Way back in 2009, I remember fielding all manner of questions from people wanting to invest in gold, having seen it spike from its turn-of-the-millennium slump, and worried about the state of the wider financial economy.
A whole swathe of those were from people wanting to invest in exchange traded funds (ETFs). I always and without exception slammed the notion of a gold ETF as being outstandingly awful, and solely for investors who didn’t really understand the modern case for gold — those who believed that gold was a “commodity” with the potential to “do well” in the coming years. People who wanted to push dollars in, and get more dollars out some years later.
2009 was the year when gold ETFs really broke into the mass consciousness:
Yet by 2011 the market had collapsed: people were buying much, much larger quantities of physical bullion and coins, but the popularity of ETFs had greatly slumped.
This is even clearer when the ETF market is expressed as a percentage of the physical market. While in 2009 ETFs looked poised to overtake the market in physical bullion and coins, by 2011 they constituted merely a tenth of the physical market:
So what does this say about gold?
I think it is shouting and screaming one thing: the people are slowly and subtly waking up to gold’s true role.
Gold is not just a store of value; it is not just a unit of account; and it is not just a medium of exchange. It is all of those things, but so are dollars, yen and renminbei.
Physical precious metals (but especially gold) are the only liquid assets with negligible counter-party risk.
What is counter-party risk?
As I wrote in December:
Counter-party risk is the external risk investments face. The counter-party risk to fiat currency is that the counter-party — in this case the government — will fail to deliver a system where that fiat money will be acceptable as payment for goods and services. The counter-party risk to a bond or a derivative or a swap is that the counter-party will default on their obligations.
Gold — at least the physical form — has negligible counter-party risk. It’s been recognised as valuable for thousands of years.
Counter-party risk is a symptom of dependency. And the global financial system is a paradigm of interdependency: inter-connected leverage, soaring gross derivatives exposure, abstract securitisations.
When everyone in the system owes shedloads of money to everyone else the failure of one can often snowball into the failure of the many.
Or as Zhang Jianhua of the People’s Bank of China put it:
No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.
So the key difference between physical metal and an ETF product is that an ETF product has counter-party risk. Its custodian could pull a Corzine and run off with your assets. They could be swallowed up by another shadow banking or derivatives collapse. And some ETFs are not even holding any gold at all; they may just be taking your money and buying futures. Unless you read all of the small-print, and then have the ability to comprehensively audit the custodian, you just don’t know.
With gold in your vault or your basement you know what you’re getting. There are other risks, of course — the largest being robbery, alongside the small danger of being sold fake (tungsten-lined) bullion. But the hyper-fragility of the modern banking system, the debt overhang, and the speculative and arbitrage bubbles don’t threaten to wipe you out.
Paper was only ever as good as the person making the promise. But increasingly in this hyper-connected world, paper is only ever as good as the people who owe money to the person making the promise. As we saw in 2008, the innovations of shadow banking and the derivatives system intermesh the balance sheets of companies to a never-before-seen extent. This often means that one failure (like that of Lehman brothers) can trigger a cascade that threatens the entire system. If you’re lucky you’ll get a government bailout, or a payout from a bankruptcy court, but there’s no guarantee of that.
Physical gold sits undaunted, solid as a rock, retaining its purchasing power, immune to counter-party risk.
I think more and more investors — as well as central banks, particularly the People’s Bank of China — are comprehending that reality and demanding the real deal.