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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TWSceptic's picture

It's funny how Keynesians expect Austrians to predict the future to the exact date, but they (Keynesians) fail to predict any bubble or crash regardless of the date.

Republicae's picture

Such mentality is interesting isn't it? For rarely do people consider the future until it is right upon them. Take for instance those few voices which were saying that there was the potential for crash in the markets back in 1928 and early 1929, few took heed or paid much attention, yet there were those who just happened to be reading the signs well enough to know that such a potential existed. Likewise, there were those who saw the potential for a crash/panic, they were declaring that the potential was there as far back as 2006, yet few people took heed or paid much attention.

We, or perhaps I shoud say the "collective" population of his country perfers not to see, not to pay attention, not to take heed, rather we like to assume that everything will continue as it has, that some magic concoction can continue to divert the laws of economics just long enough to avoid a disaster, but that can rarely continue for a long period of time before the patchwork simply no longer holds the system together. The FED has tried to patch up the system with every manner of monetary tricksterism possible, but all of the tricks in the world can not avert eventual fiat monetary failure since no such systems have ever been sustainted in history, they all implode.

sessinpo's picture

Check the actual author. Many if not most articles are not by ZH but by other authors that ZH redistributes. But no matter where an article comes from, it is up to the reader to do due diligence and research. Obviously, something you don't.

Bansters-in-my- feces's picture

Here here....


Chemtrails all round.

DoChenRollingBearing's picture

Paper gold?  Read FOFOA!  Bitchez!

dlmaniac's picture

The funny thing is FOFOA's Freegold system is a PAPER SCAM in iteself. Bitchez!!

It advocates such snake oil that bankers should still force people to use FIAT paper as currencies but offer them gold as savings so that bankers would discipline themselves from inflating it too much. 

To those of you believing in such banker offer I've got a bridge in Alaska ...

DoChenRollingBearing's picture

Ahh, no.  

No junk, but I think you are reading FOFOA wrong.

He really is in favor of competitive currencies, and not by force.  There will ALWAYS be a need for some kind of fiat, for easy transactional use.  FOFOA posits that gold will be used as a store of value, and that paper currency will flow for everyday purchases.  You will not hold paper currency (for long anyway), you will SPEND it!  That's what the paper is for!

You could always use your gold (silver) to spend, but that would be a little inconvenient, just as it is now.

dlmaniac's picture

The key flaw in his freegold theory is still letting bankers issuing FIAT. Once you allow the bankers to do it you will have them attack your gold for sure b/c the bankers would never tolerate an honest gold price revealing how much they have inflated and stolen. There's no justification in letting a privileged group issue FIAT to spend while everyone else has to work for it especially when this group is notorious for abusing it.

Motley Fool's picture

I think where you are missing the plot is in thinking the bankers are the ones with the power.

The people has always had the power.

Sadly for a long time they have saved in paper, which gave bankers the opportunity to run their scams. The people in effect screwed themselves.

Once the people save in gold, the bankers will be SOL.

The bankers never had the power you attribute to them, the power has always belonged to the people.


fijisailor's picture

Trouble in America is that the people don't save.  They run on credit. Therefore paper remains king until it collapses dramatically.

Motley Fool's picture

Well there is truth in that, but it is also a gross oversimplification.

The lower income groups that live on welfare have no savings to speak of, this much is true. And for the most part the rich are not stupid enough to save in fiat.

The middle class however, yuor consumers, have a net position that is perhaps slightly slanted towards indebtedness. On the one hand they have consumer debt, and mortgage debt, but on the other they have a small amount of savings, and then their pension funds.

While they may be debtors on net, we cannot ignore the latter.

fiftybagger's picture

It has been estimated that as much as 9% of the 1 trillion in welfare money is spent on the lottery.  That 90 billion would buy 3 billion ounces of silver.  Not only do the people have the power to end it.  Just the people on welfare alone do.

Silver For The People

dlmaniac's picture

The claim "people have the power" is misleading. If I can print FIAT whenever I feel like to while everyone else has to work to earn it then I have the power. People ain't.

Were it "people have the power", people should be able to issue and use own money but that's neither what is happening now nor what would happen in freegold. In fact, bankers are the one with the privilege to issue and force other people to use their FIAT, and would retain such privilege in freegold as FOFOA insists it'd work. 

