Following the global financial crisis of 2008, prudential regulators implemented wholesale changes to banking regulation.
Two ratios were developed to tackle potential liquidity risks in a stressed market scenario: the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). These calculations were used to set minimum liquidity requirements, intended to reduce liquidity risk and mismatched date funding risk and were incorporated into the Basel III regulations.
The rules were finalised by the Basel Committee on Banking Supervision in 2010 and included the concept of High-Quality Liquid Assets (HQLA) to be held as a liquidity reserve. Like all Basel rules, they were subsequently implemented according to specific legislation in each jurisdiction. In 2013, the European Banking Authority created its own list of assets that could be used as HQLA; gold was not included.
And so started a multi-year campaign by the industry, led by LBMA and the World Gold Council, to change that outcome. In the decade since the definitions were written, the landscape of global financial markets has changed dramatically and new market transparency, such as gold OTC trade data, has become available. We believe that it’s time to review the uniform definitions to include recent liquidity events and changes to trade data transparency.
HQLAs – What’s Included
HQLAs are split into different groups according to perceived liquidity characteristics: Level 1, Level 2a and Level 2b assets. Level 1 is referred to as extremely High Quality Liquid Assets (e-HQLA).
Level 1 consists of cash, central bank reserves and government bonds (or equivalent), whilst Level 2 contains less liquid assets such as qualifying covered bonds, corporate bonds, residential mortgage-backed securities, equities that meet certain conditions and other assets. Level 2 assets cannot comprise more than 40% of the total liquidity reserve. Considering that assets such as equities and residential MBS are considered HQLA, albeit level 2, it’s head scratching to understand why gold is missing from this list.
Why Wasn’t Gold Included?
Gold didn’t meet the required liquidity characteristics for HQLA for a very straightforward reason – it lacked sufficient OTC trading data to demonstrate its liquidity characteristics and in turn its Amihud ratio (the standard measure used to capture illiquidity) could not be calculated. Ten years ago, measures of gold OTC liquidity were little more than a finger in the air.
The EBA concluded that gold could not be proven to be sufficiently liquid. A second challenge is that gold is not a central bank eligible asset in the EU. This was noted in the EBA Uniform Definitions paper. However, in both the Basel Committee Banking Supervision (BCBS) criteria and the EBA definitions, an asset does not necessarily have to be central bank eligible to be a
HQLA.
In the case of gold, its wide investor base means that it is not dependent on central banks to provide liquidity in a crisis, unlike other HQLA. Furthermore, there is no good practical reason why gold could not be central bank eligible, if this community chose to make it so.
What Has Changed?
OTC Transparency In 2018, LBMA started to calculate weekly OTC trading data from its Members, before moving to daily reporting in 2019; thus actively demonstrating gold’s liquidity characteristics plus OTC market depth and breath. OTC trade data is captured from 69 reporting entities, which includes all LBMA Market Makers and Full Members who trade above deminimis levels across spot, forward, options, and lease/loans/ deposits.
In August, the average daily OTC gold market volume was $125.6 billion. This has grown from an average of ~$80 billion traded daily during 2023, helped by a rallying gold price as well as higher volumes. While LBMA trade data demonstrates that the London OTC market is the most liquid of all trading venues, gold’s liquidity is strengthened by important trading venues around the world including exchanges such as CME, SGE and SHFE as well as gold ETFs.
While significant transparency strides have been made across the market, and not just with OTC trade data, we’re trying to do more. One area is enhancing visibility on bid/ask spreads – whilst spread data (spot/forwards) is available, it’s patchy and not accessible in one central place – thus we are exploring ways to aggregate bid/ask spreads from different trading venues and
platforms to create one concise LBMA price.
Secondly, as part of the requirement for a robust market infrastructure with an active outright or repo market, we have been exploring the creation of a regulated forward benchmark to increase transparency and further our HQLA argument. Leveraging LBMA trade data, using tom-next swap trade data, a compounded in arrears Gold Swap Rate could be created. Look out for more on this in the coming months as we further explore its viability.
LBMA Gold Price
One of the most recent changes in the wholesale OTC market is the innovation of an electronic, accessible and independently managed regulated price benchmark, the LBMA Gold Price. The main benefits are the regulation and management of dual capacity house and client orders, and the broadening of access to the market. When the old gold fixing was discontinued in 2015, there were four members, all of which were banks. Today, there are 19 participants (15 direct, 4 indirect), the majority of which are non-banks.
