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How the Paper Gold Market Influences Gold’s Price

An explanation of the crucial differences between real gold and financial derivatives often referred to as “paper gold.” Along the way, we solve one big mystery…

For Birch Gold Group

For centuries, gold has historically protected against purchasing power lost to inflation and added a crucial diversification element to savings.

Today’s investors are spoiled for choices when they want to buy gold… They get to choose from:

  1. Physical gold bullion bars and coins
  2. Exchange-traded funds (ETFs) based on gold
  3. Exchange-traded notes (ETNs), a kind of debt security based on gold’s price
  4. Gold futures on commodities exchanges (like COMEX)

Of these three choices, the first – physical ownership of tangible gold – is by far the least convenient. Any financial advisor will tell you that!

ETFs and financial derivatives are so much easier to transact. Just log on to your brokerage website (or open Robinhood on your phone), click a few buttons, and boom – you’ve got gold*.

*The truth is, actually, you don’t.

Here at Birch Gold, we sell tangible precious metals. I speak to many people every day who don’t understand the difference between, say, a 1 oz American gold eagle and 10 shares of State Street’s SPDR Gold Shares (GLD) ETF.

They cost about the same. Their value tracks the spot price of gold. Why is one better than the other?

I’ve worked in this industry for a long time, and here’s what I’ve learned about the difference between physical gold you can hold in your hand and “paper gold” like ETF shares and futures.

How gold price works

Like nearly everything else, gold price is based on price discovery in the open market. In other words, it’s an auction between buyers and sellers, people who have gold and people who want gold. “Spot price” is a snapshot of the current trading price at which sellers are willing to sell and buyers are willing to buy.

Both buyers and sellers are dependent on the supply of gold in the market.

So far, there’s nothing new here – this is just how markets work.

Here’s where it gets interesting…

Where paper gold comes from

Most paper gold works like this (a simplified explanation, but fundamentally correct):

  1. A company puts, say, 100 oz of gold in a vault.
  2. They announce, “Hey we’re selling 100 oz. worth of paper gold.”
  3. They sell shares in exchange for dollars.

Now, the important part here is there’s no reason to look in the vault! So long as traders are willing to buy and sell the shares, and the per-share price stays in the neighborhood of the spot price of gold, what’s actually in the vault is irrelevant.

Traders who buy paper gold pay, say, $100 for a share. If the price of gold rises 10% and they sell, they get $110 – they do not get $110 worth of goldThis is important! The vast majority of ETFs and other paper gold funds don’t let traders claim physical gold. Instead, they accept and dispense dollars.

So it’s pretty clear that paper gold is a bet on gold’s price – in fact, Matthew DiLallo at Motley Fool puts this very well:

Gold ETFs allow investors to speculate on gold prices without buying physical gold.

Now, some people think that’s good enough. A lot of people (including central banks, hedge funds, billionaires and Birch Gold customers) want tangible, physical gold they can hold.

But that doesn’t change the “paper gold effect” on spot price…

How paper gold influences gold’s price

Modern financial markets aren’t exactly engineered to facilitate the movement of tangible goods from one place to another. Think about it: when’s the last time you saw a stock certificate? A paper bond (complete with coupons to clip and cash in)?

You can buy a share of paper gold on your smartphone. When you do, no gold moves anywhere. Instead of owning physical gold, what you own is a claim on whatever is in the paper gold company’s vault.

Since the financial market pretty much treats physical and paper gold as if they’re the same thing, demand for paper gold can drive up the price of physical gold (and vice versa). And, since we’ve all seen financial assets trade far beyond their fundamental value, there’s nothing at all tying the price of paper gold shares to the value of gold in the issuer’s vault.

So what’s the difference?

Paper gold is subject to the same volatility, speculation, and manipulation as any other financial product. Traders can “short” paper gold in an attempt to drive its price down, or borrow funds on margin in an attempt to drive prices up. Like other shares, paper gold is subject to both liquidity risk and counterparty risk as well.

Physical gold, however, is subject to none of that. 

During times of intense demand, it’s not at all uncommon to see a strong divergence from the prices of paper and physical gold. For example, back in September, Reuters reported on extreme premiums over spot price for physical metal in India and Shanghai (up to 5x historical premiums in India recently; Bulmint has an excellent discussion on this topic).

When these premiums over spot rise, they represent how insistent buyers are on holding gold in their hands. In times of crisis, well, the supply of physical precious metals is constrained in ways that paper gold shares just aren’t. A big increase in premiums for physical metals indicates massive demand – during the pandemic panic, we saw premiums over spot price for physical gold increase by 700%.

Is owning physical gold worth it?

This is a question each of us must answer for ourselves.

Here’s what I think…

You can’t manipulate the value of a gold bar. You can’t sell it for more than its true value. You can’t speculate on its future price. The only thing you can do is buy it, store it, and sell it.

When you own physical gold, you’re insulated from much of the volatility of the financial markets and protected from the whims of speculators, traders, and manipulators.

Physical gold ownership is the only way to own gold that’s truly free from the financial markets and all their associated risks. Owning real gold is not a get-rich-quick scheme, and it’s not for active traders or people who look at their net worth multiple times a day.

It’s definitely not for everyone! Only for those who take comfort in knowing their savings are insulated from inflation and market volatility for the long haul.

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