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The 30 Billion Dollar Not Sure Thing - HD Schultz & JE Sinclair

Section: Essays

We herewith discuss, via the kindness of Bill Murphy ( and in HSL (, the unique and weak character of the vehicles used for hedging by the majority of gold producers of 100,000 ounces per annum and up. To review for our new readers, those instruments are briefly:

  1. Unregulated.
  2. Traded in private treaty negotiations.
  3. Price determined not by market forces but rather by computer simulation.
  4. Short gold spreads mainly in one form of another.
  5. Far dated.
  6. Non transparent
  7. Without a clearing house function in order to guarantee the financial integrity of the instrument.
  8. Traded with in most cases between the gold producer and their gold bank which is usually a non guaranteed as to trade debt subsidiary of a major investment bank or commercial bank holding company.
  9. The Gold Banks do not as a rule publish the total nominal value of derivatives issued to all clients to which the bank is guarantor. Therefore there is no way to know the real financial integrity of even a rich gold bank.
  10. We know of no gold producer. hedger that has a right of offset in their client contracts with their gold bank. This is a critical point that is discussed in the body of this article.

We could write tomes on the technical nature of the construction of these instruments speaking to counter party risk among other weaknesses but that is not the purpose of this communication. Let us say that the brief review above of stand out points suffices to bring you into our conclusions.

We and our friends at GATA believe strongly in free markets. That is a gold market free of all manipulators both quasi-legal and illegal. We believe that a free market is not participated in by governments using extraordinary powers. We feel that governments must comply tightly with industry created referees rules that insure level playing fields for all interests. That being said we cannot oppose the practice of hedging by any commodity producer for whatever purpose that free agent has in the mind. The market, being a great leveler of interests, will work out the merits and the punishments of each entity's decision

Yet we have a great concern for gold itself. There is no question that a 30 billion dollar participation in hedging instruments by the gold producer can only result in a significant if not history making melt down of the hedging vehicles.

Should this melt down occur few participants in the industry will avoid the consequences which are:

  1. An unexpected and severe cash and cash flow strain on the major gold producers. Possible bankruptcy of the minor producers who are hedging more than one year's production thereby placing their assets on an auction block.
  2. Significant embarrassment to the regulators who have publicly avoided exercising their authority over the derivative markets in effect blocking transparency.
  3. Severe and probable terminal pressures of gold exploration and development companies that have percentage deals with majors. These companies in all probability do not realize they are obligated on the risk of the hedge entered on their behalf for their percentage of the loans developed thereby to build the infrastructure of the new mine. In almost every case the gold exploration and development company has to pledge their share of the property and accept the risk of the loan produced. A non recourse loan is non recourse to the project but totally recourse to the hedge required to obtain the property development loan.

Let us be perfectly clear. A so called "balanced" hedge book carries with it in today's world an enormous risk to the hedger. That risk is the counter party risk. If you have a group of gold derivative contracts that are balanced between the long side and short side you might consider yourself relatively without significant risk. What happens if all your contracts are with the same dealer and that dealer goes broke. Assuming, and this is a key factor, that you do not have the right of offset you are still liable for your debits to a gold bank. The receiver for the gold bank has every legal right to demand and perfect your obligation to pay the bank what you owe.
All you will get of the credit you had with that bank in your derivative account is pennies on the dollar at the resolution of the bankruptcy, assuming there are any pennies to dispense. The presence of many different gold banks in the hedge book of the gold producer is hollow comfort. The nature of the derivative contract today is that the gold bank does not generally permit a closing of their contract with another dealer. The problem remains the same.

Our concern is the financial integrity of the instruments and we do not care what anyone does in a free market as long as there is a level playing field for all participants. A so called "balanced" hedge books as some producers claim as protection is no valid claim to comfort. The counterparty risk is still wide open. Spreading your business to many gold banks is no protection from a potential melt down of the derivative vehicle because it will be an industry total phenomenon. Having many different dealers all of whom require the gold producer to close each commitment as a spread ( both long and short) back to the dealer provides no protection against counterparty risk in a industry-wide potential phenomina.

We do have a solution to the problem which is;

  1. The establishment of a clearing house for all gold derivative vehicles that would as it does in the listed commodity markets provide a reasonable guarantee of financial integrity of the instruments transacted.
  2. An open out cry pit on an established exchange wherein bids and offers for gold derivative spreads could be transacted regardless of how the bids and offers of these spreads are developed. This will provide transparency and regulation

In closing let us keep in mind the non transparent and unregulated so called markets always attract to some degree unregulated people who thrive in non transparency. Arguments that counter our suggestion are hollow in their motivation. We wish the producers to be able to deal in any hedge positions they wish. We encourage non recourse borrowing and understand the lenders need for the hedge so as to be able to grant loans of this sort. What we want is for this industry to survive. That survival depends on financial instruments different from those utilized today.

We close by reminding our industry colleagues that those pieces of paper they hold so close to their hearts are promises to pay which total $30,000,000,000. Should gold trade at $354, we for professional and knowledgeable reasons, stake our reputation on the following. They will not pay.

Harry D. Schultz can be contacted at and James E. Sinclair at