How Gold is Different

This is a Speakeasy post from January 18, 2017:

In a recent comment, I wrote:

"...it is one of the key differences between a Freegold understanding and the rest of the gold bug sphere. They all believe that the paper market is ultimately subservient to the physical side..."

I want to explain this in a little more detail.

Commodity markets work like this, hypothetically. You essentially have four parties. You have producers, consumers, middlemen, and speculators. The middlemen operate the physical side, buying from producers and selling to consumers, and they hedge their price risk on the paper side, buying and selling paper claims to and from the speculators who assume the risk.

With this basic setup, supply and demand are always equal on the physical side, because gradual price movements make it so. This is important in commodities. Producers, middlemen and consumers are not in it for the risk of price speculation. Producers and middlemen are in it to make a steady and predictable income, and consumers are in it because they need the commodity, to consume or for some other practical purpose. So speculators are like the shock absorbers that make the ride smooth for everyone else.

To explain what I mean when I say the paper market is (or is not) ultimately subservient to the physical side, let's take a quick look at the mechanics of a "short squeeze".

First, we have a middleman who fills his warehouse with goods purchased in bulk at a wholesale price from the producer, and his plan is to mark them up to a retail price and sell them one at a time to consumers. The difference between the wholesale and retail prices is called his spread, it's the middleman's income, and it's the reason he's doing this. His risk, however, is if the base price of those goods drops while they're filling his warehouse. If that happens, he could go out of business.

So to insure against this risk, the middleman sells paper claims to speculators at the same wholesale price at which he purchased the goods. This is called a hedge, and it transfers the price risk to the speculators. If the price falls, he still makes his expected spread, and if the price rises, he also makes his expected spread and the excess profit goes to the speculators. So by selling these paper claims, the middleman offloads price risk (and reward) to financial speculators.

The number of paper claims in the paper market will equal the amount of goods stored in the middleman's warehouse. If he expands his inventory, he'll also sell more paper, and if he runs down his inventory selling it off to consumers, he'll buy back the paper. He is hedging against the price dropping, so unless he becomes a gambler (like Hannes Tulving), he's always essentially betting on the price falling.

The speculators are the gamblers. They are placing bets on whether the price of the goods in the middleman's warehouse will go up or down. Because the middleman is essentially betting on the price falling, we'd expect to see most of the speculators taking the other side, betting on the price rising. But there are some speculators who will bet with the middleman on the price falling, and those are called the shorts, or the "spec" shorts, to distinguish them from the middlemen who are the "commercial" shorts.

Of course, if there is more money betting on the price falling than on it rising, the price will fall, and that's how the paper market drives the price in the short run. But how do spec shorts sell the same paper claims as the commercial shorts, you ask? Good question. Because they don't have a warehouse of real goods to back newly issued claims, they borrow illusory-goods-on-paper from a spec long and sell more paper claims against them. This creates the effect of extra (synthetic, i.e., not physical) supply, and thereby puts downward pressure on the price.

A short squeeze is when the price rises unexpectedly, catching the spec shorts by surprise. The middleman (commercial) shorts don't care, because they were just hedging actual inventory, so they were going to make the same spread no matter which way the price went. But the spec shorts were just betting, not hedging actual inventory, so they have to take a loss. Long positions have a limited downside and, potentially, an unlimited upside, but shorts have a limited upside and an unlimited downside, so they must cut their losses.

The way spec shorts cut their losses is the same way they book profits, by "covering" their shorts. This means buying back the very paper claims they borrowed and then sold, which can start a feedback loop of buying (rising demand-diminishing supply) which can drive the price up spectacularly. All of a sudden everyone's a buyer, even the shorts!

Supply and Demand

What I just explained was a supply and demand event on the paper side, but the physical side has its own supply and demand dynamics, so now I need to explain briefly how supply and demand works on either side. Very simply, supply and demand should probably be stated as three variables of equilibrium (or disequilibrium), instead of two.

Supply, demand and price are the three variables. If one of the three changes due to exogenous factors, some combination of the other two will change in response. Say demand increases, then either price will rise until demand subsides, or supply will ramp up until it meets demand, or some combination of the two. If price rises due to an exogenous factor, then either demand will decline in response, or supply will ramp up in response, or more likely both will happen simultaneously until supply and demand meet at the exogenously-caused price. (This is a very complex dynamic, so please don't take my reductive explanation too literally. Take it for what it's worth, which is to help you understand, in the context of this post, why gold is different.)

As I said, the short squeeze above was a supply and demand event on the paper side, but what made it an "event" at all was that it caught the shorts by surprise, forcing them to react. And it caught the shorts by surprise because the supply and demand dynamic on the physical side was different than on the paper side, and, except for gold which I'll get to in a moment, the paper market is ultimately subservient to the physical side.

In the short squeeze example above, there was more money betting on the price falling than on it rising, so the price fell, because as I said, the paper market drives the price in the short run. It works basically like this. As I said, the supply of paper provided by the middlemen will be fully backed. In other words, it'll match their physical inventory. So absent short sellers, paper supply would be the same as physical supply, and the long bettors (paper demand) would drive the price up or down and win or lose accordingly.

It would be a simple matter of paper demand trying to guess and match physical demand. In the short run, paper demand would drive the price and be self-fulfilling in terms of winning or losing. If it drove the price up, it would see profits. But if it was insufficient compared to supply at a given price, the price would fall and paper demand would take the loss.

In this hypothetical example with no spec short sellers, paper demand could only potentially levitate the price above where it would be in a physical-only market, it could not suppress it. If paper demand was consistently lower than physical demand, the paper market would cease to exist because the specs would all be perpetual losers. If, on the other hand, paper demand was consistently higher than physical demand, it would become a bubble and would eventually pop as all bubbles do, when the participants, all of whom would be potential winners, tried to lock in their profits by cashing out. The point being that, even in this hypothetical example with no speculative shorts, the paper market is still ultimately subservient to the physical side.

With speculative shorts, as we have in the real world, of course, we have a much more complex dynamic, with a variable supply differential between the paper and physical sides, as well as the potential for the paper side to also suppress the price, at least for the short run. This is because, as I already mentioned, speculative short selling creates a greater supply on the paper side than exists on the physical side, thereby putting downward pressure on the price.

