So You Think You Own Gold?

Executive Summary

• The rationale most commonly cited for investing in precious metals is wealth preservation: precious metals provide a durable store of value that eliminates counter-party risk inherent to other investments.
• Counterparty risk is only eliminated if the investor actually owns the precious metals he invests in free and clear of any encumbrances.
• Most precious metals investments, including many touted as “physical gold” do not actually convey legal ownership of precious metals to the investor. As a result, the elimination of counterparty risk rationale for the investment is defeated!
• You do not own gold unless you have taken delivery of coins or bars personally or have received legally binding documentation showing you to be the legal owner of specific coins or bars (identified by bar serial numbers) stored with a bullion bank in an allocated account that is allocated in your name.
• The “Physical Gold” vs. “Paper Gold” debate is revisited with an emphasis on counterparty risk. It turns out there are many layers of both ‘physical’ gold and ‘paper’ gold and these are explored.
• Critics of “paper gold” ETFs are sometimes guilty of scaring investors away from the “paper” aspect of the ETFs, only to go on to sell the investor a competing “physical gold” investment that is really nothing more than another form of paper promise.
• The LBMA chain of custody system (and other similar systems worldwide) provides a way to own physical bullion stored in a commercial vault without the need to re-assay the bars each time the bullion changes hands.

Introduction

One of the most common reasons investors cite for buying gold or silver bullion is that they are losing confidence in fiat (paper) money systems and the over-indebted governments behind them. Many investors prefer to own “physical” gold rather than “paper gold”, meaning they want to own the real thing as opposed to a paper promise – a contractual commitment to deliver gold at a later date, or in other cases a contractual commitment to pay the equivalent of a future gold price to the investor. But there is an alarming deficit of understanding among investors relative to how the precious metals markets actually function. In fact, I would go so far as to opine that most investors who believe they own gold really don’t!

If you think you own physical gold or silver, one of two statements will be true:

1. You really do own physical gold and/or silver bullion, meaning that you are the legal owner of specific coins and/or bars and you hold legal title to that gold or silver.
2. You think you “own” gold or silver bullion, but in reality the truth is that somebody else owes you gold or silver bullion. There is a possibility that the other party will not make good on its obligation to you, and that risk would increase in a major systemic crisis.

Most gold investments, including some billed as “physical” bullion investments, really amount to someone owing you metal that you do not actually hold legal title to. This is not just a matter of nit-picking semantics. If someone owes you gold or silver, the other party may be a reputable dealer or even one of the world’s largest and most reputable banks. In any normal circumstance, they are going to be able to make good on their obligation to you. But hold on… If the reason you decided to buy gold or silver bullion in the first place was to hedge against the risk of a major “black swan” event, i.e. a ‘non-normal circumstance’ such as a currency collapse, hyperinflation, or worse, having someone owe you gold may not be the form of protection or insurance you thought it was. If the rationale for favoring precious metals is in part is to avoid having a counter-party who might default on its obligation, being owed gold by such a counterparty does not help you.

Having a major bank owe you gold or silver bullion won’t do you any good if a systemic crisis leaves the major banks insolvent and unable to make good on their obligations. There are many other scenarios in which having the gold owed to you, or stored for you, by a major bank or financial institution will fail to provide the protection you seek.

Scenario #2 above best describes the vast majority of precious metals investments. That’s not necessarily a bad thing – there are many cases where “paper gold” makes perfect sense. But I’ve come to realize that quite a few investors think they own “physical gold” or silver when in reality they have invested in a paper promise disguised by the salesman’s use of the word “physical” in the sales process. What’s worse, I’ve also learned that the sellers of gold and silver investments don’t always possess all the gold and silver their clients are led to believe that they possess.

I’m not opposed to the existence of investments with counterparties that owe you precious metals. For many needs, they are the best choice. Please take a moment to reflect on why you decided to invest in gold or silver in the first place. If the answer is that you’re a trader who sees an opportunity to “play the market” and profit on price swings, so-called “paper gold” products are almost certainly your best bet. But if you invest in precious metals as a hedge against economic disasters such as a currency crisis, hyperinflation, or a systemic breakdown of the highly leveraged financial derivative system, then your goals are only going to be met by owning physical bullion. Most gold and silver investments don’t fall in that category. This article will examine the difference between owning gold or silver and being owed gold or silver. I’ll examine the various ways to invest in gold and silver with a focus on the question of counterparty risk in each scenario.

A quick note on terminology

The concepts in this article apply equally to both gold and silver bullion. But if I endeavor to form sentences with phrases like “gold and/or silver bullion and/or any combination thereof”, it’s going to be hard on your eyes. So from here on, I’ll just say “gold”. Please assume that whatever I say about gold applies equally to silver unless I say otherwise explicitly.

How to tell whether you own Gold or Silver

Let’s be clear about terminology here. Owning something means that you are the legal owner of that thing. It is your property and your rights as legal owner can be enforced by a court of law regardless of what misfortune might come upon the company that you bought it from or contracted to store it for you.

In contrast to owning something, you can also be owed something. For example, you may have invested in a gold bullion certificate program that “guarantees” you the right to redeem your certificates for physical bullion. In that scenario, you don’t legally own any bullion. You own certificates, and the company that sold you the certificates owes you physical bullion if you ask them to redeem those certificates.

What many investors don’t realize is that even when the company in question has all the gold they claim to have, you’re still not the legal owner of that gold until you redeem your certificates. If that company should ever go bankrupt, you will become a general creditor in bankruptcy court. If the company really had enough gold to cover all the deposits of all their customers (and by the way, many of them don’t), then you might stand a reasonably good chance of getting your gold. Some day, after a long, drawn-out bankruptcy proceeding and considerable legal costs.

