Prophets

Gold Trading Systems Experience Growing Pains

How competition pushed the benchmark below the spot price last week.

Name your price.

Photographer: Jason Alden/Bloomberg

On the afternoon of April 11, London’s daily gold price benchmark fix took a peculiar turn: It was about $12 under the spot price. The auction appeared to be stuck on a descending escalator from an initial $1,265.75, before fixing at $1,252.90. 

Such a discrepancy affects many participants in the global gold markets -- hedgers and speculators, along with miners, refiners and jewelers, as well as banks and portfolio managers. But there was no mention of fat fingers. The initial reports attempting to explain this anomaly pointed to a new algorithm that U.S.-based Intercontinental Exchange, known as ICE, began using to determine prices, as a replacement for the standard auction chair setting the price.  

The historic London Gold Fix was a telephone-based benchmark price auction, which began in 1919, when each representative raised a tiny British flag after receiving any price change from their dealing room. As long as a flag was up, the chairman could not declare the price as fixed. In 2015, this system was replaced by an electronic alternative, the London Bullion Market Association Gold Price, due to regulatory pressure and U.S. lawsuits alleging rigging by the banks that set bullion prices.

But it’s now evident that the discrepancy was all about a rush to gain market share in the fiercely competitive global marketplace for gold trading. Only one day before, ICE, an operator of global exchanges and clearing houses and provider of data and listings services, in its urgency to obtain a bigger slice of the global gold market pie, introduced Central Clearing for the LBMA’s Gold Price Auction. The LBMA owns the intellectual property rights to the auction.

As early as October of 2016, ICE announced the introduction of Central Clearing for gold as a way to demonstrate the importance of the LBMA Gold Price as the world’s most important and trusted gold benchmark. Clearing was scheduled to go live in March 2017.

Global banks and financial institutions showed interest in participating in the LBMA gold price, as the number of participants grew from four to 14 since clearing was started last year. Central Clearing was to be enabled by a new physically settled, Loco London gold daily futures contract that would trade on ICE Futures U.S., designed to complement the existing London market, based on the LBMA Good Delivery Rules.

On April 11, it turned out that several participating banks lacked the necessary systems required for the fix, and were unable to contribute their prices. In fact, of the 14 officially accredited participants, nine weren’t present and only five were, according the website of the auction’s administrator.

ICE had already delayed the start of its clearing service by several weeks to allow the participants in the auction to adapt their IT systems, but apparently this switch is far from turn-key; it requires investment in IT processes and back-office systems and raises complex compliance issues that all require more time to bring into being.

As of April 16, companies  such as China Construction Bank, Société Générale, Standard Chartered and UBS hadn't yet confirmed a date for their participation in the cleared auction. (INTL FCStone announced April 18 that it would participate in the LBMA.) Banks that aren’t ready will be suspended from the auction until they have the necessary IT infrastructure in place or will have to participate through other players who can clear deals. 

Clearing has become increasingly more important in the trading of financial instruments because it positions the exchange as an intermediary to guarantee and settle trades. That means it’s regarded as a necessary progression for gold trading in light of tighter regulatory capital requirements. And ICE was racing to get Clearing started before rivals elbowed in on the London’s $5 trillion-a-year bullion market.

There are more than 40 gold markets around the world, and three of them -- ICE, the London Metal Exchange and CME Group -- compete to offer services through futures contracts. In fact Clearing’s debut comes just as the LME is preparing to introduce its own rival precious metals contracts in June. The LME, owned by Hong Kong Exchanges and Clearing Ltd, has moved aggressively toward reaching a 50:50 revenue-sharing deal with a company founded by a consortium of banks.

In the race for liquidity, the entity that gets it first typically tends to build upon it, albeit, U.S.-based CME started a cleared gold contract in January and thus far, has struggled to attract liquidity, as it is largely U.S.-centric.

Is there really a need for all this competition? If it addresses a marketplace whose needs aren’t being met, then the answer is yes. ICE says Clearing will open the price benchmarking process to new participants by removing the requisite bilateral credit lines placed with other direct auction participants. And it’s also a way of bringing more business to the exchange and could be key for the success its gold contract.

Once the wrinkles are ironed out, increased competition should make gold trading more efficient, allow greater trade volume, thus providing additional liquidity. Even as recent gold trading activity and prices have picked up, the outcomes from competition should still benefit a commodity that can periodically go to sleep.

Bloomberg Prophets Professionals offering actionable insights on markets, the economy and monetary policy. Contributors may have a stake in the areas they write about.

    To contact the author of this story:
    Shelley Goldberg at shelleyrg3@gmail.com

    To contact the editor responsible for this story:
    Max Berley at mberley@bloomberg.net

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