So, with short selling creating this paper supply that surpasses physical supply, the price will have to fall unless paper demand also surpasses physical demand. So while we still have the possibility of levitation and a bubble as in the previous hypothetical, we now seem to have a bias toward the opposite, price suppression. If your head feels like it's spinning, bear with me, because this is where it starts getting interesting.

This apparent bias toward price suppression is simple to see. On the supply side, we have this structural short which is the middlemen, aka the "commercial short", which must be at least matched by a speculative (paper) demand in order for a paper market to even exist. But only a minimal short interest, even a single speculative short, creates this paper supply that surpasses physical supply. I say "apparent" bias, because there are some other factors to consider in the long run.

For one thing, as I mentioned earlier, in order to lock in their profits, the shorts must eventually become buyers. They must buy back, at a lower price, what they sold at a higher price, in order to book a profit, which, if they all did it at the same time, could raise demand enough to eliminate their profit, and in the worst case, if there are too many shorts, could cause massive losses by running up a spectacular spike in price known as the short squeeze.

One of the most dramatic short squeezes in recent history happened in 2008, on the German stock exchange. Basically, Porsche wanted to take over Volkswagen by acquiring 75% of its shares, a key amount. At the beginning of 2008, Porsche owned 31% of Volkswagen, and the German state of Lower Saxony owned 20%. From March through October, Porsche secretly acquired another 43%, and on Oct. 26, 2008, announced that it owned a total of 74%, and intended to make it 75% and take over the company.


The problem was, Volkswagen had a short interest of 13%. In other words, 13% of the shares were out on loan to short sellers, and the simple math caused a short squeeze which spiked its price from $200 to over $1,000 in two days, making Volkswagen the most valuable company in the world, if only for a day.

Neither Porsche nor Lower Saxony was about to sell any of its shares, for fear of losing control of its stake, and the math was clear. 74%+20%+13%(short interest)=107%, and on top of that, the 6% not held by either Porsche or Lower Saxony was in index funds, which could not legally sell. This was right at the height of the global financial crisis, and a lot of big money was shorting the markets. Volkswagen itself had plunged 50% in October alone. But, again, to lock in a profit, the shorts had to buy back their borrowed shares, and with Porsche's announcement, it was clear that there were no more shares for sale, and so it was off to the races.


The shorts lost "tens of billions" that day. One of them was a German billionaire named Adolf Merckle. According to Forbes, he was worth $12.8B in 2007, but on January 5, 2009, he committed suicide by train. Those who knew him said it wasn't because of the short squeeze, since he only lost about half a billion on Volkswagen, and would have still been worth some $6B, but it probably played at least a part in his decision to jump in front of a train.

Of course Volkswagen is not a commodity, but the point is that the "paper market" with its fake supply of borrowed shares was ultimately subservient to the "physical side" of actual shares. And of course the price spike didn't last long, as short squeezes tend not to. In the end, Porsche made 5% of the stock available to desperate short sellers, but for them, the damage was already done.

One could say that Porsche caused the short squeeze, whether intentionally or not. In fact, you can probably imagine a bunch of activist longs in one commodity or another trying to cause a short squeeze (and, say, crash JP Morgan, for example), either by buying physical or buying paper and taking delivery, even while the price is dropping, simply to diminish the supply in hopes that the price will go up turbo charged the next time it goes up. In the case of Volkswagen, Porsche enormously diminished the supply of shares without the market being fully aware of what they were doing, and once their actual off-take became known, the price went up turbo charged.

A massive short squeeze is what most of the gold bug sphere expects in the end, because they believe the price of gold is suppressed by the synthetic (paper) supply created by the shorts. In fact, they are so close to the truth, it's really a shame they can't see it. And because they can't see it, they imagine the price of gold as it is today—the paper price—is what will go up turbo charged (and stay up). And if that's what you believe, then it is perfectly reasonable to buy silver, mining shares, paper gold and so on, to gain a little extra leverage on the move.

The problem is, they understand everything in this post above this line, but they don't understand how gold is different. They are correct that the price of gold is suppressed by synthetic supply. They are also correct that the tightening of physical reserves will ultimately result in a dramatic jump in the price of gold, and that (unlike other commodity price spikes) it will stay up. What they are wrong about is that it won't be the price of gold as it is today—the paper price—that will go up in a turbo charged bull market run, and that the rest of those things that are leveraged to the price of gold as it is today won't go along for the ride.

They are so close, yet so far away. There are even some who will, on the surface, acknowledge the physical-gold-only line, but who don't understand why, and so they personally have a large percentage of their holdings in things like silver, GLD and mining shares. Believe me. I know a few.

So now I'm going to once and for all (hopefully) explain how gold is different.

As I explained above, in our hypothetical commodity market, we have this "structural" short position put out by the middlemen, which is at least equaled by a contingent of speculative longs in order for a paper market to even exist. Then comes the spec shorts who must borrow on paper in order to place their bets, which expands the effective paper supply.

Now, the ratio of spec shorts to paper claims outstanding (what I'm calling "structural" shorts) is known as the "short interest". In the real world, if the short interest is too high, the price is thought to be too low. So, contrary to the apparent bias I mentioned above, a short squeeze price spike is expected to be more likely when the short interest is higher than when it is lower. So how high is high?

Well, in the case of Volkswagen, the short interest was 13%. I'm no expert, but from what I've found in my research, 13% is verging on high. Investopedia implies that around 3% is normal, 25% is high, and a 40% short interest makes a company very vulnerable. I found this site called shortsqueeze.com where you can check a stock's short interest. Here is GLD's:

http://shortsqueeze.com/?symbol=GLD


It says the short interest in GLD is 8,853,600 shares. Total shares of GLD right now are 270.7 million, so the short interest is about 3.3%. Pretty normal.

Another metric is the "short interest ratio", which is the short interest as a percentage of the average daily trading volume. This is important because, during a short squeeze, the shorts are all trying to cover (buy) at once, so the short interest ratio is often stated as "days to cover". In GLD, the average daily trading volume is 6,362,100 shares, and the short interest is 8,853,600 shares, so the "days to cover" is 1.4 (8,853,600/6,362,100=1.4). (BTW, I'm only using GLD as a convenient (and perhaps ironic) example of anything and everything except gold. I could have used SLV which has a "days to cover" of 1.6, or even Google (1.9) or Facebook (1.3). Try it yourself!)