It should be noted that even if you own something, it can get tied up in other people’s bankruptcy court proceedings. You can own gold that you have others store for you. If that other entity runs into financial or legal problems, however, your assets can get caught up in a legal dispute. When a refinery, bank, depository, or other corporation files for bankruptcy, in a perfect world any metal owned by investors on an allocated basis would be clearly identified to the court as someone else’s property. But the world is not perfect and that is not always the case. A bankruptcy court can tie up allocated metal for long periods of time while it tries to sort things out and figure out who owns what. Even if the metal is clearly demarcated, the bankruptcy court can hold it while it sorts out the financial affairs of the institution. Other scenarios can tie up metal owned by investors but stored by third-parties. The clearer your ownership claim, the better. If you hold a legal title certificate identifying your metal by bar serial number, that’s a whole lot better than owning “some of the gold in the vault” of a company that has more claimants than actual gold bullion.

To the best of my knowledge, there are only two scenarios where you actually own gold bullion in a legal sense:

1. You bought gold coins or gold bullion bars from a reputable dealer and you have them in your possession. You keep them in a safe deposit box or other safe location.
2. You have purchased gold bullion in an allocated bullion bank account, and the allocated account is allocated to you. (Some brokers have told investors their metal is held in “allocated accounts”, but in reality the metal is held in a third-party bank vault and is allocated to the account of the broker, not the investor. The investors are holding unallocated metal, in that the broker has not further divided the metal held on its allocated account at the third-party bank to show the ultimate ownership.) If the metal is properly allocated to the investor, the following will always apply:

a. You have received a deed or title certificate evidencing that you are the legal owner of specific gold bullion bars (identified by serial number) that are being stored for you by a bullion bank.

b. For each of your gold bullion bars, you should have received an assay report from the bullion bank that includes the following information for each gold bullion bar you own:

i. The name of the company that manufactured the bullion bar,

ii. The unique serial number and year of manufacture that are physically stamped on the bar,

iii. For “good delivery” bars (discussed later), the exact weight of the bar to three decimal places, and the exact purity of the bar to three decimal places.

iv. For “exact weight” bars, the exact purity of the bar to three decimal places.

c. You paid a premium or commission above spot price when you purchased your bullion.

d. You are paying storage fees to have the bullion bank keep your bullion in their vault for you.

If you have “invested in gold” and neither of these two scenarios describes your investment, you don’t own gold. Rather, somebody owes you gold. That’s not necessarily a bad thing, because some of the programs that involve someone owing you gold are relatively safe and fully backed by enough physical gold bullion to satisfy all the claims of all the investors. But many programs, including some billed as “physical” don’t work that way, and many investors don’t fully understand what really stands behind their investment.

Paper vs. Physical

A very common story in the precious metals investment world goes like this: The investor owned or was about to purchase shares in an exchange-traded fund such as GLD or SLV, which incidentally are very efficient, low-cost ways to invest in precious metals if you’re comfortable investing in “paper” as opposed to owning real metal. But then the investor read an article or listened to an interview that led them to believe that owning “paper gold” was a bad idea. Instead, it was suggested, they would be much better off with “physical gold”. It probably wasn’t mentioned explicitly, but in the vast majority of cases the person writing the article or giving the interview just happens to be in the business of selling “physical gold”.

So far I like the story. Owning physical bullion definitely beats a paper promise in my book. But the investor may have been led to believe that GLD and SLV don’t really have any metal and are just paper promises. For the record, the GLD ETF owns all the physical bullion necessary to back the investment. Critics point out that these ETFs hold that bullion in a very complex system of custodians and sub-custodians that some people claim is ripe for fraud. And besides, shares in an ETF are still just a line item on a brokerage account statement. If the whole financial system imploded, ETF shares wouldn’t do you much good. The ETF and its custodians would have the gold, but you might have a hard time getting your share of it if the financial system were falling apart. Favoring real bullion instead of paper promises is exactly the right idea if you’re concerned about major systemic event risk.

Unfortunately, the next step often involves the investor being sold a “physical” gold product (note the quotation marks!) such as certificates “redeemable on demand for physical gold”, usually with a sales commission of at least a few percent and possibly with an ongoing storage fee. Whoa. Hold it. Full stop. Certificates? Wasn’t the whole idea to avoid paper promises in favor of real bullion? What good are certificates if that’s the goal? And why should an investor pay a higher commission for the paper promise of these certificates over the paper promise of an ETF?

The dealer’s argument will likely be that the certificates being sold are “fully backed” by physical gold bullion, and the certificates can be redeemed for physical bullion at any time the investor likes. That’s the difference, or so goes the sales pitch anyway. But hang on a minute… the ETF is backed by real physical bullion too. Sure, fraud on the part of the ETF or its custodians could sour the deal. But fraud is just as possible with a “physical bullion” certificate program as it is with an ETF. Don’t get me wrong – I fully agree that owning physical bullion has distinct advantages over investing in a paper promise linked to gold bullion. But owning physical bullion means really owning physical bullion! Holding paper promises that can supposedly be redeemed for physical bullion doesn’t count. Ironically, dealers often succeed at first convincing investors of the risks of “paper gold”, and then proceed to sell them a different form of “paper gold” disguised by the false moniker of “physical” gold!

