Four traps for prospective gold investors A free report for gold researchers from www.galmarley.com Trap 1 - Keeping it safe Editor's note : Although what follows is considered controversial we ask readers to understand the intention is to honestly inform people who are trying to learn about gold. In particular we invite response from practitioners in the gold industry. We will gladly correct any errors we have made, and also publish any well written and fair reply to what follows. Page Contents • Gold and Custody Law • Property and Liability • The Gold Account • Allocated Gold • Unallocated Gold • How do banks manage allocated and unallocated gold? • The success of unallocated gold • The effect of the custody issue on the 'spot' gold market • The likely consequence of unallocated gold • What to look for in an allocated storage agreement • The downside of unallocated • The safe deposit box • The importance of offshore custody Gold and Custody Law The majority of investors who buy gold do so in the belief that it is "the one asset which is no-one else's liability". But there is a nasty legal subtlety which causes many of them hold it in such a way as to achieve the exact opposite, and they expose themselves to a hidden risk which may in many cases be exactly the risk they were trying to avoid. Property and Liability Money can't easily belong to a saver and his bank at the same time, so in well established law money deposited in a bank becomes the bank's property and its liability. Simultaneously it stops being the saver's property and becomes his asset, so if a bank fails the saver must stand in line with the other creditors and maybe accept a few cents on the dollar (although governments in many countries offer depositor protection, which might reduce the loss). But there is a different way to put money in the bank such that it remains the private property of the saver. Western law generally recognises the fundamental difference between a deposit in a bank (banking law) and a safekeeping relationship (custody law). With a custody arrangement the saver expects safety, and no other benefit, such as the free payment services associated with current accounts, or interest associated with deposit accounts. Instead the bank is paid a fee for looking after the property, and may not put it to its own use. The technical legal difference is that when you open a current or deposit account you transfer your property to the bank and expect them to utilise your property for your benefit. Under a custody arrangement private property is not transferred to the working capital of the bank, and may not be used by the bank. It is there only to be kept safe, and it will be returned in its entirety to the owner, even if the bank fails. Even cash can be placed in a bank so as not to become that bank's liability (for example in a safe deposit box). So in fact it is not the form of the money handed to the bank that defines whether or not it is the bank's liability but the terms under which it was placed there. Anything tangible - bank notes, diamonds, teddy bears - can be put in a bank vault or a deposit box in a way which avoids it becoming the bank's liability, and this is exactly the same for gold. The Gold Account But the flip side is that depositing gold into an account is legally like depositing money into an account. It stops being private property and becomes the bank's liability and the investor's asset. It is important that gold investors fully understand the consequences as there is a critical difference in how they are treated as account holders if the future becomes difficult - as many gold investors expect it to. The two types of treatment - custody and account - have very similar sounding names in the gold industry. They are called 'allocated' and 'unallocated' storage. Allocated gold Allocated gold is gold deposited under a safekeeping or custody arrangement. It is held as numbered bars, on labelled shelves, and it is the property of the individual owner. Even though it is held in a vault it is neither the property of the bank nor the liability of the bank. As such it is safe from bank insolvency. Investors have to pay for the storage of allocated gold. Arranging for the physical security of bullion bars requires strong vaults, wise use of technology, carefully constructed systems for security, and the monitoring and control of human factors. There is no point in arranging for all of this and then not charging for it, and all institutions which offer allocated storage must charge. In fact the charge is an important part of establishing the custodial nature of the relationship. The courts accept that payment of a fee to the custodian is powerful evidence that the relationship is a custodial one, and not a deposit into an account. Fortunately gold is a remarkably compact store of value. A tonne of gold bullion is worth about $14.5m (November 2004) yet needs only a 14 inch block of space for storage. For this reason allocated storage is not very expensive compared to - for example - typical investment management fees. It can be found for as little is 0.1% per annum for volume buyers. You should note that with allocated gold cover against theft is important. The gold is the owners property and is not the legal liability of the bank. Instead the bank has a duty of care over the security of the gold, but if it were the victim of a supremely well organised theft which it would not have been reasonable to