Gold operations

Central banks can purchase gold in the global Over-the-Counter (OTC) market, through the Bank for International Settlements or from domestic production. Most central banks purchase Good Delivery (GD) bars, which must meet certain standards. A smaller number of central banks purchase kilo bars or dore. Central banks can actively manage their gold reserves, usually via deposits and swaps. To do so, the bars must be of Good Delivery standard. Gold can either be custodied at home or overseas, usually via another official institution offering this service. 

The global OTC market

The most common way for central banks to add gold to their international reserves is to purchase Good Delivery (GD) gold in the OTC market from a bullion bank. The London market is the most liquid OTC market in the world. The London Bullion Market Association (LBMA) sets GD standards. GD bars must weigh between 350oz and 430oz and have a minimum quantity of 99.5% gold. A full list of bar requirements can be found on the LBMA's website

The London Gold Delivery (LGD) list is a list of refiners that are accredited by the LBMA to deliver gold into the London market. Gold settled into the London market is called “loco London.” Only LGD bars can be settled in the London market. A list of LGD refiners can be found on the LBMA’s website, as well as a list of custodians offering vaulting services. 

LGD gold is priced in US dollars per fine ounce and quoted on a T+2 settlement basis (see Focus Box). It is the most widely quoted gold price in the world and serves as a benchmark for other locations, which are quoted at a premium or discount to this price. 

Under IMF reserve reporting guidelines, central banks can hold gold on an allocated or unallocated basis. An allocated account is an account to which individually identified gold bars or coins owned by the account holders are credited. The gold bars or coins in an allocated account are specific to that account and can be uniquely identified. In an unallocated account, the account holder does not own specific bars or coins but has a general entitlement to a set amount of gold. The central bank is not the legal owner of any physical gold, but is rather a creditor of the provider. Allocated gold accounts, are generally preferred and more common, as they are free from credit risk.

Focus box: An example of a spot trade in the loco-London market

At trade date (T+0) a central bank, that has an account at the Bank of England (BOE), requests a spot gold price from a bullion bank, that also has an account at the Bank of England. 

The central bank agrees to buy 1,000oz from the bullion bank at US$1,309.19/oz for settlement in two days' time (T+2).

The bullion bank instructs the BOE to debit its gold account with 1,000oz gold and credit the central bank's account at T+2.

The central bank instructs its US dollar clearing bank  to pay US$1,309,190 (1,000oz*US$1,309.19) to the bullion bank's US dollar account in NY at T+2. 

The gold leg of the transaction must be settled by 4pm London time on T+2. However, the US dollar leg of the transaction does not occur until 5 hours later at close of business in New York on T+2. This creates a credit risk exposure for central banks, until both legs of the settlement take place, and should be managed accordingly.

Buying gold from local production

Some central banks acquire gold through local gold production. In this way, a central bank can purchase gold using local currency instead of an international currency. There are several central banks around the world that operate local gold purchase programmes. Bangko Sentral ng Pilipinas (BSP), the central bank of the Philippines, has operated its Gold Buying Program since 1991.

This programme buys unrefined gold directly from smallscale miners and guarantees the prevailing international gold price for transactions, converted to local currency. Similarly, the central bank of Mongolia has a gold purchase programme in place for local production. The bank acquired 21.9t of gold through local purchases in 2018. The Central Bank of Russia also buys locally produced gold, in its case from local commercial banks.

Upgrading existing gold stocks

If central banks want to actively manage their gold reserves, it is important that their gold is in global trading centre and of the correct quality. As noted above, only LGD bars are accepted in the loco-London market and thus some central banks will need to upgrade non-LGD bars to LGD standard if they intend to trade in London. The Bank for International Settlements (BIS) and bullion banks both provide these services. A central bank can undertake a quality swap (i.e. swaps its non-LGD bars for LGD bars), work with one of these institutions to upgrade its gold or work directly with LGD refiners and specialist transportation companies to undertake its own upgrading programme. The Bundesbank and the Riksbank recently implemented gold upgrading programmes.

