opportunity you want to buy (long) this cheap forward gold. Spot–forward arbitrage requires the opposite trade in the spot market – or one would just enter into a forward contract – in this case sell spot gold. If you don’t have spot gold you can borrow it. We can identify two legs in our arbitrage trade:

sell spot gold = buy spot dollars

buy forward gold = sell forward dollars

The chronological order to arbitrage undervalued forward gold would be:


  • borrow 1 ounce of gold for 6 months at 1 % (an annual GLR of 2 % divided by 2. In this example the gold interest will be settled in gold)
  • sell 1 ounce of gold on spot for $1,200
  • lend the $1,200 for 6 months at 3 % (an annual 6 % US dollar interest rate divided by 2)
  • buy long a 6 months gold forward contract for 1.01 ounce at the quoted forward gold price of $1,220 per ounce to repay the gold loan plus interest. The 6 months forward contract will have a notional value of:

1.01*$1,220 = $1,232.2

Then, in 6 months time,

  • receive $1,200 plus interest for the dollar loan:

$1,200*1.03 = $1,236

  • settle the gold forward contract by paying $1,232.2 for 1.01 oz
  • repay the gold loan with 1.01 oz

The total revenue of the arbitrage trade is $1,236 dollars. Having to settle the forward with $1,232.2, leaves a profit of $3.8:

$1,236−$1,232.2 = $3.8

The arbitrage opportunity will be taken advantage of until it’s closed, at that point in time the 6 months forward gold price is $1,223.76. For more clarity I should add that the closing of the arbitrage opportunity happens in the now, not in 6 months time. In addition, when the arbitragers step in the forward gold price could be pushed up from $1,220 to $1,223.76, as we’ve seen in the example trade, though in reality the other variables, such as the spot gold price or the GLR, can give way as well until interest rate parity has manifested. Interest rate parity suggests the spot, lending and forward markets are strongly linked. If one market is moving the others will move accordingly.

In reality everything is more complicated than in our exemplar market because of additional costs involved such as collateral/margin requirements and transaction/shipping/insurance costs (and because interest rate parity is just a theory, which does not always hold).

James Orlin Grabbe, the author who inspired me to pen this post, wrote in the late nineties: 

The forward price of gold – the price agreed now for gold to be purchased or sold at some time in the future – is a function of the gold spot price, and the interest rates representing alternative uses of resources over the forward time period.

James orlin grabbe 2
James Orlin Grabbe.

Introducing GOFO

So, we can compute the forward gold price from the spot gold price, US dollar interest rate and GLR. The formula can be written as:

F(T) = S(1+r(T/360)) / (1+r*(T/360))

F(T) = the forward gold price over a time horizon T days (up to 360 days)

S = the spot gold price

r = US dollar interest rate

r* = GLR

From this equation there is more to reveal. In our exemplar market the spot gold price is $1,200 and the 6 months forward gold price is $1,223.76. Ergo, the 6 months gold forward premium in percentages (/the forward rate) is:

($1,223.76/$1,200)−1 = 0.0198 = 1.98 %

The 6 months forward rate is by approximation 2 % and consequently the annualized forward rate is by approximation 4 %. The difference between the US dollar interest rate (6 %) and the GLR (2 %) is also 4 %. Meaning, the forward rate equals the difference between the US dollar interest rate and GLR. Why? Math. If we play with the formula above we get a nominal forward premium of:

F(T)−S = $1,223.76−$1,200 = $23.76

And by using (r−r*) as difference between the US dollar interest rate and GLR, we get:

S(r−r*)−S = $1,200(0.03−0.01) −$1,200 = $24

The forward rate equals the difference between the US dollar interest rate and the GLR. At this point I would like to bring up GOFO. Grabbe wrote:

Gold forward rates are sometimes referred to as “GOFO” rates, because GOFO was the Reuters page that showed gold forward rates.

Although this is not the official definition of GOFO, it is true that GOFO resembles the forward rate. I say ‘resembles’ and not ‘equals’, because there is a tiny difference we will discuss in the final chapter about GOFO.

Finally, we have explained two descriptions of GOFO mentioned in the introduction of this post. Namely, GOFO resembles the gold forward rate and the difference between the US dollar interest rate and the gold lease rate. The official and exact definition of GOFO we’ll save for last.

GOFO ≈ US dollar interest rate − GLR

GLR ≈ US dollar interest rate − GOFO

US dollar interest rate ≈ GOFO + GLR

GOFO, GLR and US$ interest rate
Chart 3. A positive gold forward rate is called contango.

When the forward rate is negative this is called backwardation. A negative forward rate implies gold for immediate delivery is trading at a premium to gold for future delivery. This can be caused by tightness in supply now or by market expectations the price will fall in he future. Backwardation is the opposite of contango, a positive forward rate. Historically contango has been the normal state of the gold market whereby the GLR is lower than the US dollar interest rate.

Because GOFO resembles the gold forward rate, negative GOFO implies backwardation in the gold forward price. Unfortunately, GOFO is not being published anymore after it was negative for long periods in 2013 and 2014. The LBMA writes on its website:

GOFO … was discontinued with effect from 30 January, 2015, following discussions between the LBMA and the contributors to the dataset, the LBMA Forward Market Makers.

So much for transparency.