defend the investor from then the loss is a loss of the owner's property, and the bank is not technically liable. Therefore your allocated gold needs to be specifically covered against theft. Fortunately theft of bullion from vaults is extremely rare. The result is that cover against theft is exceptionally low cost, and is usually included in the storage charge - which is a vote of confidence in the security of the vault. Unallocated gold Unallocated gold (frequently held in accounts referred to as "pool", or "metal" accounts) is simply the provider's liability. It forms part of the working capital of the bank and it can be legally used by the bank for profit. The gold investor is therefore exposed to the insolvency of the bank. But not being a depositor of currency the saver is not ordinarily subject to any degree of depositor protection. This means the 'owner' of unallocated gold in a gold account is more dependent on the financial system's robustness than even the straightforward depositor of cash, a situation which for many gold buyers would be considered upside-down. Unallocated gold is always likely to be put to use by the bank in one way or another. Although it is sometimes believed that there is a non-specific pile of gold somewhere in the bank which the customer has a share of this is not reliably true. There need be no physical pile - pooled or otherwise. And even if there is a pile of gold it is legally the bank's property, not the account holders, and would be sold for the benefit of all classes of creditor (not just the gold holders) in the event of bank insolvency. So unallocated gold's free 'storage' is a bit of a misnomer because it is quite likely that there will not be anything tangible to store. This should not be surprising, after all banks do not store the money in our bank accounts; they put it to use. With gold accounts they are just doing the same with your bullion, and the bank makes more money out of unallocated gold accounts than out of allocated storage, just as it makes more out of its current accounts than out of safety deposit boxes. This is why unallocated gold is more aggressively marketed, and being generally free for 'storage', is more popular than allocated. How do banks manage allocated and unallocated gold ? Relatively few banks make allocated gold available. The reason is that nowadays banks operate the wrong kind of business to be willing and reliable custodians of gold bullion. Modern banks make their money by providing credit and by executing transactions. They operate in a world of exceptional competition where they cannot afford to allow their working capital not to be put to profitable use. Unfortunately this means there is hardly any enthusiasm for a low margin role as physical custodians of a lump of gold. But many of them will - nevertheless - be pleased to provide customers with 'unallocated' gold. An unallocated gold holding will entitle you to physical gold if you ever ask for it, while in the meantime it will remain as a liability to you on the bank's balance sheet. You can expect your bank to charge you with fabrication and custody charges should you ever demand your gold entitlement in physical form. This is because your bank too has to pay to get the physical gold delivered to itself. But if you don't require physical gold it continues to exist only as a promise, and there are many efficient ways your purchase of unallocated gold can be managed by your bank. One of the simplest is for the bank to buy a gold futures contract to balance its position, and remove its exposure to a rising price. A future is only a contractual promise where the payment and delivery of the traded goods has been postponed. In that respect it is very like unallocated gold. But not quite, because your bank will probably not be allowed to trust your promise to pay, so you will have paid for gold without receiving it. Banks - on the other hand - are allowed to trust each other to keep their promises. So your bank doesn't yet have to pay for future gold which it has agreed to buy on your behalf but not yet take delivery of. As a result the real money they receive from you, the customer, can be put to good use financing things which the bank considers make a better return on capital than storing bullion. In this way your bank could enjoy (i) a balanced gold position, (ii) an apparently very small risk that the futures clearer might fail, (iii) a big saving on the costs of maintaining and operating a secure vault, and (iv) all your money to be lent elsewhere for profit. It can even say - in all honesty - that it doesn't lend your unallocated gold, which is true up to a point. Futures are not the only gold credit device bankers can use. Options, swaps, loans and leases are alternative mechanisms which can remove the price risk to the bank of your unallocated gold position. All ultimately depend on your first extension of credit to the bank, and each puts the bank in an extremely attractive position : having your money at no cost to the bank, so long as all the various credit risk monitoring systems in the financial world continue to operate smoothly. The success of Unallocated Gold It should now be clear why most banks offer and successfully encourage gold buying customers to remain permanently unallocated and not opt for delivery. Customers save money, banks save money, and it all works so long as the banks are safe, which they honestly regard themselves as being. This