‘Paper’ Gold Can Be Risky Business
November 21, 2019
Owning “paper” gold is not the same as possessing physical gold. Even though prices of both forms of gold-ownership are currently the same, they will not necessarily be equal down the road.
By paper gold, I include all forms that are not having direct custody in your hands or stored in a vault under your own name. There are several kinds of paper gold, including:
- Commodity futures contracts
- Options contracts
- Certificates of deposit of gold stored in the vaults of mints such as Australia’s Perth Mint, the British Royal Mint and the Royal Canadian Mint
- Shares of gold mining companies
- Gold exchange traded funds
- “Bank accounts” denominated in gold
There are multiple risks that ownership of any of these forms may not provide actual physical gold should the owner desire to take possession. For instance, the ounces of registered gold inventories in the New York COMEX could only cover around 1 percent of potential demand should all owners of these commodity futures contracts ask for physical delivery when the contract matures. This risk of non-existent physical gold also extends to options contracts.
I have not yet heard complaints about the various mints not physically having the metal represented by outstanding certificates; the certificates normally represent only partial ownership of some bars (and I generally have a high regard for those operating such programs at these mints). For example, someone may have title to 10 ounces of gold out of some unspecified 400-ounce bar on the floor of the Royal Mint, but delivery is not possible until the entire bar is melted to fabricate individual units to ship out. Back at the end of 2008, my understanding is that the Perth Mint was several months behind being able to deliver physical gold to customers trying to convert their certificates to take delivery.
Obviously, the gold mining companies own metal that is still in the ground, where physical delivery is not immediately available. In fact, accessing the gold could take years or decades.
In theory, gold exchange traded funds own physical metal covering claims of all outstanding shares. However, if you were to read each prospectus carefully, you will often see that there is no proof that this is true. The operator of such funds too many times relies on often-unverified statements by the custodians and sub-custodians that the metal really is in the vaults. Also, if someone wants to surrender their shares to take physical delivery of the underlying metal, that isn’t allowed unless a very large number of shares are tendered in a single transaction. For silver exchange traded funds, for example, the typical minimum number of shares required to redeem for physical metal is 50,000 ounces at a time.
So-called bank accounts denominated in gold also carry risks that the underlying physical metal may never exist or be under the control of the operator of this business.
There is also another risk that if an investor theoretically purchases physical gold from a stockbroker and then pays the broker for storage, the broker may never acquire the actual physical metal. A number of years ago, Morgan Stanley settled a case where it had sold physical gold to a large number of customers, was supposedly storing it in a vault for their customers and was collecting storage fees. It turned out that this broker had never acquired the physical metal so as to increase their profits. At most, this firm purchased derivatives contracts to protect them against rising gold prices.
At my own company, we had a customer who had purchased a 100-ounce silver bar from a different broker and paid $25 monthly in storage fees. When he asked for delivery, all he got was the runaround until the broker finally admitted, abut a year later, it had never acquired the physical metal for his account. That broker settled with the customer for cash rather than delivering the merchandise.
To get a better feel for the risk of owning paper gold, understand that the combined paper and physical gold trading market exceeds 33 billion ounces of gold annually. All of the gold mined throughout history only amounts to 5.5 to 6 billion ounces, and current annual mine production is only about 100 million ounces. From that, you can understand that the gold market is overwhelmingly dominated by the trading of paper forms.
When global financial markets again plummet, you can be sure that there will be a repeat of soaring demand to own physical precious metals, especially gold and silver. As that happens, there will almost certainly develop a huge divergence between the prices of paper and physical gold, with the latter potentially being worth many multiples of the former.
So, if you want to own gold or other precious metals, you really need to own the physical metal in your direct custody or with registered storage in a vault in an account with your name on it. I recommend a vault not operated by any bank to avoid a risk of government-authorized “bail-in” confiscation of your property.