The Curious Case of Precious Prices

How much is silver worth? Soon we won’t have a way of finding out. Today it has been announced that the silver fixing board will close up in August. What is it, and why is it closing? This is a good story about how markets work and the need for trust.

It’s useful to start with the most familiar market mechanism we know for setting prices: the stock exchange. We know how this works, we’ve seen it in movies. Except that, as Michael Lewis’ book Flash Boys explains, the prices of equities are no longer set by traders in coloured jackets waving at each other on an open plan trading floor. Price determination happens via a very large number of high frequency trades that take place in electronic exchanges, and not just one of them, but dozens.

The old ways were hanging on in other markets though. Benchmark prices for gold are set twice a day by four institutions speaking over the phone (Barclays, HSBC, Bank of Nova Scotia and Societe Generale – Deutsche Bank has resigned its seat). Silver prices, now that Deutsche Bank has resigned from that board too, are fixed by just two institutions, HSBC and Bank of Nova Scotia. That isn’t sustainable, and today’s announcement that the board will close is no surprise.

Though these arrangements for pricing precious metals have existed for over a century (the first gold fixing was in September 1919), in the wake of the LIBOR-rigging scandal they feel vulnerable to bad behaviour by those taking part. Sure enough there are law suits in New York courts alleging that members of the gold board trade on the information exchanged during meetings before the new price is communicated to the wider market. I haven’t seen any proof of this though it seems pretty clear that the reason Deutsche Bank is pulling out of the meetings is because they and the German regulator are concerned about perceptions.

Will the UK regulator take a similarly dim view of participation by ‘its banks’? So far the FCA – in the voice of Tracey McDermott, head of enforcement and financial crime – has said that the benchmarks for gold and silver “exist for the benefit of the market, so the market should be looking for market-based solutions to make sure it is still viable”. That seems right. Ultimately, fixing benchmark prices for gold and silver in a highly structured and infrequent way (twice a day rather than twice a millisecond) is likely to be beneficial for those who use the metals in production or buy them to hold in reserve. These market participants are looking for a single published price that carries across the world and a narrow dealing spread rather than opportunities for speculation. The current system gives them that. This is a market that has held the trust of buyers and sellers and there is remarkable continuity in the board membership itself (for example, Mocatta & Goldsmid, one of the original members still exists in the form of Scotia-Mocatta, a division of the Bank of Novia Scotia and the original chair, N M Rothschild, held that position until 2004). But now it is under threat. Silver fixing is collapsing. Even in gold, where there are four board members left, there might easily form a vicious spiral in which board members leave because they fear negative perceptions about their role in the process, yet by reducing the number of board members their departure deepens the hold of those very perceptions.

Regulators could step in to combat these. The FCA has visited the offices of Societe Generale – when it was chairing the gold board – to observe the benchmark setting meetings. It could make random visits on an ongoing basis or even sit in on every meeting. The very fact that prices are set in the old school way that they are means that there are these relatively simple regulatory solutions. It’s much harder by comparison for the regulator to set up shop inside an electronic exchange for equities and, given the frequency of price changes in those settings, plus the fact that most of them are tiny – with more digits after the decimal point than before it – it’s not just that their view of the woods would be obscured by the trees if they were observing the price-setting mechanism directly, it’s that they would be staring at a square inch of bark and wondering what on earth a ‘tree’ might be. Dialling into a meeting twice a day on the other hand looks manageable and useful.

But perhaps the market will find a way to regulate itself. Could the benchmark-setting meetings for example be webcast? That ought to eliminate any perception that someone is cheating. However, the stream of information about orders relayed during the meeting before the new benchmark is set would provide trading opportunities for speculators, especially those with the fastest network connections, who would literally see them before anyone else, exactly the problem of high frequency trading described by Lewis.

Even so, finding some solution now is necessary. The silver board will cease to exist on 14 August. Is the era of market-based trust over and so a regulator will have to step in? It is revealing that no one was willing to take up Deutsche Bank’s seat on the board in the months after they announced their intention to resign. Yet in Flash Boys, it is a private actor, in the form of a new exchange, IEX, that steps up to carry the burden of trust. Will someone do the same for silver and gold?

This post was last edited 10:30 14/05/14


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