On March 4, BlackRock, the sponsor of the gold ETF iShares Gold Trust (IAU), announced it had temporarily suspended issuance of new shares in the fund. The sponsor admitted it had failed to register the new shares with the SEC as exchange traded commodity funds are required to do. The snafu was due to an “administrative oversight,” it was later explained.
BlackRock was quick to add that IAU shares continued to trade without interruption in spite of the suspension. Nevertheless, the reality is that management lost administrative control over the fund and violated SEC regulations. As a consequence, BlackRock faces fines and penalties from both the SEC and state securities agencies, plus the possibility of lawsuits from shareholders for damages and interest.
Perhaps most alarming, the situation only came to light because the fund alerted the SEC—in other words, government regulators were unaware of the violation.
With watchdog agencies asleep at the wheel, the fund issued and sold $296 million of unregistered shares. This uber-blunder at IAU lays bare the fundamental hazard of using gold exchange traded funds: counterparty risks.
Bullion ETFs are convenient, provide exposure to one of the oldest investments, and the gold that backs the fund is inventoried, and the bar list shown on their websites.
But they come with a set of risks inherent in their structure and operation. And these risks will grow commensurately with systemic uncertainties.
Gold ETFs and bullion are very different investments. Physical gold is a tangible asset. Paper gold is a financial instrument. Your choice is to own the real thing, or a paper proxy.
As a financial product, ETFs carry counterparty risk. This means that you must rely on another party—known to you or not—to make good on the investment. With a gold ETF, you are dependent upon, among other things, management prowess, fund structure, chain of custody, operational integrity, regulatory oversight, and delivery protocols (which are available only to very large shareholders). If any of those break down, your investment is at risk.
The IAU management failure is a perfect example of counterparty risk. Further, it was off everyone’s radar (apparently even the company’s and regulators’). And that’s the problem: the frequency and severity of counterparty risks with gold ETFs are rising.
Consider the operation of the SPDR Gold Trust (GLD), the world’s largest gold ETF. This fund uses a custodian—without question the most crucial counterparty in a gold ETF—with a history of unethical behavior that many investors aren’t aware of.
HSBC is the custodian for GLD, which basically means that HSBC sources and stores the gold for the fund.
At first, a huge international bank like HSBC looks like a safe place to store gold. But Bernie Madoff was the “best” hedge fund manager in New York and MF Global was one of the primary dealers is US Treasury securities. The former was convicted of running the biggest Ponzi scheme in US history and the latter went bankrupt after illegally using client funds in a desperate attempt to remain solvent.
HSBC is teetering on disaster. Look at the behavior of Britain’s biggest bank and GLD’s custodian over the past two years:
It was fined $1.9 billion for money laundering and sanctions violations.
The US Department of Justice said the bank allowed drug traffickers to launder billions of dollars in the US and billions more to be moved across borders to countries facing sanctions, including terror-ridden Libya.
HSBC admitted to laundering $881 million for two drug cartels in Mexico and Colombia. It also accepted $15 billion in cash across the bank’s counters in Mexico, Russia, and other countries.
It has set aside $1.3 billion to settle claims that it manipulated foreign exchange rates.
HSBC faces charges that it used predatory lending practices in the mortgage market.
This is hardly the resumé of a bank that should be the custodian of the largest gold ETF. These concerns raise a couple red flags…
Will you get the best price when you buy GLD? Can we be sure the bank doesn’t “front run” its customers?
How safe are GLD’s holdings when the custodian bank has lost over $100 billion in market cap and its stock price is near the 2009 lows?
How adequate is the insurance backing those holdings?
Can we trust the custodian bank to safeguard the gold?
The level of risk this fund carries is unacceptable.
One primary reason to own gold is for it to be your last line of defense in economic or monetary crises. But since the banking system is also at risk during periods of stress, so are gold ETFs as they’re part of that very system. Why sabotage those protections by exposing your gold to an unprincipled and unstable bank?
Counterparty risk even applies to delivery…
Contrary to popular opinion, GLD does not buy and sell gold. It creates and redeems paper shares in the company. These are passed through a group of market makers who trade them on the NYSE. A corresponding amount of physical bullion is then deposited into or withdrawn from the fund’s vault in London operated by your friendly HSBC banker.
That means that you might own GLD shares, but you don’t own the metal.
Here are the requirements to take delivery of gold from your GLD shares…
You must own at least 100,000 shares. At the current share price, that’s about $12 million.
Delivery is 400-ounce bars only. You cannot opt for any other type of product or smaller weight.
The recipient must pay all settlement charges, delivery fees, and taxes.
The fund reserves the right to “settle in cash.” Even if you meet all the requirements for delivery, the fund can, for any reason it deems necessary, send you a check instead of bullion.
Other bullion-backed ETFs work similarly. Here’s the delivery requirements for IAU:
Must own 50,000 shares ($600,000 at current share price).
Make the request for redemption in writing.
Pay all fees, expenses, taxes, and charges (such as stamp taxes or stock transfer taxes or fees)
The custodian may make the gold available for collection at its office—or at the office of a sub-custodian if one is used to hold the gold. You have no right to receive delivery at a specified location.
Delivery is made in bars only.
Redemptions can be suspended if trading on the NYSE or COMEX is suspended or restricted, or one or both exchanges are closed for any reason; or if an emergency dictates that “delivery, disposal, or evaluation of gold is not reasonably practicable.”
Both GLD and IAU are obviously not structured for the average shareholder to take delivery of gold bullion.
Some smaller funds permit delivery of as little as one ounce, but it’s very expensive and delivery is not prompt.
Your risk? You decide you want gold bullion but can’t get any. Your only option is to sell the fund for cash. Either way, you don’t own any gold. Even an institutional investor faces the risk of being locked out of physical delivery at any time and for any number of reasons.
There are more effective and safer ways to buy and hold gold today. Unless you’re a short-term trader or want to use options, there’s no reason to own a gold ETF.
The path we’re on—one of chronic government missteps, interventions, and manipulations—has logical, even predictable outcomes. The negative impact on global economies, financial markets, and currencies will push more and more investors into gold. And that rush will increase the counterparty risk of gold ETFs.
Look, it’s easy to rationalize buying a gold ETF. But it is not rational to think that it offers a level of safety that a serious bullion investor should demand—because it doesn’t.
With the interest earned on cash hovering close to zero, the opportunity cost of holding gold has evaporated. That means it can be cheaper to own physical gold held in a private vault when compared to the fees for owning a gold ETF. Today, there is little reason to settle for a paper substitute when you can own the real thing.
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