The Dangers of Paper Gold

This is an article written back in 2006 as part of bullionvault's documentation. However, it also provides a very good explaination of what paper gold is and why it a very unsafe investment.

The original article can be found here.

[begin article]

Take care when buying from a bank

Unallocated gold

As you set out to buy gold the first thing you need to know is that 95% of the world's gold traders will automatically sell you the wrong type.

Unallocated gold is the most widely traded form of gold in the world. It hides a way of advantaging the provider - usually a bank - by subjecting buyers to a risk they will frequently remain unaware of until it is too late. The widely quoted 'spot price' refers to this unallocated gold, and this is how it works:-

1. When a bank sells you unallocated gold on the spot market you become a creditor - i.e. the bank owes you gold which you do not own. The bank is taking advantage of the fact that you are not quite sure what to do with any gold you buy, and it feels logical - to most gold buyers - to put the gold safely in the bank. When you do this you become, in law, a depositor of gold. Most people now relax in the belief that they own gold completely securely, and they do not pay the little extra - above the spot - to have their trade formally 'allocated'.
2. A bank is required by its regulator to hold a proportion of its liabilities as certain types of assets capable of being turned into cash quickly during times of crisis. It is a liquid reserve and it's there to protect the bank from a common type of problem - a liquidity crisis - which occurs when a bank has short term deposits, long term loans, and insufficient cash to meet the immediate demand for withdrawals. Physical gold bars are accepted as a very good form of liquidity reserve because they can be turned quickly into cash. 
3. If a bank has physical possession of some gold which it owes you as its creditor the bank itself is the current owner of the gold. While this gold remains unallocated to you the regulator considers it part of a bank's liquid reserve. This makes unallocated gold an attractive way for the bank to maintain its regulated liquidity, because you have paid for your gold, and the bank is free to use your money, while it is also able to add your unallocated gold holding to its own reserve. 
4. So your unallocated gold would be ditched if the bank were in need of cash. It has no choice in the matter because liquid reserves are there to be sold at short notice to protect the bank's general creditors - all of whom, including you, must receive a proportionate share of whatever is raised from the sale of assets should the crisis deepen and the bank become insolvent. 
5. If that did happen you would be in a bad position. The bank's small gold reserve would be diluted by non-performing bond portfolios and other assets which don't sell well in a crisis. The last line of defence for bank depositors is deposit protection, which is a state underwritten mainstay of banking confidence in the West. But it does not apply on bullion debts like yours. Deposit protection is there as a confidence-builder for the national currency only, which means unallocated gold actually offers less protection from bank failure than a cash deposit. So having been the provider of the bank's liquidity reserve you will then be in the minority of those offered no protection by the state's guarantee.
6. So it is important not to be impressed by unallocated gold, or by it being physically stored in a bank's vault, or by it being checked daily by bank regulators. Regulators are checking it to make sure the bank maintains a liquid reserve, and they are not interested in your entitlement as a bullion creditor.

Allocated gold is different because you become the outright owner of gold and you are no longer a creditor. Your allocated gold is your property and it cannot be used as the bank's reserve, so with allocated gold you get proper protection from systemic failure.

Unfortunately with allocated gold your money does the bank no good. And since modern banks reckon to earn 20% each year on capital employed, their loss of use of your allocated gold is disappointing for them. This is why banks usually charge nothing for unallocated storage and at least 1.5% per annum for allocated storage, with the result that professionals in the bullion market reckon that less than 1% of gold traded within financial markets is allocated.

[ end article ]

This means that an incredibly large sum of money has in effect been stolen from people who believe they own gold through derivatives such as SPDR and iShares. The truth of the matter is that not only is there no guaruntee that the paper you hold is even backed by actual gold, since under the fractional banking system, the bank is allowed to lend out 10 times more gold than it actually possesses, which is how the large banks try and keep the Gold and Silver bullion prices depressed. JPMorgan allegedly has short positions on 500million ounces of Silver, which is $14,200,000,000USD worth of silver. With that kind of paper firepower, you can see how the large banks can influence the market in precious metals with nothing but paper ETF's.

As if were not bad enough, because of the way the law is structured, legally speaking, you do not actually 'own' the gold backing an ETF in the same way that you own say, your car.

If your car is stolen, it is immediately recognised as your posession and the law enforcement authorities will make an effort to restore your property to you.

