Importance of Banks and Exchanges in Financialization of Gold

Harish Madaan

Indians have a strong affinity towards gold. No auspicious and family occasion, especially weddings are complete without gold. It doesn’t matter how rich or poor they are, they still own gold according to their status. Weddings are a day when people show their prosperity, the amount of gold people are wearing really matters. As per World Gold Council, annual gold demand in India is approximately 800 tonnes which is 25% of global demand and India is the 2nd largest consumer of gold in the world after China. Around 70% of demand comes in the form of Jewellery either as ornament for adoration or for investment purposes, and rest is in the form of investments in ETF and industrial purposes. Despite being the second largest consumer of gold, India is a price taker in the market.

Further as per World Gold Council, Indian households and trusts are believed to hold around 25000 -26000 tonnes of gold valued around USD 1.5 Trillion. Barred from a small part of the gold which gets recycled, the rest go to lockers and vaults, hence resulting in draining liquidity and growth capital out of the economy. However, if this money can be channelized back into the banking system, it would help to create credit and provide support to the economy. The gold holding numbers will further increase substantially due to geopolitical issues and weaponization of the global financial system.

Considering India’s gold consumption and affinity towards yellow metal, it is important for regulators to create an enabling environment to promote financialization of Gold. Banks and exchanges can play a very important part in this by bringing faith, transparency and efficiency in the entire ecosystem. Regulators have to create an enabling environment for easy participation, rather than putting restrictions.

Present Role of Banks

Presently banks’ role is very restricted in the bullion space. Banks are working under a consignment model after obtaining a license from the RBI. Products which banks can offer are very restricted and there is no scope for any innovation as the entire process is strictly designed with leaving no room for discretion for banks.

As an example, if we look at Gold Monetization schemes, complete step by step directions are given by the RBI. There is no scope for bank’s discretion. Some of those directions are not economically feasible for banks, hence not yielding any result despite repeated attempts from the regulators. However, on the contrary, if regulators create guiding principles for the conduct of the market, and let the market find its own way, we will see more feasible innovative solutions from banks.

Without active involvement of banks, neither financialization of gold nor success of exchange are possible. Hence, regulators first need to allow banks to play a larger role in the development of industry rather than restricting its activities. We are proponents of the free market, but when we look at the bullion market, banks’ activities are controlled. However, on the contrary, if regulators create guiding principles for the conduct of the market, and let the market find its own way, we will see more feasible innovative solutions from banks.

Just to highlight plights of banks, they cannot offer Gold Saving Account wherein small buyers can deposit INR where return is linked to gold, but the same product is offered by Jewellers or unregulated entities and people are putting their savings in such products. If we look at these products, it is similar to a miniature version of an ETF or Gold Saving account but is not regulated and prone to frauds. If the regulator allows banks to run such schemes, it will bring more faith and confidence as banks are regulated entities. Further, it will kick start financialization of gold on a prospective basis. As banks’ gold balance sheet grows, they will invest in necessary infrastructure to bring existing gold back into the economy.

Financialization of Gold

In the past, RBI and Government have taken many measures for financialization of Gold, like revamp of Gold Monetization Scheme, Sovereign Gold Bond Scheme, launch of India Bullion Exchange at Gift City, but the response is muted. In my view, gold monetization can be grouped into two parts.

1. Prospective gold buying
2. Bringing existing gold into the system

Bringing existing gold into the system would be a difficult task as emotions are attached to gold buying. Further, lack of institutional mechanism, cumbersome process of gold deposit and lower level of trust making it further difficult to bring the existing gold back into the system. I believe, if regulators and government first focus on reducing consumption of prospective gold buying by creating enabling policies and institutional mechanisms that will help to develop necessary infrastructure and also bring faith and ease in gold deposit and monetization process. These enabling processes and faith in the ecosystem will give a boost to the monetization process and help to bring existing gold held by households and trusts back into the system.

How to break the present situation?