It amazes me that investors seldom stop to think about what physical actually means. I met a guy recently who told me he was accumulating allocated physical bullion. He said he was already up to 25 ounces of gold in his “allocated physical bullion” account. I asked him what kind of gold coins he was investing in… Gold Eagles? Krugerrands? He replied “No, not coins – just physical gold bullion in an allocated account”. That statement simply doesn’t make sense! Aside from coins, Gold bullion comes in bar form. The bars used in allocated accounts are generally 100 ounces, 400 ounces, or 1 kilogram (just over 32 ounces). How can you own 25 ounces of physical gold bullion (other than in coins) when the smallest popular bar is the 32-ounce kilo bar? You can’t. I helped him get to the bottom of this, and it turned out that he had unwittingly invested in an unallocated account with a dealer who sold “virtual ounces”. They had promised him he could come collect his physical gold any time he liked, but he never thought to question the impossibility of taking delivery of a partial gold bar. Sadly, stories like this one are not uncommon.

So to be clear: Owning physical bullion means that you are the legal owner of one or more physical coins or bars. In the case of coins, you probably took delivery yourself and have them stored in a safe deposit box. In the case of bars, you may have taken delivery or you may have chosen to have them vaulted by a bullion bank. The exact amount of gold you were able to purchase in bar form was dictated by the available bar sizes. Each bar has a serial number that should have been provided to you, with some sort of paperwork evidencing you as the legal owner of that bar. You’ll need that piece of paper if the people storing the gold should ever go bankrupt and you need to prove to a bankruptcy trustee or a court of law that you (and not the bankrupt company) are the legal owner of the gold.

Physical bullion clearly has advantages over paper promises, but those advantages don’t come for free. Buying physical bullion always involves paying a markup (dealer commission) above the spot price. The only exception I know of to that rule is that one can buy futures contracts and stand for physical delivery (a complex process that most futures brokers don’t even allow). In that case you would have to go to a COMEX registered warehouse in New York City to collect your bullion, and 100oz bars are the only size offered. Once you’ve purchased your bullion, if you want to store it in a commercial vault, you’re going to have to pay a storage fee, typically about 2% of the purchase price of the gold per year.

Perhaps you’ve heard of a dealer who sells bullion for spot price and doesn’t charge a markup? He offers free storage too! Those deals are never bona-fide allocated accounts. In other words, you don't actually own anything. The dealer owes you gold and is promising to deliver it when and if you come asking for it. By the way, the part he probably didn’t tell you is that although he might have enough gold to cover your redemption, he probably doesn’t have enough to cover a mass redemption if all his other customers came looking for their gold at the same time (a run on the bullion bank). I’m not just talking about shady operators in hole-in-the-wall offices here. The world’s biggest and most prominent banks operate in this way. It is not a scam, but rather the way that banks and bank accounts work. It becomes a scam when the bank or depository agent does not fully inform its clients of what they are buying, what they own, and what terms and conditions apply to the asset and its redemption. Sadly, I’ve learned that such omissions of disclosure are not uncommon. It can also become a scam if the entity storing the metal has the audacity to charge you storage fees even though it has not allocated any bullion specifically for you. And yes, some banks do exactly that, and yes, it’s legal.

It’s essential not to lose sight of why you preferred physical over paper in the first place. If you have personal possession of the bullion, the benefit is obvious. But if you are storing bullion in a commercial vault, you need to remember that the benefit of owning physical bullion is that you have no counterparty to your investment. It’s yours and you own it. Unless you have documentation uniquely identifying your bullion (by bar serial number) and evidencing that you are the legal owner, you won’t derive this benefit from physical over paper! After all, you don’t have the bullion – it’s in someone else’s vault. If they go bankrupt, it will do you no good to tell the judge, “Honest, your honor, that gold is mine. Really it is, just trust me!” You’ll need formal documentation evidencing your ownership of specific bullion bars unambiguously identifiable by their unique serial numbers.

Buying Physical Gold Bullion

This section will briefly review the various physical forms in which you can buy gold and silver bullion, and will discuss the system used to assure authenticity of gold and silver bullion stored in bullion banks. I’ll revisit “paper gold” and discuss its strengths and weaknesses (it really is the best choice for some investors) later in this article.

Gold and Silver Coins

The main purpose of this article is to discuss bullion bars, which offer a more efficient (lower costs, charges, or markup) way to make a large investment in bullion. Plenty has been written by authors far more expert than me on the subject of buying gold and silver coins. If your interest is in coins I suggest reading the many excellent articles on the subject you can easily find on the Internet. I’ll briefly review the major considerations in bullet list format below, but I also recommend further reading if this is your area of interest.

• Coins should always be purchased from a reputable dealer. There is a large counterfeit market, so eBay purchases and shady back alley coin dealers should be avoided unless you have the skills to judge the authenticity of gold and silver coins yourself.
• A very popular “bait and switch” scam involves advertising gold or silver bullion at very attractive prices and then hard-selling the customer numismatic coins instead of bullion coins. Numismatic is just a fancy word for “rare coins”. Unless you are a bona fide coin collector and an expert in gauging their value, you’re going to get ripped off buying numismatics. The dealer markup is much higher for numismatics than for bullion coins, and claims that numismatics are somehow immune to government confiscation are just sales tactics. If your investment objective is to own gold or silver bullion, stay away from numismatics entirely.
• Be aware of the premium you are paying above the “spot price” of bullion. Coins always involve a premium (they have to mint the coins, which costs money), but the percentage varies considerably between dealers and products.
• Gold bullion is never sold at a discount below the spot market price. “Discount bullion” deals are always scams involving counterfeits.
• Consider how marketable the coin will be when it comes time to sell it. Gold or silver “rounds” (coins minted by a private mint that are not recognized by any government) are generally available at lower premium cost above the spot price, but a South African Krugerrand or a U.S. Gold Eagle are instantly recognizable by dealers everywhere should you need to sell your coins. A gold round from Joe’s Bar, Grill and Private Mint will be much harder to sell.

