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Basel III will be Highly Bullish for Physical Gold

Highly Bullish for Physical Gold
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EDITOR NOTE: What if gold were to be treated not as a commodity or collectible but as a real currency? What if gold were to be held at banks across the globe as a “risk-free” asset? What might happen if all paper derivatives used to suppress the price of gold were to be abolished, allowing the natural ebb and flow of supply and demand to take its natural course? What if gold were to be valued at 100% its weight and quality as the “ultimate form of money”? Would this not be the ideal scenario for all gold investors and potentially highly bullish for physical gold? It’s happening on January 1, 2023. It’s called Basel III. And its impact will bring forth a massive revaluation of the yellow metal across the globe.

Basel III is a set of international regulations concerning bank capital adequacy, stress testing, and overall market liquidity. Many of these regulations have been introduced straight after the 2008-2009 financial crisis. But there are several aspects of these agreements that will only come into effect on June 28, 2021 for European banks and on January 1, 2022 for the UK. To sum up, gold will become a risk-free Tier 1 asset and it will become more expensive to buy and sell unallocated gold. These factors are highly bullish for physical gold. So, investors in this precious metal will be generously rewarded, provided they buy physical gold. But let me explain this in a bit more detail.

Gold as a risk-free asset

Under Basel III, gold would become a Tier 1 asset or a zero-risk asset, for banks. As mentioned in the Basel III framework,

...at national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion liabilities can be treated as cash and therefore risk-weighted at 0%. In addition, cash items in the process of collection can be risk-weighted at 20%.

Source: Basel Framework, page 192

But the interesting point is that gold must be physical and held in the institution's own vaults. It should not be in paper form or owned and leased by someone else. Most gold investments are leased or borrowed or held in paper form. So, it looks like major changes are about to come.

Since gold will have such a risk-free status, many banks will be encouraged to buy more for bookkeeping purposes. This will also highly encourage every central bank to raise its physical reserves of this shiny yellow metal.

The decision to make gold a zero-risk asset was not made yesterday, of course. In 2017 it was announced gold would become a Tier 1 asset under Basel III. The year was marked by central banks' massive buying of gold. 651.5 tons of the shiny metal was bought, a record amount over the last 50 years. This fact serves as evidence that these new regulations will be bullish for physical gold, in my opinion.

What is more, under Basel III, gold is not even treated as a commodity but rather as a currency. This basically means the yellow shiny metal is far less of a risk and less volatile than most commodities since, according to Basel III, currencies tend to be more stable.

As mentioned in the Framework,

This section sets out the standardized approach for measuring the risk of holding or taking positions in commodities, including precious metals, but excluding gold (which is treated as a foreign currency according to the methodology set out in MAR20.52 to MAR20.61 above).

Source: Basel Framework, page 661

Basel III: The Net Stable Funding Ratio

Briefly, the new NSFR requirement will make the handling of unallocated gold more complicated but there is a solution to it. In plain terms, the Net Stable Funding Ratio will be used to oblige banks to finance long-term assets with long-term money (i.e., greater than one year) to avoid liquidity failures.

Specifically, for all precious metals, the NSFR requirement will imply an 85% Required Stable Funding (RSF) to be held by banks against the financing and clearing of precious metals transactions. This is a highly significant rise compared to its pre-Basel III level of 0%.

As mentioned in the framework,

Assets assigned an 85% RSF factor comprise:

... physical traded commodities, including gold.

Source: Basel III: The Net Stable Funding Ratio

In plain terms, it suggests that regulators are now considering gold to be an illiquid asset, that is even riskier to hold than exchange-traded equities (which have an RSF of 50%) and as risky as all other equities (RSF of 85%).

All that sounds quite unpleasant for the banks and their bullion business. But does it mean there will be no way to hold physical gold bars or any other form of gold without fulfilling this requirement? No, I would say just the opposite is true.

Specifically, clearing members could solve this RSF problem by allocating their precious metals. What exactly does it mean? Allocating simply means converting the clients' accounts from unallocated to allocated gold. Let me explain this with a simple example. Let us assume that a clearing bank has 40 customers holding the pool of the $50 billion unallocated gold. The bank can allocate gold bars from its balance sheet to each of its 40 clients. By converting the clients' accounts from unallocated to allocated, the clearing bank can avoid the negative impact from NSFR on its gold business as it will end up no longer holding gold on its balance sheet. This will be great for the clearing banks. However, the requirement to hold gold on an allocated basis will still be more expensive than holding it on an unallocated basis. So, the costs will still rise.

But what is the exact difference between allocated and unallocated precious metals? There is quite a big difference. In my other article, I wrote about SPDR Gold Shares Exchange-Traded Fund (GLD) and the differences between paper gold and physical gold. In short, allocated gold is physical gold, whereas unallocated gold is paper gold.

Allocated gold suggests you are the direct owner of the yellow metal and you have no counterparty risk. Unallocated gold, however, remains the property of the bank - the investor is a creditor of the bank but is not the direct owner of the bullions.

As my colleague Sprott Money explained in his excellent analysis, unallocated gold can be borrowed, loaned out, more than once. This means there might be many claims on the very same amount of gold. This cannot happen to allocated gold by definition. In other words, the banks will be punished for holding unallocated gold and rewarded for holding the actual unleveraged physical metal. In simple words, this makes it expensive for banks to engage in any forms of hypothecation or gold lending. That is also important because gold lending is one of the main tools used to short gold. That is why reducing this activity makes it more complicated to short the shiny metal and is therefore bullish.

Conclusion

The Basel III agreement will have a major impact on the European banks and also on the UK banks. The Net Stable Funding Ratio requirement will make it difficult for banks and other institutions to keep unallocated gold. So, one of the likely solutions will be to allocate gold. The very fact gold will become a risk-free asset is highly bullish. It will make central banks and other investors raise their gold reserves. All this is highly advantageous for investors holding physical gold.

Originally posted on Seeking Alpha

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All articles are provided as a third party analysis and do not necessarily reflect the explicit views of GSI Exchange and should not be construed as financial advice.

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