The Fed's (Fictional) Intervention In The Gold Market, Part IV: Faulty Logic

Includes: GLD
by: Vince Martin

In the earlier parts of this series on the gold market, I criticized the Gold Anti-Trust Action Committee (often known as GATA) and its litany of supposed evidence documenting a worldwide conspiracy to manipulate the gold price, led by the U.S. Federal Reserve.

In addition to supporting the idea of this conspiracy - mostly through selective, out-of-context quotations and questionable interpretations of supposedly "hard" statistical evidence - GATA promotes the idea that the existence of fractional reserve banking and the derivative market in gold is equivalent to a massive "naked short" used to depress the gold price. GATA consultant Adrian Douglas called these sales of "paper gold," as he refers to the market, as "a $5 trillion fraud."

This leads GATA to its mistaken conclusion that a run on the bullion bank is coming; that, should demand for physical delivery come from all investors who, according to GATA, are "long" gold, the price of gold will skyrocket, as there will be too little gold to feed the demand. Douglas, in particular, doubles down on this theory through his criticisms of "fractional reserve banking," which he called a "Ponzi scheme" during testimony in front of the Commodity and Futures Trading Commission in 2010. Douglas previously wrote that fractional reserve banking - in which bullion banks "hypothecate" bullion from its owners, lending it out for other uses - is "illegal activity," and added:

This unique wrinkle allows bullion bankers to sell gold that does not exist. This allows them to make huge profits, since they have very little cost, as they don't have the inconvenience of actually having to purchase the gold before they sell it.

Douglas appears to believe that the bullion banks can sell the same gold multiple times - again, the so-called "naked short" - without any corresponding liability. This, of course, is untrue. The bullion deposited in unallocated accounts may be lent out; but those loans are indeed recorded as liabilities on the balance sheet. The short is not naked and fractional reserve banking is not illegal. In fact, as the CPM Group's Jeffrey Christian has pointed out, fractional reserve banking IS banking and has been for centuries. A retail bank does not hold the sum of its cash deposits in an underground vault; it lends out a good portion of those deposits, earning interest on those loans and returning a portion to the original depositor. As Christian notes, the same principles apply to "allocated" and "unallocated" bullion accounts. If gold is a store of wealth - if, indeed, as many goldbugs argue, gold IS money - why should it not be treated as such?

It is true that, for those investors viewing gold as a store of wealth, or using the metal in its traditional role as a hedge against economic or political disaster, the counterparty risk created by fractional reserve lending might create enough disincentive to justify the extra cost of allocated storage or physical possession. Such a decision is hardly irrational and even critics of GATA have recommended such tactics. Indeed, for investors seeking gold in its oft-used role of protecting against financial calamity, relying on the banking system to hedge against the potential failure of the banking system seems irresponsible, even dangerous. But the existence of fractional reserve lending is not a Ponzi scheme; the existence of a derivatives market in gold not a trillion-dollar fraud made possible by the modern financial system; they are the modern financial system, for better or for worse.

GATA's misunderstandings continue in that derivatives market. Douglas has argued that gold derivatives are yet another tool used to manipulate gold prices downward. In one piece, he notes that "the increase in gold derivative notional value in Q1 is equivalent to 40 percent of all gold mined in the world during the quarter."

Who cares? Douglas' focus on notional value reveals a surprisingly ignorant and unsophisticated understanding of financial markets. Private investor Erik Townsend laid out a detailed rebuttal in 2010, but GATA's theory that derivative markets create massive selling pressure, in the end, misses one key point: there is a corresponding long position in each of the derivative contracts. The seemingly overwhelming notional value of gold derivatives is not evidence of price suppression, it is comprised of matched positions used by participants in the derivative markets, who are using their contracts for either hedging or speculation. Should, as GATA seems to propose, the market in gold derivatives be shut down, then, yes billions in gold "supply" would be withdrawn from the market. But so would equivalent billions of demand. Futures and options traders are not trading for physical delivery, in fact, as Townsend notes, most futures brokerages prohibit physical delivery. Trades are settled in cash - the intent of the overwhelming majority of investors and speculators in the so-called "paper gold" market is to bet on gold's direction (or protect their exposure to those moves), rather than to take physical possession.

