By Graham Roberts
The aim of this article is to give the reader an overview of the key participants, markets, and conventions in Precious Metal, as well as directing the reader to the variety of sources of information available for further research.
Overview of Precious Metals
A Precious Metal is “a rare, naturally occurring metallic chemical element of high economic value”:
The four major precious metals, which are most commonly traded (commonly use ISO currency code shown in brackets)
- Gold (XAU)
- Silver (XAG)
- Platinum (XPT)
- Palladium (XPD)
Other minor metals include
- Rhodium (XRH)
- Osmium (XOS)
- Ruthenium (XRU)
- Iridium (XIR)
Historical Trading of Precious Metals
- “Bullion” (a collective term used for Gold and Silver) was traditionally used as a currency, and has always been very influential on exchange rates (known as the “Gold Standard”, a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold, effectively setting the exchange rates between countries, and allowing national money to be freely converted to/from gold at the fixed price) . During the 20th Century this became obsolete as central banks began to hold reserves and settle international debts in national currencies (most commonly dollars), and precious metal prices now float freely. However precious metals are still thought of as being traded in a similar way to currency.
- Records trace bullion transactions in London back to the 17th century, however it was the introduction of the London Silver Fixing in 1897 and the London Gold Fixing in 1919 that marked the beginnings of the market’s structure and of the co-operation between members that has created the marketplace as it is today 
- Historically precious metal, in particular gold, has often been used to protect wealth against inflation or instablity in the national currencies, as it has been viewed as a secure commodity able to retain its value, and is often seen as being good collateral for currency loans as it is comparatively liquid, easy to transport and easy to sell. Regulatory requirements dictate that banks are required to hold a certain proportion of assets in liquid forms that can be quickly converted in cash in times of crisis – physical gold bars are commonly used to meet this requirement. The precious metals market is also a useful tool for precious metal related industries such as jewellery and electronic manufacturers to protect their profits during the time to manufacture through borrowing, although there is less need for this now the market is more liquid .
- Along with “Loco” London, the most widely traded market, significant other precious metal locos (markets) are located in Europe (Switzerland), North America and Asia (in particular Singapore, China and India)
- The London Bullion Market Association (LBMA) “comprises and represents the key players and their clients in the bullion market, which is centred in London but has an international footprint” . This includes banks, manufacturers, refiners, and transport companies. The LBMA specifically oversee the trading of bullion. One of the key duties is to maintain the London Good Delivery List, the standard for acceptable large gold and silver bullion bars by which it can be ensured that LBMA accredited refiners maintain high standards – only bars from those refiners can be traded on the London Market.
- The London Palladium and Platinum Market (LPPM) oversees the trading of Platinum and Palladium, and similarly maintain a Good Delivery List
Allocated / Unallocated
Precious metals are traded in two distinct ways
- Allocated trading is the trading of real physical precious metal, such as bars, coins, grain and dore. As well as private wealth clients and banks looking to hold bars and coins, the key market participants are industrial clients such jewellery producers, electronic manufacturers and refineries
- Vaulting services are provided by a number of financial institutions to hold allocated metal for clients, perhaps most well known of these is the Bank Of England, along with the London clearers, in which bars/coins etc are held for their own and client’s allocated accounts. Various storage and handling fees are charged for this service usually based on the balance held overnight, and the number of transfers done.
- Precious metal is frequently transferred between vaults, either for clients moving their own metal around, or when clients/clearers are transferring metal to one another. The clearers manage these movements, arranging with specialist transit companies such as G4S, Malca Amit and Brinks to transfer the metal between vaults. Once a delivery of bar pallets is received at a vault, a stringent check is undertaken prior to the metal being vaulted. During these tests the bars are weighed and assayed (checking the purity) in order to check that it matches with the bar list sent by the clearer, in order to guard against any discrepancies including damage in transit, misclassification of product/weight at the previous vault (bearing in mind that some bars are held in deep storage for decades), serial numbers and also as a security measure to ensure bars in circulation cannot be tampered with. Any discrepancies are then resolved between the vaults, sometimes resulting in the reclassification of the bar’s fineness and compensation paid to the purchasing client for any loss in valuation.
