Development Through Wage-Led Growth
Henry C.K. Liu
Part I:    Stagnant Worker Income Leads to Overcapacity
Part II:  Gold Keeps Rising as Other Commodities Fall
Part III: Labor Markets de-linked from the Gold Market
Part IV: Central Banks and Gold
Part V:  Central Banks and Gold Liquidity
Part VI: The London Gold Market

Part VII: Weak Political Response to Ineffective Financial Regulation

In June 2009, after just five months in office, President Barack Obama and key advisers introduced a series of regulatory proposals aimed at, among other concerns, addressing strengthened consumer protection, restraining executive pay, preventing bank financial distress, limiting systemically significant risk exposures and commensurate capital requirements to deal with them, introducing expanded regulation on the run-away shadow banking system and reining in structured finance, particularly over-the-counterr (OTC) derivatives the are not traded on exchnages. New regulatory regimes are also proposed to enhance the authority for the Federal Reserve to safely resolve distressed systemically-important financial institutions.
On October 29, 2009, Treasury Secretary Timothy Geithner, testifying before Congress, listed five elements as critical to effective finance regulatory reform:
1) Expand the bank resolution mechanism of the Federal Deposit Insurance Corporation (FDIC) to include non-bank financial institutions;
2) Ensure that a firm that takes unwarranted risk is allowed to fail in an orderly way and not be “rescued” by the government with public funds;
3) Ensure that taxpayers are not on the hook for any losses from government bailouts of distressed firms, by applying losses first to the troubled firm’s investors, including the creation of a reserve pool funded by the market’s largest financial institutions;
4) Apply appropriate checks and balances to the FDIC and Federal Reserve in the resolution process; and
5) Require stronger capital and liquidity positions for financial firms and their related regulatory authority.
In the November 2010 mid-term elections, the Democrats lost control of the House of Representatives, losing from a Democrat majority of 275 Democrat seats versus 178 Republican seats won in 2008, to a Republican majority of 242 Repiblican seats versus 193 Democrrat seats. The Democrats lost 83 seats in an anti-incumbency electoral tsunami in the aftermath of the financial crisis.  In the Senate, the Democrats mananged to hold on to a slim majority of 53 Demacrat seats vesus 47 Republican seats, but losing a near super majority of 59 Democratic seats before the election. 
A new legislation was ushered through the Democrat-controlled House of Representatived on December 2, 2009, in the House Financial Services Committee by Chairman Barney Frank.  On July 15, 2010, the Senate finally passed it by a vote of 60 to 39. Three Republican senators -- Scott Brown of Massachusetts and Olympia J. Snowe and Susan Collins of Maine -- joined 57 members of the Democratic caucus in support. Senator Russell Feingold of Wisconsin was the lone Democratic opponent, saying the measure didn't go far enough.
Many liberals have criticized the bill for failing to more forcefully reform the structural flaws of Wall Street and for leaving too many critical decisions power to the discretion of federal regulators, who had ignored or missed many of the warning signs before the crisis.
On January 5, 2011, six months after sheparding the bill through the Senate, under a cloud of ethics scandal, Senate Banking Committee Chairman Chris Dodd announced he would not seek a sixth four-year term in 2012.
Dodd’s ethics trouble began in June, 2008, when Conde Nast Portfolio revealed that he had been granted two cut-rate mortgages of nearly $800,000 by subprime mortgage giant Countrywide Financial in 2003. As the magazine reported, Dodd was a “Friend of Angelo” -- one of several notables marked for special treatment by Countrywide co-founder Angelo Mozilo.
The report triggered a dizzying carnival of misleading Dodd statements. First, he issued an angry written statement denying any favorable treatment.  A few days later, he told some reporters that he knew he had been treated as a VIP by Countrywide, while the same day assuring other reporters that he had not.
Michael Moore’s Capitalism: A Love Story shows on film that what Dodd got from Countrywide was actually over a million dollars of a sweet-heart mortgage deal. Dodd nonetheless called for stronger regulation of mortgage lenders and proposed that predatory lenders should face criminal charges.
Conde Nast Portfolio reported that several other influential lawmakers and politicians beside Dood, icluding Senate Budget Committee Chairman Kent Conrad, and Fannie Mae former CEO Jim Johnson, also received favorable mortgage financing from Countrywide by virtue of being “Friends of Angelo”.
Clinton Jones III, senior counsel of the House Financial Services Subcommittee on Housing and Community Opportunity, and “an adviser to ranking Republican members of Congress responsible for legislation of interest to the financial services industry and of importance to Countrywide” also received special treatment for a mortgage from Countrywide. Jones is now state director for federal residential-mortgage bundler Freddie Mac.
Alphonso Jackson, Acting Secretary of HUD (Housing and Urban Development) at the time and long time friend and Texas neighbor of President Bush, also received a discounted mortgage from Countrywide for himself and sought one for his daughter. In 2003, using V.I.P. loans for nearly $1 million apiece, Franklin Raines, Fannie Mae’s chairman and C.E.O. from 1999 to 2004, twice refinanced his seven-bedroom home, which has a pool and movie theater.
Paul Pelosi, Jr., son of House Democrat majority leader Nancy Pelosi, also received a VIP loan with Countrywide. Barbara Boxer, Adam H. Putnam, Richard C. Holbrooke, James E. Clyburn, and Donna Shalala are also among those with mortgages from Countrywide.
