Closing Unallocated

In the entire time I have worked in the Depository business (since 1998) through the many times I have explained our unallocated "business model", the one thing that has surprised me is no one asked a very simple question, a question that cuts to the core and would reveal whether the Perth Mint had any integrity and whether we were lying about unallocated:

"So if it is funding working inventory, you will have to close it at some point, yes?"

That point has been reached with silver as announced on the corporate blog. Gold will follow in due course, possibly quite quickly once people realise the best storage deal in the world cannot continue forever.

You would not be surprised to know that our Certificate Approved Dealers were not overly happy about it - which business wants to stop selling its best product line - but it could not go on forever.

Of course the move has raised questions, and I'm currently managing four discussions on it (Ed Steer, Kitco, Gold is Money, SilverStackers).

This move should now raise another important question, but I'm not going to wait in case no one asks it:

"So if the West Australian Government is on the hook for the Perth Mint, surely there is a limit to how much they can guarantee, so therefore a limit to Depository?"

Answer is yes, at some point Depository will also close Pool Allocated and Allocated. When is an open question depending on how fast metal flows in and what happens to the gold price. But the day will come. The Government does not have the financial capacity or willingness to guarantee massive precious metal liabilities.

This suits me fine and should suit our clients, as the bigger you are the bigger the target - theft and political.

Many people just don't get this about the Perth Mint. It is not some money hungry management team looking to take on leverage and grow for the sake of growing and bonuses. It is conservative and about looking out for the interests of its clients. When we end up closing the whole Depository business to new clients, maybe the message will get through. Problem is it will be too late for some.

PS - an excellent analysis and history of the Liberty dollar case.

Understanding Unallocated

This recent post by me on the Mint's corporate blog is the simplest way I can think of to explain the Mint's version of unallocated. Note that there are only so many "pipes", which will become clear in a few month's time.

Gold lenders of last resort

Another post by FOFOA that will get you thinking. My response below.

FOFOA,

There would be many within the Mint who would be amused at you categorising me as a “mainstream” view. I understand you are using my explanations as representative of the mainstream view but I would like readers to be clear that my personal view is different. To clarify this, some comments on your piece.

While I have no direct evidence of the bullion bank's (BB) activities, I am not as sure as others that the BBs are massively financially short gold (this is not to say they don't run short term speculative positions). My reasoning for this is that gains and losses on such positions impact their reported profit and loss. If they were as massive short for as long as some claim, their losses would have been visible.

I would also suggest readers ask why a BB would take on hundreds and hundreds of tonnes of short gold positions over time in some attempt to suppress the gold price. You only do this if you have a philosophical hatred of gold. I understand that gold ownership is a political action, a rejection of fiat currency and banking, but would (at this time) a bank with a BB division really be threatened by the pathetic fraction of a percent of those investors who hold gold? Threatened to the extent that they would of their own accord take on a massive short position?

Now the above does not mean I think everything is OK. On my fractional fubar post you mentioned, I commented “ It troubles me as well. The Mint has been under no illusions about London unallocated as the legals say we are an unsecured creditor and the bullion banks would never make any statement one way or another about what they did with it. We have operated accordingly.”

Bankers make money by intermediating – buying from one, selling to another, borrowing from one, lending to another – and taking their cut along the way. I would suggest readers consider the theory that BBs would be willing to intermediate for someone else with that philosophical hatred of gold and take their riskless cut along the way. Why risk your own money when someone else is willing to do so, with the bonus that their activity protects your banking “franchise”?

This then leads on to your statement that “there is no clearly defined lender of last resort to cover the risks”. Is this really the case? You mention two risks the BBs have.

1. Default – Borrowing gold doesn't solve this problem, as the act of borrowing gives you an gold asset but also a gold liability. The only way to solve this problem is to buy the gold, which results in a loss because you have to give up dollars to acquire the gold asset.

