A Blockchain Solution to Gold Settlement Issues

Sarah Rudolph

Sarah Rudolph

Managing Editor

Amid all the talk of blockchain and its applications for the financial and trading worlds, Euroclear and ItBit have gotten together to come up with what they feel is a solution to some of the problems in the gold market, in particular the settlement of unallocated gold.

The two companies are partnering to develop a blockchain-based service which lowers costs, makes delivery and payment systems more efficient, and reduces balance sheet issues. The service uses New York-based ItBit’s blockchain technology called Bankchain, which provides tracking, clearing and settlement of trades.

Addressing efficiency problems in the gold markets is no easy feat. There are basically two types of gold that trade – allocated and unallocated. Unallocated gold sits in a pool and when you buy and sell it, you don’t actually own a specific bar of gold but only a percentage of all the gold in the pool – similar to stocks.  So participants are basically buying and selling a credit claim on the bank that holds the gold.

Allocated gold means buying and selling specific bars of gold. But the problem with that is it is too operationally cumbersome and expensive for most investors. Also, the bars are not uniform, meaning every bar has a different fineness and weight. They are supposed to be four ounces but that can often end up being plus or minus 10 percent of that weight and still be considered good for delivery. So the unallocated market is the preference for most investors in physical gold.

Charles Cascarilla, CEO of ItBit, said capital treatments of the unallocated market have become more onerous since the introduction of the Basel III and Dodd-Frank requirements, which include increased capital charges for non-bank transactors. The unallocated market has had a number of difficulties in the past five to 10 years, with the LIBOR fix scandal, market conduct issues and the large amount of trading that is done bilaterally. Such trades also incur counterparty credit risk.

And some people believe there isn’t necessarily enough gold stored in the banks, because they are trading credit points. Like credit default swaps, there is more trading than actual bonds could be delivered, Cascarilla said.

ItBit’s technology and the agreement with Euroclear creates Delivery vs Payment (DVP), “the sine qua non of the back office,” Cascarilla said.  “We are able to make sure the gold and the dollars to pay for it move on the same day at the same time. That makes a significant improvement in the market.”

Today, in the London gold market, unallocated claims are settled at clearing banks in the UK at the end of the day, but there are still settlement gaps with New York banks which leave participants vulnerable to everything from currency to counterparty risk, Cascarilla said.

“That separation means a lot of risk builds up, which the counterparty assumes,” he said. “On top of that, you have the clearing taking place at banks, and dollars moving in New York among settlement banks, which are different from gold clearing banks. It is operationally intense, because the two are moving in separate times. Our solution enables delivery and payment to happen at the same moment, which reduces overnight counterparty risk.”

“Also, you are now settling in T2, but we have the ability to create T-zero settlement, or even instantaneous settlement. Participants can choose which settlement time they prefer. So settlement finality can happen significantly faster.”

As part of the venture, Euroclear would act as a common custodian in all the gold warehouses. This makes it possible to ensure that the settlement is in actual gold bars. So, a customer can trade unallocated gold all day, but without taking on credit claims, and the trades can be converted into actual gold bars at the end of the trading day. If the trades did not equal a whole bar, the customer would split ownership of the bar.

“We are creating an allocated market that has all the benefits of the unallocated market,” Cascarilla said. “And that makes it very easy to use gold as collateral, instead of just sitting dormant in a warehouse.”

The two entities plan to start in the London market, where 85- to 95 percent of gold trades occur, and then expand to New York and elsewhere.

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