Physical vs paper gold: what are the main dangers of virtual gold?

There has been a long-standing debate among investors about whether it pays to invest in physical or virtual gold. Let’s take a look at the different options and the risks involved in investing in so-called paper gold.

Broadly speaking, gold can be invested in four different ways. These are:

• Physical gold
• Exchange-traded funds tracking the gold price.
• Futures and other derivative instruments.
• Futures and options on gold

These can be broadly divided into physical gold and paper gold.

Many investors see paper gold as a good way to keep the cost of gold-related investments down. However, there is little awareness of the risks involved and, as will be shown below, third-party risk in paper gold exists at several different levels.

Third-party risk means that the future of your investment depends in part on someone else – for example, banks and other financial institutions. Clearly, paper gold is not an asset external to the financial system. Physical gold is the only way of investing in gold that makes your assets independent of the financial system. Let’s find out why.

Investing in paper gold through an exchange-traded fund

How can paper gold be invested in the first place? The most popular way is through exchange-traded funds (ETFs). What distinguishes ETFs from other investment funds is that their shares are traded on an exchange and can be bought in the same way as shares.

Gold ETFs hold gold as collateral and offer investors units in the fund that represent this gold. The most popular such fund is the SPDR Gold Shares (GLD), which, according to its prospectus, is ‘designed to track the price of gold. It aims to allow investors to benefit as easily as possible from gold price movements.

It is very important to understand that an investor who buys shares in GLD holds shares in the fund, but the gold backing the shares is not in his name. Most ETFs do not allow the investor to claim the gold when selling the fund shares. And even if this is possible, the investment must be very large, running into millions of dollars for larger funds. Even then, there are likely to be several legal hurdles.

The biggest advantage of exchange-traded funds is the low cost and ease of investing. There is also no need to worry about storing gold. Of course, there are also major drawbacks on several levels that investors should be aware of.

Is gold yours or not?

When talking about gold, it is very important to distinguish between allocated and unallocated gold. Allocated gold can be defined as gold that is bought in your own name, through your bank or investment fund – meaning that you own the specific bars or coins in the gold vault (or your own stash). This usually comes with some storage costs. However, that gold is 100% yours.

When a person buys a physical asset, such as a car or a property, he or she has to make an effort to ensure that the asset is actually in the person’s name. In the case of a car, for example, the make, colour and registration number are recorded. In the case of allocated gold, the same principles are followed.

Unallocated gold, on the other hand, is gold in which you have invested money but which is not in your name and which you do not physically own. The gold is owned by the bank or fund through which you invested the gold and you only have a claim on that institution. For example, holding paper gold through an ETF means that there is no gold in your name. Those gold bars are in the name of the fund. While the fund itself may hold allocated gold, the holders of units in the fund do not.

The most important thing to know is that in the event of the insolvency of an investment fund or a bank, the allocated gold is your asset to which the creditors have no access. Unallocated gold, on the other hand, is legally the property of the bank or fund and can be used to cover liabilities in the event of insolvency or other major problems. The same physical gold may also be claimed by several different parties. This is similar to a situation where, for example, a commercial bank becomes insolvent, and customers can no longer withdraw their deposits.

ETFs are therefore exposed to several third-party risks, be it the fund itself (e.g. the risks associated with its management), the bullion banks (more on this in the following chapters) or the companies that maintain and monitor the fund’s gold holdings.

The paper gold bullion industry is dependent on the financial system

In addition to exchange-traded funds, there are futures, options, and other derivatives. Like ETFs, these are substitutes for or derivatives of physical gold. Let’s take a closer look at how futures work, while options are more complex and will not be explained here.

What is a futures contract? It is a contract between two parties that commits them to buy or sell the underlying asset of a futures contract – in this case, gold – at a previously agreed time and place. However, in the case of futures contracts, the delivery of the commodity is very rare in reality, and there is usually a cash settlement when the contract expires. To trade gold futures, you need a trading account with a broker. There are additional costs involved and futures and options trading is usually the preserve of highly sophisticated and knowledgeable investors.

These trades may work under normal market conditions, but in a complex stress situation, this may not be the case. Such situations include shocks to the financial system, which is one of the main reasons why investors invest in gold in the first place. In the event of a financial system crash or banking crisis, paper gold instruments may also be at real risk as counterparties may not be able to meet their obligations.

