UNLOCKED: JPMorgan And Citi are 90% of The U.S. Gold Derivative Market
JPMorgan had $330 billion in March 2022 vs. $28 billion in Dec. 2021– an increase of over 1,000%.
The public is treated like mushrooms: kept in the dark and fed a lot of sh*t. But every once in a while the door opens and we get to see what is really going on.
Gold derivative risk exposure held by FDIC banks jumped 520% in one quarter
This was due to an accounting change where Gold derivatives were previously grouped in with Exchange-Rate currency contracts
As a result, JPM’s seen exposure jumped by over 1,000% from December 2021, to March 2022
JPM and Citi have had 90% of the Gold market derivative risk with almost all of it categorized elsewhere for some time.
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About midweek last a chart reflecting changes in bank holdings of precious metals derivatives began circulating. It rightly caused much speculation as to the reason for an enormous jump in amounts of derivatives held by US FDIC insured commercial banks in 2022.
Here is our attempt to explain: what it is, what happened, what it implies, and why it exists. Nobody has a monopoly on the truth. This is our attempt to shine some light and get the conversation going and minimizing the noise.
Table of Contents
What it is.
JPMorgan And Citi are 90% of The Gold Market
Why The Change?
Where were Gold Derivatives prior to the change?
Why were they “Exchange Rate Risk” Before?
What Advantage did this Give Banks?
Why is This Wrong?
1- What it is.
The above graph is a representation of precious metals derivative contracts outstanding to which a US Bank is counterparty. The Office of the Comptroller of the Currency (OCC) releases this report (attached at bottom) quarterly listing derivatives held at Wall Street and other US Banks. It is a derivative accounting report (without risk recommendations) for our whole banking system.
Gold Derivatives Outstanding ending March 31st, 2022 ( Dec 31, 2021 inset)…
For the first quarter (90 days) of 2022, the number of Gold derivative contracts jumped by an astounding 520% from 79.28 billion to $491.86 billion. Did activity increase that much? No. Is something going on? Yes. There was an accounting change.
The prima facie reason for this, as stated by the OCC is in a footnote highlighted below.
Starting January 1st, 2022, the largest banks became required to move all gold derivative risk, not currently in the “Precious Metals” risk category pictured above into that very category. Which Banks had the biggest changes? JPM, Citibank, and Goldman1 did. But JPM and Citi really stood out.
2- JPMorgan And Citi are 90% of The Gold Market
The two banks that stand out and carry the lion’s share of changes are JPMorgan and Citi. JPMorgan Chase rose $330 billion as of March 31, 2022 and Citibank held $114 billion in precious metals derivatives.
Notional Derivative Contracts Held by Banks at end of March 2022
According to the Federal Deposit Insurance Corporation, as of March 31, 2022, there were 4,796 federally insured banks and savings associations in the U.S. Combine that figure with the latest report from the OCC and it means that just two banks, JPMorgan Chase and Citibank, control 90 percent of the precious metals derivatives of all 4,796 insured financial institutions in the U.S.- Source
Notional Derivative Contracts Held by Banks at end of 2021…
How big of a change is that from last year? In the OCC report (attached at bottom) for the previous quarter ending 2021, JPMorgan had $28.2 billion in precious metals derivatives versus the shown above $330.1 billion at end of Q1 2022 – an increase of over 1,000%.
Why such an aggressive change overnight?
3- Why The Change.
Why would a Gold option/future be classified as an “Exchange rate contract” to begin with?
Last year, more or less, the rule change under Basel 3 in Europe forced Bullion banks and their customers to restate Gold derivative risk as notional2. Simply put, using notional value deleverages a position for risk purposes. Even more simply: banks had to answer this question: “How much can you really lose if it goes all to hell?”.
This Basel 3 change necessitated banks either: set aside more risk capital, pass through that requirement to customers where possible, or close the position down entirely.3 It, in many ways turns all derivatives into spot transactions. LBMA banks needed to get a delay on the EU side as we reported in July last year
1-Britain carves out exemption for gold clearing banks from Basel III rule: Banks clearing gold trades in London can apply for an exemption from tighter capital rules due in January 2022, a British regulator said on Friday, removing what some said was a threat to the functioning of the market.
That was a year ago. Now the US is getting it’s own golden ducks in a row given the new reality out of Russia and possibly China.
Russia Forced Our Hand
The OCC accounting change is, in our opinion, an attempt to bring uniformity (with Basel 3) to Western governance of Gold (remonetized) derivatives. It solidifies our position on the west’s Gold and potential back door destabilization during times of war. This action also discourages regulatory arbitrage by Banks between the EU and US markets as well.
It is very consistent with a world where a mercantile behavior is the norm as a result of diminished trust along nations. Much more on that in our write up entitled Gold: "A crisis is unfolding. A crisis of commodities"- Zoltan Pozsar:
..if you believe that the West can craft sanctions that maximize pain for Russia while minimizing financial stability risks and price stability risks in the West, you could also believe in unicorns.- Source
From that analysis, Pozsar explained in his own way that without collateral (an effect of sanctions on Russia as war retaliation), financial markets must shrink or destabilize.
