On the other hand, the rise in the ratio of open interest to eligible gold is unprecedented. It suggests to us that the idea that COMEX is an intermediary between physical and paper gold is more pretense than reality. The official description of the COMEX market’s raison d’être by CME group states, “Gold futures are hedging tools for commercial producers and users of gold.” There is no mention of high-frequency trading (HFT), which the CME has encouraged and by some estimates accounts for nearly two-thirds of COMEX activity. COMEX, which mirrors much larger-scale paper trading in London and OTC markets, appears to be an arena for speculation in the “idea” of gold, settled in cash, and completely divorced from physical gold. Speculators include macro hedge funds, commodity traders (CTAs), bullion banks (although to a much reduced extent since the failure of MF Global), and central banks.
Some (for example, Princeton Economics) argue that the decline in the price of oil will lead to forced divestment of gold holdings by sovereign wealth funds, estimated by The Wall Street Journal (12/23/15) to manage $7.2 trillion. Many of these funds are located in oil- or commodity-producing nations. However, the same article states, “many of the funds don’t disclose their size, holdings, or investment strategies, making it hard to gauge what risk, if any, they pose to the global financial system.” As to gold holdings, nobody can know for sure. However, based on our first-hand experience, admittedly anecdotal, the investment strategies of sovereign funds are conducted by managers oriented to the Western zeitgeist: They are designed to provide diversification away from commodities in the form of commonplace or exotic instruments that mimic “smart” hedge fund managers in the West. Lack of transparency notwithstanding, we believe that sovereign wealth funds hold very little physical gold.
Synthetic Gold: Mechanics And Plumbing
The volume of paper gold trading dwarfs flows of physical metal. According to the London Bullion Market Association (LBMA), the daily volume of notional metric tons (transfers) traded is 3248. This compares to world daily production of 7.5 t plus recycling supply of 3t for a world daily total of physical supply of 10.5 t. Based on LBMA statistics, the ratio of paper to physical gold traded is therefore 309:1. Even allowing for the fact that some paper trading, as on COMEX, is for normal commercial hedging purposes, the extraordinary discrepancy suggests to us that, as on COMEX, pure speculation, day trading, front running, and other forms of gaming exist on a very large scale.
Most, if not all, paper gold contracts are settled for cash. This explains how and why the disconnect between synthetic and physical gold can persist. It explains how the supply of paper gold can depress the price of physical gold despite the fact that synthetic sellers do not possess any gold to sell. Short sellers of gold do not borrow gold and then sell it. Therefore they do not need to deliver gold to buyers should their speculation on lower prices turn out to have been ill considered. Untethered (it would appear) from the laws of supply and demand, paper gold is a make-believe substance that trades according to rules written by HFTs, macro hedge funds, major banking institutions, and central banks. Of course, this works only so long as the buyers remain willing to settle in cash, rather than ask for actual gold.