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.
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)
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.