2. Liquidity – Buying gold doesn't solve this problem as while it gives you gold to give to your creditor but also gives you price exposure as you have technically bought your gold asset which is due in the future. The solution is to borrow gold directly, repaying it when your gold asset comes due. Alternative, you can borrow synthetically by buy spot gold and then selling forward (using the gold from your gold asset to deliver into this forward sale).

I would therefore agree that BBs have "exchange rate risk" for the default situation but not for the liquidity situation. This assumes that holders of gold (which in cases of large volume really just means central banks) are willing to sell (in case of default) or lend ( in case of liquidity) to BBs. I therefore suggest the question is not whether central banks are lenders of last resort, but whether they have the capacity, or willingness, to fulfil that role now or in the future.

In my previous post I stated that central bankers are the gold market's lenders of last resort. The fact that central banks hold gold as a physical asset (and only gold) in addition to fiat currencies is clear indication to me that gold is not just another commodity. However, the other side of this is that central banks can be lenders of last resort of this “money”, just as they are of dollars.

Central banks have been more than willing to lend dollars to banks to help them out with their liquidity problems, eg taking on their crappy mortgages etc, rather then have them fail and to avoid a systematic collapse of the banking system.

Consider the situation where a bank comes to its central bank and say “Hey, I've got all these pesky unallocated gold holders wanting physical but all I have is these long term loans. Can you lend me some of your physical gold and I'll replace it later when those borrowers repay their leases? If you don't I'll have to declare bankruptcy, the gold price will rocket up, this will cascade through the gold market and we will have a systematic collapse of the banking system.”

Why would a central bank not be willing to support a bank's BB division in such a situation, especially when they would do the same for dollars? For me this is not the issue, I think they will do (are doing?) it.

You mention the CBGA as proof that (some) central banks are “are no longer going to be the lender of last resort to this system”. I think it is therefore very interesting that the 2009 statement makes no reference to leasing as the previous two statements did. Why the change?

To me then the key issue is whether the central banks have the capacity”.The interesting thing about capacity in respect of gold of course is that you can't print it! Easy to do if your bank has a dollars problem, not so if they have a gold problem. Questions to consider:

a. How much gold would central banks be willing to lend to prop up banks? All of it? Or would they balk in the case of gold? Who cares about dollars, just print more – but risk the country's only real asset?

b. Out of the total they are willing to lend, how much has already been lent?

A speculation: maybe the reference to no more leasing in the 1999 and 2004 CBGA statements was a message to the BB to clean up their books. However, around 2008-09 the banks said they will fail without the backstop, need more time to unwind, have increasing physical redemptions, so CBGA drops the leasing reference to enable them to continue the "extend and pretend that there is not a run on the bullion bank reserves."

In conclusion, I would like to suggest the following in respect of the two risks

1. Default – This is most likely to happen if the BB lend to a short seller who is now bust. In this case we should see buying and thus an increase in the gold price.

2. Liquidity – As agreed, this will happen if unallocated holders are calling for physical. In this case we should see an increase in the lease rate.

Note that in the past the lease rate was around 1% to 2% with low gold prices, during gold's bear market. This was because of the large amount of miner forward selling that was going on. What we have seen in recent times with miners closing down their hedging is low lease rates and high gold prices (see this post for a chart). So there is a very general relationship between short selling and lease rates over the long term.

What would be interesting would be sustained increasing gold prices AND higher lease rates, as it may indicate buying to cover defaults and borrowing to cover liquidity.

Further discussions with FOFOA on GLD

FOFOA,

Firstly, I'll have to be more careful in how I write. My post was really mixing up responding to specific quotes of yours but then veering off on to related concepts/positions that are not yours. My exploration of the idea that APs would fraudulently take GLD gold or “GLD is bad because bullion banks involved” was directed at the simplistic anti-GLD ranters not looking to the subtleties and not at yourself. One of the problems with writing rather than speaking face to face I think. Anyway, on to the discussion.

“Market-price reversible swap” makes more sense, I read “essentially lent” as implying some obligation to return the physical. With regards to the “naked short” I was talking from a financial point of view, whereas you are using the term in the sense of physical.