CBS News has obtained the following list of then-Fannie Mae employees whose names have been turned over to investigators as having received VIP loans from Countrywide:
  • Sandra Adams: Fannie Mae Account Associate
  • Nitirwork Armstrong: Fannie Mae Director
  • Gregg Ayres: Fannie Mae Customer Acct Manager
  • Jeffrey Baker: Fannie Mae Business Analyst
  • Ingrid Beckles: Freddie Mac VP Default Mgmt
  • Cherry Billings: Fannie Mae Asst to CEO
  • Christine Buckley: Fannie Mae Sr Assistant
  • Sharon Canavan: Fannie Mae Govt Relations/Lobbyist
  • Delynn Conley: Fannie Mae Underwriter
  • Carla Corpuz: Fannie Mae Senior Underwriter
  • Tanguy De Carbonnieres: Fannie Mae Legal Counsel
  • Bernard Deane: Fannie Mae Director
  • Mollie Dougherty: Fannie Mae Sr Business Manager
  • Roy Downey: Fannie Mae Director
  • Cynthia Fatica: Fannie Mae Legal Counsel
  • Jamie Gorelick: Fannie Mae Vice Chair
  • Lizbeth Grant: Fannie Mae Director Tec/Secondary Mkt
  • Greta Hamilton: Fannie Mae Manager/Home Loans
  • Lester Handy: Fannie Mae Consultant
  • James Johnson: Fannie Mae Chairman and CEO
  • Jack King: Fannie Mae Manager
  • Karen King: Fannie Mae Credit Risk manager
  • Gerald Langbauer: Freddie Mac VP Sales
  • Derek Lowe: Fannie Mae Technician/Home Loans
  • Mary Lee Moriarity: Fannie Mae Sr Underwriter Consult/Lending
  • Daniel Mudd: Fannie Mae Vice Chair and COO
  • Paulette Porter: Fannie Mae Sr Proj Mgr/Mtg Securities
  • Alan Quirion: Freddie Mac Director
  • John Radwanski: Freddie Mac Sr Port Director
  • Franklin Raines: Fannie Mae Chairman and CEO
  • Robin Ramsay: Fannie Mae Customer Acct Manager
  • Rebecca Rosena: Fannie Mae Credit Risk manager
  • Irwin Rosenstein: Fannie Mae Ass. General Counsel
  • Robert Sanborn: Fannie Mae Vice President
  • William Shirreffs: Fannie Mae Director
  • Joseph Silva: Fannie Mae Servicing Portfolio Manager
  • Donna Simpson: Fannie Mae Customer Acct Manager
  • Michelle Sorensen: Fannie Mae Sr Business An/Mortgage
  • Mary Ann Staley: Fannie Mae Marketing Dir
  • Deborah Kay: Tretler Fannie Mae VP Risk Management
  • Kirk Willison: Freddie Mac VP Trade Relations/Dir Industry Relations
  • David Yoon: Fannie Mae Acct Associate
A watchdog group, Judicial Watch, filed a complaint alleging that Senator Dodd assisted a longtime friend and associate, Ed Downe Jr., to obtain a reduced sentence and ultimately a full Presidential pardon from Bill Clinton for tax and securities crimes, in exchange for gifts, including a sweetheart mortgage deal that he failed to properly disclose on his Senate Financial Disclosure forms.
Senator Dodd was elected United States Senator from Connecticut in 1980 and served for thirty years to become a powerful senior senator. But he chose not to seek re-election for a sixth six-year term in the November 2010 elections because of a number allegations of ethics viloation. His campaign war chests had been heavily funded by the financial services industry – which was regulated by committees Dodd either chaired or sat on in the Senate for decades.
Dodd’s reputation was irreparably damaged from an amendment he introduced to US economic stimulus bill in February 2009 ratifying hundreds of millions of dollars in bonuses to top executives at AIG executives at a time when the beleagured company was receiving billions of dollars in government bailouts.
AIG has had a major off-shore presence in Bermuda for more than 50 years and aside from its main operation on Richmond Road, Pembroke, operates a number of Bermuda-based subsidiaries.
On YouTube, one can watch the short clips, recorded in March 2009, of Dodd caught in stark prevarications over his role in protecting $165 million in bonuses for his generous friends at financial giant and crisis albatross AIG. Over the course of two interviews given within 24 hours on CNN, Dodd first denied with his trademark vehemence that he had anything to do with inserting a section into the February 2009 stimulus bill that allowed AIG executives to keep their staggering bonuses granted by a company that required nearly $100 billion in government rescue with taxpayer money.
Because of ethics issues involving Dodds’s role in Senate committees that regulated the financial services sector, particularly over his controversial financial ties to AIG and its one-time Bermuda affiliate, IPC Holdings Ltd, his election chances were so damaged that Dodd decided not to seek re-election in 2010 
On December 20, 2010, the Senate Select Committee on Ethics dismissed an ethics complaint filed against outgoing Senator Christopher Dodd by Judicial Watch.
Dodd, who received more than $280,000 in campaign contributions from re/insurance giant AIG and whose wife was appointed to the board of a Bermuda subsidiary of the firm, will leave office in January 2011 free from investigations or prosecution.
The proposed Act, which came to be known as the Dodd-Frank Act, was passed on December 2, 2010 as a legislative response to the global financial market crisis that began in the US in mid-2007 and the global recession that followed, was presented as the most sweeping reform of financial regulation in the United States since the New Deal that Franklind D. Roosevelt put together in the midst of the Great Depression after the market crash of 1929.

