For those who really have an interest in what is going on read the following summary from Reg Howe. The entire article is shown at the following URL from USA Gold Forum
usagold.com
Snippit:
6. Powers of Options and Politics
Almost certainly playing a key role in halting the October rally and turning the gold price south again were huge increases in the gold derivatives of just three bullion banks: J.P. Morgan, Citibank and Deutsche Bank. These increases are analyzed in two prior commentaries, House of Morgan: From Gold Bugs to Paper Hangers and Deutsche Bank: Sabotaging the Washington Agreement.
Prior to 1999, Morgan had never held more than about $20 billion in total gold derivatives, nor more than 28% of the total outstanding for all banks. But beginning in the second quarter of 1999, Morgan took on a much larger role in the under-one-year maturities, possibly presaging the the British gold sales. Then, during the last half of 1999, Morgan more than doubled its total gold derivatives, taking them from $18.4 billion to $38.1 billion, which amounted to 43% of the total for all U.S. banks reporting to the Comptroller of the Currency. What is more, Morgan's over 40% dominance stretched across all maturities. In the fourth quarter alone, it increased its gold derivatives with maturities over one year by more than 80% to $17.1 billion from $9.4 billion. Although considerably smaller in absolute scale, Citibank's gold derivatives in 1999 showed a pattern similar to Morgan's.
Deutsche Bank had precious metals derivatives (almost all are gold derivatives) the end of 1996 with a total notional value under US$5 billion. By the end of 1999, it had grown this business to a total notional value in excess of $51 billion, or by more than 10 times in three years. The increase in 1999 alone amounted to $35 billion or more than 200%, most of which came in the last half and in the longer maturities. Nor does this growth reflect derivatives added by Deutsche Bank's mid-1999 acquisition of Bankers Trust, for which the OCC reports showed precious metals derivatives with a total notional value of just over $1 billion at June 30, 1999, down from $6 billion the prior quarter.
Neither the OCC reports nor the figures in Deutsche Bank's annual reports give separate totals for forward contracts and options. However, these breakouts are available for the Swiss banks both from the Swiss National Bank and in the banks' own annual reports. At the end of 1999, UBS's precious metals derivatives had a total notional value of US$74 (SwF119) billion, with over $50(SwF80) billion in options, compared to $80(SwF110) billion at the end 1998, with about half in options. Options are plainly a major component of gold derivatives, and they appear to have taken on an increased role in 1999.
Some analysts have tried to portray the extraordinary increases in the notional values of gold derivatives at J.P. Morgan, Citibank and Deutsche Bank in the last half of 1999 as not unusual given the extraordinary volatility of gold prices during the period. But they cannot explain why the gold derivatives of UBS, the largest player in the business, and Credit Suisse remained flat to down during the exact same period. Morgan officials have refused publicly to discuss its increases. What could explain this odd picture is support from the ESF directed toward certain favored banks.
As discussed in a prior commentary, The New Dimension: Running for Cover, writers of uncovered options (puts and calls) typically limit their risk by delta hedging against their exposure. Delta hedging is described by mathematical formulas and requires quick, reliable access to a liquid market.
For example (and to oversimplify a bit), the writer of a gold call with a strike price of $300 when gold is trading spot at $250 will, if the gold price then rises, buy gold in increasing increments so that when the spot price reaches the strike price he is 50% covered. If the price keeps rising, he continues to buy in decreasing increments until he is fully covered at an average price equal to the strike price. Of course, in the real world the gold price will fluctuate up and down, but for each price the formulas tell the call writer exactly how much gold he should have to be delta or risk neutral, and he keeps adjusting his cover accordingly. But note, the purpose of delta hedging by the seller of an option, be it a call or a put, is to prevent loss on account of price changes in the underlying item (e.g., gold, commodity, stock), thereby retaining the premium received for writing the option as profit.
The purchaser of an option is in a very different situation. His risk is limited to the premium paid for the option even if he does nothing and the price moves against him. But if he is an active trader with quick, reliable access to the physical or futures markets, he can also use his calls to backstop a trading strategy designed to profit from shorting gold in a delta hedge whenever the spot price is at or near the strike price.
For example, the buyer of gold calls for 1 million ounces at $300 may choose simply to hold them as a bet on (or a hedge against) rising gold prices, but he can also employ them to backstop speculative short selling. In this event, when gold is at the $300 strike price, he could sell 500,000 ounces, an amount equal to his delta. If the sale, especially when combined with other traders doing the same thing, knocks the price down, he tries to cover quietly at lower prices, book his profits, and wait for another chance to repeat the strategy. That's a successful short sale. What is more, as long as the trader is successful, he can keep repeating the process until the expiry of his options.
