Gold leases are contracts through which central banks “lease” gold to some of the world’s major financial institutions, so-called “bullion banks,” who then sell the gold to the market. All of these transactions occur on paper only, but form the basis of world gold markets nonetheless.
Q. Now, this is a term we rarely hear, but has a central role in the price of gold. Who’s leasing gold to whom?
A. Yes, this is a very interesting phenomenon. What happens is that the central banks that are holding huge amounts of gold enter into “leases” with so called “bullion banks” — a select group of the world’s major financial institutions. They, in turn, sell the gold into the market… but, of course those are just paper transacions, and, in an extension of our rehypothication discussion from the other day, the bullion banks can–and do– sell the same gold numerous times.
Q. But it’s a lease. At some point, don’t they have to close out their contract with the governments who lent the gold?
A. Yes. So they’re hedging their positions in futures market… which is a bit ironic, because that same gold they’re selling is serving as the basis for all those futures contracts. The net impact is that gold leasing is creating a multiplier effect: there appears to be a lot more gold in the market than there really is. And that drives the gold bugs nuts.
Q. Why?
A. Because they think the central banks are using gold leasing to flood the market and suppress gold prices. But that’s the way all futures markets are: if you look at the total amounts of notional product to be delivered, its very often many multiples of the underlying that actually exist. That’s just the way the futures markets are.
Q. So how do the bullion banks make money in all this?
A. The trick is to sell the gold, use to proceeds to invest in bonds (Treasuries?), and hedge out their price exposure on returning the gold for less than their proceeds on their investment.
Q. It sort of sounds like a currency carry trade…
A. Yes. And in fact, people do refer to the idea as the “gold carry trade”.