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This past Thursday trading began on the NYSE
for what is being called a 'gold ETF'. Here's how CBSMarketWatch
described it just before the launch: "The first exchange-traded
fund investing in gold bullion
will begin trading on the New York Stock Exchange on Thursday,
said sources familiar with the situation. Called StreetTracks
Gold Shares, the ETF will trade under the symbol 'GLD' with
the World Gold Council as the sponsor." After the
launch Reuters reported: "The ETF…offers investors
the ability to access the gold bullion market,
with each share representing one-tenth of an ounce of gold."
[Emphasis added]
From these and other news reports it would appear that anyone
buying this new ETF is buying gold bullion. But a different
picture emerges from a careful reading of GLD's prospectus
and accompanying advertising material.
By way of background, I have been following very closely
the development of the gold ETF because I wanted to see if
it would have a high level of governance over its bullion
assets that was comparable to what my colleagues and I have
achieved in GoldMoney. A product launched by the World Gold
Council could have some competitive impact. Additionally,
GoldMoney is exploring the possibility of creating its own
ETF using goldgrams as the underlying asset.
Last year after analyzing the WGC's proposed
ETF, I concluded that its custodial controls were inadequate.
In December 2003 I wrote: "The risks of the WGC's
funds appear too great. Until more questions are answered
and/or the fund's structure is changed to eliminate its loose
custodial controls, I do not recommend that these funds be
purchased." To understand this conclusion, I recommend
reading that article in full. See: http://www.321gold.com/editorials/turk/turk120903.html
Shortly after my article appeared, representatives of the
WGC contacted me and threatened me with a lawsuit, unless
I retracted the article. Needless to say, I was shocked, because
I knew my work to be accurate, based as it was on publicly
available information (i.e., the draft prospectus of the proposed
US fund and the actual prospectus for similar funds in London
and Australia). Also, it was clear from my article that I
was focusing upon the importance of owning physical gold bullion,
rather than just paper promises to deliver gold. Given that
the stated mission of the WGC is to encourage ownership of
physical gold bullion and to educate consumers about gold,
why were they menacing me? But the threat of litigation does
cause one to focus their mind, so I hired a top NYC attorney
specializing in SEC law, just in case the WGC followed through
on its threats.
Fortunately, they didn't. I assume that the WGC in the end
recognized my work to be accurate, and that they didn't have
a case. My attorney came to the same conclusion. What's more,
he advised that the WGC was interfering with the work of an
analyst, which is something the SEC seriously frowns upon.
Remember the hot water Donald Trump got into when he intervened
to have a brokerage firm analyst fired after writing a negative
story on Trump's casinos?
Anyway, because of discussions with my attorney and some
additional study, I learned a lot about SEC procedures. And
one of the foremost requirements established by the SEC is
that mutual funds must have absolute control over their assets.
In other words, this requirement exists to make sure that
retail investors purchasing shares in a mutual fund are in
effect buying the assets the fund is supposed to own, and
not just some promise to deliver those assets. I understand
that this safeguard is required because of past instances
in which certain funds never really owned the assets they
purported to own, and collapsed with losses to the fund's
shareholders. Thus, by enforcing this requirement, the SEC
is doing its job of protecting the 'little guy'. The conclusion
of my December 2003 article was that the WGC's proposed ETF
did not meet this requirement, which I took to be the reason
the SEC had not registered at that time the WGC's proposed
fund despite the many months it had been under review.
Given GLD's recent launch, I was therefore interested to
learn from its prospectus how GLD had been changed to provide
the necessary assurances of integrity that the fund's gold
bullion assets really exist. More specifically, I was interested
to learn how the WGC had improved the custodial controls so
that GLD met the same standard that the SEC applies to other
mutual funds. The answer came quickly. It didn't.
Even before starting the prospectus, I downloaded
the 2-page fact sheet from http://www.streettracksgoldshares.com,
and there on the first line was an eye-opener laying out the
essential nature of GLD: "Objective: Designed to track
the price of gold".
Its objective is not to provide investors with
the opportunity to own gold bullion by investing in the shares
of an ETF. Rather, GLD is designed to track the price of
gold. That objective is no different than what is accomplished
by a gold futures contract or any of the dozens of numerous
gold derivatives available these days. More to the point,
futures and derivatives are sold even if the seller does not
own the underlying gold bullion needed to deliver on its obligation.
They are in practice fractional reserve systems, which allow
liabilities for gold to far exceed the quantity of gold owned
by the seller of that liability.
Notwithstanding the numerous news accounts that described
GLD as a means of investing in gold bullion, GLD cannot be
accused of false advertising. Based just on their 2-page fact
sheet, the WGC has by its own description created a security
which has been designed to bet on the price of gold, not to
enable investors to own physical gold bullion. My subsequent
reading of the prospectus confirmed this conclusion because
on the face of it, the weaknesses I identified in my December
2003 article have not been corrected. GLD has the same loose
custodial controls described in the early draft prospectus.
