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Jewellery has two advantages and many big disadvantages.
The advantages are :-
- It is the form of gold which gives some benefit from ownership, namely the enjoyment of being worn.
- It is very easy to buy.
The disadvantages are :-
- The acquisition costs are very, very high. Retail jewellery is often marked up by 300% or more in the shops. (Note that insurance valuations are a fantasy based on replacement cost at retail. No piece can be sold at this value.)
- The real value of jewellery is in the gemstones, the design and the craftsmanship. These greatly outrank the value of the gold.
- All pieces are different and their values are subjective. If you don't have experience you probably won't know a fair value - which for practitioners is part of the fun.
- It is by far and away the most easily stolen form of gold.
Jewellery is a profitable business for those who buy at wholesale and sell at retail. It also works for people who have a good feel for fashion, and the time to trawl through catalogues finding stuff which maybe they can re-sell. But it's a poor way of investing in gold.
If - nevertheless - you choose to invest in gold through jewellery the best advice must be to avoid the retail mark-ups as far as possible by buying at auction, where buying premiums (the fee paid to the auction room) is typically 10 - 15%. Alternatively seek out parts of the world like Dubai where it is possible to buy gold not too far from its bullion value. There machine made chains are sometimes sold as little as 20% above bullion content. Take care though, you might find it difficult to transport in any serious quantity without tax and security implications.
Gold coins come in two general classifications (i) numismatic coins and (ii) bullion coins. A numismatic coin has a price which doesn't relate to its bullion value so much as rarity and desirability for collectors. A bullion coin, on the other hand fairly accurately shadows the bullion price.
Small bars behave similarly to bullion coins.
Advantages of bullion coins and small bars
- Coins and small bars are generally a liquid market, so you can find sellers and buyers when you need them.
- They are relatively accessible to smaller investors. Coins in particular can be bought with modest amounts of money (while bars of 1 kilo start at about $12,000)
- Coins are mostly recognisable, which makes them exchangeable for goods in some circumstances. This monetary characteristic makes them attractive to people who want to take possession of gold as a means of surviving a catastrophe. It doesn't work always as they hope.
- Genuine coins have the added endorsement of a government mint which provides a level of guarantee.
Disadvantages of bullion coins and small bars
- The local custody problem. It is often the case that when gold becomes really valuable gold coin usage is made illegal by governments, or is so heavily taxed and constrained that it is nonsense to use them 'above the counter'.
- There are fakes, and these are usually only spotted by dealers, although there are tools which might help the less experienced. Dealers rate themselves at spotting fake coins from their surface, but because bars are generally bigger than coins they can be 'drilled out'. This obviously illegal activity leaves the serial numbered bar skin behind and fills the interior with an alternate, like lead. This has a consequence on resale, even by the innocent. The dealer may not trust assay marks on bars which have been in private hands, and may require an analysis before payment. Even where the bar is perfectly sound it means the seller may still end up having to pay for the refining.
- Next to most types of investment the difference between buying and selling price is significant. On the face of it this can cost 7%, but the reality is usually worse. Demand tends to come in waves, with the market producing a surfeit of buyers or a surfeit of sellers at any given time. With a wide spread to play with the dealer will shade high when most customers are buyers, and low when they are sellers. For example an international incident which encourages gold buyers might set the underlying bullion price at $400 per ounce and encourage buyers. The normal 7% differential indicates a $28 spread, but instead of being centred on the $400 mark the dealer anticipates demand and makes a spread of $396 - $424. When things calm down and people liquidate their hoards the spread, even on the same underlying $400 bullion price, will shade to the low side, and the dealer will make a price of $376 to $404. It appears to be a $28 spread, but the result of being predictable will be an effective spread for the significant majority of £376-$424, which is 12.8% rather than 7%. These sorts of spreads greatly diminish the probability of worthwhile profits to the investor. (Although note the considerable advantage for those who trade against the crowd and enjoy a 2% spread.)
Coins and small bars can be an appropriate gold investment method for sums from $100 to $10,000 especially for people whose view is long term and for whom physical possession is all. In this range it would be typical to suppose dealing costs, delivery and ownership costs in the 10-15% range overall.
The world's professional gold market trades 400 toz bars, equivalent to about 12 kilograms a piece.
Advantages of buying big bars :-
- Big bars are a deep and liquid professional market.
- The bars are serial numbered, and usually do not leave the security of industrial strength vaults. Within the LBMA's chain of integrity fakery appears to have been completely eliminated.
Disadvantages of big bars :-
- The bars cost a cool $160,000 each at $400 per toz. This is not an easily managed investment for most individuals. In fact to benefit from the truly competitive levels of the professional market 1 bar is insufficient. For most professionals the smallest trade size the markets will consider exceeds $500,000.
- The professional market trades “Over The Counter” for physical delivery, and the costs of delivery and storage have to be borne by the investor.
- OTC trading can make price discovery difficult. Access to competitive and simultaneous market pricing is restricted to those with financial sector data feeds.
Big bar trading is reserved for big companies and institutions. It is competitively priced but inaccessible to the private investor.