My point here is to give you an idea of the range of normal to very high in short interest for everything except gold. Under 5% is normal, and 40% is very high, and in days to cover, somewhere between 1 and 2 appears to be pretty normal. So what if I told you that the effective equivalent of short interest in gold is probably somewhere between 200% and 20,000%, depending on how you choose to figure it, and that gold's equivalent of "days to cover" is effectively infinite, or at least it would be better stated as "decades to cover"?

While I'm at it, I should also mention that back when gold was base money, all credit and all other forms of currency, like paper money, were the effective equivalent of short interest in gold, and so it was much higher than it is today. In fact, whatever it is today (one can only guess) is probably an historic low, when taking all of history into account.

I make these fantastic statements and give you incredible numbers not to establish some technical comparison between gold and everything else, but to make the point that there is no technical comparison between gold and anything else. It makes no difference if the short interest in gold is 100% or 100,000%, because it is so far past the tipping point for anything else that it is irrelevant. There is no technical comparison between gold and anything else, including silver, even including fiat currencies. Gold is quite literally unique, and quite simply different.

If you can set aside the notion of trying to make technical comparisons, even if only temporarily while reading this post, then I can start to explain how gold is different.

Put yourself back in time, back when gold was base money, circulating coin, and monetary reserves. Now picture the banks as the gold middlemen, and the bank vaults as their warehouses of gold. Money was gold. That's not to say all money was pieces of gold, but money, which is mostly credit, was denominated in weights of gold. So it is fair to say that, while all gold was money, not all money was gold, and gold was only a small subset of money.

I know that gold bugs like to say "gold is the real money, and all else is credit," roughly paraphrasing JP Morgan once upon a time. But FOA proved, beyond a shadow of a doubt in my mind, that money of the mind, an association of values held in our heads, and therefore credit, was the pure concept of money as it grew out of antiquity, and that gold was something different. Gold was tradable wealth, while money was just a useful concept, and trying to combine the two turned out not to be the best use of gold. Please see Moneyness and Moneyness 2: Money is Credit for more on this subject.

I'm sure that most of you are familiar with the parable of the Goldsmith, but here it is again:



I called it a parable because it's not totally true. While it does a good job illustrating the concepts of credit money and fractional reserve banking for the purpose of this post, it is way too simplistic in the way it characterizes them as a duplicitous scheme. The pure concept of money has always been, basically, credit. Gold, the most tradable wealth item, ended up as the reserve in fractional reserve banking, which, as I said, was not the best use of gold. But I'll get more into that concept in a future post. For now, I just want you to picture the banker as the middleman, the bank vault as his warehouse, and all forms of money and credit as the short interest on gold.

Over centuries, banks became quite adept at the business of gold, and London emerged as the global center of that business. Then, in 1971, the last vestige of a gold standard monetary system ended, but not the business of gold, nor the banks in London that ran it. Those same banks continued on as the gold middlemen of the world, the same vaults as the warehouses, and over the next twenty to thirty years, they evolved into the gold market as we know it today.

What was once just known as banking, when money was denominated in a weight of gold, became known as bullion banking. As I have written in many posts, modern bullion banking is simply a carryover from regular London commercial banking during the gold standard. And to understand bullion banking, and to thereby understand the modern gold market in which the price of "gold" is derived, you must understand regular commercial banking, because they work basically the same.

Ari was the one who helped me understand how bullion banking is simply banking, but using bullion as its base/denomination instead of dollars. The following is an email exchange we had on the subject back in January of 2011. I hope it helps drive this home for you the way it did for me, because this simple concept really is the key to understanding how gold is different from everything else. I have posted pieces of this before, but I think this is the first time I've ever shared the whole thing with anyone:

Me: > > I must admit I am struggling a bit with how I want to
> > present the Bullion Banks in my piece. Seems to me that
> > understanding that gold is still treated as a fractionally
> > reserved currency by a portion of the banking industry is
> > key to understanding the "free" in "Freegold."

Ari: Yes, it has long been my impression, too, that the key to helping people understand/embrace the freegold paradigm is to help them see how gold is fractionalized in the old variations of conventional gold standard banking and in the modern extension of the same old same old (and which we now refer to almost quaintly/unnecessarily as "bullion banking" as if it were as uniquely apart from commercial banking as is a "blood bank" or "sperm bank". To be sure, we haven't taken similar pains to differentiate dollar banking from yen banking, so to suggest a distinction for bullion banking is almost a disservice to the truth -- frankly, that it's all just variation on the same banking principles and practices.)

Me: > > Paper markets, schmaper markets, it's all about gold
> > being a fractional reserve in banks. It's much less important
> > that the investing public believes gold is a commodity. Those
> > that really matter know it's not. And the paper markets and
> > the public misunderstanding of gold simply help the banks
> > manage their fractional reserves to keep everyone happy.
> > Would you agree with this?

Ari: Yes! In fact, I wrote my above paragraph prior to reading onward.

Me: > > This is what gold will be freed from: the fractional
> > reserve banking practice, which is a carryover from the gold
> > standard years.

Ari: Yes yes yes! (But delivered not quite with Meg Ryan's degree of zeal in the cafe scene with Billy Crystal -- "When Harry Met Sally".)

Now I'll move on to your older e-mail...

Before addressing the specifics of your questions, a little background may prove helpful -- at a minimum it will ensure that we are continuing our discourse in the dear context of a shared frame of reference. It is here that I offer the eurodollar market as a very good parallel to the bullion sector of banking. While not a perfect parallel (for all the most obvious reasons) it provides a remarkably good bridge to help anyone who has a good footing on modern commercial banking to successfully cross over to that seemingly unfamiliar territory of "bullion banking". In fact, they need do little more to successfully cross over than to simply think of bullion banking ops as though they were eurodollar banking ops -- the difference being that whereas eurodollar banking makes extra-sovereign use of the U.S. dollar as its accounting basis in international banking activities (thus outflanking New York's purview and restrictions), bullion banking engages in similar "extra-sovereign" use of gold ounces within its operational/accounting basis (thus outflanking and overrunning Mother Earth's domain and tangible restrictions).

And just to be sure we're on the same page, the eurodollar is not to be in any way confused with the euro, but rather stands to mean the artificial supply of "U.S. dollars" that "exist" as accounting units in off-shore banks, having originally been authentic deposits of New York's finest export, but which were then subsequently lent on -- fractionalized and derivatized into a vast amorphous mass as only a network of cooperating banks can do best.