permanently 'unallocated' system has been so successful that daily 500,000 ounces of gold are traded inter-bank in London on an exclusively unallocated basis. Most of the banks involved no longer offer any convenient route to physical gold storage and have almost completely withdrawn from gold vaulting. So this highly liquid professional gold market now operates on credit, i.e. on the belief that exists between banks that each is good for the promises it makes - and of course they usually are. The effect of the custody issue on the 'Spot' gold market The success of unallocated has undermined allocated gold. When you buy aluminium, or corn, or foreign currency on their respective spot markets the seller undertakes to make delivery within a few days, and you will go to an agreed location and get what you have bought in return for your payment. You will not have that privilege with your spot gold purchase on the world's spot gold markets. When you turn up with your bank draft you will receive nothing. This is because spot market gold is now by convention 'unallocated'. This really is quite neat. Banks realised that with gold many new buyers really just wanted to put it straight back, safely in the bank. So they can save the cost of delivery and security for themselves and their customers if they can get the customers to put it back in the bank in the form of a deposit (unallocated), rather than under a custody agreement (allocated). The result is that the cheapest gold to trade is unallocated, and this has made it the most popular. The popularity of unallocated has caused it to become the de-facto standard for gold. Now the internationally quoted 'spot' price for gold is on an unallocated basis, and investors need to pay extra for delivery. With almost any other commodity they would not tolerate a surcharge for taking delivery of what they have already agreed to buy. But that's just how gold works. The spot price you see quoted all over the world is the price exclusive of delivery in physical form. The long term consequence of an unallocated gold agreement The long term consequence of the probable physical non-existence of unallocated gold is hard to believe for those who are unfamiliar with finance. People who put money in bank accounts occasionally find out a few years later that it isn't there any more. As unfortunate victims they find it very hard to accept that the loss of their money - by the bank - is treated in law as their own commercial error for investing in a bank account. It is easy to understand why they protest so loudly that a bank has taken their money, but it doesn't make it any easier to pay anything back after the money has been lost. That is a conceivable prospect for the unallocated gold depositor. It is why there is a strong case for storing gold in a good vault, and under a sound allocated agreement. What to look for in an allocated agreement An allocated storage agreement should be a legal document executed by both the vault operator (custodian) and the customer, which should make clear that the gold remains the property of the investor at all times. It should also make it clear that the placing of the gold with the custodian is performed in order to benefit the owner from the secure storage of the gold, for which the custodian is provided with a fee. Remember, in law the payment of a fee for the custody service is one of the critical markers for assuring the liquidator, and any court, that the property was not transferred to the balance sheet of the custodian, but was placed there for safe custody. The payment of the fee marks the gold as the owners property. With terms like this in place any banker or vault operator will segregate the gold, store it safely, and not use it. They know the rules! You should also make sure your allocated gold is covered against theft, because allocated gold is your property and not the bank's liability. The theft of gold from a vault is incredibly rare, which makes this one of the cheapest forms of insurance you can find. For that reason it is often included within the allocated storage charge. Indeed this is effectively a certification of any vault you choose. The downside of unallocated The alternative gold storage strategy is to save the fabrication and custody fee and take the risk of a loss of capital which could arise with unallocated storage, in the event of the insolvency of the provider. Most of the time you will be perfectly safe, but - in terms of risk - you should remember that major waves of bank failures are a regular feature of financial history. They have occurred several times in the last 100 years. The downside risk in unallocated gold deposits may be more marked than is yet widely appreciated. At the smaller end of the scale there are risks from some potentially disreputable providers of unallocated gold outside the main banking sector:- Most countries make banking a heavily regulated business; a banking licence is difficult to come by and requires a lot of capital to underpin the bank's solvency, and both the supervision of banks and their capital act to protect their customers. But because gold has lost its formal monetary status it can now be bought, sold and lent outside the scope of banking. It is now possible to set up a commercial business on very limited capital and sell gold on an unallocated basis, by which means some comparatively insubstantial and undercapitalised businesses could get hold of a great deal of