A list of LBMA members who participate in this market is available at http://www.lbma.org.uk/members_list.html
The OTC market
Gold is traded OTC - which means 'Over The Counter'. Buyers and sellers choose each other without the benefit of an exchange floor.
Buying gold at this level is more like shopping in an exclusive shopping mall than trading in a modern financial marketplace. You try one shop, then the next, and choose whichever supplier suits you best, without knowing what amazing prices the other traders are offering at the instant you trade.
It is a system very different from a modern exchange. The structure derives in part from a simpler world of 150 years ago.
Then, if dealer A sold and delivered gold to dealer B and B's cheque failed to clear the bank, it was a problem only for A. No-one would hear of A calling for rescue from other market participants (never mind them offering it). As a result A and B may both be lost to the world, and everyone else would be fine. The survivors would say that A should have been more careful about his counterparty's creditworthiness, and for a while the solidity of their own financial management would become a priority for all firms.
These self-regulating forces provided periodic encouragement to market to keep its house in order, and leads to an important advantage with an OTC market structure - participant isolation.
In a modern exchange based system there is far more interdependency. An exchange centres on a clearer which usually has regulatory and credit responsibility for the exchange's members. The clearer itself is a key point of systemic weakness in an exchange based system, and it would in most cases destroy the market and the livelihoods of many of its participants were a clearer to fail.
Most modern investors consider it highly improbable that the clearing element of a modern exchange could be at risk, but it most certainly is. Modern exchange clearers sit at the centre of an elaborate credit structure holding very large book positions of their members' assets as 'margin' cover against much larger overall gross liabilities.
So although OTC is different - and dated - it is not necessarily just plain daft. These things revolve in cycles, and maybe an OTC market will still be around after a substantial credit unwinding of the type which usually comes along and wipes out the financially adventurous every few decades.
Nevertheless, because it lacks an exchange floor a problem of the physical gold market is that it doesn't easily tell the world a current price. Modern investors expect real time price discovery, but the best the traditional bullion market in London can manage is the gold 'fix'.
The fix itself ...
The gold fix is an alternate mechanism of price discovery which is designed to allow gold traders to trade at a fair market price. It's basic mechanism is to concentrate all the liquidity in the market into two fifteen minute windows - at 10am and 3pm each day (London time).
About five professional gold market participants in London conduct what amounts to an elegant private auction, which establishes the price at which the number of professional gold buyers matches the number of professional gold sellers. The professionals will be acting both on their own behalf and for those customers of theirs who have issued orders for them to trade at the 'fix'.
The process itself requires the chair to quote a price. Then there is a bit of a scramble while all those present work out if they and their customers are net buyers or sellers at the chair price. If on balance the fixers declare as buyers then the chair has another go with a higher price. If they declare as sellers the process is re-run at a lower price. Eventually they come into equilibrium.
The resulting price is the gold fix, which is declared twice a day and published widely in newspapers, on the internet and on teletext services, and it is a good guide to the value of gold at that instant. On the internet you can see it at http://www.lbma.org.uk/statistics_historic.htm.
If you've enough money to be involved (usually $500,000) then on the face of it the fix is an incredibly efficient market. Buying through one of the central fix market makers will probably cost 25 cents up on the fix price. Sellers - surprisingly - might receive 5 cents above the fix too! So that's a 20 cent spread on a $400 price, which is less than 0.05% - almost unbelievably tight pricing for a major financial market.
But there's some funny stuff going on. The problem here is the conflict of interest that exists between principals and agents. As a gold buyer you will open your book to one of the players in the gold fix who will act in both roles - allegedly trying to get a bargain price for you, while at the same time benefiting by setting the price high. A great many other individuals and institutions are all opening their book at the same time. It doesn't need an enormous brain to work out that if most customers are buyers - and the swing producer with the gold fix seat knows if this is the case - his own profits are enhanced by not declaring as a seller until the chair price has gone up a bit.
So profits are earned for the fixers not from the 20 cent spread but by being in the know about how many customers want to buy, and by adjusting the price accordingly during the auction. It produces hidden dealing profits for the participants, and bad pricing for those who run with the crowd in their trading patterns. With the 'fix' the majority will always lose to the central market making principals.
Advantages of the gold fix:-
- There is a large pool of liquidity - albeit for only a short while. Provided there is not marked overall demand or supply the price will be very fair.
- If you're a buyer in a falling market or a seller in a rising market then the the chances are you're a contra-trender who'll benefit from the way it works.
- The dealing spreads - at 0.05% - are undeniably very fair.
Disadvantages of the gold fix:-
- As with the big bar market the entry level is high. Again the smallest trade size the markets will consider probably exceeds $500,000.
- Some intermediate sized traders will accept your order and aggregate it up with their other customers' orders into a fixable size, but they will charge, and you will pay a lot more than the 0.05% of the true professional fix market.
- Physical delivery, and the costs of delivery and storage have to be arranged, and are borne by the investor. There is very little enthusiasm anywhere for small quantities.
- Only available for a short time twice a day.
For gold the world's quoted 'spot' market is unusual.
When you buy aluminium, or corn, or foreign currency on their respective spot markets the deal is that seller will make delivery within a few days, and you will go to an agreed location and collect what you have bought in return for your payment.