Me: > > Let's say a bullion bank that is not the administrator of a
> > gold ETF has 10 million ounces of unallocated gold. I was
> > trying to think of what would be the incentive that bank has
> > to participate in the Trust. And what I came up with was that
> > the bank allocates this gold to the ETF Trust in exchange for
> > shares that it sells into the market for dollars which it then
> > uses to churn an ROI (since its former gold lending operations
> > are now dead thanks to rising gold price and the end of CB
> > backing for fractional reserve gold lending thanks to the
> > CBGA). Is this correct?

Ari: Exactly right. As mutually reinforcing factors of rising prices and termination of mine company hedging and waning carry trade activities in the wake of the 1999 CBGA left bullion banks with their full store of unallocated gold deposits but a shrinking base of usual customers for their gold lending services, the ETF mechanism provided the ideal means to relatively safely put these deposits back into play -- delivering them into allocated account with the ETF in exchange for shares that can be lent or sold in any combination for cash that can subsequently chase other pet schemes.

Me: > > And then, as the BB gets redemption notices from its gold
> > depositors (or allocation requests as the case may be) it must
> > then buy back those ETF shares from the marketplace before
> > withdrawing gold from the trust. Is this correct?

Ari: That's right, except for the term "must". Upon getting requests from its own assortment of unallocated depositors for either outright withdrawal or more simply for transfer into allocated accounts, the BB has options. Yes, it can seek to acquire (through borrowing or purchase) the requisite ETF shares for redemption of a standard basket in its special capacity as an Authorized Participant of the Fund, or it can pursue alternate avenues such as buying gold on the open market or better still, borrowing it from either its own unallocated pool of deposits (if still available in adequate in size) or turning to other members in the fraternity to borrow the adequate quantity to cover the immediate needs. Whatever combo is deemed most efficient or cost-effective is what the bank will do.

Me: > > Back to that 10 million ounces of unallocated gold; Do
> > you think the bank has gold liabilities in great excess of this
> > gold, to depositors that actually deposited physical? I'm not
> > talking about "claimants" that may have bought paper claims
> > from the bank for gold, but actual depositors of physical. In
> > other words, I'm wondering how deep these BBs are into this
> > game. It's one thing if you bought paper gold only to find out
> > later that paper gold wasn't the same thing as physical. But
> > it's something entirely different if you put your family's
> > precious nest egg in the bank only to find out it was sold to
> > someone else by the bank.

Ari: A bank can be "populated" with unallocated gold accounts in two primary ways. It can either be done as a physical deposit by a silly person or by another corporate entity, or else it can occur completely in the non-physical realm as a cashflow event whereby a customer with a surplus account of forex calls up and requests to exchange some or all of it for gold, whereupon the bank acts as a broker/dealer to cover the deal -- occurring and residing on the books as an accounting event among counterparties rather than as any sort of physical purchase. No bread, no breadcrumbs, only a paper trail and metal of the mind. This is how the LBMA can report its mere subset of clearing volumes averaging in the neighborhood of 20 million ounces PER DAY. Just a whole lot of "unallocated gold" digital activity as an ongoing counterparty-squaring exercise. [Me: It needs to be noted here that Ari's comment was on 1/19/11, so it was during 2011Q1, the subject period of the LBMA survey which wasn't released until seven months later. As it turned out, the average clearing volume for Q1 was actually 18.8 million ounces per day, so Ari's "in the neighborhood of 20 million ounces PER DAY" was correct, but what the survey revealed which had never been published before was the turnover volume that 18.8 million ounces cleared. And that turnover for 2011Q1 was actually 173.7 million ounces PER DAY.]

Me: > > I could see the system defaulting on paper sales but at
> > least trying to make good on physical deposits. But am I
> > being too optimistic here?

Ari: Does the person who established his unallocated account with a physical gold payment rank any higher in the pecking order than the earlier or later fellow who established his similarly sized unallocated position at the same bank with a cash payment? And in this light now you see your original optimism fly out the window. Whereas an Allocated account sets you more securely above the fray, an UNallocated account puts you in the same large sea of unsecured creditors bobbing in the wake of any Titanic failure.

It was also Ari who helped me come up with a way to explain commercial banking through a simple balance sheet exercise, which I used in Peak Exorbitant Privilege. Remember, in order to understand how gold is different, you need to understand today's gold market, and to understand today's gold market (which is ~90% LBMA), you need to understand bullion banking, and to understand bullion banking, you need to understand basic balance sheet commercial banking. Here's a short excerpt from that post, just to refresh your memory:

"Now let's say that one of our depositors at COMMBANK5 withdrew his deposit in cash. And let's also say that another depositor at the same bank spent his money and his deposit was therefore transferred to COMMBANK4 and that transaction cleared. Here's what it would look like:

COMMBANK1
AAACC|DDDDD

COMMBANK2
AAACC|DDDDD

COMMBANK3
AAACC|DDDDD

COMMBANK4
AAACCC|DDDDDD

COMMBANK5
AAA|DDD
________________________________________
CB
AAAAAAAAAR|CCCCCCCCCC

A few quick observations. There are now only 9 Cs in the commercial banking system even though there are still 10 Cs outstanding on the CB's balance sheet. That's because one of them is now outside of the banking system as cash in the wallet.

Also, notice that… COMMBANK5 is now out of reserves.

In this little scenario, COMMBANK4 is now extra-capable of expanding its balance sheet, while COMMBANK5 needs to forget about expanding and try to find some reserves. To obtain reserves, COMMBANK5 can call in a loan, sell an asset for cash, borrow cash temporarily while posting an asset as collateral, or simply hope that some deposits come his way very soon. But in any case, COMMBANK5's next action is, to some extent, influenced by its lack of reserve."

As we translate this exercise into bullion banking, there are a few differences we need to note. I think the most significant and obvious one is that, in bullion banking, there is no lender of last resort, no central bank that can print new cash reserves on demand. Another difference is that, while COMMBANK5 with only assets and no cash reserves in the example above is an outlier, only THREE (3!) out of the LBMA's dozens and dozens of bullion banks, 13 of which are the LBMA's main market makers, only 3 are LBMA physical gold custodians. And in the LBMA, physical gold is the equivalent of the cash (C) reserves in the example above.