Why might these obligations not be met? Futures and options use a lot of leverage. This means that they are largely purchased with borrowed money. There is far less gold as collateral than in tradable securities. According to various estimates, the trading volumes of whole paper gold are about 100-200 times the trading volumes of physical gold. Futures therefore also involve risks for the financial system and other market participants.

Gold can also be indirectly invested in through gold miners’ shares. Shares in mining companies are a riskier investment than gold itself. This means that if the price of gold moves by, say, 2%, mining company shares will often react with movements several times as large. At the same time, they often provide cash flow in the form of dividends, which is a big plus.

How does the gold banking system work?

Let’s go back to paper gold. In order to understand how the paper gold system works, we need to understand the bullion banks and their key role in shaping the gold market. Examples of bullion banks are HSBC, JPMorgan, Commerzbank, Morgan Stanley and others. It is the bullion banks that hold the gold used as collateral for exchange-traded funds and futures exchanges.

It is very important to understand how the gold banking system works in general. Different institutions and individuals hold their gold in bullion banks. This gold can be lent by the bullion bank to other banks. It can also be used as collateral, for example, to create new shares in an ETF. Only part of the gold is held as reserves. It is believed that much of the gold held by bullion banks is in turn borrowed from central banks. However, there is no precise data on this. Bullionstar has compiled a good infographic on the structure and activities of bullion banks.

The process is very similar to how traditional banking works – when you put money in a bank, the bank only has to hold a small part of it in reserves and can lend the rest out or use it for other purposes. This means that a bullion bank can create more paper gold than there is physical gold to back it up.

If all the people go to the banks to withdraw money, the banks will not have enough money to meet their obligations. Although there is no precise data on gold bank holdings, gold deposits and their origin, the same principle probably applies to gold. If all the holders of futures contracts and all the people who have invested in gold through various instruments demand the delivery of physical gold, there will not be enough gold for everyone.

A 2013 publication by the London Gold and Silver Market Association (LGBFMA) reported that the majority of trades are made without physical gold delivery. It was also reported that 95% of transactions are made with unallocated metals. This means that the London bullion market, which is run by bullion banks, is largely based on paper gold. It can be concluded that there are probably very few precious metals to cover compared to the volume of transactions.

Can bullion banks be trusted?

It is the bullion banks, which play a key role in the market, that hold the gold in the popular gold-backed ETFs. They have the right to add or withdraw ETF shares. However, many questions have arisen about the credibility of the banks and the origin of their gold holdings.

One of the most important gold banks, HSBC, has been very secretive about its gold holdings. In 2011, the bank allowed news agency CNBC journalist Bob Pisan into its vaults. He had to give up his phone and was taken by a black-glass car to an unknown location. In the vault, Mr Pisani was handed a box of gold and told they were all registered and numbered. ZeroHedge later wrote that the number of the bullion Pisani was holding was not on the HSBC bullion list, sparking further speculation.

The transparency of gold banks is generally very poor. For example, it is not known exactly where the gold comes from and what kind of gold the bullion banks use as collateral for ETFs. Also, in recent years, there has been no accurate overview of how much-unallocated gold is held on paper and how much physical gold is held in gold banks’ reserves compared to this.

Nick Barisheff, head of the BMG Group, has aptly put it: ‘If the gold bank behind the ETF becomes insolvent, the lawyers will get rich and start arguing about who owns the real gold.

The ‘market maker’ for the exchange-traded GLD fund is JPMorgan, for example, as well as HSBC Bank. Both banks have been convicted in recent years of manipulating the precious metals market. JPMorgan was fined nearly a billion dollars in the autumn of 2020.

Inevitably, the question arises: can you trust all the players in the financial system on which your investment depends? In 2008, for example, Lehman Brothers was one of the gold banks that collapsed. If the US government had not come to the rescue of the financial system, this event could have been devastating for paper gold ETFs.

Why invest in gold at all?

People need to ask themselves what they want to invest in gold for. If you trust the financial system or want to make short-term bets on gold price movements, it may make more sense to buy paper gold. For those who also want to earn cash flow and are willing to take more risk, mining company shares may also be worth considering.

Clearly, paper gold has created a massive airlock that depends on many different financial institutions. If the gold derivatives market collapses (for example, if everyone starts demanding physical gold), this could mean that physical and virtual gold prices move sharply in different directions. For example, signs of this are already starting to appear in the silver market. It is very important to be aware of the risks an investor is taking when putting money into paper gold.

If you are investing in gold to protect yourself against inflation, a possible banking crisis and a crash of the financial system, physical gold is the only thing that is external to the financial system and protects against such risks.