You will not have that privilege with your spot gold purchase on the world's gold markets. When you turn up with your bank draft you will receive nothing. This is because spot market gold is now by convention 'unallocated'.
There's quite a lot about unallocated gold - not all of it very flattering - further down this report and elsewhere on this site, so we won't go into it any deeper here. Instead we'll just talk about spot gold.
The most important thing about spot gold is that because it is not ordinarily delivered or even in physical form it is cheaper than real physical gold and can be bought in multiples which are not ordinarily deliverable. This will suit those who trust banks' long term credit control capabilities and just want some price exposure to gold.
Advantages of the spot market:-
- Unlike the fix it's a professional market open all day
- You can get a price. The banks love to sell 'spot' gold, and they compete vigorously through the price dissemination services (like Bloomberg) to quote a gold price.
- The dealing spreads are tight.
- It's wonderfully hassle free. There isn't anything to deliver or keep safe.
Disadvantages of the spot market:-
- It's inaccessible. The main spot market is called EBS which is a co-operative venture of 13 major international banks. Although it trades 500,000 ounces daily it is a closed market. Only the banks themselves and the large institutional customers are welcome. Why is this? It's because as it is credit related banks only want to deal with people whose credit they rate highly, and while this often includes some pretty flaky other banks it rarely includes private individuals.
- You won't have any gold. If you do trust the balance sheet of your bank it's almost a nonsense to buy straight unallocated gold. Surely it would be more efficient to invest in an earning asset through the bank, and find a cheaper way to speculate on the future price of gold. This way would be better value for you provided your bank stays sound.
- It is highly unlikely that an owner of a gold account would benefit from depositor protection schemes which protect most customers of banks. Governments - the underwriters of such schemes - will probably be hostile to gold owners during a banking crisis, and will consider only national currency subject to depositor protection.
Shares in gold mines are a popular way of investing in gold.
Advantages of gold mining shares:-
- The advantage of investing in a gold mine's shares is that its value is much more sensitive to the price of gold than even a gold bar. This is because gold mines are valued on the basis of their anticipated cashflows through the life of the mine, and these depend on the reserves, and on the relationship between production costs and the anticipated value of the gold extracted.
Suppose a mine has 1,000,000 ounces underground and the above ground value is $400 per ounce. If the production cost is $300 per ounce the mine will make $100,000,000 over its life. But if the gold price rises by 25% to $500 the mine will make $200,000,000 overall. This demonstrates a 'gearing' effect of four times - i.e. for a rise in bullion of 25% the share will rise by 100% (all other things being equal).
Of course the flip side means that these gold shares would fall four times as quickly on a falling bullion price.
Disadvantages of gold mining shares:-
- The quantity of a mine's reserves is never accurately known. Reserves (and their poor relative 'resources') are assessed by miners' core drilling programs which sample a prospective gold seam to measure gold concentrations in the rock. The amounts discovered in chemical analysis are extrapolated over a wider area to identify the likely reserve amount overall, but there is no guarantee it will be found in mining. Consequently there is a risk that recorded reserves do not reflect reality. Human nature gets in the way of accurate sampling, especially in companies whose function is principally exploration rather than the operation of mines. Prospectors raise money by encouraging investors that there is gold underground, and although a great deal of effort may be made to keep the process honest you only have to overlook a couple of poor rock samples (let's just call them damaged) to manipulate the likely reserves upwards. In the end the investor must trust both the geologists and the company's financial controller - both of whom may have to make the occasional fine judgement. It is almost always in their interest to err on the side of optimism. A pessimistic outlook rarely got a mine built.
- There can also be unforeseen engineering problems in extracting ore. These can increase the production costs, and only small percentage increases can eat into the mine's profitability.
- Another issue is that the costs of the mine can be borne in a currency other than dollars - the trading currency of the output. Exchange rate movements can greatly affect mine profitability by creating currency translation adjustments - both profits and losses.
- Perhaps the greatest variable is shareholder sentiment. Because of the wide attraction of gold shares in good gold markets the shares tend to greatly outperform not only gold, but also any reasonable valuation of the mine's future cash-flow. Investors are often not familiar with the yield numbers they should expect on a mine compared with - say - a supermarket, because whereas there is no reason that using a supermarket will wear it out, the mine certainly will be worthless within a few years, once its ore is gone. So the return on a mine must pay back both the original investment and provide some profit during its life. A 20 year lifetime mine must yield in excess of 5% per annum before it makes any profit for the long-term investor at all. Few mining shares can do this, so in effect the share price of many mines already discounts a substantial bullion price improvement.
- Corporate culture is another problem. These days many companies (not just mining companies) are run more for the benefit of their managers than their shareholders. Many managers don't like paying dividends because it diminishes the cash pile remaining for staff salaries and new corporate adventures - like exploration or takeover activity. Very few mining companies could be accurately described as vehicles for the straightforward exploitation of underground ores in the interest of shareholders. Instead the assets can become the playthings of boards of directors whose best interest tends to be served by punting shareholders' money on opportunities which are sufficiently credible to grant a possible future beyond the current working mine's life. In the absence of strict and generous dividend policies shareholders in gold mines are investing in the strategic competence of their board at least as much as in gold.