- Inventory management of allocated metal is crucial, the high value of the metal means that accuracy of recording the metal held is of utmost importance. In order for a bar to be traded at loco London, it must meet the stringent set of criteria defined in the Good Delivery list. The traded weight of precious metal is measured in Troy Ounces (one Troy ounce is equivalent to roughly 31.1 grams, just over the more commonly used “avoirdupois” ounce). Gold is unique in that it is traded in fine Troy ounces (this ensures that the weight traded represents the amount of pure gold, irrespective of the purity of the bar). Other significant data attributes of the bars include a unique serial number, year of manufacture, the brand of the refinery (not all bars are equal, and brand can be a factor in considering whether a bar is “premium” with some investors attaching sentiment to certain brands), and the purity (or “fineness”) of the metal which varies between bars is measured in terms of the fine metal content in parts per 1,000, for example the finest commonly traded gold bar is a 400 Oz 9999 large bar (meaning 99.99% pure). Due to variations in fineness and mass, a significant number of different precious metal products are traded, standard kilobars and 400 Oz large gold bars being some of the most common to be found in vaults – the LBMA maintains a list of the various products available.
- One common way of investing in physical bullion without having to actually handle the metal is through Exchange Traded Funds (ETFs) which are offered whereby for example a bank stores a number of bars as part of a fund, and investors can buy/sell a small share of this “pool” of metal – sometimes as part of a combined commodities fund . This is especially useful for small investors as the minimum investment may be just a small percentage of a single gold bar eg one tenth of an ounce.
- Rather than holding real physical bars, the holder of unallocated metal simply holds an entitlement to metal, which they can ask to be “allocated”. Should an allocation be requested, the clearing bank will reduce the client’s unallocated balance and either deliver the physical metal to the client at a vault (in reality this will usually be a transit company on their behalf, to move it to their account at another vault), or assign physical metal to their allocated account. However the majority of unallocated positions are never allocated, and are eventually closed out.
- Unallocated trading gives clients access to take a position in precious metal markets for hedging/speculative reasons, without having to worry about the logistics and security risks of physically holding metal bars/coins.
The majority of trades are unallocated trades, with counter currency of US Dollar . Some of the key instrument types available to taking and managing risk in the precious metal are as follows:
Over the Counter
- Spot trades: metal is bought/sold for settlement in two working days, in exchange for currency at an agreed rate.
- Outright Forward: as per Spot trade, but delivery is future-dated
- Swaps: conventionally a Precious Metal “swap” refers to a trade where metal is bought/lent against currency. Most commonly the “borrower” buys metal for delivery on the spot date in exchange for currency payment, then sells metal back on a forward date in exchange for currency payment (although both legs can be forward dated). Other types of Swap can be traded, including location swap.
- Loans/Deposits: a notional quantity of metal is lent/borrowed, in exchange for interest payments. The interest rate, usually referred to as the “lease rate”, is usually calculated on a 360 day basis (as per most currencies) in ounces (although sometimes settled in dollars), paid monthly or annually. Interest is conventionally calculated as:
- Interest (Troy Oz) = B x (R/100) x (d/360) x P
- where B is ounces of bullion, R is the lease rate, D is the number of days and P is the Price of gold or silver agreed for calculation of interest . At maturity the principal loaned is likely to either be paid back, or the loan may be rolled. In order to eliminate the credit risk of a party being unable to pay back the principal amount loaned plus the interest due, the loan may be collateralised.
- Forward Rate Agreements (FRA) and Interest Rate Swaps (IRS): these instruments are used to hedge / speculate against future movements in gold lease rates. They are Contracts for Difference (ie involve no actual payment of metal, just the difference in rates at the pricing date is settled) used to lock in an agreed fixed rate of interest on a loan by offsetting it against the floating interest rate, for example based off the GOFO rate (before it was defunct)
- Options and Futures: available for example on the ICE US and COMEX exchanges , can be exchanged for physical positions if required
- The market is generally quoted in US dollars per Troy Ounce (Fine Troy Ounce for Gold), although fixings are also set in GBP and EUR.
- Until recently fixings were negotiated by members of the Fixing companies (primarily major banks), with the fixing process determined by iterating through a theoretical trading process, changing the price until one was found at which all member’s positions are netted off . However following investigations into the manipulation of the process during 2014, the responsibility for the fixings process is moving to external companies and based off real transactions via an auction process.
- Gold settlement prices are set twice daily (the morning 10:30 fix and afternoon 15:00 fix) by the Gold Fixing Company, responsibility will be taken over by the ICE Benchmark Administration in Q1 2015 .
- The Silver, Platinum and Palladium official settlement prices are set once daily at midday. Since 2014 these have been managed by CME Group/Thompson Reuters and the London Metal Exchange respectively.