Zoltan’s version of Exeter’s pyramid….
The west is now protecting what it has to in light or Russian aggression and sanctions. That means Gold must be corralled into strong hands. Since the Gold market is international with very strong ties between the LBMA and US Comex, it could be assumed that regulatory rules would at some point converge, as they almost always do.
This is all very consistent with the western world in general deleveraging, especially with the shortage of good collateral for commodity trades once the Ukraine war started. Which begs the question,Where did these positions come from if they weren’t labeled Gold before?
4- Where were Gold Derivatives prior to the change?
Gold contracts are to foreign exchange contracts what zebras are to a centipede.- Pam and Russ Martens4
That is a question easily answered with a little digging, but harder to understand “Why were they there to begin with?” follow up. We will try to answer both questions.
A section of the footnote pictured above answers the Where were they? question. It states (our emphasis):
“Beginning January 1, 2022, the largest banks are required to calculate their derivative exposure amount for regulatory capital purposes using the Standardized Approach for Counterparty Credit Risk …
…gold derivatives are [now] considered precious metals derivative contracts rather than an exchange rate derivative contract resulting in an increase in reported precious metals derivative contracts compared to prior quarters….”
The footnote states that prior to this rule change, Gold options, futures, and other derivative contracts were placed in the bucket of risk entitled Exchange Rate Derivative Risk.
Banks had, prior to June 2022 been placing most if not all of their gold position risk (net shorts we’d imagine) in a different category called “exchange rate derivative contracts” with the OCC’s blessing.
What is an Exchange Rate Contract?
It is a form of swap for one monetary unit to another that is also linked to exchange rates. It can be in the form of swap, option, swaption, etc. But it has to do with interest rates on foreign currencies.
An exchange contract is an agreement under which a business agrees to deliver or take a certain amount of foreign currency ( versus his own) on a specific future date. The purchase is made at a predetermined exchange rate.
An exchange rate contract is therefore an agreement under which a business agrees to deliver or take a certain amount of foreign currency’s interest rate differential (versus his own currency’s interest rate) on a specific future date at an agreed upon interest rate differential.
They are: A derivative instrument, used to trade interest rate differentials tied to (currency) exchange. So, why would a gold option/future be classified as an “Exchange rate contract” to begin with?
5- Why were they “Exchange Rate Risk” Before?
The broad simple answer is: the market structure had a flaw in it, possibly set up this way for good reason back in the day5 (although we severely doubt it was kept like this so long for justifiable reasons). But why were they accounted for like interest rate swaps?
The report in question…
One Possible Explanation
If physical gold wasn’t money since 1971, why were its derivatives bucketed with Forex risk even while the asset itself became demoted to a cash and carry commodity? And what, if any interest rate trades were conducted using Gold as collateral6?
One possible explanation: Once upon a time before the 1990s Gold was treated like money by banks, even if the gold standard ended in 1971. We believe this categorization may have something to do with a legacy rule that they never changed once gold was demonetized. This gave an advantage to Banks who operated in both markets. But we cannot be sure of the original “why”.
When we started in the industry, Bond traders had Gold on their accounts all the time as part of their FX risk hedge.
It was probably successfully lobbied at some point by Bullion Banks that Gold derivatives are really proxies for FX market trades, and not so much a call on physical bullion itself, since noone ever took delivery. Almost noone took delivery, so it’s not bullion risk as much as it is interest rate risk? Fancy that!
Exchange Rate Risk minus Gold still went up in Q1…
That Market structure flaw was exploited for years ( kind of like pooled dealer gold accounts were as well ), and despite the cries of foul play from excessive rehypothecation, incentivized manipulation, and criminal proceedings; the market structure remained gamed by people who understood which way the water flowed easiest.
“Other Commodities” didn’t jump like Precious Metals, because no other commodity was treated as an FX Exchange Rate risk prior…
6- What Advantage did this Give Banks?
You would have to ask Banks for specifics but here is our take as long time participants in the industry with some academic knowledge7.
Categorizing Gold derivatives not as Gold lowers stated capital at risk for carrying gold positions. When you (a bank) combine that with ability to borrow from the Fed, your ROI under VaR explodes higher. Further, if your clients are:
marking their books to market daily while you are not,
borrowing off their Visa/ Mastercard while you have access to the Fed,
and unable to allocate their own risk in a non-notional way while your risk is placed under “exchange rate risk”
We believe you then have a serious structural advantage against those speculators in the game that is Gold Poker. As a player with those advantages, you want to take the opposite side of spec trades every day, all day. You bluff a pot here and there, and you just play as the house should, passively and patiently8. And since specs are usually biased long, you by necessity are usually biased short. Remember, most of your clients are Muppets anyway. And you also have the market structure9 in place to win.