investors' money "on account". Then the business of using gold can be legally performed by people who have no banking licence, who are inexperienced in banking type operations, and who are short on capital. Moreover there is nothing which obstructs the commercial lending of unallocated gold to the highest payer of interest (possibly a weaker organisation which banks and other respectable businesses won't lend gold to). The disreputable unallocated provider can then receive extra interest for taking that extra risk. This extra income will not remunerate their unallocated gold account holders for that extra credit risk - because their gold account pays no interest. Instead that extra money can for a long time finance salaries and dividends out of the interest received on customers' gold, and this remuneration to the provider's staff and directors is legal provided the gold appears to have been lent to generate income in good faith - even if a little riskily. Following a default, any gold loans will probably be found to have been made in good faith - but rather stupidly. This would be scant consolation to those customers who had lost their whole account balance of gold. Meanwhile at the larger end there is the material risk of general financial instability:- Just as unallocated gold is a form of credit so is the modern financial derivative. The increase in size of the world's derivative markets is beyond the numerical comprehension of most people. It has expanded from about $1 trillion in 1986 to about $300 trillion in 2003. Through these instruments banks have taken to underwriting financial insurance where the potential for claims - if the world's credit system falters - is of the order of $1m per head for the world's richest 300 million people. To put that number in perspective there are only about 7 million dollar millionaires in the United States, and maybe 20 million worldwide. By another comparison the US national debt - widely regarded as unsustainably large - is about $7 trillion. Meanwhile all the gold ever produced in the world is worth about $2 trillion. So $300 trillion is a large overhang, whichever way you look at it. Derivatives - just like unallocated gold - are credit based promises to deliver future value. The original contract remains open, or unsettled, because settlement involves shipping, transfer, administration and other expenses and sometimes even tax. By avoiding payment, transfer and delivery, and by holding settlement liabilities open, derivatives reduce trading cost. But they extend credit which is underpinned by the financial assets in bank balance sheets, and by the ability of a bank's counterparties to pay. The risk in unsettled derivative positions ultimately rests against exactly the same pot of bank capital as unallocated gold. So unbeknown to many owners of unallocated gold they are full participants in the stockpile of global derivatives. This is one of the ironies of modern financial practice. No-one knows when a major financial collapse might occur. Not even pessimists can claim to understand the very considerable increase - thanks to modern computers - in our powers to monitor and manage thousands of complex and inter-related financial situations at once, and this might mean we can safely manage a derivative marketplace at 10 or 100 times its current size. But whatever the limiting size is it is likely that unallocated gold and modern derivative finance will eventually fail together under dramatic circumstances. Can there be many serious buyers of gold who intended to run that risk? Trap 2 - Resale integrity The safe deposit box is often used as a way of circumventing on the one hand the ongoing custody charges of allocated gold and, on the other, the notional status of unallocated gold. The problem with the safety deposit box is the loss of integrity of the gold which is stored in it. A bullion bar bought in the professional bullion markets has been refined by an accredited bullion refiner, and stamped with :- • a serial number, • its purity (at least 99.5%), and • the official bar weight (about 400 Troy Ounces). The original verification process is called assaying. Bars which pass the strict scrutiny rules of bullion assaying are classified as Good Delivery Bars by their local professional bullion dealing community. They retain this status as long as they are kept in vaults within the recognised gold bullion dealing community. Within that community a record is made of every movement of a bar between recognised vaults. This builds what is called the "chain of integrity" which is broken if the bar leaves the custody of the bullion community, for example when it is withdrawn to be placed in a deposit box (from which it could conceivably be tampered with). Gold kept within the recognised bullion dealing community gets a better price when it is sold, because professional market buyers will accept it at face value - without assay - when it is delivered to them in settlement of a sale. If - on the other hand - a bar has been outside the system of recognised vaults it is instantly devalued. A future buyer of such a bar within the recognised bullion dealing community (where sale prices are highest) has to begin a new chain, with himself as the ultimate guarantor of the bar's quality. If a subsequent spot check of that bar shows it to have been tampered with it will be the original acceptor who takes a hit, because he was the first link in the new chain. This