Lowering the flag

The announcement by N.M. Rothschild & Sons, the London banking firm that has presided over the daily gold price fix since 1919, that it would withdraw from the bullion and commodity trading business in London, has shocked some in the gold business, and prompted others to suggest either that Rothschild senses the top of the bull market in gold or that the physical gold market as a pricing mechanism may be in irreversible decline.

We don’t feel worried on either score; the grand old family firm hasn’t reliably picked other peaks or valleys in the gold market since Fort Knox closed its US$35 gold wicket in the early 1970s, and “good delivery” is still practised even in the most sophisticated futures markets. When Crdit Suisse First Boston withdrew from the fix late in 2001, Socit Gnrale was quick to step in; several candidates have appeared to take Rothschild’s place. But Rothschild’s move out of the market does point up an evolutionary trend in the gold market.

Even as gold prices have risen, the physical trade in gold through London has declined. In 1997, 442 million oz. were traded through London; except for a brief peak in the first half of 2001, that figure has declined steadily — to only 188 million oz. in 2003. So far as there has been an increase in investor interest in gold, it has shown in the paper gold market instead.

For Rothschild, that — and the narrower margins gold traders have been making — have meant the gold-trading business has provided an ever smaller fraction of the company’s earnings. In 2003, Rothschild made 2% of its operating income from gold trading; in 1998, that figure was 8%.

So to Rothschild, gold “is no longer a core area of activity.” Instead, the storied financial house will concentrate on “specialist commercial banking, private banking and trust services, and objective relationship-based investment banking advice.”

We’ll leave aside the mechanics of how “relationship-based” advice of that sort can be objective, and note that Rothschild still plans to be lending and floating paper for companies in the resource industry. Like most sensibly run businesses, it wants to be where the high margins are. Rothschild also said it would continue to operate as a metals broker in Australia and Singapore. That suggests to us that it is Rothschild’s London office, rather than the general metals trading business, that is fading.

The symbolism of Rothschild’s losing the cachet of being “in at the fix” is one thing; but that, for all its high profile, is not the real story. What Rothschild won’t be doing any more is taking mining companies’ hedge contracts.

In one sense, that’s not surprising. Rothschild was one of a handful of banks that had sat across the table from the gold producers during hedging’s heyday in the 1990s. The bank kept at it, so it stands to reason that the counterparty business was making money back then. (That also implies that Rothschild entered into countervailing contracts that passed losses from its contracts with the happily hedged producers on to other gold market players, perhaps the central banks. Not everybody won in those days.)

Today, the hedging stream has narrowed, though new projects have ensured it hasn’t completely dried up. It’s widely recognized that counterparties to hedge contracts are now taking greater risks, spread over fewer contracts and fewer market participants.

Lending for projects has generally relied on hedging to ensure that one element of risk — volatile prices — could be factored out of a project’s economics. It has been standard procedure for lenders to require a hedge book to be built for every project, lasting at least until the project is meeting specific financial tests and often until the project has paid back its initial capital cost.

If lenders themselves begin to abandon the role of counterparty, they may find few other financial institutions willing to take their place in what has become a low-margin, high-risk undertaking. Should that happen, they will have little choice but to soften their hedging requirements until projects can advance. Paradoxically, getting out from under counterparty risk may force the lenders to shoulder more of the price risk in project finance, probably in exchange for a higher interest rate.

The alternative — to accept project hedges made with financially weak counterparties, whose default might place a borrower’s revenue stream in jeopardy — is even less attractive, and even less responsible.

If it is Rothschild’s strategy to continue as a leading lender for gold projects, it had better hope for a reasonably liquid gold market, and a stable one too.