Gold Bullion Unique as No Counter Party Risk
Gold is unique among asset classes as it is the only asset class not
dependent on the performance of auditors, management, corporations, financial
institutions, banks, politicians and governments. Nor should physical gold be
dependent on the performance of trustees, custodians and or sub custodians.
Gold does not depend on the performance and health of the wider
economy and as importantly when you buy gold in its physical form there is no
third party liability or credit risk. Or at least there should not be. Gold
has an intrinsic value in and of itself that is not contingent on someone
else's or some entities performance or mere promise to pay.
Thus, gold in its physical form is still the ultimate form of
financial insurance. This is why every major central bank in the world still
maintains a significant portion of their reserves in gold bullion and many,
such as the Chinese, are now increasing their gold bullion reserves.
Exchange-traded fund (or ETF)
An exchange-traded fund (or ETF) is an investment vehicle or a
security that tracks an index, a commodity or a basket of assets like an
index fund, but trades like a stock on an exchange. A gold exchange-traded
fund is an exchange-traded fund that tracks the price of gold. It is akin to
a derivative that derives its value from the value of the underlying asset.
Gold exchange-traded funds are traded on the major stock exchanges including
Zurich, Mumbai, Sydney, London, Paris and New York. One can sell short, buy
on margin and purchase as little as one share.
In November, 2004 the first gold exchange-traded fund in the United
States started trading. Known as GLD, this exchange traded fund allowed stock
investors to buy a stock-like asset designed as per the GLD website to
"track the price of gold". Thus it was beneficial in allowing
speculators to gain exposure to the gold price and go long or short gold.
Risks Posed by ETFs
From the outset many respected analysts have questioned the precious
metal ETFs and their precious metal backing and have warned of risks in these
ETFs and warned that they should not be confused with owning physical gold
and actual physical bullion.
When one buys an ETF or exchange traded fund, one is buying a
derivative or a financial instrument which derives its value from or whose
price is dependent on the underlying equity, indices, commodity or precious
metal. One does not directly own the underlying asset and one does not have
an automatic right to take possession of the underlying product.
This defeats the purpose of buying a hard tangible asset and finite
currency like gold. This is because the fundamental point of investing in
gold bullion is that it is the safe haven asset which investors turn to in
times of geopolitical, financial and systemic uncertainty - the asset of last
Gold's primary investment purpose is as a long term or permanent
defensive portfolio holding which can be used during one's retirement, passed
to children, grand children and great grand children. It is used to diversify
one's investments, as a hedge against macroeconomic factors such as inflation
and systemic risk and most importantly as financial insurance.
ETFs Good for Speculating but not for Safe Haven Investing
ETFs are paper vehicles or derivatives that track the price of gold or
silver. With ETF's a speculator is hoping to profit from short term
fluctuations in the price of or value of the derivative instrument. Thus ETFs
are not assets in the traditional sense of that word. An asset is an item of
property or an item of monetary value owned by an individual or institution.
ETFs are a form of debenture. Unlike physical gold bullion which is
held in personally allocated storage, if an ETF provider went into
liquidation the investor will only become a general creditor. In the event of
a 1929 style stock market crash or a systemic crash, banks and financial
markets may be closed for a period of time and financial markets including
ETFs would become illiquid (as recently happened to some Exchange Traded
Commodities (ETCs). Immediately after his inauguration as president in 1933,
Franklin Roosevelt instituted a four-day bank holiday and Italian Prime
Minister Silvio Berlusconi recently said that political leaders are
discussing the idea of closing the world's financial markets while they
"rewrite the rules of international finance."
Unlike gold, an ETF confers a possible future financial benefit on the
owner. But when one possesses real gold bullion one owns in the present a
real tangible asset which one can see and touch and can sell at anytime -
especially in a financial crisis when demand soars and prices soar.
Derivatives are derivatives and are nor hard, tangible assets.
Derivatives can become illiquid and impossible to sell. If an investor wants
to invest in property, they do not buy a derivative. One can speculate on
property prices through spread bets, contracts for difference (CFDs) and
covered warrants on the Halifax house price index and on indices in the US.
But property like land and gold is a hard tangible asset and most investors
rightfully prefer the security of directly owning their own home, investment
apartments, houses, offices, land or gold. It is the physical and tangible
dimension of property or 'bricks and mortar', land and gold that is
rightfully attractive to investors internationally.
Paper derivative property vehicles are better used in order to hedge.
If one already has a large portfolio exposure to property one could use these
instruments to 'short' the property market and hedge one's investment.
Similarly some investors who have large gold bullion holdings might use the
ETF to hedge themselves against pull backs in the gold price.
Other Possible ETF Risks
Some of the other issues facing these recently created financial
instruments include valuations, annual fees and expenses, counter-party risks
as well as liabilities and responsibilities of the market participants such
as the auditors and custodians. Also, only very large investors with a holding
of over 100,000 shares (worth some $9 million at today's prices) can take
delivery of the exchange traded fund gold.
Some of the many "Risk Factors" detailed in the prospectus
for GLD and replicated largely by other precious metal ETFs are:
- "The Trust's gold may be subject to loss, damage, theft or
restriction on access."
- "The Trust may not have adequate sources of recovery if its
gold is lost, damaged, stolen or destroyed and recovery may be limited, even
in the event of fraud, to the market value of the gold at the time the fraud
- "The ability of the Trustee and the Custodian to take legal
action against subcustodians may be limited, which
increases the possibility that the Trust may suffer a loss if a subcustodian does not use due care in the safekeeping of
the Trust's gold."