In the chart below we can see GOFO went negative repeatedly in 2013 and 2014. The cause was presumably tightness in spot gold supply, as every time GOFO went sub-zero the spot gold price was pushed up.

GOFO 2013 and 2014
Chart 4. The 1, 2, 3, 6 and 12 months GOFO rates from July 2013 until April 2014.

In the interest rate parity chapter we examined an arbitrage trade that surfaced when the forward gold price was too low in relation to the prevailing US dollar interest rate and GLR in our exemplar market. Naturally, a comparable arbitrage opportunity arises when the forward gold price is too high in relation to the prevailing US dollar interest rate and GLR. Say, the 6 months forward gold price in our exemplar market is not $1,223.76, but higher at $1,300. This time we want to sell overvalued forward gold and buy spot gold to strike a profit:

buy spot gold = sell spot dollars

sell forward gold = buy forward dollars


  • borrow 1,200 dollars for 6 months at 3 % (an annual US dollar interest rate of 6% divided by 2)
  • buy 1 ounce spot gold for 1,200 dollars
  • store the gold for a storage fee of $5 for 6 months
  • sell short a 6 months gold forward contract at $1,300 for 1 ounce. The forward contract will have a notional value of:

1*$1,300 = $1,300

In 6 months time,

  • settle the forward: deliver 1 ounce of gold and receive $1,300
  • pay storage costs $5
  • repay the initial dollar loan:

$1,200*1.03 = $1,236

The proceeds of the gold forward are $1,300. Total expenses of the dollar loan ($1,236) and storage costs ($5) are $1,241, which leaves a profit of $59.

$1,300−$1,236−$5 = $59

The trade can also be executed by buying spot gold end lend the metal for 6 months instead of storing it. In that case the profit would be higher as the storage costs would be replaced by interest accrued on the gold loan. A 6 months gold loan of 1 ounce would grow into 1.01 ounce. When this gold loan is settled in dollars, the return would be the interest in ounces converted to dollars based on the spot gold price:

0.01*$1200 = $12 (dollar return on 6 months gold loan)

Using a dollar return on the gold loan would give a profit in our previous arbitrage trade of:

$1,300−$1,236+$12 = $76

The difference in profit ($76 – $59 = $17) is of course equal to the storage costs plus the dollar return on the gold loan ($5 + $12 = $17).

More on the pricing of commodity forward/futures contracts and the interaction between the theory of interest rate parity and the theory of storage will be discussed in a forthcoming post.

Gold Forward Swaps & GOFO

We’ve arrived at the official definition of GOFO, the swap. From the website of the London Bullion Market Association we can read the following official definition of GOFO:

GOFO represents rates at which the market making members will lend gold on swap against US dollars.

In parlance of the precious metals markets the word swap usually refers to a forward swap, whereby gold is sold spot and bought forward, or bought spot and sold forward. Essentially this is what GOFO is all about, a forward swap. The swap always has two legs, namely a spot and a forward leg. Consequently, the swap rate equals the forward rate.

gold swap rate = gold forward rate = US dollar interest rate − GLR

When market makers are willing to “lend gold on swap against US dollars” in the official definition of GOFO, they’re willing to execute a forward swap by selling gold spot and buying gold forward. The word “lend” in the official definition can be slightly deceiving, as strictly speaking there is no lending, the swap simulates lending: a gold loan to the market taker collateralized with dollars.

When a swap is executed and the market maker (dealer) sells spot gold to the market taker (client) and simultaneously signs a forward contract to buy it back in due time, the client buys that spot gold with dollars (collateral) and is obligated to return the metal through the forward contract at a fixed price. From the client’s perspective the process can be viewed as borrowing gold (collateralized with dollars), from the dealer’s perspective the process can be viewed as lending gold (on swap against dollars).

In the official definition of GOFO the dealer is the lender of gold but naturally he offers the reverse swap as well, whereby the dealer is the borrower. Let’s have a look at an example trade in which the dealer borrows gold: a central bank owns gold that it wants to put up as collateral for a 1 year dollar loan. The central bank and its dealer agree on a swap transaction. Based on the data from our exemplar environment the central bank will sell gold on spot to the dealer at $1,200 an ounce and then buy back the metal in 1 year’s time at $1,248 an ounce.

$1,200*(1+(0.04(360/360))) = $1,248

Essentially, the central bank has borrowed dollars for 1 year at 4 % instead of 6 % because it has collateralized the loan with gold (/lend its gold simultaneously at 2 %). Again, the swap rate is the difference between the US dollar interest rate and the GLR.

