Those BIS Gold Swaps – what are they and what do they mean...?

In its 2010 ANNUAL REPORT, the Bank of International Settlements said that "gold, which the bank held in connection with gold swap operations, under which the bank exchanges currencies for physical gold, stands at 8,160.1 million in special drawing rights, equivalent to 346 tonnes this year, up from nil in 2009."

Apparently this amount has now climbed to 382 tonnes since the report was issued, writes Julian Phillips at GoldForecaster.com.

Swaps are financial instruments that allow for the exchange of one asset for another, in this case, gold for currency. They are not gold leasing, futures or options (which both the 1999 and 2004 Central Bank Gold Agreements stated would not be increased; the 2009 renewal did not repeat that statement). Gold swaps, however, could be undertaken by the signatories of the CBGA, as these were not included in any of the three Agreements.

Gold swaps are usually undertaken between central banks: One central bank exchanges foreign exchange deposits (or other reserve assets) for gold with an agreement that the transaction be unwound at an agreed future date, at an agreed price.

The monetary authority acquiring the foreign exchange will pay interest on the foreign exchange received, the rate of which is currently very low. Gold swaps are usually undertaken when the cash-taking central bank may want foreign exchange but does not wish to sell outright its gold holdings.

The Wall Street Journal informs us that the BIS did these swaps with commercial banks. We know of no commercial bank that has 382 tonnes of gold on their books. It is likely then that should these commercial banks have been in the deal, they would have been acting for a central bank (or several over time) who wished to remain anonymous.

The BIS received the gold into its safekeeping for the nation that required the foreign exchange for the swap period. Swaps of this nature are renewable once the time runs out, so it is impossible to say how long the swap will last for. The central bank that undertook the swap would have to be certain that it could return the currencies to get the gold back at some point in the future. If that country defaulted, then and only then could the BIS go ahead and sell this gold. Any sale in the open market would be trumpeted loudly to all as well as reported in the press, or by the World Gold Council, the BIS or IMF.

Why use gold and not currency? The financial crisis has led to a decline in the number of credit-worthy counterparties and a reduction in credit lines these counterparties can offer. This is significant in a world where credit risk and debt problems have been the subject of banker's fears since the appearance of the Greek debt crisis. For someone in the trouble Greece is, gold swaps allow a central bank's reserves to be lent in a credit-secure fashion.

In other words, a gold swap allows the lender of currency to benefit from greatly reduced credit risk, as the gold can be held in an allocated account, usually at the Bank of England. The currency deposit is secured with gold throughout the life of the deposit.

Any country such as Ireland, Portugal, Spain, Italy, the UK and the USA. can follow this route. Yes, sales may not be permitted for fiscal reasons under Eurosystem rules, but these are not sales, but swaps. So, of the utmost importance is just who swapped this gold? Could it be one of the countries we just mentioned? If so, their situation is far graver than previously thought. The implication is that the collateral they offered just wasn't good enough, so they had to use their gold. This is major news for the monetary system.

What is significant about this or these transactions is that Gold Bullion is being used in international settlements after so many decades of being sidelined in the monetary system. The transaction itself confirms that gold is being used in international settlements, which is a dynamic confirmation of gold's return to the monetary system.

A "gold swap" might be the first desperate step in such a transaction with the swapping bank hoping to repay the foreign exchange, but should it fail, the BIS would have to decide either to keep the gold on its books or to sell it. Again, keeping it on its books is part confirmation that gold is active again on the monetary system, a big boost by itself!

Gold, in short, is back in the monetary system.

What appears to have really happened is that one nation or more needed foreign exchange to counter some shortfall in its accounts and raised these funds as a short-term liquidity measure, believing that it would be able to return the currency and receive its gold back. The gold would then be returned at the conclusion of the swap period in return for the currencies swapped. If it fails to return these funds to the BIS, then the BIS could discreetly place the gold with another central bank, should it not want to keep the gold. If it did so, the BIS would simply report its disposal of the gold, the originating central bank would report the drop in its gold reserves and the gold-buying bank would report its increase in the reserves.

This puts the transaction into an entirely different category. It seems that one or more of the developed world's central bank's credit is not good enough for other governmental institutions. If word got out as to which this country is, then the financial markets would go into quite a spin, shaking the global financial system to its core.

No wonder the BIS is keeping such a low profile!

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