By Peter Hobson

LONDON, May 24 (Reuters) - London's gold benchmark experienced large, unpredictable fluctuations after some banks left the auction that sets the price relied upon by the $5 trillion-a-year bullion market, according to a Reuters analysis of trading data.

The benchmark is meant to be a fair and accurate daily snapshot of the fast-moving "spot" market and is used by gold producers and consumers around the world to price contracts.

Its level is set by the London Bullion Market Association (LBMA) Gold Price auction, which sees big banks and brokers electronically input their trading orders, with an algorithm matching buyers to sellers and setting the price.

But trading volumes fell sharply after April 10, when four of the 14 participating banks and brokers stopped taking part after the auction's administrator, Intercontinental Exchange (ICE), introduced a requirement to clear that meant participants had to modify their own IT systems and procedures.

Lower liquidity - which fuels volatility - led to the benchmark diverging more widely from the underlying spot price, according to the analysis of ICE and trading data, leaving gold buyers and sellers around the world with large unexpected gains or losses.

In the three weeks after clearing was launched, average trading volumes were a quarter lower than in the previous three weeks and the average difference from the spot price tripled to 87 cents from 29 cents, the analysis shows.

The biggest divergence, on April 11, saw the auction settle $12.20 - or 1 percent - away from the spot price. Even excluding this large swing, the average divergence in the period rose to 42 cents.

Volumes have, however, recovered since the start of May and divergences have narrowed.

Market and banking sources have told Reuters that ICE had moved fast to introduce clearing into the benchmark before the London Metal Exchange (LME) launched a rival set of cleared gold futures contracts in July, even though not all participants were ready to use the service.

Four sources familiar with the matter said that ICE was warned by at least two participating banks that the loss of those banks who were not ready to handle clearing would make the benchmark significantly more volatile.

The LBMA referred requests for comment about the price divergences and the effect of the banks leaving the benchmark to ICE.

ICE declined to comment.

Clearing - where an exchange acts as an intermediary to guarantee and settle trades - is regarded as a necessary progression for the gold trade as tighter regulatory capital requirements increase the cost of trading off-exchange.

ICE has said it will widen participation in the auction by making it easier for newcomers to join, and will ultimately boost liquidity and reduce volatility. Indeed, quantitative trading firm Jane Street Global Trading joined the auction on May 15.

MANIPULATION FEARS

When clearing for the auction was launched last month, four banks - China Construction Bank, UBS, Standard Chartered and Societe Generale - ceased participating.

The reason, according to 10 banking sources and an LBMA source, is that they did not have the necessary IT systems and procedures in place in time, and were thus suspended from the auction by ICE.

UBS, Standard Chartered and Societe Generale are highly unlikely to rejoin the auction, according to three sources familiar with the matter.

UBS, Standard Chartered and Societe Generale declined to comment, while China Construction Bank did not respond to requests for comment.

The volatility was heightened by the reluctance of participants to add so-called flexible liquidity to the benchmark by buying or selling gold during the auction to ensure it stays close to the spot price.

Traditionally banks did so, but most changed their approach after the scandal over the manipulation of the Libor interest rate benchmark and are now unwilling to intervene beyond inputting their orders beforehand, fearing that might be construed as price manipulation by regulators.

Five banking sources said that of the 14 banks and brokers that participated in the auction before clearing began, only four at the most were willing to adjust their orders during the auction. These were key to keeping the benchmark stable because they could respond to imbalances between buy and sell orders, the sources said.

At least one of the four banks that left the auction last month were among those willing to offer flexible liquidity during the auction, according to the sources.

"Adjusting liquidity definitely went down (after clearing began)," said one of the sources, who works at a bank still involved in the benchmark.

On April 11, when the divergence was $12.20, buy and sell volumes did not change for much of the auction as the benchmark moved away from the spot price.

The remaining participants in the benchmark are Bank of China, Bank of Communications, Goldman Sachs, HSBC, ICBC, JPMorgan, Morgan Stanley, ScotiaMocatta, Toronto-Dominion Bank and INTL FCStone.

Goldman Sachs, JPMorgan, Morgan Stanley and Toronto-Dominion Bank declined to comment. Bank of China, Bank of Communications, HSBC, ICBC and ScotiaMocatta did not respond to requests to comment, while INTL FCStone was not available for comment. (Reporting by Peter Hobson; Editing by Pravin Char)

© Reuters News 2017