Rickards: 'Unallocated Gold Is a Euphemism for No Gold.'

I think that Rickards is correct in his judgement, and joins many others including Kyle Bass, who because of their backgrounds are much harder to ridicule and dismiss by the creatures of the bullion banks.  And in some of their more recent remarks about this, one can almost feel the desperation.  And here and there, the rats seem to be leaving the ship.

When this pyramiding of bullion and price manipulation falls apart, which history suggests that it must, there will be many angry investors demanding explanations of officials and regulators and bankers who will be shuffling from one foot to another, trying to excuse their lack of good fiduciary judgement and responsibility.

I just wonder if they will try to wait for some 'big event' to disclose this, in the hopes that fewer questions will be asked, and will be more easily dismissed.

As Rickards notes, and again I think he is right, they will 'close the gold trading window' and force settlements for cash at one price, and then reopen the price for actual bullion at a price that will climb  shockingly higher, despite a determined PR campaign by their friends in the media.

Perhaps I am wrong about this, but to me it has seemed for some time to be all too similar to the improbable sustainability of the Madoff scheme, and other such arrangements that depend on large numbers of people accepting a proposition that is dangerously misconstructed, misrepresented, and therefore mispriced in terms of risks.

"If JP Morgan leases gold from the US Treasury it does not mean that they back up a truck in Fort Knox and drive the gold away. There is no need for that. It is just a paper transaction. The gold can sit in Fort Knox. JP Morgan can take a hypothecatable title. Now once JP Morgan has the gold what they do is they sell it at times 100 to gold investors who think they have gold but what they really have is what is called unallocated gold.

Unallocated gold is a euphemism for no gold. If I call up JP Morgan and I say, 'You know I wanna buy a million dollars worth of gold,' they will say, 'Fine. Here is our contract. Send us the million dollars.' I sign the contract. I send the million dollars. They send me a confirmation and it says I own a million dollars worth of gold subject to the contract.

Well, read the fine print in the contract. What it says is your gold is unallocated which means that they do not claim to have any specific bar with a serial number or your name on it. In reality they have taken the same bar of gold and sold it to a hundred different investors.

Now that is fine if we are happy with the paper contract, but if all 100 of us show up at JP Morgan and they have only got one bar of gold, the first person may get the gold. The other 99 people, they are going get their contracts terminated. They are going to get a check for the value of gold at the close of business yesterday, but they are not going to get today's price movement or tomorrow's price movement when super spiking going up to $2,000, $3,000, $4,000 an ounce. That is when you want your gold for the price protection when everything else is falling apart. That is when you are going to discover that you do not have gold."

Read the entire interview with Jim Rickards here.

Very unlikely you say? Do you remember what happend to those who were holding their bullion in these warehouses through MF Global? And this was a relatively isolated event. A more general break in the chain of cross ownership and counterparty risks at 100 to 1 leverage would create a market dislocation that would be quite memorable.

And as a reminder, here is what Kyle Bass had to say about unallocated and hypothecated gold, even that held within a 'fractional reserve' exchange structure.

An Essay Considering the Current Monetary Order and Gold

This message from a person in the financial business,which is included in quotations below, was shared with me by a reader who received it from a journalist for a major media outlet.  Since it was not clear if this was intended as a private communication or public statement, I will not attribute it by name.

I wanted to use the word 'modern' in the title of this, since this pronouncement below smacks of modernism. You know, the belief that all those who have come before us were ignorant primitives, and those who are not of the same received insights now lack sufficient wisdom and piety.  But since those two words combine to describe a particular and unrelated school of thought, modern monetary theory, whose adherents have already excommunicated me for my stubborn and profane disbelief, I think I will skip that and use 'current' instead of 'modern.'

I could not resist sharing this message with you because it is such a nice, compact expression of what the modern financial media thinks about gold and money. Or at least to the extent that they think about anything, and do not just read their thoughts off the teleprompter provided by the moneyed interests that sustain them.  Or what is considered 'acceptable' by the very serious people, those who are described by Larry Summers as 'insiders.'

It starts as many of these things do, with a few simple statements that seem reasonable and ordinary enough, and use a sort of formalistic style to make it seem 'scientific' and contrast our modern thought with the ignorance of prior days.

"Why do you invest in anything? Because you want to extend the duration of your surplus earnings, the sort of stuff that would have been perishable in olden times.

There are two ways to do that:

1. Share your surpluses today and run a credit exposure to the counterparty that is obliged to pay you back in the future an absolute relative rate that compensates you with respect to income lost and potential earnings made.

2. The alternative is to sell transform your surpluses into something more durable, but which maintains market risk exposure."

Ok, fair enough.  If you have an excess of some presumably perishable asset, you want to do something with it to extend its usefulness to you. Or else it ends up like the neglected lettuce left in a damp plastic package in the back of the fridge.

One way to do that is to provide its use to someone else on loan, and receive adequate compensation that may include some allowance for risk.  Or you may wish to sell it outright, and receive something more durable in return, but again with some allowance perhaps for risk.

Hard to argue with that, right?  It is perhaps a bit simplistic, narrowing down all human economic activity with regard to 'surplus wealth' as investing or saving.  One may donate that surplus to some charitable endeavor, or sacrifice it to their gods of the day for example.  Didn't we just do that with TARP, and the uncounted trillions in bank subsidies?

Or perhaps trade it for something not required but desirable nonetheless, like finely crafted jewelry for one's beloved. Investment? The commercial messages for jewelry would like us to think so, but it rarely works that way in romance except for a fleeting moment, and with a greatly diminishing effect over time.

Not all exchanges of 'surplus wealth' are for productive investments or a truly more durable asset.   What then is 'surplus?'  Anything more than food, water, and shelter?

But let's not quibble about what defines 'surplus' and just say all right for now.  But believe we when I say that people's definitions of what is 'surplus' versus necessary wealth can vary widely, especially in these days of elephantine greed.

That definition of 'surplus' is important because it is so subjective, and yet is later used in this modern theory as a high falutin' accounting entity, the equivalence of all monetary valuation.  But it sounds so 'scientific.'  Is what we spend on food and shelter necessary and all else 'surplus?'  How about healthcare?  Cars and electric lighting?  Things that support knowledge like books?  Would there be a common consensus on what the definition of surplus represents, from let's say between Dorothy Day and Donald Trump?

Let us bookmark that thought and move on.

"Gold was an obvious choice because you could keep it under your bed and it wouldn't depreciate in form ."

Ok, that is a bit snarky, since I do not believe there is a long history of people hiding their gold, or any other large amounts of their durable wealth,  cavalierly 'under the bed.'  But it does serve the modern polemicist who seeks to disparage a choice they do not favor as uninformed, primitive, and naive.

Let's just say that for one of the alternative uses for 'surplus' wealth which is 'savings,' some durable, compact assets were found to be very useful. And that they were stored safely in some appropriate manner, since everyone who was born before our time was not necessarily a complete fool or incompetent naif.

We need to distinguish I think between what is asset barter and what is actual money at some point.  I would like to think that describing the difference is achievable.  For example, we might apply some criteria that suggests that a widespread, highly organized society might be more applicable to our thinking than an isolated island people who have no means of mining or access to precious metals and little access to widespread consensus.

As I recall the first formal coins made for widespread use were gold, silver, or an alloy of gold and silver that started showing up around 600 BC in the eastern Mediterranean. You know, that place where trading cultures that sailed from place to place flourished. Although it is known that gold and silver and certain precious and semi-precious stones were recognized as having great value, as shown by artifacts found as early at the 5th millennium BC in the graves of Varna man.