additional risk diminishes the value of the bar delivered from outside the recognised bullion dealing community. In fact your buyer will probably decide to re-refine the bar, which will eventually re-emerge from the melting pot with the refiner as its new guarantor. This way there is a new certified bar containing your gold, and your buyer is not left with a bar circulating around the community for a long period, with him as its possibly nervous long term guarantor. Melting down and re-assaying costs money, and even if your bar is perfect someone - usually you - will pay for that work one way or the other. It is this cost of re-asserting the gold's integrity that makes the deposit box option not as good value as might at first be thought. Trap 3 - Confiscation Being rich when no-one can find any credit at all is rapidly deemed by everyone else to be selfish and highly anti-social. When gold becomes valuable during a crisis the common view generally develops that 'hoarders' are at the heart of the problem, and are preventing money from circulating for the general economic good. Governments find the pressure to legislate against hoarders to be very convenient, both in terms of populism and fiscal necessity. They will likely implement prohibition or excessive taxation. The US government did exactly that in April 1933 and anyone found hoarding over $100 in gold or gold certificates was made subject to two years imprisonment and a $10,000 fine. Not surprisingly the US banks were not keen to assist individuals in breaking the law, so holding assets in domestic banks turned out to be pointless. The French had a similar experience 140 years earlier - except the penalty was famously more severe. Holding gold as a personal possession is equally useless because it cannot safely be used in a country where ownership of it is illegal. It also presents the problem of who to trust. Tell no-one and the hoard will probably be enjoyed by some fortunate treasure hunter in a few thousand years. Tell anyone at all and the illegal store can be stolen with impunity. You can't even take it out of the country. Few people would risk carrying it illegally through an airport any more than they would currently have the nerve to smuggle drugs. Go abroad So perhaps the best way to store gold is to make use of a country which you are not too keen to live in, which benefits from the robust rule of property law, and which has an enormous vested interest in retaining its international reputation as a discreet haven for legally acquired international money. Then you can quit wherever you live without the asset transfer problem. It is a hard decision to make, yet the practical solution is to follow the rest of the world's rich and preserve your wealth - for the moment - in Switzerland. Switzerland The Swiss must be among the shrewdest people in the world. Although a poor country 150 years ago they constructed the soundest of constitutions and adopted a policy of strict international neutrality - a position which they retain. There is no hint of internal political upheaval. There is no hint of military adventure. They are on excellent terms with all their neighbours. And they fully understand that a significant part of their wealth is due to the fact that the world trusts them to look after its money securely and discreetly. But there are qualifications. Swiss bankers are required to know their customer, to understand the source of their customers' money, and to report transactions relating to money laundering and other serious crimes to the authorities. They understand that if their banking law is to remain tolerated by Western governments they must not manage the finances of those governments' enemies and then hide behind a constitutional veil of secrecy. Provoking your neighbours is bad for business! So a highly pragmatic approach to the problem has been adopted which serves Switzerland and its customers without antagonising the jurisdictions over foreign money. The Swiss refuse to make banking secrecy absolute, and they raise the cloak of secrecy on all Swiss bank accounts which are involved with serious international crime. Yet while that certainly includes trafficking in drugs and guns they leave the definition of "serious" crime just a little bit vague, and then interpret it so as to be wholly in their customers' interest. If - for example - your own country suddenly imposed an annual wealth tax of 75% then your government would certainly consider its evasion to be a serious crime, and would probably call on Switzerland to view it likewise. The Swiss would not then be so accommodating. "Swiss bank secrecy is not lifted for tax evasion, even upon the request of a foreign government. The failure to report or underestimation of income or assets on a tax return are not considered a crime in Switzerland. The Swiss are unique in that they attach greater importance to the respect of private life than they do to taxation. Banks do not have the right to inform the Swiss tax authorities. They have even less right to inform foreign tax authorities. As Switzerland does not consider tax evasion to be a crime, it does not comply with any requests for judicial cooperation (also known as mutual assistance) from other governments." Quoted from http://switzerland.isyours.com/e/banking/secrecy/tax.html More privately held gold has been lost to domestic government than to any other individual cause. A material risk for gold owners is a government