The Danger of Paper Gold

Recently, a reader of International Man responded to an IM article regarding the danger of trusting banks (or anyone, for that matter) to hold gold in their names. He said, "How would a bank sell gold to a client and the client not take delivery? This seems strange to me."

For those of us who have held gold for decades and have therefore had the advantage of watching the gold market develop with a seemingly endless number of permutations of ownership, the answer might seem obvious. However, his question is a reminder that there exists a great variance in the level of knowledge as to what, on the surface, seems to be a simple act - buying gold.

To those who are new to gold ownership (and I believe their numbers will soon be increasing exponentially), it would seem perfectly reasonable that gold could be purchased as simply as buying any commodity. If, for example, someone were to want to buy an apple, he would simply go to the grocery store and pay the price marked on the apple bin. If, however, he wanted quite a lot of apples, he might go to several stores and have a look at the prices marked, then choose the lowest price. Looked at from this perspective, it seems perfectly reasonable that the purchase of gold would not be significantly more complicated.

However, our local grocer, unfortunately, does not have bins full of Krugerrands and Maple Leafs with prices marked above them. While we sometimes have the opportunity to buy gold from private parties or coin dealers in which a selling price is stated up front, most gold purchases are done through middlemen (banks, investment funds, etc.) who do not actually own the gold they are selling. The middlemen, understandably, are forever seeking ways to maximise their profits on the transactions, and this has led to the number of permutations that exist today.

Risky Business

One of the most risky of these, to my mind, is the Exchange Traded Funds (ETFs), investment funds traded on stock exchanges. Not surprisingly, this method of purchase is the favourite of stock brokers. It is an easy sell for them, since it is structured the way stocks are structured. It therefore seems safe to stock investors. It is not.

With most stocks, the buyer owns a portion of the company, rather than a specific number of the products that the company deals in. When investing in a fund, the fund generally owns a portion of the companies it has invested in. With buying gold through ETF's, however, the buyer is under the impression that he has bought the actual product, when he has not. In many cases, the fund does not have possession of the gold. Therefore, the buyer has bought the "promise" of future ownership.

The first step for many first-time buyers is to say to himself, "I don't know much about this gold craze, but I'm getting worried, and I'm beginning to believe that gold can give me a measure of security. I'll go to my broker and ask him what I should do." When the broker gives him the "inside scoop" on the best ETF, the buyer may say, "What do I do with the gold? How do I store it?" He is likely to be advised, "Don't worry, the fund handles all of that. You won't actually have to deal with the physical gold at all. You just benefit as it goes up in value."

At this point, the new buyer has the answer to the question asked by the reader in the first paragraph of this article... or at least he has an answer that sounds reasonable to him. He is, however, buying into a scheme that, to my mind, is almost guaranteed to lose his investment for him.

When the Bottom Falls Out

The trouble with ETF's is that, since the fund may not actually purchase the gold, since they have only issued a promise to purchase the gold if it becomes necessary, the fund only works as long as gold trading remains fairly stable. If, however, there is ever a rush on the part of purchasers to take delivery of their gold, ETF's will be the first to go under.

Why?

Because at this point, banks worldwide, stock traders, bullion dealers and others are all offering gold for sale. Most of them do not actually buy and store the gold as their clients purchase it. Banks, for example, typically operate under a Fractional Reserve system, which means that they maintain only a small portion of what they have agreed to supply.

If, for example, each bank were to hold only 10% of the gold it has sold (10% is a commonly accepted banking standard, although many banks hold nowhere near that amount), they make a handsome profit by selling gold without ever actually purchasing it. Since this is standard practice amongst the banks and other financial institutions, funds, etc., it is entirely possible that the total amount of gold that has been sold worldwide greatly exceeds the amount of gold that exists in the world.

The reader above might then be inclined to say, "But that can't be. They must know that they are taking a terrible risk." There can be little doubt that those who sell gold which they do not possess are very aware of the risk. The layman might imagine that they would stop selling gold, but this has not been the case. What they have done instead is cover themselves for the eventuality of a run on gold.

Whenever anyone is considering buying gold, he should first look at the paperwork very carefully. Almost invariably, he will find disclaimers that allow the seller an "out" if the scheme fails. Sometimes the fine print will state that all that is being sold is a promise. In other cases, it will say that the seller makes use of an outside facility for storage, and the buyer is therefore subject to the conditions of that storage facility. If the buyer were to request a copy of that agreement he might find that the terms of the "storage facility" amount to only a promise to purchase. (Incredibly, this is now the case with one of the world's most trusted national mints where large-volume buyers believe their gold to be stored for them.)

So, considering the above, is there a safer way to buy gold? Yes, "safer", but not necessarily "safe".

"Midnight Gardening" & Other Gold Storage Options

A safer way is to purchase gold through, say, one of the Swiss banks, which have a reputation for actually buying and storing the gold in your name. In particular, the Cantonal banks, which are legally restricted from having branches outside of their Cantons, offer a margin of safely from pressures brought to bear by foreign governments. However, a premium is paid for this service. The transaction costs are high, and, understandably, there is a storage charge. Additionally, in order to retrieve your gold at some point, you would have to take physical delivery, then transport it to a new destination to be sold.

Few banks are free from danger from the governments of the First World. Amongst the exceptions would be Hong Kong and Singapore.

You may wish to consider them. You may also consider taking delivery in your own country and renting a box in the vault of your local bank. This would be secure unless the bank were to fail, in which case it is possible that your gold would "disappear". The advantage would be that, as the bank is local, you might have the opportunity to act before the bank folds.

Some people install a safe in a wall of their house, but, whoever does the installation knows that it is there. Additionally, burglars are accustomed to looking in all the standard locations. If you were to go away for the weekend, you might return to a large hole in the wall where your safe was.

You might also consider "midnight gardening", a time-honoured method that involves digging a hole in the backyard and burying a box filled with gold. However, this is not very handy if you need to keep adding to it. Also, if the neighbours saw you bury it, you may find the hole empty one day.

You may choose GoldMoney or GlobalGold, which will buy and store your gold, or arrange delivery.

An alternative method of storage, such as Das Safe in Austria, is entirely separate of a purchase account and simply acts as storage. Again there is a downside in that, if you do not live in Austria, delivery may be problematic.

Gold Ownership: The Final Verdict

If the reader in the beginning of this article finds that his head is now swimming and that, whatever method he chooses to purchase gold, it has its inherent strings attached, he will be correct.

There is no one "safe" way to own and store gold, there are only methods that are safer than others. However, "paper gold," that is, any gold ownership that is merely an agreement, is very risky. The ownership of physical gold is certainly better, in spite of the storage problem.

Possibly the safest thing you can do for your wealth (even if it is small) is to put a portion of your money into physical gold and keep it in a country that is amongst the least likely to suffer government confiscation or have its financial institutions fail during the coming years. While the problem of "where to put it" is somewhat discouraging, perhaps the most important question you can ask yourself is, "What if I leave my money where it is, in the form that it's in... Would that be as safe as gold?"

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