The point here is that it was not just 'gold' that was considered a durable asset.  Silver was valued as well as a few other things from time to time. They all tended to have similar characteristics.  But at some point the precious metals passed from 'grave artifact' to widely accepted 'coinage' and were used for widespread, diverse trade across governing bodies in addition to asset barter.  And I would not discount barter, which may also be called the black market, as a continuing alternative which may be more viable even now than most theorists will allow.

So why not just trade with rocks and put them under one's bed?  Granite and marble are very durable.

Yes the asset must be durable in that it does not spoil or rot or rust away.  It has to be enduring with regard to time.  But there has to be enough of the durable asset to function as more than ornamentation for a few of the finest people.  It must be malleable enough to be systematized into some uniformity of size and purity so that it can be easily weighed and measured and exchanged to facilitate trade without introducing excessive transactional friction.

And so we notice that the author has ignored one key point: manageable scarcity.  What facilitated that transition of precious metals from grave artifact to money?  I would suggest that it was a manageable scarcity combined with social organization and broad consensus that set standards on purity and form.  It was both a natural and social agreement that was widespread and acceptable enough to be effective.  And that manageable scarcity had to be as reliable as the durability of the material.  The scarcity was not expected to be wildly unpredictable and certainly not discretionary by some ruler over time.

So we will not use common rocks because they are not scarce, and not particularly portable.  There has to be a natural scarcity, to make that durable item 'special.'  But there does have to be enough of it so that it can be widely used by more than just a few of the top people.

Moving along.

"Gold is only worth the total surplus of the nation.  When surpluses are running high there's a lot of spare capacity in the system. Gold will be easily swapped into almost anything."

This is of course where we start to smell a reductio ad absurdam and the authority of the modern equivalent of a burning bush.   Let's read on a bit and see where this is going.

If there's a deficit of stuff, neither gold nor money guarantee you access to current output. 

Yes, is there is a deficit of highly desirable 'stuff' any money and not just gold will guarantee you access to it. Unless it is backed by some hairy knuckled fellows holding weapons, in which case they do not even need to bother with the facade of money.   In the strict sense of the word only your own death is guaranteed.  And maybe the recurrence of whacky theories designed to separate the common people of their rights and wealth.

But assuming that a market still exists, which presumes the dynamic of supply, demand, and price,  and a willingness of participation, then the 'prices' or the exchange value of money of whatever form will rise to meet whatever the holders of that highly desirable item may be.  If there is no market, and the item is highly desirable enough, they may be robbed of it, and they have been, but that is besides the point.

I think this may be the point where someone who was writing this has had a recollection of Adam Smith and is distorting the things which he has said to justify some modern theory.  As if Adam Smith was a received source of truth when it suits their purposes, or so they think.

One of the few advantages of not belonging to a 'school of economic thought' is that you are not compelled to carry its baggage, pro or con.  And believe me when I say that in economics there is more baggage, and much of it having nothing to do with economics and everything to do with politics and a pursuit of position and advantage, than on a Kardashian vacation.  While people say 'money is power,' it might be more correct to day that for some types of people power is everything, and money is just a means to it.

There is no shame in misconstruing Adam Smith's thought.  Some of our finest economic minds may have done it from time to time, despite an otherwise admirable record for the most part.  Nobel prize winner Paul Krugman did it in spades not all that long ago by misconstruing things that Adam Smith 'said' about gold.

What Adam Smith was actually addressing in the paraphrased thought was the non-productive hoarding of 'money' while placing greater emphasis on widespread economic transactions, the 'organic real economy' if you will as opposed to the financialized economy.  And he did favor the flexible expansion of money, as typified in fractional banking it seems, as long as it was in response to a legitimate increase in real activity that produced things.

I do think that Smith would have been dismayed though by the actions of the monetarists who believe that one can create the vigor of a wealthy economy by merely expanding the money supply, in QE for example, and doing nothing else in conjunction with it.  I have previously described that as 'cargo cult economics.'   If big plane of real economic activity brings nice things, we can get more nice things by building some things that look like the big plane of real activity out of paper and sticks.

I wonder at what point the money masters will admit that QE is counter-productive rubbish?  Don't hold your breath.  People of privilege will never let go of what gives them advantages willingly.

I like Adam Smith.  I recall visiting his grave once in Edinburgh.  And he was therefore just a man, whose ideas must be considered as his and of his time and experiences.  I do not hold any dictates of dead economists as sacred, and their 'laws' are all too often opinions and observations written in sand.

Paul Krugman Does Some Injustice to the Thoughts of Adam Smith On Money, Gold, and Silver

Adam Smith was no economist.  He was a 'moral philosopher.'  And many of our modern financial shamans have tried to take the moral considerations completely out of economics, in their vain quest to turn it into a pseudo-science of equations and a priori pronouncements from the god of the market that dictates policy as if it were an oracle, or a black box.

But I digress.  Let us move on.

"Money [fiat money] will hold its value better because in an inflationary period it can't be mined."

There it is. The modernist 'money shot.'  And delivered with a straight face.

There is a lot of nonsense wrapped up in this, combined with a leap of faithlessness to the facts.  Let's just take supply, demand, and price and throw them out the window, along with geology and any sense of the current reality.

Firstly, one of the enduring attractions of gold, and to a slightly lesser extent silver, is that they cannot be created by human means.  They exist on and in this world at least in what can be described as a natural scarcity relative to other things.

I cannot speak to the specific numbers, but it is my understanding given the current state of reality that one does not add to the supply of gold via actual mining without effort and delays.  And I think if we keep distorting the markets and driving the mining companies into red ink we will obtain a serious object lesson in this.

Mining takes time and effort, implying 'costs' and 'risks.'  Yes, the supply of gold and silver may be increased, but it takes money, luck and hard work.  And the pricing of the market adjusts to supply and demand with valuation dynamically as it does all commodities.  And gold and silver are commodities as well as 'money.'  More gold is not mined unless it is a profitable venture in a market economy.

But to contrast gold with fiat paper money and say gold is more easily expansible is a real howler.  Has the author looked at the Fed's Balance Sheet lately?  How much time and effort did that take?

Yes gold and silver can be mined.  There is also the recovery of scrap which, like real physical mining, is more difficult and costly to do than just creating fiat money out of thin air, electronic digits.  We have thousands of years of experience with mining and scrap recovery. How much and what type of experience do we really have with purely fiat money tied to no external standard or limiting factor including transparent exposure to public scrutiny?

Unfortunately it is true that the Western gold supply these days is increasingly 'synthetic' in that the financiers are expanding this supply through selling and reselling claims on the same bullion with leverage.  But this is not real gold or silver but paper claims to it.  They are non-transparently mining the stores of gold in central banks and funds and unallocated supplies and multiplying it on paper in a web of non-transparent counter-party risks.

"Money on the other hand can be withdrawn from supply and ratioed up."

Ok, there is the real heart of the matter. This is where the rubber of financial engineering hits the road to power.

Gold can be 'mined' and therefore it is no good, but 'money' can be manipulated quite easily, both up and down.

But now we get into a stickier subject of a 'gold standard,' of gold and silver as formal money.  As you may recall I am making the case for gold and silver as private stores of wealth, against what are some fairly narrow and nonsensical arguments.  The reasons for this will be provided later.

Our experience with a gold standard and its uses are historically knowable.  Which of course the author completely ignores.  Gold and silver are physical units of measure by purity and weight.  They act as a 'brake' on money supply of sorts.