Let’s take it one step further and add bid-ask spreads to learn what GOFO is exactly. In more academic literature (The Non-Investment Products Code, NIPS code) we can read:

GOFO is the Gold Forward Offered Rate and is the rate at which dealers will lend gold on the swap against US dollars. As such it provides an international benchmark and is the basis for the pricing of gold swaps, forwards and leases. …

From GOFO rates, indicative mid-market gold lease rates can be determined as:

Mid-market lease rate = (US dollar LIBOR less 0.0625%) minus (GOFO plus 0.125%)

To explain the equation mentioned in the NIPS code, we should compare it to the one I penned in the previous chapter:

GLR ≈ US dollar interest rate – GOFO

The formulas are to a great extent similar. Though, the NIPS code uses LIBOR as the US dollar interest rate, which it corrects downwards by 0.0625 % because LIBOR is an offer rate – LIBID is its related bid. To compute the mid market US dollar interest rate the slippage, in this case 0.0625 %, is subtracted from LIBOR. In turn, GOFO is increased by 0.125 % because a “lend gold on swap against dollars” deal from a market maker’s perspective is based on the mid market spot leg, while the forward leg is the bid (in the official definition of GOFO the market maker buys forward, so the forward leg is the bid). To calculate the mid market forward leg GOFO must be increased by the slippage, which according to the NIPS code is 0.125 %. In the Nips code formula LIBOR is adjusted to come to the mid-market US dollar interest rate and GOFO is adjusted to come to the mid-market swap rate, in order to compute the mid-market GLR.

In the end both formulas are:

Mid-market gold lease rate = mid market US dollar interest rate – mid market gold swap rate

Hopefully by now you can see how understanding GOFO helps understanding the essential workings of the gold wholesale market – which is very valuable for understanding gold in general.

A Close Look At The Chinese Gold Lease Market

An important segment of the Chinese gold market that is often misunderstood in my opinion is the gold lease market. To get a better perspective on gold leasing in China I present a translation of a paper written by the PBOC, Problems Affecting The Development Of The Gold Lease Market And Recommendations, originally published in 2011.

Although the lease market was much smaller back then, the structure of the market hasn’t changed. Bullet points from the paper:

  • All leases are done through the Shanghai Gold Exchange (SGE).
  • In 2011 the PBOC had no gold leased, but the paper suggests the PBOC may participate in the domestic gold lease market to provide liquidity and develop the lease market. (If the PBOC has any gold leased at this moment I don’t know.)
  • The PBOC wanted to boost the lease market in 2011 to develop the overall Chinese gold industry – the mining and jewelry business. (This has been realized, the Chinese lease, mining and jewelry markets have grown substantially.)
  • There was a shortage of physical gold back then to meet demand in the lease market. The paper recommends to lift import restrictions, while preserving export restrictions. (This has also been realized; net gold import was 1,500 tonnes in 2013.)

To illustrate gold leasing by Western central banks, please read the next quotes from an IMF paper, Repurchase Agreements, Securities Lending, Gold Swaps And Gold Loans: An Updatepublished in 2004:

Gold loans or deposits are undertaken by monetary authorities to obtain a non-holding gain return on gold which otherwise earns none. The gold is “lent to” (or “deposited with”) a resident or nonresident financial institution (such as a bullion bank) or another party in the gold market with which the monetary authority has dealings and confidence and which is probably acting as an intermediary for a gold dealer or gold miner which has a temporary shortage of gold.

In particular, gold may be double counted with either a gold swap or gold loan/deposit if the party acquiring the gold were to on-sell it outright, because both the original owner and the outright purchaser would report ownership of the gold.

In contrast, the SGE rulebooks:

Article 3

Any member or customer who is the holder of such precious metals as gold, platinum, or silver that are placed under the custody of the Exchange may use the leasing services offered by the Exchange.

Article 4

The lessor and lessee to a stock of gold, platinum, silver or other precious metals to be leased shall sign a lease agreement. The Exchange shall be responsible for transferring the possession of such precious metals in accordance with the requests put forth by the lessor and the lessee.

Article 12

Upon a lessor approved for transfer and the corresponding lessee each submits a leasing request to the Exchange’s system, the system shall verify the requests and transfer the precious metals from the lessor’s Bullion Account into the lessee’s Bullion Account.

UPDATE 12 December 2014: after a post from Bron Suchecki it made me realize the two examples above are hard to compare. My reply on Bron’s post can be read here.  

For the ones who are unfamiliar with gold leasing I have penned three simplified examples:

  • A gold miner needs funds to invest in new production goods. It can borrow dollars from a bank at an 7 % interest rate, or borrow gold from a central bank at 2 % – the gold lease rate is usually lower than the dollar interest rate. The miner chooses to borrow 10,000 ounces from a central bank and sells it spot at $1,500 an ounce. The proceeds are $15,000,000 that can be used to invest in new production goods. In a years time the miner has mined 10,200 ounces to repay the principal debt plus interest (the interest on gold loans can be settled in gold or dollars, depending on the contract). Through gold leasing the miner has acquired cheap funding, if compared to a dollar loan. The movement in the price of gold during the lease period is neglected in this example.
  • A jeweler needs funds to buy gold stock for production. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. The jeweler borrows 10,000 ounces, with which it can start fabricating jewelry. To hedge itself against price fluctuations the jeweler can sell spot, for example, 10 % of the 10,000 ounces it has borrowed (1,000 ounces at $1,500 makes $1,500,000) to buy gold futures contracts in order to lock in a future price. After a year the jeweler has sold the 9,000 ounces (as jewelry) for dollars and can take delivery of the long futures contracts to repay the gold loan. If one buys (long) 10,000 ounces through a futures contract for delivery in a year’s time, initially he is required to pay a margin, for example 10 %. When the contract expires and he wants to take physical delivery he must pay the remaining 90 %.
  • A pseculator is looking for cheap funds. It can borrow dollars from a bank for 7 %, or borrow gold for 2 %. He borrows 10,000 ounces, sells it spot at $1,500 an ounce. The proceeds are $15,000,000 and subsequently these newly acquired funds can be used to invest in higher yielding products (> 2 %). If the trader chooses to hedge itself in the futures market is up to him. After a year the 10,000 ounces plus interest need to be repaid, either the trader can purchase gold with the profits made on the higher yielding investment or from delivery of futures contracts.

