The current situation has been taking a toll on financial institutions the world over. As the economy grounds to a halt, so do many of the daily transactions that keep money moving and ensure the balance of financial markets. As companies start massive layoff programs and furlough their employees, liquidity demand is rising to levels similar to those of long-forgotten bank rushes. In a bid to prevent widespread commercial bank failures and worldwide financial collapse, 
Central Banks are extending their liquidity facilities and slashing official interest rates. While this does help commercial banks with meeting their immediate needs for cash, it is nothing short of financial Armageddon for investment banks.

The first signs of a severe banking crisis are already showing in the precious metals derivate market, and especially the gold market. As you know, a derivative is a financial instrument that derives its value from an underlying asset or group of assets. A simple example is a call option: instead of buying a stock today, you can buy the right to acquire it in the future at a set date and price. If the stock price at that date is higher than the price set in the call option, you can make a nice profit by exercising the call and then re-selling the stock at the higher market price. Of course, if the stock price at the exercise date is lower than the call price, then there is no point in exercising it and you lose the money you paid for the call option. Given that chance plays a significant role in the prices of stock and other assets, people usually compare derivatives to betting on the markets. Nonetheless, they also play a significant role in risk management by companies and, hence, are cornerstones of the financial markets.

 Because New York and London are both major world finance centers, any negative impact on the precious metals derivatives market can quickly spread to other markets as a sort of financial virus, much like the current pandemic. This is why the oncoming collapse of gold derivatives can have disastrous consequences and, with Central Banks focused on injecting liquidity into the economy, there is nothing to stop it.

For almost a year, gold prices have been on the rise. In the past few months, this growth in prices has dramatically accelerated, mostly due to the quickly deteriorating health situation. This has created a situation in which gold has become bid-only, as professional traders say: there are many more buyers than sellers, so instead of announcing their prices, sellers simply pick the buyers who are willing to pay more. In practice, this means that the gold market is operating much like an auction house. As a consequence, competition becomes even more pronounced and leads the price further up. Additionally, as Central Banks begin massively increasing the money supply, gold will be subjected to significant inflationary pressure, adding speed to its already fast-rising price.

The problem with mounting gold prices is that bullion banks, which are banks that trade significant amounts of precious metals, have been buying derivatives that turn a profit if prices go down. In effect, these banks have been betting on the exact opposite of the current situation, through a financial operation called short selling. According to data from Comex, the net value of swap contracts has been on negative ground since 2018 and, right now, it is near historical lows. This means that not only have bullion banks been short selling, but they have been doing it to a tune never hitherto seen. As contracts start reaching their expiry date and people demand their gold, investment banks will simply not have enough money to buy all the gold that their clients are demanding.

In this situation, it seems that the only solution would be the Central Banks stepping in to bail out these failing banks. However, the problem isn’t simple and, therefore, the solution can’t be that simple either. You see, there isn’t enough gold in the world to cover all contracts made by bullion banks. That’s right: these banks have been trading gold that doesn’t really exist… and it’s all perfectly legal. This situation arises from the way that both the financial and the monetary markets operate. The financial aspect is rather easy: it has become common for gold mining corporations to sell their production before it is extracted, as a way of financing their operation. Think of it as a sort of an advance payment by the buyers. With mines stopped due to the lockdown imposed in reaction to the current pandemic, the pre-sold gold isn’t being mined, but its ownership is still being traded.