So if I were to do a similar exercise for, say, the 13 LBMA market makers, 10 of them would have only A's on the asset side. Their "reserves" would actually be liabilities of the three custodians. Those "reserves" could, of course, be allocated or unallocated, but for clearing purposes, it makes sense that most if not all of them are unallocated (which of course implies that even the LBMA's "reserves" are fractionally reserved!). Also, I would change the C's (standing for "cash" reserves) to G's (standing for physical "gold"), and I would change the D's (standing for "deposits") to L's (standing for "liabilities"). The number of L's in excess of the number of G's would be the effective equivalent of short interest in gold. It might look something like this:




In the above example, the effective short interest is 1330% (ratio of synthetic to real supply of 133:10), which is completely meaningless. It's not even a guess; it's only an example of how it works. But let me give you some real numbers with real meaning. Today the LBMA has 81 "Full Members". Back in 2011, it had 56 "Full Members", of which 36 responded to the LBMA Gold Turnover Survey for Q1 2011. What those 36 LBMA members (65% of the membership) reported was a daily turnover of $240.8B.


That number is useful in a couple of ways. It is useful in comparison to the clearing volume during the same period, because we have average daily clearing volumes for each month going back to October of 1996, and it is useful in comparing to other markets, because the survey methodology is basically the same. Here I'm going to cut to the chase, because $240.8B compares to only one market in the world, which happens to also be the largest market by volume in the world, and that is the FOREX or foreign exchange currency market.

For comparison to other markets, here are some of the most active stocks by volume right now, like Apple, Facebook and Microsoft:


If you add up the daily volume and prices of all of those top five stocks and multiply them, it totals to only 15% ($37B) of the daily volume in gold as reported by 36 LBMA members. For further comparison, the average daily trading volume in GLD shares is less than $1B, for COMEX, the average is around $21B per day, and on the Shanghai Gold Exchange (SGE) it's $4.2B per day (calculated from the SGE's own Daily Volume Report for 1/16/17, adding up all AU categories, and converting yuan to dollars). That puts SGE daily volume at about 1.7% of the LBMA by comparison (note that the LBMA's daily clearing volume is roughly the same right now as it was in Q1 2011, both by weight and value, so it's fair to also assume similar daily turnover). In fact, if we add up the daily volumes in gold from these four markets, which are indeed the four largest gold markets (SGE, COMEX, GLD and LBMA, I'll even throw in another $4B for TOCOM and MCX combined), it comes to about $271B per day, which makes the LBMA roughly 89% of the gold market, and remember, only 65% of the LBMA membership participated in that survey. So that's where I got my ~90% number above.


Gold as a FOREX Currency

As I already stated above, there's only one market that compares to the turnover volume reported by the LBMA, and therefore only one plausible explanation for those numbers. And that explanation was clear even back in 1997 when the LBMA first began releasing its clearing statistics. These are from The Red Baron series in 1997:


And that was based on only the clearing volumes the LBMA had just begun reporting in January of 1997. Comparing the turnover reported in 2011 to mine supply in 2011, instead of 100 times, you'd have to say more than 500 times the annual world's gold production rate is traded annually at the LBMA. Or if you included scrap recycling in the production numbers you'd say more than 300 times, just FYI.


Again, that was 1997, and they were only looking at the LBMA's average daily clearing numbers, which as we now know are only about 10.8% of the total loco London daily turnover. So you can multiply them by 9.25 to get a rough idea of turnover, and you can find all the average daily clearing numbers from 1996-2016 here.

Oh, and the FOREX market which was a $1.2T market in 1997, today is a $5.1 trillion per day market according to the BIS's Triennial Central Bank Survey of foreign exchange and OTC derivatives markets in 2016. This would make the LBMA's $240.8B per day equal to roughly 5% of the market, smaller than the volume of trading in the euro, pound or yen, about equal to the Aussie dollar, but more than the volume of the Canadian dollar, the Chinese yuan, and the Swiss franc.


Back in October of 2013, another gold writer was emailing with me, and in one of his emails he asked me to explain this concept. He wrote, "The area where I’m still hazy is the gold as a FOREX currency," and my reply turned into my post titled, Gold as a FOREX Currency. Following that post, he decided to email the LBMA and ask them straight out if the 2011 survey included gold trading as a FOREX currency. He wrote, "I emailed LBMA this morning asking for some more info on what actually constitutes the large spot trading volume (as it couldn’t possibly be physical) so I’ll let you know whether they come back with anything useful." Here was his actual email to the LBMA:

Sent: Friday, 18 October 2013
To: mail@lbma.org.uk
Subject: Some information please

Hi there,
I am conducting some research into the gold market.

I am trying to gain a little more understanding about LMBA turnover.

According to your 2011 survey, average daily trading volume in the London market in this period was 5,400 tonnes, equivalent to US$240.8 billion at the time.

Given that most of this is ‘spot’ gold trading (and its understated given the lack of full responses from members) and it’s clearly not that much physical changing hands/ownership (more than annual scrap and mine supply trading per day would be impossible, despite the large outstanding stock of gold) can you provide some information as to what accounts for this huge level of trade?

The only thing I can come up with is that it’s related to currency trading. As you probably know, you can trade gold on a computer screen in the same way you can trade global currencies. Its currency code is XAU. I’d imagine XAU/USD long or short is a pretty popular pair trade. Is it this ‘gold as a FX currency' trade that accounts for the huge amount of daily spot volume?

Would gold as FX trade be reported to you as part of the survey?

Any info you could provide to clear this up would be much appreciated.

Cheers,

It took more than five months of pestering the LBMA to get an answer. The email was passed around the office, and ended up with LBMA Public Relations Officer, Aelred Connelly, who wrote in January that he'd have to do some research in order to answer the question:

From: Aelred Connelly
Sent: Thursday, 30 January 2014 1:32 AM
To: XXXX
Cc: LBMA Mail
Subject: RE: Some information please

Dear Mr. XXXX,

I refer to your questions below which have been passed to me. First of all, I would like to take the opportunity to apologise for the delay in our response.

This was a one-off survey which was conducted before I joined the LBMA with 36 of the 56 full members involved in gold trading. As I was not directly involved in the survey I will need to some research to find answers to your questions. I will come back to you as soon as I can with a response.

