Here’s the bloomberg article. And here’s the one on Mr Paulson. And here’s a Businessweek piece that doesn’t add anything at all.

In case you missed it, here’s a picture:


Which, you know, has made John Paulson’s gold holdings look like this:

And I think that this deserves a bit of discussion. Because while I often criticise the gold obsession (some posts: “Why Buy Gold? Buy Oil”, “Gold: the Yays and Nays“, “Gold: the Buffett Opinion“), I don’t think that the crashing gold price represents some grand realisation in the investing world.

Nor do I entirely believe, like the Businessweek article suggests, that the plunge is because “gold bugs who were betting on an outburst of inflation are scrambling to reverse their bets and exit their gold positions at any price”.

Please. Even if inflation is falling, the market does not wake up one morning and decide “you know what, we’ve been wrong about inflation”, and then descend into a gigantic sell-off at any price.

In order to explain it, I think that we need to pay more attention to the way that gold trading works.

Intriguingly, the spot price of gold is set in a fairly similar way to that of Libor (posted about that here):

  1. Five banks* sit in telephone conference at 10:30 am in London;
  2. The nominated Chairman announces a price;
  3. The other four banks “go back to their customers” to establish if they have buyers and/or sellers at that price;
  4. If there are both buyers and sellers at that price, and the quantities they want to buy/sell are within 50 gold bars of each other, then that price is set as the benchmark Gold Spot Price for the first part of the day.
  5. There is a second setting in the afternoon.

The spot gold price then becomes the theoretical benchmark for all the gold Exchange-Traded Funds and Gold Futures traded until the next re-setting of the spot price.

Most investors will not be involved in trading on the Gold Spot price, mainly because that involves a two-day delivery of gold. And how much of a hassle would that be to store? You have to organise safe boxes and private armies and such…

So to avoid the hassle, they will trade on gold futures, being the right to buy gold at a certain price at some point in the future. And when it gets close to delivery date, they roll the investment (that is, they avoid ever having to physically hold gold). Now obviously, there is a very close link between the spot price and the future price (the subject of tomorrow’s post) – but I think we can accept that the two are fairly dependent on each other.

The important thing about gold futures trading that I’d like to emphasise: you don’t pay for the gold upfront. Rather, you put down some of the money as a deposit (in trading lingo, this is referred to as “margin“). And sometimes, if things are not moving in your favour, the futures exchange will make a “margin call“, which means that they’d actually like you to put down a bit more deposit, thanks.

An example:

  1. I buy a gold future that gives me the right to buy gold at a price of $2,000. The exchange asks for a 5% deposit (called “initial margin requirement“), so I deposit $100 with my broker.
  2. One day later, the gold spot price has fallen to $1,900.
  3. I am trading at a loss of $100.
  4. The exchange looks at my position, and says “This guy is committed to paying $2,000 for gold that is currently trading at $1,900. He’s already making a loss of $100!! What’s the likelihood of him disappearing and just buying the gold for $1,900 from someone else? No ways – we need more margin from him to protect ourselves”.
  5. So they make a margin call of, say, $50. And now they’re holding my loss of $100 in hand in case I disappear before settling the trade, as well as an extra $50 in case it goes even worse in my favour.
  6. If I don’t make the margin call, the exchange will sell my future contract to recover the losses. And they get to keep my initial margin.

This should tell you that there is a significant liquidity issue here. If I can’t raise the cash to meet a margin call, then my position is immediately sold off to recover losses.

  • What causes a margin call? A fall in the gold price.
  • What causes a fall in the gold price? Lower demand for gold, and/or a greater supply of it.

A far more likely explanation for the sudden plunge in gold prices:

  • The market wakes up one morning and realises that George Soros just disappeared from the gold market (lower demand). And that Cyprus might sell some gold to recover itself (greater supply).
  • So the market pauses cautiously, and begins to engage in less gold trade.
  • Some investors, more panicky than others, start to sell some gold futures off.
  • The falling price of gold futures makes the spot-gold investors a bit edgy about whether they’ll be able to re-sell their gold holdings. So they bid lower in the teleconference.
  • The spot price of gold falls.
  • Futures traders start getting margin calls from the exchange as a result of the falling spot price.
  • More traders fail to make margin, so their futures contracts get closed out, causing lower futures prices.
  • This drives the spot price lower.
  • Now, even the traders that were meeting margin calls struggle to make margin call.
  • Liquidity to make margin dries up.
  • Cue: last week’s spiral.

And the point is that the big holders of gold (the gold bugs) don’t even have to liquidate their holdings for the gold price to plummet. Even a small decrease in their demand to buy can have dramatic ripple effects when it impacts gold futures.

I’m not sure if that consoles poor** Mr Paulson though.

PS: a shout-out to Gareth, who got me thinking about this article.

*The five banks: HSBC, Barclays, Deutsche, Bank of Nova Scotia, and Societe Generale. For more on this, I found this article quite informative.

**well, maybe not “poor” exactly. Just a lot poorer than he was four days ago.