The new bill aimed at effectuating a paradigm shift in the loose US financial regulatory environment that had resulted from the steady dismantlement of New Deal governmental regulation on financial markets during the decades of market liberalization the eventually led to global systemic financial market failures in mid 2007. The proposed bill was intended to protect both the US financial system and the US investing public from practices that led to excessive systemic risk. The bill also aimed at curbing rampant moral harzard, which occurs when instituions, insulated from the consequences of risk, behave differently and recklessly than it otherwise would if they were fully exposed to the consequences of their risk taking.
Moral harzard, coupled with Federal Reserve loose monetary policy of easy money, had fueld the emergence of structured finance that led to the debt bubble, the bursting of which forced the government to bailout distressed “too-big-to-fail” institutions with taxpayer money in order to avert a systemic meltdown.
The new bill also aimed at re-establishing the largely-dismantled New Deal era mandate for Federal financial regulatory agencies to reactivate procedures of effective systemic market risk management that will affect paractically every aspect of the nation’s post-crisisfinancial services industry going forward.
The Dodd-Frank Act
On July 21, 2010, three years after the financial crisis broke out in July 2007, President Obama signed into law the 2,300-page-long Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173, Dodd-Frank Act), named after Senate Banking Committee Chairman Chris Dodd (D-Connecticut) and House Finance Committee Chairman Barney Frank (D-Fourth Congressional District of Massachusetts), passed by the Democrat-controlled Congress, four months before Obama’s first mid-term elections. The Dodd-Frank Act is a direct Congressional response to the need for re-regulation of the financial markets in the aftermath of the 2007 financial crisis.
The stated aim of the Dodd-Frank Act is:
“To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”
While few who are not specifically paid to do so have read the entire 2,300-page-long legislation, one Wall Street law firm counted the Act as requiring 243 rulemakings and 67 studies and 22 periodic reports. Law students are required to read 60 pages of law a day with comprehension and detail retention while in law school as part of their legal training. At that rate, a law student would take 40 days simply to read through the Dood-Frank Act.
Lukewarm Reception
Still, the American Bankers Association officially charaterizes the reforms proposed by the Dodd-Frank Act as “haphazard and dangerous”. Other critics argued that the Act is too weak on consumer protection and, more importantly, it does not end the “too-big-to-fail” problem, particular on the issue of moral hazard, a term used in banking circles to describe the tendency of bankers to make bad loans based on an expectation that the lender of last resort, either the Federal Reserve domestically or the IMF globally, will bail out troubled banks caught with bad loans. (Please see my September 23, 2008 article: Too Big to Save vs Moral Harzard)
SEC Clarification on the Dodd-Frank Act
On July 27th, 2010, the Security and Exchange Commission (SEC) provided additional clarification on the Dodd-Frank Act regarding the valuation of an individual’s primary residence when calculating net worth, a figure that affects the individual’s credit capacity.  In particular, the SEC has interpreted this provision as follows:
“Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation…Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth.”
In other words, as far as the SEC is concerned, if the outstanding amount a home mortgage becomes greater than the market value of the home, an “under-water” condition  prevalent after the overleveraged housing market crashed in 2007, the under collateralized liability to the lender needs to be deducted in calculating the net worth of the borrowing home owner. This ruling will incentivize holders of “under-water” mortgages to default to protect their net worth from declining, contrary to government desire to reduce the number of home mortage defaults.
CFTC Proposed Rule on Position Limits for Derivatives
On January 13, 2011, the Commodity Futures Trading Comminssion (CFTC) approved, by a 4 to 1 vote, issuance of a proposed rule that establishes limits on positions in physical commodity futures contracts as well as swaps that are economically equivalent to those contracts.
The proposed position limits framework would enable the Commission to meet its statutory responsibility for setting limits in order to combat excessive speculation and manipulation while ensuring sufficient market liquidity and efficient price discovery.
A total of 28 specific exempt and agricultural commodities are covered by the proposed regulations.  Exempt commodities broadly include, but are not limited to, gold, silver, copper, platinum, palladium, crude oil, natural gas, heating oil, and gasoline.
The position limits will apply to contracts in 28 commodities, consisting of contracts in 19 agricultural commodities, 5 metals (gold, silver, copper, platinum, palladium), and the following 4 energy commodities:
- NYMEX Light Sweet Crude Oil;
- NYMEX New York Harbor No. 2 Heating Oil;
- NYMEX New York Harbor Gasoline Blendstock; and
- NYMEX Henry Hub Natural Gas.
The proposed rule is similar in structure to the position limits rule proposed by the CFTC in January 2010 regarding only energy commodities, which was later withdrawn to accommodate the current rulemaking under the expanded authority provided by the Dodd-Frank Act.
Under the Commission’s proposed rule, position limits on physical commodity derivatives will be established in two phases. In the initial transitional phase, limits will be imposed on spot-month positions only, and the limits will be based on deliverable supply determined by and levels currently set by Designated Contract Markets. In the second phase, the spot-month position limits will be based on the Commission’s determination of deliverable supply and limits on positions outside of the spot month will also be imposed.

The Limits

The proposed rule calls for:
- Spot-month position limit levels set at 25% of deliverable supply for a given commodity, with a conditional spot-month limit of five times that amount for entities with positions exclusively in cash-settled contracts.
- Non-spot-month position limits (aggregate single-month and all-months-combined limits that would apply across classes, as well as single-month and all-months-combined position limits separately for futures and swaps) set for each referenced contract at 10 percent of open interest in that contract up to the first 25,000 contracts, and 2.5 percent thereafter.
Bona Fide Hedging Exemption
The proposed rule exempts bona fide hedging positions from counting towards the limits. Notably, the Commission scrapped the controversial “crowding out” provisions from its January 2010 proposed rule, under which an entity seeking to hold hedging positions in excess of an applicable position limit could not generally also hold speculative positions.