The freegold folks get upset when we call them out on being banker apologists. Well, if they keep defending such privilege for the bankers then they technically and necessarily are banker apologists.

Motley Fool's picture

The problem is not in what people are forced to used to spend with, the problem is that people should be free to choose in what to save in...and that they really should not save in paper.


Where does fiat money get it's value? The printer of it certainly doesn't tell you what it is worth in trade for real goods. You find out it's worth when you offer it in payment for real goods.


There is a definate need to store value, to defer consumption, for say retirement. You have any number of choices of what to store value in. You might choose paper money, or silver, or art, or property or gold, or hell nickels.


The problem with most of these things is that they can be manufactured on demand. The exceptions here are silver and gold, where despite massive rises in price, mine supply has not increased much.


If people no longer store value in money ( for savings for eg retirement), then there is a much smaller pool of true value which the bankers can dilute. And, if people save in gold, and they try dilution of the paper currency, well it reacts pretty quick spoiling the scam.


Fiat is usefull for making payments in. Just think about buying some online music.


With the pool of value stored in fiat drastically reduced people would only keep such currency as they need for daily expenses. So the fiat would still have some value as long as it is freely exchangeable for gold at demand. And as I have said, any crazy inflation that the bankers tried would mean people drop the currency in favour of gold or other currencies, which means the bankers lose all benefit.


Hope these thoughts help.

sessinpo's picture

dlmaniacL  "The claim "people have the power" is misleading. If I can print FIAT whenever I feel like to while everyone else has to work to earn it then I have the power. People ain't."


Comment: You miss the concept that power isn't just in printing. In other words, you can take your fiat currency and convert it to whatever assets you like, thus the power still remains with you despite whatever printing occurs. You lose your power as government enacts more restrictions on you to convert your assets or if government simply confiscates assets.


Some like to talk about the hidden tax in inflation. Why aren't those people talking about places to reinvest their assets to beat inflation? But that point is mute. Since my opinion is that we are in a deflationary environment, that should direct the discussion.

Optimusprime's picture

You might wish to read Dave Harrison's ruminations on the "divorced currency" agenda and FOFOA's probable role in all this.  Trade with Dave is his blog.  He has read FOFOA but is not onboard. 


Dlmaniac may be on the right track in his skepticism.

Motley Fool's picture

I have followed your advice and went to Dave's blog. I searched in vain for sensible criticism. Most of what I saw was vague inuendo like "I don't trust him", and promises of more later.

I have mailed with him to ask for help in this regard. We will see what ensues.

Marco's picture

You don't need fiat for transactions, 100% reserve gold certificates facilitate transactions just fine ... what you "need" fiat for is the ability to inflate the money supply together with economic growth, because supposedly without that the (psychological) incentive to invest for most holders of financial capital would not be sufficient.

dumpster's picture

all the paper gold stuff .. gold is not paper ... those who write about paper gold are probably also setting in little plastic pools of spit calling them swimming pools .

long articles to fill up space .. and still not having a clue .    since 250 gold and 4.00 silver the on lookers try to do the song and dance to cover up their inability to act for the loss of the value of paper .

the buck has lost value and buys less and less of gold even at 1750 ..the buck goes down and the little brains think the game has not changed ..

looking at life through the lens of purple bubbles


ATM's picture

Those who lean most towards Totalitarianism also seem to be the most anti-gold. I wonder why that is?

sessinpo's picture

Relative to the amount of debt and massive printing, the US dollar has held up quite well. Conversely, considering the massive printing, why isn't gold over $3000/oz?

Yen Cross's picture

Look up David Smith in the "Yellow Pages"... It's just above Fiscal Cliff...

AUD's picture

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.

More of the erroneous & pernicious quantity doctrine.

Even if there is no flow at all, it doesn't mean there is any demand, thus price. Quantity has no bearing on value, thus price. The fact that gold has a large stock to flow ratio is an irrelevant consequence of its quality. It is quality that determines value, thus price. The quality of gold is eternal, it thus a standard. Gold is unlike anything else on Earth.

And the rest of this article is worthless.

mayhem_korner's picture



You need to explain your "thought" in terms understandable by those who speak logic and can add.  Cuz your word salad ain't makin' sense, Jethro.

