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Gold and Banks: Debunking Another Misconception

By Alex Dumortier, CFA - Updated Apr 6, 2017 at 11:44AM

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Gold swaps puzzle the market.

Gold came under pressure this week as news surfaced that European commercial banks have borrowed money from the Bank for International Settlements (BIS) by putting up nearly 350 metric tons of gold -- currently worth approximately $14 billion -- as collateral. I believe the market's concern reflects a misunderstanding of the dynamics behind these gold swaps, which will prove to be either neutral or bullish for the yellow metal.

Not an everyday transaction
Under the swaps, banks borrow funds from the BIS against gold with an agreement to repurchase it at a future date. The BIS, which typically acts as a bank for central banks, released the information in the annual report it published last week. Such transactions are rare: According to the BIS's historical annual reports, the last time it acknowledged the use of gold swaps was in the 1970s.

3 reasons gold swaps shouldn't hurt gold
More than their rarity, it is the aggregate size of the recent gold swaps that spooked the gold market; investors reasoned that the BIS could sell the gold on the open market in the event of non-payment. Under that scenario, a large new source of supply would weigh on gold prices; however, there are at least three reasons to believe that is highly unlikely to occur:

  1. The BIS said that the gold is being stored at central banks. This suggests to me that the gold could, in fact, belong to national central banks, which are effectively acting as guarantor on the BIS loans on behalf of the commercial banks. If the gold does belongs to central banks, the risk of it being seized and sold by the BIS is small.
  2. Even if the gold doesn't belong to central banks, it's not clear that the central bank of a European nation would allow a commercial bank to default on the gold swap with the BIS.
  3. Even assuming that the first two arguments don't hold up, a third argument is even more powerful. Let's step back for a moment: If a bank were to default on their gold swap with the BIS, that would suggest it is facing a liquidity crisis. If the entire amount of gold backing these swaps were sold on the market, it would represent less than 9% of the gold supply in 2009; however, now we are talking about multiple defaults by European banks. In that situation, it's likely that concerns about the health of the European banking system would overwhelm considerations relating to an increase in gold supply. I'd expect the former to produce a flight to safety into gold that would at least mitigate the latter.

For an indication of this, just look at the rise in the price of gold since the European sovereign debt crisis flared up at the beginning of the year -- the two largest gold ETFs, the SPDR Gold Shares ETF (NYSE: GLD) and the iShares COMEX Gold Trust (NYSE: IAU) have gained approximately 10% year to date against a 5% loss for the SPDR S&P 500 ETF (NYSE: SPY), which tracks the S&P 500.

Bullish, not bearish
Speaking of timing, it's surely no coincidence these swaps took off during the first quarter -- the same period during which the Greek sovereign debt crisis became a European financial crisis. That event has had a material impact on the ability of some European banks to fund themselves. All but the largest Spanish banks, such as Banco Santander (NYSE: STD) and BBVA (NYSE: BBVA), have been frozen out of interbank markets, for example. In that context, it should be clear that the gold swaps with the BIS are rather more bullish than bearish for gold.

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Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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