By Clara Denina and Jan Harvey
LONDON (Reuters) - The Chicago Mercantile Exchange (CME) (CME.O) is developing a European gold futures contract to serve customers in London, three sources familiar with matter said, which could present a direct challenge to London's traditional cash market.
The contract would mirror existing futures traded on CME's New York COMEX platform, which has a 100 ounce contract size and typically trades volumes of between 15 million and 20 million ounces daily.
That is the world's most liquid gold contract, essentially setting the benchmark for bullion futures globally.
"The CME has been working on a loco (deliverable in) London futures contract for a while," one source familiar with the matter said.
"Comex futures are deliverable at Comex warehouses, instead with London futures you would take delivery at your London vault," the source added.
"Potentially they would see a lot more futures being delivered if customers could have London gold."
The CME declined to comment.
London's gold market is primarily over-the-counter, meaning that trades take place privately between two counterparties rather than on an exchange. That gives greater flexibility in terms of price, size and delivery terms, but less transparency.
Spot market volumes have dropped to their lowest in a year, with slowing interbank trade and ebbing liquidity making customers reluctant to transact. Several banks withdrew from the commodities sector due to tighter regulation and credit constraints resulting from the financial crisis beginning 2008.
One senior precious metals trader at a bank said a move onto a cleared platform was inevitable given the greater regulatory scrutiny in the gold market.
"Whether this is the right (solution) remains to be seen," the trader said. "But you can't (operate) in an OTC environment as we used to for much longer. The regulatory demands will force you to be on a cleared platform – information on volumes, trade reporting, flows all has to be out there."
The London Bullion Market Association is reviewing the London gold market, including the possibility of creating an exchange for gold trading in the city.
The size of a typical London Good Delivery gold bar is 400 ounces, or 12.4 kg. However, customers could take deliveries of 100 ounces.
The good delivery is a set of rules compiled by the LBMA, describing the weight and purity of gold bars used by traders in the London bullion market.
"Banks are really under pressure (to clear through exchanges), but ultimately it's whether their clients are happy with it," bullion broker Sharps Pixley CEO Ross Norman said.
"The futures market is great for leverage and for those who want to hedge and those who want additional risk exposure," Norman said.
"But I don't think there is a culture for leverage in Europe, where you will have some producers doing some futures, but not consumers."
CME Group, jointly with Thomson Reuters (TRI.TO), took over the administration of the silver benchmark (XAGLDN=) in August 2014 following sweeping reform of precious metals benchmarking.
That was triggered by a regulatory push for more transparency following the 2012 Libor interest rate-rigging scandal saw banks stop acting as both data providers and market makers.
The exchange also introduced a physically settled kilobar contract in Hong Kong earlier this year, but this has failed to garner significant trading volumes.
(Additional reporting by Pratima Desai; Editing by Veronica Brown)