declaration - on a sound democratic mandate - that your hard saved assets shall be re-distributed for the common good. With your assets in Switzerland you - perhaps only you in your entire district - could be free to quietly exit to a country of your choosing, and you won't need to carry your assets with you. Swiss bankers reliably defend your right to do that even if your own government withdraws it. In fact - once you are abroad - you will probably be invited home by your own country, while your money stays safely offshore (non-domiciled). The authorities are not usually so stupid as to reject your wish to spend your foreign held money at home, and indeed the tax arrangements of people who have shown themselves to be prepared to switch countries are frequently far better than lifelong patriots. To win those advantages you will need to get yourself in a good negotiating position at the start. Trap 4 - Hidden costs in trading futures Apart from the obvious risk of prices going the wrong way there are several little discussed problems with trading gold futures. They combine to make the futures market a dangerous place for the private investor. Systemic failure Automatic instability The stop loss The hidden financing cost Private investor psychology Trading costs - % of what ? Well hidden rollover & closure costs The risk of systemic failure Gold is bought as the ultimate defensive investment. Many gold buyers hope to make large profits from a global economic shock which might be disastrous to many other people. Indeed many gold investors fear financial meltdown occurring as a result of the over-extended global credit base - a significant part of which is derivatives. The paradox in investing in gold futures is that a future is itself a 'derivative' instrument constructed on about 98% pure credit. There are many speculators involved in the commodities market and any rapid movement in the gold price is likely to be reflecting financial carnage somewhere else. Both the clearer and the exchange could find themselves unable to collect vital margin on open positions of all kinds of commodities, so a gold investor might make enormous book profits which could not be paid as busted participants defaulted in such numbers that individual clearers and even the exchange itself were unable to make good the losses. This sounds like panic-mongering, but it is an important commercial consideration. It is inevitable that the commodity exchange which comes to dominate through good times and healthy markets will be the one which offers the most competitive margin [credit] terms to brokers. To be attractive the brokers must pass on this generosity to their customers - i.e. by extending generous trading multiples over deposited margin. So the level of credit extended in a futures market will tend to the maximum which has been safe in the recent past, and any exchange which set itself up more cautiously will have already withered and died. The futures exchanges we see around us today are those whose appetite for risk has most accurately trodden the fine line between aggressive risk taking and occasional appropriate caution. There is no guarantee that the next management step will not be just a bit too brave. Automatic instability In normal markets a falling price encourages buyers who pressure the price up, and a rising price encourages sellers who pressure the price down. This is relatively stable. But successful futures exchanges offer low margin percentages (of about 2% for gold) and to compensate for this apparent risk the exchange's member firms must reserve the right to close out their losing customers. In other words a rapidly falling market can force selling, which further depresses the price, while a rapidly rising price forces buying which further raises the price, and either scenario has the potential to produce a runaway spiral. This is manageable for extremely long periods of time, but it is an inherent danger of the futures set-up. It was virtually the same phenomenon which was paralleled in 1929 by brokers loans. The forced selling which these encouraged as markets started to fall was at the heart of the subsequent financial disaster. The stop-loss Many futures broking firms offer investors a stop loss facility. It might come in a guaranteed form or on a 'best endeavours' basis without the guarantee. The idea is to attempt to limit the damage of a trading position which is going bad. The theory of a stop loss seems reasonable, but the practice it can be painful. The problem is that just as trading in this way can prevent a big loss it can also make the investor susceptible to large numbers of smaller and unnecessary losses which are even more damaging in the long term. On a quiet day market professionals will start to move their prices just to create a little action. It works. The trader marks his price rapidly lower, for no good reason. If there are any stop losses out there this forces a broker to react to the moving price by closing off his investor's position under a stop loss agreement. In other words the trader's markdown can encourage a seller. The opportunist trader therefore picks up stop loss stock for a cheap price and immediately marks the price up to try and 'touch off' another stop loss on the buy side as well. If it works well he can simulate volatility on an otherwise dull day, and panic the stop losses out of the market on both sides, netting a tidy profit for himself. It should