The Rehypothecation Of Gold, And Why It Matters

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

Claiming to own X quantity of gold is one thing, and reporting how many times the gold has been pledged as collateral is another.

When correspondent Scott A. Batten offered to write an explanation of the rehypothecation of gold and why it matters, I quickly accepted. Like many others, I have breezed over the word rehypothecation with the basic understanding that it means assets pledged by counterparties (such as the infamous copper stored in Chinese warehouses) are reused as collateral/repledged--in effect, the same assets are pledged as collateral multiple times.
But beyond this, I have not had a clear understanding of how the rehypothecation of gold reserves threatens the whole shaky edifice of Infinite Greed, oops, I mean neoliberal capital markets.
Here is Scott's commentary:
When introducing a new concept, it is best to start with the definition of the words to be used. In this case, the discussion of rehypothecation and how it places the world at risk with the fun and games played in the stock market.
Rehypothecation occurs when your broker, to whom you have hypothecated -- or pledged -- securities as collateral for a margin loan, pledges those same securities to a bank or other lender to secure a loan to cover the firm's exposure to potential margin account losses.
When you open a margin account, you typically sign a general account agreement with your broker, in which you authorize your broker to rehypothecate.
Now, let’s put this into easy to understand language. Let’s say that you have ten dollars. You take it to the bank to let them “borrow” it, while paying you interest. What you have done, in reality, is given them your money to use as they see fit, while giving you a small percentage of the gains that they will earn. A bank would loan the money to a home buyer or perhaps a small business. At the very least, they can lend all the money in excess of their requirement to hold some cash as reserves--say 10% for ease of math.
They now have nine dollars to invest. Their last resort is to offer it to another bank for that bank to “hold”, because that bank doesn’t have enough money to meet its required reserves. Seems simple enough, right?
Welcome to the games bankers play to make money. Now that this simple format is in place, let’s move to where the serious dangers lie.
Precious Metals:
During World War II, many foreign countries feared that their gold reserves, which at the time backed their paper money, might be taken by an enemy and in 1939, the good old USA was a very neutral country, like Switzerland, only there was a much better deterrent than the Alps-- the Atlantic Ocean. So, many countries--England, France, and others--sent us their gold bars to be stored alongside ours in Fort Knox. Later, after the war was over, we convinced them that it was fine to leave it there and in fact, with the Cold War starting other countries joined in, including Germany.
Now, what good is a pile of gold sitting in a fort going to do? It costs a lot to protect it, and the US was paying a small sum in interest, while getting a smaller sum back in “protection fees”. So, the Federal Reserve had a wonderful idea, at least in their minds.
Since we have this gold, let’s issue paper on that gold as though it was ours, after all it is sitting in Fort Knox, and earn a bit of money on the side. So long as the Cold War lasted, the gold certainly wasn’t going anywhere. Here is where the trouble began. It was pretty small potatoes for a good while, until we went off the gold standard in 1971 during the Nixon Administration. What good is having a precious metal to back fiat currency, when a promise is just as good? Enter the danger zone.
Now, the gold in Fort Knox isn’t doing anything. So, what to do? Well, each bar of gold has a unique mark on it to say who owns it. The Cold War is still raging, so no one is going to ask for it back anytime soon. Let’s melt down some of that gold, just a small percentage of it, and sell it off as bullion. Gold is high and the foreign countries won’t ask for it all, so let’s skim a bit here and there. No one will know, and we can make money.
Then debts started to accrue, so they got brazen and started melting bars and reselling bars as their own gold, because they don’t want to use their own gold, when German gold is just the same, except for that little mark. Erase the mark and put your own on it and sell it as yours, using your gold as the “backer” in case Germany asks for some of it back.
