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Thoughts from Asia's Gold Exchange

The Tokyo Commodities Exchange is a pretty unassuming place.

The Exchange is housed in a non-descript eight-story office building. In the relatively non-descript Tokyo borough of Kodenmacho, far from the hustle of the business districts.

In times past, the area was the center for Tokyo's cotton trade. The exchange sprung up in service of this industry. Today, the firm no longer trades cotton but instead specializes in oil, rubber and especially precious metals.

Passing by on the street, you'd never guess this is the second-largest gold exchange in the world.

In 2008, more than $300 billion worth of precious metals traded on TOCOM. Volume dropped off a little in 2009, but still averaged 2 to 3 million lots monthly. And in the first half of the year, 60% of that trading was in gold.

Only the NYMEX and India's MCX challenge TOCOM for supremacy in gold trade. The exchange is a hub for gold buyers worldwide, with significant trade volumes coming from Hong Kong, Singapore, Australia, Britain, and the U.S.

As I toured TOCOM earlier today, a few interesting points emerged.

Tokyo's trading is less speculative than in other parts of the world. Most of the volume is transacted by large, institutional buyers. Individual traders are relatively rare.

And those buyers tend to favor longer-duration trades. In North America, near-month contracts tend to see the most volume. But watching TOCOM's screens today, the contracts for the next several months were running illiquid. Only in the November and December 2010 contracts did the volume pick up significantly.

It seems that TOCOM's traders like to give themselves more time for a trade to work out. A sensible strategy. (Although the illiquid near-term contracts could offer some opportunities for steel-nerved traders.)

It's also notable that investment at TOCOM has been slow to spread to new metals. In North America, fund money has played "merry-go-round" with gold, silver, platinum, copper, zinc, lead, uranium and almost anything else that can be stacked in a warehouse.

TOCOM however, recently delisted its sole base metals contract, aluminum. The metal was seeing almost no action.

Despite the conservative stance, TOCOM trading is changing. In May 2009, the exchange upgraded its platform to a quicker system. One of the benefits being that large-volume, rapid-fire traders like quant funds can now execute in Tokyo.

This introduces potential for prices to become disconnected from fundamentals. Quant fund traders don't care a whit about supply and demand. They may know nothing about the market. They simply plug share prices and trading volumes into a formula and buy when the computer goes beep.

Such trading has had a dramatic effect in North America and on other exchanges globally. Such that it's very difficult today to tell the "proper" price for a commodity based on supply and demand. Investment money pushes prices too high when it enters and too low when it leaves.

Which has major implications for capacity growth. When prices are higher than supply-demand would dictate, it "fools" metals producers into believing there is excess demand. They build new mines and smelters to add supply.

But this is illusory. If and when investment money exits the market, prices fall unexpectedly. Eventually real buying comes in and stabilizes the market. But at a much lower level then producers expected. Suddenly all those mines that looked great at $4/lb copper are now money pits.

The trend of increasing access for investment money to commodities markets will continue. And it's important for investors to bear in mind.

Are you willing to bet that $3.35 is the right price for copper? That there's enough oil demand in the world to support $80 per barrel?

By. Dave Forest of Notela Resources

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