How the International Gold Market Works (Part 3)

Author: Jan Nieuwenhuijs

Click here for the second part of this series

In the first part of this series, we discussed how the physical gold market works, while in the second part, we saw how the London gold market functions and how it is connected to the physical market. In this concluding section, we briefly discuss how Exchange Traded Funds and the futures derivatives market function, and how they are connected to the physical market. Going forward, we'll take a closer look at how all derivatives markets work individually.

Exchange Traded Funds

Exchange Traded Funds (ETFs) are funds backed by commodities, stocks, derivatives, or other financial assets. Shares of ETFs are traded on a stock exchange. Gold ETFs are almost always backed by physical gold. The largest gold ETF globally is GLD with a current coverage of around 1,000 tonnes of London Good Delivery gold bars. A position in GLD does not give you access to physical gold, you only get a share in the Fund. Investors choose to invest in ETFs because they are regulated financial products and easily accessible through brokers. GLD gives you exposure to the price of gold without leverage.

One share of GLD represents approximately 0.1 troy ounces of gold. This weight decreases over time, as storage costs are deducted from the assets (gold) held by the Fund.

The price of GLD is tied to the physical price of gold, because a select group of arbitrators, the Authorized Participants (APs), may create and redeem GLD shares with the Trustee of the BNY Mellon Asset Servicing Fund. For example, when supply and demand cause the price of GLD to fall below the spot price in London, the APs will buy GLD shares and exchange them at the Trustee for physical metal that they sell for a profit in the spot market. As a result, GLD inventory is decreasing.

Should the price of GLD rise above the spot price in London, the APs will do the opposite: buy physical metal and create GLD shares to sell on the exchange. When stocks are created, the APs must deposit gold on the Allocated account of the Trustee ("All gold in the Fund is fully allocated at the end of each business day"). As a result, GLD inventory is increasing. Through arbitrage, GLD and the physical market are connected and influence each other.

Gold stock GLD (Source: SPDR Gold Trust)

The futures market

A futures contract is a standardized agreement between two parties to trade a commodity (or stock index, bond, etc.) at a set price on a fixed date in the future. These contracts are tradable on a futures market. It should be noted that most futures contracts are never physically delivered: most contracts are closed or "rolled over" before the contract's expiration date has passed. Futures contracts are leveraged, as traders only need to put up a small amount of collateral for each contract. In the case of gold contracts, this collateral amounts to about 5 percent of the total value of the contract. Market participants use futures contracts to hedge positions. They are also used by speculators.

Futures contracts are traded for many months into the future, but for this article, we'll focus on the "next month contract," which is where most of the trading always takes place. After this, I will simply refer to the price of the next month's contract as the futures price.

The most traded gold futures contract is GC, listed on the COMEX futures market in New York. Similar to GLD, futures interact with the spot market through arbitrage. Because London is the most liquid spot market, this is where most arbitrators will trade versus the COMEX.

Suppose the futures price in New York exceeds the spot price in London to such an extent that arbitrators can profit by buying spot gold and taking a short position (the selling party of a futures contract) on the futures market. Then, the arbitrators could melt down the physical metal in London to 100 ounce bars, fly the metal to New York, and opt for physical delivery to cash in on their winnings. In reality, however, this will rarely happen. Unless, for example, there is a pandemic that derails global air travel, arbitrators will take a long position in London and a short position in New York, waiting for both markets to converge and close their positions. (Because a spot supply can actually take place on the expiration date of a futures contract, the spot price will be equal to the futures price at that time. As the expiration date of a futures contract approaches, this is referred to as the convergence of the spot and futures prices.) Of course, arbitrators will do the opposite if spot price is higher than the futures price: take a short position in London and take a long position in New York.

The futures market is therefore also connected to the physical market by means of arbitrage.

It is worth noting that when a long (short) futures position is rolled over to the next month, and the futures trader's initial purchase (sale) caused an arbitrator to take a long (short) spot position, then on a systemic level, the arbitrator will also roll over his position. London thus serves as a warehouse for the COMEX.

Conclusion

Below is an overview that shows how GLD and the futures market are connected to the physical market in London, and how London is connected to the rest of the world. In fact, all gold markets are interconnected.

Arrows have been added between different physical markets to illustrate that Switzerland is the largest refining center. There are no LBMA-accredited smelters in the United Kingdom.

The price of physical gold is determined by "regular traders" in the physical market and arbitrators who trade physical gold versus derivatives. That is why, in the introduction to Part 1 wrote, "The price of physical gold is determined by the supply and demand of physical gold." Gold derivatives should be seen as an extension of the physical market. Measuring the impact of derivatives on the physical market is beyond the scope of this article, but we will discuss it in a future article.

This article originally appeared on The Gold Observer