Custody options

The choice of custodian is an important consideration. Gold can be custodied at home or overseas, usually in another official institution offering this service. The Bank of England, the Bank for International Settlement (BIS), Banque de France and the Federal Reserve Bank of New York are the most important institutions offering this service. 

In recent years, a number of central banks have moved part of their gold reserves home. In some cases, the decision has been prompted by their populations expressing a preference for domestically-vaulted gold. Alternatively, the decision has been driven by security concerns and a desire for geographical diversification. Increased interest in the location of gold has led some central banks to start publishing the geographical distribution of their gold reserves. 

Active gold management 

Gold can be actively managed in order to generate a return, reduce credit risk or raise foreign exchange liquidity. The most commonly used instruments are gold deposits (to generate a return) or gold swaps (to raise foreign exchange liquidity or to generate return).  As noted previously, gold must be of GD standard and be in a centre of global liquidity for active management purposes. 

Gold deposits

Gold is a monetary asset held by central banks. As such, it can be lent out on term deposit in the same way as any other currency in the central bank’s reserve portfolio. By placing its gold on deposit with a bullion bank, a central bank can not only generate returns (the central bank earns the lease rate or deposit rate) from its gold holdings, but it also saves on storage fees, which are passed on to the borrower. The interest is generally paid in US dollars at the end of the term. It is important to note that when the bars are returned, they may be different bars than those originally lent out. If there is any weight difference, it is settled on the benchmark price on the day of redelivery.

The central bank bears the credit risk vis-à-vis the counterparty, a risk that must be accounted for in the central bank’s risk limit system. Due to this counterparty risk, central banks will only entrust their gold reserves to highly credit-rated bullion banks. The central bank can also mitigate counter party risk by negotiating collateralized gold deposits, although the return on such transactions will be smaller. Collateralised gold deposits require additional legal procedures in the form of a Global Master Repurchase Agreement (GMRA). The collateral management must also be processed. 

Gold swaps

Gold swaps can be used to raise foreign exchange liquidity or to generate return. Swaps are particularly popular during times of crisis, as they are a way to manage funding strains without portfolio liquidations. The fact that the gold price often increases during period of financial crisis, makes gold particularly attractive in this respect. 

Gold swaps work in the same way as foreign currency swaps, in that the transaction is an exchange of a fixed amount of gold and US dollar between buyer and seller on an agreed spot and forward date. In a liquidity-generating gold swap, the central bank exchanges gold against foreign exchange with an agreement that the transaction be unwound at a future time at an agreed price. Because it is a collateralised transaction it bears little credit risk. 

If the central bank decides to include gold swaps in its investment guidelines, then legal documents  from the International Swaps and Derivatives Association (ISDA) need to be signed with eligible counterparties, a process that is fairly lengthy and can take 4-6 months to complete. Legal agreements are not necessary, however, if the swap is conducted with another central bank.

Focus box: Example of a central bank gold swap transaction against US dollar in the loco-London market

On trade date (T), a central bank that has an account  with the Bank of England requests a three-month gold swap from a bullion bank (90 days, with a spot date of  4 February and a maturity date of 4 May). 

The bullion bank quotes 2.56%/2.66%, for example. 2.56% is where the bullion bank lends gold and borrows US dollars; and 2.66% is where the bullion bank borrows gold and lends US dollars. 

The central bank lends 1 LGD gold bar of 400oz and borrows US dollars at 2.66% from the bullion bank. The banks agree the basis price for the deal (i.e. the current market price, e.g. US$1,309/oz) and they calculate the forward price, as follows:

((US$1,309 x 2.66%) * 90)/ 360 = US$8.7049 + US$1,309 = US$1,317.705 

In this example, the central bank sells 400oz gold  at US$1,309/oz to the bullion bank on 4 February. 

And the central bank purchases 400oz gold at US$1,317.705/oz from the bullion bank on 4 May.

The deals are booked simultaneously as a spot sale and forward purchase.