Could Fractional Gold Banking Cause a Buying Panic?
Paul Mylchreest, in his May 4th, 2016 Report, examines gold trading in the London Bullion Market (LBMA). His data suggests the possibility of a future buying panic in gold. In essence, there is almost no physical gold in storage to cover the enormous number of paper claims on gold represented by unallocated accounts at the bullion banks.
Could Fractional Gold Banking Cause a Buying Panic?
Paul Mylchreest, in his May 4th, 2016 Report, examines gold trading in the London Bullion Market (LBMA). His data suggests the possibility of a future buying panic in gold. In essence, there is almost no physical gold in storage to cover the enormous number of paper claims on gold represented by unallocated accounts at the bullion banks.
Unallocated gold accounts are accounts in which depositors of gold, or purchasers of securities such as gold certificates, have elected not to pay for allocating and storing their gold separately from the bank's assets. Although terms may vary, this typically means that gold held against these claims, if any, can be re-hypothecated by the custodian bank in other transactions. The original claim may even be settled unilaterally in dollars if so-called force majeur clauses are triggered. The LBMA itself has estimated that unallocated accounts generate more than 95% of total market sales volumes.
Now, this arrangement is not a problem as long as there is confidence that physical gold is available at the market price. After all, it is very convenient to hold and trade paper. But the value of these claims is absolutely dependent on physical backing. For example, if gold certificates have been pledged as a hedge in a currency transaction, what happens if the one holding the pledge demands the real thing?
Here are Mylchreest's numbers on gold holdings in London, home of the LBMA, which is still the world's pre-eminent and highest volume gold exchange:
The critical 6,220 tonne number comes from the CEO of the LBMA herself in a June 2015 presentation confirming that there were approximately 500,000 London Good Delivery 400 oz. bars of gold stored in London at that time.
If this is analysis is correct, the London Bullion Market is facing the biggest challenge since the London Gold Pool collapsed from an insufficient supply of physical gold in March, 1968.
More than US$200 Billion in unallocated (paper) gold is traded every day. If some buyers suddenly face the need to hold or deliver physical, confidence in the market could be lost. We believe that the market would become disorderly (via an old fashioned "run" on the vaults) as it sought to discover the true price of physical gold. Not surprisingly, the ratio of physical gold to unallocated gold accounts is a closely guarded secret.
We do not foresee a shortage of physical gold. There are nearly 6 billion ounces of above ground supply. In our view, price would ration supply, re-establishing stability after a possible buying panic.
It may be that the pressure will be felt sooner than later. Demand for physical is on the rise. Gold ETFs have been increasing their physical holdings since January, 2016, as western investors dip their toes back into physical gold. And Chinese gold demand has reached astonishing levels as indicated by withdrawals of bullion on the Shanghai Gold Exchange...2,597 tonnes in 2015 alone, which is more than 80% of all of the gold mined worldwide that year. This demand is why substantial gold exports from the UK have been a feature of the market since 2013.
The vast pools of western capital are not underweight gold; they are essentially zero-weighted. Meanwhile, the reasons to own gold proliferate.
Gold is a bet on financial system mismanagement in its many guises...inflation, deflation, rising credit risk, declining confidence in policy makers and the degradation of property rights. The fact that mainstream investors and commentators have started to have doubts about central bank policies has been positive for gold. And unlike every other financial asset, including sovereign bonds, physical gold has no counterparty risk.
For years, the typical pushback on investing in gold by western investors was that it had no yield. However, more than US$7 Trillion of sovereign bonds now have negative yields meaning that gold accumulation can be justified on a yield basis.
A succinct explanation of the LBMA's structural flaws comes from Adrian Ash of BullionVault. "Imagine you could sell someone something, but keep ownership of it, and then use it yourself. You could lend it out for interest, say, or raise loans of your own by pledging it as collateral. Or even sell it to raise cash when things get tight. And if your business fails entirely, the 'owner' will just have to queue up with all of your other creditors, and be thankful with whatever small change is paid out by the courts. This is pretty much what big banks get away with in gold."
Does any of this matter? We think it could. Unlike dollars, real gold cannot be created out of thin air. We suspect that if enough investors who think they own gold actually try to take delivery, gold will be re-priced in an ensuing buyers' panic.