If one wishes to expand their money supply against a gold standard, are they stuck?  Not happening?  No, they alter the valuation of their particular currency against gold, which is the 'universal money' especially with regard to trade amongst diverse currency regimes.  This is what Roosevelt did in 1933.

What makes this particularly unattractive to the modernist is that it requires a transparent and conscious act which the people can see for themselves.

Since 1971 the world has substituted the US dollar as the 'gold of universal reference,' the reserve currency.   This was the replacement of the 1944 Bretton Woods agreement, which tied the US dollar to gold directly, with what some have called 'Bretton Woods II.'

The Federal Reserve of the US has quite a bit of latitude with regard to the expansion of that US dollar supply AND the distribution and use of that creation through its member banks.  And that is power, real power.

And people who have that kind of power do not give it up easily.  Theoretically in the hands of philosopher princes a purely fiat monetary system can 'work' like a gold standard.  Greenspan said it could 'emulate it.'  And by that he implies restraint and rigor and transparency tied close not to economic models and the whims of power but to real economic activity. And then he betrayed this principle himself.

In every case of recorded history the financiers have stretched and strained against any and all regulatory restraints, and abused their power to create money.  Even for Adam Smith this was already a recognized phenomenon in 1776 when he published Wealth of Nations.  How could it not be with the memory from 1716 of fellow Scotsman John Law and his Banque Générale and the enormous wreckage it caused in continental Europe still fresh in his mind?

"When the people of any particular country have such confidence in the fortune, probity, and prudence of a particular banker, as to believe that he is always ready to pay upon demand such of his promissory notes as are likely to be at any time presented to him; those notes come to have the same currency as gold and silver money, from the confidence that such money can at any time be had for them...

The commerce and industry of the country, however, it must be acknowledged, though they may be somewhat augmented, cannot be altogether so secure, when they are thus, as it were, suspended upon the Daedalian wings of paper money, as when they travel about upon the solid ground of gold and silver."

Adam Smith, Wealth of Nations

But I would like to stop here and see if there are any real objections to what I have said in your mind. Think about it. Gold and silver are stores of value of wealth and, with the proper attention to form and purity, have functioned as a store of wealth, and of money at times, both widely and throughout record history in industrialized and organized societies.

Let us trudge on to the end of this.

"Gold is a volatile asset because it is only ever worth what anyone is currently prepared to pay for it. Since it has little consumption utility, the value is mostly maintained by the mass cornering effect of goldbugs who refuse to sell under any circumstances."

Gold and silver are not particularly volatile.  In their synthetic form, which is leveraged and hypothecated representations of bullion, they are volatile and encumbered with counterparty risks.  There are some who think that the current price manipulation in certain markets is intentionally volatile, for all the reasons that the recent rigging in so many other markets has occurred, and for years.

And that last sentence about gold bugs is just fatuous.  Who holds the greatest concentration of the world's gold?  Those ravening lunatics, the central banks.

One of the characteristics of 'money' versus asset barter is that money ought not to have much consumptive value in addition to its durability and nominal stability.  Have you ever tried to eat dollar bills?   People have used paper money to heat their houses.  But it is not very good at it.

What is particularly volatile now are the financial and international monetary markets, because the 'Bretton Woods II' monetary regime based on the US dollar as purely discretionary reference asset for international trade is falling apart, as theories such as Triffin's Dilemma have suggest that any fiat reserve currency would do.

"The use of a national currency, such as the U.S. dollar, as global reserve currency leads to tension between its national and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account, as some goals require an outflow of dollars [Eurodollars, a component of M3] from the United States, while others require an overall inflow."

When considering who the stronger dollar benefits, would you be surprised to learn that it is primarily the dollar based financial sector?

I think the current volatility may continue for some time due to an historical event that so few really remark upon or even understand fully:  the unraveling of Bretton Woods II, and its slow replacement with something else.  But that begs the question of cause and effect.  It is not gold that is changing.  It is as it always is.  And so is silver.  It is the context in which they exist that is changing.

Valuations are wildly swinging in certain markets because of the mass creation of 'synthetic gold' that, with the effects of Gresham's Law, has caused real physical bullion underlying it to flow in increasing amounts to the centers of real wealth creation.   The 'synthetic gold' remains in the vaults of the West, and the real gold is accumulating in the vaults and strong hands of the East.

I am not proposing a return to the gold or silver standards.  As I have said previously, the existing financial system, and the political process it has corrupted, is in dire need first of rigorous reform. Our system is capable of corrupting almost any monetary changes that are introduced, including a gold standard.

Addressing a final assertion, we can stipulate that valuation of most things, and even people, can be purely arbitrary if such a valuation is enforced with sufficient, draconian power.  Some of the most notorious tyrants of the twentieth century have not only believed this, but have embraced and used it to inflict widespread suffering and death on their people.

What I would like is government to keep their noses out of precious metal pricing, so it may reach an equilibrium that is at least mildly sustainable in the face of massive flows of bullion into Asia. And to start reforming the financial system which quite frankly has slid off the rails several times already and looks perfectly capable of doing it again.  Our philosopher kings have feet of clay.  What a surprise.

But since the banking elite are living a lie, that the precious metals are not a currency even though they treat them as such, hold them as such, and interfere with their pricing relative to other currencies as such, it may take some time for that to unfold.

These poorly thought, often contrived, and politically motivated policies that serve special interests are the sort of things that plunge a country into endless wars, a proliferation of unproductive spending for anti-human purposes, increasing repression, and a financial culture of systemic fraud that over time drains the real economy of all of its vitality.

But what is power, if the powerful and privileged do not exercise it.  Even until their own eventual destruction.

Lions and Tigers and Deriding the Theory of Gold Tightness At the Comex, Oh My!

“Our clients will call up saying ‘I hear the Comex is running out of gold, what do you make of it?’ and our quick answer is that this is a non-issue,” Jeffrey Christian, managing director at CPM Group, said in a telephone interview.

“Even if you look at the fact that registered stocks have declined, the fact of the matter is most Comex futures contracts” are cash-settled, and traders don’t take delivery of the metal, he said.

While the percentage of Comex gold open interest covered by total Comex reported stocks has fallen over the past year and a half, it “remains very high by historical standards and presents no perceptible risk of imminent problems with deliveries,” CPM Group said in a report dated Sept. 14...

Barclays Plc said in a report this week that emerging-market demand for gold has shifted some metal into Asia, and that “coverage of physical stocks in Comex remains solid.”

Joe Deaux, Gold Shortage Theory Derided as Comex Seen Well Supplied, Bloomberg News, Sept 16, 2015


“Anything that has more upside than downside from random events (or certain shocks) is antifragile; the reverse is fragile.”

Nassim Taleb, Antifragile

Gold is anti-fragile. This is why it must be handled with care, and not with fragile systems. Gold is intractable to the kinds of manipulation by the financial system that can bend paper to its will. This is why they hate gold, and seek to paper over it with leverage and secrecy.

Above is a commentary on the physical bullion situation at the Comex as it was reported at Bloomberg News yesterday.   The 'deriding', which means ridicule and contempt, is coming from CPM group's Jeff Christian, and from a report from Barclays.

The title of the article is a bit odd, because I have not see any 'theories' about this subject at least here, just presentations of the facts using exchange provided information.  And as for deriding, it seems more like a sign of weakness and fear than solid reassurance.  But that is just my own experience in seeing that sort of thing when someone points out a changing situation that could pose a problem.

