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«The liquidity of gold under proposed EBA liquidity tests An analysis for the World Gold Council 20 March 2013 -1Europe Economics is registered in ...»

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Executive Summary

The liquidity of gold under

proposed EBA liquidity


An analysis for the World Gold Council

20 March 2013

-1Europe Economics is registered in England No. 3477100. Registered offices at Chancery House, 53-64 Chancery Lane, London WC2A 1QU.

Whilst every effort has been made to ensure the accuracy of the information/material contained in this report, Europe Economics assumes no

responsibility for and gives no guarantees, undertakings or warranties concerning the accuracy, completeness or up to date nature of the information/analysis provided in the report and does not accept any liability whatsoever arising from any errors or omissions © Europe Economics.

All rights reserved. Except for the quotation of short passages for the purpose of criticism or review, no part may be used or reproduced without permission.

Contents 1 Executive Summary

1.1 Concepts of Liquidity

1.2 Critique of the EBA Discussion Paper

1.3 Gold’s Performance on Liquidity Metrics

2 What is Banking Liquidity?

2.1 The Concept of Liquidity

2.2 Convertibility

2.3 Transaction Costs

2.4 Price Impact

2.5 Liquidity for a Bank

3 Policy Background on Liquidity Requirements

3.1 Basel I and Basel II

3.2 Basel III and the Financial Crisis

3.3 Capital Requirements Directive and Capital Requirements Regulation

3.4 EBA Assessment of Bank Liquidity

4 A Critique of the EBA Discussion Paper

4.1 Dimensions of Liquidity

4.2 Choice of Measures

4.3 Weighting of Measures for the Ranking

5 Proposed EBA Liquidity Measures and Alternatives

5.1 Liquidity Measures Proposed by the EBA

5.2 Alternative Liquidity Measures

6 The Liquidity of Gold and Other Assets

6.1 Scale Measure

6.2 Correlation of Need with Price Measures

6.3 Transaction Cost Measures

6.4 Price Impact Measures

7 Implications for the Use of Gold for Bank Liquidity

-1Executive Summary 1 Executive Summary The World Gold Council wishes to understand how gold will perform in a variety of liquidity metrics proposed by the European Banking Authority (EBA) to be used in its assessment of assets for the Liquidity Coverage Ratio and the Net Stable Funding Ratio. The World Gold Council commissioned Europe Economics to investigate how gold would perform on the EBA’s proposed liquidity metrics, in addition to critiquing the EBA Discussion Paper (DP) that lays out the EBA’s proposed methodology and proposing additional liquidity measures for the EBA to consider.

1.1 Concepts of Liquidity Liquidity is a notoriously difficult concept to pin down. Many discussions on liquidity boil down to transaction costs, which are often measured by the bid-ask spread of an asset. We conceive of

liquidity as being composed of three distinct aspects (the first being composed itself of three aspects):

 Convertibility  Size of market or scale  Diversity of asset holders  Correlation of price with the need to sell  Transactions costs in trading  Price impact of trading Many treatments of liquidity focus solely on the “transaction costs in trading” measure, but we feel to focus only on this aspect of liquidity could be dangerous in designing a regulatory capital buffer since different aspects of liquidity could be key in financial crises.

1.2 Critique of the EBA Discussion Paper We argue that the EBA DP does not capture certain aspects of liquidity. In particular, there are no measures proposed by the EBA that measure the correlation of price with need and diversity of asset holders, which we feel are two crucial aspects of liquidity in times of financial stress. Furthermore, the EBA has indicated that it would like to develop a set of uniform liquidity measures that could be applied across all assets, but we caution against striving for uniformity if that means not capturing all of the aspects of liquidity. Our view is that it is most important that the main dimensions of liquidity be considered, even if the specific measures for each differed across asset classes.

1.3 Gold’s Performance on Liquidity Metrics Out of the five dimensions of liquidity that we identify in this paper, namely scale, diversity, correlation of price with need, transactions costs and price impact, gold performs well in four of these (scale, correlation of price with need, transaction costs, and price impact) under various measures. Although we do not have access to data in order to calculate a measure of diversity of asset holders, our intuition is that gold will perform well on this dimension.

Gold performs well when relative, as opposed to absolute, spread measures are taken into account.

This is because the quoted unit of gold (troy ounces) is often much more valuable than the quoted unit of other assets, such as a single stock or bond, rendering inter-asset comparisons using absolute spreads misleading. Gold also typically performs better in times of adverse financial conditions, making it a strong candidate asset for a regulatory capital buffer.

-2What is Banking Liquidity?

2 What is Banking Liquidity?

This chapter offers our understanding of the concept of liquidity and why liquidity is important for a bank. We begin by discussing three aspects of the concept of liquidity and then offer three reasons for the importance of the liquidity profile of banks in particular.

2.1 The Concept of Liquidity When economists talk of the “liquidity” of an asset, they mean the ability of the owner to convert the asset into things the owner wants to purchase — the ability, as it were, to “spend” it.

One standard way to make this idea more concrete is to say that the liquidity of an asset is the ability to convert that asset into cash — where cash is, by definition, perfectly liquid. Such a concept is not relevant to all important assets, however. For example, in foreign exchange one might convert one form of cash into another, but the relevant concept of liquidity relates to the ability to convert the asset into the form of cash one requires for purchasing — the ability to “spend” the asset.

So, let us assume that the cash in the currency of the economy where the asset-owner lives (“domestic cash”) is, by definition, perfectly liquid. What will be the liquidity of other assets, relative to this perfectly liquid domestic cash? Or, to put the matter another way, in what ways are other assets less liquid than domestic cash?