be noted that the broker gets commission too, and what's more the broker benefits by being able to control his risk better if he can shut down customers' problem positions unilaterally. Brokers in general would prefer to stop loss than to be open on risk for a margin call for 24 hours. Only the investor loses, and by the time he knows about his 'stopped loss' the market - as often as not - is back to the safe middle ground and his money is gone. Without wishing to slur anyone in particular the stop-loss is even more dangerous in an integrated house - where a broker can benefit himself and his in-house dealer by providing information about levels where stop-losses could be triggered. This is not to say anyone is doing it, but it would probably be the first time in history that such a conflict of interest did not attract a couple of unscrupulous individuals somewhere within the industry. Investors can prevent being stopped out by resisting the temptation to have too big a position just because the futures market lets them. If the investment amount is lower and plenty of surplus margin cover is down, a stop loss is unnecessary and the broker's pressure to enter a stop loss order can be resisted. A conservative investment strategy with smaller positions achieves the goal of avoiding catastrophic losses by not keeping all eggs in one basket. It also avoids being steadily stripped by stop loss executions. On the flip side you cannot get rich quickly with a conservative investment strategy (but then the chances of that were pretty small anyway). Futures contain a built in price differential to account for the financing cost Before a salesman tells you that with a future you won't have to pay interest it is important to understand the implicit financing cost in a futures price. A gold futures contract will almost always be priced at a different level to spot gold. The differential closely tracks the cost of financing the equivalent purchase in the spot market. Because both gold and cash can be lent (and borrowed) the relationship between the futures and the spot price is a simple arithmetical one which can be understood as follows: "My future purchase of gold for dollars delays me having to pay a known quantity of dollars for a known quantity of gold. I can therefore deposit my dollars until settlement time, but I cannot deposit the gold - which I haven't received yet. Since dollars in the period will earn me 1%, and gold will only earn the seller who's holding on to it for me 0.25%, I should expect to pay over the spot price by the difference 0.75%. If I didn't pay this extra the seller would just sell his gold for dollars now, and deposit the dollars himself, keeping an extra 0.75% overall. Clearly this 0.75% will fall out of the futures price day by day, and this represents the cost of financing the purchase." Rollover applies acute psychological pressure As a contract ends an investor who wants to keep the position open must re-open by 'rolling-over' into the next period. This 'roll-over' has a marked psychological effect on inexperienced investors. Having taken the relatively difficult step of placing some of their savings in gold futures investors are required to make repeated decisions to spend money. There is no 'do nothing' option, like there is with a bullion investment, and rolling over always requires the investor to pay-up while giving him the option to cut and run. The harsh fact of life is that if investors are being whip-lashed by the regular volatility which appears at the death of a futures contract many of them will cut their losses. Alternatively they might attempt to trade cleverly into the next period, or decide to take a breather from the action for a few days ('though days frequently turn into weeks and months). Unfortunately every quarter lots of investors will fail the psychological examination and end their position. Few return. The futures markets tend to expel people at the time of maximum personal disadvantage - as the section below clearly shows. Costs - as a percentage of principal When a future is traded the broker will frequently compute dealing costs as a percentage of the principal. This is deceptive. The principal has not actually been settled, so the costs of settlement - where the real expense lies - have not been borne. The expense in a future is the cost of taking out a notional promise, which one should expect to be pretty low. It is sneaky to quote a percentage on the basis of an irrelevantly large principal when the costs of settling that amount have yet to be added. Were it instead computed as the percentage of the margin - a more relevant figure - futures would look like substantially more expensive instruments to trade. Hidden costs at the close and/or rollover Each quarter a futures investor receives an inevitable call from the broker who offers to roll the customer into the new futures period for a special reduced rate. To those who do not know the short term money rates and the relevant gold lease rates - or how to convert them into the correct differential for the two contracts - the price is fairly arbitrary and not always very competitive. It can be checked by referring to gold lease rates and interest rates. Suppose that gold can be borrowed for 0.003% per day (1.095% per annum) and cash for 0.01% per day (3.65% per annum). The fair value for the next quarter's future should be 90 days times the interest differential of 0.007%. So you would