The New Case for Gold by James Rickards

Author:James Rickards [Rickards, James]
Language: eng
Format: epub, mobi
Publisher: Penguin Books Ltd
Published: 0101-01-01T00:00:00+00:00

The Paper Gold Market vs. the Physical Gold Market

There’s another puzzle in this story. Investors assume that prices of goods are driven by the laws of supply and demand. When looking at the global market for physical gold it seems there is a massive increase in demand and no particular increase in supply. Why isn’t the gold price responding to this mismatch?

Investors should understand that there’s a physical gold market and a paper gold market. The paper gold market consists of a number of contracts: COMEX futures, exchange traded funds (ETFs), gold swaps, gold leasing, forward contracts, and so-called unallocated gold issued by London Bullion Market Association banks. Those derivatives—futures, swaps, ETFs, leasing, forwards, and unallocated gold—form the paper gold market.

The paper market could easily be one hundred times the size of the physical market. This means that for every hundred people who think they own gold, ninety-nine of them are wrong. Only one of them is going to get physical gold when the panic begins.

That kind of leverage is fine as long as there’s a two-way market. As long as price action is not disorderly, as long as people are willing to roll over contracts, and as long as people don’t insist on physical delivery, the leveraged paper system works fairly well. The problem is that a lot of those assumptions, even if true initially, can disappear overnight. More investors are demanding physical delivery. Central banks around the world are also demanding physical delivery from custody at the Bank of England or the Federal Reserve Bank of New York. We’ve seen Venezuela taking back its gold to Caracas, Germany taking back its gold to Frankfurt, and smaller players like Azerbaijan taking their gold back to Baku.

The paper market is geared to certain depositories in New York and London and bank intermediaries that are members of the London Bullion Market Association. If you take the physical gold in New York and move it to Frankfurt, it reduces the floating supply available for leasing in New York. There is no well-developed leasing market in Frankfurt. The result of moving gold from New York to Frankfurt is to reduce the gold available to cover short positions in New York. That either increases systemic leverage or requires the short positions to be covered elsewhere in the physical market.

With regard to the pure physical market, there are a number of revealing transactions going on. If you’re a large buyer of physical gold, you will discover that you have to source the gold directly from refineries, which means there are no sellers in the secondary market. In a normal, healthy market, if I’m a buyer, and someone else is a seller, a broker will find the two of us, buy from one, deliver to me, and earn a commission. Now what’s happening is that there are buyers in the market but few sellers, so the only way a broker can get gold is straight from the refinery. The backlogs at refineries are running to about five or six weeks.

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