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In our last post, we saw that gold trackers – which replicate the price of gold in a given currency – have three advantages: they are easily accessible, very liquid (in principle) and not very costly.
As you know, there exists no financial product entirely devoid of inconvenient, and gold trackers are no exception.
A difference in nature: gold trackers expose you to 6 risks that could be avoided with physical gold
Those risks are theoretical, of course. However, a string of scandals these recent years (MF Global liquidation in October, 2011, PFGBest scandal in 2012...) that saw precious metals investors left with only their own eyes to cry with are a reminder of having to vet financial partners with the utmost thoroughness.
Hinde Capital manages the Hinde Gold Fund. It published a report that shows the different risks associated with gold trackers. Here is a summary I made of it in my book:
“Not all gold trackers treat shareholders the same as far as ownership rights on the underlying gold go. Contract clauses to the effect that the operator reserves the right to reimburse shareholders in cash or to not deliver more than a certain quantity of bars put limits on real ownership rights. Professor Antal E. Fekete reminds us that, “even if the gold is allocated or kept in a separate location, (...) the operator may be tempted to default”, which is akin, for the saver, to having a sword of Damocles overhead.
Multi-ownership risks are due to the accounting standards in place for gold trackers. Since the custodian bank of a non-allocated account has the right to lease the gold in that account, analysts at Hinde Capital estimate it is “highly probable” that non-allocated accounts – and also some allocated accounts – comprise double-entry accounting physical bars, meaning several owners. Nobody knows for sure how much paper gold has been issued with no underlying physical gold to back it up. In 2009, GATA’s analysts evaluated that each bar had been sold “at least 20 times”. At the end of 2012, many experts agreed to a ratio of 100:1 between paper gold and its physical counterparty really available.
Intermediation (or counterparty) risks
Operating the gold trackers system involves the intervention of several intermediaries, notably the custodians, under-custodians, depositories and many more. Hinde Capital analysts estimate that, “in the case of custodian insolvency, the administrator in bankruptcy could try to freeze access to the gold held on all the custodian’s accounts, including allocated ones”.
In case of widespread loss of faith in the capacity of depositories to fulfill their obligations or in a systemic risk scenario, many gold tracker shareholders would ask for delivery of their bars (provided their contract allows for that possibility) to ensure real ownership of their metal. If there are multiple owners of bars, certain shareholders could not obtain delivery in a timely way (if at all), since depositories would first have to recover the bars they leased to other institutions (non-allocated gold may be leased to other banks that use that gold to increase their stocks on which their own GETFs are guaranteed, which opens the doors for a Ponzi scheme). Moreover, a systemic risk situation is precisely when everyone wishes to benefit at once from full ownership of their metal. And it’s the same thing with hyperinflation, when cash offers no use.
A run on trackers would take the form of musical chairs. But, contrary to the children’s game where only one of them is condemned to remain standing when the music stops, there will probably be many more people without a chair. No one knows for sure how many contenders there are per chair, but massive redemption requests translate migrating from a world of promises to the real world or, in other words, de-leveraging. Whereas it is quite easy to get into this market, getting out of it in a context characterised by strong competition to obtain delivery of one’s metal could prove to be quite ruinous.
Risks arising from custodians’ conflicts of interest
The fact that JP Morgan Chase and HSBC are the depositories of GLD (gold trackers) and SLV (silver trackers) ETFs and, at the same time, own the largest naked positions on those markets (see p.106) throw an air of suspicion. Many analysts are worried that those two banks use the gold under their custody to short the gold and silver markets.
In light of this patent conflict of interest, it appears that physical gold is safer when stocked with depositories specialised in storage than with entities whose main activities consist in lending money.
Paper gold is mainly traded in US dollars. Savers using another benchmark reference currency are thus exposed to a currency risk, because fluctuations between their currency and the dollar have an impact on the value of their gold tracker shares.
However, certain gold trackers are available in multiple currencies and come with a currency hedge. They allow to be solely exposed to the gold price variations in dollars (minus the cost of hedging) without any monetary incidence.
With “paper gold”, one favours flexibility over the security brought by owning physical gold directly.
To conclude, gold trackers cannot be put on the same level as physical gold, which remains the only gold asset that serves as real wealth insurance. In a coming post, we shall see what kind of performance your clients can expect by taking a position in this asset class.