One thing the story fails to make clear is that only registered gold is deemed deliverable to fulfill futures contracts.  Yes, all the gold in all the warehouses could potentially satisfy demand, IF IT WAS UP FOR SALE.   But it is not.

The total supplies at the Comex have as much to do with the current demand for bullion as all the automobiles in your neighborhood have on the price that you are going to pay tomorrow for a used car, eg. the calculation cannot include items that are not up for sale.  Yes there are many cars that would satisfy your requirements.   But only those that are for sale are available for you to drive home.

Jeff Christian says that "even if you look at the fact that registered stocks have declined..."

Yes, 'even if' you look at the heart of the argument, 'registered stocks have declined,' and that is quite the understatement of the facts.

Here is the history of 'registered gold bullion' on the Comex going back to 2001.

And of course if almost no one asks for any of the gold, then there is no problem.   Yep.

This is the problem. For anything except speculating with paper the Comex is now significantly fragile, moreso than at any time it has been in the last twenty years at least.

Jeff goes on to say that "most Comex futures contracts” are cash-settled, and traders don’t take delivery of the metal,"

And that is correct.  Here is the history of deliveries, ignoring any cash settlements, on the exchange.

As should be easy to see, the amount of gold bullion deliveries is declining quite a bit.

The Comex lacks the market discipline of delivery of the goods and restraint on the potential hypothecation of available supply.  What is acting to hold leverage to some reasonable level other than 'nothing has broken yet.'

Let's take a quick look at the ratio of total contracts to registered gold, that is gold up for sale.

The Comex is a significant price discovery market for the global gold supply.  The data shows that it has diverged significantly from the physical bullion markets primarily in Asia.

While the inventories at the Comex remain flat overall and declining sharply with regard to deliverable bullion, the physical deliveries of gold into India and China are increasing steadily.

And I hasten to remind everyone that gold is truly a global market.

Nick Laird at sharelynx.com has created chart that tracks the known physical gold demand for what he calls 'The Silk Road.'

Even though I do not expect a default at Comex, as I have said many times before, the point is that if there is even a mild problem in one of the physical markets in Asia or London, the Comex is price positioned for a market dislocation and potential fails to deliver bullion on request.

The deliverable gold is a little under 6 tonnes.  But even if price were no object, the total gold held in private hands in all the Comex warehouses is about 6,716,000 troy ounces, or roughly 209 tonnes. That is all of it no matter who owns it or why.

Or less than one month's supply for the Silk Road countries.

Normally none of this *should* be problem, although one has to admit that according to historical norms the amount of deliverable gold is very thin by any measure.  Why is this?  Why are the better informed withdrawing their bullion from the deliverable category?  I read that they are afraid of the bullion being caught in a 'short squeeze,' but the trader who said that did not specify a short squeeze where.

This week I learned from an interview with Jim Rickards that some very large bullion banks were said to be using the Comex gold futures to hedge shorts in bullion delivery markets in London, called the LBMA.

That kind of a hedge might work to guard against paper losses, but against a genuine fail to deliver in a physical market you can see that the immediate deliverables at these prices are about 6 tonnes, which is a rounding error on the Silk Road.

It's the fragility, always the fragility.

What if something that is not completely normal and expected happens?  What if, instead of 2% of the contracts asking for delivery, a delivery short squeeze in London prompts 4 or 5 percent of the contract holders to attempt to exercise their contracts to receive physical bullion to cover their obligations elsewhere?

The fragility of such an arrangement is bothersome to anyone from outside who looks at it from a systems engineering perspective.

If some firms are using the Comex as a backup system for gold deliveries in London and points east, it is hardly equipped to take that role without a significant market dislocation in price.

If I was only working short term trades and would never mind a settlement in cash, then the Comex seems like a fine place to do the trade.

However, if my goal is to have a solid claim on physical bullion, even within some reasonable length of time measured in several months, it does not appear that the Comex is appropriate for that particular objective.

Do you see the potential problem here that is so blithely 'derided?'

I do not wish to alarm anyone. I am putting out the word because I do not think people understand the situation that has developed, over the past two years in particular, as shown by the potential claims per ounce.

Globally huge market with increasing demand, a market where the available inventories are exceptionally thin, and a price that is derived without a tight rein on leverage and the discipline of delivery. What could possibly go wrong?

The usual retort is 'it has not broken yet.' Yes, and in the light of our experience over the past ten years or so, some might find rather thin comfort in that.  The important thing is for traders and investors to be fully informed,  that they may use financial instrument in a manner that is appropriate to their objectives.

For example, using Comex as a backup for bullion positions on the LBMA might be fine, if you are not expecting to receive delivery of bullion that can be used to satisfy your obligations there.

The exchange might consider another look at their rules in the light of this unusual 'leverage' of potential claims to bullion, rather than count on price fixing all problems, and few standing for delivery, especially in a changing and very dynamic global market.

I do not have good visibility into the leverage and available inventories at the LBMA in London.  If those are in any way similar to the Comex, then I would take some action fairly quickly to secure my ownership of bullion given the potential for a misstep that spins out of bounds.

If you hold an allocated receipt that is as 'good as gold?'  Tell that to the investors who used MF Global,  and found their holdings sorted out in court against a lawyered up megabank.

I do not know Jeff Christian or the fellow from Barclays.   I am sure that they have good reasons for what they are saying and the advice they appear to be giving to their customers.  I am sure they can all work out all their concerns and particular issues among themselves.

Objectives amongst customers do vary and it is the fiduciary duty of any advisor to help them make an appropriate choice.  And I can see many uses for Comex positions that are entirely suitable for some.   A short term trader for instance, who in merely placing wagers that he expects to settle for cash.

But as for this article in Bloomberg, it is a bit of a gloss, heavier on the deriding and short on information for readers to use in making their own informed decisions.  'Trust us' and 'nothing has broken yet' are, as I said previously, non-starters these days.

I have set forth only a few of the oddities that are becoming apparent in the gold market.  There are quite a few more, including backwardation and tightness in the London physical market as noted by Peter Hambro and an analyst at Mitsubishi recently, and in articles by Koos Jansen and Ronan Manly.

How about the pivotal London market, is it 'well-supplied?'  How well supplied is it?  What is the potential impact on the Comex of a bullion shortfall at the LBMA?

Jim Rickards had something to say about the LBMA and its relationship with the Comex recently.  You may read it in a larger commentary titled On the LBMA and Their Unallocated Holdings - 'Tightness' In Gold Bullion - Backwardation.

Has there ever been a 'stress test' of what it would be like at the Comex if there were an afternoon failure to deliver physical bullion in London?  Or are you assuming as your baseline that such a shortfall could never happen in any non-Comex market?  Is the process at Comex for some event like that, besides halting the exchange and forcing cash settlements?

I do think that one can become so involved in a system, for so long a period, that when it changes, when the market dynamics start shifting, the old hands may be the last to notice the forest for all those familiar trees.  That is why companies bring in quality teams to inspect their processes for soundness and failure points.

What could have possibly changed in the global gold market in the past few years.  "Barclays Plc said in a report this week that emerging-market demand for gold has shifted some metal into Asia,"

How about this?  Some shift.  Some metal.

Here is what Kyle Bass recently had to say about the situation.  Maybe you can 'deride' him. Then again, maybe not.

Investment and Insurance: Prospective Risk and Return in Various Precious Metal Investments

To buy, or not to buy? Allocated, unallocated, or exchange-traded, derivative, or nothing? That is the question.