expect to see the next future at a premium of 0.63%. But there are strange extra forces at work. They come from predictable facts about the distribution of gold futures positions :- • The shorts are mostly market professionals. They might well be miners, who traded futures intending to settle, or they might be experienced market operators, but whatever they are they tend to be of substantial size. On the long side the buyers are likely to be smaller scale - maybe jewellers, their suppliers and private speculators (all much more likely as buyers than sellers). So while the gross open interest of longs and shorts is in perfect balance, the average size of position is smaller for the longs and there are correspondingly more of them. • The longs, being smaller, have a predictably larger cost of borrowing to finance settlement. Suppose the old future is fairly priced at 100. The normal spread is - we'll say - 0.20%. So a typical roll-over - selling the old and buying the new - would trade from 99.9 (selling the old future at 100 less half the spread) to 100.73 (buying the new future with the 0.63% of financing cost + half the spread). There would also be commission on top, but that is not hidden. That 0.63 of the differential represents the financing cost of the entire principal. So you are paying interest on it. In addition the trader can improve his profitability, because of the different profiles of longs and shorts. What he does is anticipate the likely direction of a random customer who contacts him, and the nearer the end of the period the more the odds are stacked that whoever is on the phone will be selling a small quantity to close the old future. Of course these should be balanced by the occasional large purchase, but as we will see that can be got round. The trader lowers both his trading price, and his liquidity. The quote becomes 99.825 - 100.025 sized in one lot, not ten. It seems to the casual eye that there is still a 0.2% spread, but is there? Look at the following table - constructed on the basis that there are ten small sellers and one large buyer. Because the trader has reduced his liquidity the buyer has to execute three trades (at different prices) to buy what he wants to close. +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 +1 old -99.825 -1 old (bigger customer wants to do 10) +100.025 -4 old (adjusted price on larger purchase order) +100.1 -5 old (adjusted price again to complete larger purchase order) +100.125 Do the arithmetic and you'll see the trader has engineered to buy from sellers 10 lots at an average price of 99.825 and to sell to buyers 10 lots at an average price of 100.205. It might look like a trading spread of 0.2% when it's quoted but it's actually 0.38%. The trader's profit has increased by 90% because of his successful anticipation of the distribution of orders. Perhaps you could rollover early to avoid the problem. If you try you'll find plenty of liquidity in the old future but hardly any in the new one. You'll fall victim to much the same mechanism on the other side. Meanwhile the professionals are busy fixing to finance settlement - a luxury not available to the private investor. A big futures player can probably arrange a short term borrowing facility for 3%, whereas a private investor might pay 12%-15% which prices settlement out of the investors reach. The known imbalance allows a few large shorts to elect for settlement (i.e. not buying back to close) which cannot easily be duplicated longs. A shortage of buyers in the old futures contract develops at the death and it presses the price for small bulls lower. How low? Clearly there is a floor - because bigger participants will come in to snap up cheap futures. But the price must fall low enough to enable them to profit from the arbitrage. It turns out the lowness of the price relates to the hassle cost of small deals. They have to be executed, matched, margined, reconciled and all of this takes people, systems, time and money. Because the professionals all have electronic processing facilities connected to each other the error rates on small private investor trades are the largest and many even require customer side paper as well as salesman time on the telephone, to say nothing of a raft of regulatory obligations which don't exist for trades between market professionals. As a result the trade processing costs of small trades are actually bigger than professional trades of many times their value, so the profitability on transacting them is reduced. Support doesn't even appear until there is enough margin in the arbitrage to pay for the costs of many small and expensive-to-process trades. All this is predictable by professionals - and it is self-justifying. It encourages still more professionals - those without any particular view on gold prices - to be short at the death, which amplifies the effects of both. Succeeding in the futures market is not easy. To be successful you need strong nerves and sound judgement. Investors should recognise that they are at their best for market professionals and short term speculations. They are not a good home for private reserves. Underlying it is a rule based on common sense. "For investors the probability of long term profit in a marketplace is inversely proportional to the number of livelihoods the marketplace supports". On that basis the futures markets are unlikely to profit private investors in gold, and that certainly has been the experience of many.