Basel III, a set of international banking regulations that came into effect at the end of June has caused a lot of debate and speculation among gold investors and industry experts. The new rules have the potential to drastically reshape the dynamics of the gold market, especially affecting the demand for physical gold, and certainly support the bullish case for the metal in the months and years to come.
The Basel III agreement, developed by the Basel Committee on Banking Supervision, is a sweeping set of international banking rules that were originally created in response to the last financial crisis in 2008, encompassing bank capital adequacy, stress testing, and market liquidity.
One of most important regulatory changes was the re-classification of allocated, physical gold as a “Tier 1”, or a risk-free asset, equivalent to cash and currencies, with unallocated or “paper” gold remaining in “Tier 3”, the riskiest asset class. Furthermore, according to Basel III, European banks will now have to comply with new liquidity requirements, known as the Net Stable Funding Requirement (NSFR).
The aim of the NSFR is to “oblige banks to finance long-term assets with long-term money”, according to the LBMA, in order to avoid liquidity failures and to minimize systemic risk. Under the new rules, banks will have to hold 85% Required Stable Funding (RSF) against the clearing and settling of precious metals trades.
These two changes will very likely translate into a significant overhaul in the way banks handle gold. Until now, unallocated gold was the industry standard, as it represented the most convenient and cheapest way for banks and professional investors to trade the metal. However, after this regulatory shift, many banks will have to buy and hold a lot more physical gold, as relying on paper contracts will become a lot more complicated and expensive.
At this point, it is still difficult to estimate the precise impact of Basel III on the gold market. Nevertheless, it is clear that the overall effect of these new incentives will be positive. We already saw some solid evidence to support this scenario: these regulatory changes have been discussed for years and the reclassification of physical gold as a Tier 1 asset was announced in 2017. Shortly after that, we witnessed a dramatic acceleration in central bank purchases and a record-setting increase in gold reserves.
The timing of the rule change is also very interesting. It coincides with a noticeable uptick in inflation data across many advanced economies, as well as an increase in equity market volatility. Both factors are already reliably supportive of gold prices, and the addition of regulatory pressures to that mix can clearly contribute to higher demand levels from the institutional side too.
At Global Gold, while we certainly share in the optimism and we see the introduction of Basel III as bullish for gold, we also recognize that it is possible for many banks to sidestep the new requirements to some extent and there are ways to comply without a full shift to physical gold. In fact, in July, a British regulator already determined that banks clearing gold trades through London could apply for an exemption from these tighter capital rules. The LBMA lobbied against it, claiming it would force banks, and particularly gold clearing banks, to stop trading.
Therefore, the new rules do not mean that we’re about to see the end of gold contract trading or a mass conversion of all paper gold into allocated bullion within the banking system. Such a scenario is not just unlikely, but physically impossible, given that there is more paper gold traded in a single day than all the physical reserves in the world.
What we can say for sure, however, is that the new rules can definitely be seen as yet another reason for gold investors to be optimistic and as a contributing factor to higher prices going forward. And frankly, it’s a bit surprising that we haven’t heard more about this in the mainstream media.