Gold And The Potential Dollar Endgame Part 2: Paper Gold, What Is It Good For?

Tyler Durden's picture

Authored by Dan Flynn and Joe Yasinski of Gold Bullion International,

Part 2 of 3: “Paper Gold, what is it really good for?”

In our first installment of this series we explored the concept of stock to flow in the gold markets being the key driver of supply/demand dynamics, and ultimately its price. To briefly summarize the STF concept, the “stock” of existing gold is the total amount ever mined and the “flow” is the amount of physical gold available for purchase on any given day. Obviously the more flow, the more for sale and presumably, the lower the price. Today we are going to explore the paper markets and, importantly, to what degree they distort upwardly the “flow” of the physical gold market. We believe the very existence of paper gold creates the illusion of physical gold flow that does not and physically cannot exist. After all, if flow determines price – and if paper flow simulates physical metal movement to a degree much larger than is possible – doesn’t it then suggest that paper flow creates an artificially low price? If the physical metal does not actually flow along with paper representations of flow, then isn’t it true that the current stock to flow ratio may already be much higher than previously imagined?

When we talk about “paper” markets, we are broadly referring to derivative markets; forwards, swaps, and in the case of gold, unallocated gold accounts as well. Derivative markets for commodities were developed to smooth the wild price swings caused by supply gluts or unexpected shortages. The first modern exchange for rice dates back early 18th century Japan. By 1848, the Chicago Board of Trade was formed, originally clearing trade of forward contracts on corn. Consumed commodities tend to exhibit tight supply/demand dynamics so it is easy to understand the necessity for such ‘paper’ markets for legitimate hedging purposes. As discussed in part one, gold is not consumed and given the existing stock and annual mine production – there is an approximate 65 year ‘overhang’ of new mining supply. Can you imagine the need of Cargill to hedge the cost of corn if a non-perishable, 6 decade supply sat in their warehouse? With a relatively massive existing stock of gold, there is no potential supply shock to hedge against – and the need for a large derivative gold market seems completely illogical. It follows that as the derivative market for most commodities developed over the last 3 centuries, the gold market remained “physical only”. Whether for settlement of international trade or otherwise, there was no need for ‘paper gold’ as the marketplace for and the flow of physical gold bullion was robust.

Things began to change in the 1970’s following the US default on the Bretton Woods agreement as the $ Dollar detached from its’ golden anchor. The $USD price of gold rose over the decade from $35/oz. to $200, then $300, then $400, reflecting the uncertain value of the newly fiat currency. As gold’s price rose, its’ flow slowed dramatically, putting further upward pressure on the price, ultimately pushing it above $800/oz. Seeing higher gold prices, many new mines came on-line chasing the higher prices. The new mines needed cash capital to get up and running, and the bullion banks offered loans. The US futures market for gold opened in January 1975, and by the late 1970’s, a gold company could take a loan, denominated in ounces of gold, at a much lower rate than they could take a traditional cash loan. Originally referred to as “mine finance” (Guy, 2012), bullion banks could offer lower rates of interest on loans tied to physical gold as they didn’t have to compensate for the rapid loss of purchasing power in fiat-currency denominated loans. By 1987, the London Bullion Market Association was incorporated. This collection of dealers and banks developed guidelines for clearing arrangements, options, and the development of the Gold Forward Option Rate (GOFO) – furthering the development of bullion banking. “Paper Gold” was born.

In typical Wall Street fashion, below-market interest rate gold loans began to attract the attention of hedge funds and other large pools of capital interested in using leverage to take advantage of the spread between various “risk-free” rates. Bullion banks were able to offer attractive terms to private holders of gold in return for gold deposits. This in turn allowed for more gold-denominated lending, even to borrowers who were not producers of gold. Great idea! What could possibly go wrong?

Most gold trading – both physical and paper - clears through the London market, with dealers and banks settling transactions for clients around the world. According to the LBMA website, “a credit balance on a loco London account with an LBMA member represents a holding of gold or silver the same way that a credit balance in the relevant currency represents a holding on account with a New York bank or Tokyo bank.” Further, the LBMA explains “Credit balances on the account do not entitle the creditor to specific bars of gold or silver, but are backed by the general stock of the bullion dealer with whom the account is held. The client is an unsecured creditor.” (London Bullion Market Association, 2012)

Let us pause here to re-emphasize a point. When you deposit money at a New York or Tokyo bank, you no longer own the money. You own a claim – you own bank credit. Banks are free to use deposits as they please – typically as a base to leverage – aka fractional reserve banking. As the LBMA points out, loco London accounts operate in the same way – they are bank credit denominated in gold. So long as the bank meets its’ contractual obligation, paper gold and allocated physical are fungible.