The general consensus in the gold space is that gold leasing is bad thing, though in essence it’s not. If gold is a currency what’s wrong with lending it? The problems emerge when there are multiple claims on one gold bar.

The oncoming paper is translated by Soh Tiong Hum, who I like to thank from the bottom of my heart. He has translated most of the essential articles on my blog and has helped us all in understanding the Chinese gold market. Without him we would never have gotten such accurate information out of China. Thanks TH!

The People’s Bank Of China

Problems Affecting The Development Of The Gold Lease Market And Recommendations

Source: Shanghai Finance, Date: January 2011, Authors: Ji Ming, Yan Xiaomei, Zhou Qiong, People’s Bank of China, Shanghai Headquarters.

Summary: This paper describes the current status of China’s gold lease market, discusses the problems that exist in the gold lease business and puts forward policy recommendations.

1. Brief introduction of gold leasing

The concept of gold leasing

Gold leasing is a business model carried out by commercial banks whereby physical gold is leased to fellow banks or enterprises, the same amount of physical gold is to be returned at the expiration of a contracted period together with an interest or fee. In practice, according to the nature of the counter-party, an arrangement between commercial banks is also known as gold lending whereas commercial banks to lease gold to business enterprises is called gold leasing.

Background of the emergence of international gold leasing

International gold leasing business began in the 1980s, when central banks were willing to lent part of their gold reserves to commercial banks, commercial banks then provided gold financing services, thus increasing physical support of gold in the international gold market. The appearance of gold leasing was widely welcomed by gold producers and gold jewelers. For gold producers [mining companies], gold leased from banks offered supply ahead of upcoming production, which could be sold spot to pay for operating expenses and to lock in stable prices in anticipation of a fall in the price of gold. As for jewelers, gold leasing helps to lower costs of goods sold, avoids the impact of gold price fluctuation on company finance and lowers associated market risk. The world’s first gold leasing deal was done in 1988 when three banks including the Royal Bank of Canada leased 30 tonnes to a US miner. The domestic commercial bank gold lease business in China came into being after 2005 following rapid developments of the country’s gold market with emerging demand for gold leasing from gold producers, jewelers and small and medium commercial banks.

The international gold lease business model

After twenty years of development, the gold lease market is more mature in terms of market size, body composition, pricing models and system development. Central banks (especially banks of European countries) are major suppliers of physical gold for leasing. Central banks lease out part of their gold reserves at lower rates (for example 1 % per annum) to bullion banks like HSBC, Scotiabank and JP Morgan. Once the gold is in their possession, these bullion banks can make two kinds of deals:

  1. Sell gold for US Dollars, and then use the US Dollars to invest in assets with higher returns like government bonds for spread income. These kind of deals are also known as a ‘carry trade’.
  2. The second deal, which is a traditional lease deal, is to lease physical gold to other commercial banks or producers and jewelers. At expiration, interest can be settled in physical gold or currency. The gold lease rate (GLR) is LIBOR minus GOFO, with tenors from 1 month to 1 year.

International gold leasing is very market-oriented. It has a high level of transparency as rates are published daily on major websites. The gold lease rate plays an important role in the gold market; on one hand the gold lease rate is the benchmark for gold derivatives and new product innovation in the international gold market, on the other hand it is seen as an indicator for short term central bank-controlled supply and demand, because central banks lease supply affects the gold lease rate and causes gold price fluctuations.

2. Current shape of China’s gold lease market

Status of gold lease market participants

Current participants in the gold lease market are commercial banks, gold miners and jewelers. Commercial banks stand on the supply side while gold producers and jewelers fall on the demand side. Industrial gold users capture the bulk of demand with jewelers as the main body. Jewelers utilize gold leasing to lower working capital requirement and avoid price fluctuations. There is less participation from gold producers because gold producers have always been a minority among members of the Shanghai Gold Exchange (SGE). Besides, gold producers have the option to hedge market risks through gold futures or by delaying physical delivery; because of complicated vetting and approval required by leasing operations, gold producers are not keen about leasing. China Construction Bank is a major commercial bank participating in gold leasing.

Besides market participants discussed above, the SGE provides a crucial role in gold leasing. The SGE’s block trading system is the trading platform used by gold leasing participants; the SGE also provides transfer and settlement services.

Mechanism of domestic gold lease operations

China’s gold leasing does not involve the central bank. Gold leasing takes place between commercial banks and enterprises as well as between commercial banks, the former being key. Commercial banks have similar processes but there is no standardized approach.