GATA's misunderstanding of this concept is illustrated by their relentless hyping of Christian's now-infamous comment in front of the Commodity and Futures Trading Commission that "there is a hundred times" as much gold in the market as is actually produced. Douglas uses this information to support his argument that a massive default, and accompanying bank run, is coming, which will force the price of gold to skyrocket as investors realize they do not actually own the gold that is claimed. Douglas claims that Christian "confirm[ed] that the LBMA [London Bullion Market Association] trades more than 100 times the gold it has to back the trades."

Christian did no such thing. As Townsend points out, Christian was attempting to clear up the very misunderstanding that GATA is making [emphasis Townsend's]:

One of the things that the people who criticize the bullion banks and talk about this undue, uh, large positions, don't understand, is the nature of the large positions in the physical market. And we don't help it. The CFTC, when it did its most recent report on Silver, uh, used the term which we use in the market: "The Physical Market". And we use that term, as did the CFTC in that report, to talk about the OTC market: Forwards, OTC options, physical metal and everything else. And people will say - and you've heard it today: "There's not that much physical metal out there." There isn't! But in "The physical market" as the market uses that term, there's much more metal than that. There's a hundred times what there is.

In other words, what traders refer to as "the physical market" includes futures and options - derivatives. In his testimony, Christian previously noted - and attempted to clarify - the confusion created by the use of the term "physical" but Douglas misunderstands - at best - his point, using the statement to back up his contention that physical gold is sold on the LBMA at a ratio of 100:1, or worse. Quite clearly, neither Douglas nor GATA understand the difference between derivative contracts and physical sales; nor do they understand the massive difference in intent between traders in either market. Douglas has repeatedly written that settlement in cash is a "default," which will lead to his predicted run on the bullion banks. For derivative contracts, cash is not a default - it is usually the only possible settlement mechanism.

In short, GATA simply appears to have little or no understanding of the derivatives market, its functions, and its purpose. In fact, GATA would have its readers and supporters believe that the derivative market not only suppresses the gold price, but is designed solely for that purpose. Yet what of similar markets in oil, copper, wheat and dozens of other commodities? Is the market for oil futures another creation of a conspiratorial elite? According to GATA, yes; in April 2012, GATA Secretary/Treasurer Chris Powell quoted GATA consultant James Turk: "Any firm willing to go naked short can do so. They just call it 'financial derivatives.'" This theory, by extension, means that literally every asset class with a derivative market - from gold to soybeans to oil to publicly traded equities - is the victim of a multi-trillion dollar "naked short."

Jeffrey Christian - a frequent critic and target of GATA - rebutted this argument in a 2000 essay entitled "Bullion Banking Explained":

Producers in the petroleum, natural gas, copper, aluminum, nickel, corn, wheat, soybean, and numerous other commodity markets all sell forward. In some of these commodities markets the equivalent share of annual production sold forward is much larger than that in the gold and silver markets. Yet, in none of these markets do producers, analysts, and others suggest that someone loans physical supplies of these commodities to dealers, who sell it on a spot basis to cover their forward purchase commitments. No one pretends that the central banks of the world have untold oil stocks that they secretly lend to dealers, who sell this on the spot market to cover forward purchase commitments. Producers in these other markets do not accuse themselves of unduly depressing glutting the physical market with their forward sales.

Analysts do not include lines of "supply from hedging" in their tallies of annual new supply entering the market.Years ago, I made that point in response to a question after a speech. I ended my response with the rhetorical question: Why would a trading company, able to hedge its forward purchase commitments in all commodities with paper hedges, choose the expensive and cumbersome route of hedging its gold and silver forwards with physical sales, when it was clearly unnecessary?

In other words, the physical and derivative markets are separate, serving separate functions. The existence of gold derivatives do not presage a massive rise in the price of physical gold any more than the millions of shares of Intel (NASDAQ:INTC) currently covered by in-the-money options will lead to a huge gain in INTC at the next expiration date. Nor can those derivatives be used to directly expand the available for-sale supply of gold, any more than a massive purchase of out-of-the-money INTC puts entails what Turk called a "naked short" on INTC stock.