"Simply, antifragility is defined as a convex response to a stressor or source of harm (for some range of variation), leading to a positive sensitivity to increase in volatility (or variability, stress, dispersion of outcomes, or uncertainty, what is grouped under the designation "disorder cluster").

Likewise fragility is defined as a concave sensitivity to stressors, leading a negative sensitivity to increase in volatility. The relation between fragility, convexity, and sensitivity to disorder is mathematical, obtained by theorem, not derived from empirical data mining or some historical narrative. It is a priori".

Nassim Taleb, Mathematical Definition, Mapping, and Detection of (Anti)Fragility

Yes, there is a certain fiendish humour as Taleb introduces this quotation with 'simply' and then goes on to use enough jargon to make the layperson's eye glaze over.

But what Taleb is describing here is a fundamental that many have forgotten. It is the corollary to his more famous observation about 'black swans' and 'tail risks.'

What Taleb is basically saying is that a system or investment that is designed to accommodate infrequent but outsized and somewhat unpredictable risks performs one way he calls anti-fragile. And other systems and investments are designed so that they perform well under 'normal conditions' but tend to underperform, and often badly, during the unexpected.

Here is my own picture of Taleb's concept of how investments react.  It might not be exactly what Taleb himself has in mind, but it something that fits certain other types of information systems in a prior occupation, and how I remember it for my own purposes:

If you want to grossly oversimplify this principle, and remember it as a saying, pick the right tool for the right job, and remember that nothing comes for free. I used this in describing tradeoffs in very complex products and networks, and while it may sound tritely obvious, it worked with a lot of upper level executives.

But what is the job itself? Well, the application defines it of course. But one must also take performance criteria into account, and with performance there are environmental conditions and variabilities. Would you like to have a network that can function for your casual use in your home, or a high performance network that can survive arctic cold and desert heat?

Don't laugh. we used to drop networks into some of the more out of the way and volatile places around the world, put electronic equipment in explosive environments, and met application criteria that had many other product groups running out of the room screaming for momma. It was our particular competitive edge. It only comes with experience, confidence, and a fanatical understanding of the odds and how they can mount against you.

But you don't want to waste money and over engineer something either. That is a good way to go broke. One needs to understand expected performance, and the risk profiles for just about anything that is not merely incidental.

And if there is anything that I wish you to remember from this blog, after all these years, it is the deadly trap of undisclosed risks and the tendency of some to understate those risks for their own short term advantages. And how other people will go along with them for the sake of position, power, and prestige. In a nutshell, this is the story of our recent financial crises.

It is far too complicated to get into this afternoon, but lets just say that a number of mathematicians and industry analysts, among them Taleb, Mandelbrot, Tavakoli, William Black, Yves Smith et al., saw that there was significant undisclosed risk in the system because models (Black-Scholes for example) greatly simplified the risks, and assumed distributions of variability that were not real world realistic.And even worse, in many cases the risks were actively hidden, and even more despicable in the worst of them, purposeful.

There was a movement in finance to force normal distributions onto data that did not really justify it. In order to achieve this, the risk models made certain assumptions, and thereby 'flattened' reality in order to fit the model. What one ended up with was a mis-estimation of the risk probabilities. And so we saw 'once in a hundred year events' happening with alarming frequency, despite the best efforts of the financial planners to smooth them over with piles of bailout money.

Here is a picture of what such a discrepancy might look like:

So the financial system designer likes the normal distribution and makes their operational plans based on that. But why is this? Are they diabolical fiends? Do they enjoy screwing up?

No, they are ordinary people for the most part, but following orders. And the orders are sometimes to take the faux normal approach because it costs less to implement, allows for greater leverage, and fattens profits, at least in the short term. Watering the cattle, cutting a corner,  putting lipstick on a pig. 

Careerism's second law is if you are wrong with everyone else, no one can blame you. And so many financial myths have thereby obtained extended lives, because they provided a fig leaf for someone's self serving ends and moral trembling.  This is in some ways the story behind the failure of our regulatory systems, often staffed by good people but who are underpaid, overworked, and subject to extraordinary political pressure to turn a blind eye to which otherwise might provoke their action.  Especially where there is a lack of complete certainty, which is all too often the case in real life.  The rationalizations are venerable, with their roots in the Garden of Eden.

So what is the punch line?   If you are buying an investment as a safe haven, something that will perform well in a difficult and somewhat unpredictable circumstance, you may wish to take your money into something that is highly transparent, robust made to endure the unexpected, given to few assumptions, and perhaps even strongly guaranteed.

And if you are not, if you wish to invest in something with a decent return, but in your own estimation performs adequately for your time horizons and expectations, then pick the product in which you have confidence, provided it meets your needs and possesses some advantages in features and price.

These principles can be applied to the pros and cons of certain types of gold and silver investments.   And those pros and cons are ALWAYS going to be affected by how you perceive the risks, and how that investment fits into your plans.  This is a given.  And this is why I would never give anyone specific advice, because I am not a financial advisor and do not have the knowledge of their own particular situation, their goals and time horizons.

I will use myself as an example.   I tend to gravitate a portion of my portfolio into very transparent and 'safe' gold and silver investments, where I have a very high confidence in them based on audits, ownerships, and so forth.  There is not much about them I do not know and have to assume.  Yes there are the high improbable outliers like a meteor hitting the earth and bringing on Mad Max and cyclist cannibals, and so one might drop a dime or two on arms and infrastructure just for grins, but by and large I think we can ignore them for now.

But for the most part a failure in the financial system that could be adverse to one's wealth seems a little more likely.  And so a part of my portfolio is in reasonably secure investments that will benefit somewhat from disorder and provide a small premium on return or at least weather the situation well.

And other parts of my portfolio are in investments that are more fragile as Taleb would say.  But they provide a nicer short term return with less expense.  And there is nothing wrong with this.  Not at all.

By the way, and I hate to even bring it up, but gold and silver themselves suit slightly different purposes. Silver is less 'anti-fragile' than gold in dire circumstances, generally.  But it offers some juicy upside in certain circumstances in compensation. And there are always special situations to consider, and for this one might read Richard Russell or Ted Butler among others, who track imbalances and trends that could provide opportunities or risks.

I do not consider gold better than silver; they are different.   And I own both, and invest speculatively in both, at varying intensities depending on the changing context of the markets.  What is better, a hammer or a screwdriver?  It depends on what you wish to do with them.

I would certainly buy some other financial instrument or stock I consider less robust for a quick flip or outsized return.  The miners would fall into this sort of category.  I am sure some of my bank accounts would as well, depending on how high the risks,  And physical property is notoriously non-portable if you decide to take up roots and go to another place.

So, as far as unallocated gold goes, there is nothing inherently wrong with it.   It is a very nice way to own gold with a reduction in expenses.  I am sure not all providers of such a service are equally reliable, and their representatives would do well to discuss their own advantages, guarantees and superior performance as would any provider of products when faced with less reliable competitors.

I will say that deriding critics as loons and charlatans, and referring to a portion of your prospective clients and client influencer base in a generally derogatory manner with a pejorative nickname promulgated by economists who hate precious metals on principle, is probably not a high profile technique in the salesperson's handbook for success.  Answer with facts.  Once you descend to name calling you have lost.  Just a word to the wise, and enough said about that.

Know why you are buying what you are buying, and how it fits into your overall scheme, and what assumptions you are using.  And do not be afraid to have contingency plans and change them if new data comes your way. 