To clarify the distinction for our readers, let us consider a bullion bank with a physical ounce asset backing an unallocated ounce liability to its clients. If that bullion bank then lends that physical to a jewellery company who use it in their operations, then the bullion bank now has an ounce claim asset backing it unallocated ounce liability. From your point they are short “physical” but I would also note that the bullion bank is not short “financially”, that is they are not exposed to any movement in the price of gold.

Yes they are exposed to the risk the jeweller does not return the physical at the end of the lease. Probably more importantly, they are exposed to liquidity risk. I think this is the sense that you use “short” and is reflecting the issue of “maturity transformation” (see Unqualified Reservations blog for an excellent explanation of why this is a big problem).

My use of the word “short” is for situations where the bullion bank exchanges (or sells) the physical backing its unallocated ounce liabilities for cash. This creates a financial risk as there is a mismatch between the denominations of the liability (ounces) and the asset (dollars). When you used the phrase “sell them for dollars that can then chase an ROI” this implied to me a financial short and that was what I was addressing.

I now understand what you meant by "special right" when you say “once the price of physical gold starts running away from the paper price”. I will have to disagree with you on this to some extent. Now by that I'm not saying GLD does not have its risks or that any not-in-your-hands gold is better than in-your-hands gold, but I have, maybe naively, a stronger belief in arbitrage and greed.

Let us consider your scenario where the markets have been closed for a week, during which no doubt the price for physical gold has risen. On market opening I agree we are likely to see much selling by retail investors who no longer have any trust in the markets. They are wanting cash so they can buy physical gold. Their selling pushes the price of GLD down.

Now you state that “the APs can just scoop up those shares at a panic discount”. This I'm not so sure about. The prospectus lists 16 APs, only some of which are actually bullion banks (with their angry) unallocated creditors):

BMO Capital Markets, CIBC World Markets, Citigroup Global Markets, Credit Suisse Securities, Deutsche Bank Securities, EWT, Goldman, Sachs, Goldman Sachs Execution & Clearing, HSBC Securities, J.P. Morgan Securities, Merrill Lynch Professional Clearing, Morgan Stanley, Newedge, RBC Capital Markets, Scotia Capital and UBS Securities.

I find it hard to believe that all of these will conspire to agree to hold off on buying GLD until a significant discount appears. Arbitrage traders in each firm will be watching GLD drop relative to the physical price of gold. As it goes to $1 to $2 discount per ounce etc, the traders will be thinking “if I don't take that discount and lock in easy profit now then one of the other APs will and I'll lose the profit”. With 16 traders I find it hard to believe that one will not jump first, providing offers to buy and thus arresting the decline in GLD's price. What does Newedge care about JP Morgan's angry unallocated customers and why let them get GLD gold at a big discount to save them and deny yourself a profit?

Now I will concede that for my scenario to work all of the 16 APs have to have access to physical in the OTC market, which may not be the case for the smaller players. But then when you say the physical price is diverging from GLD's price, this implies that there is market for physical at a price and thus would it not be more easier for the 16 APs to acquire physical compared to retail investors, given their connections in the OTC market?

As you say we are talking about systemic failure. I suppose I'm nit picking, but is not systemic failure a situation where gold goes into Feketian “hiding” in which case there ceases to be a gold price? What I'm saying is that up until that parabolic breaking point, while gold is still being sold for cash, the backstabbing greedy profit motive of the 16 APs will ensure GLD's price stays in touch with the physical gold price. That is my answer to your question “Will anything other than physical gold itself track the price of physical gold in a physical-only market?”

For readers who don't find this particularly helpful or are not comfortable assessing these risks, I would suggest taking FOFOA's advice:“I don't know the answers but I do know one way to avoid the risks.” - that is, buy physical!

The ability of non-APs to borrow GLD shares and then sell them short I think we are in agreement on and is another problem with GLD, or to be fair with stock exchanges in general it seems.

