GOFO And The Gold Wholesale Market

An essay on the relationship between GOFO, gold forwards, the gold lease rate and the US dollar interest rate.

In order to continue to reveal essential information about the physical and paper gold markets around the world, first I would like to expand on the inner workings of the gold wholesale market. In this post we’ll use the Gold Forward Offered Rates, in short GOFO, as an excuse to illuminate the most vital gears that drive the gold market engine. For, if we truly understand GOFO we also understand gold leasing, forwards and swaps, which are the building blocks of the gold wholesale market.

GOFO officially “represents rates at which the market making members will lend gold on swap against US dollars”, but GOFO also resembles the gold forward rate and the difference between the US dollar interest rate and the gold lease rate. The purpose of this post is to explain all this in a simplified way.

Gold Forward Contracts

In the gold market there are several possibilities to enter into contracts for buying or selling gold at a future date. These contracts can be used by gold market participants to lock in a future gold price or for speculation. The most common contracts are forwards and futures. On exchanges (organized markets) such as the COMEX gold futures contracts are traded, in the over the counter (OTC) market gold forwards are traded.

For this post we’ll mainly work with forwards. Below is a chart in which I’ve plotted an exemplar gold forward curve with bid and ask quotes. The bid quotes represent the prices at which market making members are willing to buy gold at a pre-determined date in the future. These are the same prices at which we the market takers are willing to sell gold at a corresponding date in the future. In addition, the ask, or offer, quotes represent the prices at which market making members are willing to sell gold at a pre-determined date in the future (market takers buy at these prices). Please note, forward prices reflect what the market expects now about the future based on present circumstances. Forward prices do not determine what the actual spot price in the future will be.

Forward curve gold price
Chart 1. Gold forward curve. The slippage is $0.15.

The bid-ask spread in this example is a constant $0.3 for every gold forward. In reality these spreads are determined by the liquidity of the forward contract. For liquid contracts the spread is thin, for illiquid contracts the spread is wide. The difference between the mid market rate and the bid (or ask) is called the slippage.

A gold forward contract can be used, in example, by a gold mining company that anticipates the gold price will decline in the future. Simplified: if the miner has a steady output of 1,000,000 fine ounces a year and his annual expenses are 1.3 billion dollars, all to be paid at the end of the year, his business is viable starting at a gold price of $1,300 dollars an ounce. To ascertain to stay in business over one year’s time the miner can choose to enter into a 12 months forward contract to sell gold for $1,310.74.

The seller of a forward contract is said to be short, the buyer of the contract is said to be long. The total amount of shorts and the total amount of longs are always equal with respect to forward and futures contracts. The total amount of outstanding contracts is what is referred to as the open interest.

The long, in example, is a jewelry company that in turn seeks to lock in a future price for the well being of his enterprise. Perhaps it makes economic sense for the jeweler to borrow gold for the fabrication of gold ornaments, a loan he’s required to repay in one year’s time. Not to be exposed to future swings in the gold price he can choose to buy 12 months gold forward, assuring him to be able to honor the gold loan when it comes due.

The Gold Lease Market

In a free market any currency can be lent out. Whether it’s the US dollar, euro, Norwegian krone or gold. Interest is paid from the borrower to the lender in order to compensate for the risk of defaulting on the loan and postponement of using the currency. For precious metals it’s the same. Gold safely stored in a vault does not yield, however, when it is lent out, the gold will accrue interest. Gold lending in the gold wholesale market is referred to as gold leasing, and the acronym for the gold lease rate is GLR.

Posted on 22 Feb 2016 by

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