Kind regards,
Aelred

A bit more pestering, and he finally came back with an answer in March:

From: Aelred Connelly
Sent: Monday, 24 March 2014
To: XXXX
Cc: LBMA Mail
Subject: RE: Some information please

Hi XXXX

Apologies for the delay, but I thought that my colleague had already responded to your questions. The Survey included all forms of gold trading so certainly included gold currency trading which would have contributed to the significant numbers that came out of the Survey. We are in the process of discussing with market participants running more regular surveys. I will keep you posted on developments. I am not sure if you have seen the article that accompanied the results of the 2011 Survey, see below. Once again apologies for the delay in responding to your questions.

http://www.lbma.org.uk/assets/Loco_London_Liq...ty_Surveyrv.pdf

Kind regards,
Aelred

Of course, I didn't personally need official confirmation for something that was so obvious, but it is interesting nonetheless. This does, however, raise a puzzling question. What was not so obvious was what assets the bullion banks could possibly be using to balance their books against a trading volume that was clearly much larger than the physical side of the gold market.


Not surprisingly, the answer came to me from FOREX Trader, who, just in case you were wondering, actually is a large scale professional FOREX trader. He explained that they are synthetic gold assets, complex derivatives based on other commodities and currencies that tend to have a price correlation with gold, probably in combination with OTC gold options as well. The price correlations are never exact, but over long periods of time they can be relatively stable and predictable, so using complex math, derivatives with a delta of 1, meaning a 1 to 1 price correlation with gold, can be created. Or they can get close to 1.00 and make up the difference with OTC gold options.

He target="_blank" wrote:

"Hi FOFOA,

Re correlated assets:

All the big IBs [Investment Banks] have delta-1 desks. Do you remember the UBS trader that blew up and was big in the news last year? He worked the UBS delta-1 desk.

What is delta-1 trading? It's exactly what's described:

"The only answer I can think of is that they hedge it by going long correlated (but not identical) assets. What's correlated with paper gold? Silver, copper, euros, crude oil, interest rates, yield curve spreads, whatever."

The job of the trader is to use quantitative methods to build a synthetic instrument with a delta as close as possible to the desired underlying.

I made a quick delta-0.7 using some regression and eyeballing, with AUDUSD+(0.5*CADUSD)+(0.2*10YNotePrice) providing a good starting 'kernel'. Good enough that you could make up the other 0.3 deltas dynamically in the OTC/FOREX gold options market. Obviously any quants who want can build their own synthetic too. If they have access to OTC markets, it will be very very simple. Obviously the goal would be to 'long' this synthetic, to hedge the underlying short, to reduce deltas to 0 or near 0…

If you are long/short the underlying and don't want the directional risk you can hedge your deltas relatively cheaply by trading around your position using options. If you are a big player in the market, you can actually make money doing this, using the options to get better prices for your underlying position that the market wouldn't be able to otherwise cope with."

I need to include a disclaimer here that we don't know for a fact that this is precisely what all of the bullion banks are doing all of the time to balance their books. But it is the best explanation I have encountered, and it opens up a world of possibilities and combinations of possibilities outside the physical gold market, which is necessary to plausibly explain such overwhelmingly large volumes.


What I can tell you, is that this topic was under debate for a year and a half, from June of 2012 when I first posted FOREX Trader's email above, until November of 2013 when Bron and I agreed to disagree on the subject. Most of what was considered debatable is now considered settled. For example, some argued that "delta-one" was as narrow a field as some of the news articles made it seem.

For example, Bron argued that "Delta One desks are no more than speculative trading, gambling," based on a target="_blank" Reuters article about rogue trading at the UBS Delta One desk. And Texan argued that "Delta one is equity derivatives, primarily equity repo. They do not touch commodities," based on the target="_blank" Delta One Wikipedia page.

As it turns out, however, "delta-one" is not as narrow a field as that. As Izabella Kaminska wrote target="_blank" here (linked through web archive because otherwise a subscription is required):

"Ask someone from outside the industry to define Delta one, and you’ll struggle to get a cohesive answer. Ask the industry to define it, meanwhile, and you’ll get a multiple of different explanations. And that’s because Delta one means different things to different people. Every financial institution seems deeply involved — all the usual big-name suspects, and many smaller names you might not have heard of too."

And as to whether Delta One is only equities, target="_blank" here's the answer to that:

"Delta One desks at banks can cover a range of asset classes – everything from currencies to equities and commodities."

And, of course, in 2014, the LBMA itself confirmed that the 2011 survey "certainly included gold currency trading which would have contributed to the significant numbers that came out of the Survey," putting to bed once and for all any notion that the volume could be explained by the physical gold wholesale market. As if that wasn't obvious from the moment the survey was released. Yet some gold analysts today still apparently think that way.

Of course none of these large trading volume numbers, in the range of $271B per day for "gold", include your and my small shrimp purchases and sales, nor do they even attempt to aggregate them. And neither do they count the millions of small trades made by small FOREX traders every day around the world. We can tell by the number and size of the (quote-unquote) "trades" that were counted.

In the case of the LBMA survey, the $240.8B per day in turnover came from 6,125 individual trades per day. So we can simply divide $240.8B by 6,125, and we see that the average trade reported was $39 million. That's $39 million per trade, and an average of 170 of these $39M-trades reported by each of the 36 reporting LBMA members, every day.

So these trades were likely the net result of many smaller trades, by clients of clients of clients of the banks. I don't know this, but I think it makes sense. Who, other than the LBMA, could make 6,125 different trades each day, each one averaging $39M? And this is "gold" (in quotes) they're trading. So the average trade was the equivalent of 28,361 ounces, or 9/10ths of a tonne. 6,125 of those trades each day, representing (6,125x28361=) 173.7 million ounces, or 5,400 tonnes… per day. I really don't think I can overstate this. As big as that number is, I think it makes sense that it's actually net of a much larger number. It's called tiered settlement, or settlement hierarchy, if you want to look it up. But that's beside the point here, because like I said above, even with just the numbers we have, we are so far beyond comparison to other markets that, whether the volume was halved or two orders of magnitude larger is irrelevant.

Now that I've hopefully established in your minds the sheer magnitude of the paper side of the gold market, I want you to understand that this is the effective equivalent of short interest in physical gold:


This is what I was talking about in target="_blank" my comment to Aaron the other day:

"As FOFOA once said, GLD is just a huge short position on physical gold."