Who Will Be Affected?
The Commission estimates that, on an annual basis:
- Agricultural contracts–70 traders will be affected by the proposed spot month position limits, 80 by the all-months-combined and single-month position limits.
- Base metals contracts–6 traders will be affected by the proposed spot month position limits, 25 by the all-months-combined and single-month position limits.
- Precious metals contracts–8 traders will be affected by the proposed spot month position limits, 20 by the all-months-combined and single-month position limits.
- Energy contracts–40 traders will be affected by the proposed spot month position limits, 10 by the all-months-combined and single-month position limits.
Dodd-Frank Act Impact on the OTC Gold Market
The impact of the Dodd-Frank Act on commodity futures, over-the-counter retail foreign currency (“OTC forex”), and over-the-counter retail precious metals (“OTC metals”) transactions are as follows:
Elimination of OTC Forex
Effective 90 days from its inception, the Dodd-Frank Act bans most retail OTC foreign exchange (forex) transactions.  Section 742(c) of the Act states:
“…A person [which includes corporations as legal persons] shall not offer to, or enter into with, a person that is not an eligible contract participant, any agreement, contract, or transaction in foreign currency except pursuant to a rule or regulation of a Federal regulatory agency allowing the agreement, contract, or transaction under such terms and conditions as the Federal regulatory agency shall prescribe…”

This provision would not come into effect, however, if the CFTC or another eligible federal body were to issue guidelines relating to the regulation on foreign currency trading within 90 days of its enactment.  Registrants and the public were encouraged by the CFTC to provide insight into how the Act should be enforced. The primary impact of the new CFTC regulations for retail, off-exchange foreign currency trading is the impact on leverage. The maximum leverage had been 100:1.  It is now 50:1, and for exotic currency pairs, to 20:1 (down from 25:1).
On September 19, 2010, the CFTC issued Final Rules re:
Regulation of Off-Exchange Retail Foreign Exchange Transactions an Intermediaries (75 FR 55409) and
Performance of Registration Functions by National Futures Association With Respect to Retail Foreign Exchange Dealers and Associated Persons (75 FR 55310)
Elimination of OTC Metals
As for OTC precious metals such as gold or silver, Section 742(a) of the Act prohibits any person [including corporations as legal persons] from entering into, or offering to enter into, a transaction in any commodity with a person that is not an eligible contract participant or an eligible commercial entity, on a leveraged or margined basis.  This provision intends to expand the narrow, so-called “Zelener fix” in the Farm Bill previously ratified by congress in 2008. 
The Zelener fix
In 2003 the CFTC filed what came to be known as the Zelener case. The CFTC complaint alleged that over a two-year period, Michael Zelener operated a foreign currency boiler room that fraudulently solicited millions of dollars from over 200 unsuspecting customers in violation of the Commodity Exchange Act.
“Boiler rooms” are operations that use high-pressure sales tactics, usually including false or misleading information, to solicit generally unsophisticated customers.

Although the contracts that Zelener was peddling purported to require delivery of currency within two days (T+2), in reality, the contracts were repeatedly rolled over and no delivery of currency was ever made. The CFTC contended that these contracts were, therefore, futures contracts, but the trial court ruled that the CFTC lacked jurisdiction over the contracts because Zelener’s “customers were not trading in futures contracts; rather speculating in spot contracts.” The trial court’s ruling that the CFTC lacked jurisdiction over the “rolling spot” contracts at issue in the Zelener case was upheld by an appellate court in 2004.
The financial press has referred to the provisions regarding leveraged forex as the “Zelener fix,” because they empower the CFTC to pursue anti-fraud actions involving rolling spot transactions or other leveraged forex transactions without the need to prove that they are futures. Congress took this approach in lieu of declaring such transactions to be futures.
The Farm Bill and Commodity Trading
The Farm Bill is the primary agricultural and food policy tool of the Federal government. The comprehensive omnibus bill is amended and passed every 5 years or so by the United States Congress and deals with both agriculture and all related affairs under the purview of the US Department of Agriculture. It usually amends some and suspends other provisions of permanent law, reauthorizes, amends, or repeals provisions of preceding temporary agricultural acts, and puts forth new policy provisions for a limited time into the future.
Beginning in 1973, farm bills have included titles on commodity programs, international and domestic interstate trade, rural development, farm credit, conservation, agricultural research, food and nutrition programs, marketing, etc.
Farm bills can be highly controversial and can impact international trade, environmental preservation, food safety, and the well-being of rural communities. The agricultural subsidy programs mandated by the farm bills are the subject of intense debate both within the US and internationally in the World Trade Organization (WTO).
The current farm bill, known as the Food, Conservation, and Energy Act of 2008, replaces the previous farm bill which expired in September 2007.
The Farm Bill empowered the CFTC to pursue anti-fraud actions involving rolling spot transactions and/or other leveraged forex transactions without the need to prove that they are futures contracts.  The Dodd-Frank Act now expands this authority to include virtually all retail cash commodity market products that involve leverage or margin – in other words, OTC trades on precious metals.
The prohibition of Section 742(a) does not apply, however, if such a  transaction results in actual delivery within 28 days, or creates an enforceable obligation to deliver between a seller that has the ability to deliver, and a buyer that has the ability to accept delivery of the commodity in connection with their lines of business.  This may be problematic as in most spot metals trading, virtually all contracts fail to meet these requirements.  As a result, although the courts’ interpretation of Section 742(a) is unknown, Section 742(a) is likely to have a significantly negative impact on the OTC cash precious metals sector. 
