26 Mar 2017
by Mark O’Byrne, Gold Core:
Gold ETFs are rising in popularity due to their convenience. They’re easy to trade, there’s no need to store anything, and no one is going to break into your house to steal your GLD shares.
But there are a lot of hidden dangers inherent in the structure and operation of gold ETFs that few investors are aware of—and these risks are more pronounced than ever, as the threat of another financial crisis is always around the corner.
Considering the public’s waning trust in the banking system, many investors find themselves wondering how GLD stacks up to owning the real thing. When you look at both assets more closely, it’s clear that gold ETFs and gold bullion are very different investments.
Why GLD Is Not the Same as Gold
SPDR Gold Trust (GLD), the largest, most popular gold ETF, is an investment fund that holds physical gold to back its shares. The share price tracks the price of gold, and it trades like a stock, but the vast majority of investors don’t have a claim on the underlying gold.
The reason for this is that you can only request physical delivery of metal if you own a minimum of 100,000 GLD shares (most investors don’t: at $1,000 gold, 100,000 shares is more than a million dollars). Even if you do own enough shares, the GLD ETF reserves the right to settle your delivery request in cash.
So why is GLD appealing to investors if you never actually own any gold?
For one, the fund is both convenient and low cost. If you’re looking for an inexpensive way to invest in the direction of the gold price, GLD is ideal.
The other advantage is you can employ leverage with options, which can be risky, but it’s something you can’t do with gold bullion. If you’re an investor who doesn’t plan to take delivery and you’re comfortable with a higher degree of risk, GLD can be a good way to gain exposure to the price of gold.
Counterparty Risk on All Levels
While gold ETFs can be a fine investment, they come with a lot of counterparty risk inherent in their chain of custody. And this risk will only grow commensurately with systemic uncertainties.
Think about it: If you own GLD, you must rely on a counterparty to make good on your investment. If the fund’s management, structure, chain of custody, operational integrity, regulatory oversight, or delivery protocols break down, your investment is at risk.
It all raises too many questions. Can you be sure the bank doesn’t front-run its customers? How safe are the fund’s holdings? Is the fund protected by adequate insurance? Is the custodian bank trustworthy enough to safeguard the gold?
The best reason to own gold is as a hedge against risk. It can be your last line of defense in an economic crisis—a form of wealth insurance, if you will. But since gold ETFs are part of the very banking system you need protection from, you must ask yourself if they serve one of the primary purposes for owning gold.
In a period of financial crisis, the risks inherent in holding GLD would only rise. In fact, the frequency and severity of counterparty risks with gold ETFs are already rising.
When you consider how these ETFs function, the problem of counterparties quickly becomes apparent:
When you invest in GLD, you buy shares through an Authorized Participant, which is usually a large financial institution responsible for obtaining the underlying assets necessary to create ETF shares.
When it does so, it is buying shares in the fund’s trustee, the SPDR Gold Trust. The trustee then uses a custodian (HSBC) to source and store the gold for it.
Trust in the custodian is paramount: If you’re buying gold as a hedge against a failure in the financial system, you must be confident that the custodian would not be impaired if a crisis were to happen.
As HSBC is one of the world’s largest banks, you simply don’t have that assurance. If there’s a systemic disruption, your GLD shares would likely be negatively affected.
Custodians like HSBC can use sub-custodians, such as another bank, to source and store gold. So in addition to the risk you assume with the fund’s primary custodian, you’re now exposed to even more risk because it has added another counterparty.
There are no written contractual agreements between sub-custodians and the trustees or the custodians, which means if a sub-custodian drops the ball, the ability of the trustee or the custodian to take legal action is limited.
This leaves the trustee on the hook for any negligence. But trustees don’t insure the gold for gross negligence; they leave that to the custodian, who secures limited general insurance coverage for the contents of the vaults. The value of the gold in the vaults is likely to be much greater than this limited policy would cover.
What this all boils down to is that if anything happens to any of the counterparties, you’re the one who loses. And you have zero recourse.
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