Over the decades, the derivative market for gold has grown exponentially. What began as a means to finance new gold production has morphed into an untenably leveraged marketplace.

As US Dollar denominated obligations have skyrocketed, so has the demand for hedges against the US Dollar. Gold is the ultimate fiat currency hedge. As discussed in part 1, gold is a Giffen good. Unlike other commodities, physical gold becomes scarcer as its price rises. As long as the marketplace holds “paper” gold on par with physical gold, the dollar price of gold is suppressed because of the new, synthetic paper flow. In order to maintain confidence in the $USD as a store of value – flow of gold bidding for dollars is desperately needed. As we see it, the US Dollars’ ability to function as a store of value, and global reserve currency, is now completely dependent on the continued flow of (and confidence in) ‘paper’ gold.

How big is the flow of this combined market? Total trading volume for 2011 was estimated at 50,459,865,000 ounces. (Gold Fields Mineral Services, 2012) 50 BILLION OUNCES!! As a point of reference, the World Gold Council states that annual mine production for the last 5 years has averaged approximately 83,000,000 ounces, and total above ground stock of physical in all forms is approximately 5,465,500,000 ounces. (World Gold Council, 2012) One might conclude that a significant amount of leverage exists in the gold markets given the fact that in 2011, the volume of paper gold that traded equaled 10x the amount of physical gold that has been mined in history! Consider further that the WGC estimates that only 19% of existing above ground stocks is categorized as “investment”, and nowhere near all of that 19% sits in LBMA vaults in good delivery form, ready to satisfy paper claims. Further, Central Banks (estimated to hold approximately 20% of the gold stock) today are net buyers – not sellers.

Gold spot futures and options

At its April 2011 meeting, the LBMA Management committee agreed to survey its 56 full members for trading turnover in the loco London gold market. The World Gold Council, who has been advocating for the inclusion of gold as a high-quality liquid asset under Basel III, wanted the LBMA to help demonstrate the depth and liquidity of the gold market. (Murray, 2011)

Typically, only monthly clearing statistics are available from the 6 clearing members that form the LPMC (Barclays, Deutsche Bank, HSBC, JP Morgan, UBS, and ScotiaMocatta). These clearing statistics include transactions executed within their own books and between each other. The last liquidity survey was carried out and published in 1996 and was restricted to the LBMA’s market makers. By August 2011, 36 of the 56 Full LBMA trading members submitted returns for the new survey, and the results were rather shocking. Quietly, the size of the “paper” gold market had grown to monstrous proportions – successfully creating a tsunami of paper gold flow. In fact, according to the Q1 2011 LBMA Liquidity survey, over 173,713,000 ounces or 5,400 tons of “paper gold” per day (more than 2 year annual physical production) turns over with only 2/3 of LBMA members reporting! The surveyed turnover of the 56 LBMA trading members demonstrates total loco London volumes (perhaps not surprisingly) ten times the size of the 6 LPMC members. Without question, the gold market “flow” is dominated by the paper market. Yes, good old fashioned physical bullion does trade hands OTC – and at GBI we facilitate physical transactions every day. But the great majority of physical lies very still while paper changes hands rapidly.

We have a better idea now how much paper gold is flowing, but it’s crucial to understand the leverage that paper flow represents. How many paper claims exist on the relatively small stock of bullion? For a few hints, we can look to the COMEX. As of October 30, 2012 COMEX gold Open Interest equaled 454,742 contracts (45,474,200 ounces of gold). COMEX registered inventory stood at 2,735,041 ounces for a factor of 16.6X. (CME Group, 2012)

Is a leverage factor of 16 enough for you to take action? For some very prominent fiduciaries, the answer is a resounding “YES”. In a 2011 interview Kyle Bass of Hayman Capital (who helped the University of Texas Endowment take delivery of nearly $1 Billion in physical gold bullion) described a conversation he had with an exchange official:

