The Role of the Bank of England in the Gold Market

In light of the fact that gold has been an ever popular topic of discussion within our UK Economy class, while visiting the Bank of England on October 31st, I decided to find information on the role of the Bank in the gold market. There are many facets to this topic; the first to be discussed is the Bank’s management of the UK’s official gold reserves on behalf of the Government. Another aspect is the Bank’s involvement in the gold market, in particular the Bank’s provision of custodial and account management services to central banks and to commercial firms active in the London market. This reflects its role in seeking to ensure the efficiency and effectiveness of the UK financial sector. The final aspect of discussion is the Bank’s contribution to the self-regulation of the wholesale gold market.

In regards to the official reserves, the UK is a little unusual, although certainly not unique, in that the official reserves of foreign currency and gold are held on the balance sheet of the Government rather than of the central bank. The Bank of England’s role is to manage the reserves portfolio, embracing both foreign currency assets and liabilities, on behalf of the Government or more specifically the Treasury, the Finance Ministry. The Bank performs this role according to a Remit, which the Treasury sets for the Bank each year. Strategic decisions about the reserves portfolio, such as high-level asset allocation, are taken by the Treasury. The Bank provides analysis and advice to assist the Treasury in making these decisions; it implements the decisions that the Treasury makes and also manages the reserves on a day-to-day basis. In (relatively) recent years, the Bank’s management of the official gold reserves has also taken place within the framework of the 1999 Central Bank Agreement on Gold. In the context of gold, perhaps the most significant strategic move was the Government’s decision to reduce the holdings of gold in the reserves by just over half as a portfolio diversification measure. This was achieved through the series of auctions that the Bank conducted between 1999 and 2002. Despite the decrease in holdings, the UK still remains a significant holder of gold; it has around 315 tons, which is worth over $3½ billion, making the UK still among the largest twenty official holders.

Like many other central banks, whether or not they have the reserves on their own balance sheet, the Bank’s day-to-day management of the gold holdings in the reserves is aimed at achieving a return on them; this is done by lending a portion to the market. As is increasingly common among central banks, the Bank has a strategic benchmark for this gold lending portfolio, which is, in its case, set by the Treasury. The Bank is able, subject to market and credit risk limits, to adjust the maturity distribution of the actual portfolio, relative to that of the benchmark, in search of additional returns. The return on the actual portfolio relative to the benchmark measures the value that the Bank has been able to add by this ‘active management.’ Within fairly recent years, gold lending rates have been extremely low. Commentators seem to be in broad agreement as to why that is. There has been a low interest rate environment globally, and one might expect that to influence interest rates on gold. But there are also factors specific to the gold market. In particular, much, although not all, gold lending ultimately facilitates the hedging by gold producers of their future output. And, as is well known, producer hedge books have become smaller. Over a matter of years, a number of central banks withdrew some of their gold from the lending market. Gold Fields Mineral Services estimated that outstanding lending by the official sector was 266 tons lower at the end of 2002 than it had been a year earlier. In reality this just reflects lower demand from the ultimate borrowers, communicated via the interest rate. In the context of short-term rates in the single digit basis points, one might perhaps have expected official lending to fall further, when allowance is made for the compensation necessary to take account of credit risk and transaction costs.

