Cat Meets Pigeons in London Fix Regulation

Gold Fix loses Deutsche Bank within 18 hours of regulator BaFin speech. Coincidence...?

 

The LONDON GOLD FIX is going to get smaller, and potentially less liquid, with news that Deutsche Bank is quitting, writes Adrian Ash at BullionVault.

 

Lower liquidity is the opposite of what Germany's financial regulator BaFin said only last night it wants to foster. But the two events would seem far from unrelated.

 

You've heard of Deutsche no doubt. Big investment and retail bank, based in Germany (and so regulated primarily by BaFin, the German financial authority), it is also a market-making member of the London Bullion Market Association. It guarantees to quote bid/offers in gold and silver throughout the day.

 

Deutsche Bank is also a member of the London Gold Fixing and London Silver Fixing companies. Entirely independent of the LBMA, these limited businesses exist for the sole purpose of reaching and reporting the Fix price each day.

 

The Fix is a shapshot of where the London price is sitting at a certain time (10.30am and 3pm gold, midday silver). Because London remains the centre of bullion dealing worldwide, it acts as THE global benchmark.

 

Jewelers use the London Fix to price their product. Central banks use it to value their hoards. Investment funds use it to track gold's performance (once up, now down). Mining companies use the Fix to sell their product to the wholesale market, once refined into large, Good Delivery bars. Miners also use the benchmark to raise finance through those same bullion banks, referencing far-distant Fixes as the settlement price for forward contracts.

 

How is each Fix achieved each day? It is created in parallel to the "spot" market, but is pretty much where spot prices trade at the moment that the Fix is set. In spot, each buyer and seller meets directly (just as you can on BullionVault), setting price as they choose in individual deals, rather than market-wide. Whereas the Fix sees a small group of big banks (5 in gold, 3 in silver...or now 4 and 2) bring their client orders for that event to the table.

 

Together, they then seek a single market-wide price which will clear the greatest volume of those client requests. (Again, Bullionvault users can trade at that daily price point too if they wish.)

 

So unlike the headline scandals in Libor and Euribor interest rates, the London gold and silver Fixes are built from "actual transactions in liquid markets." That's according to Dr.Elke König, president of German financial regulators BaFin, in a speech in Frankfurt last night.

 

So far, so good for the London Fix, then.

 

Indeed, "Benchmarks should be as far as possible based on real transactions," König said, contrasting the currency and precious metals benchmarks with those discredited Libor and Euribor interest rates, which are merely "estimates of the banks", not real prices created by real supply and demand.

 

But there was more from the BaFin chief. And while it's perhaps coincidence that within 18 hours of her speech, Deutsche Bank said it's quitting the Fix (and so far without a full press release online), Dr.König was plain about where the German financial regulator sees the future for financial benchmarks like the London gold and silver Fixes.

What's more, "In Brussels, new market abuse regulations are now being prepared. Manipulation of benchmarks should become a crime."

 

The London Fixes, of course, happen in the UK – and London stands accused by its European (and US) partners of allowing the financial crisis to build and explode through too much "light touch" and not enough "central control". So the UK regulator, the Financial Conduct Authority, has already started looking into the London Gold Fix. Word is, the FCA has an observer there, just as it has for some time on the management committee of the much wider London Bullion Market Association.

 

Like the spot market, the Fix is also done away from any formal, centralized trading exchange. Which is just how the free-market likes it. Willing seller to willing buyer, with each judging the other's credit-worthiness for themselves against the standard two-day settlement terms. This keeps everyone on their toes, rather than letting "regulatory oversight" lull everyone into thinking they're safe because a bureaucracy says so.

 

But as the financial crisis recedes, regulation is enjoying a bigger bull market than US biotech stocks. And "market transparency and market control are only possible if the countless flows of business are centralized," reckons BaFin's König. "One would therefore want these benchmarks to move as far as possible onto a transparent and directly or indirectly state-supervised trading exchange."

 

To sum up then: Criminalization, loss of client (or at least trade-flow) privacy, and transfer to a centralized "government-supervised" exchange.

 

If it is coincidence that Deutsche said it's quitting the Fix this morning, straight after BaFin's speech, it would be rare timing indeed.

 

Look, we hold no candle for the bullion banks, let alone their investment banking parents. But we have shown before how the London Fix works, why it's useful, and how it achieves a price through freely-decided buying and selling.

 

Regulatory rumour and now comment today look directly responsible for removing one-fifth of the Gold Fix's client-base, and one-third of silver's. (Deutsche's loss is the first change to Fix line-up since N.M.Rothchild Bank quit in 2004, just as gold's two-decade bear market was really switching into a powerful uptrend.) That's hardly good for the liquidity which BaFin itself says is vital to a sound benchmark.

 

More broadly, the loss of "prop trading" by banks in precious, commodities and other markets (locked out by the rules of the US Dodd-Frank Act in the main) also threatens to cause a loss of liquidity in regular daily trade as well. Deutsche and other banks have already shrunk much of their other commodity business. Deutsche this week also suspended a handful of currency traders from its New York office, now under investigation for allegations of manipulating its 15% share of the FX market, alongside other "cartel" players. No doubt banks trading their own money (or rather, their shareholders' funds) is a risky business. And no doubt reported benchmarks, rather than those created by client order flow across different firms, open the door to malfeasance. So if the banks are to get state guarantees, bailing them out when they hit trouble, then that risk should be eliminated to save taxpayers subsidizing reckless trading and the fat bonuses which can follow manipulation.

 

The alternative (can you imagine!) would be to remove that state guarantee, letting the banks trade as they wish and go to the wall when they fail, while clients take responsibility for judging market prices as they choose. We can but dream, right? Instead however, and should this trend continue, expect thinner trade long-term, punctuated by spikes on heavy volume when big investment positions or deals are done.

 

All in a day's work for regulation. State-guaranteed banks and free markets cannot go together.