“When I talked to the head of deliveries at COMEX NYMEX, I was like, ‘What if 4% of the people want deliveries?’ He said, ‘Oh Kyle, that never happens. We rarely ever get a 1% delivery.’ And I asked, ‘Well, what if it does happen?’ And he said, ‘Price will solve everything’ and I said, ‘THANKS, GIVE ME THE GOLD’. (Bass, 2011)

Let’s look at the leverage a different way. In 1Q11, the 36 reporting members of the LBMA disclosed gold sales of 5,593,743,000 ounces versus purchases of 5,350,183,000 ounces (see line 1 – London Turnover). Based on the survey, we deduce that in 1Q11 excess demand for gold was 243,560,000 ounces which translates into approximately 7,575 metric tons. In a typical year, quarterly physical production (new mining supply) is approximately 625 tons. One would imagine that with a traditional commodity, physical demand outstripping new supply in a given quarter by a factor of 10 would cause a significant increase in price!! And for commodities like copper, corn, or cotton that would certainly be true. Yet during 1Q11, the price of gold rose from $1410 to $1439…a $29 dollar per ounce increase. (LBMA, 2011)

Q1 turnover

If one is viewing gold as a currency, this data is to be interpreted differently. A large player using paper gold to hedge $USD exposure doesn’t necessarily think of gold in terms of ounces, but instead looks at these contracts in terms of dollars. (FOFOA, 2011) For the currency trader or $USD hedger, the more relevant data point is quarterly demand of $337 Billion (Line 1, total value of sales net of purchases). We believe that the largest holders of physical gold have very strong hands – and $1,400 per ounce is nowhere near high enough a price to coax significant new flow into the market. As a simple mind exercise, let’s imagine this dollar denominated gold demand was met exclusively from new mine production – no paper flow and no existing physical bidding for dollars. Based on the LBMA liquidity survey and WGC data, newly mined (average) per quarter flow of 625 tons physical gold would have needed to absorb 100% of that $337 Billion dollar demand. And in order to do so – gold could not have been at $1,400/oz. Instead, to clear the market gold would have averaged a price of $16,920! This is a partial glimpse at the true Freegold concept (Another, 1997) – no paper gold flow – a return to a purely physical marketplace. Although this may sound like an amazing price - if we apply a “reserve” factor of 16.6 to the LBMA demand statistics, we’d suggest that $16,000 gold would be a bargain. It’s all a matter of perspective.

Leveraged systems are based on confidence – confidence in efficient exchanges, confidence in reputable counterparties, and confidence in the rule of law. As we have learned (or should have learned) with the failures of Long Term Capital Management, Lehman Brothers, AIG, Fannie & Freddie, and MF Global – the unwind from a highly leveraged system can be sudden and chaotic. These systems function…until they don’t. CDOs were AAA… until they weren’t. Auction Rate Securities were great ‘cash management’ vehicles…until they weren’t. “Principal Protected” Convertible Notes underwritten by Lehman Bros were like CDs…until they weren’t. Paper Gold is just like allocated, unambiguously owned physical bullion…until it’s not.

At GBI, we believe THE WAY to hold gold is via unambiguous ownership, allocated and held outside of the banking system. Any other way introduces unnecessary and potentially catastrophic counterparty risk. We’ve built our company to give clients the same or better liquidity and trading convenience as the ‘paper gold’ alternatives – but with the safety and security of insured storage, geographic diversification and clear title that whole bar and/or coin ownership brings.

In the final part of this series we will discuss what we see as signs of major stress in the paper gold market and what the end-game might look like for holders of paper contracts as well as owners of physical bullion.

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davidsmith's picture




And ZH has been writing articles about the dollar endgame many years now?


How's that dollar endgame thingy workin' out for you?  Oh I forgot.  It's just around the corner!

topspinslicer's picture

the road to the end game is expensive as in gas at 3.69 rather than 1.69 douchebag

Bay of Pigs's picture

GOLD vs the US Doelarr?

Set to close up for the 13th year in a row. So what's your point? That it isn't losing purchasing power?

Stick it in your ear assclown.


flacon's picture

It's good for options trading to make more electronic to buy more physical. 

TwoShortPlanks's picture

@davidsmith, yeah, let me know how eating out of a wheelie bin goes for ya fucktard. Oh, that's right, I won't be in YOUR neighbourhood.

Supernova Born's picture

Since gold was about a 1/3rd or so of its present cost in FRN?