Enough said on coins. There’s plenty more to know – junk silver, currency value vs. private mint, and so forth. But plenty has been written on these subjects and the primary focus of this article is on bullion in bar form that can be stored in a bullion bank. If you’re interested in coins, please Google “buying gold and silver coins” and you’ll find plenty of information on the subject.

LBMA and “Good Delivery” Systems

If each company that manufactures bullion bars were just to market and sell its products independently, it would be very hard for investors to judge the authenticity of the products sold, or to know which companies are reputable. The solution to this problem is a good delivery standard. There are several such standards set forth by various industry organizations worldwide. By far, the most well known trade organization is the London Bullion Market Association (LBMA). LBMA is a trade association of major banks that engage in the sale and purchase of gold bullion, and in gold trading centered around the London interbank, over the counter market. As the name implies, the organization is headquartered in London, England. However, the LBMA network of bullion dealers and vaults is global in scale, and is generally regarded as the de-facto worldwide marketplace for sale and storage of gold and silver bullion in bar form. The relevance of LBMA and its Good Delivery system is best understood by example.

Suppose that you purchase a gold bullion bar from a private-label dealer such as Kitco.com, a popular Internet retailer of bullion products. How do you know the gold is real and that you’re not being sold a lead or tungsten bar coated with gold colored spray paint or a thin layer of gold? To a large extent, you have to rely on the reputation of the seller. Kitco is a widely respected name, but there are many other dealers that are less well known. To really be certain, you’d have to pay a credentialed expert to inspect the coins or bars and make sure they’re really pure gold. For rare coins, this process involves performing chemical and ultrasonic tests to verify that the coins are made of pure gold. For bars, in most cases the test involves melting down and re-manufacturing the bar. The process of verifying purity and authenticity is called assaying, and the practice of melting down and completely re-manufacturing the bar to verify the purity of the gold is called a full-melt assay. To perform a full-melt assay to verify authenticity of the bars you bought from some guy on eBay wouldn’t be practical in most cases. What’s needed is for some reputable organization to certify the manufacturers and dealers, and keep tabs on them to make sure they deliver pure, authentic bullion bar products.

To address this need, the gold market for many decades has used what is known as the London Good Delivery system. (The LBMA only came into existence in the late 1980s. Prior to that the banks and dealers active in the London market worked with the Bank of England, which had supervisory authority over the London market, in organizing and agreeing to proceedures.) To participate in the system, a bullion bar must be manufactured by an LBMA-certified and regularly inspected refinery. A system of checks and balances assures that only genuine pure gold (or silver) bars can get into the system. The bar is generally transferred from the manufacturer directly to an LBMA-certified vault, several of which exist around the world. LBMA vaults are insured, and employ processes designed to make certain that the chain of custody is closely monitored, to prevent bars from being substituted or tampered with. In most cases, the bar will never leave the LBMA system. If a buyer takes delivery of a bar and removes it from an LBMA recognized depository, when that bars is later re-sold, the purchaser has the right to have the seller pay for an assay to ascertain that the bar has not been tampered with, altered, or adulterated. The buyer may or may not exercise this right, but always has it. If the bars remain in the custody of the depositories, there is no need to re-assay a bar when it changes hands.

Bullion bars that meet the qualifications to be delivered in the London interbank market through this system are known as London Good Delivery bars, meaning that they meet the specifications for London delivery. The standard good delivery bar is the 400-ounce gold bar or the 1,000-ounce silver bar.

These names are deceptive, however, because in practice the actual weight can be anywhere from 350 to 430 ounces for gold, or 750 to 1,100 ounces for silver. This is because the physical process for manufacturing bullion bars makes it difficult to create bars that are exactly 400 or 1,000 ounces. Thus, the good delivery system has a range of tolerance in weight. Individual bars are sold based on their actual measured weight and purity, as determined by assay.

The owner of a bar stored in the LBMA system has the option to take delivery of that bar, but the instant the bar leaves the custody of the LBMA warehouse, it is subject to re-assay on re-sale. It is possible for the owner of the bar to later re-deposit the bar into the LBMA system, but, as discussed above, they may have to pay to have a full-melt assay performed to re-verify its exact weight, purity, and authenticity. In other words, you can take a manufactured bar out of the LBMA system, but you might face a significant charge (and time delay) to put one back in.

The goal of this system is to increase assurances of the metal’s authenticity through the London custodian system by providing a way for bullion to be transferred from one owner to the next while remaining in the custody of trusted intermediaries. This allows the market to avoid having to re-assay bars every time they are sold to verify their authenticity. Buyers are thus assured that the bullion they buy within the “Good Delivery” system is real.

What does all this mean to the investor? Basically it means that you have two choices when buying Gold Bullion in bar form:

1. Take delivery of bullion bars yourself, and accept responsibility for paying to assay the bars to prove their authenticity when you eventually sell them.
2. Buy bullion and pay storage fees to keep it in the London Good Delivery system, so you can later sell your bullion without need to re-assay the bars.

Other parts of the market operate in the same way. There are depositories that are recognized by the dealer market as being trustworthy depositories. If metal is held in those vaults and does not have the physical appearance that it has been adulterated or altered, or in some other way may not be real, the metal can change hands repeatedly over many years without being re-inspected and assayed.