Gold shares are potentially risky but simultaneously an exciting investment. They tend to be reasonably correlated to gold prices but typically much more volatile, and subject to many variations which are independent of bullion market forces.
There are far too many of them to keep track of, and anyway individual analysis is well beyond the scope of this site. Fortunately stockbrokers will usually perform this function willingly, and many of them post their analysis - or at any rate a teaser - on The Gold Report's Analyst Section.
Mining shares might be considered an appropriate gold vehicle investment for sums from $5,000 range upwards, but investors should remember the gearing and invest appropriately less than they would in bullion. Buying and selling costs vary from market to market. Not uncommon is a spread of 2% (lower for the bigger mining companies) and transaction costs of 1-1.5% each way. Combined, the trading costs would amount to up to 4-5% of the capital cost for each investment undertaken.
The internet spawned e-gold (it spawned e-everything). In fact, e-gold is pretty close to straight gold, and a good thing too!
The basis of e-gold is that international debts, and even some domestic debts, can be paid more efficiently in gold than in foreign currencies, which have to be converted back into host currency through the bank. So wherever a supplier and a customer both have an e-gold account they can transfer ownership of gold between themselves across the internet, and this constitutes payment.
To get started you use your own currency to buy grams of gold. Real gold is delivered into a depository, and is credited to your own e-gold account. You then get a secure internet identity, and thereafter you can instruct your e-gold provider to debit your e-gold account in favour of your supplier - another account holder in the system. Whatever you have bought from them is delivered to you independently.
It is primarily a payments system, but it doubles as a route for owning and storing gold.
Advantages of e-gold :-
- The great virtue of the system which sets it apart from our national currencies is that at all times the number of grams credited to all accounts is guaranteed to be exactly the same as the number of grams in the depository. It is to all intents and purposes a private currency system based on the gold standard.
- You do not have to spend your gold grams. You can sit on them, in which case you are using the system not as a payments mechanism but as a store, and you can then sell the gold back in return for straight cash (usually this is done through a liquidity provider, not to the e-gold provider itself).
- You can buy small amounts of gold at relatively economic prices - well below the costs of coins and small bars.
- The costs are competitive on larger holdings too.
- You benefit from an unallocated share of an allocated quantity of gold. This mixing of the two statuses of stored gold sounds as if it offers what really counts - which is 100% backing of positions with stored metal.
- The custody charge is very competitive under normal circumstances. E-gold has turned out to be a convenient payment mechanism for ebay (the internet's highly successful auction system) because it offers rapid guaranteed payment without all the sellers' overheads and expenses of credit cards. This makes it work very well for once off sellers who want quick, sure, electronic settlement. Because of its use as an ebay payments mechanism it has a large number of users with tiny amounts of gold, so it has opted for a fixed price custody service at an incredible $1.30 per month - including insurance. This pricing subsidises the very few serious gold investors who use it, and they can currently get a great deal; storage and insurance for $500,000 of gold for $16 a year! Unfortunately they tend to reserve the right to charge on 'commercial quantities' - whatever that means. In effect they are covering their backs against a sudden rush of volume hoping to benefit from the cheap custody.
Disadvantages of e-gold
- The main disadvantage of e-gold is the inevitable up-front load. For new customers the load may start at 3% and diminish to 1.6% - (the 1.6% rate is for trades over $100,000). Even on those large quantities of gold that amounts to $6.40 on a $400 ounce, which makes the product look expensive next to futures. In theory this would be paid back over several years of cheap storage, but it is unlikely the cheap storage is sustainable if serious investors start using this service in any volume.
- There is a degree of intermediation in the holding. Your gold is the legal property of trustees who have a fiduciary duty to you. This appears to be a reliable mechanism in normal circumstances but is still not quite the same as outright ownership.
- The system was designed for payments, and in order to make it acceptable for suppliers outward transfers may not be repudiated. The system's direct competitors - visa, mastercard etc - are very big and can offer suppliers guarantees about payment which do not necessarily mean that customers forfeit all rights after a payment has been correctly initiated. The e-gold providers perhaps do not feel big enough to wear the risk of customer repudiation, so the gold holder ends up wearing the risk of an unauthorised payment being made out of his account. The worrying element of that is the relative ease with which serious hackers can break internet access (using such devices as keyboard grabbing software).
- The providers are not especially liquid. If you want to buy a serious quantity (1kg in one case) they may deny you immediate execution. This means you must wait until the following day's gold 'fix'. You might well miss your intended dealing price.
- There may be some obscure charges. For example, your right to exit at the 'spot' price is not as fair as it sounds. Firstly there is no central spot price for gold. Secondly, exiting at the spot price is - possibly - a bit of a trick to make the provider look good. The world spot price quotes gold without physical delivery. So to turn spot "unallocated" gold into physical gold you must pay fabrication and delivery charges. In paying your surcharge up front of maybe 3% you were already paying those charges, but you are selling it back at a spot price. Effectively what is happening is that the provider is saving his next load of delivery costs by buying your gold pre-delivered, at the undelivered spot price. He'll be making good profits off you if he can re-distribute that gold to new customers.
- There may also be money transmission charges.
