Perspectives 2020-2021 Public Sector

Citi Perspectives for the Public Sector 48 49 The importance of storing gold in a liquid market location has faded in recent years as several central banks have decided to rebalance the geographical distribution of their holdings and repatriate large quantities of gold to reduce concentration and exposure to geopolitical risks. Additionally, to improve transparency many central banks now publish detailed information on the origin, quantities and location of their reserves. Why quality and specification matter The rebalancing and new transparency measures described above have, in some cases, been combined with upgrade programs to convert old gold bars or coins to the London Good Delivery (LGD) standard. The size and purity of bars is important as it can impact liquidity and valuation; old bars need refining and/or recasting in order to be sold or swapped and therefore trade at a discount to the benchmark. The price of Gold futures at the end of the first quarter for June delivery traded on the CME in New York climbed to a peak premium of $67.57 an ounce over spot prices in London highlighting the importance of location and quality of gold holdings on liquidity and pricing, especially during disruptive events such as COVID-19. London and New York are both very liquid markets but differ in terms of location, quality and timing of metal deliveries. The Loco London price represents the value of standard 400 ounce bars for immediate delivery in a vault in London; the price of a futures contract on CME refers to the delivery of Comex- compliant 100 ounce bars at a future time stated in the contract and in one of the CME depository vaults in New York. While trading unallocated gold is more convenient from an operational point of view, when holding gold with a long-term investment horizon and in order to minimize their credit risk, central banks typically hold their balances in an allocated account. Storage: The impact on safety and liquidity Certain vaults or countries are considered safer than others and their distance to the main trading centers can affect the ability to bring the bars to a liquid market. Once the gold is in a liquid location, an active market for location swaps enables investors to swap between locations, for example between London, Zurich and New York. In London, the Bank of England (BoE) vault is a preferred location for reserves managers, as it combines access to the liquidity of the London market with the security guaranteed by the allocated nature of the accounts. Gold held in the BoE vaults can be quickly traded or swapped without incurring credit exposures typically associated with the wider unallocated market. This is possible because many commercial and bullion banks also have allocated accounts at the BoE so bars can be transferred across accounts simply by book entry, without the need to be physically moved. 11 11 LBMA Alchemist 95, The Bank’s Golden Evolution 12 Gold Market Snarled by Virus Lockdown as World Races for Haven https://www.bloomberg.com/news/articles/2020-03-24/scramble-for-gold-sends-new-york-premium-to-a-four-decade-high - Thoughts from a market professional: A modern Fairy-Tale: Gold, the Comex and the new Fools (of) Gold https://www.linkedin. com/pulse/thoughts-from-market-professional-modern-fairy-tale-gold-ross-norman The importance of storing gold in a liquid market location has faded in recent years as several central banks have decided to rebalance the geographical distribution of their holdings and repatriate large quantities of gold to reduce concentration and exposure to geopolitical risks. Gold traders access exchange liquidity to manage their risks in the OTC spot and forward markets, but rarely consider the different physical specifications of these instruments. Under normal market conditions this is inconsequential. The price differential between the two, expressed by the EFP (Exchange For Physical), is relatively stable and reflects the costs of sourcing the CME bars, insuring, transporting, financing and storing them in New York; the futures contract is usually slightly more expensive than the spot price. However, when the normal market dynamic was disrupted by COVID-19 – gold refiners closed their factories and airlines suspended flights to New York – the inability to source 100 ounce bars and move them to a CME vault caused an imbalance; the price differential widened to a multiple of its previous value. Markets started to re- converge only when the refineries reopened, transportation channels were re-established and the CME extended the range of bars accepted for delivery on the exchange to include popular formats such as 1kg bars. 12 Accounting for gold Another important aspect in the valuation of gold in a portfolio is the way it is accounted for. Historically, CBs accounted for gold based on acquisition cost. In recent years, most central banks have updated their accounting policies to dynamically track gold’s market value in order to express its portfolio diversification and inflation hedging properties. Those few CBs that still account at static prices should consider the benefit of alternative approaches. Revaluations resulting from accounting changes can have profound effects. In December 1999, the IMF entered into separate but closely linked transactions with member countries that had financial obligations falling due to the IMF. In the first step, the IMF sold gold to a member state at the prevailing market price, and the profits from the sale were placed in a special account and then invested for the benefit of the Heavily Case Study: Gold Upgrade Solutions Under a typical gold upgrade transaction, a central bank would deliver old bars (non-LGD) to a refiner which would refine and recast the metal into new LGD bars in exchange for a refining fee. Under such a structure, the central bank does not earn any yield when the gold is being refined, and is subject to the operational risks and limited processing speed of the refinery, which could lead to significant processing time for large orders. In order to mitigate these aspects Citi can offer a location and quality swap, where the central bank delivers gold to Citi, which simultaneously provides LGD bars (in London, for example), on the same value date and without requiring the payment of any refining fees. In order to cover the costs of the upgrade, the central bank would agree to place the metal in deposit with Citi for a pre-agreed duration and at a rate that would embed that cost as well as a positive yield. Such a solution would remove any exposure to the refinery, would reduce processing times and generate a saving on storage costs for the duration of the deposit as well as generating instantaneous yield. Citi can also facilitate upgrade programs designed to bring the quality of bars into line with LGD requirements via quality swaps. 13 IMF: News Brief: Financing the HIPC and ESAF Initiatives September 27, 1999, https://www.imf.org/en/News/ Articles/2015/09/29/18/03/nb9962 Leveraging the New Gold Rush: How to Extract Greater Value from Gold