Paper V Physical Gold

The most common method is through exchange-traded funds (ETFs). ETFs differ from other investment funds as their shares are listed on a stock exchange and can be purchased like any other stock.

Gold ETFs use gold as collateral and offer investors shares in the fund that represent the gold. The most recognized of such funds is the SPDR Gold Shares (GLD), which, according to its prospectus, ‘is designed to follow the price of gold, allowing investors to profit as simply as possible from gold price fluctuations’.

It’s crucial to understand that an investor who buys GLD shares only holds shares in the fund, the gold backing the shares isn’t in their name. Generally, ETFs do not permit the investor to claim the gold when selling the shares. In the rare occasion they do, the investment needs to be significant, often in the millions for larger funds. Even then, there are likely to be numerous legal obstacles involved.

ETF’s most noticeable advantage is their affordability and ease of investment. There’s no concern regarding the storage of gold. However, it’s also important to note that there are significant disadvantages on multiple levels, which would be prudent for investors to consider.

Is the gold really yours?

When discussing gold, it’s vital to discern between allocated and unallocated gold. Allocated gold refers to gold purchased under your name, via your bank or investment fund – signifying that you own the specific bars or coins in the gold vault (or you own it personally). This typically incurs some storage expenses but assures that the gold is entirely yours.

When someone purchases a tangible asset such as a property or car, they must make an effort to confirm that the asset is genuinely in their name. In the case of a car, the registration, colour and make are formally documented. The same principles apply to allocated gold.

In contrast, unallocated gold is gold you’ve invested in, which is not under your name and which you don’t physically possess. This gold belongs to the bank or fund through which you’ve invested, and you only have a claim against that institution. For instance, holding paper gold via an ETF means you do not have any gold in your name. Those gold bars are under the fund’s name. While the fund may hold allocated gold, unit holders in the fund do not.

The most crucial consideration is that in the insolvency of an investment fund or bank, your allocated gold is your asset, inaccessible to creditors. Conversely, unallocated gold is legally owned by the bank or fund and can be used to offset liabilities during insolvency or other severe issues. The same physical gold may also be claimed by multiple parties. This is akin to a situation wherein a commercial bank goes bankrupt, and customers cannot withdraw their deposits anymore.

Consequently, ETFs are exposed to several third-party risks—whether from the fund itself (like risks connected to its management), the bullion banks or the entities that manage and survey the fund’s gold holdings.

The paper gold bullion sector relies on the financial system.

Amongst others, derivatives predominately include futures and options contracts. Just like ETFs, these also serve as substitutes of physical gold. Let’s examine how futures work below as an example (we’ll leave options for now as they are even more complex).

What’s a futures contract?

It’s an agreement between two parties to buy or sell the underlying asset of a futures contract – in this case, gold – at a predetermined time and location. However, in the case of futures contracts, actual delivery of the commodity is very rare, and there is usually a cash settlement when the contract expires. To trade gold futures, you need a trading account with a broker. There are extra costs involved, and futures and options trading is typically the domain of highly experienced and knowledgeable traders.

Whilst these trades may function under normal market conditions, in the event of a financial shock they will more than likely fail.  In the case of a market crash or banking crisis, paper gold contracts will come under risk as counterparties fail to fulfil their obligations.

Why might these obligations not be fulfilled?

Futures and options employ a considerable amount of leverage, meaning they are mainly purchased with borrowed money. There’s much less gold acting as collateral than in tradable securities. Estimates suggest the trading volumes of the entire paper gold market are up to 200 times the trading volumes of physical gold. Futures therefore not only carry risks for the financial system but to other market participants too.

Gold can also be invested indirectly through shares in mining companies. Mining company shares are a much, much riskier investment than gold itself, however. Not only is there huge operational and debt risks, but geopolitical uncertainty to deal with. This can bankrupt a company overnight and numerous, otherwise healthy companies have fallen this fate regardless of the due diligence carried out by investors.

How does the gold banking system operate?

To comprehend how this system functions, we need to delve into the crucial role of bullion banks in shaping the gold marketplace. Bullion banks like Morgan Stanley, HSBC, JPMorgan, Commerzbank,  among others, keep the gold that serves as collateral for exchange-traded funds and futures exchanges.

Understanding how this system works is crucial here. Various institutions and individuals store their gold in bullion banks. This gold can be loaned by the bullion bank to different banks or used as collateral to generate new shares in an ETF. Only a tiny portion of the gold is kept as reserves, with a the majority of gold stored by the bullion banks in turn being borrowed from central banks.

The process closely mirrors how conventional banking operates – when you deposit money in a bank, the bank only needs to keep a fraction of it in reserves and can lend the rest or use it for other objectives. This implies that a bullion bank can generate more paper gold than there is actual gold to back it.

If all individuals rush to the banks to withdraw money, the banks won’t have enough funds to meet their obligations. The same principle applies to gold, despite the lack of precise data on bank gold deposits, and their origin. There simply wouldn’t be enough gold for everyone if all the holders of futures and other financial instruments demanded delivery.

As per a 2013 report by the London Gold and Silver Market Association (LGBFMA), the majority of trades are conducted without delivering physical gold. In fact a staggering 95% of transactions are executed with unallocated metals. This implies that the London bullion market, supervised by bullion banks, is majorly reliant on paper gold. It can be concluded that there’s a significant shortage of precious metals to cover the transaction volume.

Can we trust bullion banks?

Bullion banks play a crucial role in the marketplace by overseeing the management of gold the gold-backed ETFs. They have the authority to add or withdraw ETF shares. However, numerous questions have surfaced regarding the reliability of the banks and the origin of their gold reserves.

HSBC, a crucial gold bank, has been extremely elusive about its gold reserves. In 2011, CNBC reporter Bob Pisani was allowed inside HSBC’s vaults under strict conditions. He was handed a gold box inside the vault and informed it was all recorded and numbered. This incident led to further speculation when ZeroHedge pointed out that the number of the bullion Pisani was holding was not listed on the HSBC bullion list.

The transparency of gold banks is therefore extremely low. It’s unknown where the gold originates and what type of gold the bullion banks use as collateral for ETFs. JPMorgan and HSBC are the ‘market makers’ for the exchange-traded GLD fund and both have been prosecuted recently for manipulating the market. JPMorgan being fined nearly a billion dollars in 2020 for this.

Inevitably, the question arises: can we trust all the participants in the financial system upon which your investment relies? The answer is a categorical no.

Just look back to 2008 where Lehman Brothers, one of the gold banks, collapsed. Had it not been for the intervention of the US government this would have been catastrophic for paper gold ETFs.

• Individuals need to question their motives for investing in gold. If you have faith in the financial system or want to speculate on short-term gold price fluctuations, purchasing paper gold might be a better idea. For those who are also seeking cash flow and are willing to undertake more risk, shares in mining companies could be an alternative choice.
• Without a doubt, paper gold has created a significant vacuum that is dependent on numerous financial institutions. If the gold derivatives market collapses (for instance, if everyone starts demanding physical gold), this could cause physical and virtual gold prices to diverge significantly. Signs of this have already begun to emerge within the silver market. It’s vital to be cognizant of the risks an investor is taking when investing in paper gold.
• If you’re investing in gold to safeguard yourself against inflation, a potential banking crisis, and a collapse of the financial system, physical gold is the only asset external to the financial system that provides such defence.