  1. An enterprise that intends to be a lessee approaches a branch office of a commercial bank with a rate request and application.
  2. The commercial bank carries out due diligence and then submits a review to their head office for approval.
  3. Upon approval the head office quotes a lease rate with the international gold lease rate as a benchmark plus additional basis points taking into account the potential lessee’s credit, physical gold management costs and other factors.
  4. If potential lessee accepts the offer, a commercial bank branch manager will sign a lease contract with the customer including the terms and conditions clearly laid out.
  5. According to the “Shanghai Gold Exchange Lease Transfer Procedure”, after signing the lease, the head office of the commercial bank and lessee, or his agent, shall make a lease application through the exchange’s membership system. After verification, the SGE shall transfer the commercial bank’s gold from its SGE bullion account to the lessee’s SGE bullion account. The lessee can now trade the physical gold that it has leased or withdrawal the gold from vaults.
  6. Upon expiration of the lease the lessee shall deposit or purchase physical gold through the SGE to repay the gold. Corresponding physical gold will be transferred from the lessee’s SGE bullion account to the commercial bank’s bullion account. Leasing fees involved will be settled in currency. At this point, the lease is completed.

Leasing between commercial banks basically follow the flow between commercial bank and enterprise but is carried out between head offices of both parties. As commercial banks enjoy higher credit ratings, gold leasing rate is slightly lower than the rate applied to enterprises.

The size of domestic gold leasing business

China’s first leasing deal was done on 11 March 2005 when China Gold Coin Incorporation [the Chinese Mint] leased 800 kilograms of gold from the Bank of China (BOC). More organizations participated in gold leasing once they understood the process. A new bull market in gold arrived after 2007 that spurred leasing activity and doubled the size of transactions. As of 2009, cumulative leasing to enterprises by commercial banks reached 200 tons while trading volume reached an average annual growth rate of 2 – 3 times. Leasing commanded an increasing share of the SGE’s trading volume and became one of SGE’s businesses with the highest development potential.

3. Issues that exist in the current leasing business

Limited domestic supply for physical gold

Since the establishment of the SGE, China’s physical gold market has grown rapidly every year with rising efficiency from domestic sources. Annual domestic production, however, is under 300 tones while demand is 400 tons. Under-supply persisted for years combined with low turnover in domestic physical gold so that the demand of some players could not be met by the market. Therefore many domestic and foreign commercial banks adopt a proactive attitude and have high hopes for gold leasing, especially foreign banks like Scotiabank and ANZ bank, which have rich operating experience.

The biggest problem at the moment is source physical gold. Firstly, after long operating under direction, key participants in the gold market including commercial banks have limited physical gold in reserve. Not enough to support development of the huge leasing business. Secondly, gold produced by domestic producers are sold directly into the market. From capital utilization point of view, these producers have little incentive to retain large inventory. Thirdly, China limits import of goods so that apart from the four banks [currently 15 banks] that can import physical gold according to quota, no other financial entity has any channel to acquire physical gold from the international market. In addition, the PBOC’s gold reserves have never entered the domestic gold market. Over the long run, shortage of physical supply will curb development of gold leasing in a big way.

Few players, the system is not mature

Gold leasing requires demand and supply of physical gold to have a match through price discovery. A physical gold user must find a supplier, build trust, reach an agreement on the gold lease rate and then arrange the transactions, custody, settlement, transfer and so on to be completed on time. A sophisticated gold lease market requires an electronic trading platform, physical custodian and settlement entity as well as accompanying support. At the moment there are few participating organizations in China. Among physical suppliers, there are only seven commercial banks. There are also very few enterprises on the demand side. In the leasing business, most participants are large scale gold merchants reaching private deals with lessors that they have a long established relationship with. Most of market demand is not met because information is unavailable or parties that want to deal are unable to build trust or evaluate credit. As can be seen in recent years, more small and medium commercial banks want to participate in gold leasing. They, as well as recent foreign entrants, show strong appetite but because of poor policy, understanding and inadequate service, their participation can be improved.

Differences in the way commercial banks operate

A survey of some commercial banks found there are differences in the way banks operate.

One, there are differences in commercial banks their management model. For example, ICBC’s gold leasing is centrally managed by head office with centrally defined direction and operating procedures. On the other hand, CCB’s head office only supplies physical gold but business management is run out of branch offices. CCB does not have a specialized management for gold leasing.

Second, there are differences in the way the gold leasing rate is determined. CCB’s leasing rate is derived from its own leasing rate from the international market, plus risk premium and management fee. ICBC’s asks for a sales fee on top of gold leasing rates and quotes the gold lease rate in fixed rate and floating rate.

Third, difference appears in the way counter-parties are selected. ICBC sets requirements for potential lessees, for example having an existing fund settlement account with the bank but CCB accepts lease applications from potential lessees that are arranged through third party banks. Each commercial bank also has different templates for lease agreement, penalty for non-compliance with leasing terms and so on.

Information is inadequate

At the moment, most leases are privately negotiated. Apart from information available at the SGE, the PBOC and its subsidiaries have few other sources for information. The PBOC does not fully follow the development of the leasing business much less provide direction. Despite rapid growth in the gold lease business since 2007, the PBOC’s level of attention in this business is not high. Many SGE members remain uninformed about the business and even deals between commercial banks are few in number and volume.

4. Policy recommendations

Actively acquire new sources of physical gold

China should consider policies that increase the number of sources available to market participants. Limitation to imports should be loosened in favor of a policy that is ‘easy in, strict out’. Specifically, set up a qualification for the Big Four banks according to their market scope and level of development and contribution, so as to increase their imports in accordance with performance of joint stock company. Physical gold import must meet the volume required for gold leasing. Concurrently, foreign banks that have plentiful experience in gold leasing such as HSBC, Standard Charted, Scotiabank and ANZ may be given approval to import physical gold from their head office within the “People’s Republic of China Foreign Exchange Management Regulations”. Additionally, consider employing some of the PBOC’s gold reserve for market operations and as a macro-control tool.

