Central banks hold large gold reserve assets. Unlike their treasury assets, these do not yield any return. Central banks are, therefore, known to lease indeterminate volumes of these risk- free assets to bullion banks at around one per cent annual interest. Bullion banks, in turn, sell the gold in the London Bullion Market to invest in higher yielding, but risk-free, long-term treasury bonds. This is, however, not risk-free arbitrage since bullion banks need to buy gold back at the end of the period to return to central banks.
If the price of gold appreciates sharply in the interim, they can book huge losses. It is, therefore, in the interest of bullion banks to keep gold prices low. However, over the short-run, any lumpiness in the amount of gold to be returned to central banks could drive up prices in the short term; alternatively, there is an incentive for bullion banks, and associated hedge funds (since the division is not water-tight) in these circumstances to try and drive down gold prices when large volumes are to be returned to central banks. Read More