- There is a custody charge, (but it includes insurance, and is so low that it has been included in the advantages section!)
This is a useful internet way of owning real gold. Although the up-front costs are significant they may pay themselves back - particularly if you are going to hold gold for a considerable period. Through the custody charging policy alone it makes for a cost-effective long term reserve against calamity.
Some of the providers allow you to freeze an account. This is a useful extra facility which allows you to be a bit more relaxed about the internet access issue.
Advantages of gold futures:-
- For traders who don't want custody it eliminates the hassles and costs of settlement and storage. This significantly reduces costs.
- Investors need much less money to participate even in quite large scale. Futures are 'margined'. In effect you don't have to pay for what you buy when you buy it, and if you sell reasonably quickly (i.e. usually within a month or two) you will never pay for all the gold you bought. Instead you will pay about 2% of the value up front, and any profit or loss will be adjusted on your down-payment and paid back to you net.
- You can short sell. Provided you buy an equivalent contract back before the contract expires you will have been able to profit from a falling price. This can only be done on spot markets with great difficulty, because it requires a seller to borrow gold for delivery, which is next to impossible for retail investors.
- The market is deep and liquid.
- It is quite easy to track the true worth of your futures contract by following the exchange price.
Disadvantages of gold futures:-
- Artificially volatility. Futures have to be closed out periodically, usually every three months, and at these times trading is suspended in the current contract. In the final run up to suspension trading becomes a difficult game of “chicken”, with high volatility, which can be extremely painful for people who do not have the privilege of being on the floor of the exchange.
- Futures contain a built in price differential which can obscure their true value. When gold is cheaper to borrow than cash the futures price is higher than the spot price. By how much depends on the market's view of interest rates for cash and gold in the period between buying and suspension. What investors need to understand is that if they buy a future at $1.50 above the spot price 30 days ahead of suspension then the value of that future will fall out at about 5 cents a day for the next 30 days.
- Predicting and calculating the correct value is not straightforward and in practice investors assume that professional arbitrageurs and their computers are keeping the market honest by buying cheap futures and selling the resulting physical gold (or vice versa). But the transaction costs for arbitrageurs prevent this working very efficiently, and as a result when investors depend on the market for fair pricing it tends to fail them. In effect the market uses complexity to shroud its inefficiencies.
- Credit risk. This is the risk of default during the period from trade to future settlement date - leaving someone entitled to a profit but unable to collect it. Almost all futures traders are unconcerned by this risk, but it is material and gold buyers as a breed are aware of it.
- Automatic instability. With all futures (not just gold) a rapidly falling market will force selling, which further depresses the price, while a rapidly rising price forces buying which further raises the price. Either scenario has the potential to produce a runaway spiral. This is manageable for long periods of time, but it is an inherent danger of the futures set-up. The same phenomenon of structural instability was paralleled in 1929 by brokers loans.
- The stop-loss. The stop-loss sounds like a great idea and is offered and encouraged by many brokers for reasons of safety. But it can work profoundly against the interest of the investor.
Seeing where the costs are in futures trading is not easy to do. A $10,000 margin down-payment could probably finance a notional $500,000 gold future purchase, and transaction costs would be very small. But the position would be very thin on margin, and even a touch of weakness in the gold price would see the $10,000 lost.
A more conservative approach would allow some tolerance of a market moving the wrong way. If a $10,000 down-payment financed a $100,000 position successfully for a year the costs assimilated over the period would include the commissions (four sales and four purchases) 4 trading spreads on a notional $100,000 position, and the loss of interest on the margin. On the most generous interpretation this will cost about $1,000 - i.e. about 1% of the notional principal but a high 10% of the down-payment. After adding the marked effects of predictable volatility as the contracts are rolled forward, and the depleting differential between the spot and futures prices, the trading costs could be significantly higher. Do not be fooled into thinking you are saving the cost of financing the trade. It's in that depleting price.
For investors who are prepared to underwrite for a short period the systemic risks of derivatives gold futures remain a sensible and cost effective way of executing a short term gold punt.
Finding gold futures dealers is easily done on any search engine using phrases like 'commodities broker', 'futures broker', 'commodities exchange', 'gold futures' etc. Commodities trading businesses are some of the most prolific advertisers on the web.
The following section of the report looks in greater detail at:
The stop loss
The hidden financing cost
Private investor psychology
Trading costs - % of what ?
Well hidden rollover & closure costs
Gold is bought as the ultimate defensive investment. Many gold buyers seek to defend themselves, and even make large profits, from a global economic shock which might be disastrous to many other people. Indeed many gold investors fear financial meltdown occurring as a result of the over-extended global credit base - a significant part of which is derivatives.
The paradox in investing in gold futures is that a future is itself a 'derivative' instrument constructed on about 98% pure credit. There are many speculators involved in the commodities market and any rapid and significant movement in the gold price is likely to be reflecting financial carnage somewhere else. Both the clearer and the exchange could find themselves unable to collect vital margin on open positions of all kinds of commodities, so a gold investor might make enormous book profits which could not be paid as busted participants defaulted in such numbers that individual clearers and even the exchange itself were unable to make good the losses.
