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Myths continue to surround gold lease rates, with notions such as market manipulation and government intervention rampant in the blogosphere. This may upset a number of people but the recent dynamics in gold leasing are actually fairly easy to explain. Here are the two key questions:

1. Why have gold lease rates been negative in recent months?

Recently as the usual sources for dollar funding (U.S. money market funds) in Europe have been dried up, banks are resorting to some nontraditional approaches to fund their dollar based assets. Some borrow from the ECB via the Fed liquidity swap, others resort to borrowing euros from the ECB and swapping these euros into dollars for a short period of time via a currency basis swap.

A number of European banks hold gold as part of their asset portfolio. They haven’t been eager to sell it as they continue to be concerned about the stability of major currencies, particularly the euro. They also enjoy the price appreciation gold experienced in recent years. However, they desperately need short-term dollars, so they lease out their gold. In a lease transaction typically a bank turns the gold over to a counterparty for say 3 months and receives gold “lease rate”. The counterparty in turn places dollars with the bank as collateral on which the bank pays “LIBOR-like” rate. Now the bank has access to dollars it needs. The demand for dollars has become so great, that banks are willing to accept negative lease rate, just to obtain term (1-12 months) dollars. Therefore negative lease rates is not a surprise.

2. Why have gold lease rates spiked recently?

As banks and other investors realized that gold prices can indeed drop significantly, many decided to hedge their positions by putting on gold forwards to lock in the price. A gold forward involves a future sale of gold at a fixed price. Whoever sold them the forward becomes long gold for future delivery. The forward provider will hedge her position by borrowing gold (via a lease) and selling it into the spot market. Now the forward provider will receive gold in the future on the forward contract and can deliver it against her lease, and is therefore fully hedged. Some market participants also entered into “naked” forwards to short gold as a speculative trade. All these forward transactions generated incremental demand to borrow gold, creating a spike in lease rates (though still negative.)


(Click to enlarge)
3m gold lease rates (Bloomberg)

One of the stories circulating on the web is that this spike in lease rates forecasts an impending improvement in gold price. In fact the spike is saying that investors are nervous and are hedging or shorting gold. With the precious metal down another 1% today, there is no evidence for this relationship between the two. And for those who are still looking for manipulation conspiracy theories in gold lease market, just remember your Occam's razor. Simple explanations must be exhausted first.

Source: Busting The Myths Behind The Gold Lease Rates