Paper Gold: Scams, Markets, and Reality

Gold futures, ETFs, and options are traded in enormous volumes that often dwarf the actual physical gold supply. These offer liquidity and allow investors to gain “exposure” to gold without taking possession of the metal…but do these financial products actually provide “exposure” to gold at all? Paper gold introduces distortions and opportunities for dishonesty that don’t exist with the real thing.

The notional value of gold futures traded on the Chicago Mercantile Exchange (CME) is often in the hundreds of billions of dollars, while the total amount of gold ever mined is around 200,000 metric tons. Gold ETFs, which hold physical gold in trust and issue shares that represent fractional ownership of that gold, have become another popular avenue for gold exposure. The most widely known, SPDR Gold Shares (GLD), tracks the price of gold and has billions in assets under management. Similarly, gold options give investors the right to buy or sell gold at a predetermined price within a specified timeframe.

While these instruments provide unparalleled “access to gold” for retail and institutional investors, they also introduce abstraction from the gold market in potentially perverse ways. The derivatives market has large amounts of “paper gold” being traded that may not correlate directly with the amount of physical gold available. Paper gold products also introduce leverage. This is a far cry from owning the real thing, and provides financial institutions many opportunities to defraud the market in ways that physical gold wouldn’t allow. 

Notice last week’s slam-down in silver to get below the popular moving averages used by hedge funds, followed by the inside money getting long. This is the same play book that has been used forever and that JP Morgan has paid almost $1-billion in fines for gold/silver spoofing… pic.twitter.com/8Q3Y5eg83u

— Presley Reeves (@PresNav) December 14, 2023

Enter JP Morgan. JPMorgan Chase was implicated in a scheme to manipulate the gold and silver futures markets. The scandal involved a practice known as “spoofing,” where traders would place large orders for gold contracts with the intention of canceling them before execution, creating the illusion of market interest and pushing prices in a favorable direction. This practice disrupted the price discovery process and allowed traders to profit by stealing from investors in the paper gold market. 

In 2020, after years of legal proceedings, JPMorgan agreed to pay $920 million in fines for its role in the scheme, marking one of the largest settlements ever reached in a commodities market manipulation case. The head of JPMorgan’s precious metals trading division, along with an underling, got a year or two in prison and had to pay a small fine amounting to much less than their multimillion-dollar salaries.

It’s exactly what you would expect from a company that conspires with other big banks to steal basically 24/7 though market manipulations ranging from single-market spoofing scams to epic, mass-scale interest rate fixing schemes that rob from millions of people at once, affecting the prices of goods all across the planet. Far from being a case of a few bad apples, banks like JPMorgan are systemically criminal institutions, and the temptation of paper gold fraud is too tempting for any white-collar bandit to resist.

Meanwhile, their bankster executives are appointed to positions at the Federal Reserve Bank’s Board of Governors, where they get to help set official interest rates and monetary policy as well. Imagine running a company involved in all kinds of interest rate fixing and spoofing frauds while you simultaneously are one of the people who gets to help decide what interest rates should be for the entire United States of America.

Then there’s Deutsche Bank, which reached a polite settlement to resolve allegations that its traders used fake orders to manipulate gold and silver futures markets over several years. Whether it’s gold, silver, mortgage-backed securities, or something else, all the biggest banks have adopted fraud as a key component of their business model. They know that they’ll get a slap on the wrist if they’re caught — and a taxpayer-funded bailout when they fail on a larger scale.

Citigroup has been fined many times for spoofing scams across multiple markets, including paper gold. Citigroup’s traders used the gold futures market to manipulate prices and harvest profit from legions of suckers, placing deceptive orders to create false market signals and gaining from the price movements that it engineered. 

These banks then get praised by bodies like the CTFC for “cooperating” so eagerly, and release creepy, nudge-nudge wink-wink public statements like this one released by Citi after paying a fine for spoofing Treasury futures markets:

“We are pleased to have resolved this matter.”

Gold is insurance against the ill-effects of several kinds of bank fraud, but only if you can hold it in your hand. In theory, the price of gold should be determined by the supply and demand for the physical metal, factoring in mining production, recycling, central bank purchases, other institutional buyers, and demand from jewelry makers, tech industries, and retail investors. 

However, the day-to-day machinery of the paper gold market distorts price discovery mechanisms. The massive volume of paper gold trades means that because markets like gold futures are so large, it can move gold prices even if little or no physical gold is changing hands. 

Gold/USD, 1-Year

Large institutional investors or traders can sell massive amounts of gold futures contracts without any intention of taking delivery of physical gold. Speculative activity in the futures market can easily overshadow the physical market as products like gold ETFs create an additional layer of demand that doesn’t necessarily correspond to the amount of physical gold being mined, refined, and sold. Paper gold is for speculation, physical gold is for investing, and protecting your purchasing power in the long-term. 

In 2020 during COVID-19, the price of gold surged to record highs. Physical gold coins and bars became harder to obtain, with delivery times stretching for weeks or even months. Meanwhile, the price of gold futures and ETFs was still able to trade at near-record levels, creating a huge divergence from the price of paper and physical gold—that is, a divergence from reality caused by distortions in the market.

During periods of market dislocation, paper gold prices can decouple from physical gold prices, leading to a situation where investors can be left holding paper contracts that don’t guarantee delivery of real metal. This decoupling poses a risk for investors who might assume they are buying gold exposure but are instead acquiring a claim on gold that isn’t matched by reality. Counterparty risk means that you’re reliant on intermediaries like exchanges, banks, and custodians to ensure that the gold they are buying or selling is backed by physical metal. During times of market turmoil, there’s always the possibility that these intermediaries might not be able to deliver on their promises. 

This was highlighted during the 2008 financial crisis when numerous financial institutions faced liquidity problems, raising concerns about whether futures markets like the CME are able to follow through on redemption promises if investors all show up at once looking to receive delivery of the physical metal. Looking at physical delivery from futures contracts is crucial to understanding the overall state of the market.

Paper financial instruments have their place, but they provide ways for commodities markets to detach, for some period of time, from physical reality. So if you’re overexposed to paper gold without any physical bullion in your possession, you don’t have the “stack” you think you do.