I know it is hard, especially in times of currency wars, because the first victim in all war is the truth.   But don't go off the deep end either, and waste your money on over complex plans or put all your eggs in an improbable basket.  It's your call, and perhaps you need a professional to help sort out exactly what your priorities are. 

I keep a spreadsheet, and on it there is a summary of all my assets, and it fits them into a simple risk portfolio so I can see how they are distributed by risk and by total value.  Since the prices of things change, you have to be aware of how that affects your overall portfolio. I have to say that physical bullion has taken a much larger place in my overall profile since 2000.  But that is fine, I just need to be aware of not letting it become a risk, and to balance it as required.

Would I personally buy GLD as 'insurance' against a systemic failure?  Hell no.  Maybe as a flip investment on a technical trade.  Would I buy some physical trust with strong outside auditing and redemption features that were practically available?  Probably, because it covers a bit of both insurance and investment.  But it lacks the leverage of a small cap miner just for example. But it does not nearly have the risk.

Yes it is 'that simple.'  Which is to say, it can be simple to understand but hard to implement. But you have to start somewhere, and if you start all wrong, it gets worse as you go.  Some parts of my portfolio are for insurance, and other parts are for investment.  They serve different purposes.  I had the damnedest time trying to convince a broker at a white shoe firm who was managing my stock options portfolio of this.  He thought I was schizoid.  He only thought in terms of good stocks and great stocks.  So I got rid of him, as he was too focused on his own goals, even when he feigned altruistic concern for my money.

And sad to say, for most people, their major task is just getting by day to day.  And so the pros and cons of various investment techniques is so much hoohah because their most ambitious aspiration is to stay out of debt, especially usurious and fee laden debts, while putting a little bit aside.  And this is why I spend quite a bit of time writing about these abuses, because I am not only a caterer to the elite, but to our little community which has a range of wonderful souls in it.

As always, the devil is in the details, but it helps if you know the lay of the land, and where you think you are heading, and why.  And of course, you adjust for changing circumstances as they occur.

Gold Daily and Silver Weekly Charts - Word for the Day: Rehypothecation

"The commercial world is very frequently put into confusion by the bankruptcy of merchants that assumed the splendour of wealth, only to obtain the privilege of trading with the stock of other men, and of contracting debts which nothing but lucky casualties could enable them to pay; till after having supported their appearance a while by tumultuary magnificence of boundless traffic, they sink at once, and drag down into poverty those whom their equipages had induced to trust them."

Samuel Johnson, Rambler #189, January 7, 1752

This is not a technically precise description of rehypothecation, but the terminology has been simplified a bit for the sake of understanding by the lay person.  But the risks described herein are real, and need to be understood.

I thought of this when I read a question that a reader had about how fractional reserve bullion banking works.  Like so many other things financial, it can seem almost foolproof on paper.  Somewhat like the efficient markets hypothesis, or the trickle down, supply side, recovery boogie woogie.

But one might ask, how is it that occasionally things in bullion banking seem to go awry, so that even the great monetary power and experience of the Governor of the Bank of England might find himself 'staring into the abyss.' 

Where are the risks in this, and in any other type of fractional assets arrangement?

And that brings us to our word for the day:

Rehypothecation: The practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients. Clients who permit rehypothecation of their collateral may be compensated either through a lower cost of borrowing or a rebate on fees.

An example of rehypothecation might be used in any fractional asset system. One example might be a bullion bank, or mint, that offers the sale and storage of unallocated gold and silver.  You may buy the bullion from them, but you agree to leave it there in an unallocated pool of assets.

The advantage for the customer is that they are given a significant break on storage fees for not demanding the delivery of specific bullion.  

It does not even have to be a bank or mint, but a larger dealer in metal.  Any entity that offers unallocated bullion storage can use that unallocated bullion to smooth the delivery process to retail and wholesale customers that prefer to take delivery of their bullion.  For the sake of clarity I will refer to the bank, mint or dealer offering unallocated storage as Dealer.

As in the case of the more familiar commercial banking, the 'deposit' of the customer, with cash left 'on deposit,' makes them a creditor of the bank.  The return which the customer receives for this loan of their asset is interest, or some other value such as a reduction in fees.  In the old days they used to even kick in toasters and TVs, but those were other times when deposits seems to matter more.

In the case of metals, typically the unallocated bullion is rehypothecated by the dealer to some degree.  It is often used as a classic 'float' in support of their own operations.

It is a way for the dealer to obtain short term bullion to supply their day to day transactions with people to whom they take and deliver bullion in various forms, such as delivering title of a certain amount of refined gold in return for the delivery of intermediate stage material, in the form of doré bars from a mine for example.  And generally the dealer would receive some fees in return for this service to the miner. 

The reason that the dealer might not charge the unallocated owner a storage fee is because the customer has agreed, even if in the fine print, to allow that entity to use their bullion as collateral in unspecified third party transactions.

 The customer has deposited their asset to the dealer, in return for some form of reimbursement.  And in turn the dealer may rehypothecate, or use, that asset for their own purposes.

The same asset can be rehypothecated many times, so that a single ounce of gold and silver, or any piece of property, may be encumbered by a chain of ownership claims, some of them downstream from the original dealer.   Practices may vary, but rehypothecation has become commonplace in our modern financial system.  Leverage pays off well when it works.

This is all very well and good, as long as the different parties in the chain do not overdo the leverage, or number of claims, applied towards that particular asset.  And of course if there are no untoward counterparty risks or failures in the chain, or disruptions in expected supplies either in terms of availability or price.  If that happens we can see a domino like effect.

So when you are given a nice textbook example of how fractional ownership of anything works, keep in mind that there is never a free lunch. If you are receiving some sort of benefit for keeping your assets at a particular place, chances are quite decent that they are being utilized for the advantage of someone else.

And if there is a disruption somewhere in the markets, and  the chain of rehypothecation is broken, difficulties may most certainly arise.  Often a dealer will be in a position to offer some sort of guarantee, as in the case of FDIC insurance for monetary bank deposits.  Results may vary.

Although I have not discussed it, it is also possible that an asset held specifically without any prior agreement for reuse, such as the case of allocated bullion being held through a broker, might be subject to cross claims of ownership, as in the sad case of MF Global.  In that case the customers had to lawyer up against other counterparties and wait for some sort of settlement.  This does not happen very often, but it can and does as we have seen.

Sometimes the leverage in a vehicle is not always easily seen.  Is GLD fractional?  Does all their gold hold clear title to some specified percentage of an investment unit?  I don't know.  How much 'leverage' is there in a particular bullion bank at any given time?  We have seen them occasionally seen them get 'over their skis' as in the case of Scotia Mocatta some time ago, but it is hard to tell because audited results are not frequently available.   We know they are running floats, unless they are otherworldly saints, or just fools.  The question is, how much?

I wonder under what auspices central banks lend out the gold of their people to bullion banks?  Do they realize that their gold is being rehypothecated, often by third parties?  Have they ever agreed to it?  Do the central banks even have to disclose such arrangements?  What oversight is there from the civil authorities?

And what happens if the central bank asks for the return of their bullion, and it was not there?  One can only wonder. Perhaps Germany offers a contemporary example of how to manage such a situation.

Speaking of the movement of bullion, there was a whopping warrant issued by JPM on 109,856 ounces of gold bullion in its storage yesterday, adjusting it over to the registered (deliverable) category.  And there was a lesser amount of 11,056 adjusted over to registered at Scotia Mocatta.