The choice as to whether to leave the metal in a recognized depository or take actual physical delivery really comes down to whether you intend to take delivery of your bullion personally and store it in a safe deposit box, or have it stored for you by a bullion bank. The advantage of keeping your bullion in the London Good Delivery system or another market-recognized system is that you don’t have to worry about counterfeit gold or paying to have your bars assayed. In my opinion, for large investments, the Good Delivery system is the way to go. If your circumstances dictate taking physical delivery yourself, please be very careful to make sure you’re getting real gold. If the seller is anyone other than an LBMA-certified dealer providing bars from Good Delivery inventory, it’s entirely reasonable for you to demand that the seller pay for a full-melt assay to your satisfaction. And for heaven’s sake don’t store bullion in your home. In a serious economic crisis, the bad guys will come and kill you and your family to get your gold. If you’re not comfortable with the London system for some reason, I suggest using a safe deposit box instead. Should you ever need to sell your gold, expect to pay several hundred dollars per bar to have them assayed again (full-melt process) to satisfy the buyer that they’re real.

The LBMA system is the best-known, but there are other good delivery standards around the world. The New York market uses the Comex system of good delivery metal. This includes 100-ounce gold and 1,000-ounce silver bars from Comex-registered refineries. Comex has a network of depositories it has registered as being good for delivery of metal to Comex against its futures contracts. Metal that meets the Comex depository and good delivery standards can remain in that system for many years, changing hands repeatedly. As with the London market, the metal can be taken out of the system, but the owner then is liable for re-assaying if the metal is resold. The Zurich market uses a slight variation of the London good delivery standards.

Gold Bar Products

In addition to “Good Delivery” bars that may vary in weight, there are also exact weight bars. The LBMA website lists 17 different sizes of exact-weight bars. However, the common sizes that bullion banks are likely to offer in conjunction with allocated storage accounts will generally be limited to the most commonly traded sizes:

• London Good Delivery Gold Bar (350 to 430 troy ounces, priced by assayed exact weight)
• COMEX Good Delivery Gold Bar (95 to 105 troy ounces, priced by assayed exact weight)
• One Kilogram Exact Weight Gold Bar (32.119 troy ounces at 999.0 purity)
• London Good Delivery Silver Bar (750 to 1100 troy ounces, priced by assayed exact weight)

Allocated and Unallocated Accounts

The LBMA defines two categories of bullion accounts. By far the most common type is the unallocated account. Many investors who seek to own “physical” bullion wind up being sold an unallocated product. This is a farce; an unallocated account is basically a paper promise that is not really backed by physical gold bullion. Many investors do not realize that they are arranging for unallocated metal storage when they agree with their dealer, broker or bank to let them “store” the metal at little or no charge.

If you have an unallocated account, you don’t own gold or silver bullion! Rather, the bullion bank owes you bullion. Although many banks charge storage fees for bullion “held” in these accounts, they don’t really have the bullion in most cases!

The bank probably has enough bullion on hand (although they are not required to) if you wanted to take physical delivery of your metal. But they are allowed to fractionalize their bullion holdings. In other words, they are not required to actually have all the gold needed to back all the deposits of all the customers. They keep enough gold to satisfy whatever redemption demand they think is likely. If a crisis prompted all the investors to demand delivery of all their gold, the bank might quickly run out and there wouldn’t be enough to go around! Yes, this is perfectly legal and it’s standard practice. Regular bank accounts work the same way – the bank loans out most of the money they take in as deposits and they don’t really have enough cash to protect against a run on the bank. In the United States, the FDIC system protects owners of regular currency accounts from such situations, but unallocated gold accounts are not FDIC insured.

In my opinion, the GLD ETF represents a far more sound investment than an unallocated bullion bank account, although neither will help you in a true crisis (where an allocated account will). Most ETFs, including the GLD, supposedly have all the gold to back all the shares. (There are some gold ETFs that do not use physical gold backing, but these are few and small.) Critics have argued that some of the ETF custodians could be leasing out some of the gold owned by the ETF, and thus there might be multiple ownership claims on the same bullion. There is no evidence that any of the major ETFs offered by money center financial institutions do this. The criticism is limited to speculation by others – usually people with a vested interest in discrediting the ETFs – that such shenanigans could be going on. Another claim made by critics is that the gold in the ETF was itself actually leased from a central bank so the ETF doesn’t really have clear title to the metal. Again, there is absolutely no evidence that this in fact is the case. Frankly, I think these allegations amount to fear mongering on the part of critics who have a financial incentive to scare investors away from the ETFs in favor of other products being sold by those same critics or their associates. Here’s the relevant language directly from the GLD Authorized Participant Agreement:

Section 16. Title To Gold. The Authorized Participant represents and warrants on behalf of itself and any party for which it acts that upon delivery of a Creation Basket Deposit to the Trustee in accordance with the terms of the Trust Indenture and this Agreement, the Trust will acquire good and unencumbered title to the Gold which is the subject of such Creation Basket Deposit, free and clear of all pledges, security interests, liens, charges, taxes, assessments, encumbrances, equities, claims, options or limitations of any kind or nature, fixed or contingent, and not subject to any adverse claims, including any restriction upon the sale or transfer of all or any part of such Gold which is imposed by any agreement or arrangement entered into by the Authorized Participant or any party for which it is acting in connection with a Purchase Order.

I am not a lawyer and I’m not qualified to give legal advice, but that language seems pretty darn clear to me. The authorized participants (who create GLD shares by depositing gold) have to deliver clear, “unencumbered” title to the gold. Could other parties also have a claim on that same gold? This language is pretty clear in saying that liens, security interests, claims, options, etc. are all prohibited. Clear, unencumbered title to the gold must be transferred to the trust when an Authorized Participant creates new GLD shares. Period.

