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Page added on January 26, 2011

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The London gold market’s detachment from physical gold

The London gold market’s detachment from physical gold thumbnail

There is no such phenomenon as “Peak Gold”, as the term “Peak Oil” is bantered about in the socio-technical discourse on non-renewable energy. Physical gold will continue to increase in quantity as long as gold mines continue to produce gold. But if and when all the gold in the ground has been mined, including those under deep sea beds, physical gold will still only stay constant in quantity without quantitative decline. Gold consumption involves only a transfer of ownership, not a physical depletion of gold. This is why referring to oil as Black Gold is problematic. And why oil is only a commodity, albeit a prime commodity, and why oil cannot perform as a reserve monetary asset.

London Gold Market not for individual traders
The London gold market is not accessible to individual traders because of two big barriers:
1. Large transaction size – The standard physical bullion accepted in trade is the London Good Delivery Bar, which weighs 400 troy ounces each (12.4 kilograms). At a price of $1,400 per troy ounce, each Good Delivery Bar is worth $560,000. This standard per trade module is too high in price for most individual traders. Even if gold price falls to $400, and one London Good Delivery Bar being worth $160,000, individual accounts are not large enough to attract the attention of dealers, the business economics of which prefers trades of $500,000 as a transactional minimum. That minimum is expected to increase over time due to rising overhead cost. The day will come when the trading unit of gold is 10 Good Delivery Bars. This high entrance threshold of individual investors is what drives the emergence of gold exchange traded funds (ETFs).
2. High regulatory qualification for opening gold trading accounts – Even if an individual is able and willing to trade sufficient amount of gold, most dealers will not accept an individual account except for extremely high-net-worth individuals. Logistical, regulatory and business considerations add to the high threshold of entrance to the gold trading game. Logistically, storing and delivering gold are costly undertakings that continually discount the monetary value of gold held. Regulatory requirements also place strict legal obligations on firms that deal with the retail public, These facts make individual accounts not a cost-effective business for profit-minded gold dealers.

Gold trading account types
There are two types of gold trading accounts:
Allocated Gold Accounts – These are accounts held by gold dealers in each client’s name on which are maintained balances of specifically identifiable bars, plates or ingots of metal “allocated” to a specific customer and segregated from other gold held in the dealer’s vault. A client with an allocated account has full title to the specific physical gold in it, with the dealer acting as custodian holding the “allocated” gold on the client’s behalf. To avoid confusion, gold in a client’s allocated account is separated from a gold dealer’s assets.

Unallocated gold accounts – These are the most common vehicle for trading, settling and holding gold, as well as other precious metals such as silver, platinum and palladium. Transactions may be settled by credits or debits to an unallocated account without specific direct allocation in a general pool of gold. The balance in an unallocated account represents the indebtedness or financial obligations between the client and the dealer based on an underlying notional amount of gold that is not expected to be delivered physically.

Credit balances on an unallocated account do not entitle the creditor to specific bars of gold, but are backed by the general stock of the gold dealer with whom the unallocated account is held. A client with an unallocated account is an unsecured creditor to the gold dealer for the monetary value of a notional amount of gold the client bought or sold at a specific price. Profit and loss in an unallocated gold account is calculated from the difference between the transaction price and the spot price of gold. Unallocated gold trading is a transactional platform that creates profit opportunities by price volatility, which is one of the conceptual components behind the logic of an asset price bubble and also behind the logic of the bubble’s eventual burst.

Unallocated gold account risks
The total quantity of unallocated gold in the gold market is estimated to be around 15,000 tonnes at the end of 2008. The 2,134 tonnes on a daily average of spot gold traded through London represent 14.2% of the unallocated gold pool. This amount of daily gold turnover is high compared with the average daily turnover in UK equities of between 0.34% and 0.63% for the 12 months ending September 2009.

While LBMA members are not required to provide information on the amount of unallocated gold held in their books, the relatively high turnover in gold trade suggests that gold dealers operate at a low fractional reserve system where unallocated gold accounts are only fractionally backed by physical gold.

When gold is bought and sold by clients of LBMA member dealers with no intention of taking delivery of physical gold, the amount of gold reserve needed to back the volume of unallocated gold trade remains unaffected by the volume of trade because a buy must be balanced with a sale simultaneously in a trade.

Unallocated gold trades require gold reserve only as a notional value that provides adequate backup for net balances, and not a physical reality because the same non-delivery gold can be traded many times in the course of a trading day. The gold market expands by increasing transactional velocity, unrelated to the size of the pool of unallocated physical gold. Transactions that depends on the velocity of trades generally contributes to the forming of price bubbles.

Since there is no minimum gold reserve requirement set by the LBMA for member gold dealers, unallocated gold trading accounts are in fact fractionally backed only by a notional amount of gold made credible by the collective credit standing of the gold dealers, unrelated to the amount of physical gold actually held collectively or individually by LBMA members.

Gold dealers can always meet requests for physical delivery of the gold they sell by buying it in the gold spot market. The uncertainty involves only the spot price at which dealers can acquire the gold for delivery, physical or virtual. This spot price is a function of the balance between buyers and selling. When the number of buyer exceeds the number of sellers, the spot price of gold rises and vice versa. Since gold trade is mostly non-delivery trades, the spot price of gold is determined by imbalance between buys and sells, unrelated directly to the supply and demand for physical gold. This makes the gold market highly susceptible to market trend imbalances.

Gold trading is a transactional platform on which price is determined by the directional flow toward equilibrium between buying and selling, which is one component way to define the logic of a trade bubble. Ironically, the directional flow towards equilibrium in a reverse-resistant imbalance between buying and selling will also lead to market failures when no seller can be found at any price (inflationary bubble) or no buyer can be found at any price (deflationary bubble). The gold market’s detachment from physical gold substantially increases the probability of such scenarios of market failure.

Asia Times



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