GetZeeGold's picture



Gold was 1/43 the present cost in today's FRNs the last time Fort Knox was audited.


Not to worry....I'm sure the government is on top of it.

EnslavethechildrenforBen's picture

By definition, the word "economy" can only be used to describe the conditions of a country that is on a Gold Standard.

Paper currency is not money and is always used to trick people out of their land, resources and labor.

Gold is not printable.

 GLD is only paper, printable for eternity, allowing for complete control and manipulation of it's price .

EnslavethechildrenforBen's picture

To value your assets or wages in real money, divide your paycheck by the price of silver. If you make $350 a week, you are actually earning about $10 in real money, otherwise known as Silver Dollars.

If the price of Silver were not being manipulated downward with the use of SLV paper, and Silver were allowed to find it's actual paper value of $200 per ounce, your $350 paycheck would actually mean that you are only getting paid $1.75 for your 40 hours, or less than 5 cents per hour.

Therefore, if you wait to buy Silver, when you get around to it you will only be getting 5 cents worth for an hours labor, thanks to your United States (Banker) government. You might want to buy Silver, Gold , Platinum and/or Palladium now, while they're at a discount.

And why are you learning this from the comments section rather than from one of the so called authors here on Zerohedge?

sessinpo's picture

I know you have a lot of up arrows but you comment is false. Up arrows were given by people that have an emotional perogative towards a gold standard.  I noticed you didn't qualify you statement with a definition of economy.


The fact is, an economy is the financial conditions of a region using whatever ACCEPTABLE means of trade. The US dollar is the current acceptable means of trade. While I wish it wasn't so, that is still reality.


Anything can be used as a means of trade. And, more importantly, which many gold bugs seem to miss, gold as with other markets, can be manipulated to trick people out of their land, resources and labor.


ActionFive's picture

sly way to favor electronic transactions

Harbanger's picture

 "Central Banks today are net buyers – not sellers. "

Buy Gold and become your own Central Bank, Bitchez!

Yen Cross's picture

The Peoples bank of China ( tourism) / welcome " PROMO"...

Poor Grogman's picture


Paper Gold, What Is It Good For?

Arb-ing physical of course..

My speciality.


Next question???

Supernova Born's picture

Paper "gold" is ironically one step FARTHER away from actual possession of gold than is $1714 in paper FRN currency.

Mr. Mandelbrot's picture

Paper gold is like a lesbian: when it really comes down to it, it won't function . . .

WmMcK's picture

Paper gold is like a lesbian: when it really comes down to it, it ...

doesn't no dick?

Yen Cross's picture

 Come on fellas/ I'm just joking with you...  I have been gobbling up the shiney stuff for quite some time!

CheapBastard's picture

Zombie Banks borrow at 0% from the Fed then max leverage shorting the yellow metal. It's the 'New Paradigm.'

kliguy38's picture

yeh that barbarous relic is posing a major problem for the game.....two word explaines the ultimate checkmate.....physical possession

August's picture

"Once the precious metal leaves the approved chain of custody, it loses its authenticity."

-  Gold Bullion International

Urban Redneck's picture


You do know it costs less than $1/oz to have new good delivery bars made from GD bars you take delivery of (versus far for more than $1/oz daily volatility), and that there is no guarantee that an approved bar received from an official custodian is actually gold in the first place, unless you have it melted.  


August's picture

"You do know it costs less than $1/oz to have new good delivery bars made from GD bars you take delivery of...."

Thanks for that; I'd hate to be stuck holding a bar which lacked "authenticity".  I'm a firm believer that one's deep gold should be held directly under one's own physical control, not allocated to an account by what appears to be a trustworthy dealer or financial firm. I thinks it's slightly amusing that the authors, who debunk paper gold, represent a firm which strongly suggests that one should hold metal in an account ("allocated" or not), rather than take possession.

Unfortunately, I don't own any GD bars, but I suppose in a pinch one could melt down Maples;  I suspect, however, that holding one ounce Maples gives one a more flexible and less conspicuous position as compared to a GD bar.

Urban Redneck's picture

The cost per oz is much higher with the smaller units.  Coins are also much easier to measure and ping against the table top, which would weed out any fakes, and your risk is divided across all the coins you own.  However, unless you can print your own fiat, the GD bars hold a lot of risk when each single brick is 1/2 million and the guarantee is only a few hundred dollars.