The next topic of discussion is the Bank’s involvement in the gold market. Comparative international data on turnover in the wholesale gold market is sparse, but London is generally considered to be the most significant center for spot and forward purchases and sales, over-the-counter gold derivatives, and, in particular, for gold lending. What is the Bank of England’s place in this? First, it is a very significant custodian of physical gold. Primarily this is gold that belongs to other central banks, but the Bank also stores gold in its vaults on behalf of a number of commercial firms that are active in the market. In fact, most of the gold it stores is not its own. The Bank is certainly not unique among central banks in this custodial role. Most notably, the US Federal Reserve also offers this service to other central banks, although not to private sector institutions. The Fed has the advantage of being located on bedrock so it is able to pile its holdings up to the ceiling, but the Bank is limited to a certain number of bars per pallet because of London’s clay. With this, though, there are many commercial firms providing vaulting facilities in London and elsewhere around the world. Most often, however, commercial bank storage services are conducted on an unallocated basis. This means that the owner has a claim on the commercial bank, where it is held for a certain amount of gold, but does not have title to specific bars. What the Bank provides is an account management service on an allocated basis. That means that those holding gold at the Bank, particularly other central banks, have the reassurance of knowing that they have title to specific bars; but they are also able to mobilize those gold holdings conveniently by making or receiving so-called ‘electronic book entry transfers’ between their account at the Bank and the account of their counterpart. Such a transfer does not require gold to be physically moved within the Bank’s vaults; rather, title to the bars in question is transferred within the Bank’s IT systems. The Bank is probably unique in offering this kind of account management service on the scale that it does, and to a large number both of central bank and private sector participants in the market. The significance of this facility is that it provides an important element of the infrastructure that brings market participants together. This system is one that has grown up organically over a long period of time, and very much in response to representations from the central bank customers and from the London market itself. It has no doubt been a factor in London, maintaining its position as the most significant international center in the wholesale gold market. However important this factor may be, other factors have been even more significant. One of these factors is the establishment and promotion by the LBMA of London Good Delivery standards. Many aspects of the wholesale market could not exist in the absence of the general acceptability of different bars within the London clearing system. Such is the confidence in this market standard that the term London Good Delivery is recognized and respected worldwide.

A further activity, one that grew out of the Bank’s custodial role, is that it is prepared to accept gold deposits from other central banks, which it lends on to the market in its own name, at a margin to reflect the cost and credit risk incurred. Central bank customers thereby gain the convenience of being able to generate a return on part of their gold holdings while only having to manage a single front and back office relationship. The assets and liabilities denominated in gold on the Bank’s own balance sheet derive entirely from this borrowing and lending activity. Since these figures are published on its website each month in accordance with the IMF’s disclosure standards, anyone who is interested may track this business from there. While the Bank is satisfied with its assistance in the development of the market in these ways, it is not wholly selfless. The Bank does charge fees for the facilities it provides. More broadly these activities reflect the Bank’s role in seeking to ensure the effectiveness of the UK’s financial services, which it does in part by supporting the development of an efficient financial infrastructure.

The final topic of discussion is the Bank’s role in the regulation of the gold market in the UK. This is, in fact, a very limited one. Since the establishment of the Financial Services Authority in 1998, it has been the regulator of individual institutions. The wholesale bullion market is considered to be an inter-professional market, or, in the distinctive parlance of the UK regulatory framework, a ‘non-investment products’ market. This means that, in general, the principle of ‘caveat emptor’ applies and the market is expected to be self-regulating. The same is true, as it should be, of the foreign exchange and cash money markets in the UK. As has always been the case, the Bank of England contributes to the self-regulation of all these markets. Nowadays it does that by facilitating the production of the Non-Investment Products Code, known by its acronym, the NIPs Code. This is a code of good practice for participants in these wholesale, over-the-counter markets, covering such things as dealing procedures and conventions. It provides a framework for market participants to gauge what is, and what is not, reasonable and professional conduct. The NIPs Code is produced and maintained jointly by the London Foreign Exchange Joint Standing Committee, for which the Bank of England provides a Chairman and a secretariat; by the Money Markets Liaison Group, for which it provides a similar service; and by the Management Committee of the LBMA. The Financial Services Authority has also participated in the development of the Code and says that it expects the management of authorized firms to take due account of it. The LBMA has endorsed the NIPs Code on behalf of the bullion market, and is consulted on all proposed changes to the Code. With this, it should become apparent that the Bank works very closely with the LBMA in a variety of contexts. Representatives of the Bank are invited to attend meetings of the Management and Physical Committees of the LBMA as observers, and beyond that the two groups have a very close ongoing working relationship.

While rates, sales and information on gold is liable to changes and updates at any time, I hope that this report has given an accurate and intimate look into the role of the Bank in the gold market. As has been hopefully displayed, the Bank plays a vital role in the regulation of gold and also works with a variety of other groups to handle the many facets of the market. I greatly enjoyed my tour of the Bank of England and learned a great deal while there in addition to the topic I have just discussed.