While all of these conditions are reasonable and standard in typical
ETFs, they show the risk of owning these financial instruments rather than
owning physical bullion in one's possession or in a personal allocated
Another important and very worrying indemnification is with regard to
the very important matter of the standard and the purity of the gold meant to
be held in the exchange traded fund:
- "Gold bullion allocated to the Trust in connection with the
creation of a Basket may not meet the London Good Delivery Standards and, if
a Basket is issued against such gold, the Trust may suffer a loss.
Neither the Trustee nor the Custodian independently confirms the
fineness of the gold allocated to the Trust in connection with the creation
of a Basket. The gold bullion allocated to the Trust by the Custodian may be
different from the reported fineness or weight required by the LBMA's
standards for gold bars delivered in settlement of a gold trade, or the
London Good Delivery Standards, the standards required by the Trust. If the
Trustee nevertheless issues a Basket against such gold, and if the Custodian
fails to satisfy its obligation to credit the Trust the amount of any
deficiency, the Trust may suffer a loss."
These many important indemnifications mean that the
these ETFs carry additional risks and are not the same as owning
actual physical gold.
There are too many parties, intermediaries such as trustees,
custodians and sub custodians between you and the gold in the ETF.
Worryingly, doubts have been raised by respected individuals in the gold
industry regarding the auditing of the gold. This should be automatically
done in order to confirm the fund is fully backed by gold bullion and to
verify that all the gold is of the right purity. Also, an audit is necessary
to confirm that the gold is fully accounted for and not swapped and leased
which has been common practice in recent years.
This is the only type of fund that the SEC has ever approved for the
retail level that isn't required to audit the assets that are meant to back
the fund. Many precious metal ETFs have loose custodial controls which
conflict with longstanding SEC and other jurisdictional requirements. Given
the SEC's and other regulatory bodies complete failure to properly regulate
and protect investors in recent months, it would be best to err on the side
of caution when dealing with these new financial instruments.
Thus ETFs are a great way to speculate on gold's spot price, just as
futures contracts are a great way to speculate on gold's future price. But
neither should be viewed as an alternative to owning the physical metal
either in your personal possession or in bullion accounts in safe and secure vaults.
Thus, the key issues facing these emerging financial instruments
include the fact that
- they are derivatives backed by gold and not outright or titled
ownership of physical bullion
- the ongoing annual fees and expenses
- poor level of governance and custodial control
- auditor risk - the bullion holdings are not independently audited
- indemnification from many substantial risks
- intermediation, counter-party risk and systemic risk involving the
sponsor (World Gold Trust Services), the trustee (The Bank of New York), the
custodian (HSBC) and the many sub custodians who include the Bank of Nova
Scotia (BNS), ScotiaMocatta, Deutsche Bank AG (DB),
JPMorgan Chase Bank (JPM), and UBS AG and the Bank of England
These are the primary reason why we do not recommend investors buy the
ETF. We believe that ETFs are a good way to speculate on gold's spot price or
to speculate or invest for the short term. But we do not believe that the ETF
should be viewed as an alternative to owning the physical metal either in
your personal possession or stored with secure and trusted third parties.
A fundamental consideration for investors and savers in these
extraordinary times is counterparty risk and thus proximity to one's gold.
Gold is the only asset class that is not someone else's liability and
thus it is important when owning gold to not be exposed to counterparties in
the form of brokerages, banks, auditors, insurance companies, trustees,
custodians and sub custodians. Intermediation is to be avoided and this is
why many investors are increasingly favoring taking
delivery of gold bullion (storing in safety deposit boxes, home safes or
elsewhere in the one's home with home insurance), owning gold certificates
where bullion can be taken delivery of, if need be and safe allocated
accounts with secure and trusted third parties in safer jurisdiction (such as
There is a risk that many hapless and badly advised investors will
realize too late that precious metal ETFs are akin to derivatives, investment
vehicles or securities that track the price of gold and not the financial
insurance of real physical bullion.
Gold remains the ultimate safe haven asset and investors should be
certain that they own actual physical bullion in order to protect themselves
from very significant macroeconomic, systemic and monetary risk.
Gold & Silver Investments Limited trading as Gold Investments is
regulated by the Financial Regulator as a multi-agency intermediary. Our
Financial Regulator Reference Number is 39656. Gold Investments is registered in
the Companies Registration Office under Company number 377252. Registered
for VAT under number 6397252A. Codes of Conduct are imposed by the
Financial Regulator and can be accessed at www.financialregulator.ie or
from the Financial Regulator at PO Box 9138, College Green, Dublin 2, Ireland. Property, Commodities and Precious Metals are
not regulated by the Financial Regulator
information in this document has been obtained from sources, which we
believe to be reliable. We cannot guarantee its accuracy or completeness.
It does not constitute a solicitation for the purchase or sale of any investment.
Any person acting on the information contained in this document does so at
their own risk. Recommendations in this document may not be suitable for
all investors. Individual circumstances should be considered before a
decision to invest is taken. Investors should note the following: The value
of investments may fall or rise against investors’ interests. Income
levels from investments may fluctuate. Changes in exchange rates may have
an adverse effect on the value of, or income from, investments denominated
in foreign currencies. Past experience is not necessarily a guide to future
All the opinions expressed herein are solely those of Gold & Silver
Investments Limited and not those of the Perth Mint. They do not reflect
the views of the Perth Mint and the Perth Mint accepts no legal liability
or responsibility for any claims made or opinions expressed herein.
Mark O'Byrne is the Managing Director of Gold Investments,
Ireland's Asset Diversification and Wealth Preservation Specialist. He is
regularly quoted and writes in the financial media and was awarded
Ireland’s prestigious Money Mate and Investor Magazine Financial
Analyst of 2006.
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