Hello Aaron,

Actually, that's not what I said, and I never would say that. What I said is that bullion banking, the LBMA's massive (5,400 "tonne" per day/$240 billion per day turnover, according to its own 2011 survey) system of spot unallocated credit gold, is essentially a huge short position on physical gold. The word physical there is important, because it's not an unhedged position. The banks' position is flat, or neutral, but it has a lot more --- A LOT MORE --- gold-ounce-denominated liabilities than it has in physical reserves as assets. The balance of (non-physical) assets are paper assets, complex derivatives mathematically based on price correlations with other commodities and currencies, notes, someone else's gold-ounce-denominated liability, maybe a mine, a mint, a refinery, a hedge fund, or even another bank, etc…

I want you to notice, too, that this is a "structural short" as I called it above, because it is put out by the middlemen, whose price exposure is flat, or neutral, so they don't really care which way the price moves. The difference, of course, from the middlemen in other markets as I explained above, is that the "structural short" of the bullion bank middlemen is not fully backed by goods in the warehouse. It is backed by synthetic supply, just like your balance at your local bank is not backed by physical dollars in its vault. Only, your neighborhood bank has a central bank that can print more "goods" if necessary, but no one can print physical gold.

Yes, there are, of course, speculative shorts in the gold market too. These are the ones we hear most gold bugs whining about. But the volume of spec shorts pales in comparison to the volume of the LBMA bullion banks, which I'm calling the effective equivalent of short interest in physical gold.

Another thing is that the spec shorts, like the gold shorting hedge funds, and even some of the non-bank commercial shorts, like the hedging miners, mostly disappeared from 2002-2011, during the run-up from $256 to $1,896. It doesn't make much sense to be short gold when the price is obviously rising, but the bullion banks' "short position" never went away. Notice that? It's because, like I said, they're flat, neutral, so they don't care which way the price goes, and, in fact, they can control the price to some extent by actively expanding or contracting their balance sheets.

These banks are the market makers. They are quoting bid and offer prices to sellers and buyers, and if they wanted to exert some control over the price, all they'd have to do was expand or contract their gold-ounce-denominated balance sheet. If the price was rising faster than they wanted, they could simply issue more paper gold, increasing the effective supply, while balancing their books with derivatives. They could theoretically make the price decline in the same way. Remember when Another said this?

"Someone once said, "noone wants gold, that's why the US$ price keeps falling". Many thinking ones laugh at such foolish chatter. They know that the price of gold is dropping precisely because "too many people are buying it"!"

And:

"Some say, "gold fall because noone was buying it". I say, "gold fall because many were buying it"! They buy as the "trading market" was made "much fat" with added paper! Understand this: The US$ price of gold could only fall if a market existed for paper gold priced lower each time of offer! If the price did not fall, this paper market "could not function" as "it would not be profitable to the writer"! It was, for many years, in the good interest of all, for the dollar to find a gold price close to production cost. That time has now much passed!"

Let's see if I can help you understand these confusing quotes, now, in the context of this post!

Those quotes were both from 1998, and at that time, the price of gold had been steadily declining since December of 1987, from $500 down to about $280, a steady decline for ten straight years. That was also the decade when the CBs got the mines to hedge, to sell their gold forward through the LBMA (which had also just been established in 1987). So, we've got gold mine hedging and the LBMA being established at about the same time, followed by a decade straight of a declining price.

"The writer" in second quote was the miners who constituted the short interest, and as I just explained above, it was only profitable for them to hedge like that while the price was declining. Once it started rising in 2001, they stopped hedging and eventually even bought back their hedges at a loss, just to get out of them. So that's what he meant when he wrote, "If the price did not fall, this paper market "could not function" as "it would not be profitable to the writer"!" If the price wasn't falling, the mines wouldn't be hedging, and there wouldn't be paper gold for the longs to even buy.

On the other hand, as I explained at the very top of this post, the "commercial short" paper supply, which from 1987-1998 came from the miners, must be at least matched by a speculative (paper) demand, the "longs", in order for a paper market to even exist. This is what Another meant by saying that it wasn't a matter of nobody buying gold, there were in fact plenty of people buying gold… paper gold, that is. If there hadn't been demand for the paper the mines were selling, then they wouldn't have had a market to sell into, and if the price hadn't been declining, they wouldn't have been selling. So the trick was, to constantly meet the demand with more (paper) supply, and keep the price declining (but only until it reached production cost). It was in that way that Barrick made billions "mining money" rather than gold. From FOA:

"It truly started with Barrick, in Canada in the 80s…

All that happened was that Barrick could earn interest on its unmined reserves and call it "the higher price they were getting for gold"!

…You see, the mines motive was not to receive a higher than market price for gold, rather receive a stable price for gold so financing could be arranged. The fact that gold prices fell made Barrick (and many others) look real good and their staff stood for all the praise…

ABX [Barrick] has evolved into little more than a banker's extension. One that trades gold for their gain. On ABXs side,,,,, I see their massive paper short position as a financial tool that allows them to make a return on in place reserves without mining them in total,,, at once. That is all their program is really doing. It's a product of banker's games."

And from Peter Munk's own biography:

"Peter Munk was beginning to maximize the leverage that only ownership of the gold reserves of producing mines could bring… Munk's involvement in pioneering gold-backed financings was emerging…

During the remainder of 1987, Munk focused on raising capital for American Barrick Resources. He left the mining development to Bob Smith and his professionals. Munk and Gilmour, with their expert number-cruncher partner, Bill Birchall, would orchestrate the money mining…

Munk had successfully completed, in September, a deal with Merrill Lynch Canada Inc. for the sale of C$43 million worth of units of American Barrick's common shares and gold purchase warrants. Each unit offered consisted of one common share and two warrants to purchase gold at US$460 an ounce. For those who had faith (or were prepared to bet) that the price of gold would rise beyond US$460 by September four years later [which of course it didn't], the enticement was complete. Merrill Lynch had no trouble selling them."

Another's comments should make sense now! Of course the miners are no longer "the writers", and it's no longer their gold in the ground backing the short interest on physical gold. Today "the writers" are the bullion banks, and they don't care if the price goes down or up, because they are effectively neutral to the price. Which brings us back to the main question in this post: how could a short squeeze in physical gold force up the price of paper gold?

