Eric King subsequently interviewed Mr Davies about this report:
The basic message of Mr Davies is that serious investment professionals should avoid investment in gold Exchange Traded Funds (ETFs), but should be invested in physical gold instead.[ETFs are funds which wrap commodities or baskets of other shares, inside a share structure. For instance, with a gold ETF, the fund buys and sells gold in the commodities market and then buys and sells shares representing this underlying gold in the stock market. The idea is that investors can then buy and sell gold via the convenient and liquid channel of the stock market, instead of the more complicated commodities and futures markets. As well as buying and storing physical gold, ETFs may also engage in complex derivatives trades to maintain share price liquidity. Perhaps the best known precious-metals ETF is the SPDR Gold Shares trust, which is denominated on the markets by the GLD ticker, and which is currently valued at approximately $50 billion Dollars.]
The contention from Mr Davies is that Wall Street did not invent ETFs for altruistic reasons. The fund managers take a management fee and the construction of an ETF provides the liquidity required for swift arbitrage trades in a chosen market. It is an unwieldy process moving bars of physical gold around, from one secure Swiss vault to another, but it is the work of a nanosecond to buy or sell an ETF share.
The problem is that the main reason you buy gold is to mitigate the effects of potential systemic risk. If the world should walk into a hyperinflative shock or some other systemic meltdown, then physical gold will be an island of economic safety. If you hold a bar of physical gold, aside from the security risk of needing to keep it safe from thieves and government officials, you encounter no counterparty risk and therefore no default risk. You buy gold to retain wealth, rather than to accumulate wealth.
But ETFs only work in a ‘normal’ market of wealth accumulation, thinks Mr Davies, because when the balloon goes up, precious metal ETFs are subject to indemnification risk with the ETF’s chosen vault; audit risk, with the ETF appointing the people who inspect their vaults; counterparty risk with the ETF fund managers; and worst of all, title risk.
The ETFs may have real gold in a real vault (subject to audit risk) to back their shares, but who owns this gold? The 53rd page of a complex prospectus addendum might reveal that in a systemic global financial meltdown, the gold bar property title reverts to the monetary authority central bank who leased out the gold bar which is currently backing the ETF share.
Mr Davies thinks that if you’re below £25,000 pounds in your investments, then ETFs may be a valid vehicle to keep things simple for yourself as a retail customer. However, if you are above that number, and especially if you are in the £500,000 investment league, then you should buy allocated physical gold yourself and store it yourself, rather than through an ETF.
International Accounting Standards governing property titles can be ambiguous and gold leased into the Over The Counter (OTC) markets, by monetary authorities, could sit inside an ambiguous grey area. This kind of gold is said to have its property title ‘encumbered’, and Mr Davies thinks it is inconceivable that ETFs have not been trading with encumbered gold to keep their costs down.
The danger comes if we should encounter a monetary breakdown of the type described in Alongside Night. Real physical gold prices will then rocket out to the Moon, while ETF share prices may collapse due to fraught legal dispute about encumbered titles, with the central banks and governments possibly even declaring emergency laws in their own favour to settle such cases.
With just a small handful of major bullion banks dominating the precious metals business, and with some of these banks being investigated for price manipulation on the COMEX markets, Davies thinks that the physical gold market has degenerated into a fractional reserve system, with more pieces of paper out there representing gold, than actual bullion bars of gold. This is why he compares gold ETFs to the infamous CDOs.[The Mogambo Guru thinks there are 50,000 less tonnes of gold in the world than are officially represented by fancy stamped pieces of paper, which is about 25 years of current gold mining production. For another interesting slant on the background to the attitude adopted by Mr Davies, Cobden Centre readers might also want to read a Huffington Post report from last year, on COMEX, entitled Where’s the Gold? This report is by Nathan Lewis, author of Gold: The Once and Future Money]
Fortunately, many people are recognising the leveraged basis of the gold market and they are moving into allocated physical gold. This is a good thing, because every time someone buys paper gold, they may be expanding the gold fractional reserve and driving the gold price down lower, but when they buy physical gold and take it off the market, they are boosting the price.[Indeed, Mr Davies thinks that holders of ETF contracts should demand delivery of physical gold, if possible, to weed out what is fictitious paper metal and what is tangible real metal.]
With this increased demand for physical metal, especially from Switzerland and the Far East, Davies thinks that when the pullback in the gold price settles down, and the bull market gets going again, we could see gains of between $400 Dollars or $500 Dollars an ounce, in the next leg up.[I am confident that every Austrian gold bug in the world hopes he is right. I must say, as an Austrian gold bug, it’s painful to find that the one market we like to believe in, the gold market, has been so ruthlessly infected by the same fractional reserve virus we think gold is going to save us from.]