Well, it wasn’t long until greed set in. Those gold bars that were sold to say, China or Japan, were resold to Austria or Iraq. Much like the bundling and reselling of home loans in the 1990’s, soon the German melted gold was in seven different countries with seven different marks, but no German mark upon them remained. This still wasn’t the breaking point though, after all there is still plenty of Gold in Fort Knox to cover what is owed to them.
I don’t know who’s idea it was, but it was a bad idea. They decided that they could sell paper promises of gold being held in the vaults. The last number I saw was 140%. Which means that if they have 100 pounds of gold, they can sell paper as though they have 140 pounds of gold. Now, they can also sell that gold outright as well. So, it's possible that they could sell 140 pounds of paper gold and sell a portion of the physical gold. too.
Confused yet? Here is where we stand today. No one knows how much gold is really in Fort Knox. We only know what they say is in Fort Knox. The same is likely true for the Federal Reserve and possibly the major banks; after all, if the Fed starts demanding to know what’s in those banks, they might have to show theirs too. So, let’s say that the economy starts to really go south around the world. As you know from the news, Germany asked to see their gold at Fort Knox and were denied, so they asked for their gold back. Smart move on Germany’s part in my mind. Answer from the Fed, we will get it to you sometime in the near future. This wasn’t challenged by Germany.
Why? Rehypothecation. Germany knows that they have been doing the same thing with gold that we have. It’s been sold to multiple people at the same time, under the theory that not everyone will want it at the same time, so we can just move it around as needed.
This game of musical golden chairs works fine, until the musical economy stops. When countries start to rack up debt and desire to sell their own gold to pay the bill, and they can’t get it, they get nervous. Now, if the economy is going south and the price of gold is heading up because of fear, those people holding paper gold in the form of futures or just deposit promises begin to sell off for profit or out of financial need. So long as it’s a trickle, no problem, but if it becomes a torrent....
Remember the 140% rule? Well, what if the Federal Reserve only kept 60% of the 100% that the paper gold was written on? Now there is an 80% shortage. Someone is about to have their musical golden chair pulled out from under them. They will get paid, BUT that payment will come as fiat currency. As the golden parachute deflates, how good is fiat currency? This is why there are so many on the fringe demanding to see the gold reserves and others are saying gold will hit $5,000 an ounce or higher. It is theoretically possible that for each gold promise, that it is backed by 1/5 or less of physical gold. No one knows, because no one can audit the physical gold.
China is getting ready to release their gold reserves. That is, they will do like the Fed and say how much they have. We cannot call them on their real reserves, because then they can do the same to us. Now, if all the gold is still in Fort Knox and the Federal Reserve, then the US can call for a real accounting and show ours as well.
However, if we don’t and China does, and calls for the US to do the same, then a lot of fear enters the market. There is a reason that people say "never own paper metals." This is that reason. You might get the value of that gold, but it will be in fiat currency and if things are crumbling then fiat promises become flat losses.
Thank you, Scott, for the explanation. It's a funny thing about financial games; whatever the Mainstream Financial Media mocks as conspiracy theories often later turn out to be accurate.
I do not claim any expertise in the gold/paper gold markets, but it's clear that claiming to own X quantity of gold is one thing, and reporting how many times the gold has been pledged as collateral is another. In a transparent financial system, the citizens of the U.S. would be invited to tour Fort Knox (in small, secure groups, of course) and count the nation's gold directly. What's the harm in showing off the gold to anyone willing to go through security?
Why keep the nation's gold reserves so mysteriously secret? What's the point in being so cagey about it? Maybe rehypothecation isn't the reason for the secrecy; then what is? Fear of precisely what? Isn't gold supposed to be a foolish relic? What's the danger in letting people look at the foolish relic and count the bars and note the serial numbers on the bars? What's the risk in that?

