Why Do Gold Traders Require a Performance Bond?
The introduction of the Comex Gold Futures Contract was the first time that traders could speculate on the price of gold without needing to buy the physical metal. Following a study by the Commodity Futures Trading Commission (CFTC), which “concluded that trading in futures contracts for commodity options would be beneficial to both producers and consumers,” the contract was established in December 1974. The CFTC’s conclusions were based on the following findings:
- Price unpredictability is reduced by trading in futures markets.
- Increased liquidity leads to more efficient transaction execution.
- Risk can be managed by the use of regulated futures exchanges; and
- There is enough information available to allow educated traders to engage in trading.
Individuals and organizations, including non-commercials, traded the Gold Futures Contract at first, which had a contract size of 100 ounces (100 oz). The Comex then expanded to a five-ounce (5 oz) micro contract a year later, breaking the model of commodities futures contracts. Comex would continue to add additional tiny contracts until 2003 when it established a one-tenth (1/10th) of an ounce (0.1 oz) lot size.
When compared to insurance, why is a surety bond required?
Gold futures contracts were settled “physically” in Comex’s early years. To put it another way, a paper trade in the form of a futures contract had to be delivered in metal. As Comex puts it:
A sale of a commodity nowadays on most exchanges results in both parties providing and receiving the commodity. But not in this case… Every day at 10:30 a.m. [EST], we settle in cash based on the COMEX closing price or the midpoint between bid and asked prices.
Investors became apprehensive in the late 1970s that their profits might not be realized due to non-delivery by the buyer against whom they traded (failure by one party to deliver is referred to as “failure to deliver”). As a result of these worries, investors began to demand so-called performance bonds.
Exchanges utilize performance bonds as surety mechanisms to safeguard both parties in a contract against non-delivery… In this case, the exchange just serves as a mediator, ensuring payment between two unconnected parties.
In international trade, what is a performance bond?
A surety bond, also known as a performance bond, requires a third-party assurance of the transaction. This third party in international trade is usually an insurance business that guarantees that a buyer will pay for products or services purchased from a seller. The publication “Performance Bonds and Guarantees” by the International Chamber of Commerce (ICC) contains the following information:
- Performance bonds, like other types of guarantees, are utilized when one of the contracting parties is regarded to be at risk of defaulting on its obligations.
- Such risks are mitigated by performance bonds.
- They offer an extra layer of protection for a relatively low price.
- Performance bonds, rather than individual letters of credit, maybe more cost-effective and certainly less risky for a provider facing multiple unknown hazards.
In order to be bonded, what information do I need to provide? What is the bonding procedure like?
When applying for a performance bond, you must supply the following information:
- Name and address of the individual or business whose credit will be insured;
- a list of references for the guarantor, containing names and addresses;
- A schedule of the commodities involved, detailing the projected delivery dates, the expiration dates of all contracts, their prices and quantities, identification numbers (such as CUSIP), broker names, and telephone [numbers]. A FinCEN number should be obtained by all guarantors.
To put it another way, a corporation must be in good standing with FINCEN and provide a phone number and contact information before becoming a surety for a contract on Comex or any other futures market in the United States. This rule has been in place since the creation of FINCEN in 1996.
This technique is used by [Comex] to ensure that you will be able to fulfill your contract’s obligations. However, the performance bond, which is an independent third party, is still looking at it.
Why not utilize insurance firms instead?
Both insurance firms and surety suppliers have disadvantages. For the expense of risk connected with gold futures contracts, insurance firms often want high premiums, whereas surety businesses want modest rates but take on unlimited responsibility.
Furthermore, insurance contracts are easily sold from one party to another, making risk assessment and management challenges. As a result, performance bonds are preferred over insurance policies as a source of guarantee in the gold trade.
What factors decide how much of my contract must be bonded?
Comex does not specify a minimum or maximum value for a performance bond (except for Spread Contracts). The higher the level of guarantee required to assure that payment is made, the larger and more essential the transaction.
A buyer will demand more surety because if they do not receive their gold, they will be unable to fulfill their obligations under the contract and will have no recourse but to sue the guarantor (e.g., SURETY), who may choose not to pay. As a result, it is not uncommon for the buyer to request any guarantors in order to ensure greater certainty.