To explain this point, the London bullion market operates
on a 'trust-me' basis. Rather than move gold bars around when
they are bought and sold - which is a costly process - the
various participants accept the word of their counter-party
that the bar they just bought really exists, and that it is
safely stored in the counterparty's vault or the vault of
another market participant.
Thus, for example, when GLD adds a gold bar,
there is no assurance that the gold bar really exists unless
it is in the vault of the custodian, HSBC. But the prospectus
discloses that HSBC uses subcustodians and even sub-subcustodians,
and what's worse, "the Custodian is not liable for the
acts or omissions of its subcustodians". In other words,
if the subcustodian does not have the gold, GLD "Shareholders
cannot be assured that the Trustee will be able to recover
damages from subcustodians...for any losses relating to the
safekeeping of gold by such subcustodian". This means
that "Because neither the Trustee nor the Custodian oversees
or monitors the activities of subcustodians who may hold the
Trust's gold, failure by the subcustodians to exercise due
care in the safekeeping of the Trust's gold could result in
a loss to the Trust." To be blunt, these disclosures
mean that there is no certainty that the gold supposedly owned
by GLD really exists. After all, if there was complete certainty
that the gold did exist, the objective of GLD would be to
provide investors with the opportunity to own gold bullion
by investing in shares of an ETF, rather than its stated objective
to just track the price of gold.
To explain this gold storage risk in greater detail, it is
necessary to describe how the London bullion market functions.
There are several vaults in London used by the various market
participants, but I want to draw attention to only one - the
vault owned and operated by the Bank of England. The BoE plays
a central role in the operation of the London bullion market,
as its vault is actively used as a clearing agent. In other
words, the various bullion banks keep storage accounts with
the BoE, and here's an example of how the clearing process
works.
Say, Morgan Bank buys a gold bar from HSBC. Rather than incurring
the cost of shipping the bar from HSBC's vault to Morgan's,
HSBC says that Morgan can have one of HSBC's bars held on
account with the BoE. The BoE makes a bookkeeping entry ('clearing'
HSBC's obligation to Morgan), while enabling HSBC and Morgan
to save the expense of shipping the bar between different
vaults. Morgan now owns the gold bar in the BoE vault that
was previously owned by HSBC. The BoE is reputed to store
more gold than any other participant in the London bullion
market, and here is where the problem arises.
The BoE does not allow the gold in its vault to be audited.
In fact, there is no way of substantiating that the gold stored
there is not owned by multiple parties, or for that matter,
that the gold supposedly stored there even exists. Like the
gold reportedly stored in Ft Knox, there is no verification
of its existence by independent (i.e., non-government) auditors.
This reality is surprisingly not acknowledged
by the GLD prospectus, which states: "The Trust's
independent auditors may…visit the Custodian's premises
in connection with their audit of the financial statements
of the Trust." In what appears to be a glaring omission,
the prospectus fails to disclose the important risk that the
independent auditors will not visit the vaults of the subcustodians
and sub-subcustodians, and more to the point, that the BoE
does not allow auditors into its vault, even though the prospectus
allows for the possibility that all of the fund's gold may
be stored in the BoE.
Hence, by accepting the loose custodial controls of GLD,
the SEC has thrown caution to the wind. It has inexplicably
accepted for registration a fund that does not meet the same
custodial standards required of other retail-oriented mutual
funds. The question is why? For what reason has the SEC established
this dangerous precedent with these nebulous custodial arrangements
that could be exploited in GLD or in the future by unscrupulous
operators who mimic the custodial structure, but have no intention
of delivering the underlying assets to the fund? And after
sitting on the WGC's filing for 18 months, why was GLD finally
registered and launched this week?
Readers who are familiar with www.GATA.org
and its research will no doubt recognize the subtle coincidence
of surprising occurrences. For those not familiar with its
work, GATA is an informal association of analysts (I am a
card-carrying GATA member and proud of it) who contend that
the gold price is being managed by central banks. For several
years GATA's analysts have been providing ongoing evidence
to support this conclusion.