This sounds like panic-mongering, but it is an important commercial consideration. It is inevitable that the commodity exchange which comes to dominate through good times and healthy markets will be the one which offers the most competitive margin [credit] terms to brokers. To be attractive the brokers must pass on this generosity to their customers - i.e. by extending generous trading multiples over deposited margin. So the level of credit extended in a futures market will tend to the maximum which has been safe in the recent past, and any exchange which set itself up more cautiously will have already withered and died.
The futures exchanges we see around us today are those whose appetite for risk has most accurately trodden the fine line between aggressive risk taking and occasional appropriate caution. There is no guarantee that the next management step will not be just a bit too brave.
In normal markets a falling price encourages buyers who pressure the price up, and a rising price encourages sellers who pressure the price down. This is relatively stable. But successful futures exchanges offer low margin percentages (of about 2% for gold) and to compensate for this apparent risk the exchange's member firms must reserve the right to close out any loss-making customers.
In other words a rapidly falling market can force selling, which further depresses the price, while a rapidly rising price forces buying which further raises the price, and either scenario has the potential to produce a runaway spiral. This is manageable for extremely long periods of time, but it is an inherent danger of the futures set-up.
Many futures broking firms offer investors a stop loss facility. It might come in a guaranteed form or on a 'best endeavours' basis without the guarantee. The idea is to attempt to limit the damage of a trading position which is going bad.
The theory of a stop loss seems reasonable, but in practice it can be painful. The problem is that just as trading in this way can prevent a big loss it can also make the investor susceptible to large numbers of smaller and unnecessary losses which can be even more damaging in the long term.
On a quiet day market professionals will start to move their prices just to create a little action. It works. The trader marks his price rapidly lower, for no good reason. If there are any stop losses out there this forces a broker to react to the moving price by closing off his investor's position under a stop loss agreement. In other words the trader's markdown can encourage a seller. The opportunist trader therefore picks up stop loss stock for a cheap price and immediately marks the price up to try and 'touch off' another stop loss on the buy side as well. If it works well he can simulate volatility on an otherwise dull day, and panic the stop losses out of the market on both sides, netting a tidy profit for himself.
It should be noted that the broker gets commission too, and what's more the broker benefits by being able to control his risk better if he can shut down customers' problem positions unilaterally. Brokers in general would prefer to stop loss than to be open on risk for a margin call for 24 hours.
Only the investor loses, and by the time he knows about his 'stopped loss' the market - as often as not - is back to the safe middle ground and his money is gone.
Without wishing to slur anyone in particular the stop-loss is even more dangerous in an integrated futures firm - where a broker can benefit himself and his in-house dealer by providing information about levels where stop-losses could be triggered. This is not to say anyone is doing it, but it would probably be the first time in history that such a conflict of interest did not attract a couple of unscrupulous individuals somewhere within the industry.
Investors can prevent being stopped out by resisting the temptation to have too big a position just because the futures market lets them. If the investment amount is lower and plenty of surplus margin cover is down, a stop loss is unnecessary and the broker's pressure to enter a stop loss order can be resisted. A conservative investment strategy with smaller positions achieves the goal of avoiding catastrophic losses by not keeping all eggs in one basket. It also avoids being steadily stripped by stop loss executions. On the flip side you cannot get rich quickly with a conservative investment strategy (but then the chances of that were pretty small anyway).
Before a salesman tells you that with a future you won't have to pay interest it is important to understand the implicit financing cost in a futures price.
A gold futures contract will almost always be priced at a different level to spot gold. The differential closely tracks the cost of financing the equivalent purchase in the spot market.
Because both gold and cash can be lent (and borrowed) the relationship between the futures and the spot price is a simple arithmetical one which can be understood as follows:
"My future purchase of gold for dollars delays me having to pay a known quantity of dollars for a known quantity of gold. I can therefore deposit my dollars until settlement time, but I cannot deposit the gold - which I haven't received yet. Since dollars in the period will earn me 1%, and gold will only earn the seller who's holding on to it for me 0.25%, I should expect to pay over the spot price by the difference 0.75%. If I didn't pay this extra the seller would just sell his gold for dollars now, and deposit the dollars himself, keeping an extra 0.75% overall. Clearly this 0.75% will fall out of the futures price day by day, and this represents the cost of financing my future purchase."
Many people - your editor included - have experienced the frustration of buying futures, seeing a small price rise in the underlying commodity, and still having a loss on their books when they are forced to sell the future as it approaches its expiry. This is the effect of the financing cost of a $100,000 purchase dripping away - day by day - and finally being subtracted from their original $5,000 down-payment - against which it appears substantial.
When a future is traded the broker will frequently compute dealing costs as a percentage of the principal. This is deceptive.
The principal has not actually been settled, so the costs of settlement - where the real expense lies - have not been borne. The expense in a future is the cost of taking out a notional promise, which one should expect to be pretty low. It is sneaky to quote a percentage on the basis of an irrelevantly large principal when the costs of settling that amount have yet to be added. Were it instead computed as the percentage of the margin - a more relevant figure - futures would look like substantially more expensive instruments to trade.
