The spread between the spot price of gold—that is, to buy/sell physical gold for immediate delivery—and the price of an active futures contract for gold—a paper trade guaranteeing physical gold at a later date—is typically fairly efficient. That is to say, the two prices are normally within a few Dollars. In late March of this year, as the Covid-19 pandemic crisis firmly wrapped itself around the global economy, that same spread (often referred to by traders as the EFP, or Exchange-for-Physical) blew out as the gold futures price rose an unreal $80 above spot. The market has been making efforts to moderate the drastic dislocation, but last week the gap was still $35/oz; even in this morning’s trading the EFP is roughly $15.
The event certainly has affected even those who trade only in physical gold, as it’s been a contributor to gold’s recent rise without a doubt. So, let’s talk a little bit about what’s behind the move.
For those who aren’t familiar with the commodities future market and its relation to spot, we thankfully don’t need a deep dive into the mechanisms involved in order to get a grasp on this large price disruption. What’s most useful to remember is that the global hub for the physical (and thus, “spot”) gold market is in London. While a retail buyer/investor can be receiving coins or bars from a local shop or an online retailer, banks and institutional buyers are most often buying and selling metal that sits in London when they trade on spot price. On the other side of the Atlantic, COMEX futures contracts (the dominant market) are fulfilled by delivery of physical gold to the CME in New York. If you buy a June Gold contract today, what you’re buying is physical gold delivered to New York City in June.
So then: “spot” is the price of physical gold in London, while the “futures price” is the price of physical gold delivered to New York. The 3,459 miles between the two prices is at the core of the blown out spread that’s complicated gold markets.
Why the EFP Spread Blew Out: The London-to-New York Breakdown
When the world’s developed economies were taking the first of their more painful steps to curb the accelerating spread of the novel coronavirus across the globe in March, one of the first things to go was international flights. In the gold market, this meant there was suddenly a much lower number of transatlantic flights that could move physical gold from London for delivery against futures contracts in New York. Through basic economic functions, this inflated the perceived additional costs of owning spot/London gold and eventually moving it to New York. Rather than putting pressure on the price of gold in London, it served to elevate the relative value—and therefore the futures price—of gold contracts in New York.
There was a second inefficiency forced into the gold industry’s normal operations: while the physical gold that is vaulted in London for institutional traders is most often in the form of 400 oz bars, the standard COMEX gold futures contract stipulates that only 100 oz bars can be delivered against it. (Why is a matter for another time, but this too has always been a factor in the EFP between spot and physical values.) As social distancing orders took effect in the UK and other parts of Europe—in Switzerland and Germany most importantly for our purposes—another bottleneck was created in what is a typically seamless process of converting the larger London bars into COMEX-acceptable units. It’s a process that can only be done in highly regulated refineries, and so capacity initially fell to the floor as those operations were forced to shut down or at least cut back substantially. This too made gold in New York a better proposition than gold in London.
These inefficiencies in how the gold market typically operates smoothly between global banks’ commodities trading began spreading the EFP by a wide and growing margin. As enforced travel bans and regional lockdowns spread through Europe and New York, a fear gripped traders that the movement of gold from London to New York to fulfill futures contracts would go from difficult and expensive to outright impossible, and this bold of panic created the blowout to an amazing $80/oz EFP with futures soaring above the value of physical gold. Because some trading and pricing systems automatically factor this spot/futures spread into their own offerings, this resulted in some premiums for retail buyers widening to as much as $50/oz between bid and ask.
Why the EFP Spread Remains Wide: Nervous Banks and Low Liquidity
Once the dislocation had reached its widest, basic forces of the efficient market and supply-chain economics moved in to calm the waters—at least as much as they could manage. Adjustments were made in the chain of transportation and at refineries as quickly as was possible to alleviate the stresses outlines above while still maintaining safety protocols, the CME rather quickly announced a new “expanded” gold contract that would allow for delivery of 400 oz and kilogram gold bars against it, and traders (those whose coffers were large enough and risk managers lax enough) moved in to arbitrage the inefficiency by purchasing what they could in London and selling it for a mint (pun intended) in New York.
The corrective forces these actors could provide has been limited of course, as evidenced by the fact that the EFP remained over $30/oz as recently as a week ago. The masters of the gold market’s logistics have after all only been able to loosen their own restraints so much ahead of more widespread easing of government-imposed restrictions; while the fear of a full-on collapse of the delivery mechanism to New York seems to have faded under the light of reason, the logistical bottlenecks are still a reality that needs to be accounted for in pricing and, according to industry sources, will take some time to catch up even after lockdowns and distancing orders abate. And while the enhanced COMEX delivery contracts are a novel (if partial) solution to the problem, in reality it’s a very slow-moving transition as it will take large-scale managers and investors time to roll positions from standard futures contracts into the new—and that’s assuming there is rapid interest in doing so, which so far has not been the case.
The most dramatic limiter on correcting the spread however has been a lack of liquidity in the markets. For one, even the actors who have the means and the will to step into the EFP right now are slowed by the CME’s contract limits which are restricting the impact that arbitrage can have on the dislocation. More than that though, the initial blow-out of the EFP spread was so dramatic and such an outlier, that there simply are not that many banks getting involved with the trade. Risk managers who hold the purse strings are enforcing caution and keeping their institutions’ traders out of the EFP trade until the real-world logistics are sorted. As BMO Capital Markets’ head of metals derivatives trading told Bloomberg: “Until the machinery of the world is largely functioning normally again, you have to think very carefully about selling the EFP until you are sure you can get material to cover.”
With trading volume measurably down in both the London spot and New York futures markets, the excessive spread has been more than cut in half but is still trading roughly ten-times its usual value.
How the Dislocated Spread Influences Spot Gold Prices
As I mentioned at the top, this hasn’t been a phenomenon relegated to the futures market or institutional transactions; it’s had a real impact on spot prices just due to momentum alone. While the motivating factors are based around disrupting the tight tether between futures and spot prices, the rip higher in futures marks has pulled spot gold higher as well: first through $1600 in late March when the spread was at its widest, and it surely contributed to the initial move through $1700 last week. Think of it like water skiing: while the boat initially takes off leaving the skier behind, because the two are tethered there comes a point where the trailing skier is forced to move in the same direction and at similar velocity.
So, if physical prices are involved in the move, can your average retail investor get involved with this (somewhat frightening) arbitrage opportunity? In short, no. There’s not really an inefficiency available to play in purely physical trading; most of those trading operations that initially showed egregious bid/ask spreads have corrected their boards. Otherwise, it’s prohibitively expensive for a retail investor to get involved with the futures side of the trade to a degree that would balance out risk vs. upside in a worthwhile manner.
Semi-live futures contract prices are readily available from the CME however, so it’s certainly useful for now to be aware of their behavior. I’m not willing to say that the EFP spread could blow out once again, but if it did—like the water skier—you would probably see futures prices accelerate before spot finishes a move higher. Correspondingly, when we make it to more normalized shores, it’s uncertain if the process of drawing the EFP back to its usual $0.50-2.00 mark will allow spot prices to remain elevated or pressure them lower.