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Why Basel III regulations are poised to shake up the gold market

June 26, 2021
Myra P. Saefong

New banking rules, part of a sweeping international accord known as Basel III, will come into effect on Monday and mark a big change for European banks and their dealings with gold — potentially altering the landscape for precious metal demand and prices.

Like many reforms put in place over the past decade that aim to avert another global financial crisis, the new banking rules come with some controversy — and caveats.

Allocated gold, in tangible form, will essentially be classified as a zero-risk asset under the new rules, but unallocated or “paper” gold, which banks typically deal with the most, won’t — meaning banks holding paper gold must also hold extra reserves against it, said Brien Lundin, editor of Gold Newsletter. The new liquidity requirements aim to “prevent dealers and banks from simply saying they have the gold, or having more than one owner for the gold they have” on the balance sheet.

In response to the global financial crisis of 2007 to 2009, the Basel Committee on Banking Supervision, which sets standards for regulation of banks, developed what is called Basel III. It’s defined by the Bank for International Settlements as an internationally agreed set of measures that aim to strengthen bank regulation, supervision and risk management.

In its essence, Basel III is a multiyear regime change that aims to prevent another global banking crisis, by requiring banks to hold more stable assets and fewer ones deemed risky.

Under the new regime, physical, or allocated, gold, like bars and coins, will be reclassified from a tier 3 asset, the riskiest asset class, to a tier 1 zero-risk weight —putting it “right alongside with cash and currencies as an asset class,” said Adam Koos, president of Libertas Wealth Management Group.

Since physical gold will have a risk-free status, this could cause banks around the world to continue to buy more, Koos said, adding that central banks already have stepped up purchases of physical gold to be held in the institutions’ vaults, and not held in unallocated, or paper form.

Allocated gold is owned directly by an investor, in physical form, such as coins or bars. Unallocated gold, or paper contracts, often are owned by banks, but investors are entitled to that gold, and avoid storage and delivery fees.

Under the new rules, paper gold would be classified as more risky than physical gold, and no longer counted as an asset equal to gold bars or coins.

Liquidity requirements

As part of the Basel III reforms, European banks will face new liquidity requirements, known as the Net Stable Funding Ratio (NSFR).

It’s a liquidity standard that banks must follow to ensure adequate stable funding to cover their long-term assets. The ratio is the amount of available stable funding relative to the amount of required stable funding, which should be equal to at least 100% on an ongoing basis.

NSFR regulations will be introduced to banks in the European Union on Monday, the U.S. on July 1, and in the U.K. on Jan. 1, 2022, according to Alasdair Macleod, head of research at Goldmoney Inc.

The objective of the NSFR is “oblige banks to finance long-term assets with long-term money” to avoid liquidity failures that were seen during the 2007/2008 global financial crisis, according to the London Bullion Market Association (LBMA).

“It affects all bank liabilities and assets” and the objective is to ensure that bank assets are “properly funded and that depositor withdrawals will not lead to bank insolvency and the transmission of systemic risk,” said Macleod.

The new rules will mainly impact banks and their unallocated gold, as the majority of regular investors tend to hold physical, allocated gold, analysts have said.

New liquidity ratio requirements imply that banks may “need to set aside more funding for ‘unallocated’ gold,” analysts at BofA Global wrote in a Monday note.

Raising funding requirements for unallocated gold means the financial institution would either “reduce the bullion business” or “sustain activity and put more funding aside,” said analysts at BofA.

Those two options have slightly different implications for the gold market, “ranging from a reduction in liquidity to rising costs for market participants,” the analysts said. Either way, they do not believe these dynamics are bullish for gold. Also, it’s “unlikely that banks would replace usage of unallocated gold by gold purchased outright.”

Benefits of unallocated gold and NSFR impact

In the past, banks have dealt with unallocated gold because it makes trading the metal easier.

Unallocated gold “provides the most convenient, cheapest and…effective way for trades to be done between professional counterparts, rather than having to move physical bars against each trade,” said Ross Norman, chief executive officer at Metals Daily. It’s primarily an “interbank mechanism” to help professional participants with clearing and settlement of trades.

Under the NSFR rules, however, “unallocated gold goes into the balance sheet of the banks involved” and the rules “propose to make it much more expensive for banks to hold unallocated gold balances,” said Norman.

The rules will not only “make the cost of clearing and settling trades more expensive, but the lending of precious metals to industrial counterparts, including miners, refiners and fabricators will become much more expensive as the costs get pushed down the value chain,” he said.

It follows that the “proposed changes will make dealing in gold much more expensive for everyone in the sector,” even those acquiring physical bars, and it could make the market smaller, Norman said. All in all, the changes are “retrograde” may “render gold less relevant as an investible asset.”

If a physical gold broker’s cost of financing his stock of coins and bars, for example, doubles, then it’s likely he’ll hold less inventory, and charge higher premiums for his products, Norman explained. “If financial markets become stressed and gold demand rises sharply, then physical supply would be greatly constrained – “you have just burned half of your lifeboats.” In turn, that would make gold less attractive as a safe haven, he said.

In a recent letter on the impact of the NSFR on the precious metals market, the LBMA and World Gold Council said the proposals under the NSFR “fail to take into account the damaging effect that the rules will have on the precious metals clearing and settlement system, potentially undermining the system completely, and on the increased costs of financing of precious metals production.”

The majority of precious metals held by the London Precious Metals Clearing Limited, which was created by the LBMA and operates the clearing and settlement for precious metals transactions, is unallocated metal.

The vast majority of gold trading takes place in the London bullion market, said Gold Newsletter’s Lundin. The regulations are expected to take hold in the U.K. at the start of the new year, so the “real impact won’t be seen this month.”

Gold market impact

Analysts, meanwhile, differ greatly when it comes to their options on the impact of Basel III and its NSFR requirements on the gold market.

Goldmoney’s Macleod expects banks to be “discouraged” from dealings in gold forward contracts in London and in futures contracts on Comex.

That can lead to “greater price volatility and at the margin, some bank customers who have had unallocated gold and silver accounts will seek to maintain their exposure by buying physical bullion,” he said.

These new changes also come at a time of accelerated monetary inflation and it’s “very likely” that the combination of the two events “will drive price higher,” Macleod said. How much higher depends on how weak the dollar becomes in terms of its purchasing power, he said.

Gold futures hit a record-high settlement in August 2020 at $2,069.40 an ounce on Comex, but they’ve dropped about 14% since then, to $1,783.40 on Wednesday.

Norman, however, thinks the new rules will “not have any significant effect on gold prices…only on the cost of dealings in these markets.”

But Gold Newsletter’s Lundin seems to explain it best: “The range of opinions on the matter extend from no effect on one side, to absolute mayhem on the other, peppered…with a ‘believe it when I see it’ attitude.”

“The range of opinions on the matter extend from no effect on one side, to absolute mayhem on the other, peppered…with a ‘believe it when I see it’ attitude.”  — Brien Lundin, Gold Newsletter

The implementation of the Basel III rules has been postponed so many times, there’s still lingering doubt it’s going to actually happen, he said.

Lundin also said he does not believe the bullion market and central banks would allow these regulations to interfere with the system they have set up, but he holds out hopes that they will.

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