Now don’t get me wrong, I’m not saying this is foolproof. The folks who “represent and warrant” the free and clear title to the gold are investment banks (J.P. Morgan Chase and HSBC are the Authorized Participants who create GLD shares). Fraud, deceit, and corruption are not unheard of in investment banking, and for all I know they don’t really own the gold. However, the gold holdings of the ETFs are audited by independent auditors regularly, at least annually. Could the auditors be fooled and miss something? Yes. That would not be unheard of. However, there are layer upon layer of safeguards to prevent this, so if an authorized participant has defrauded the ETF manager, they also have the trust’s auditors fooled. Yes, there was Enron and auditors can sometimes be unreliable, but so far as I can tell the allegations that the GLD trust doesn’t really own the gold are for the most part baseless fear mongering. The legal documents behind the GLD ETF demand that the trust owns all the gold, free and clear. The only way for that not to be true would be if a massive fraud has been perpetrated by two very large investment banks and that fraud has gone undetected by the trust’s independent auditors.

So there is only a very small risk that because of rampant fraud and corruption maybe GLD doesn’t own all the gold it claims to. But I know for certain that the bullion banks definitely do not have all the gold needed to back all their unallocated accounts in physical form. No fraud is involved there – it’s just how unallocated accounts work. The LBMA website is very clear (follow this link to see for yourself) that the owner of an unallocated account does not own bullion. Rather, they are an unsecured creditor of the bullion bank, which owes them bullion. What’s more, if the bank did actually buy bullion with the client’s money, they may very well have hypothecated the bullion, meaning that it was lent out to third parties. The irony here is that when investors become concerned about market manipulation theories, they often opt to pay more to buy “physical” bullion rather than “paper gold”. Then they end up being sold unallocated accounts, and the bullion they have paid for is leased out to the very same short sellers who are alleged to perpetrate the market manipulations! And to top it all off, some of the most prominent and reputable banks in the world are charging storage fees to clients who own these unallocated accounts. Yes, you read that right: First you pay extra fees to get “physical” bullion, and then the bank lends “your” bullion out to short sellers who drive down the price of your investment, after your bank charges you a storage fee for gold they don’t really have!

In my opinion, unallocated bullion bank accounts are not a good deal for the individual investor. The investor doesn’t own metal in the strictest sense. They own paper promises. The major difference between these so-called “physical bullion” accounts and other “paper gold” investments is that the client is paying higher fees for the same paper promise. If you have purchased “physical bullion” and were not charged storage and sales fees, you were probably sold an unallocated account. If you bought ounces and there was no need to match your desired investment size to the exact size of available bars, you were probably sold an unallocated account. The way to tell for sure is simply to ask your bank or broker to provide you with the serial number(s) of your bar(s). If they are not willing to do so, you almost certainly have an unallocated account. In my opinion, you’d be better off with ETF shares. At least that way you’re not paying for what you’re not getting. And unless there is fraud or corruption going on, the ETF actually owns all the gold. The bullion banks only own some of the gold because unallocated accounts are fractionalized.

Allocated Accounts are those in which the investor actually holds legal title to the bullion in question. Aside from storing the bullion yourself in a safe deposit box, an allocated account is the only way to own physical bullion. You can’t buy an arbitrary number of ounces in an allocated account. You have to tell the bank or broker approximately how much metal you want to buy, and they will match your order up with the available inventory of bullion bars. You will be provided with the unique serial number, gross weight, purity and fine weight of each bar you purchase. If the bank or broker won’t provide this information, you probably don’t have an allocated account and you don’t really own bullion.

Transaction and Storage Fees

Unfortunately, if you want to own physical bullion in an allocated account you’re going to have to pay several fees. Unlike the “paper world” where unlimited numbers of ETF shares can often be traded for a miniscule $8.95 commission to an online broker, the physical bullion market involves human beings moving physical things (your bullion) around. The fees are considerably higher as a result. If you think you’ve found a broker or dealer who doesn’t charge these fees, the most likely explanation is that they are really selling you bullion on an unallocated basis.

Here’s what you should expect to pay for a physical bullion purchase, above and beyond the spot price of the metal at the time of your purchase:

• A sales fee or commission. Some dealers will claim to have no sales fee but instead quote a “house price” that is higher than the spot market price, but this is just a disguised fee. More reputable dealers will simply quote the spot market price plus a sales commission of several percent. 5% or more is not unusual.
• If you opt to take physical delivery, there will be a delivery fee. It’s going to cost considerably more than regular postage because of the need to insure the value of the bullion. For larger purchases, an armored car delivery service will be required.
• If you opt to store your bullion in the bullion bank’s vault, there will be a storage fee. The annual fee is typically a percentage of the purchase price of the bullion. 2% or more per year is typical.
• When you ultimately sell your bullion, there will be another commission, usually about the same as the sales commission.
• Depending on where you live, you may be liable for sales tax on physical bullion purchases.

Sound like a lot of fees? True physical bullion ownership doesn’t come cheap, unfortunately. If you want to eliminate the shortcomings of “paper gold” ownership, the fees are significant. In the next section I’ll revisit the question of paper gold investments and review those shortcomings. In many cases they’re really not as bad as the critics hawking competing products try to make them sound.

Paper Gold Revisited

A whole lot has been written about the shortcomings of “paper gold”. Most of it was written by people selling “physical gold”, and in my opinion the “paper gold” scare has been overblown. Furthermore, there are several different categories of “paper gold” with different risk characteristics. Some of them are seriously delinquent in contrast to physical bullion, but some really aren’t so bad. In this section I’ll review the paper gold options that are available.