Positions would be understated to prying eyes as well, notional risk could be minimized in the asset class, and of course profits could be made with this bias culturally10. It all worked unless someone stood for physical gold delivery on a contract that was erroneously listed as “exchange rate risk”.
What About that Risk?
Your shareholders never knew you had 90% of the whole Gold derivative market risk on your books. But let’s face it, your bank was so plugged in to the market that you’d see a problem from miles away. You were the conduit of all trade. You are the house.
The risk was not big at all. You *are* the market as far as your government is concerned. So you keep doing it with their blessing. You are a capitalist, here to make money. You play the cards you are dealt, even though you are dealing. But why not? Your government told you to shuffle, make the rules, and deal the cards yourself?
The real risk was minuscule to the bank if it was a TBTF type. Which is partly why over the last few years almost all biz gravitated to the largest, lowest cost operators with the biggest balance sheets.
So Why Change?
Noone had incentive to stop the game from going until it behooved them personally. And now, in the wake of Basel 3, Russian collateral off the market, and a war in Europe it certainly behooves them. Kind of like how Pay for Order flow recently changed. Half the world seceded from our financial markets. That means we had to tighten up our risk to prevent attack now. It is no longer in their interest to have a market structure like this, even though it was wrong to begin with from a free market point of view. But there are admittedly things we cannot know about the biggest picture of all, waht ever that may be.
What was wrong about it then?
7- Why is This Wrong?
The real risk here is and has always been to the market itself. Even if you can rationalize the damage done to investors for decades on behalf of the bigger picture11, the banks playing this way were at immense measurable risk. And it is all about marketshare.12
Frankly, as someone just said: It makes a mockery of positions limits; something all traders have to adhere to for risk management as mandated by the government. We care that it could bring the whole thing down.
How can anyone (bank exec, shareholder, or regulator) accept 90% market share in an asset class that has liquidity gaps and is subject to global market forces? Now that asset is Tier 1 again and fast becoming remonetized globally.
It Wasn’t Acceptable and Can’t be Tolerated Anymore
The answer is: They can’t accept it and that is why it was kind of off-balance sheet to begin with, but blessed by the Fed going back to Greenspan. And now, given the Russian problems you can’t rationalize it at all anymore13.
Once upon a time Gold was a threat to the US dollar’s hegemony and had to be kept in its place. Now, the USD reserve currency status is being threatened by outsiders (Russians/ Chinese etc) and Gold is no longer the enemy. Gold is now the hedge against USD disaster. Time to own up to your risk.
That is why these changes are being made. The Fed is trying to fix this with as little disruption to the status quo as possible. The banks with the most risk are the ones the government needs to protect. The US and EU are preparing for escalation of an ongoing economic war. The US must protect against sudden debasement if reserve status is lost. Finally, actual war escalation is a very real possibility.
Why JPM? Ask Blythe etc when they took on the Bache/Drexel/Bear Silver book from the Hunt brothers. Why Citi? Ask Robert Rubin about his deal with Alan Greenspan during the Clinton Administration. Why Goldman? Ask any number of execs there between 1994- 2000.
Notional in finance means actual monetary value based on spot price. Listing something as notional removes leverage from risk calculations. “The notional value is the total amount of a security's underlying asset at its spot price.”
The effect of which makes business flow into the most efficiently, and largest banks with the most capital to spare. It shrinks the universe into fewer hands
One possible explanation: because Gold was no longer perceived as money its price was largely based on fiat fluctuations since it no longer competed monetarily. It was lobbied by bullion banks that Gold derivatives are really proxies for FX market trades maybe, and not so much a call on physical bullion itself, since noone ever took delivery. We can also imagine politicians being paid money by these banks went right along with this, since they didn’t understand to begin with. Finally, we can see bank traders being told which way the water flowed easiest in this set up.
We’re looking at you IMF and Benoit Gilson
We are sure each concept above can be refuted on a case by case basis. The evidence explaining this all is circumstantial, actions of a rogue, etc etc. None of it illegal in itself. It is all known and public. It is also a gross abuse of market structure by banks enabled by inept politicians.
Now throw in exchange margin requirements which must be adjusted to help broad industry liquidity, not just one segment with speculators who cannot allocate capital for taking delivery without destroying their ROI and possibly their reporting requirements- and you have a a perfect recipe for stronger hands to wipe out the weaker hands due to an unlevel playing field. One final thing: your captive client book is almost entirely natural sellers (miners) who call you almost exclusively (you also took them public and handle their credit lines) to sell and hedge their risk.
encourage amoral behavior and bad risk management due to the protection afforded
We cannot, but know intimately how they can envision their higher purposes and dong G-ds work
Which is actually all about monopoly and antitrust law. That can be easily seen by the marketshare
Also: Shareholders may have cause to take action, considering the understated VaR