I propose turning Fort Knox into a profitable tourist attraction. If gold is just a foolish relic, then charge $50 a person to wander around "our" gold. It's not like anyone can slip a heavy bar into their purse or pocket without being detected. Put it behind bulletproof glass if you want. What's the risk?


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kchrisc's picture

Rehypothecation = Theft.

Liberty is a demand. Tyranny is submission.

Soul Glow's picture

Absolutely not.  If you agree to rehypothicate your gold the jokes on you.  Thus why I hold my own bullion.

Thus why the Fed is not able to be trusted to hold the United States Treasury's gold, let alone German and French gold - they likely lie about the reserves in the vault as their actual account is likely far below the accounted amount (Arthur Anderson and such).  China and Russia too. They have been buying gold on the open market sure, but have we audited the vaults?  The chance wealthy Chinese oligarchs have the actual tonnage is likely.

The same is for Europe, Africa, every where.  The gold we are told is in one place is likely in another.  This in all likelyhood.  I mean, you know the dudes at the top are not to be trusted.  Don't you?

Motasaurus's picture

You make a valid point. 

For the general population they say that posession in 9/10ths of the law. But for the top 1% posession is the law. If they hold it, they own it.  

Soul Glow's picture

My point is if you don't have it don't expect it.

Billy the Poet's picture

"Let’s say that you have ten dollars. You take it to the bank to let them “borrow” it, while paying you interest. What you have done, in reality, is given them your money to use as they see fit, while giving you a small percentage of the gains that they will earn. A bank would loan the money to a home buyer or perhaps a small business. At the very least, they can lend all the money in excess of their requirement to hold some cash as reserves--say 10% for ease of math. They now have nine dollars to invest."


A bank with a ten percent reserve requirement holding ten dollars in deposits can "lend out" ninety dollars. 

Soul Glow's picture

Yes that is the ponzi scheme in definition.

Thank you Billy.  You have done well.

Stuck on Zero's picture

Each working U.S. citizen alive and unborn has been rehypothecated by the Federal Government at least a few times over.  The Federal government has pledged a percentage of our labors for the next thirty years as collateral agains the United States debt.  How does that make you feel?

Soul Glow's picture

What debt?  I didn't land on the Fed, the Fed landed on me.

And I own silver bullion.  I don't need them.

BaBaBouy's picture

For A Cheap Margin Of Around 5% or 7% You Can Sell Paper GOLD Into The Market, Virtually As Much As You Like...
Gee Whiz, I wonder How They Are Keeping The GOLD PRICE Down ??????????

KnuckleDragger-X's picture

If you can't touch it, you don't 'own' it. The paper promises that are gold notes are just the beginning, they've bent reality into an idol we must sacrifice our lives to and the end game will be bloody and long.....

acetinker's picture

Plus one for the Malcolm X reference, but unfortunately  for you, the masses have no clue of the value of bullion.  Thus, it will be mostly worthless in the next Greater Depression

Verily, they are correct- if only because they are the masses; But more importanly, the only value in this realm is that which we provide each other.  That is to say, that gold and silver don't mean shit when you don't know where your next meal is coming from.

The bankers will scoop up your PM's for pennies on the dollar, and everything you have built, for that matter- and you will acquiesce, because the market will demand an ounce of gold for a loaf of bread.

Do the bankers think PM's have intrinsic value?  Nope.  But it beats nothing- so they will take it from you.

I know that silver is used extensively in electronics, but have you had a look at those markets lately?

You don't need the Fed, huh?  Nobody needs the Fed, but they own your medium of exchange.

Sllver won't cut it.  Only a fair and honest monetary system- owned by the people who use it- will do.

Chat_noir's picture

you don't understand what rehypothication is about.

the guys who don't take physical delivery of paper gold.... just don't care about that... !

so for every so called "short paper manipulator" there is a "long paper speculator" who both cancel out...

the argument about short paper manipulation is totally stupid

there are arbitrage bounds, if paper and physical markets are too disconnected (less than 1% in price), arbitragers step in for a riskless profit.

Gold prices are depressed, because theres not enough (new) buyers.

Alea Iactaest's picture

You are right, in a way. There are not enough buyers for all the unbacked paper gold being sold. And many of these gold buyers are not really gold buyers, they are paper buyers.

If the paper gold buyers decided they actually would rather have physical gold instead of paper gold you would quickly see that there is a shortage of seller, not buyers.

That day will come. It will come when there is someone who seeks to buy physical gold but the physical gold is not available for delivery. And on that day you will understand what the author is trying to tell you about rehypothecation. (Probably not a moment sooner is my guess.)

