The Big Long was big already. It just got bigger. In the previous article, I noted that Goldman Sachs (NYSE:GS) and HSBC (NYSE:HSBC), had taken delivery of a staggering 7.1 metric tons of physical gold in August, 2015. Since then, they've gobbled up tons more.
As of Wednesday, Goldman Sachs bought 142,100 troy ounces (4t 419.8040 kg.) worth of physical gold bars into its proprietary trading account at CME, Inc. HSBC bought a total of 154,800 troy ounces (4t 814.8181 kg.). The two banks have now scooped up approximately 9.23 tons worth of hard metal.
These physical gold bars are headed into the banks' own vault. That's what the banks say. They are being purchased as a proprietary trade. That's what the COMEX exchange says. We know this because commodities regulations require that clearing firms declare the intended ownership of such deliveries.
To better understand what I am talking about, let me explain a few things about how clearing houses work. All clearing brokers who are active at any CME, Inc. exchange, including COMEX, have both a house and a customer account registered with the exchange. The "house account" is the "clearing firm's proprietary, non segregated trading account."
You read that correctly. The words are "PROPRIETARY TRADING"! No, they are not my words, but the words of CME, Inc. At this point, I can be relatively certain that the naysayers will be climbing, one on top of the other, to participate in the "comments" section. Some will state that banks can no longer do that, because of the Volcker rule. As usual, they will be wrong.
I may as well head the nonsense off at the pass, so that serious readers will not become confused. First, Goldman Sachs, alone, has some $14 billion invested in a series of private equity and hedge funds. That is a huge amount of money, but it is made even larger by the fact that it is typically deployed with very high leverage. Goldman executives are in complete control of these funds. All big banks have such funds under their control.
The Dodd-Frank, for better or worse, has put the Federal Reserve Board in charge of enforcing the Volcker Rule. In December, 2014, the Fed granted banks a one year extension during which their funds can continue speculative proprietary trading. The reason it was only one year is because Dodd-Frank authorizes year by year extensions. So, the Board also announced that it intends to extend the time for compliance to July 21, 2017.
In short, the big banks can and are continuing to do as much proprietary trading as they wish using their hedge funds as their proxies. But, proprietary trading by the bank, itself, doesn't even need such an extension so long as it is restricted to physical bullion. The Volcker Rule prohibits proprietary trading of financial instruments. When it is in bar form, gold is not considered a financial instrument. This was explained fairly well at a recent IMF seminar.
Allocated gold bars are financial assets. Their value is deemed inherent, not dependent upon creditworthiness of a counter-party. That's why they are not financial instruments. Non-allocated (a/k/a unallocated) precious metals schemes are treated differently. They are financial instruments. The promoter "owes" you a gold bar, but you have no title to any. If the promoter goes belly-up, you end up as an unsecured creditor who ran out of luck.
A lawyer's opinion, however, isn't needed. The Volcker rule contains a very specific list of the financial instruments it covers, and gold bullion bars and coins are not on it. A bank can trade in bullion as much as it wants, so long as we are talking physical bullion, and not paper-gold. The bureaucrats wanted this to be so crystal clear that they even added a specific administrative exception for spot trading.
What, then, will be the effect of the eventual expiration of the exemption of bank controlled hedge funds on June 21, 2017? I would suggest that short side futures trading, including periodic so-called "bear raids", will be much diminished. That is not to say that they won't happen. But, they will be diminished in size, scope and frequency. We may still see it when the US Treasury or ECB decides that gold prices are trending too high. But, we are unlikely to see it on every single options maturity date, for example.
In order for readers to understand the Volcker rule, here is how it defines financial instruments:
(1) Financial instrument means:
(NYSE:I) A security, including an option on a security;
(ii) A derivative, including an option on a derivative; or
(NASDAQ:III) A contract of sale of a commodity for future delivery, or option on a contract of a commodity for future delivery.
(2) A financial instrument does not include:
(ii) A commodity that is not:
(NYSE:A) An excluded commodity (other than foreign exchange or currency);
(NYSE:B) A derivative;
(NYSE:C) A contract of sale of a commodity for future delivery; or
(NYSE:D) An option on a contract of sale of a commodity for future delivery; or Foreign exchange or currency.
Note that section 1-iii omits "contracts of purchase" (A/K/A "long" futures positions) from Volcker-regulated activities. That means a bank can buy as many speculative long futures positions as it wants. The problem will be in closing those positions, because a bank cannot engage in the proprietary trading of naked short positions. Any bank that buys long futures, therefore, must be ready to take physical delivery of the actual commodity.
The net effect will be to stabilize commodity prices. Up till now, primary dealers could borrow at near-zero interest rates at the Federal Reserve so-called "loan windows". Window loans, technically are supposed to be "overnight" or, at most, a few days in duration. In practice, however, they are renewed a seemingly infinite number of times. This gambit, wherein primary dealers capitalize on ultra-short term Fed loans as long term loans, has been active for years.
The importance of Fed loan windows was illustrated best in the period prior to the first QE in 2009. Since year 2001, after the tech bubble's crash, the Fed balance sheet shows a continuous and growing "overnight" component of "repo" loans. By March 2009, hundreds of billions of dollars were continuously on loan from the Fed. The balance sheets show that these remained outstanding and growing, for most of the first decade of the 21st century. With the advent of QE, these ultra-low interest rate "overnight" loans (each "night" apparently lasts a decade or so at the Fed) appear to have been paid off with newly printed cash.
At any rate, this process freed up cash for the bank-owned hedge & private equity funds to use. Then, adding high leverage by purchasing futures, it was possible to bully smaller institutional and individual traders. Commodities futures markets could be moved up and down like a yo-yo, in the short to medium term, without regard to real-world supply and demand.
After June 21, 2017, this should change. Any fund that uses more than 3% of bank-derived capital will be prohibited from speculative futures trading. Banks will forced to trade physical metal for their own accounts, just as Goldman Sachs and HSBC are now doing. The paper-gold market will essentially be castrated, and prices set in the physical market are likely to dominate. Since physical gold cannot be printed the way paper-gold can, there should be strong upward pressure on prices.
Gold trusts are not physical gold bullion. Schemes like (NYSEARCA:GLD) & (NYSEARCA:IAU) are irredeemable unless you are an "authorized participant" who can cash in more than 100,000 shares. Even then, there is no claim to any particular bar. Therefore, such trust amount to paper-gold, and will not qualify, under the Volcker rule, as a financial asset. They are financial instruments. This may partially explain the sell-off of GLD in 2013/14.
Non-allocated gold schemes, such as those promoted by LBMA banks and the Bank of England, are also financial instruments, not pure assets, and therefore subject to the Volcker rule. Your best bet is to buy physical gold, though in the case of small investors, a few gold coins are obviously more appropriate than a set of bankers' bars.
I explained the options in taking a long position in gold in a prior article that can be found here. Much of the same concepts apply to other bank metals, like silver and platinum. Don't expect banks to tell you that. As other banks catch on, and try to build up their own Big Longs, they won't want competition from you. The type of hypocrisy, described here, is likely to spread.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.