As a contract ends an investor who wants to keep the position open must re-open by 'rolling-over' into the next period. This 'roll-over' has a marked psychological effect on inexperienced investors.
Having taken the relatively difficult step of placing some of their savings in gold futures investors are required to make repeated decisions to spend money. There is no 'do nothing' option, like there is with a bullion investment, and rolling over always requires the investor to pay-up while giving him the option to cut and run.
The harsh fact of life is that if investors are being whip-lashed by the regular volatility which appears at the death of a futures contract many of them will cut their losses. Alternatively they might attempt to trade cleverly into the next period, or decide to take a breather from the action for a few days ('though days frequently turn into weeks and months). Unfortunately every quarter lots of investors will fail the psychological examination and end their position. Few return. The futures markets tend to expel people at the time of maximum personal disadvantage - as the section below clearly shows.
Each quarter a futures investor receives an inevitable call from the broker who offers to roll the customer into the new futures period for a special reduced rate. To those who do not know the short term money rates and the relevant gold lease rates - or how to convert them into the correct differential for the two contracts - the price is fairly arbitrary and not always very competitive.
It can be checked by referring to gold lease rates and interest rates. Suppose that gold can be borrowed for 0.003% per day (1.095% per annum) and cash for 0.01% per day (3.65% per annum). The fair value for the next quarter's future should be 90 days times the interest differential of 0.007%. So you would expect to see the next future at a premium of 0.63%.
But there are strange extra forces at work. They come from predictable facts about the distribution of gold futures positions :-
Suppose the old future is fairly priced at 100. The normal spread is - we'll say - 0.20%. So a typical roll-over - selling the old and buying the new - would trade from 99.9 (selling the old future at 100 less half the spread) to 100.73 (buying the new future with the 0.63% of financing cost + half the spread). There would also be commission on top, but that is not hidden.
That 0.63 of the differential represents the financing cost of the entire principal. So you are paying interest on it.
In addition the trader can improve his profitability, because of the different profiles of longs and shorts. What he does is anticipate the likely direction of a random customer who contacts him, and the nearer the end of the period the more the odds are stacked that whoever is on the phone will be selling a small quantity to close the old future. Of course these should be balanced by the occasional large purchase, but as we will see that can be got round.
The trader lowers both his trading price, and his liquidity. The quote becomes 99.825 - 100.025 sized in one lot, not ten. It seems to the casual eye that there is still a 0.2% spread, but is there? Look at the following table - constructed on the basis that there are ten small sellers and one large buyer. Because the trader has reduced his liquidity the buyer has to execute three trades (at different prices) to buy what he wants to close.
+1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 -1 old (bigger customer wants to do 10) +100.025 -4 old (adjusted price on larger purchase order) +100.1 -5 old (adjusted price again to complete larger purchase order) +100.125
Do the arithmetic and you'll see the trader has engineered to buy from sellers 10 lots at an average price of 99.825 and to sell to buyers 10 lots at an average price of 100.205. It might look like a trading spread of 0.2% when it's quoted but it's actually 0.38%. The trader's profit has increased by 90% because of his successful anticipation of the distribution of orders.
Perhaps you could rollover early to avoid the problem. If you try you'll find plenty of liquidity in the old future but hardly any in the new one. You'll fall victim to much the same mechanism on the other side.
Meanwhile the professionals are busy fixing to finance settlement - a luxury not available to the private investor. A big futures player can probably arrange a short term borrowing facility for 3%, whereas a private investor might pay 12%-15% which prices settlement out of the investors reach. The known imbalance allows a few large shorts to elect for settlement (i.e. not buying back to close) which cannot easily be duplicated longs. A shortage of buyers in the old futures contract develops at the death and it presses the price for small bulls lower.
How low? Clearly there is a floor - because bigger participants will come in to snap up cheap futures. But the price must fall low enough to enable them to profit from the arbitrage. It turns out the lowness of the price relates to the hassle cost of small deals. They have to be executed, matched, margined, reconciled and all of this takes people, systems, time and money. Because the professionals all have electronic processing facilities connected to each other the error rates on small private investor trades are the largest and many even require customer side paper as well as salesman time on the telephone, to say nothing of a raft of regulatory obligations which don't exist for trades between market professionals.
As a result the trade processing costs of small trades are actually bigger than professional trades of many times their value, so the profitability on transacting them is reduced. Support doesn't even appear until there is enough margin in the arbitrage to pay for the costs of many small and expensive-to-process trades.
All this is predictable by professionals - and it is self-justifying. It encourages still more professionals - those without any particular view on gold prices - to be short at the death, which amplifies the effects of both.
Succeeding in the futures market is not easy. To be successful you need strong nerves and sound judgement. Investors should recognise that they are at their best for market professionals and short term speculations. They are not often a good home for private reserves.
These are a relatively new innovation. They aim to combine the benefits of physical gold bullion with the liquidity and infrastructure of traditional securities market. Currently they are available in Australia, London and Canada, in slightly different forms.
To create a gold backed security a company is set up which has the right to issue a paper instrument which can only be issued in direct proportion to gold deposited in a vault. The securities are then traded on a normal stock exchange, or by a broadly equivalent market mechanism.