Small Pool Exemption Eliminated
Pursuant to Section 403 of Doos-Frank Act, theprivate adviserexemption, namely Section 203(b)(3) of the Investment Advisers Act of 1940 (“Advisers Act”), will be eliminated within one year of the Act’s effective date (July 21, 2011).  Historically, many unregistered US fund managers had relied on this exemption to avoid registration where they:
(1)   had fewer than 15 clients in the past 12 months;
(2)  do not hold themselves out generally to the public as investment advisers;  and
(3)  do not act as investment advisers to a registered investment company or business development company.
At present, advisers can treat the unregistered funds that they advise, rather than the investors in those funds, as their clients for purposes of this exemption.  A common practice has thus evolved whereby certain advisers manage up to 14 unregistered funds without having to register under the Advisers Act.  Accordingly, the removal of this exemption represents a significant shift in the regulatory landscape, as this practice will no longer be allowed in approximately one year’s time.
Also an important consideration, the Dodd-Frank Act mandates new federal registration and regulation thresholds based on the amount of assets under management (“AUM”) controlled by a fund manager.  Although not yet underway, it is possible that various states may enact legislation designed to create a similar registration framework for managers whose AUM fall beneath the new federal levels.
Accredited Investor Qualifications
Section 413(a) of the Dodd-Frank Act alters the financial qualifications of who can be considered an accredited investor, and thus a Qualified Eeligible Participant (“QEP”).  Specifically, the revised accredited investor standard includes only the following types of individuals:
       1)       A natural person whose individual net worth, or joint net worth with spouse, is at least $1,000,000, excluding the value of such investor’s primary residence;
       2)       A natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year; or
       3)       A director, executive officer, or general partner of the issuer of the securities being offered or sold, or a director, executive officer, or general partner of a general partner of that issuer.
Based on this language, it is important to note that the revised accredited investor standard only applies to new investors and does not cover existing investors.  However, additional subscriptions from existing investors are generally treated as requiring confirmation of continuing investor eligibility.
Loco London Accounts
In the London gold market, qualified institution clients are invited to open bullion accounts in London gold trading houses. These accounts have acquired the designation of loco London accounts, which were initially used to settle transactions between clients and dealers. Later, as ultra high-net-worth individuals, financial companies, investment banks and commercial bank trading desks become more active in bullion trading, the loco London account holders also handle transactions from third parties who wish to transfer bullion in London. Today, all such third party transactions are handled by the London Bullion Clearing System (LBCS). The basic unit of loco London Good Delivery gold is the 400 troy ounce (large) bar or 12.5 kilograms, 995.0 fine.
Loco London Bullion Clearing
The principal activity of the London Bullion Clearing System (LBCS) is the daily clearing (or settlement) of precious metal transfer instructions, bullion account management and the resultant end of day position squaring and covering between the six LBCS members (Barclays, Deutsche, HSBC, JPMorgan, The Bank of Nova Scotia - ScotiaMocatta and UBS). This bullion clearing settles trades between London bullion clearing members who are all  members of the London Bullion Market Association (LBMA), as well as trades of their respective client loco London accounts.  LBMA is only loosely overseen by the Bank of England.
Most global OTC gold and silver trading are cleared through the LBCS managed by the not-for-profit London Precious Metal Clearing Limited (LPMCL), which operates a central electronic metal clearing hub called “AURUM” for trades between parties throughout the world that are settled and cleared in London.
The most widely traded market for bullion dealing globally is for delivery of metal in London. Consequently, the volume of loco London metal settlements between counterparties requires an effective and efficient daily clearing system of paper transfers, which avoids the security risks and costs inherent in the physical movement of the precious metal. LPMCL, which is operated by six market-making members of the LBMA, provides an electronic matching system to effect the daily settlements in gold and silver.
The six LBCS members listed above each provide a senior employee as a director of LPMCL to represent their interests in the clearing company. Each LBCS member uses its respective bank’s bullion operations group to control the clearing function. Such groups are closely aligned to the foreign exchange trading business, because in many ways their function is similar to the treasury management of currency nostro accounts (nostro is Latin for “our”). It is crucial for each LBCS member to position its bullion stocks in the most efficient way, so as to be correctly structured for the next day’s business, in order to meet its own and its clients’ settlement requirements, as well as to minimise its credit risk exposures.
The role of LBCS members encompasses both the daily settlements and client record keeping maintenance, which collectively results in the end of day production, by each member, of a balance sheet for each precious metal, detailing precious metal asset holdings and the liabilities in the form of customer account holdings.
Each client will derive a list of bullion settlements for the next business day, resulting from the trades that have been transacted with their own group of counterparties. These settlement instructions to receive or deliver bullion will be forwarded to their LBCS member, usually via an intranet system, telex, fax or Swift message. In many cases, each of these settlements will be the “net” of several purchases and sales with their counterparties. The bullion market has generally advocated the netting of same day value trades by counterparties, as a means to reduce the number of settlements, but more importantly, in order to reduce the amount of credit risk both while the trades are live but not yet due for settlement, as well as at the actual point of settlement.
In a trade purchase or sale of bullion, the counter-value will require a sale or purchase of currency, the US dollar being the most frequently used currency, representing at least 95% of the market for loco London trading, in normal circumstances. Other currencies are accepted for their derivative value to the dollar. Thus on the value date the currency leg of a bullion trade will be settled over a currency nostro account, in the currency of the foreign country. This arrangement allows for easy cash management because currency does not need to be converted. This practice is usually denominated in US dollars routed through a New York-based bank, while the gold or silver leg of the trade, will usually be settled in the “AURUM” hub of LBCS through one of the six LBCS members.