The story gold bugs tell themselves goes something like this: The LBMA bullion banks are suppressing the price of gold (or at least somebody evil is), but when the wholesale physical market (driven by Asia) demands physical delivery that they can't supply, they'll have to go out into the world's physical market to buy that physical in order to deliver it. This will start the standard short squeeze feedback loop of buying (rising physical demand and even further diminishing supply) which will drive the price up, "turbo charged"! All of a sudden, as in past short squeezes in other markets, everyone will be a buyer, even the shorts (who are, in this case, the bullion banks). Of course all of the gold ever mined is still out there somewhere, so the theory is that they'll run up the price of gold as everyone knows it today—the paper gold price—to $5,000, or $10,000, or even Jim Sinclair's $50,000, whatever it takes to shake enough physical loose from those stingy old evil gold hoarders to cover the shorts and cut their (in this case, the bullion banks') losses.

Here's the problem with that (and note that it is unique to gold). The paper gold market is probably 90% of the paper and physical markets combined, at least the parts where price is determined. So the paper market does indeed drive the price as we know it today, and the LBMA bullion banks are not only 90% of that market, they are also almost the entire short side of the market, similar to how the miners were almost the entire short side back in the early 90s.

So let's say the physical does run out. Let's say I'm right and what's left in GLD is almost all of what the LBMA has left, and most of that is already spoken for anyway. And let's say China and the SGE is what drained the LBMA of all of its gold. And let's even say that the spread explodes as the premium on physical skyrockets.

What then? Paper longs start demanding delivery from the LBMA bullion banks? Arbs buy paper gold while simultaneously selling physical? Yeah, right. As FOA said, at that point taking delivery will mean settling in cash and running with it as fast as possible over to the physical dealers, and it'll be the longs that will be dumping their paper and forcing the discount. No one will be buying paper at that point, and even if they did, the banks could just expand their balance sheets to meet the paper demand.

You see, it won't matter what the physical price is elsewhere, because the LBMA bullion banks are their own market. So what, if the physical price is running away elsewhere? Their price (today's paper gold price) is all that matters to them. There is no law anywhere that will force the biggest banks in the world to commit suicide by going broke in order to preserve the LBMA. Instead, just like GLD, the LBMA will be terminated, its assets liquidated, and its unsecured creditors settled in cash (and all unallocated bank depositors are unsecured creditors—you can't force a bank to give you "cash reserves" it doesn't have; just try withdrawing $100K in cash from your bank without notice and see what happens) at the low $POG from the moment of termination.

How low could it be? Well, I'd say zero, but that would make them look pretty bad. So maybe some nominal amount like $10 an ounce (which is a number Another once suggested), but probably much lower than where GLD terminates. You see, a very low gold price at termination will be a HUGE windfall for these banks, while any attempt to chase the physical price would have been suicide. So they'll just shut down the LBMA and call it a day. But then it gets interesting for any entities elsewhere with "gold" liabilities and unsecured creditors.

This is where I say that physical in your possession is the only way to be sure that someone else doesn't claim your windfall, because it will be tempting. If such an entity outside of the LBMA (I won't name names here) is even a tiny bit fractionally reserved, the explosion in the physical price could make that tiny bit huge, even bankruptingly huge. And here is where I once suggested that it's best not to even trust one's own sister with a dilemma like financial windfall versus financial devastation.

"The paper market" is the LBMA, for all intents and purposes. It is not COMEX as is a common misconception. And the LBMA, while it must manage its physical side as long as it wants to be a going concern, is not ultimately subservient to that side. It can simply pull the plug when the time comes, and the time will come.

It's not about people owning paper who think they own physical, or even think they might have a right to take delivery. Gold is different because its price is driven by bullion banking, which is an unfortunate carryover from the monetary gold standard of the past, unfortunate because denominating money, and thereby becoming monetary reserves, was never the best use of gold. And with a daily trading turnover volume on par with major currencies, and another $5.5T-worth of physical (at today's prices) in private ownership (more than three times the market cap of Apple, Microsoft, Facebook, Cisco Systems and Volkswagen… combined!), it is clear that gold, or at least the idea of gold, is anything but a relic from the past.

The gold price tracks or correlates with other commodities like copper and silver, and other currencies like AUD or CAD, because paper traders make it so. As I wrote in my target="_blank" Candid View series:

"Today gold is chained to both commodities and foreign currencies like the AUD through the paper markets. This is why we see gold moving in lockstep with either other commodities or as the inverse of the dollar. And what this means is that it would be virtually impossible to control the price of gold in isolation. If you even attempted such a feat, you'd have a world full of paper traders working against you no matter which direction you were trying to move the POG…

Now think about this in terms of the "gold thesis" of almost every gold bug in the world. They all have it basically right. They all think that gold should be much higher. But how can gold get there when it is chained to all of these other commodities through the regressive expectations of a massive Superorganism of traders that far outnumbers the gold bugs? It can't!

So in this case, all of the publicly traded commodities in the world constitute a weight around gold's neck holding it under water. If the gold bugs try to drive gold higher in isolation, the rest of the trading world will see a profit opportunity in selling gold and buying whatever their favorite correlated commodity is. This will keep gold correlated with all of the commodities it was correlated with yesterday. And if those commodities are not ready to explode in price, then neither will gold. The only way we get $3,500 gold is with $230 oil and $70 silver. And that's not a revaluation. That's either a commodity bull run or inflation."

Paper traders essentially perform a paper arbitrage between different commodities and currencies based on expectations which are in turn based on past performance. It's not perfect, but it's why things we expect to rise together, like gold and silver for example, usually do. But when the paper gold market is suddenly terminated, there will be no way to arb the physical market with the rest of the paper trading arena, and that's why nothing else will go along for the ride. I'll just leave it at that for now. Some topics are just too big for one post, and this is almost one of them.

The Free in Freegold

Okay, here it is. What you've been waiting for patiently, I presume. This is what gold will be freed from: The fractional reserve banking practice, which is a carryover from the gold standard.

This is the free in Freegold.

-From Freegold Foundations

Apologies to anyone who jumped down here to the last paragraph hoping to gain the wisdom of a post in just a few lines; I must admit that I ended this one purposely trying to avoid that. But for those who made it here the long way, I hope you'll agree it was worth the trip. Understanding how gold is different is key to understanding Freegold, and understanding Freegold is key to peace of mind, which is priceless. At least that's been my experience so far. :D

If you would like to join the discussion, you can target="_blank" click here to join the Speakeasy.

Sincerely,
FOFOA