Let’s Talk About Gold Leasing

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Gold’s primary function is as a store of value. That is to say that it is valuable qua its exchangeability. This is why central banks hold gold and not, say, oil or stocks or copper. Yet unlike other central bank assets, gold has no yield — it sits in a vault gathering dust. So in the 1980s, central bankers decided to let their gold work for them: they wanted to earn interest on their gold in the same way they did holding bonds. Gold leasing was born.

Gold leasing is a process whereby central banks lend their physical gold to banks in exchange for a small interest payment and a promise to pay back the gold. While this interest rate has been relatively low compared to the interest earned on bonds, central banks were better off, at least on paper, because they found another source of income.

Gold leasing started as a very small business, with central banks having a “net-leased” position of only a few hundred tons by the end of the 1980s. But in the 1990s, gold leasing began to boom. Not only did central banks want to earn interest on what would otherwise be a “non-performing” asset, but the banks that they leased the gold to — called bullion banks — were making money, as well. Bullion banks found it profitable to put on a gold carry trade. They would sell the gold into the market in exchange for a currency or bond that had a higher yield than what they were paying the central bank for the leasing privilege.

Thus the bullion banks would earn the spread between the gold leasing rate and the interest rate they earned on whatever currency they bought in exchange for the gold. But the gains were compounded as a result of a declining gold price — the bullion banks could buy the gold back at a lower price when it came time to close out the trade.

As a result, by the end of the 1990s, gold leasing increased to more than 4,000 tons of gold officially, although unofficially, some analysts — most notably Frank Veneroso — believed that the figure was substantially higher. We simply cannot know how much gold central banks had leased out, especially since they have been extraordinarily secretive about it.

The amount of gold that central banks leased out was (and still is) kept secret through an accounting ambiguity — central banks do not differentiate between “gold reserves” (i.e., how much gold is in the central bank vaults) and “gold receivables” (i.e., how much gold was owed to the central bank, presumably because it was leased out). This secrecy is no secret: it became International Monetary Fund policy in 1999 that this ambiguity remain in place due to the market-sensitive nature of this information.

These facts hold true today, or at the very least, there is no evidence to the contrary. This means that, implicitly, the bullion banks hold a sizable short position in the gold market. They may have covered somewhat with the price increase that has taken place in the 21st century, but central banks still do not differentiate between gold reserves and gold receivables, which means that there very well could be thousands of tons of gold sold short by bullion banks that needs to be bought back. This begs the question: Is there a short squeeze in store for gold in the coming months and years?

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