In the first half of 2010, official gold reserve increased from 600 tons to 1054 tons – sixth placed in the world. From a strategic point of view, increasing gold reserves optimizes the makeup of China’s assets which will lay a good foundation for RMB internationalization. Gold however is an asset that has little yield. Therefore while restricting gold export, taking part of PBOC reserve gold to participate in leasing operation is a win-win policy. Specifically, the PBOC may select commercial banks as counter-party to lease out reserve gold when supply is tight. Gold lease rates may be established through bidding, PBOC participation would increase liquidity. When gold in the domestic market is sufficient, or for strategic needs, PBOC may purchase gold from commercial banks to reach its gold reserve target. 

Set up electronic trading platform for gold pricing and transparency

At the moment, gold leasing’s core areas – physical handling, custody and settlement are done at SGE and demand and supply participants are members and customers of the exchange. Setting up a price-finding and information platform at the SGE is a foremost way to expand the exchange’s service competency. Once an electronic trading platform is set up, commercial banks and large gold merchants can use the platform according to their own business model, to engage in one-to-one and one-to-many trading and price discovery, which will lead to higher physical gold turnover. For example, bank A may want to borrow 2 tonnes of gold whereas B and C each have 1 tonnes available. A can approach B and C concurrently so that all 3 parties reach a deal. The electronic trading platform is conducive to a fair and transparent gold lease system. By disclosing gold lease information on the electronic platform, participants can get more timely information on lease volume and rates. This will give them better judgment of demand and supply and is good for reference and strategizing. Supervisory functions would also be improved leading to more effective monitoring.

Improving effectiveness of regulation

Firstly, perfect various control measures. The PBOC should quickly come up with its guidance for the gold lease business, to come up with regulatory principles separately for businesses between commercial banks and businesses between commercial banks and enterprises so as to achieve an orderly market to avoid unfair competition. Next, the SGE must become supervisor in the lease market – to perfect various control measures. Thirdly, commercial banks in the leasing business must define management measures, report to the PBOC, the China Banking Regulatory Commission and the SGE, to accept supervision and management.

Methods to regulate business. Gold leasing is a no-leverage, low-risk transaction where the biggest risk encountered by participants is the credit risk of counter-parties. Over the long run, commercial banks constantly improve risk management but also establish a set of effective risk management rules. They have accumulated a lot of experience to select counter-parties and evaluating exposure. Therefore regulators do not have to set barriers of entry for commercial banks that want to participate in gold leasing as long as they are SGE members that are financial in nature and can be both domestic or foreign. Enterprise participants can be left to commercial banks to be evaluated for risk of doing business, not unlike evaluating business loans. In day-to-day operation, PBOC regulation should focus on monitoring market information. Firstly, support SGE business information disclosure, timely release information on market supply and demand and report on penalizing violators. Secondly, look out for irregular transactions (example, wide discrepancy between market rate and transacted rate), conduct in-depth analysis on the occurrence of irregularities and provide warnings for systemic risk.

Guest Post: The Gold Market, Part 3

Where Grabbe uses the term eurodollar rate he refers to what we nowadays call the LIBOR interest rate on fiat money. Read gold libor as gold lease rate.

Written by James Orlin Grabbe in the late nineties.

Part 3

Now that we have seen how spot gold is priced “loco London,” we can examine how other local markets, and other types of gold contracts, are priced in reference to the London spot market. This includes other spot delivery locations, gold forward and futures contracts — such as the gold futures contract at the NYMEX in New York — and gold swaps, forward rate agreements, and options. (In 1994 the COMEX merged with the NYMEX, and the principal gold futures contract now trades there.)

London is only one of many important centers for gold trading. The second principal center for spot or physical gold trading, for example, is Zurich. For eight hours a day, trading occurs simultaneously in London and Zurich — with Zurich normally opening, and closing, an hour earlier than London. During these hours Zurich closely rivals London in its influence over the spot price, because of the importance of the three major Swiss banks — Credit Suisse, Swiss Bank Corporation, and Union Bank of Switzerland — in the physical gold market. Each of these banks has long maintained its own refinery, often taking physical delivery of gold and processing it for other regional markets.

(On December 8, 1997, Swiss Bank Corporation and Union Bank of Switzerland announced plans to merge, the combined bank to be known as United Bank of Switzerland. The net effect such a merger would ultimately have on the Zurich gold market is not yet clear.)

In addition to other gold delivery locations, there are other weight and quality standards which create differential prices. Examples include the London and Tokyo kilobars (which are 32.148 ozs., instead of the circa 400 oz. “large bars”), the 10 tola bars (3.75 ozs.) popular in India and the Middle East, the 1, 5 and 10 tael bars (respectively 1.203, 6.017, and 12.034 ozs.) found in Hong Kong and Taiwan, and the baht bar (0.47 ozs) of Thailand. Gold content is another difference. The London good delivery bar is only required to have a minimum of 995 parts gold to 1000 parts total. But a gold content of 9,999 parts gold to 10,000 parts total (“four nines”) is commonly traded, as is a content of 990 parts to 1,000 total (the baht bar being an example of the latter ratio). Gold purity is important to industry. Jewellers might want gold in the form of grain for alloying, while electronics firms may require “five nines” — meaning .99999 purity.