Netting is particularly important given that the vast majority of bullion trades are denominated in US dollars, when the metal leg is settled in London by 4:00 pm, but the party due to receive the dollar counter-value in New York will not normally know whether or not the dollars have been received in their account, until the US dollar clearing closes at the end of the New York business day (4 pm). For most European trading entities, that means they are unable to confirm receipt of US dollars until the following business day. For trading entities in Asia, there will be a time gap for both London metal clearing and New York dollar settlement.
The role of the LBCS members involves a considerable degree of direct client contact, electronic interfaces between the six members, plus close liaison with the Bank of England, together with many overseas bullion depositories.  
Physical Aspects of Gold
Each of the six members of the LBCS maintains confidential secure vaulting facilities within central London locations, using either its own premises, or those of a secure storage agent, which are used to process and store precious metals (mostly gold and silver), for both the member and those of its clients who require custodial storage, including some central banks.
Two key features of these vaulting facilities enable the depositories to process large physical transactions with a high degree of confidentiality, given the sensitivity many governments and their central banks place on gold transactions. Also, these vaults provide the potential of some modest income from client storage requirements.  
There are close ties between the vault operations and the precious metal trading and sales team on physical movements, particularly when scheduling consignment stock deliveries, but also where key government or central bank physical transactions are being undertaken, which require sensitive and confidential handling, and often involve taking ultra high security precautions.
These clearing and vaulting services help facilitate physical precious metal movement logistics, location swaps, quality swaps and liquidity management.
LPMCL, working in close conjunction with the LBMA, strives to maintain an orderly and efficient loco London bullion clearing service, to facilitate the international trading of gold on the OTC bullion market centered in London.
However, the London bullion market is quite diverse when compared to the London Metal Exchange (LME) which deals with other future exchanges in the world’s largest market. It trades other metals as well on the basis of contracts.
According to LBMA estimates, the daily net amount of gold that was transferred between loco London accounts averaged US$19.9 billion in 2009 (based on the average 2009 gold price). As mentioned earlier, the net trading value is geometrically lower than the face value of the actual number of trades.
By comparison, roughly 1.2 billion shares worth roughly $33.8 billion are exchanged daily on the floor of the NYSE on December 22, 2010.  As of November 2009, there were around 8,500 companies listed on NYSE with a market capitalization of nearly $17 trillion.
To be listed on the New York Stock Exchange, the company must have in excess of 2,200 shareholders with an average daily trading volume of at least 100,000 shares.  Generally, the company must have a total capitalization of $750 million or pretax earnings in excess of $10 million.  There are several combinations, but the bottom line is that a company needs to be either very big or very profitable to make it onto the NYSE.
The mother of all markets is the foreign exchange market which trades $4 trillion a day in 2009. It is a worldwide decentralized over-the-counter financial market for the trading of currencies and their derivatives. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.
The composition of the trades are:
$1.490 trillion is in spot transactions
$475 billion in outright forwards
$1.765 trillion in foreign exchange swaps
$43 billion currency swaps
$207 billion in options and other products
The foreign exchange market determines the relative market values of different currencies that are freely convertable.
Of the $3.98 trillion daily global foreign exchange turnover in 2009, trading in London accounted for around $1.85 trillion, or 36.7% of the total, making London by far the global center for foreign exchange. In second and third places respectively, trading in New York City accounted for 17.9%, and Tokyo accounted for 6.2%. In addition to “traditional” turnover, $2.1 trillion was traded in derivatives.
Exchange-traded FX futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.
As many gold trades are simply netted out, trading volumes among the bullion banks are much higher than they might appear. Traders estimate that actual daily turnover is a minimum of three times the estimated figure, and could be up to eight times higher. This figure would put global OTC trading volumes settled using gold stored in London vaults alone at between US$59-159 billion. Such volumes would make the gold market more liquid than the UK Gilt and German Bund market, but less liquid than JGBs and US Treasuries.
In reality, global gold trading volumes would be higher still given that considerable volumes of OTC trades are settled outside of London and as gold derivatives are traded on several exchanges around the world.
Central Banks as Gold Market Particpants
Central banks are very important market participants in the physical gold market because they are the willing sellers which make up for the global production short fall relative to demand growth. A central bank selling trend developed in the 1980s and accelerated in the 90s. Between 1989 and 1996 the US Federal Reserve Board records that around 2,000 tonnes were sold by various governments - mostly European, mostly to intervene in currency exchange rates. There was at that time also a strong distaste for gold among central bankers who considered gold’s role as a monetary asset to be obsolete.
Facing concern that the US would be the last gold seller, after other gold holders had dumped their own at better prices, the Fed commissioned and published studies by economists to establish the effects of immediate gold sales versus gold leasing policies, and delayed sales. These studies concluded that the Fed should sell its gold, though there is a suspicion that they simply found what they were asked to find. This recommendation was a confirmation of the policies of European central banks which had sold physical gold before, during and after this period.
Other ways of buying physical gold for individual consumers include jewellery and bullion coins and small bars. There is no truly viable way for most private individual retail investors to buy, store, and sell gold at competitive rates or cost. The mechanisms accessible to individuals are usually expensive, and those which are not expensive only involve gold in intangible ways. Many individuals who set out to buy bullions have been frustrated to find it is hard to find simple and cost-effective transactions.