Chat_noir's picture

you still don't get it.

there is exactly enough buyers at the current price for the paper sellers, and enough sellers at the current price for the paper buyers... for each buyer there is one seller and vice-versa.

if there was unlimited paper selling, the price would already be 0.

there is no manipulation. the paper price cant deviate from the physical price. because you one can just buy physical sell paper if physical gets too cheap or vice versa when it gets too expensive. when i say deviate, i say less than 1%. it depends on the cost of the balance sheet of professional arbitragers.

Soul Glow's picture

Chat Noir said -

"the argument about short paper manipulation is totally stupid"

Are you even fucking sane?

The conetxt for "short paper manipulation": or market manipulation in general is absolutely valid.  You have a buyer, you have a seller, then you have a fucking seller who doesn't have the collateral because there isn't enough collatreal out there.  Don't you fucking get it?

There is no bullion out there!  If someone made large enough a claim - such as the United States Treasury -per the Federal Reserve on the gold in reserve then the ba;ance would be indoubadbly indebtable!  In other words -There is no way the Federal Reserve could ever pay the United States Treasury their quantifiable gold back.  Not in actual account!  Not in actual bullion.

Bay of Pigs's picture

He's a newbie (26 weeks). We will cut him some slack on this issue.

He can go read this for starters.

OldPhart's picture

Let's try it this way.

I don't invest in paper.  I buy physical.

But , to give an example.  I buy 10,000 paper shares of gold, each paper share has been inflated by 100% or more from the actual physical gold.  (ie.  1 ounce of physical gold has 100 claims on it [zero hedge covered this a couple years ago, though by now it may be 200, 500, or a 1000].)  I buy 10,000 paper ounces of gold now, today, and pay all costs...full fucking price.

Now I demand the physical gold.

Others get wind of this, realize that they are holding whatever shares that are on margin and that my withdrawal of physical gold could weaken their share, so they begin to demand physical.

At a hundred to one, physical value jumps by a factor of 100 as the paper value deflates by a factor of 100.  And suddenly there's no more physical gold left to distribute to millions of shares that remain.  And it's gone.

So I don't play with paper.  I buy physical metal, and have it shipped to me personally.  I then take a leisurely fishing trip in my rickety boat...I'm lucky to have a good life jacket after all the boating accidents.

spieslikeus's picture

Lake Erie is kinda rough this time of year. One has to be careful.....careful I say.

MonetaryApostate's picture

Then the government & banks ban Cash & Gold, you lose.... 

(If you think that's impossible, think again...)

Bioscale's picture

Then the price of gold and everything will skyrocket. They will call it black market, but black market is the real market.

Cumulus Nimbus's picture

No manipulation to the short side you say? Paper shorts are balenced by paper longs? I guess you could say that is correct at the present time but when unknown entities dump hunderds of millions in paper gold on the market at times of little volume and without regard for best price then only an idiot would believe there is no manipulation.

The purpose of these 'price raids' is clear, to scare potential buyers away and thus keep the price supressed.  Of course gold etfs are a fraud in themselves since they sell many more gold contracts than they have actual gold. This has been all been discussed many times here on the Hedge an even a lay person like me can understand how it works.

Also, don't you think it peculiar that the massive sell orders only seemed to start after the US down grade in 2011? Funny how that works isn't it? I mean the whole financial world is in turmoil and gold has been rising for years, then suddenly there is a downgrade of US debt and gold goes into reverse? Just a coincidence i'm sure.

RockyRacoon's picture

The cutest part of all this is that the bullion banks charge storage fees for the "gold" that they sold that doesn't even exist.   They're charging for storing thin air.

seek's picture

It's theft if the actual gold is used to make good on the rehypothecated claim.

It's fraud if the rehypotecated claim isn't made good by those that underwrote (regardless if they had the gold or not.)

Either way.. 99% of the gold market is a crime waiting to be discovered.

OC Sure's picture

The purpose of the fraud is to execute the theft.  The theft is of the money obtained by the pledged collateral. The fraud is the deceiving of the underwriter who is told that their loan is collateralized. 