Pricing Nonstandard Contracts

Nonstandard contracts can be priced by reference to the standard loco London good delivery bar, by taking into account the simple arbitrage relationships that would turn one into another. The primary variables to keep track of are the costs of shipping gold from one location to another, the cost of refining gold to different purity levels, and the interest or financing cost for the time required to accomplish these activities.

Suppose a dealer is offered non-good delivery bars of .995 purity loco Panama City. Here is one chain of calculations the dealer might go through to come up with a price quotation. First the dealer notes that London good delivery bars of .9999 purity can be sold in Tokyo for $.50/oz premium to the standard loco London price. He knows that if he buys the bars in Panama, he could sell them in Tokyo, but first he would have to ship them to an appropriate location to upgrade their purity.

The dealer also knows that he can upgrade to London large bars for good delivery, and have the gold content refined to .9999 purity, for $.50/oz at the Johnson Matthey refinery in Salt Lake City, Utah. There is a two-week turnaround time for the upgrade. Shipping time is one day from Panama City to Salt Lake, and two days from Salt Lake to Tokyo.

The dealer calculates the cost of shipping and insurance from Panama to Salt Lake as $.40/oz, while shipping from Salt Lake to Tokyo is $.70/oz. The total time consumed would be 15 days, which at 6 percent interest and spot gold at, say, $300/oz amounts to 300 x .06 (15/360) = $.75/oz.

So the dealer adds up: shipping costs $1.10, plus interest cost $.75, plus refining cost $.50, minus selling premium in Tokyo of $.50. The net cost to the dealer to sell the Panama bars in Tokyo is $1.85/oz.

Therefore the dealer’s best, or break-even, quotation to the person offering him non-standard gold bars in Panama City would be the spot price for good delivery loco London minus $1.85. If spot gold were at $300/oz. bid, the most the dealer could afford to bid for the Panama bars would be $298.15/oz.

The Gold Lease or Gold Libor Rates

Gold bears interest. Positive interest. Many people do not know this. They are used to the notion of storing their gold with some bank or warehouse, and paying for storage cost. They then view the storage and insurance cost as a negative interest rate. But this has little to do with the way gold is priced or traded in the wholesale market.

The forward price of gold — the price agreed now for gold to be purchased or sold at some time in the future — is a function of the gold spot price, and the interest rates representing alternative uses of resources over the forward time period. So before we discuss gold forward prices, we should discuss gold and dollar interest rates.

This brings us to the gold lease rate, or the gold interest rate paid on gold deposits. Another term that is used is gold libor, by analogy with the London Interbank Offered Rate for eurocurrencies traded in London. Despite the apparent literal connotation of each of these labels, “gold libor rates” and “gold lease rates” are alternative descriptions that refer to the bid-asked gold interest rates paid on gold. The bid rate (deposit rate, borrowing rate) is the gold interest rate paid for borrowing gold (that is, on gold deposits), while the asked or offered rate is the gold interest rate quoted for lending gold. The expressions “bid-asked gold lease rates” or “bid-asked gold libor rates” are thus interchangeable.

If the gold borrowing rate is 2 percent per annum, for example, then 100 ozs of gold borrowed for 360 days must be repaid as 102 ozs of gold. (Gold interest rates, like most money market rates, are nearly always quoted on the basis of a 360-day year.) In the early 1980s gold deposits rarely yielded over 1 percent, but in recent years have rarely yielded less than 1 percent.

Because of large central bank gold holdings, gold loans are one of the cheapest financing sources for the gold mining industry. A mining company borrows gold and sells it on the spot market to obtain funds for gold production. The interest installments on the gold loan are payable in gold. And when the loan matures, the principal (and any final interest due) is repaid directly from mine production.

Central banks are the major lenders of gold. They accounted for around 75 percent of the gold on loan, estimated at around 2,750 tonnes, at the end of 1996. Central banks in recent years have been under pressure to earn a return on their gold holdings, and therefore lend to, for example, gold dealers who have mismatched books between gold deposits and gold loans. (The practice of central bank gold lending first became newsworthy in 1990, when the investment banking firm Drexel, Burnham, Lambert went bankrupt while owing borrowed gold to the Central Bank of Portugal.)

The gold lending (or borrowing) rate, then, is one of the components that determine the gold forward price. Let’s see how this works.

The Gold Forward Price

Suppose the spot price of gold is $300/oz. The gold lease rate for 180 days is 2 percent per annum. And the eurodollar rate for 180 days is 6 percent per annum. (For simplicity here, we ignore all bid-asked spreads. But they are easily included in the following calculations.)

I borrow $300 at the eurodollar rate. In 180 days I will have to repay the dollar borrowing with interest in the amount $300 (1+.06(180/360)) = $300 (1.03) = $309.

With the borrowed money I can buy 1 oz. of gold, and place it on deposit for 180 days. The amount of gold I will get back is 1 (1+.02(180/360) = 1 (1.01) = 1.01 oz.

