Conventional wisdom tells us that owning gold does not accrue interest. If you are simply a retail gold owner, this much is true. However, what if gold could bear interest? That’s the question that was asked when the practice of “gold leasing” was invented. Gold leasing is something that only a handful of investors know about. Well, now the secret’s out. Here’s what you need to know to better understand this practice.
Gold Leasing 101
Investopedia defines a lease as, “a contract outlining the terms under which one party agrees to rent property owned by another party.” This contract can apply to cars, homes, and even gold. In the gold market, companies partake in this practice when it’s beneficial to both sides. One side has gold they want to put to work to make more money and the other side will have gold in the future but needs cash now.
Think of a gold lease in a way similar to “corporate paper.” A company needs to borrow short-term funds in order to make payroll, or rent. That company goes into the money market to borrow short-term funds, pays its bills using borrowed funds, and then pays back the lender a few days later. Simple, right? In the gold market, miners do something similar, but the term of the loan may last a bit longer.
Take gold mining companies. They will have a certain amount of gold in the future, but with mining, refining, processing, and selling, seeing a return on that gold will take time. So, they borrow gold from a bullion bank that holds gold and wants to make a profit on it and sell the gold for short-term cash. When the mining company’s gold is ready to sell, they pay it back to the bullion bank, plus interest. This interest is usually less than the rate of borrowing cash.
Interestingly this practice has been misunderstood by many, acquiring a bit of notoriety over the years. Some people believe that gold lenders – many of which have historically been central banks – lease gold to manipulate the price of gold. This is not necessarily the case though. One can argue the opposite case: the price of gold is what drives the gold leasing market, not the other way around.
When the price of gold drops, the demand for leasing gold increases. This is evidenced by the practice known as “gold carry trade”. This is when investors lease gold, sell it, and use the cash to invest in other assets with a higher interest rate. It was especially common in the 80s and 90s when gold was in a long-term bear market (many investors thinking it wouldn’t end) and central banks were lending gold at an incredibly low rate.
You can continue to see this trend play out in the 2000s. As gold prices rose and a bull market for gold came about, lending gold became an unprofitable investment strategy. As prices rose, hedging against falling prices dropped and the demand for gold borrowing ceased. Miners found it pointless to hedge. As the gold lending rates fell to zero, even dipping to negative rates from 2009-12, there was no demand for leasing.
How Is the Gold Leasing Rate Calculated?
Okay, now comes the nerdy part. The way that the gold lease rate (GLR) became negative is based on how you calculate it. To get this number, you take the difference between the Gold Forward Offered Rate and the London Interbank Offered Rate (LIBOR). Depending on what you get with this number, the rate can be positive or negative. In short, that’s how the gold leasing market works.
Remember: When prices are low, and if companies forecast a gold bear market, there tends to be lots of hedging. This is an ideal time for both lenders and borrowers. When the gold market is in a bull cycle, meaning prices are on the rise, hedging doesn’t make sense, and so leasing activity tends to cease.
Either way, the most important thing to understand is that prices drive the leasing market, not the other way around.