Kchrisc pledges the same bar of gold to Soul Glow, Seek, and Not_FieldingMellish. Each give kchrisc $400,000. Kchrisc, receives $1,200,000. The fraud is that he has misrepesented the collateral to 2 out of 3 underwriters. The theft is of $800,000. 

Even if kchrisc pays back all 3 loans and never loses his pledge, there was still fraud and theft.

TheReplacement's picture

Unless he can manipulate the price of gold down below what he sold it for.  In a way it could be used as a short tactic. 

Every professional cheerleader, stripper, uninfected hooker, and dancer could show up at my door demanding, absolutly DEMANDING to have sex with me and each other until the end of time is in the same realm of possibilities.

Arius.'s picture

@ OC Sure


isnt this the same as the multiple receipts for same stored gold with money changers in old times?

OC Sure's picture

Yes, and the current monopoly on banking operates on the same premise.

fwiw imho's picture

"Even if kchrisc pays back all 3 loans and never loses his pledge, there was still fraud and theft."

Isn't that exactly what corzine did?  Can't be fraud and theft because he still walks the streets. /s.

logicalman's picture

The crime is known by many.

It's prosecuting the perps that's lacking.

capital one's picture
capital one (not verified) kchrisc Apr 24, 2015 9:43 PM

I freelance over th? internet and earn about 80-85$ an hour. I was without a job for 7 months but last month my paycheck with big fat bonus was $15000 just working on my computer from my home for 5-6 hours. Here's what i have been doing...

TheReplacement's picture

That's nothing.  My pal Bill banged his troll wife once and now their kid is married to a rich banker and never has to work again the rest of her life.  Of course, she couldn't make herself care about money anyway.

Not_FieldingMellish's picture
Not_FieldingMellish (not verified) Apr 24, 2015 8:10 PM

Just wait until Modi gets his hands on the 20,000 tons sitting in the Indian temples. Double digit gold anyone?

illyia's picture

Well that's not going to happen.
File under things I do not have to worry about.

Not_FieldingMellish's picture
Not_FieldingMellish (not verified) illyia Apr 24, 2015 9:37 PM

Apparently, some of the big temples are considering it depending on the interest rate. If its sufficient, they will lend.

Wile-E-Coyote's picture

You really don't understand the Indians relationship with Gold, they absolutely love the stuff, they would only sell if their life depended on it....................... Oh wait!

Bay of Pigs's picture

He doesn't seem to understand much of anything when it comes to gold except to troll these threads bashing it.

Good news is that HSBC is the custodian of all the GLD gold and JPM has all the silver for SLV. Im sure its all safe and sound.

BeanusCountus's picture

This would actually turn gold into an "income producing" asset.  All things equal, the price should go up as a result.

Condition 1SQ's picture

Would you mind holding your breath until that occurs?

lakecity55's picture

Modi will not do that, it is central to Hindu shrines.

Winston Churchill's picture

Most in Sikh temples. The Sikhs are the officer corp of the Indian army.

See the problem.

Remember Sikh killed Indira Gandhi.

Chupacabra-322's picture

Robbing Peter to pay Paul.

Soul Glow's picture

Robbing Paul to pay themselves....

The gold is not in the vaults.

F0ster's picture

Robbing Ranjit to pay Sanjit

mt paul's picture

just the 400 oz bars next time....

A Lunatic's picture

'We were just getting ready to open up Fort Knox to the public when some crazy ass Homegrown Ron Paul supporter detonated a dirty nuke right in the middle of all of the gold. And yes we mean all of the gold, which was there, because we have morals and scruples, and honor and stuff and would never rehypothecate anything. Ever. Honest.....'

Rock On Roger's picture

Gold makes a better radiation shield than lead.


That's why the gods valued it so much.

Soul Glow's picture

And silver best

Hang ten surfer ;)

davidalan1's picture

The yellow dog sits and awaits, beatien abused, maniipulated and he eyes the  humor of paper and the ever increasing  defaults. One day he will rise and destroy...