Douglas attempts to square this circle by claiming, "Gold is unique among all commodities. It is the only commodity that is not bought to be consumed. Rather, it is purchased as a store of wealth." This is true, in some sense, but not completely true; many tons of gold are consumed annually, for jewelry and for industrial uses. But more importantly, gold's role as a "store of wealth" does not mean it needs to be removed from the financial system, or that the traditional laws of supply and demand somehow do not apply. By Douglas' logic, gold's "uniqueness" means that it should never be sold forward; never be the basis for a derivative contract; and, apparently, never be traded except in a strict exchange for fiat currency; because, according to Douglas, all of those mechanisms - the same mechanisms used to trade every other asset class on the face of the Earth - are part of the global conspiracy to suppress gold prices.

They are not; they are part of the modern financial system, across asset classes. Skeptics can criticize that system and the lack of a gold standard, the seeming worthlessness of fiat currency, and the dangers of derivative trading in physical commodities, including gold. Certainly the events of the last five years, and the worldwide economic carnage wrought, gives those skeptics plenty of ammunition. But the faults in the current system do not, in and of themselves, prove the existence of a secretive worldwide cabal of bankers who have, according to GATA, executed a multi-decade, multi-trillion dollar conspiracy to rig the gold market.

The problem with Douglas' and GATA's argument is that gold is not different; it is not the victim of some massive back-room conspiracy; it, in fact, trades just like any other commodity. And therein lies the key problem with GATA's logic: gold is money, but should not be treated as such; except when it's a commodity, when it should also not be treated as such. And GATA uses its view of gold -- as a pure store of wealth that should not be bastardized or consumed in any way -- as a measuring stick for what it deems illegal behavior.

This is not to say that manipulation does not, or has not, occurred in the gold market. The current scandal involving alleged manipulation of the LIBOR rate is just one of many recent instances where larger players in various markets worldwide have used their muscle to put smaller investors at a noted disadvantage. But, it's worth pointing out that Barclays and its trading partners were caught. Bernie Madoff was caught. The Hunt Brothers were nearly bankrupted in their attempt to corner the silver market. And the London Gold Pool - a publicly announced cooperation between Western central banks in the 1960s to attempt to maintain the gold standard - collapsed in an epic failure.

To GATA's credit, they are incredibly diligent in their mission, and they have clearly put impressive effort into their search for evidence of the market manipulation they allege. Yet, after thirteen years of existence, their evidence remains weak, and their logic often circular. They have found no "smoking gun," and, despite their protestations, no "whistle-blowers," simply innuendo and interpretation, selective quotation and questionable statistical analysis to allege the existence of a conspiracy that literally dominates the world economy. This conspiracy is so powerful as to involve literally hundreds, if not thousands, of people acting in concert over decades, with nary a leak; but weak enough to let the object of its suppression nearly triple in just a few years. It is brilliant enough to concoct multi-national agreements such as the Washington Agreement to depress the price of gold; yet dumb enough to let bombshell statements about its existence slip in PowerPoint presentations and minor courtroom filings. And it is entrenched enough to manipulate a trillion-dollar market; yet too small to simply and directly fix prices without a multi-step process encompassing literally dozens of banks, governments, and regulatory agencies.

GATA's problem is its belief that, as Adrian Douglas wrote, "gold is unique." It's not; it is an item of value that trades in a market. That market is imperfect and occasionally irrational and likely, on occasion, influenced by actors using techniques of dubious morality - or even legality - to make a profit. So are all markets. Investors need to judge the risks in the market; analyze the various ways to enter the market; and make prudent decisions on the size, entry point, and duration of their positions, should they choose to play that market. But believing in a massive conspiracy, buying gold on the belief that its "true value" is double or triple its current trading price, save for the existence of evil-doers at central and commercial banks, is a recipe for financial disaster. Gold trades based on supply and demand, with the occasional imperfections created by the human actors in the process. Investors in the metal should trade based on those same principles.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. My household owns a small amount of physical gold in the form of jewelry, weighing substantially less than one troy ounce.