Gold’s Role During Various Financial Market Crises
One of gold’s key characteristics is its ability to provide a safe haven in times of stress. We believe that the use of gold within the prudential regulatory system could be part of the solution for future adverse financial liquidity events and other forms of systemic risk as was demonstrated during the COVID-19 and the 2023 US banking crisis.
*As of 13 March 2023. Gold volumes based on OTC spot. US Corporates volume based on primary dealers. Source: Bloomberg, LBMA, Nasdaq, World Gold Council
In Chart 1, we chart the performance of various assets on 13 March 2023, a day when four banks with around US$900 billion in assets were either closed or merged with another bank (and again, by 1 May, when another bank with a balance sheet of US$230 billion was sold).
*Treasury data based on Bloomberg Treasury Indices. Gold prices based on XAU. Source: Bloomberg, World Gold Council
Chart 2 displays the timeline either side of the weekend of the SVB collapse and charts the price performance of HQLA. Equities represented by the S&P 500 Index fell slightly, whilst US Treasuries increased by a similar measure. Spot gold rose by almost 10% over the 10-day period.
Would holding gold as a liquidity buffer have improved the outcome of this event? In Chart 3, below, we can see that gold is not only generally uncorrelated to US stocks, but its correlation turns negative when US stocks fall sharply. This is not always the case for US Corporate bonds or even US Treasuries (other than T-Bills). The ‘All S&P 500 returns’ displays the average correlations since March 1994 and the chart also displays how those correlations become broken when the S&P500 falls by more than two standard deviations.
*As of 30 June 2023. Correlations based on weekly returns in US dollars for ‘US equities’: S&P 500 Index; ‘US Treasuries’: Bloomberg US Treasury Index, 'US T-Bills': ICE BofA 3m Treasury Bill Index, 'US Corporates': Bloomberg US Corporate Index, and ‘Gold’ LBMA Gold Price PM since March 1994 due to US Treasury availability of data. The top bar corresponds to correlations between the S&P 500 weekly returns and each respective Index, while the bottom bar corresponds to the respective correlations in days when the S&P 500 weekly returns fall by more than two standard deviations (or ‘’) . The standard deviation for the S&P 500 is calculated using weekly returns over the full period. Source: Bloomberg, World Gold Council
Deeper Engagement and Changing Perceptions
Since the 2023 US banking crisis, there have been calls to review LCR and NSFR requirements.
LBMA, together with the World Gold Council (WGC), has been engaging with BCBS as well as prudential regulators and central banks from strategically aligned nations. In Q4, we have a busy schedule of outreach with these various stakeholders and will be updating you, the Member, on significant developments.
Back in 2013, there was an uninformed perception of gold and a broad lack of understanding of the market dynamics and its infrastructure; it was perceived to be an asset with too much volatility.
It’s reasonable to argue that in the intervening years much of that perception challenge has changed – in 2010, the official sector purchased a paltry 79.2 tonnes of gold, but by 2023 that buying had surged to 1,030.4 tonnes (source: WGC). A central bank community that continues to buy a lot of gold reflects gold’s merit within the financial system.
The WGC has commissioned an independent academic study to examine gold’s case for HQLA reclassification, the results of which will be published later this year. The early learnings show that gold’s liquidity, as indicated by bid-ask spreads, is similar to typical Level 1 HQLAs including 30 Year US Treasuries; gold’s spread was one of the most favourable of a host of global government bonds during the SVB crises. Looking at the volatility of the bid/ask spread, gold’s is very similar to that of 30 Year US Treasuries. In short, gold hedges risk assts and performs differently to bonds, hence contributing to the resilience of a portfolio.
According to the BIS LCR dashboards, Level 1 assets are the most widely used within a bank’s Liquidity Coverage Ratio; indeed, many banks don’t want to hold Level 2 assets. We believe
that broadening the amount of assets available in Level 1 to include gold would create a diversification benefit as gold is negatively correlated with many asset classes. Current data shows that gold’s liquidity characteristics as measured under the Uniform Definition of Liquid Assets hold similar liquidity metrics to those of 10 Year US Treasuries.
We feel very confident to state that had the gold trading data available today been accessible in 2013, gold would have undoubtedly been classified as either an extremely High-Quality Liquid Asset or a High-Quality Liquid Asset.
Gold doesn’t deserve a reclassification simply because the data now shows that it meets the criteria; perhaps more importantly, gold has demonstrated through the GFC, through COVID-19 and through the US banking crisis that it contributes to the stability of the financial system. The process for change is long and drawn-out, but we are hopeful that change will happen.