- The Gold Forward Offered Rate (GOFO) is currently published by the LBMA. LBMA Forward Market Makers contribute to the GOFO each business day. These are rates at which contributors are prepared to lend gold on a swap basis against US dollars  to provide an indication of forward market value. Since publication started in the late 1980’s, typically GOFO’s have been positive (market conditions known as “contango”), so people would pay money to borrow dollars (using gold as collateral). However when rates are negative people are willing to pay interest to borrow gold, using U.S. dollars as collateral (market conditions known as “backwardation”) – in other words, there is high demand for physical gold.
- The GOFO values as of 31 Dec 2015 (the most recent dataset) are:
|Forward Rate 1-Month|
|Forward Rate 2-Months|
|Forward Rate 3-Months|
|Forward Rate 6-Months|
|Forward Rate 12-Months|
- One interesting point to note is that when the 12 month rate is zero, it means you can get an interest free loan for a year, as long as you back it with gold as collateral.
- The London Gold Lease Rates (LGLR) are also published (ie the interest rate which will need to be paid if you want to borrow gold), simply derived by subtracting the GOFO mean averages from the corresponding values of the US LIBOR (London Interbank Offer Rates).
- The GOFO has been used widely used internationally to price a variety of products, including Interest Rate Swaps between metal and currencies, however following the exit of two of the eight financial institutions who set the GOFO rate, this price will no longer be published from Jan 2015 and existing positions indexed to this price are being closed out. It can be argued that in the short term this is likely to lead to less transparency of pricing for forward loans in the market, leading to wider diversity of pricing and increasing the value of gold, while in the longer term a replacement method for valuing forward lending rates is likely to be established 
Settlement and Clearing
The settlement process can be likened to that in international foreign exchange markets, where settlement is effected by debits and credits over currency nostro accounts in the relevant banking systems. A credit balance on a loco London account with an LBMA member represents a holding of gold or silver in the same way that a credit balance in the relevant currency represents a holding of dollars on account with a New York bank or yen with a Tokyo bank. Because of this, nearly all global OTC gold and silver trading has historically been cleared through the London bullion market clearing system .
In London, for many years clearing was facilitated by the clearing members of the London Bullion Market (LBMA) via phone, fax and SWIFT messages. In the mid-nineties in order to improve auditability and speed of transfers, it was decided to form a separate company called the London Precious Metal Clearing Ltd company (LPMCL), who co-ordinate clearing and vaulting. These days there are six precious metal market makers who make up the LPMCL:
- Deutsche Bank
- JP Morgan Chase Bank
In order to manage the high volume of unallocated trading (including physical movements, over 20 billion USD worth of gold was cleared every month in London in 2014 ), the LPMCL run an electronic payment matching system for daily settlement between the six clearers, called AURUM
- Every day the clearers send the transfers for settlement today down to Aurum (netted according to the payment netting rules agreed with the opposing bank for each counterparty)
- These payments are matched off within Aurum throughout the day, any discrepancies are resolved until fully matched around 4pm Uk time
- Following this, in order to limit exposure to one another, the six clearers calculate their total exposure of unallocated metal to one another. If this exposure is above agreed limits, the clearers will transfer allocated metal to reduce the balance.
 London Bullion Market Association (LBMA): http://www.lbma.org.uk/what-we-do
 London Precious Metals Clearing (LPMCL) website: http://www.lpmcl.com/
 Deutsche Bank ETF products offered: http://etf.deutscheawm.com/GBR/ENG/Product-Overview/Commodities
 Gold Fixing Company: https://www.goldfixing.com
 Gold Fixing Company History: https://www.goldfixing.com/gold-fixing-history
 History of the Gold Standard http://www.econlib.org/library/Enc/GoldStandard.html
 Replacement of Gold Fixing process: http://www.bloomberg.com/news/2014-11-07/ice-to-run-replacement-for-century-old-london-gold-fixing.html
 London Platinum and Palladium Market: http://www.lppm.com/index.aspx
 LBMA OTC guide: http://www.lbma.org.uk/assets/market/OTCguide20081117.pdf
 Comex Exchange Product List: http://www.cmegroup.com/product-codes-listing/designated-contract-market.html#comex
 Nasdaq article on the implications of GOFO rates no longer being published http://www.nasdaq.com/article/gold-forward-rate-to-end-jan-30-and-trigger-change-in-market-cm434498