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The London gold market is an OTC market, where there are no trading rules set as with an exchange. To some extent, however, this unique market is organized. Let's start with the basics. How does this market work? And why is London so important to the global gold market?
Globally, there are 71 LBMA-accredited refineries (smelters), which are the gatekeepers of the LBMA's integrity chain. These smelters only accept gold from verified sources. When LBMA smelters produce ingots weighing between 350 and 430 troy ounces, with a fineness of no less than 995 parts per 1000, they meet the "LBMA Good Delivery" standards. The integrity chain is a closed system of smelters, logistics companies, and custodians—all members of the LBMA—around the world, who ensure that all metals within the chain are of the right quality. Bars that are withdrawn from the integrity chain can only return to the chain via the accredited smelters.
The number of LBMA-accredited smelters by continent in 2021 (Source: The Alchemist)
When the logistics companies just mentioned transport large gold bars to vaults located within London's M25 ring road, these bars are officially "London Good Delivery," and serve as physical cover for trading in the London gold market. Although this gold is located in London, traders from all over the world participate in the London gold market.
London's system of safes should not be confused with the LBMA's chain of integrity. The integrity chain spans the entire world, and gold bars with weights other than LBMA Good Delivery are also stored here.
Gold bars produced by LBMA-accredited smelters are the global standard. The Shanghai Gold Exchange (SGE), for example, accepts LBMA-certified metal in its vaults in addition to gold bars from SGE-certified smelters.
Number of LBMA Good Delivery gold bars in London (Source: LBMA)
At the heart of London's gold market is an electronic Clearing system AURUM, which connects the LBMA clearing banks. The London gold market can be thought of as a banking system with physical gold in London as reserves, and AURUM as the clearing agency. How clearing works is covered below.
Gold trading in London mainly takes place on a Unallocated basis. An unallocated account with a bullion bank is a claim on a pool of physical gold owned by the bank. Holding an unallocated position (or "unallocated" for short) in a bullion bank can be compared to a fiat deposit in a regular bank. You do have a claim, but it is not fully covered by the bank. Unallocated is the credit in the London gold market.
If a customer has a Allocated holds a position in a bullion bank, he owns uniquely identifiable gold bars that have been set aside and are not on the bank's balance sheet. Customers pay storage fees for holding allocated metal, as opposed to much lower fees for storing unallocated metal. Any customer can switch from unallocated to allocated, and vice versa, connecting the paper market to the physical market in London. Precious metals banks have agreed that any charges for allocating metal can only be changed within a period of 30 days after announcement.
The main reasons why the majority of trading in the London gold market takes place on an unallocated basis are convenience and efficiency. What makes gold special is that it is both a commodity and a currency. For example, trading on an unallocated basis makes it possible to buy gold for exactly $1,000,000 US dollars, or borrow exactly 25,000 troy ounces. The size of a Allocated Transaction is always linked to different weights of different physical gold bars, which leads to awkward numbers. This is why "loco London unallocated" is used as the primary currency in the global OTC gold market.
Clearing through AURUM is supervised and managed by London Precious Metals Clearing Limited (LPMCL). The clearing banks participating in AURUM (the LPMCL members) are HSBC, ICBC Standard Bank, JP Morgan and UBS. Other banks and participants in the London gold market are connected to the clearing banks in one way or another. These banks settle transactions in the London gold market.
Clearing banks either have their own vault in London, have an account with custodians such as Brinks or Loomis, or use the Bank of England's vault.
Illustration of the structure of the London gold market. The clearing banks are connected to each other through AURUM, and client banks and sub-clients are connected through the clearing banks. All clearing banks, but not all client banks and sub-clients are included in this chart. All connections between the companies are hypothetical.
How does actual trading work? Let's say a gold mining company borrows 180,000 troy ounces of unallocated gold from a bullion bank in London at a 2% interest rate. In this example, it's the bank UBS, which happens to be a clearing bank. After receiving the loan, the gold mining company sells the metal directly on the market, to use the proceeds for a mining project in Australia. A year later, the gold mining company has mined 183,600 troy ounces and is looking to repay UBS the principal plus interest (assuming it has been agreed that the interest will be paid in gold).
The gold mining company then takes the unrefined gold to a smelter in Australia, and indicates that it wants to be paid unallocated in London loco. The smelter takes delivery of the gold and informs its precious metals bank in London, Merrill Lynch, to transfer 183,600 troy ounces from its own account to the gold mining company's account with UBS (see the chart above for clarification). Merrill Lynch informs its clearing bank JP Morgan of the transfer of 183,600 troy ounces to the gold mining company's account at UBS. When UBS has received 183,600 troy ounces via AURUM, the gold mining company's account is debited with 183,600 troy ounces and the loan is repaid.
What is settled in Australia are the out-of-pocket costs for refining the gold and a correction for the local gold price discount/premium compared to the price in London.
Unrefined gold bar, called "doré", which usually has a purity of 80%. Doré bars are traded at a discount compared to refined bars due to refining costs (Source: Barrick)
Whether physical gold is transferred between JP Morgan and UBS via AURUM depends on all transactions of these banks and their customers. In the London gold market, thousands of unallocated transactions are executed every day, which means that the clearing banks have many claims on each other at the end of each day. The clearing process begins at 16:00 GMT each day with the settlement of all claims that LPMCL members have against each other. After this process, the remaining receivables are settled in physical gold.
Other ways in which the London gold market is traded are companies, central banks and investors who trade through Forwards, swaps and options trade in gold just as they trade in other currencies through foreign exchange markets.
Trading in the London gold market takes place between all LBMA members. But with so many participants, you might be wondering what the spot price of gold is in this market. Technically, in this web of trading, there is no single gold price.
The core of this market consists of 12 LBMA market makers, who must quote a two-way market (bid and ask price) throughout the day. These rates are only accessible to those who have a business relationship with these banks. The spot price of gold that you see on Bloomberg, Reuters or Netdania, for example, is often a composite of different prices from LMBA market makers. As a result, prices may differ between the media just mentioned.
Which brings us to another function of the London gold market: the "LBMA Gold Price" benchmark. The LBMA Gold Price, which was previously called the London Fix, is an auction held twice a day: at 10:30 a.m. and at 3:00 p.m. This benchmark is used for a variety of purposes, such as industrial contracts.
There are 16 registered direct participants in the LBMA Gold Price, who can provide access to the auction for their customers. An auction starts with the announcement of a starting price. Based on the starting price, the direct participants and customers present whether they are buyers or sellers and in what quantity (loco London unallocated). Usually, after the first round, the buying and selling volumes of all participants are not balanced, and the price is adjusted up or down, followed by a new round of bidding. This process is repeated until the net volumes of all participants are within the predetermined tolerance. Finally, the metal is settled and the auction price is published.
LBMA PM Gold Price data as of March 1, 2021. The price ended at $1,734.15 US dollars per troy ounce (Source: ICE)
The above is a simplified representation of the London gold market. For more information, please refer to the LBMA OTC Guide and visit the LBMA Website.
For my research on the London gold market, I consulted insiders Bron Suchecki, Ross Norman and Jeffrey Christian. Any inaccuracies in this article remain my responsibility.
This article originally appeared on The Gold Observer