So now the total deliverable category is back up to 616,519 ounces, which is a good thing, since one might have wondered how they were going to fulfill those contracts that have already stood for delivery.  I expect that they will be posting the drawdowns in the foreseeable future.

Also at Scotia there was a withdrawal of 40,395 ounces of gold from the warehouse altogether.  All the transactions and totals are included in the report below.

As a reminder, tomorrow is a Non-Farm Payrolls day, and shenanigans are often in fashion.

Have a pleasant evening.

The Amazing Disappearing Gold Bullion: Major Precious Metal Inventory Changes in 2013

The difference in the changes between gold and silver inventories is interesting.

I suspect that a great deal of the gold that has been lost this year has been repurposed to private ownership in China, the Mideast, and India among other places.

Although I do not show them here, Palladium and Platinum look much more like silver than gold.

Most of the conventional, off the cuff explanations do not seem to hold together under serious scrutiny.  Yes, silver is 'poor man's gold,' but Platinum certainly isn't.  And an aversion to paper gold, but not to paper silver? 

Gold seems to be somewhat different, even unique, with a large amount of physical inventory leaving the West.

Overall about 811 tonnes of gold have been withdrawn from inventory, while 1,434 tonnes of silver, 21 tonnes of platinum and 1.5 tonnes of palladium were added to these same types of ETFs and funds during 2013.

A remarkable short squeeze on gold bullion supply might occur if the price of gold breaks out, stimulating more investment in these 'paper gold' instruments.

The data for these charts came from Nick Laird at ShareLynx.com. 

COMEX Gold Inventories - A Towering Citadel of Paper

Lower and lower, to new record lows.

Weighed, and found wanting.

Who is running this sideshow?

And where will it end?

Let's take a closer look at today's gold market action on the COMEX...

The Longer Term Fundamentals of the Gold Market As They Are Today

There should be no doubt in anyone's mind that the fundamentals for world gold supply and demand have changed dramatically over the past ten years at least.

The world's central banks, most significantly in the West, had been selling bullion from their central bank reserves since 1989. The first chart below shows the long decline in the official gold reserves of the central banks through the long bear market from 1979 through 2000, and even in the beginning of the bull market.

There was an explicit public arrangement called the Washington Agreement struck in 1999 to regulate that official selling after a particular central bank had disrupted the market.

"Under the agreement, the European Central Bank (ECB), the 11 national central banks of nations then participating in the new European currency, plus those of Sweden, Switzerland and the United Kingdom, agreed that gold should remain an important element of global monetary reserves and to limit their sales to no more than 400 tonnes (12.9 million oz) annually over the five years September 1999 to September 2004, being 2,000 tonnes (64.5 million oz) in all.

The agreement came in response to concerns in the gold market after the United Kingdom treasury announced that it was proposing to sell 58% of UK gold reserves through Bank of England auctions (aka Brown's Bottom), coupled with the prospect of significant sales by the Swiss National Bank and the possibility of on-going sales by Austria and the Netherlands, plus proposals of sales by the IMF. The UK announcement, in particular, had greatly unsettled the market because, unlike most other European sales by central banks in recent years, it was announced in advance. Sales by such countries as Belgium and the Netherlands had always been discreet and announced after the event. So the Washington/European Agreement was at least perceived as putting a cap on European sales."

There is some speculation as to the reason why the UK's Brown decided to engage in that rather extraordinary action, against the counsel of his own advisors, but that does not concern us here. 

This outright selling in gold by central banks is different from the leasing of gold by central banks, which is generally not transparent and openly announced. In this leasing operation, bullion banks pay a small lease rate to the central bank for the right to use that gold as collateral and for sale, with the promise to replace it after a period of time with a fee. It is a subject of controversy how much of the existing stock of central banks has been committed to the market through leasing arrangements. The number is not insubstantial. The gold is likely to have been sold or otherwise committed, and must be repurchased to be returned.

There is a very high likelihood that gold collateral has been rehypothecated, or used many times with a number of parties holding claim to it. This is a common practice and is referred to as fractional gold reserves. These most often take the form of 'unallocated bullion' which is when a certificate of ownership is issued, but no particular bars have been identified. And as we saw in the failure of MF Global, even allocated bullion ownership, in which specific bars are committed and paid for, ownership can be a rather philosophical concept in which possession is nine-tenths of the law.

The second chart shows the period from 2000 to 2012, with emphasis on 'the Turn' which is when central banks turned from net sellers to net buyers of gold. I cannot stress enough how important this is to the fundamental outlook.

Economists, pundits and investment managers can say whatever they like, but the proven fact remains that the world's central banks, on the whole, do not agree with them that gold is not an important store of value, and likely to become more important in the future. It is somewhat ironic that these same fellows would uphold the power of the central bank on one hand, and say things like Don't fight the Fed, or Bernanke says what the market is, but then will turn around and suggest you ignore what the central banks of the world are doing on the whole. It is hard to imagine that this is not someone woefully ignorant of current trends or with some other agenda who would take such an obtuse position.

And of course we also have the statement and opinions of those who say, personally I think gold is barbaric and useless, but then will say, money is based on consensus, and so fiat money is sound. Again, the clear consensus of the central banks is that gold is an important facet of their reserves, and the importance to their future plans is growing, for whatever reasons they have not yet disclosed.

The third chart demonstrates the significant increase in gold bullion acquired by the Chinese. This is both private and official purchases. A large producer in their own right, China exports little of their domestic production, and is a large net importer. Several other countries are following the same pattern, the common thread being that they are the high growth countries who have the need to increase their reserves, or whose people have new wealth they wish to deploy.

The fourth chart shows the well established fact that the increase in the gold supply through mining is relatively inelastic with regard to price. It takes significant effort and capital to create new mining operations, and there is a natural decay in the productivity of existing mines as with most natural resources. The estimate is that the gold supply can increase through mining at roughly 2% per year. This is one of the features that has long made gold attractive as a form of money.

As demand increases therefore, the price of gold must rise. If someone wishes to hold the price steady, new supplies of gold must be found, and they will not be discovered in mines.

There is a fairly well established 'scrap market' in which old jewelry and other gold objects can be purchased and melted down for bullion. But this market again is not robustly elastic although it can respond to higher prices more readily than mining operations.

So for ready access to gold to meet market demands, other sources of gold must be found.

This is where we get into the concept of 'fractional reserve gold' and 'paper gold' in which ownership is more of a financial concept than a hard reality. This includes both the leasing of official reserves, and the use of unallocated reserves that would be discovered in purchasing programs and perhaps even some well known funds.

One would hope that highly transparent audits of such things would exist from impeccable sources, but sadly that does not seem to be the case.

Leverage and rehypothecation are two of the largest factors in the recent financial crises, in addition to the mispricing of risk and fraudulent representations.

I think one of the more remarkable features of the current situation is the storage of official bullion in custody in New York and London. Venezuela was one of the first countries to demand that their gold be repatriated from New York, and this has happened despite much scoffing and derision by the usual pundits.

But then in response to domestic requests and changing circumstances, the German central bank requested that some portion of their gold be returned from out of country.

The German gold had been stored out of country in response to concerns that the gold was not safe, given the divided nature of the country and fears of a Soviet incursion. Obviously with their country reunited and at peace, it would make sense to return things to normal.

They had already received much of their gold back from London, in large part because it was incurring significant storage fees. They are also requesting their gold back from France.