But suppose the trader does not succeed, and the gold price does not return below the strike price. There are two possibilities. First, increased volatility may cause the value (price) of the calls to rise by more than the increase in the underlying gold price, so that profits from sales of the calls would more than offset losses on the short positions. If so, despite the unsuccessful short sales, he can close out his positions at a net profit. Alternatively, in the absence of any possibility for profit, he can cover his shorts with his calls at no net additional cost provided that he has managed his short position within the limits of his delta. Thus, the purpose of delta hedging by an option purchaser is to earn a profit on changes in the price of the underlying item while limiting his risk to the premium paid for the option.
In the absence of delta hedging, writers of options are exposed to potentially huge risk. Buyers of options, on the other hand, can at no additional risk use their options to backstop trading strategies designed to profit from price movements contrary to those that would benefit the option. In other words, holders of calls are positioned to try to profit from short selling. Buyers of calls can also use them to close out or cover short positions without actually going into the underlying market, but of course the writers of those same calls will have to turn to that market (or a reliable substitute) to hedge their risk.
Barrick Gold, a leading gold mining company with a large forward sales program, revealed in February that in the last quarter of 1999 it purchased call options on 6.8 million ounces of gold (or almost 212 tonnes) to cover its entire expected production from March 1, 2000, through 2001 at strike prices of $319 in 2000 and $335 in 2001. Along with other measures, these call options reduced Barrick's net exposure on forward sales from 18.8 million ounces at the end of the third quarter to a net 9.8 million ounces at year-end. While traders wondered what Barrick might do with the calls, others asked who would sell calls in this volume under these market conditions to this company. All indications now are that J.P. Morgan wrote these calls (although there have been rumors that Deutsche Bank might have written some).
Well-grounded rumors of severe liquidity constraints in the physical gold market, particularly when coupled with the high level of volatility prevailing in the last quarter of 1999, seemed to foreclose the possibility of effective delta hedging in physical gold. The initial delta on Barrick's calls must have approached 75 tonnes. What is more, Barrick itself might act in a way that could drive gold prices much higher, such as by quietly closing still more forward positions and then disclosing this fact. Indeed, announcement in February of planned hedging reductions by Placer Dome, another major gold mining company, set off the sharpest rally in gold prices since last October.
Accordingly, the magnitude of the apparent risk to the seller suggested that Barrick's calls were not an ordinary option transaction but were instead part of some special deal, most likely arranged with official support, to allow Barrick a measure of protection against rising prices while permitting (or persuading) it to remain out of the physical market, where any substantial short covering by it would have forced gold prices much higher.
Another feature of Barrick's call options also raised eyebrows: a provision for cash settlement. There are contradictory reports as to whether the calls are limited to cash settlement only or whether there are circumstances under which Barrick can demand physical gold. A special cash settlement provision appears peculiar in call options aimed at covering forward contracts that require delivery of physical gold. However, this type of provision would be quite understandable in any options written or ultimately backed by the ESF. With its large financial resources, the ESF might find the dollar risk of backing unhedged call options acceptable but not the risk having to deliver physical gold, especially under circumstances that might require use of official U.S. gold reserves.
The refusal of Secretary Summers to address directly suspected activities by the ESF in connection with gold and gold derivatives invites speculation about improper political influence. Robert Rubin, the former treasury secretary, is closely identified with two major bullion banks: Goldman Sachs, where he was co-chairman before his service in Washington, and Citibank, where he is now a top executive. Other current and former senior partners of Goldman Sachs have close ties to the British government and the Bank of England. Yet another is a former head of the New York Fed. Goldman Sachs participated in the bailout of LTCM, which counted among its principals a former vice chairman of the Fed. There may be nothing improper in this web of connections, but the way money flows through U.S. politics these days, the public deserves more than stonewalling by Secretary Summers.
Deutsche Bank apparently learned of the British gold sales a day ahead of the announcement, and perhaps not coincidentally at the very time that its acquisition of Bankers Trust was being finalized. As The Economist recently observed (May 27, 2000, p. 81): "Deutsche Bank is still striving for a place in investment banking's 'bulge bracket' of big American firms." The modus operandi of the Clinton administration offers little reassurance that it did not take advantage of the Bankers Trust deal, which the administration certainly could have killed, to secure the big German bank's cooperation in manipulating gold prices. In this connection, Deutsche Bank offered something of importance that J.P. Morgan and Citibank could not: a seat at the London fix. |
