By: Carolyn Cui and Rhiannon Hoyle, 2/8/2011
Provided by: The Wall Street Journal
Gold hasn’t reinvented itself as a currency yet. But it is getting closer.
J.P. Morgan Chase & Co. (NYSE: JPM – News) said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.
By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasurys, adding to a movement that places gold at the top tier of asset classes. It also is trying to capitalize on all the gold now owned by hedge funds and private investors that is sitting idle in warehouses.
“It’s solidifying a trend that gold is re-establishing its role as a monetary and financial asset,” said Carlos Sanchez, associate director of research with New York commodities consultancy CPM Group.
J.P. Morgan said it is responding to demand from clients, many of which also store gold in the bank’s vaults.
“Many clients are holding gold on their balance sheets as an inflation hedge and are looking to make these assets work for them as collateral,” said John Rivett, collateral-management executive at J.P. Morgan Worldwide Securities Services.
J.P. Morgan’s decision Monday reignited debate among gold’s fans and detractors. For decades, supporters have argued gold is a monetary asset and should be treated on an equal footing with cash. However, gold critics argued the market has been too volatile and too small for it to be considered a legitimate currency.
Recently, though, gold’s status has been rising.
Exchanges in New York, Chicago and Europe recently agreed to accept gold as collateral for certain trades. And the World Gold Council also is gaining traction in its push to have the Basel Committee on Banking Supervision accept the precious metal as a Tier-1 asset for banks, along with government bonds and currencies.
In India, many financial-services companies are offering personal loans against physical gold, a market that is expanding.
“Gold is increasingly being used as collateral around the world,” said Natalie Dempster, the gold council’s director of government affairs. “All these moves reflect a growing recognition of gold’s role as a high-quality, liquid asset.”
Gold futures for February delivery on Monday settled 70 cents lower, or 0.1%, at $1,347.60 a troy ounce on the Comex division of the New York Mercantile Exchange. It reached a nominal record close on Jan. 3 of $1,422.60.
In essence, J.P. Morgan is creating another role for gold, which has limited use now. One of the main laments of the metal’s critics is that, once bought, the metal doesn’t generate any income, compared with interest on bonds or dividends on stocks, and mainly just sits in vaults, rising and falling in value.
“It gives another use to gold as a cash instrument,” said Tom Pawlicki, an analyst at MF Global, a commodities brokerage. Investors who hold gold, he said, “might be less likely to sell it.”
Gold still is far from being the integral part of the monetary system it once was.
After World War II, under the Bretton Woods agreement, several countries pegged their currencies to the dollar, which in turn was fixed to the price of gold. President Richard Nixon ended the dollar-gold peg in 1971.
It is unclear whether customers need to hand over the physical bullion to J.P. Morgan or at what haircut the metal will be pledged with the bank.
There still is risk for financial institutions in taking gold as collateral.
If prices fall sharply, along with the value of the underlying trades, the collateral value could fall short of covering the trading positions, leaving banks scrambling for more margin to cover the losses.
In the past, worries about a lack of liquidity in the gold market have prevented banks from taking gold as collateral. But as investors piled into the market in recent years, the market has deepened.
The market is more liquid than many government-bond markets in Europe, with daily trading volumes normally exceeding $100 billion, according to the World Gold Council.
“When a bank, such as J.P. Morgan, is willing to extend collateral value against an asset such as physical bullion, it shows that they are not worried about the liquidity issue if they might take the collateral over or they have to liquidate the collateral,” said Frank McGhee, head precious metals trader at Integrated Brokerage Services, a Chicago broker.
—Liam Pleven and Matt Whittaker contributed to this article.
All Things Considered – John’s Commentary
Short and sweet: Gold is once again being recognized as a legitimate monetary asset. As opposed to traditional forms of collateral (stocks, bonds, real estate etc.), gold has the greatest liquidity, is accepted globally, and is not subject to any counter-party risk.
Look for silver to be the next accepted collateral asset.