Diverse Range of Gold Buyers and Sellers
Gold’s liquidity is underpinned by its diverse range of buyers and sellers. Unlike financial assets, the gold market is not solely dependent on investment as a source of demand. Gold has a wide range of buyers and sellers each of whom has different trading motivations and reacts differently to price movements.
Average Daily Gold Trading Volumes (US$ Billions) in 2009:
UK Gilts                                                   28.8
German Govt. Securities 25.9
US Federal Agency Securities1 77.7
Gold traded OTC and settled in London 59-159
Japanese Govt Bonds 288
US Treasuries1 407.9
Note 1: Primary dealer activity
Sources: Securities Industry and Financial Markets Association,
UK Debt
Management Office, Bundesrepublik Deutschland Finanzagentur GMB,
London Bullion Market Association, Japan Securities Dealers Association.
In the five years previous to 2009, 61% of gold demand came from the jewellery sector, 27% from investment and 12% from industrial uses. Gold has a diverse range of buyers, stretching from Indian jewellery manufacturers, to electronics manufacturers in Asia, from worldwide dentistry and medicine, to retail investment demand.
Demand for gold has risen among institutional investors, including pension funds, endowments and central banks. Central banks became net buyers of gold starting in the second quarter of 2009, ending two decades of annual net sales of substantial quantities of gold to the private sector.
The motivations for investment demand in gold are disparate. Some investors buy gold as a long-term strategic asset, others are seeking hedges against inflation or currency debasement. Some buy gold as a safe-haven from market volatility, others because of their tactical view on the gold market.
The sources of supply are equally disparate, being a combination of newly-mined gold, the net mobilisation of central bank reserves and the recycling of above ground stocks.
In the five years previous to 2009, 59% of gold supply came from newly-mined production (net of producer de-hedging). A further 10% came from net official sector sales with 31% from the recycling of fabricated products - principally jewellery from emerging markets.
The long time lags in mine production adjustments mean changes in the gold price will only influence supply after a number of years. Other factors influencing supply include the extent and success of past exploration spending, the actual cost of extracting gold, and various geological factors.
The gold price, price volatility and general economic conditions in the mining host country are factors that most affect recycled gold supply levels. Central banks’ reserve decisions have most impact on net official transactions.
Flight-to-Quality Tendencies
Gold has a history of being a fungible safe-haven asset that attracts inflows of funds during times of financial market duress and war. This market tendency stems from a perception of gold as an asset of free intrinsic value, independent of any credit risk. Gold holding commands a value independent of socio-political conditions. Gold’s value cannot be debased by government measures to respond to economic problems, e.g., central bank quantitative easing in recessions, which can lead to inflation and erode the value of fiat currencies.
Jean Bodin (1530-96), a French social/political philosopher, attributed the price inflation then raging in Western Europe to the abundance of monetary metals imported from the newly opened gold and silver mines in the Spanish colonies in South America. Though he held many aspects of mercantilist views, Bodin asserted that the rise of prices was a function not merely of the debasement of the coinage, but also of the amount of currency in circulation.
John Law (1671-1729), a contemporary of Bodin, elaborated in 1705 on the distinction drawn by Bernardo Davanzati (1529-1606) between “value in exchange” and “value in use”, which led Law to introduce his famous “water-diamond” paradox: that water, which has great use-value, has no exchange-value, while diamonds, which have great exchange-value, have no use-value. Contrary to Adam Smith, who used the same example but explained it on the basis of water and diamonds having different labor costs of production, Law regarded the relative scarcity of goods in demand as the generator of exchange value.

Davanzati showed how “barter is a necessary complement of division of labor amongst men and amongst nations”; and how there is easily a “want of coincidence in barter”, which calls for a “medium of exchange”; and this medium must be capable of “subdivision” and be a “store of value”. He remarked “that one single egg was more worth to Count Ugolino in his tower [prison] than all the gold of the world”, but that on the other hand, “ten thousand grains of corn are only worth one of gold in the market”, and that “water, however necessary for life, is worth nothing, because superabundant.” That was of course before International Monetary Fund (IMF) conditionality requiring the poor in the indebted Third World to pay for water through privatization of basic utilities to service foreign debt.
Davanzati observed that in the siege of Casilino, “a rat was sold for 200 florins, and the price could not be called exaggerated, because next day the man who sold it was starved and the man who bought it was still alive.” Of course, modern economists would call that a market failure. Davanzati viewed all the money in a country as worth all the goods, because the one exchanges for the other and nobody wants money for its own sake. Davanzati did not know anything about the velocity of money, and only recognized that every country needs a different quantity of money, as different human frames need different quantities of blood. The mint ought to coin money gratuitously for everybody; and the fear that, if the coins are too good, they should be exported is simply illusory, because they must have been paid for by the exporter. (Please see my November 2002 article: Critique of Central Banking - Part I: Monetary theology)
The 2007-2010 banking crisis is a good case in point. Between June 2007, when the credit crisis first began, and June 2009, when the global financial system if not world economy was showing signs of stability, gold price increased by 43% in dollar terms. This compares with increases of between 3% and 9% (local currency terms) in the major sovereign bonds held by central banks.
The 2007-2010 financial crisis did have some impact on gold price. Some investors sold gold to raise vital cash, as liquidity constraints in other markets became acute.
Between the end of Q2 2008 and November 12 that year, the gold price fell from US$925.40/oz to US$712.30/oz. This was the most severe phase of the financial crisis, covering the period when Lehman Brothers collapsed and liquidity constraints in the wholesale market for dollars and the FX swap market were most pronounced.