Let’s define paper gold as someone owing you gold. There are three subcategories of paper gold:

1. Somebody owes you gold and they really and truly have enough physical bullion on hand to satisfy not only your claim, but also those of all their other clients. And they don’t lease your gold out to third parties or engage in any other monkey business. In other words, they really have the gold. All of it.
2. Somebody owes you gold and they have physical bullion ready to deliver to you if you ask for it. What you might not realize is that they may not have as much physical bullion as all their investors have purchased from them and asked them to store – they only have enough to cover the expected redemptions. In a “run on the bank scenario”, which is entirely possible in a crisis, they won’t have enough gold to meet all their obligations to all their clients. Not even close. Most “certificate programs” work this way and I’ve found that few investors in these programs realize that this is the case.
   
3. Somebody owes you gold and they don’t really have gold. Your money is invested in derivative products such as futures, forwards, and option contracts that will track the price of actual bullion so long as the counterparty or exchange in question does not default.

Category 1: They really have the gold - All of it

The first subcategory of paper gold really isn’t such a bad deal. The big question is whether or not a given investment vehicle really falls into this category. First, the people selling the paper gold product need to have enough physical bullion to satisfy all their investors’ claims. Next, they need truly to own that gold with clear title, meaning that any gold that was leased from an institutional investor, other bank, or central bank doesn’t count. Furthermore, they must refrain from leasing this gold out to third parties or otherwise creating a situation where there might be more than one ownership claim, or encumbrance in legal terms, on a single piece of bullion. If those conditions are met, the next question is whether the company running the show engages in other businesses. If they are a large bank, in a bankruptcy the bullion clients might end up fighting with the other creditors of the bank over the gold. But if the outfit with the gold is only in the gold business and doesn’t have other major business risks, this form of paper gold really isn’t such a bad deal. In fact, it’s a much better deal than unallocated bullion bank accounts that are sold as “physical bullion” when in reality they amount to a paper promise backed by the bank’s assets which may not even include the gold in question.

Several critics have argued that the GLD ETF does not fall in this category because there may be multiple ownership claims on the gold it owns. A popular allegation is that the authorized participants may be leasing gold from central banks, then depositing that leased gold (which is really still owned by the central bank) to create GLD shares. Referring to the quote from the GLD Authorized Participant Agreement cited earlier, I have to disagree with that argument. It appears clear to me that GLD really does own all the gold, or at least it’s supposed to. Obviously, fraud could exist in any situation, but the commonly touted allegation that GLD does not require the Authorized Participants who create shares to actually own the gold appears to me to be incorrect. On the other hand, one criticism of GLD that I do agree with is that it’s a very complicated investment vehicle. The sponsor who runs the ETF itself is one company. Separate authorized participants are allowed to create shares by transferring physical metal that is actually held by custodians to the GLD trust. There are several different players involved, and the complexity of the whole scheme might make it possible for a clever banker to commit fraud. Critics have argued that the legal documents don’t adequately require all of the different companies involved to legally guarantee that they are holding up all their obligations and to indemnify the GLD Trust against resulting losses if they don’t. But so far as I can tell, there would have to be outright fraud for GLD not to qualify as a Catergory 1 paper gold investment. Unless a massive undetected fraud exists, GLD really does own all the gold. The only valid objection I see is that GLD is so complicated in terms of legal structure that hiding fraud from an auditor might not be as hard as it would be in a simpler structure.

In the interest of space, I need to leave the subject of the GLD controversy there. If you’re still concerned by the allegations about GLD, I encourage you to read Catherine Austin Fitts and Carolyn Betts’ paper on the subject. I don’t agree with them on several points, but I think they’ve done an excellent job of summarizing all of the controversy about the GLD and SLV ETFs. My own conclusion is that the ETFs are among the best paper gold investments available, but at the end of the day they’re still just paper promises and are no substitute for truly owning physical gold. If you use paper gold vehicles for trading (not for wealth preservation in a crisis), I think the objections about GLD are overblown and that GLD is actually an excellent vehicle for trading purposes. But if your goal is wealth preservation in the face of financial Armageddon, there’s simply no substitute for owning physical metal in your own name.

The PHYS fund is often referred to as an ETF, although it really isn’t an ETF at all. PHYS was purportedly conceived to overcome the complexities of GLD. The supposed advantage of PHYS is that they own all the gold, it’s all in one place, there’s no complex network of authorized participants and custodians, and thus only one company (Sprott Asset Management) is wholly responsible for making sure all the gold is really there. They also make very clear representations about not hypothecating or fractionalizing the gold holdings. Central Fund of Canada is another similar investment vehicle. But in my opinion PHYS and Central Fund of Canada are horribly flawed products for other reasons. The problem with PHYS and Central Fund is that they’re structured as closed-end mutual funds. The price they trade at is therefore not linked directly to the spot price of gold. PHYS shares recently reached a premium of more than 30% over their NAV. In other words, investors buying $13,000 worth of PHYS were only getting $10,000 worth of gold. The enormous 30% premium collapsed when new shares were subsequently issued. As a result, some investors who bought PHYS immediately saw a 10% reduction in the value of their investment, despite the fact that the price of gold had actually gone up, not down! For sophisticated investors who understand the nuances of closed-end mutual funds, PHYS might be an attractive play if you’re willing to arbitrage the premium against a hedge that tracks the spot market directly. But for most investment objectives, I would avoid closed-end gold funds.

Category 2: They have some of the gold

Some “paper gold” investments are backed by physical bullion, but they don’t have enough bullion to cover all the investors. In many cases, the fact that they have some of the gold will be used as justification for the seller to claim the investment is a “physical” bullion product. In reality the claims of the investors are backed by the general creditworthiness of the institution in question.

The biggest offenders in this category are the unallocated bullion bank accounts. That’s right, the same people who may have scared you out of investing in the GLD ETF with hyped up claims about “paper gold” being “unsafe” may have turned around and sold you “physical” gold that actually amounts to a paper promise with less backing behind it than the ETF has!