Thus, 1 oz. of gold with a spot price of $300 has grown into 1.01 ounces in 180 days, with a value of $309. This translates into a 180-day forward value of $309/1.01 = $305.94.

Spot price: $300.00

180-day Forward Price: $305.94
Notice that both the gold lease and the eurodollar rate have gone into this calculation. Specifically:

$305.94 = $300 [1+.06 (180/360)] / [1+.02 (180/360)].

In general, if the spot price is S, the forward price is F(T) for a time-horizon of T days (up to a year), the eurodollar rate is r, and the gold lease rate is r*, we have the relation

F(T) = S [1 + r (T/360)] / [1 + r* (T/360)].

Notice that in the numerical example we just used, the forward price $305.94 is approximately 2 percent higher than the spot price of $300. That is, the 180- day forward premium of $5.94 is approximate 2 percent of the spot price of $300. (An exact 2 percent would be $6.) Why is this?

To see what is involved, let’s subtract the spot rate S from both sides of the above equation. The left- hand side will be the forward premium F(T) – S. Simplifying the right-hand side, we obtain:

F(T) – S = S [( r – r*)( T/360)] / [1 + r* (T/360)].

That is, the forward premium (F(T)-S) is approximately equal to the spot rate S multiplied by the difference between the eurdollar rate r and the gold lease rate r* (once we have adjusted this rate for the fraction of a year: T/360).

Since in the numerical example the eurodollar rate was 6 percent, while the least rate was 2 percent, the forward premium at an annual rate is approximately 6-2 = 4 percent. For 180 days, or half a year, it is approximately 2 percent.

So, as long as we are talking about an annual rate — that is, before we do the days adjustment — the gold forward premium in percentage terms is approximately the difference between the eurodollar rate and the gold lease rate.

We can view this same relationship in other ways: given a eurodollar rate and a gold forward premium (in percentage terms), we can back out the implied lease rate.

Looking back at the chart from Kitco, above, it is easy to see that subtracting the gold lease rate from the “prime rate” gives us approximately the gold forward rate. (Note that “prime rate” is a misleading term to use: the relevant interest rate in the gold market is the eurodollar rate by which banks borrow and lend among themselves, not the commercial “prime” lending rate — which is often an administered, rather than a market, interest rate.)

Gold forward rates are sometimes referred to as “GOFO” rates, because GOFO was the Reuters page that showed gold forward rates.

Gold Swaps

There are many different hedging and trading operations in the gold market, all of which bring us back to the same relationship between forward and spot rates we saw in the previous section.

For example, gold dealers will buy gold forward from mining companies. The mining companies, thus assured of a fixed forward price at which to sell their production, go to work producing. Meanwhile, the gold dealers, to hedge themselves against movements in the gold price, borrow gold and sell it in the spot market. (To repeat, dealers “borrow” gold by taking in gold deposits, and paying out the gold lease rate.)

Restated, gold dealers buy gold forward from mining companies at a price F(T). To hedge themselves, the dealers borrow gold at an interest rate r*, and sell it in the market at a price S. They earn interest on the dollar proceeds of the spot gold sale at an interest rate r.

Thus, for each ounce of gold purchased, the dealer must pay

F(T) [1+ r* (T/360) ].

While for each ounce of gold sold, the dealer earns:

S [1 + r (T/360)].

All excess profit (beyond bid-asked spread) gets eliminated when these amounts are equal. Which gives

F(T) [1+ r* (T/360) ] = S [1 + r (T/360)].

This is, of course, exactly the same formula as before.

Generally speaking, gold dealers will quote forward prices to their customers (these are called “outright” forwards), but forward trades beween dealers mostly take place in connection with a simultaneous spot transaction. That is, in the form of “swaps.” A swap transaction is a spot sale of gold combined with a forward repurchase, or a spot purchase of gold combined with a forward sale. This type of trading requires less capital and is subject to less price risk. The swap rate is F(T)-S, and as we saw before, this difference is (when quoted as a percentage of the spot price) essentially the difference between the eurodollar rate and the gold lease rate.

A spot sale of gold combined with a forward purchase is also called a cash-and-carry transaction. The transaction provides immediate cash, the cost of which is the carry, or the difference between forward and spot rates. The dollar lender (who buys the gold), meanwhile has possession of the gold as security. So a cash-and-carry (one form of a swap) boils down to a dollar loan collateralized with gold.

The typical dealing spread between eurodollar deposits is 1/8 of 1 percent, or .125 percent, while the typical spread between gold deposit and loan rates is .20 percent. This translates into bid-asked swap rate, or cash-and-carry, spreads of about .30 percent. For example:

_______________Eurodollar rates          Gold lease rates      Gold swap rates
1 month                   3.0625-3.1875               0.50-0.70                     2.35-2.65
3 months                 3.1250-3.2500               0.55-0.75                      2.40-2.70
6 months                 3.3125-3.4375               0.70-0.90                      2.45-2.75
12 months                3.5625-3.6875              1.00-1.20                      2.35-2.65

Note that the gold swap rate can be independently viewed as the collateralized borrowing rate. A small central bank, for example, with plenty of gold to spare, could borrow dollars for 3 months and pay — not the 3-month asked eurodollar rate of 3.25 percent — but rather the gold swap rate of 2.70 percent.

James Orlin Grabbe