Three-month LIBOR rates soared as high as 366 basis points above the Overnight Swap Index. Fund managers facing large redemptions and/or margin calls turned to gold as an “asset of last resort” to stay solvent. The Swedish Riksbank also relied on its gold reserves for liquidity at the height of the crisis, using gold to finance temporary liquidity assistance.
Investors tend to buy as a knee-jerk reflex to hedge against inflation. Gold futures have jumped 26% in 2010 as a response to central bank quantitative easing.  Gold for February 2011 delivery on the Comex in New York was 0.2 percent higher at $1,382.70 an ounce by 11:31 a.m. in London on December 27, 2010.
Bullion reached a record $1,432.50 an ounce on December 7, 2010 and was heading for a 10th consecutive annual gain, the longest winning streak in at least nine decades.
The dollar dropped for a third session against a basket of six major counterparts after China raised the benchmark one-year lending rate 25 bases points to 5.81%, and the one year deposit by 25 basis points to 2.75%. to cmpat inflation. It was the second rate increase in a month.
Gold assets held in exchange-traded products fell 3.12 metric tons to 2,101.3 tons on December 23, 2010, according to data compiled by Bloomberg from 10 providers. Holdings reached a record 2,114.6 tons on December 20.
Silver for March 2011 delivery fell 0.3% to $29.25 an ounce. The metal has climbed 74% in 2010.
Platinum for April 2011 delivery rose 0.7$% to $1,739.80 an ounce and palladium for March 2011 delivery gained 0.6% to $762.70 an ounce. Both metals are used to make jewelry and catalytic converters for automobiles.
There does not seem to be any direct correlation with the stock market and the gold makket. The DJIA hit a high of 14,164.53 on October 9, 2007, with gold price at $747 per troy ounce. The DJIA fell to a low of 6,547.05 on March 9, 2009, with gold at $920 per troy ounce.  The DJIA hit 11,980.52 on January  24, 2011, with spot gold at $1,332.75 per troy ounce.
While the DJIA fell 7,617.48 points between October 9, 2007 and March 9, 2009, gold price rose $153 per troy ounce.
When the DJIA rose 5,433.47 points between March 9, 2009 and January 24, 2011, gold price rose $412.75 per troy ounce.
Trading and Vaulting Gold
Most central banks either purchase gold directly from bullion banks, or buy domestic mine production, or locally recycled gold. Banks buying gold bars will typically purchase in the global OTC market, the majority of which is settled via London Good Delivery Bars stored in London (“loco London”). 
London Good Delivery Bars form the basis of this market. Available from bullion banks, these bars must be at least 995 parts gold out of 1000 and weigh between 350 and 430 fine ounces. The bars must also meet other stringent conditions set by the London Bullion Market Association (LBMA).
The OTC market trades continuously on a 24-hour basis with spot gold settled two business days after the date of trade (T+2). Twice daily during London trading hours, a fix provides reference gold prices for that day’s trading. Either the morning (a.m.) or afternoon (p.m.) London daily fix forms the pricing basis for many long-term contracts. Market participants will usually refer to one or other of these prices when seeking a basis for valuation.
Central banks that buy their own local mine production will typically have the gold refined up to internationally acceptable standards (London Good Delivery) - if it is not already in that state - and will often ship the gold overseas for safe storage.
Vaulting gold overseas with another central bank or bullion bank is common practice, and can be done on an “allocated” or “unallocated” basis. In an allocated account, the gold is physically segregated from all other gold stored in the vault, the client has full title to the gold in the account and the client’s holdings are identified by bar number, size, fineness and weight. In an unallocated account the client has a general entitlement to a portion of a pool of gold, which allows the bullion bank to lease out the gold for a small yield. The Federal Reserve Bank of New York and the Bank of England are the two largest custodians of gold stored on behalf of other central banks.
The gold market is mostly self-regulated. In the post-crisis era of bailouts and government takeovers, there seems to be little interest in imposing government regulation on the gold market even on predatory and unfair practices by many “cash for gold” firms in the same way “payday loan” services with outlandish interest rates are regulated. The likelihood of government intervention in the gold market solidly overwhemes the prospect of government regulation. The gold bull market will end as soon as the Fed stops it quatitaive easing orgy and raises dollar interest rate.
The World Gold Council (WGC) works to create freedom for all individuals to own gold, unhindered by punitive tax treatments or regulatory barriers or fiscal disincentives. WGC was instrumental in helping to establish comparatively free regimes for the import, export and trading of gold and general gold market liberalization in Turkey, India, China, Korea and Vietnam.  In China, the Shanghai Gold Exchange announced that the turnover in gold trading was up 58.7% at 3,741.5 tonnes in the first six months of 2010, at the same time that spot trading volume reached 834.6 tonnes.
The debate over new global banking regulation in the wake of the 2007-2009 financial crisis has revived interest in a new form of gold standard. The role of gold in the new banking regime governing capital adequacy ratios for commercial banks is coming under consideration within the G20 and beyond. The WGC submitted evidence to the Basel Committee on Banking Supervision to demonstrate that gold deserves to be numbered among the high quality liquid assets the committee is recommending commercial banks should hold.
Writing in the Op-Ed page of the Financial Times on November 8, 2010, Robert Zoellick, World Bank president since 2007, said a successor is needed to so-called the “Bretton Woods II” system of floating currencies that has held since the Bretton Woods fixed exchange rate regime broke down in 1971 when Pressident Nixon decoupled the dollar from gold. Zoellick called for a new international system of commerce, one which “should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.  However, the call did not receive much support.
January 14, 2011
Next: Gold and Fiat Currencies