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BookmarkThe price of gold recently plunged against a backdrop of increasing global money printing and increasing demand for physical gold. On the face of it, this is odd. It is however quite rational, due to some perverse incentives in the structure of the gold market that are not well understood.
Three gold markets
The first market is for physical gold. It consists of all the gold that has ever been mined, maybe 175,000 tonnes, and increasing by the annual production of 2,700 tonnes per year. This gold is held in safekeeping, mainly by Indians, Chinese, Arabs, some western investors, by repositories like the Perth Mint, in vaults in London and Zurich, and so on.
The second market is for paper gold. Paper gold is a piece of paper that says you own some gold. The paper gold market is run by banks known as “bullion banks”, which hold gold in their vaults, mainly in London. The bullion banks include JP Morgan, Deutsche Bank, HSBC, Barclays and UBS, and belong to the London Bullion Metals Association (LBMA). If you want to buy some paper gold, you go to them and hand over some cash. They type up a nice certificate saying you own some of the gold in their vaults, and you go home with that bit of paper. When you come to sell your paper gold, you hand over the paper and they give you some cash. Both transactions are at the prevailing spot gold price.
You can ask to redeem your paper gold for physical gold, but in the fine print of the contract you signed with the bullion bank, they can choose to give you either physical gold or cash. Although this market is known as the “London physical market”, it really buys and sells paper. It is an OTC market, without a public exchange trading standardized products—you must do your business with the bullion banks.
Now the bullion banks noticed that most of their customers never see their gold in the vaults (and even if they did ask to see their gold, they could in principle be shown any old gold because all gold looks much the same). Over the years, the bullion banks have, well, sold more paper gold than they have physical gold in their vaults. Quite a lot more. You can see the temptation. It’s all perfectly upfront, there is nothing hidden or underhand about this, but while many people may think they purchased gold, all they own is a paper claim to some gold.
When a customer buys some paper gold from a bullion bank, the bullion bank takes the customer’s cash and uses some of it to buy physical gold (some of which they store in their vault, and some of which they lend out to other clients who want to borrow gold), some to buy gold via futures contracts on the COMEX, and some of it for other purposes. What they do with the customer’s cash shapes their exposure to the price of gold: if they spend it all on gold in one form or another then they basically have no exposure to the price of gold, and if they spend none of it on gold then they are completely exposed to the price of gold. A prudent bullion bank would not have a large exposure, so we can safely assume the bullion banks spend the bulk of the customer’s cash on gold in form or another.
However the bullion banks only hold a fraction of the gold sold as paper gold in their vaults. That is, of the paper gold sold to their customers, they only hold a fraction in their vaults. In this sense they are like a traditional fractional reserve bank, but unlike a bank they are immune from a “gold run” because they can settle in cash rather than having to redeem in actual physical gold. But settling in cash would get expensive for the bullion banks if the price of gold had risen and there were more redemptions than customers for their paper gold (so while paper gold is not a Ponzi scheme, it does bear a passing resemblance). To the extent that they don’t spend all of their customer’s cash on gold, the bullion banks are short gold and must rely on new customers outweighing redemptions.
So the paper gold market is comparable in size to the physical gold market.
Important to note: this sort of scheme can only exist in gold and silver, because all other commodities are produced for consumption. One cannot get away with selling some other commodity that does not exist or will not be produced soon, because the consumer would demand delivery before long.
The third market is the futures market, where contracts for future delivery of gold are bought and sold. This happens mainly in New York at the COMEX. It is a relatively tiny market, but crucial because this is where the price is discovered (the London paper market arguably also does some price discovery): the spot price of gold quoted around the world is the latest price on the COMEX. At any one time there are open contracts for about 1,500 tonnes. The COMEX warehouse generally holds about 300 tonnes of gold for buyers to take delivery if they settle their contracts in physical, but most contracts are settled for cash.
The essential fact that links the three markets is that all three markets accept “the” price of gold as the latest COMEX price: gold is traded on the physical and paper markets at the latest COMEX price.
Redemptions of paper gold
By early April the bullion banks were in an unpleasant position. They were facing increasing redemptions of paper gold, for both cash and physical gold. From their perspective there was a trifecta of benefits if only the price of gold was lower:
- The bullion banks would pay less cash to people redeeming their paper gold for cash.
- The level of redemptions would likely be lower.
- The gold ETF’s would likely end up selling gold to the bullion banks, as would their own clients who are short gold, mainly at the lower price. This gold could be paid to the redeemers of paper gold who need to be given physical gold. This is cheaper than having to buy that physical gold at the current higher price on the open market.
So in the face of increasing redemptions of their paper gold, the bullion banks stood to improve their financial position if the price of gold was lower. As it happens, the bullion banks can lower the price of gold without expending any gold, by selling futures contracts on the COMEX. It merely costs them some cash.
At some level of demand for redemptions, it becomes worth the risk and probable cash cost of selling futures contracts on the COMEX, in order to save cash on their paper gold obligations and to help acquire gold to meet redemptions that have to be made in physical gold.
It is rational for the bullion banks to push the price of gold lower on the COMEX, in the face of increased redemptions of their paper gold, which was caused by increased demand for physical gold. How ironic for gold holders.
Can the physical market set the gold price?
Any perverse incentives in the gold market, and any gold price manipulation scheme, can be overcome if the physical market takes control of the price – by simply wiping out the physical gold underpinnings of the COMEX and the paper gold markets. Simply take physical gold for delivery, do not settle for cash. Gold is special: you actually have to have it in your possession, or in your mining lease, or as allocated gold in a trusted repository that is not running a fractional reserve scheme. A piece of paper is not good enough