Question arises, how to break this situation, where banks can play an important role as a conduit to support economic development by facilitating bullion industry and to promote financialization of gold. In my view, if regulators create enablers where Gold is treated like a currency, it will open up new opportunities for innovation for the banking sector. Banks understand price, liquidity, credit and market risk management. They are well equipped to manage gold balance sheets similar to INR provided enabling environment and broad policy indicators being devised. Banks can devise products and policies as per their expertise and risk appetite and participate in the financialization process.

Importance of Banks and Exchanges in financialization of Gold:

Banks and exchanges play a very important part in financialization of Gold. For the discussion on this topic, I will bifurcate my perspective into three segments

1. Bullion Banking: Present banking system is known as fractional reserve banking where banks put their capital and leverage the balance sheet to create advances and investments. Banks manage their ALM actively to manage market and liquidity risk. It also manages credit and operation risk.

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Banks act as conduit to support economic development by providing finance. Similar to payment banks and small finance banks, dedicated bullion bank licenses can also be issued by the RBI to facilitate bullion and jewellery industry. Over the period, this will discourage investments in physical gold by providing alternative mechanisms like Gold Saving and Fixed Deposit Account, digital gold etc. where the return is linked to gold. Further these expert banks will also provide financing to the entire supply chain for the development of the market.

2. Price Discovery: Most important function of exchanges is to bring all market participants to one platform for trading and to create efficient price discovery mechanisms. Exchanges create an efficient ecosystem for trading and bring transparency in trading and settlement which encourage greater market participation. Settlement risk is mitigated by settling trade through designated CCPs. Hence, increased transparency and higher volume help in efficient price discovery.

For deep and liquid markets, each player has its important role. If we look at it from the perspective of bullion exchanges; participation of suppliers (International Banks as bullion suppliers) and Indian domestic banks as speculators are key for its success. Indian domestic banks will not only create depth in the market but also help in distribution function where it enables retail market participants to trade on exchanges.

Participation of banks at initial stages of exchanges is very important for its success. Foreign suppliers will not increase their participation unless there are healthy volumes. They also run credit risk on exchange which is determined by size and volume of the exchange along with who are promoters of the exchange. As volume increases, foreign suppliers will further increase their supplies and activities on the exchange. At initial stages, foreign suppliers will prefer to trade through large Indian Banks or Foreign Banks who has presence in India rather direct participation by putting all stock at exchange due to internal credit risk guidelines of respective supplier bank, hence underlies the importance of domestic banks for the success of bullion exchange which will drive financialization of gold by enabling large market participation.

3. Reduce cost of Transaction Execution and Increase Efficiency: Bullion spot exchange will help to reduce cost of transaction execution. Under the present consignment model, banks import gold/silver on the back of customers’ orders. Banks get goods cleared from the Customs Department by paying applicable custom duty. Till the stock is not sold to the customers, funds are tied up in the form of custom duty which entails cost for banks which ultimately will be passed on to customers. With dealing on the bullion exchange, custom duty will be payable at the time of final sale as bullion is either vaulted at IIBX Gift City or at Bonded warehouse at respective location operated by IIBX. This will eliminate funding for custom duty hence reduce cost of transaction. Further this will also remove custom duty arbitrage which sometimes become a point of litigation.

Since goods are stored at respective locations irrespective of which supplier has brought those goods, will facilitate in T+0 delivery. For Example: Though a deal is executed by a customer with X supplier which does not have goods at a specific location, the supplier can execute loco swap (Location Swap) with another supplier or borrow gold to fulfill its commitments. This mechanism will increase efficiency further.

Conclusion: Despite repeated efforts by regulators to encourage financialization of gold, it is not getting success. Regulators have to look at challenges as a whole rather than taking piecemeal actions. Government has taken an initiative to study the entire ecosystem and Niti Aayog has come out with a report stating the importance and challenges of the industry. Government has also set-up the India Bullion Exchange to bring more transparency in dealing. I believe without banks’ active participation; the gold financialization process cannot be successful. Regulators should create enabling infrastructure and let banks decide on products within a broader policy framework.

Views expressed by Harish Madaan, Director, Industrial & Commercial Bank of China.

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