If there is 10x the claims as there exists the physical product, then what is the actual value of the physical product?  Take your time...

awakening's picture

25x (10x for price correction + my 15x guestimate for the demand increase).

Banjo's picture

Forget about price and a liquid market for the time being, If there is NO FLOW bearing in mind with gold a 65 year production overhang. Then we are saying at the extreme of S&D supply is ZERO or demand is ZERO as either extreme.

To increase supply price would have to go up. (liberate some of the 65 year overhang or current production)

To increase demand price would have to go down.(send it to 50 cents a kilo and I can buy shiny stuff for the wife and kids)

There IS DEMAND as exhibited by golds risen in price for over a decade. This clearly indicates DEMAND.

If you increase gold supply by PAPER flow you satisfy demand with promises and reduce price pressure.

ArrestBobRubin's picture

"Paper Gold" is a great example of Orwellian newspeak. An oxymoron.

Don't be a moron. Just go with Gold Gold.

Supernova Born's picture

Paper Gold*

Nutritional Information:

Contains 100% of your FRB daily recommended amount of Au.

*contains 0 nanograms of gold per serving

tradewithdave's picture

Who needs paper gold, or even physical gold when there is the much more secure In-Situ gold?  ... nearly impossible to steal.


Yen Cross's picture

 I trade paper for a living, and I'm telling you to buy metal!  Get smart people, and buy in tradeable denominations/


Urban Redneck's picture

ALL denominations are tradeable- a 1 gram sliver can be traded to fill up a sedan with 89 octane for a trip across town, or a 10oz bar can be traded for enough A1 for a transoceanic hop.  If your usual counter party is a bullion bank- they prefer GDs or KGs.  I think the more important point is don't put all you eggs in ONE basket, bar, or coin.

If you wanted to convert a nice house into a good delivery bar, DON'T, but rather go for 40 x 10oz bars, or

If you want to forgo the nice new car and get a kilo bar, DON'T, but rather get 30 x 1oz coins, or

If you are getting sick of that few grand of fiat that is getting moldy and worthless while sitting in your bedroom closet safe, convert into a bunch of gram, tenth oz, or quarter oz pieces.   

reader2010's picture

There isn't any Paper Gold since I haven't seen and touched any. What so-called Paper Gold in reality is the digital gold that they can type it up at any moment. At least in the worst case senario you can wipe ass with paper gold. but you can't say the same for the digi-gold.

Yen Cross's picture

/.20 /.50 /1toz tradeable denominations.  Coins that you can walk away from" with out", asking for change.

  I just bought a shitload of platinum and silver

yabyum's picture

Did you buy a boat? do you know how to read a river? run a rapid? All of your shit GONE...gone to the bottom...Well done young hedger!

Yen Cross's picture

 Nice to meet a fellow "  salvage operator".

R Man J's picture

I am shocked at the many physical metal investors who have had boating setbacks. I do not own a boat, but the DNR has designated the back of my property a "wetland".

Yen Cross's picture

We can find a spare Dinghy for ya! ;-)

Bastiat's picture

You don't even need a dinghy to lose your gold-- I've heard terrible stories of people burying the stuff and forgetting where,  Either that our somebody find it and did it up.


Bastiat's picture

You don't even need a dinghy to lose your gold-- I've heard terrible stories of people burying the stuff and forgetting where,  Either that our somebody find it and did it up.


Bastiat's picture

Double post and spelling worse than usual-new 7" tablet.

EARLPEARL's picture

never owm a boat...always rent boats,much cheaper and more convenient than owning

tenpanhandle's picture

"I do not own a boat, but the DNR has designated the back of my property a "wetland"."

I believe, in this instance, falling into the bog in your chest waders while carrying your stach of heavy coin is sufficient to be classified as man overboard and your coin becomes trove.

mayhem_korner's picture



YC...also "junk" silver - pre 1965 quarters, pre 1944 dimes/nickels, etc. should be viable currencies in small denominations.  Lotsa (first) depression-era folks have stocked them for that rainy day that's a-comin'.

Drachma's picture

"...the total amount ever mined..."

What an intriguing concept, rife with suppositions in calculation.

Yen Cross's picture

 No tungsten in my inventory!

tenpanhandle's picture

All my gold is belong to me!