Finally, I take some issue with your statement that “or some other coin the ETF shareholders would have bought had there not been an ETF. The ETF diverted demand in many ways”.I partly disagree with this, but I also partly disagree with those who think GLD's tonnage is “additional” demand. The truth is in between both in my opinion.

There is no doubt that a fair portion of investment in GLD would have occurred anyway, either into other funds (eg Central Trust), Allocated account or cash and carry coins and bars. In this sense all GLD does is make this investment more visible than it would have been. Unfortunately commentators obsess about GLD simply because it is visible and ignore the other 28,000t or so of privately held gold (not to mention Asian demand in “jewellery”, which is really investment in nature).

However, I do believe that the creation of stock exchange listed gold products has increased demand for gold by making it easier to get exposure to gold. Buying it through a stock broker eliminated the perceived inconvenience to some investors of having to go down to a coin shop and then worry about where to store gold.

As to the WGC, in my dealings with them I don't agree with your view that “they are focused on all aspects of the gold market, including the structural integrity of the Bullion Banks' fractional reserves given that the CBs have removed their physical backstop.” They are a miner trade group. Their focus was on physical offtake and thus obsessed about the metal behind GLD being Allocated gold. Funny when you consider that the legal structure introduced, in my opinion, some holes that negated the “security” of the Allocated gold backing.

I can't say anymore except that I'd guess I'm one step closer to them than yourself (note: the first exchange traded gold product in the world was the Australian Gold Bullion Securities, the second was the Perth Mint's ASX code:PMGOLD, the WGC naturally took some interest in these Aussie upstarts). Unless of course you are close to the WGC, but then that would be revealing a bit too much? :)

Fraud on GLD holders?

Further to my post yesterday, FOFOA left this comment on his blog discussing two risks he sees with GLD:

1. That the gold in GLD has multiple claims on it. Quote: “GLD's gold bars originated as reserves in the mainstream bullion banking system. That is, they are essentially reserves on loan to the ETF from the bullion bank's fractional reserves. And the lending of anything always creates a synthetic supply” and “that lent its reserves to paper GLD investors in the first place”

2. That shorting of GLD results in multiple claims on the gold: Quote: “The other side is the lending of this "synthetic gold supply" that creates an additional synthetic supply of synthetic gold. When someone shorts GLD they borrow the shares from someone else. And that same share can potentially be borrowed again and again.”

My short response is I disagree with 1 in respect of “lending” but agree with 2. Now for the long response.

The idea in point 1 that GLD has encumbered gold in it was raised in Catherine Fitts’ “Precious Metals Puzzle Palace” and also Hinde Capital’s “Precious Metals ETF Alchemy GLD – the new CDO in disguise?”

I discussed this issue in this post. If Authorised Participants borrowed physical (or used physical backing their unallocated liabilities to their clients, which is the same thing) and delivered that to GLD, there is no claim or encumbrance by the original lender to the Authorised Participant on those bars held by GLD.

To claim otherwise is to question the entire basis of Allocated gold that the market (and “giants”) operate and rely on, as no giant with a couple of tons of gold can just bury it in their backyard. It would also question the integrity of GATA consultant James Turk’s GoldMoney as well.

The second part of FOFOA’s comment is that any delivery to GLD by a bullion bank of physical gold that was supporting/backing the bullion bank’s fractional unallocated liabilities is a “synthetic supply” that effectively suppresses price by “divert[ing] growing investment demand away from the tightening physical market.”

I would note that for this statement to be true the bullion bank(s) in question must be naked short. Not all Authorised Participants for GLD would have access to the physical to do this, nor would they all be willing to take on such a financial exposure. Question to FOFOA: how many tonnes of GLD do you think are short?

A final point (and FOFOA probably won’t like this conclusion). I would claim that those at risk from this activity are not holders of GLD, but bullion bank unallocated clients because the legal title to the metal in GLD is held by the Trust, not the Authorised Participants or bullion bank unallocated clients.

