"The commercial world is very frequently put into confusion by the bankruptcy of merchants that assumed the splendour of wealth, only to obtain the privilege of trading with the stock of other men, and of contracting debts which nothing but lucky casualties could enable them to pay; till after having supported their appearance a while by tumultuary magnificence of boundless traffic, they sink at once, and drag down into poverty those whom their equipages had induced to trust them."
Samuel Johnson, Rambler #189, January 7, 1752
This is not a technically precise description of rehypothecation, but the terminology has been simplified a bit for the sake of understanding by the lay person. But the risks described herein are real, and need to be understood.
I thought of this when I read a question that a reader had about how fractional reserve bullion banking works. Like so many other things financial, it can seem almost foolproof on paper. Somewhat like the efficient markets hypothesis, or the trickle down, supply side, recovery boogie woogie.
But one might ask, how is it that occasionally things in bullion banking seem to go awry, so that even the great monetary power and experience of the Governor of the Bank of England might find himself 'staring into the abyss.'
Where are the risks in this, and in any other type of fractional assets arrangement?
And that brings us to our word for the day:
Rehypothecation: The practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may be compensated either through a lower cost of borrowing or a rebate on fees.An example of rehypothecation might be used in any fractional asset system. One example might be a bullion bank, or mint, that offers the sale and storage of unallocated gold and silver. You may buy the bullion from them, but you agree to leave it there in an unallocated pool of assets.
The advantage for the customer is that they are given a significant break on storage fees for not demanding the delivery of specific bullion.
It does not even have to be a bank or mint, but a larger dealer in metal. Any entity that offers unallocated bullion storage can use that unallocated bullion to smooth the delivery process to retail and wholesale customers that prefer to take delivery of their bullion. For the sake of clarity I will refer to the bank, mint or dealer offering unallocated storage as Dealer.
As in the case of the more familiar commercial banking, the 'deposit' of the customer, with cash left 'on deposit,' makes them a creditor of the bank. The return which the customer receives for this loan of their asset is interest, or some other value such as a reduction in fees. In the old days they used to even kick in toasters and TVs, but those were other times when deposits seems to matter more.
In the case of metals, typically the unallocated bullion is rehypothecated by the dealer to some degree. It is often used as a classic 'float' in support of their own operations.
It is a way for the dealer to obtain short term bullion to supply their day to day transactions with people to whom they take and deliver bullion in various forms, such as delivering title of a certain amount of refined gold in return for the delivery of intermediate stage material, in the form of doré bars from a mine for example. And generally the dealer would receive some fees in return for this service to the miner.
The reason that the dealer might not charge the unallocated owner a storage fee is because the customer has agreed, even if in the fine print, to allow that entity to use their bullion as collateral in unspecified third party transactions.
The customer has deposited their asset to the dealer, in return for some form of reimbursement. And in turn the dealer may rehypothecate, or use, that asset for their own purposes.
The same asset can be rehypothecated many times, so that a single ounce of gold and silver, or any piece of property, may be encumbered by a chain of ownership claims, some of them downstream from the original dealer. Practices may vary, but rehypothecation has become commonplace in our modern financial system. Leverage pays off well when it works.
This is all very well and good, as long as the different parties in the chain do not overdo the leverage, or number of claims, applied towards that particular asset. And of course if there are no untoward counterparty risks or failures in the chain, or disruptions in expected supplies either in terms of availability or price. If that happens we can see a domino like effect.
So when you are given a nice textbook example of how fractional ownership of anything works, keep in mind that there is never a free lunch. If you are receiving some sort of benefit for keeping your assets at a particular place, chances are quite decent that they are being utilized for the advantage of someone else.
And if there is a disruption somewhere in the markets, and the chain of rehypothecation is broken, difficulties may most certainly arise. Often a dealer will be in a position to offer some sort of guarantee, as in the case of FDIC insurance for monetary bank deposits. Results may vary.
Although I have not discussed it, it is also possible that an asset held specifically without any prior agreement for reuse, such as the case of allocated bullion being held through a broker, might be subject to cross claims of ownership, as in the sad case of MF Global. In that case the customers had to lawyer up against other counterparties and wait for some sort of settlement. This does not happen very often, but it can and does as we have seen.
Sometimes the leverage in a vehicle is not always easily seen. Is GLD fractional? Does all their gold hold clear title to some specified percentage of an investment unit? I don't know. How much 'leverage' is there in a particular bullion bank at any given time? We have seen them occasionally seen them get 'over their skis' as in the case of Scotia Mocatta some time ago, but it is hard to tell because audited results are not frequently available. We know they are running floats, unless they are otherworldly saints, or just fools. The question is, how much?
I wonder under what auspices central banks lend out the gold of their people to bullion banks? Do they realize that their gold is being rehypothecated, often by third parties? Have they ever agreed to it? Do the central banks even have to disclose such arrangements? What oversight is there from the civil authorities?
And what happens if the central bank asks for the return of their bullion, and it was not there? One can only wonder. Perhaps Germany offers a contemporary example of how to manage such a situation.
Speaking of the movement of bullion, there was a whopping warrant issued by JPM on 109,856 ounces of gold bullion in its storage yesterday, adjusting it over to the registered (deliverable) category. And there was a lesser amount of 11,056 adjusted over to registered at Scotia Mocatta.
So now the total deliverable category is back up to 616,519 ounces, which is a good thing, since one might have wondered how they were going to fulfill those contracts that have already stood for delivery. I expect that they will be posting the drawdowns in the foreseeable future.
Also at Scotia there was a withdrawal of 40,395 ounces of gold from the warehouse altogether. All the transactions and totals are included in the report below.
As a reminder, tomorrow is a Non-Farm Payrolls day, and shenanigans are often in fashion.
Have a pleasant evening.