Mr Pink's picture

Yeah! stick it in your ass earclown!

mayhem_korner's picture



LOL!  Brilliant.  I'm picturing Joe Biden (the plagiarist).

Seize Mars's picture

Clown it in your stick, EarAss.

(I just wrote a computer program that came up with that. Pretty nifty, right?)

mayhem_korner's picture



Umm...maybe avoid posting that on your page.

zerozam's picture

Dude... rule 1: algos are never nifty.

StychoKiller's picture

Hmm, algorithms can be elegant though!

Northern Lights's picture

How about that can of Coke Cola that was a $1 now costing you $20?

prole's picture

I think that is what a can of beer costs these days about 20 bux.

As far as Coke they want you to poison yourself with that krap and consume their subsidized HFCS/poison concoction too so they give that (used motor-oil-like liquid substance) away for free.

Free beer? Nyet comrade. High sin-taxes for anything you actually want ( and a dozen other taxes )

Seize Mars's picture

I spent about 50USD on a six pack of Bud in Tokyo one time.

mkhs's picture

Why? It's not like it is even a good beer?

Seize Mars's picture

Bitter resentment toward the locals. I just wanted something that said "Made in St. Louis, Missouri" on it. Well, as it turns out, they charge you for that.

Jonas Parker's picture

How about that can of Coke that used to be 10¢?

stant's picture

currency induced cost push inflagtion sucks

Bear's picture

Best possible play. Take all the money now deposited in banks and buy physical gold and simultaneously sell paper gold. Physical gold relative to paper can never go down, but the collapse of paper gold could make a lot of scratch and still hold physical in your hands.

Yen Cross's picture

aud/usd is going down/ next week Bear! It's going into the 90's!  usd/jpy-audjpy   eur-aud gbp-jpy!

  I'm on that trade like " boobies on a sunny day"...

killallthefiat's picture

Seems like forever coming, but once it gets here, you won't believe how fast it came.  +1david

ali-ali-al-qomfri's picture

FOREX play, all anticipation then wham!, done.

mayhem_korner's picture



Hey long has the US dollar been in existence?  And what percentage of that existence has zerohedge been around?  Not a real long time, eh?

Oh, and by the long has the US federal deficit exceeded GDP?  And for how many multi-year stretches of history has the Federal Reserve maintained ZIRP?  And how many of the last 100 years or so of the dollar's existence has the Fed's balance sheet reflected multiple $Trillions of "asset" purchases? And why is it that there is chronic inflation in commodities and deflation of leveraged assets over the past 5 years of "recovery"?

Last question: apart from printing more fiat dollars, how is a $100+ Trillion GAAP debt going to be paid down on the back of a nominally $15T GDP?

BTW...this is a great article to those of us who are not infested with logic-repellent antibodies.

fockewulf190's picture

The article shocked me, and I´ve been stacking since 2008.  I knew paper gold was the instrument responsible for the market price manipulations, but never imagined just how unbelievable this trading system has degenerated into.  If the gold market is being raped this bad, the silver markets must be getting absolutley gang-banged.  No wonder the Chinese are buying up as much Phyzz as it can and encouraging it´s population to own gold and silver.  No wonder the CFTC isn´t doing jack shit.  They can´t.  This bitch is economic nitroglycerin and when it drops it is going to be the primer charge that causes the rest of the $650+ trillion derivatives market to detonate and cause the Great Reset. 

Future generations are going to curse the people of our time for the festering shithole this Earth will end up being for them. 

Time to go all in with the last of my powder, get my Phyzz, and go on a boat ride.  What the hell else can you do?

fockewulf190's picture

PS: Sprott may end up being a trillionaire when this story finally plays out, but I doubt he is going to have much shadenfreude.

The Duke of New York A No.1's picture

Sell Dollars and go Long NY FED Tungsten! - oh ya Baby!.

SeattleBruce's picture

@davidsmith: "And ZH has been writing articles about the dollar endgame many years now?"

And that makes it any less true?  Have you read any financial history, ever?

BadKiTTy's picture

@ davidsmith

Not many is the the answer to that. Just because things don't happen in your ADHD timeframe does not mean they won't happen!


boatman's picture

google david smith.............comes up bernanke's brother in law.

there are guys sitting in dusty little cubes paid to pound on the keys to be david smith.