Does The Precious Metal Market Need Another Derivatives Exchange?

Precious metals have significantly outperformed all other asset classes with year to date gains of 44% in Silver, 31% in Platinum, 28% in Palladium, and 26% in Gold. 2016 marks the highest recorded annual gain for gold in 36 years. Investment demand for the metal is 16% higher this year than the previous recorded high reached in 2009. Attempting to capitalize on this growing investment interest, the London Metal Exchange (LME) announced this week its plans to launch a gold and silver London based listed derivatives exchange in the first half of 2017. The new exchange will compete directly with the existing London over-the-counter market (OTC) system, the listed COMEX exchange in the U.S, and the Shanghai exchange in China. Contract sizes will be identical to those traded on the COMEX exchange.

London’s role as a major precious metal trading center harkens back to the 17th century but volumes have recently eroded as major banks pulled out of London precious metal trading due to increased regulatory scrutiny since the financial crisis and accusations of past market misconduct. The local precious metal market has an annual turnover of $5 trillion per year.

The 139 yr old LME has traditionally focused on the industrial metals with the exception of a brief and unsuccessful 3 yr foray into gold during the 1980’s. In 2014, the LME lost the bid to administer the important London gold benchmark fixing to one of its major rivals, the Intercontinental Exchange (ICE). The London precious metal market is administered by the London Bullion Market Association (LBMA) and dominated by privately negotiated (OTC) off exchange transactions. Listed trades have historically flowed to the U.S. COMEX exchange but have gravitated in recent years towards the Shanghai exchange as physical gold demand in Asia continues to outpace that of the U.S. and Europe combined.

30 banks were initially approached to take part in the LME venture but only 5 ultimately committed to the scheme. Important to note and critical to the long term viability of the nascent exchange is that none of the members are large gold clearing banks and the LBMA itself, the arbiter of good delivery standards, is not involved in the project. Like the OTC market, the new contracts will settle on an unallocated basis. This means that once the contracts reach maturity, investors own a fractional interest in a pool of gold or silver held by a bank but not specific bars. In the event of a bank failure, like in the case of Lehman Brothers 8 years ago, investors rank as unsecured creditors without a specific claim to physical gold or silver bars. This, in my opinion, is the critical flaw of the LME proposal. The new venue might be useful for high frequency traders that seek to arbitrage minute price differences between exchanges around the globe or front run customer orders but it does not offer investors a new or more secure alternative to what is already widely available in other markets. The financial crisis made it abundantly clear to long term precious metal investors that gold and silver should be held in physical form and outside of the banking system.

By Eric Schreiber from EMS Capital

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