This concept of ownership is easily understood by most people. However, when you own gold shares or other derivatives, you do not actually own the asset that the derivative is backed by, you only own the derivative, which, being made of paper is basically worth nothing.
As if that were not bad enough, there is no real legal way to recover your property if a bank that issues a derivative either collapses or is found to be engaging in systemic fraud. Since the gold holdings of the bank are regarded as Tier 1 (the most liquid kind of asset) they are the first assets seized by the creditors.
Another thing that is not widely known is that there is a pecking order when it comes to money recovered from a bankrupt company. The first in line are large financial institutions that the bank owes money to, after all, if they are not repaid, it could possibly cause bank failure and contagion.
Next are the shareholders and finally, if there is anything left over there are the bond and derivative holders. Needless to say, the chance of an average person getting any of their money back in the event of a bank failure is practically zero. Also, derivatives are not insured by the FDIC, they only insure cash deposits, so there wont be any help from the government either. -Ed ]

This is how the huge majority of the world's owners of bank held gold are - probably unwittingly - storing their personal reserve in a way which fails to meet the most common objective of gold buyers.

The only way out of this predicament is to place physical bullion with a company under the terms of bailment. Bailment is in effect much more like the kind of property law that people instinctively understand, for instance, if you pay to leave your car in a car park, it is treated as a bailment. The property remains yours, the car park (in this instance) is only taking care of it. Not only do they have a duty of care to make sure that your car is safe, they often have insurance in case of theft.

Essentially, you are paying someone else to take care of your property. There is never any question of whether the property is yours and the comany holding it has a duty of care to look after it 

Now imagine if when you parked your car, you were given a 'derivative' on your car. You go on your merry way, without realising that the garage can lend out your car and make money off it while it is in their posession. Not only that, buy they can actually sell ten times more cars than they actually have in the garage.

So you come back to carpark to pick up your car and guess what? It isnt there. The carpark has gone bankrupt and creditors have siezed all the remaining cars in the garage (in other words, the Tier 1 capital, stuff that can be easily turned into cash)

When you look into trying to recover the money that your car was worth, you find there is nothing left, since the creditors have taken everything. All you have is a fancy looking piece of paper and a feeling of intense regret and confusion.

Now, I know this is a rather complex example, but it has alot to do with what people mean by 'ownership' generally, people think that if they own something, even if it is being kept by someone else, they will get it back when they need it, they dont think that the person holding the property has the right to sell it (this is known as theft).

In the case of derivatives, all you actually own is a piece of paper with a number printed on it that refers to an asset that may, or may not exist. Generally in times of economic expansion, these scams, like Ponzi schemes, work fine, because there is enough new money coming in to cover any withdrawls that people make from thier accounts. Generally, after people have withdrawn their money a couple of times and gotten consistant high retuns on paper, they will assume that the scam is real and will start throwing as much money as they have at, watching the numbers on the computer screen go up and up, without realising that they are not actually backed by anything.

Bullionvault allows people to purchase gold and silver on bailment, which means that they have a duty of care to the gold that is indisputably yours. They can't lend it out, they cant shave bits off it to cover expenses and if for some reason your gold were to dissapear, then from the point of view of the law, it is as though your valuable property, like your car or your jewellry, was entrusted to a custodian who then stole it, which is theft and punishable as a criminal offense in a much more direct manner than matters relating to derivatives.
Frequently when derivative funds collapse, there is great difficulty in people getting back their assets, because they may have been lent out to another bank, who then lent them to another bank, who then securities them and sold the paper on to a bunch of middle class people with no knowledge of finance.
This was the big problem with Credit Default Swaps during the financial crisis, because they had been sold on so many times, no one had any idea who actually owned them. The same was true with securitised mortgages, or Collateralized debt obligations, (CDO's) since the banks had been making more money selling off the securitised loans, they just gave loans to anyone, hoovering up loans that they could then sell on as CDO's. When it all came down, no one had any idea who owned which house, in many cases, banks had forgotten to get title on the property, they were so anxious to complete the loan, which has lead to a number of sucessful legal challenges against forclosures in the USA, since the law stipulates that a property cannot be repossessed unless the bank has a copy of the deed.


Anyway, I think that is enough for one post. I guess if there is one thing I want you to take away from reading this article is the realization that you cannot really 'own' equities, derivatives or bonds in the same way that you can own actually assets or commodities.
You would think that this is obvious, but many people dont really think about it, or even worse, believe what their bank tells them. Despite what the banks say, their only aim is to use your money to make more money for themselves, which means that much of what they say and do is either bent, fraudulent or blatantly criminal.
We have gotten to a point now where the Shadow Banking System has become massive because of the huge size of the global black market, which, believe it or not, now account for 50% of the planets GDP.
This money has to go somewhere and the big banks are willing to look the other way to get their hands on that money, as the recent revelations about HSBC show.
Trusting Banks is a sure fire way to ruin. Screw the banks, own things yourself. =)


Christopher Carrion