Conceived in Iniquity and Born in Sin

The size and complex nature of today’s fractional-reserve-bullion- banking system far exceeds historical precedent, . . . this practice has always led to financial disaster and most often violence. Each day that this market continues, the underlying stresses continue to grow.

Conceived in Iniquity and Born in Sin

Action in the gold market in the last two weeks, while surprising some analysts, again exhibits the underlying stress that continues to develop in the gold market . . .

Lease rates are critical to watch in today’s gold and silver markets. To overview what regular readers would already know, over the last decade, demand for both gold and silver have far exceeded new mine supply. In the last several years, this gap between supply and demand has been met with ever-increasing amounts of bullion being “leased out” by central banks.

This process, dubbed the “Gold Carry Trade”, is where central banks take an asset, that otherwise sits on their books earning no interest or return, and lease it out for a small return. The interest they gain from this transaction is called the “Lease Rate”. This loaned bullion is then in-turn sold into the physical market, helping to satisfy the supply shortfall. What many people don’t realize is the size that this leased gold has become, as a overall part of annual supply. Today it is estimated to represent nearly 1/3rd of overall total supply into the market each year. This physical short constantly requires further new bullion to enter the system just to maintain the current position.

As we have discussed before, when bullion is leased out and sold into the physical market, it remains an asset on the books of the bank that have loaned it, while it now also becomes an asset of the new purchaser. This exceedingly dangerous and shortsighted practice effectively creates a double claim on all the bullion that enters the market in this manner (i.e. now two people own it). Further, when this bullion is purchased by a fabricator, it then finds its way onto printed circuit boards or into gold jewelry. This means it is “consumed” or lost from available supply, meaning that it cannot reasonably be returned to the original owner (central bank) now or anytime in the future.

Lease rates remain low and stable while there appears to be ample gold available to be leased into the market, but when bullion available for leasing is restricted, or appears that it may become restricted, the lease rate soars.


In early September 1999 gold was contained in a 20 year low trading range of $250 – $260 oz., and lease rates were running at around 1%. Then suddenly and without notice, in mid September, several European Banks, meeting in Washington, signed what has become know as the Washington Accord, where these European banks agreed to restrict future central bank gold leasing and outright sales.

Subsequent to the announcement of the signing of the agreement, the lease rate on gold soared to levels not seen before, triggering a massive spike in the price of gold. Gold shot from its lackadaisical $250 – $260 range to $340 in a matter of 10 short days.

Very quickly it appeared as though the complexly messy and fractionally reserved bullion market would unravel before the eyes of the world. Forward sold and heavily hedged mining companies became exposed to margin calls from their bullion bankers, while bullion banks themselves scurried to cover their huge outstanding short positions. This price reaction to the increase in lease rates demonstrated to those watching the thinness of the physical market and potential for future market disruption.

Late in September and October of that year a short squeeze in the bullion market was deferred some time into the future, as the UK and US moved quickly to bring physical metal to the market. We only need to reflect on Alan Greenspan’s comment made two years earlier when he said “central banks stand ready to lease ever-increasing amounts of bullion into the market, should the price start to rise.”

MARCH 2001
Again in the 1st week of March lease rates dramatically spiked from a little under 1% to just over 7% on Friday 9th, while the gold price quickly responded, moving from $261 oz to $272 oz. As I said at the beginning of today’s report, this again exhibits the stress that underlies today’s gold market.

Last month the World Gold Council released figures confirming record global demand for gold in the last quarter of 2000. Meanwhile mine supply continues to shrink as more mines around the world scale back production due to a protracted low gold price.

Despite central banks “standing ready to lease every greater amounts of bullion into the market should the price start to rise”, today’s gold and silver markets are very, very thin; there is simply not enough physical metal available to go around if every one piles in at one time to take delivery of the bullion they currently hold claims over. Further, this precarious condition does not take into account a drove of new investors rushing into the market to escape collapsing equities markets and currency instabilities.

In the early 1900’s Sir Josiah Stamp, the President of the Bank of England, said “fractional reserve banking as we know it today, was conceived in iniquity and born in sin”.

Whether gold, cash or other bank instruments, the practice of a banker holding only a fraction of something in reserve against the total outstanding claims against it, is called “Fractional Reserve Banking”, and is a custom that is as old as banking and indeed man himself.

Bankers have always fallen into the fraction-reserve-banking snare. At first no-one seems to notice or care, and the banker profits greatly from writing more claims than he has gold in his vault. Throughout history however, this practice has always led to financial disaster and most often violence.

The size and complex nature of today’s fractional-reserve-bullion-banking far exceeds historical precedent. Central banks have leased out gold, which they continue to carry on their books as a current asset. Bullion banks have likewise leased large amounts of the metal from their own unallocated inventory, as well as selling leased gold into the physical market, which in-turn is consumed by the purchaser. Mining companies have leased gold as a form of financing and forward sold large amounts of future production at a fixed price. Layered over all of this is a huge derivative time bomb which, in itself, far exceeds the entire asset base of the banking institutions that have written these paper contracts.

Most people agree that iniquity and sin ultimately end in disaster. From where we stand in March of 2001, it is impossible to conceive how today’s large central banks, bullion bankers, producers and other financial institutions can step back from the plate and unravel this fractional-reserve-bullion-banking nightmare without catastrophic dislocation, major market disruption and upheaval, and maybe even violence. Everyday this market continues, the underlying stress will continue to grow.

As numerous examples in history have shown us, market disruption and upheaval will afford those who are correctly positioned, not only financial protection, but a unique and once in a lifetime opportunity for profit.

by Philip Judge