Basel 3: a risk for the gold market and private investors?

The Basel III regulation has changed our financial system step by step over the past decade – with the aim of making it more robust. Another part of the regulatory framework has now come into force. The new regulations aim to reduce the credit risk on the financial markets. But they could have significant and unintended side effects for a very important market: the gold market.

This is one reason why they are being implemented in a watered-down version in London, the heart of the global gold market. This is to ensure that credit risks are offset by the bank’s own assets so that liquidity and pricing do not suffer.

Adrian Ash, Bullion Vault

Why is? Since June 28, 2021, banks in the European Union have had new rules governing how much capital they have to hold for credit positions with customers. These rules will come into effect in the UK on January 1st, 2022.

What the regulation means for banks

Allocated physical gold that is held by the bank but assigned to specific customers who fully own the precious metal is in fact considered to be a risk-free asset. That sounds good at first. But there is also a downside for banks – in the form of the new rules for unallocated gold.

This is gold that customers deposit with banks, which means that they are only creditors, similar to what happens when they are deposited in an overnight money account. The precious metal is on the bank’s balance sheet as an asset for which it has a liability to the customer in the same amount.

Why does allocated gold exist? There are countless companies who take advantage of the ability to buy unallocated gold and secure the price before deciding on allocation and delivery. Countless others need and benefit from the option of borrowing precious metal or lending it as security.

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Think, for example, of a mine operator who is looking for funding for future production, of a refiner who accepts semi-pure bars (doré) for which the mine operator (or collector) wants to receive finished bars. Or to a dealer who wants to hedge his price risk for bars that he has bought from a provider of purely physical gold, who in turn has bought the precious metal back from his customers.

And in addition to all these precious metal deals, unallocated accounts are also interesting for many speculative traders who want to expose themselves to the gold price without taking on the delivery and paying storage fees.

Expensive business for banks

The new regulations now aim to ensure that banks have to deposit 85 percent of unallocated gold with core capital – this is what is known as Required Stable Funding (RSF). And this core capital costs money because the banks do not receive it from their lenders for free, but in return for expected returns that are significantly higher than those of loans or traditional bonds.

In short, keeping unallocated gold on the balance sheet becomes expensive for banks as a result of Basel III. This effect, whether really wanted or not, will limit the extent of gold lending and similar practices. However, the change can also be drastic – when you consider that the RSF level was zero percent before the introduction of Basel III. And that someone has to bear the additional costs.

What this can mean in practice is best seen by looking at the types of business for which banks use unallocated gold. These include the short-term loan transactions already mentioned. Such loans are used, for example, by non-banks – for example as a material for the manufacture of jewelry and other items.

In addition, it is also – especially at the world’s most important gold trading center in London – the most important means of clearing and settling transactions in physical gold between market participants. Unallocated gold is therefore a crucial source of liquidity in the gold market.

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A dwindling of this liquidity would have consequences for the entire market: Trading becomes more difficult and more expensive – for example due to increasing spreads. And the volatility of the gold price would increase. Because of these risks, the gold industry, led by the London Bullion Market Association (LBMA) and the World Gold Council of the Mining Sector, has lobbied regulators to reconsider these rules.

Individual regional and national regulatory authorities have leeway to set certain rules. And while the European Banking Authority (EBA) has not yet announced any changes, the UK’s Prudential Regulatory Authority (PRA, a division of the Bank of England) has accepted the argument that the 85 percent RSF on gold is likely to affect liquidity and increase volatility instead of doing the opposite.

Therefore, it will allow UK bullion banks to account for unallocated customer accounts that are “intertwined” with the precious metals physically held on the bank’s balance sheet.

This “exemption” means that the RSF of 85 percent imposed by the Basel 3 framework on unallocated gold positions does not have to be applied. This is good news – not just for the clearing banks, but also for investors around the world. For banks and gold dealers in mainland Europe, on the other hand, there could be an even greater competitive disadvantage compared to trading in London.

So how can private investors deal with the new set of rules?

It is not yet clear how retailers, banks and other institutions in Germany will react to this in the long term. Gold trading in London should continue relatively unchanged due to the looser interpretation of the British regulatory authorities. But the costs for various gold savings plans or gold accounts available in Germany, which often work with unallocated gold, could rise.

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Or – thought a step further: the offers could even disappear from the market altogether. This is because they are more expensive for the banks than allocated gold – and less attractive for customers than allocated gold that is owned by the investor and for which storage fees are incurred.

Private investors should therefore pay more attention to what the spreads look like when buying and selling gold. And they should pay more attention to where they reinvest their money and what fees are incurred for custody when buying gold. Basically, it can be said that unallocated gold is a debt security. For both banks and investors. Only allocated gold offers investors freedom from the credit and counterparty risk associated with real physical gold.

Author Adrian Ash is Director of Research at BullionVault.