Now this is a simple legal fact. It does not mean that in any meltdown when fractional claims come home to roost, holders of GLD will survive while bullion bank clients will not. It may happen that the custodians do “take” the gold behind GLD and give it to their unallocated clients first and use the get out clauses in GLD to say they “lost it” or some such other fraud if they are unable to subsequently replace it. Some believe that this is likely behaviour, others that no matter how ruthless bullion banks may be, that they would not engage in such outright fraud. I'll leave that to you, the reader, to have an opinion on.

FOFOA seems to think this is a possibility because he thinks that the bullion banks somehow have a special right to the gold in GLD, see this comment:

A place to park your unallocated deposits and sell them for dollars that can then chase an ROI, knowing that the gold will still be there for you to buy back any time it is needed, because you are an Authorized Participant with special rights to the gold.

I do not see how Authorized Participants have any special rights. Once they deliver gold and get GLD shares and then sell them for cash which they then "chase an ROI", they give up an rights to the GLD share or gold. Yes an Authorized Participant has special ability to redeem GLD shares for gold, but they have to tender the GLD share first, which in the situation above, they can only obtain by buying GLD shares off investors, thus pushing the price up.

If you, the reader, think that it is likely that bullion banks would steal Allocated gold, I would then argue that if a bullion bank was to consider engaging in such fraud, it would not do so with GLD’s Allocated metal because that is an exchange listed product with regulatory, audit and client visibility (through the bar list). Using Allocated metal held by other clients with the bullion bank would be a far lower risk as that is an over-the-counter market arrangement, subject to far less oversight as it is in the "dark". Again, GLD represents the least risky paper gold – the last to fall, so to speak.

Remember that gold ETFs are only 2,000t out of 30,000t of privately held gold, a fair bit of which is Allocated with bullion banks and other custodians. I think it is a more believable thesis that any short covering, fraud etc is more likely to occur in the over-the-counter "dark" market first, leaving the visible ETFs to maintain the façade that everything is OK.

The point of my discussion above is not to suggest GLD is a safe investment. It is just to introduce a little more nuance beyond a simplistic “GLD is bad because bullion banks involved.”

In respect of point 2 about the shorting of GLD, I would like to see some numbers on that. I am not sure it is as pervasive as implied. This article on ETF shorting in general and ETF settlement fails give a sense of the extent of the issue, but unfortunately GLD is not mentioned.

One final comment by FOFOA:

From my perspective, GLD had the opposite effect on the price of gold (and may have been intended for just that purpose) as it diverted growing investment demand away from the tightening physical market.

All I will say to this is that is was not intended by the WGC for that purpose and there was obsession about creating a product that resulted in "physical offtake". Whether the vehicle that resulted was the best design is another matter. There seems to be this view that the WGC is part of the "bullion bank conspiracy". I suggest one look at the membership of the WGC and some of the companies and their involvement in other activities supportive of gold. WGC wanting the gold price to drop doesn't stack up in my view.

Funny business in GLD

FOFOA has an interesting speculation on the movements in GLD:

So now I offer up a scenario, not as a statement of fact, but as fodder for thought and discussion. In this scenario I am not assuming that the drain on GLD to date has been the direct redemption of ETF shares by Giants. I presume it is simply redemptions by Bullion Banks in order to meet the delivery demands of "important clients," real Giants, perhaps from Asia and the Middle East. And because the BBs would normally have better options than plundering GLD, I am assuming those options are either gone or far more problematic than legalized looting.

Also, following Lance Lewis' "puke indicator," one could be forgiven for suspecting that the Bullion Banks have some way to temporarily "pound" the price of gold down on the COMEX in order to buy back ETF shares during a "good price window" with the intention of redeeming those shares into deliverable gold for clients that purchased it at a higher price.

I left a comment, which I post below FYI:

The reason one cannot correlate gold price and GLD holdings is because authorized participants (AP) don't have to create and redeem GLD shares on a daily basis in response to investor activity in GLD.

