What Causes A Gold Flash Crash? Liquidity Squeeze Seen as the Main Culprit

As a proven safe-haven asset, gold withstands period of crisis, fluctuation and inflation. This, however, does not mean that the gold market wouldn’t be subject to speculation and volatility, and the safe-haven metal is hit by a flash crash now and then as are other assets. 

Take the recent two years as an example. Gold crashed in both August of this and last year, making the month appear somehow adverse to the gold market. 

Back on August 11, 2020, gold plunged 4.6%, its biggest single-day decline in 7 years, after a massive precious metals rally amid the coronavirus pandemic. 

Furthermore, last month, after a relatively poor performance in the prior week when it fell over $40 and closed at $1,762.70 an ounce on Friday, gold went into a flash crash in early Asian trade on 9th, tumbling over $150 to $1,670 per ounce, its lowest point since march.

Typically, various explanations will be offered in all kinds analyses minutes after a market crash, where, in the case of gold, poor liquidity, and unsurprisingly the initial trigger — robust US jobs data, will mainly be blamed. This article is dedicated to addressing exclusively the role liquidity problems played in a gold flash crash.

Gold Liquidity

Liquidity refers to how easy it is to trade an asset at a widely recognized fair price. This means a highly liquid financial product must have many potential buyers and sellers. 

As a proven instrument that generates long-term returns, physical gold is one of the most liquid asset classes in the market, with average daily turnover in 2021 of around $183 billion, second only to the S&P 500.

In addition to high average daily trading volumes, gold is one of the most liquid assets also because all investors, big or small, have easy access to the gold market, where they can start from individual bars and coins. Furthermore, gold prices can be accessed 24/7. This, plus the large global market capacity and a low cost for implementing the investment, makes gold a unique liquid asset.

The gold markets access liquidity from two primary sources — Over the counter (OTC) bullion trading and trading taking place on futures markets, which account for over 85 percent of gold market turnover. Other sources also include turnover on the Shanghai Gold Exchange, the London Metal Exchange and the global gold ETF market.

Liquidity Squeeze Triggered by Basel III

Basel III was rolled out by the Basel Committee on Banking Supervision in response to the credit crisis of 2008. The voluntary implementation deadline for the new rules, after being repeatedly pushed back from 2015, currently stands at January 1, 2022.

The internationally agreed-upon agreement reclassified the precious metal from a Tier 3 asset to a Tier 1 asset. This will not impact the allocated gold, which is physically sitting in a vault and owned outright by an investor. However, the unallocated gold remains the property of the bank which can be sold 20 times to 20 people, and the investor is essentially the creditor of the bank. Following the implementation of Basel III, the unallocated gold will be considered risky as equities.  

The new Net Stable Funding Ratio (NSFR) requirement in Basel III stipulates that an 85% Required Stable Funding (RSF) needs to be held by banks against the financing and clearing of precious metals transactions, which is a big change compared to the pre-Basel III level of 0%. This means banks or dealers need to collateralize 85% of the value of their unallocated gold, and the cost of holding unallocated gold will increase significantly.

When it will no longer make money, a lot of unallocated gold trading businesses will shut down, triggering a liquidity squeeze in the gold markets.

Multiple Chinese Banks Tighten Precious Metal Transactions

Banks in China, including the Bank of China, the China Merchants Bank and the Postal Savings Bank of China, have successively issued notices to adjust, or more specifically tighten, precious metals business in response to the recent volatility in the precious metals markets.

The Bank of China said in its announcement on July 30 that after completing upgrading its systems on August 7 and 8, the bank will change the trading conditions of some precious metals, lowering the single transaction limit and the position limit of a single trading account. 

Also, the China Merchants Bank revealed its plan to further restrict certain precious metals trading businesses in the notice issued shortly before the flash crash of August 9.

These, along with holidays in Japan and Singapore, two of the main trading centres in Asia, also put the squeeze on liquidity.    

Illiquid Asian Session Met Panic-driven Sell-offs 

Typically, markets are at its most illiquid during the Asian trading. The Asian trade of August 9 was, however, the first opportunity for Asia-based investors to react to the prior Friday’s better-than-expected non-farm payrolls data. 

The yellow metal was heavily sold off in the morning of August 9 after the Asian markets opened. In the futures market, activity surged in a typically quiet trading period, with more than 3,000 contracts changing hands in a one-minute window, representing over $500 million in notional value. Also, the gold price chart showed that a break of 1760 seems to have triggered a cascade of stop losses, prompting large sell orders under thin liquidity conditions.

In short, the market’s free fall looks to be a natural consequence of the combination of poor liquidity and flood of sell orders.