For example, in an article published last week,
John Brimelow <JB@johnbrimelow.com>
states: "It was interesting to find in Paul Volker's
memoirs the following comments about the aftermath of the
successful American effort in 1973 to force a 10% currency
revaluation on Europe and a 20% revaluation on Japan: 'The
key was the yen currency of Japan, which had an enormous trade
surplus. Appreciating the yen 10% against gold, and devaluing
the dollar 10% against gold would mean that the yen would
have appreciated by 20% against the dollar. European currencies
would remain stable against gold and appreciate 10% against
the dollar. On the condition that Japan agreed to revalue
the yen, the European countries agreed to the realignment
of exchange rates and the U.S. announced that the dollar would
be devalued by 10%. By switching the yen to a floating exchange
rate, the Japanese currency appreciated, and a sufficient
realignment in exchange rates was realized. Joint intervention
in gold sales to prevent a steep rise in the price of gold,
however, was not undertaken. That was a mistake. Through March,
the price of gold rose rapidly, and that knocked the psychological
props out from under the dollar.' One can infer that the mistake
of allowing gold an unrestrained voice at times of policy
shifts was subsequently guarded against." In other words,
the gold price is being thwarted by active central bank intervention,
so that central banks do not repeat the 1973 experience described
by Mr. Volcker - or more broadly, today as in 1973, gold and
the dollar are competitors, and gold is being managed to make
the dollar look better than it really is.
Therefore, is it just coincidence that British exchequer
Gordon Brown was recently trotted out again as the gold price
was climbing to raise that old canard about the IMF selling
some gold? When his statement had no effect and the gold price
continued to rise, it was clear that gold's price managers
needed stronger medicine.
So on Friday the Banque de France said it would dishoard
500 tonnes of gold over the next five years, a conspicuously
timed announcement given the quiet accompanying the 2nd Washington
Agreement on Gold after the IMF meeting in early October.
As John Brimelow astutely remarked: "Experienced observers
of the gold market will have been amused to see the French
gold sale announcement, sustaining the long tradition of this
type of thing happening during interesting phases of gold
price activity." But in contrast to past anti-gold announcements
by central banks, recent jawboning has had little visible
effect in talking down the gold price, which continues to
rise.
Thus, jawboning by central banks is no longer
enough. And given the ongoing decline in hedging by gold miners,
the central banks need new tools in their attempts to suppress
the gold price. One of these tools is apparently now being
delivered by GLD. Because of its loose custodial controls
and the opaque cloak thrown over vaulting at the Bank of England,
GLD can deflect demand for physical gold into the paper market.
Mineweb.com neatly explained this outcome in a recent article,
the title of which makes clear the essential nature of a new
security launched in South Africa with WGC support, "Paper
gold for Johannesburg". http://www.mineweb.net/sections/gold_silver/385325.htm
People who might have otherwise bought physical gold coins
or bars, but wanted the same thing with more convenience,
could be misled into thinking that they are buying physical
gold by investing in the shares of GLD. But given GLD's loose
custodial controls, there is no certainty that the investor
is actually buying gold bullion in the form of an exchange-traded
security. They may instead only be buying paper (i.e., a promise
to deliver physical metal, rather than the metal itself) because
there is no possibility by independent auditing or other means
to substantiate that the gold supposedly owned by GLD and
stored in the BoE and other vaults (other than HSBC's vault)
really exists. This mechanism thus provides the central banks
managing gold's price with a tool to divert into paper promises
the money coming from investors who otherwise think they are
buying physical metal, thereby enabling these central banks
to relieve the upward pressure we have been seeing on the
gold price. Therefore, if you are intending to buy physical
gold bullion, do not buy GLD.
I would like to thank the many members of the GATA army who
supplied information and ideas for this article, particularly
Ron Lutka. But I would like to call on the army for another
task. A lot of important questions need to be answered.
We need to find out why the SEC registered GLD. What's more,
why did it happen just as gold's price managers are starting
to lose control of the gold market and need new tools to bolster
their efforts to keep a lid on the gold price?
The SEC has broken with precedent. Like the bucket-shops
of the 1920's that allowed investors to bet on price changes
without owning the underlying security, GLD enables investors
to bet on the price of gold, without GLD being required to
meet the same custodial standards required of other retail-oriented
mutual funds. Why? Did central banks force the SEC to register
the WGC's fund? Did the SEC cave-in under central bank pressure,
even though GLD's loose custodial controls conflict with longstanding
SEC requirements and establish a dangerous precedent? Why
did the SEC register GLD in a week when anti-gold jawboning
by central banks wasn't working, making clear they need new
tools to keep a lid on the gold price? And why doesn't the
prospectus disclose the big risk that there are serious restrictions
on auditing the gold supposedly owned by the fund?
The SEC needs to be called 'on the carpet'. And I call on
the GATA army to do it.
In conclusion, as gold climbs higher, the nefarious scheme
to manage its price comes closer to collapsing. When it does,
many ill-fated and uninformed investors will come to understand
that the promises they hold to deliver gold to them aren't
worth the paper they are printed on. Don't fall for that trap.
Don't take risks with your bedrock asset - gold. Demand physical
bullion. Don't take paper.
***
Copyright©
2004 by The Freemarket Gold & Money Report. All rights reserved
James Turk is the editor of Freemarket
Gold & Money Report
and the founder of GoldMoney
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