In researching this article I learned that at least one very large and very well known international bank actually charges its clients bullion storage fees for these unallocated accounts. I guess they figured that charging storage fees helps make the client feel like they have something “physical” when they really don’t! I see very little appeal in these unallocated accounts. I think the GLD ETF or another Category 1 fund (meaning they have ALL the gold) is a better investment.

There are also several “certificate programs” where investors buy “virtual ounces” that can supposedly be redeemed for physical bullion when desired. In most cases, these are Category 2 paper gold investments, despite being sold as “physical gold”. They usually do not charge storage fees. That should prompt investors to ask themselves, how do they make a profit if they provide the storage for free? Usually, the answer is that they make their money by leasing out the same bullion they sold investors to third parties. The other possibility is that they make money by fractionalizing – meaning they have gold but not as much as all the investors’ accounts put together would call for. Either way, the result is that in a crisis scenario there could be multiple claims of ownership on the same bullion. Despite being marketed as “physical gold”, these programs are paper promises that are only as good as the certificate issuer’s ability to make good on those promises. In a bankruptcy, certificate holders would be classified as unsecured creditors and would have to share whatever gold actually exists with the other claimants, including other general creditors who never even invested in gold.

Category 3: Pure paper

The final category is paper contracts that are not backed by any physical gold. This category includes futures contracts and options against futures contracts or other gold investments such as ETF shares. This is truly a “paper investment” because it’s nothing more than a contract that obligates a counterparty to pay up if the price of the underlying asset goes up. In the case of futures contracts and listed options, counterparty risk is mitigated by an exchange clearinghouse, which serves as the investor’s counterparty. But in a systemic crisis, the exchange itself could default if it is unable to meet all of its obligations. Such a default by the exchange would be likely in a cataclysmic financial system meltdown. It should be noted that one of the great aspects of the U.S. futures exchange system is that there has never been a default by the Comex or Nymex clearinghouses. During the recent financial crisis in the second half of 2008, the presence of the clearinghouse system at Nymex allowed the exchange to operate at a heightened volume, as trades that could not be executed in the over the counter market (where the principal to principal credit exposure was limiting transaction volumes) were able to be made on the Nymex and its Comex division. In other words, the system can and has survived crises of considerable magnitude. But in a true global systemic collapse, all bets are obviously off.

There are some gold investment funds that track gold prices by investing in futures and/or options. These funds are therefore vulnerable to counterparty risk (exchange default) in a major systemic financial crisis. These “pure paper” funds are admittedly risky investment vehicles, and these risks are often cited by those who seek to scare investors away from Category 1 investments such as GLD. In reality, the risks are completely different. The truly amazing part is that Category 3 risks are sometimes used by clever salesmen to scare investors out of Category 1 paper investments, and straight into less desirable Category 2 investments! The word “physical” is remarkably effective at enticing investors into what actually amounts to just another paper promise.

Conclusions

Is “physical” really better than “paper”? If you get real physical, meaning bullion you actually own and either take custody of personally or store on an allocatedbasis with a bullion bank, the answer is yes. There is definitely an advantage to owning your bullion rather than having a counterparty owe you bullion. If you are concerned about wealth preservation through an extreme crisis such as a banking system melt-down, real physical metal that you truly own is the only way to go. But that advantage comes at a cost. Whether you store your bullion in a bullion bank vault or rent a suitable safe deposit box from a local retail bank, it costs money to store and securely transport bullion. If you are concerned about government confiscation risk, you’ll want to store your bullion in a country other than the one where you reside, and that generally dictates the need for an allocated bullion bank account and the fees that come with it.

In my opinion, unallocated bullion accounts (including “physical gold certificate programs”) are no better than other forms of paper gold. They are worse in the sense that they involve higher fees and may not be fully backed by physical bullion. I personally think that criticisms of the GLD ETF are overblown, and I view GLD as a better choice than an unallocated account.

Ultimately, I think it comes down to why you are buying gold and what purpose it serves in your investment portfolio. For preservation of wealth and to hedge against the possibility of a financial system implosion, my opinion is that there is simply no substitute for owning physical bullion stored in a vault in a country other than the one you live in. That means an allocated bullion account, and I would never accept anything less than a written deed or certificate of title evidencing that I am the owner of the bullion, and identifying my bars uniquely by serial number. But I also speculate in the precious metals markets, and for that purpose I have no hesitation whatsoever about pure paper products (I trade futures contracts actively for this purpose but would feel equally comfortable with the GLD ETF). It all comes down to matching the investment vehicle to the intended purpose of the investment.

Full Disclosure

During the course of researching this article, I apparently impressed Nick Barisheff with my knowledge of precious metals products. (Nick is the CEO of Canada’s Bullion Management Group, a prominent seller of physical bullion bars and storage services in Toronto.) In fact, he even went so far as to offer to make me a dealer for his allocated physical bullion program. My first reaction was to say “No, you don’t understand – I’m a private investor; I’m not in the business of managing other people’s money.” But after thinking about it, I’m seriously considering the idea. I don’t have any desire to be a door to door precious metals salesman, but I would save paying a commission to another dealer for my own physical bullion purchases, and would also be able to offer my high net worth investor friends a discounted commission schedule. Maybe it’s not such a bad idea after all.

As of this writing, I haven’t taken Mr. Barisheff up on his offer. But after criticizing other authors who fail to disclose their financial stakes in subjects they write about, I thought I should mention that this possibility is under consideration. The prospect of becoming a dealer for BMG’s allocated metals program had nothing to do with my reasons for writing this article, but I felt obliged to disclose this information just the same.

Erik Townsend is a private investor based in Hong Kong. © 2010 Erik Townsend, ErikTownsend.com