A Guide to the Loco London Precious Metals Market
9. Lending and Borrowing Metal
It is often blithely asserted that precious metals have no interest rate. This is incorrect.
Deposits and Leases
The rationale for lending and, particularly, borrowing metal will vary between gold, silver, platinum and palladium. However, very broadly speaking, lenders of metals will be seeking a return on their investment, whereas the borrowers will have a variety of motives. These can range from miners seeking to hedge future output to industrial companies borrowing platinum and palladium that will be turned into catalytic convertors before being installed in a petrochemical plant.
Clearly, the range of motivations is far wider than those listed above, but the calculation on deposits and leases remains the same.
For example, a fibreglass manufacturer wants to borrow 2,000 ounces of platinum for a year to use the metal in the industrial process. For illustrative purposes, if it is charged an interest rate of 4% and the day count is exactly 365, then the calculation for the interest owing at maturity is simply:
((2000 x 4%)/360) x 365 = 81.111 ounces
At maturity, the loan can be rolled over (depending on credit considerations), either with the existing lender or with another bank.
The lender has full credit exposure to the borrower over the amount of the loan – the currency value of which will fluctuate as the underlying metal price increases or decreases.
However, it is unlikely that the fibreglass manufacturer will have ready access to additional platinum (save by buying it) to repay the interest and may not be willing to accept the unquantifiable risk in being effectively short platinum for a year. Therefore, the loan is likely to be converted from one where interest is payable in metal to one where it is payable in currency – on the basis that a manufacturer is more likely to have access to currency than metal – at the spot price at inception.
Using the same numbers and example, a fibreglass manufacturer wants to borrow 2,000 ounces of platinum for a year to use the metal in the industrial process. For illustrative purposes, if it is charged an interest rate of 4%, the platinum price is $1000 per ounce and the day count is exactly 365, then the calculation for the interest owing at maturity is simply:
((2000 x $1000 x 4%)/360) x 365 = $81111.11
At maturity, the loan can be rolled over (depending on credit considerations), either with the existing lender or with another bank. The lender has full credit exposure to the borrower over the amount of the loan – the currency value of which will fluctuate as the underlying metal price increases or decreases. However, the manufacturer has certainty over the amount of interest owing at maturity – obviously, this could equally be priced in euros and so on.
Manufacture of fibreglass
The day count convention used in the above example calculation is known as actual/360 (actual over 360) – the total number of days for the loan divided by the theoretical length of a ‘year’. This applies for the metals whenever interest is to be paid in metal or in a currency and where the convention is for a 360-day year.
However, where interest is to be paid in a currency where there is a 365-day convention – in GBP (pounds sterling), AUD (Australian dollars) and ZAR (South African rand), for example – then the calculation becomes actual/365 (actual over 365).
It is perhaps worth noting that a leap year would not result in the theoretical length of a year increasing to 361 or 366 days (from the 360 and 365 date conventions mentioned above, respectively).
Interest Paid in Currency or Metal
In a low interest rate environment, there is generally no difference in the rate as to whether the ultimate interest is to be paid in currency (US dollars as in the example above) or in the metal itself.
Indeed, it is unlikely that a fibreglass manufacturer would have the ability to pay 81.111 ounces of platinum in interest – it would also expose it to price movements in the value of platinum, which may well be undesirable from its point of view. Therefore, and as illustrated above, it is much simpler for the lender to translate the loan into USD equivalent and for the borrower to settle the interest charge in USD (or JPY, EUR, etc.). However, it is generally true that the principal – the 2,000 ounces in the example – will be repaid in metal.
The rationale, and impact on the rate levied, for whether interest is repayable in currency or commodity is dealt with later in this section.
Lending Allocated Metal
The simple answer is that it’s not possible to lend allocated metal. Allocated metal is associated with specific bars in an account and, clearly, it is not possible to lend specific bars and expect to get the same ones back while receiving a return – in the same way that no one would be interested in a currency loan in which the requirement was to hand back the same banknotes as were originally lent.
Therefore, allocated metal becomes unallocated when it is lent but can be returned as allocated. Albeit, it will be returned with different bars and will likely be of a (slightly) different weight.
The single grouping with the greatest concentration of allocated metal is the world’s central banks and the stocks of gold that they hold. Some of this stock will be held domestically, some may be held in the Federal Reserve in New York, while a major proportion is likely to be held in the vaults of the Bank of England in London. Indeed, its vaults held in excess of 163 million ounces of gold, equivalent to some 5,080 tonnes, as of March 2017. For the latest data, please see the Bank of England’s website. It should be noted that all gold held in the Bank of England is allocated – no metal other than gold is held at the Bank.
One of the Bank of England gold vaults