2022 was a milestone year for the gold market, in that we witnessed the largest volume of central bank gold buying ever recorded. As inflation grew and international sanctions were applied, central banks began building larger gold reserves. Of the 1136Mt purchased by central banks last year, 800Mt were bought in the second half alone*. To put this into perspective, when central banks previously purchased gold, the average would normally be between 400 and 600Mt.
To offer some rationale on the drivers for this, the International Monetary Fund recently published a paper referring to gold as “The Barbarous Relic No More”**. It explained how the dynamics of central bank reserve asset management have changed in recent times, alongside analysis that showed the depth-of-market and resilience characteristics of gold.
When creating a diversified portfolio, a central bank reserve asset should hold certain characteristics and qualities. One of those qualities should be that the asset must be liquid. Liquidity should exist not just when an asset is purchased but must be reliable should there be a need to liquidate.
The uniform definitions of liquidity have been discussed and debated for many years. Three factors that are not always mentioned are the correlation of price with the need to sell, and the number and diversity of asset holders in the marketplace. This is where gold has a strong advantage over other asset classes which have a lower diversity of asset holders in comparison - when there is an immediate need for a flight to quality to an asset that is increasing in value when others within the portfolio are declining.
Gold ‘increasingly meeting’ many requirements
The recent central bank purchases would imply that these institutions feel that gold increasingly meets many of their requirements, and that in the liquidity tranches of their portfolios, they can rely on 100% of the gold without a ‘haircut’.
For commercial banks too, as holding gold as tier 1 capital is allowed without any haircut. However, when writing rules on liquidity, prudential regulators within central banks have not yet allowed gold a seat at the sought after “high quality liquid asset” (HQLA) table. The reason they gave in 2013 was due to a lack of data for gold compared to other HQLAs such as government bonds and residential mortgage-backed securities.
Why is HQLA status important for gold? Without it, banks are forced to provide other non-gold assets towards their liquidity coverage ratio. The Liquidity Coverage Ratio (LCR) rules state that a bank must hold the next 30 days of outgoings in the form of a high-quality liquid asset. For a bank that holds 100% of its assets as a mixture of gold, cash, government debt, qualifying corporate debt, common equity shares and residential mortgage-backed securities, the bank can use all the assets (proportionately) towards its LCR apart from the gold. Any shortfall in LCR would have to be made up of other non-gold assets in order to be compliant.
Market Data Developments
What has changed since 2013 is the availability of market data for OTC traded gold.
The market can now demonstrate more than four 4 years of data to measure liquidity. These metrics do show that gold is a highly liquid asset. However, some more work is required to determine the remaining criteria of a HQLA as laid down by the Basel Committee on Banking Supervision (BCBS).
This will mean publishing more data, providing high-profile written explanations of the gold market and maintaining more frequent contact with prudential regulators.
If the non-HQLA burden can be removed, the cost of holding gold will decrease, which will increase participation and volumes, leading to better liquidity and lower volatility. This will benefit the whole value chain from rock to ring – including central banks.
The opportunity to present the case for gold as a HQLA will only be available when there is a revision to the Basel rules, but unlike the last occasion when this assessment was made, there will be current and accurate data along with strong anecdotal evidence.
LBMA will continue to campaign for gold as a HQLA and is watching closely how the market will develop throughout 2023.
*Metals Focus and World Gold Council
**Credit IMF and Serkan Arslanalp, Barry Eichengreen, and Chima Simpson-Bell.
PRUDENTIAL REGULATORS WITHIN CENTRAL BANKS HAVE NOT YET ALLOWED GOLD A SEAT AT THE SOUGHT AFTER HIGH QUALITY LIQUID ASSET (HQLA) TABLE