For example, if you're an AP and have a view that the market is bullish, then you expect over time to see net buying of GLD. Therefore, if on one day there is net selling of GLD, then you can:

1. Buy GLD shares

2. Immediately lease gold and sell it (or just short futures).

3. AP is now long GLD and short unallocated gold or futures. Important to note they have no exposure to gold price movements.

4. Sit on the GLD shares and when investor bullish sentiment returns

5. Sell your GLD shares

6. Buy unallocated gold and repay your lease (or close out your short future).

The above process means that the AP avoids GLD share redemption and creation costs.

Same thing happens in the face of net buying - an AP borrows gold and delivers it to GLD for shares, which they sit on an over a period of time sell into demand for GLD.

This is a way of minimising transaction costs when making a market in GLD or SLV or any other ETF.

The end result is that we see lumpy creation and redemptions, reflecting accumulated buying or selling activity over a number of days.

In the case of large lumpy redemptions, that can reflect an AP who held on to GLD shares in the expectation they would be able to offload them later into expected buying. If that buying does not eventuate, then the AP offloads the lump of GLD share they have as they are incurring ongoing funding costs.

You are correct in that redemptions of GLD cannot really be used to infer too much about what is going on re investor sentiment. The GLD bought back by an AP and gold redeemed is just sold by the AP to someone else, ultimately.

All GLD holding movements tell us is the sentiment of GLD holders. All that futures tell us is the sentiment of futures traders. Are these markets representative of the all private investors in gold. Maybe, maybe not.

What commentators miss is the OTC "dark pool". Consider that ETFs + Futures only represent less than 10% of estimate privately held gold (see this post).

In that case, we should not get too excited by the activity we see with ETFs and futures as it is not where the real giants are.

Consider also that bullion banks know their activities in ETFs and futures can be seen/deduced in some way. Therefore you must assume they let you see what they want you to see, with their real position and activities hidden in the "dark" OTC market.

Australian Housing Prices

I've been following an excellent series of posts on the high cost of Australian housing and land from The Unconventional Economist blog. Worth a look if you are interested in the reasons why this is the case - Leith van Onselen's puts it down to restrictive government policies on land use.

Reserve Bank of Australia Gold Sale

Further to The Australian's 11 January article "Reserve Bank's gold sale cost us $5bn", I thought my readers may be interested in the then Perth Mint CEO's response to the 1997 sale.

Consider these quotes:

"It is important to remember that we are evaluating gold now in a low-inflation environment, in which other financial assets are currently performing extremely well, the most important of which is the stockmarket. However, current conditions are not going to last forever. In my experience, in the long term, politicians cannot help themselves. When they are faced with a really tough decision, such as the one creeping up on them now - that of how to create jobs - they will take the easy option and let inflation go."

and

"When the crunch comes, governments will want to be re-elected. Rather than take the tough decisions, they will turn the inflationary tap back on. For that reason, I believe that gold will again have its day. I have not lost faith in gold."

The foresight of these statements come from the fact that Mr Mackay-Coghill worked for International Gold Corporation (Intergold) from 1971 to 1986. Intergold represented South African miners in the production and selling of Krugerrands and Mr Mackay-Coghill was responsible for the introduction of the Krugerrand to world markets in his role as CEO of Intergold.

Sprott says SLV has physical?

I found it interesting in this Sprott piece The Silver Lining that Sprott includes SLV in his table of "real investment demand for silver".

In the context of his point that GFMS and The Silver Institute neglect investment demand, I assume by the use of the word "real" Sprott must mean physical. In which case by including SLV's 305,205,951oz he is therefore saying it does have the physical.

If SLV doesn't, then he shouldn't include it in the table as their holdings would represent fake paper silver. However if he doesn't include SLV then he has no point about GFMS/Silver Institute missing investment demand of 225,783,924oz because without SLV the "aggregate implied investment demand" figure from GFMS/Silver Institute covers the other funds' inflows.

Recent Posts

I'm posting now on the corporate blog, recent posts FYI:

A World Of Multiple Reserve Currencies

Vote On Proposed Changes To PMG

Gold Helps Manage Risk More Effectively