By 2020, the Bundesbank intends to store half of Germany’s gold reserves in its own vaults in Germany. The other half will remain in storage at its partner central banks in New York and London. With this new storage plan, the Bundesbank is focusing on the two primary functions of the gold reserves: to build trust and confidence domestically, and the ability to exchange gold for foreign currencies at gold trading centres abroad within a short space of time.

The following table shows the current and the envisaged future allocation of Germany’s gold reserves across the various storage locations:

	31 December 2012	31 December 2020
Frankfurt am Main	31 %	50 %
New York	45 %	37 %
London	13 %	13 %
Paris	11 %	0 %

To this end, the Bundesbank is planning a phased relocation of 300 tonnes of gold from New York to Frankfurt as well as an additional 374 tonnes from Paris to Frankfurt by 2020.

What is so remarkable is the response from New York. The Fed is agreeing to return a portion of Germany's gold in SEVEN YEARS. 

Until the fundamentals change, the offtake of gold will continue to deplete supply, until the price moves to strike an equilibrium.

And as I have attempted to show at some length and detail on this site, the recent sell off in the price of gold was largely motivated by speculation in paper gold on western markets, specifically London and New York, that resulted not in a decrease in demand but an increase in demand that led quickly to spot shortages, delays, and premiums over the paper price for actual bullion.

I do not know the future. It is patently obvious that China and Russia and a few other countries, are making a concerted effort to increase their gold reserves for some reason. There is significant speculation that the nations will be changing to a new form of reserve currency for trade that will be backed at least partially by gold.  In addition, several countries are said to be making plans to back their national currencies by gold in some manner as the devaluations of world currencies obtain momentum.  I think these all these plans are under serious discussion today. There is no doubt that international discussion have been going on for some time.

I am aware that there are other, more specialized and sophisticated, studies out there about the gold and silver markets.  Much of them are with regard to the shorter term for traders.  But there are a few extraordinary efforts conducted by groups like GATA, data compilers like the World Gold Council, and individuals such as Eric Sprott, who has done a remarkable job of attempting to derive the demand and supply data for gold over a longer period of time.

My goal here is to present what I like to think of as the bigger picture.  My own analysis of the global economy started in 1992 in a brief return to academics, and a natural interest as someone involved in international business. 

Starting with the Asia currency crisis of the 1990's and the collapse of the rouble, my thinking led me to assume that there was going to have to be a significant change in the structure of the global trading arrangements with regard to currencies.  Up to that point in 1999 I had no interest in gold whatsoever.  I discovered gold and silver in my process of thinking about other things, and everything I had anticipated seems to have been unfolding, with variations of course.

There is the little detail that the second credit bubble tied to housing has collapsed, and the powers that be will not take the banks down, but are going to try and reflate the financial paper, particularly bonds and equities, by devaluing the major developed currencies.  They are doing fairly well of hiding its effects, but at some point it is going to bite.  A lot of the shenanigans going around now are trying to position the public, weakest segments first, into picking up the tab.

Make of this what you will, but I think the facts are sound. I suggest you look at this, and then come to their own conclusions.  It may provide a framework with which to interpret events as they continue to unfold.

Silver in Backwardation and the Emperor, Once Again, Nearly Naked

Growing panic in Paperville. The central banks have no silver, and the Comex is being depleted. Interesting that the SLV ETF inventories are experiencing large outflows. The patriotic miners are being called upon to hedge their deep storage inventories, that is, unrefined metal in the ground, to provide more paper.

This manipulation of silver and gold could be a John Law class debacle when it is exposed and collapses, depending on how high the leverage in paper has gone. And of course how deeply down the rabbit hole the people are willing to go in the discovery of real value and the truth.  Given what has recently transpired, I suspect not too far.

The mailbag this morning has the usual dose of overly kind words for which I am always grateful, useful information and notification of alas, typos. But also of hysteria, from those who fear the government is going to come and take their money, or who think that people like me are going to spoil their good thing by warning people about it. Thank God for spam settings.

I don't think most people realize how little their opinion matters anymore. At some point the truth is simply what it is, without regard to what we think about it, or whether we like it. Their good thing is over. It's in the end game now, and we are all in God's hands.

John Law (baptised 21 April 1671 – died 21 March 1729) was a Scottish economist who believed that money was only a means of exchange that did not constitute wealth in itself and that national wealth depended on trade. He was appointed Controller General of Finances of France under King Louis XV.

In 1716 Law established the Banque Générale in France, a private bank, but three-quarters of the capital consisted of government bills and government-accepted notes, effectively making it the first central bank of the nation. He was responsible for the Mississippi Bubble and a chaotic economic collapse in France."

I believe that "modern monetary theory" owes much to John Law, and Money and Trade Considered, with a Proposal for Supplying the Nation with Money (1st ed., 1705; 2nd ed., 1720).

“An abundance of money which would lower the interest rate to two per cent would, in reducing the financing costs of the debts and public offices etc., relieve the King.”

John Law

Here is a brief discussion of John Law and the parallels for today's crisis from Buttonwood at The Economist.

I think there is a bit of disinformation going about. The implication from some corners is that those who sell silver as a hedge borrow it from existing physical supply, drawing down physical stocks. What they do not realize, or admit, is that borrowed silver is not held as allocated and discrete collateral in any system with which I am familiar, but is at best resold again into the bullion markets, if it ever experiences any movement at all beyond some multiple ledger entries.

The dirty little story of the metal markets is leverage and fractional ownership, not always disclosed, which some say is as high as 100 to 1. And this is in the so called physical bullion markets like the LBMA. I could not even imagine how badly mispriced the counter party risk is in the hedges. But when the music stops and the tide goes out, we may see who is naked, and there will most likely be a surfeit of some rather ugly bums.

Reuters
US silver term structure inverts as supply tightens
By Frank Tang
February 11, 2011

NEW YORK, Feb 11 (Reuters) - The tightest physical silver supplies in four years have tipped the U.S. silver futures market into backwardation this week, making near-term prices more expensive than more distant months.

Market watchers said that it has been more than 10 years since silver futures were last in backwardation, an unusual term structure, associated with shortage of physical supply. Warehouse stocks of the white metal have dropped to a four-year low on surging demand, while miners have hedged their future production.

Booming industrial demand for silver and record U.S. coin sales, combined with a surge in demand from mining companies to borrow the metal for their hedge programs have led to a squeeze in the physical silver market.

"The problem is that there is great industrial demand for a specific grade of silver, and there is not enough coming fresh from the mines," said Miguel Perez-Santalla, vice president of Heraeus Precious Metals Management.

"The stocks are being pulled for all the high grade and better materials, and that essentially put a squeeze on the physical market," he said.

Perez-Santalla said that silver futures have not been in backwardation since billionaire Warren Buffett bought 130 million ounces of silver between 1997 and 1998.

Backwardation is a condition where cash or nearby delivery prices are higher than the price for delivery dates further in the future. Usually, forward prices are higher than cash prices to reflect the costs of storage and insurance for stocks deliverable at a later date.

"The extent of the backwardation in silver is unprecedented. It suggests that retail investment and industrial demand internationally is very robust and the small silver bullion market cannot cater to the level of demand for refined coin and bar product," bullion dealer GoldCore said in a note on Friday.

Warehouse data from COMEX showed that silver stocks fell to a four-year low at 102.5 million ounces (3,188 tonnes) on Feb. 5, about 30 percent below a peak at over 141 million ounces (4,395 tonnes) in June 2007.

Strong silver coin sales have more than offset outflow from the world's largest silver-backed exchange traded fund iShares Silver Trust (SLV), which notched its biggest one-month drop in its silver holdings in January...