Perspectives 2020-2021 Public Sector

Citi Perspectives for the Public Sector 50 51 Yield Enhancement includes strategies that introduce an element of credit or market risk to gold in order to generate return: swaps, deposits and bonds fall into this category (Citi can offer a comprehensive range of such solutions). Under a swap transaction, gold is converted into a currency of choice with the agreement to reconvert it back at a future date; the proceeds of the initial sale are invested in money markets instruments to generate a return. When the swap matures, both the currency and the gold are returned: the net yield of the transaction is the differential between the return generated by the currency investment less the cost of swapping the gold. This cost is known as contango if it is positive, as is normally the case for USD denominated swaps, or backwardation if negative, for example for EUR, CHF and JPY. A currency can also be swapped into gold to generate a return on the currency itself. In this case, gold is acquired without the intention of holding it in the long term and is held only Indebted Poor Country Initiative (HIPC) and Enhanced Structural Adjustment Facility (ESAF). In the second step, which followed immediately, the IMF accepted, at the same market price, the same amount of gold from the member state in settlement of that member's financial obligations falling due to the IMF. The net effect of these transactions left the IMF's holdings of physical gold unchanged. No gold was released to the market, and thus there was no impact on the supply and demand balance. However, the IMF's gold holdings accepted in settlement of members' obligations (the second step above) was recorded at a higher value in the IMF's balance sheet. 13 Generating returns from gold Just like currencies or other assets, gold holdings can be deployed for yield enhancement to generate interest income or for monetization strategies to raise financing. Case Study: Citi Gold Notes Citi successfully structured a Gold Settled Note issued for a central bank seeking to generate yield from its gold reserves held at the BoE. The transaction used Gold (XAU) as investment currency, enabling Citi to pay positive interest on the investment. Under the transaction, Citigroup issued a Note to the central bank with a maturity of three years and a coupon of 0.20% per annum. In exchange, the central bank delivered a specified number of ounces of gold to Citi as the investment currency. The note also offered an option for the central bank to redeem it, either in gold or USD at maturity. By investing in the gold note, the central bank generated yield on a quantity of gold that ordinarily would incur custody fees (negative yield), while keeping its economic and balance sheet exposure to the price of gold. This transaction highlighted the importance of gold as a reserve currency for central banks. The Citi Gold Note is appealing for investors seeking fresh exposure to the price of gold, while earning a positive yield and carrying the credit risk of the issuer (Citigroup). In this case, the initial investment was in USD (rather than XAU) in exchange for a USD-denominated bond that replicates exposure to the gold price, pays a coupon and gives the right to delivery of gold ounces at maturity. This is potentially an alternative to other gold-tracking products, such as ETFs or certificates that incur custody/management fees while not paying a coupon (all subject to the investor accepting the liquidity and credit risk of the Citi Note). The Note also provides access to an accumulation of physical gold for future delivery to reserve managers that do not have an existing custody account. for the duration of the swap (usually in an allocated account). The reserve manager buys the metal at inception, stores it and agrees to sell it back at maturity at a higher price that corresponds to the initial price plus contango. The net return on the transaction is contango minus the storage cost charged by the custodian. Such a trade has the added benefit that the investor holds physical gold for the duration of the trade as a form of collateral. Combining potentially higher returns and a mitigated credit risk profile, these swaps can be an attractive alternative to traditional money market currency deposits. All swap transactions generate a credit risk exposure between central bank and bullion bank and would typically need to be documented under ISDA, sometimes limiting volumes and access to these products. As an alternative to swaps, gold balances can also be leased via deposits placed with commercial banks following the same construct for other currency deposits. In this case, the central bank receives interest at maturity (paid either in USD or in gold) in exchange for taking the credit risk of the counterparty, as well as eliminating custody fees for the duration of the deposit. For added flexibility, Citi can also offer Gold Settled Notes (see case study), combining issuers and tenors of choice to generate coupons on the gold invested. Gold monetization (see case study) refers to strategies that generate currency liquidity by leveraging holdings of metal, typically in the form of sale and repurchase transactions. CBs can raise financing using their gold holdings in an economically efficient way and without the need to sell it outright, which would result in the loss of the asset. Mobilizing bullion reserves requires careful consideration: Citi’s proven solutions enable central banks to raise financing in a cost effective and prudent way. Increasing and rebalancing gold reserves The share of gold in the reserves of emerging market countries is much lower than advanced economies, 14 and therefore there is potential for it to grow. While gold-producing countries have access to local production and can buy metal locally, other CBs need to purchase gold in the international market. Citi can assist by providing liquidity in spot and forwards as well as custom-made hedging solutions. Changes in the price of gold have the effect of increasing or decreasing the share of bullion in the total value of reserves, potentially deviating from the desired allocation. Central banks can rebalance their holdings by operating sales and purchases in the market or by employing ad-hoc solutions like Dual Currency Notes. Case Study: Gold Monetization The CB enters into a Gold Sale and Purchase Agreement (GSPA) with Citi, with Citi purchasing LGD bars on a spot basis at the Bank of England, for example. The purchase price paid by Citi is subject to a haircut and the transaction includes a margining or hedging mechanism that guarantees protection if the value of the bars falls below the agreed price. The CB also enters into a forward transaction to buy back the same quantity and quality of gold at maturity at, or below, the market price (thanks to an embedded hedging mechanism). In addition, the CB agrees to make periodic coupon payments to Citi that are typically lower than those of government bonds with similar maturities. The duration of these trades can range from one to five years. One of the key features of this solution is the embedded hedging mechanism that compensates the investor if the price of gold declines, effectively combining both financing and hedging in a single transaction. 14 WGC: A Central Banker’s Guide to Gold as a Reserve Asset Leveraging the New Gold Rush: How to Extract Greater Value from Gold