Did The London/New York Markets Default On Gold Deliveries?
April 2, 2020
By Patrick A. Heller
On Tuesday, March 24, two different bullion wholesalers told us that the London Bullion Market Association, the world’s largest gold market, was not delivering any gold to settle maturing contracts that had been called for delivery of the physical metal.
While this cessation of delivery was accurate, there were multiple possible explanations as to what occurred, each of which avoided terming the non-delivery of gold as a “default” by the exchange.
One story said that it was not possible to arrange shipment of gold on passenger flights across the globe. It is true that much of the gold shipped from London travels as cargo on passenger flights and that such flights have decreased during the current efforts.
Another report was that the Brinks vaulting operations for the LBMA was responsible for the interruption of delivery. Apparently, the Brinks vault operations in India this week have encountered logistical difficulties receiving all incoming gold shipments.
Last was an official statement by the London Bullion Market Association that read, “LBMA has offered its support to CME Group [which owns the New York COMEX] to facilitate physical delivery in New York and is working closely with the COMEX and other key stakeholders to ensure the efficient running of the global gold market.” In effect, the LBMA was blaming the New York COMEX for whatever delivery problem that existed.
The problem appears to stem from the dominant use of the “exchange for physical” option in settling COMEX gold contracts that are called for delivery of the physical metal upon contract maturity. Normally, COMEX contracts called for delivery would be settled by providing the underlying physical commodity. Another option is a cash settlement. For gold and silver contracts, a third option is to deliver shares in exchange traded funds for an equivalent number of ounces of the COMEX contract.
Around 2005, the COMEX began to allow a fourth option of “exchange for physical” where the party liable for delivery would pay some cash to the contract owner plus tender an equivalent contract for delivery of the same amount of metal on another exchange. The exchange for physical option is the most expensive way to settle a contract, which is why it was considered an emergency measure. Starting about 18 months ago, a rising percentage of gold contracts called for delivery were being settled via the EFP option, with the contract delivered almost always being for gold in the London futures market. Today, a majority of COMEX gold contracts are settled using EFP.
There are some logistical problems with delivering a London gold contract. First, London gold contracts are for 400-ounce bars whereas the COMEX contracts are for 100-ounce bars. Second, like the COMEX, the LBMA also has a huge shortage of physical gold to deliver against maturing contracts called for delivery. As a consequence, a higher percentage of London gold contracts are being settled for cash than in years past. Even worse, from the standpoint of the LBMA, is that the negotiated cash settlements now are for an increasing premium above the spot price than in the past. What that means is that short-sellers of contracts in the London market were suffering financially when the COMEX passed along its gold contracts.
In response to the initial news of the lack of London market gold deliveries Tuesday last week, the physical gold market developed a large bid/ask spot price spread—as much as $100 that day. The bid/ask spot price spreads also widened for silver, platinum, and palladium. As of Wednesday this week, these spot price spreads are much slimmer, though gold and silver are still larger than they were before Tuesday last week.
Industry officials have gone out of their way to avoid calling last week’s interruption in gold deliveries a default. A formal default (which, by the way, came close to happening in the palladium market earlier this year) would send a signal of a major shortage of physical metal that would result in a huge disruption in paper contract market trading for precious metals. Even though this event was effectively a default, exchange officials are trying to reassure investors and industrial users that there are adequate physical precious metals inventories. At worst, they are claiming, the physical metals were simply in the wrong location.
The LBMA and COMEX have taken steps since this failure of delivery to try to backstop a repeat by changing how gold trades at the COMEX. It has added a new kind of gold contract (the name may be “Gold Enhanced Delivery”) which may include kg, 100-ounce, or 400-ounce gold bars as being available to deliver against mature contracts (kg bars are the standard contract size on the Shanghai Gold Exchange). This would give the COMEX some flexibility over what kinds of bars were received at its warehouses and also eliminate the need to melt down 400-ounce bars to refabricate as 100-ounce ingots.
Another change is that the COMEX has amended its gold contract rules so that a new settlement option is available. Instead of delivering the physical metal, cash, ETF shares, or Exchange for Physical to settle a maturing contract called for delivery, a short-seller can now deliver a new form of paper gold called “Accumulated Certificates of Exchange” (ACE). This enables the short-seller to be settled with the “fractional” delivery of a 400-ounce bar theoretically in the COMEX warehouses. The ACE could be delivered as fulfilling a future delivery obligation. Or, someone could acquire four of these ACEs and turn them in to receive the full 400-ounce bar.
There was one problem with the unveiling of the ACE option to settle gold contracts—as of earlier this week, the COMEX warehouses did not have any 400-ounce bars.
The sum total of all the developments at the LBMA and COMEX last week reinforces the fact that there is a huge shortage of physical gold (and, by extension, silver) inventories available to cover all promises for delivery. As more people are willing to pay ever-higher premiums to get their hands on bullion-priced physical coins and ingots, the risk of collapse—a formal default—of the “paper” gold and silver markets is also rising.