The price of those securities actually reflects only supply and demand for the shares themselves in the relevant market for the securities, but this will tend to shadow bullion because there is usually a right of redemption, allowing them to be surrendered in return for the gold which backs them. There will be a fee for redemption which is fixed, and relatively high to prevent lots of nuisance redemptions, but it allows market professionals to leave a bid on the exchange consistently near the value of the gold. In the absence of other bidders they will pick up securities which can eventually be redeemed profitably. This tends to hold the security price at or near bullion value.
Advantages of gold backed securities :-
- Gold backed securities are close to owning bars in a vault. The bars should be stored on a proper allocated basis, which means they are not lent or made subject to any form of derivative transaction.
- Being quoted on stockmarkets there is an accessible market for relatively small investments - certainly more accessible than true bullion.
- The dealing spreads are considerably lower than coins and small bars. Typically they are 0.5%.
- The custody problem is resolved. A professional vault is used to store the gold, and this is statistically much safer than any form of private storage.
Disadvantages of gold backed shares :-
- There is a degree of intermediation in the ownership of the gold. Although the shares confer a right on the gold it is neither owned by the investor nor in his possession. Technically the gold is owned by the trustees whose duty it is to defend the entitlement of the beneficiaries under the trust. The legal position is that even though it is properly allocated the entitlement to bullion still rests on the trustees' promise to pay, and on the custodians ability to do so. Of course trust arrangements cost money to set up and to keep running, and this manifests itself in a steady depletion of the amount of gold which underpins the investment. The gold backing is removed via a monthly management charge.
- Although the dealing spreads are smaller the brokers in a stock exchange tend to remunerate themselves with commissions - absent when you trade direct with a gold dealer. Commission levels vary widely from stock market to stock market, and from broker to broker. Sometimes they can be flat fees and suitably small, but these tend to be on internet dealing sites, where deals are done automatically at what is known as 'best price' but which is really best quote, which is often less attractive than on a parallel professional order board.
- Some stock exchanges impose extra charges on each transaction. In the UK, for example Stamp Duty applies - which levies an additional 0.5% on each purchase. Other levies may also apply.
- Some of the advantages of private investment in shares - like tax shelters - are not applicable to securities whose purpose is to act as asset stores.
Gold backed securities have a lot to recommend them. The security of gold is more solid than the margin based security which underpins futures. They do not incur the periodic volatility inherent in futures. The custody charges, although still quite high, are generally lower than other forms of custody available to medium sized investors and the transaction costs are no worse than with other stock market investments. These are innovations which appear to encourage private gold ownership, and with a good degree of security - but a little too much cost.
Gold pool accounts allow the customer to buy a gold liability from the account provider. Effectively the customer pays cash, and the supplier treats him as a creditor for bullion which may or may not have been actually bought. Pool accounts are synonymous with unallocated gold.
The advantages of gold accounts are :-
- They are easily accessible.
- They have relatively low dealing costs - there is usually no commission and the spreads are fairly tight - at about 1% and sometimes less.
The disadvantages of gold accounts are :-
- Unallocated gold grants very substantial unsecured credit to the account provider and places the bullion 'owner' at material credit risk. The owner is benefiting from a promise, and unlike the bank's promise to repay there is no assurance underlying the promise that the provider is competent to operate in much the same way as a bank. The problems with unallocated gold have been addressed at length elsewhere on the www.galmarley.com site.
In spite of the apparent attractions of unallocated gold [pool] accounts it is extremely hard for any serious investor to recommend them - because of the unquantifiable risks. The customer's investment rests as a liability on the provider's balance sheet and there is no obligation on the provider to buy the gold. If there were unscrupulous individuals in the gold industry (and nothing here would suggest that there are) their natural service would be offering gold pool accounts. That way they can take customers' money and put it to work for their own profit, without even paying interest.
A common misconception about unallocated pool accounts is that there is a physical pile of gold in a bank - or some such place - which 'belongs' to the customers even if it does not actually have their name on it. This is not true. The legal ownership of the gold in an unallocated account rests with the provider, even where there is such a pile which in quantity perfectly matches the liabilities to gold account owners. If there were to be a problem elsewhere in the provider's business - and it could have nothing to do with gold - a subsequent liquidation would render the pile of gold useless as security. This is because the law will require any liquidator to show no preference for any particular class of unsecured creditor - and this means any gold pile that exists MUST be sold so that all similarly low ranking creditors, gold and others, will suffer the same eventual return of a few cents on the dollar. This will seem like a foul piece of trickery to any future gold buyers who might suffer in this way, but of course it is perfectly fair. After all - why should a busted organisation treat gold owners preferentially over other creditors. It wouldn't be right.
Gold buyers whose objective is to put money away safely, and for the long term, against an unknown and in their opinion potentially dangerous economic situation should consider these types of risk very carefully and choose a provider with extreme caution.
So what did I choose and why?
WelI - for different reasons I was unhappy with the available methods - so I decided it was time to improve things! It took two years to plan and develop but now there is a new way which offers a unique combination of safety, accessibility, and price.
I hope this report has helped you understand more about the gold market. If you think so then maybe it's time to visit BullionVault.com. Of course on this one I am biased, and you will have to make up your own mind.
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