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) Continued