There are many dimensions in which other assets have lower liquidity than domestic cash. Three

particularly important ones are:

 Convertibility  Transactions costs in trading  Price impact of trading We discuss each of these measures in turn below.

2.2 Convertibility If you hold an asset, are there people willing to buy it and how quickly can they do so? Even if your asset has an acknowledged value, will there be people willing to buy it from you at that price? How does the price of the asset move with your need to sell it? How straightforwardly and quickly can you actually convert market value into domestic cash? The harder it is (e.g. the more time it takes or the more work you have to put in) to find purchasers for an asset or the lower the price of the asset at precisely that moment in which you need to sell it, the lower its liquidity is.

Convertibility is an umbrella concept that covers three related concepts. First is the total number of asset holders in a market. Second, is the diversity of asset holders in a market. A third aspect of convertibility is the correlation of the price of an asset with the holder’s need to sell it for liquidity purposes.

2.2.1 Number of asset holders Being able to convert one asset into another depends the presence of other asset holders that are willing and able to buy your asset. This, in turn, depends on two points: the “depth” of the market –

–  –  –

the sheer number of market players demanding the asset you hold – and the “breadth” of the market – the diversity of the market players demanding your asset. Let us first consider market depth.

Liquid markets are often characterised by high aggregate trade volumes. One factor contributing to these characteristics is the presence of a sufficient number of buyers and sellers of assets in these markets to exchange assets with one another, generating high trade volumes and broad consensus on the market value of an asset via price discovery. If an asset holder wants to keep her asset for liquidity purposes, then she must be confident that when time comes for her to demand liquidity a sufficient number of buyers of the asset will be available.

2.2.2 Diversity of asset holders In some instances, the pool of buyers of an asset might be very deep but also very homogeneous. If something were to adversely affect this pool of buyers, an asset that typically meets high demand in the market might cease to be sellable. For this reason, it is also important that there is a diversity of holders of an asset to ensure that it is liquid. Holding assets with a diversity of holders might minimise general counterparty risk when trading those assets. That is, conditions that adversely affect one set of asset holders might have little effect on other sets of holders, so some buyers should always be available.

2.2.3 Correlation of price with need Another key aspect of convertibility is how much cash one will get for one’s assets when one needs to sell them.1 If the price of an asset deteriorates when conditions become such that one needs to sell that asset, then one is at risk of being insolvent given a fixed amount of holdings of that asset. If, on the other hand, an asset actually becomes more valuable in adverse financial conditions 2 – perhaps via a “flight to quality” effect – then holding that asset puts one in a better liquidity position in periods of financial stress compared with more normal periods.

The correlation of the price of an asset with the need to sell it has consequences for regulatory capital.

Subprime mortgage-backed securities were an investment-grade, generally liquid market where securities commanded a relatively high value. As the financial crisis of 2008 picked up steam, these once liquid assets quickly became illiquid and lost a considerable amount of their market value. Where these assets were held as regulatory capital, the capital buffer began to deteriorate. In these cases, the capital that was built up to ensure solvency had exactly the opposite effect.

2.3 Transaction Costs One can convert cash into other cash (e.g. a €20 note into two €10 notes) near-costlessly. This allows one to hold different forms of cash with almost no transactions costs. By contrast, trading into and out of other assets may result in costs of trading — the cost of buying even small volumes of an asset may be higher than what one would secure by selling it at the same moment; and the process of purchase may involve brokerage and other such fees.

Independent of brokerage fees, bargaining dynamics between asset suppliers and asset demanders might also influence how much it costs to convert one asset into another. Prices quoted by sellers This point captures both the “low correlation with risky assets” and”flight to quality” aspects of the HQLA under the Basel III LCR. See http://www.bis.org/publ/bcbs238.pdf, p. 7-8.

One recent phenomenon that highlights this point is the fears stoked by the tax on deposits in Cyprus. Many safe haven assets, such as “core” European bonds and gold, rose in value on the Monday following the announcement of the tax. Riskier assets, such as equities, fell in value. Gold in particular rose 1.7 per cent in euro terms. See: http://www.telegraph.co.uk/finance/personalfinance/investing/gold/9937128/Gold-price-jumpson-Cyprus-worries.html.

-4What is Banking Liquidity?

(asks) are often higher than prices quoted by buyers (bids). Often the realised transaction price is somewhere between the ask price and the bid price; buyers pay a higher price than they originally quoted and sellers receive a lower price. 3 Therefore parties on both sides of an asset exchange often incur a cost relative to the price at which one party would like to exchange. Incurring these monetary costs in trading reduces one’s ability to convert a notional market value of an asset into the same value of domestic cash, and thus reduces liquidity.

In addition to monetary costs, there are also opportunity costs that might arise in trading. Time needs to be invested in OTC markets to find a counterparty, creating search costs for traders. The delay between making an order and that order being filled can represent an opportunity cost where attractive trade opportunities are missed because of this delay.4

2.4 Price Impact Apart from investors that are governments and central banks, the process of acquiring cash does not itself materially change the value of cash. But the process of acquiring or disposing of other assets might have an impact on the price.5 This can happen through at least two channels. First, buying or selling asset might signal to the market one’s opinion in the current or future value of those assets.

Two well-known examples on this point are the way prices of shares change when a takeover bid is announced, and the way the price of a plot of land might change if it were one section of a potential large development (such as a shopping complex).

Another price-impact channel is the size of a trade. Most markets exhibit some price volatility if a large quantity of a product is introduced to or taken off of the market. Some markets are more sensitive to large quantity changes than others. Generally speaking, liquid markets are less sensitive to large trades, as a single large trade in a liquid market is more likely to be a small proportion of overall trading volume as compared with an illiquid market.6 If markets are liquid, then a large trade might be expected to have a smaller price impact than would be realised in an illiquid market.

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