Synthetic supply of gold?

In the comment section at FOFOA’s blog (see the messages by DP and Jeff), we had a discussion about whether you can create synthetic supply, i.e. a form of paper gold, using the futures markets such as the New York Commodities Exchange (COMEX).

In the following, I explain why I think the answer is no.

What exactly is meant by synthetic supply? Let us interpret this term in a broad sense as any measure which makes the market for gold look bigger than the market for physical gold actually is, or any measure which tempts people to trade a substitute for physical gold instead of the real thing, a substitute which can be supplied in larger quantities.

Let us assume we are a large financial institution, we have some physical gold, but we wish to create a much bigger such synthetic supply. Which choices do we have?

1. The brute force method. We sell short more gold than we own

If we wish to do this with physical gold, we can use the commodities exchanges and sell futures contracts, write call options or purchase put options. We would sell short more gold than we have actual physical. If we have gold in an unallocated account with a bullion bank, we can also use this strategy and sell more forward contracts than we have unallocated gold.

This strategy is profitable if the price of gold is in a downward trend such as the period from 1995 to 1999. In fact, it is very likely that this was indeed done as part of the so-called gold carry trade. The gold carry trade consists of borrowing gold, selling it for US$ in the spot market and investing the proceeds elsewhere. The position is closed by buying back the gold in the spot market. This strategy has a positive carry as long as the forward or futures market is in contango and borrowing gold is cheaper than borrowing US$, but it has the obvious exchange rate risk if the price of gold in US$ rises while the carry trader is short gold.

When the downward trend in the price of gold stops and reverses such as it did between 1999 and 2001, however, the carry trade starts losing money and we will have to unwind it. Depending on how crowded the trade was, this may become difficult because everyone will run for the same exit. In fact, it is very likely that some of these carry trades indeed ‘blew up’. The signature of such an event is a sudden drop in the Gold Forward Offered Rate (GOFO) a few of which can indeed be found in the historical data as we have seen in a previous article.

Since 2001, the price of gold in US$ has been in a strong and steady upward trend. Shorting gold against such a trend, except perhaps as a technical trade for a very short period, would be financial suicide. We would probably not even find any bullion bank who would enter such a forward contract with us, simply because they know we would blow up. Of course, we can still sell futures contracts at the COMEX, but we would keep getting margin calls and would burn more and more capital.

So is it plausible that any significant synthetic supply is being created by systematically shorting the forward or the futures market? If anyone has been doing this, they must have lost hundreds of billions over the previous ten years. Very unlikely.

2. The elegant method. Unallocated accounts

If we are a member of the LBMA and if we offer unallocated gold accounts to our customers, then creating synthetic supply is straightforward. We just need to find somebody who is willing to borrow gold, and we are in business. For example balances sheets of how this works, please refer to this previous article. Update (20 March 2012): For further examples on how synthetic supply is obtained by creating credit, we refer to How Credit Suppresses The Gold Price.

The only limitation is our reserve ratio, i.e. the ratio of gold we lend per physical bullion in our vaults. If this ratio is stretched too far, we risk a run on the bank.

The beauty of lending gold to unallocated account holders is its simplicity. It works just like conventional commercial banking in US$, except that we are not required to hold a banking license (because we do not create credit in a legal tender currency that is regulated by a government. In legal terns, unallocated gold accounts are just derivatives on a commodity). The downside is that there is no guarantee that one of the central banks helps us out when our customers run on the bank and try to withdraw physical gold.

3. Other ways of lending gold

In addition to lending gold to an unallocated account holder, we can also lend gold to the general market. With physical gold, we would sell physical gold for US$ and purchase a futures contract in order to buy it back at some point in the future. But we can lend physical gold only if we have some. With unallocated gold that we hold in our account, we can enter the analogous transaction. We sell it in the spot market and purchase a forward contract. Again, we can lend only what we own, but not create any new supply.


Apart from entering a high risk naked short position, the only way of creating synthetic supply is the lending of unallocated gold while we hold a physical gold reserve only for a fraction of the amount that we lend. This is completely analogous to the creation of US$ in the commercial banking system.

10 Responses to Synthetic supply of gold?

  1. kid dynamite says:

    Victor, I am going to eventually write a similar post, with the key concept: “you cannot manipulate a physically settled commodity contract from the short side for any period of time longer than the contract you are trading.” Bottom line: shorting futures contracts does NOT create additional supply of the physical metal – full stop.

  2. The third method would not work, as the sell pushes down the spot price and the purchase increases the futures price. This widens the basis and creates an arbitrage for other players. Over time the sell and buy are price neutral.

    • Bron,

      I agree with the facts, but not with the interpretation. The lender of gold (against US$ collateral) in a fixed-term swap is short the contango whereas the borrower is long the contango. This is relevant only if they want to close the position ahead of maturity as the contango exposure goes to zero when the swap matures.

      Yes, you can lend gold to the market in this way, but still you can lend every ounce only once.


  3. Victor,

    If we make some different, but related, starting assumptions, perhaps a synthetic supply of gold could be produced another way, and at an acceptable cost.

    Let’s assume the existence of a Big Entity (BE), running a big surplus, and BE wants to accrue a large physical gold reserve commensurate with BE’s high and advancing global status. BE is expecting the future gold price to be much higher vis-a-vis the goods BE produces.

    To avoid unduly running the price whilst accumulating, BE indirectly sells gold to those not demanding physical delivery.

    Who makes the XAU/USD market? The LBMA? Information on XAU/USD seems pretty thin on the ground, with the exception of the live charts which appear to be the accepted proxy for the price of all forms of gold.

    If BE sells XAU/USD via an LBMA BB, won’t said BB need to hedge their exposure, by selling commensurate gold futures or other correlated instruments for example? This makes it the BB’s problem to find and if necessary “stimulate” unallocated demand in order to make a low-risk spread. This is what banks do, no? Match supply and demand.

    Concurrently, BE could be buying allocated and physical gold from numerous other sources in an artificially depressed market, could they not?

    Obviously BE are net overpaying for these reserves, but not necessarily if BE was projecting the future price to be enough multiples of the current price. Any “overpayment” is simply the cost of slowing the ascent of the price and affecting the mood of the market, regularly shaking out weak hands and stop-loss orders.

    When the market at last runs away, BE has plenty of otherwise practically worthless T-Bills with which to fulfil contractual obligations to BB, which were accumulated as another leg of the gold accumulation strategy, instilling confidence in the dollar’s debt and thus also reducing gold demand.

    This is synthetic gold supply, and there must be some potential future price of gold at which it would be worth the costs to BE to create such a supply, when compared with the crude strategy of just entering the gold market as a buyer. BB just looks like the “bad guy” to goldbugs, but is really a net-neutral participant.

    Expensive gold acquisition from today’s perspective may turn out to be cheap by tomorrow’s, if BE is reading their tea leaves correctly. Just depends how important BE feels it is to acquire more gold reserves.

    Your thoughts?

  4. Big Entity would be net short “gold” because their paper gold short would be bigger than their physical long position, no?

    Of course, this makes a lot of sense. Big Trader, pardon me, Big Entity, would have quite a nice poker hand. If the U.S. say “Ooops. We are sorry, we cannot afford to honour all of our foreign debt”, Big Entity might respond by “Ooops. We just realize we cannot honour our paper gold short commitment with your friend’s, the UK’s, banks”. Mutual nuclear deterrent.

    BE might not only be China, but also the oil countries at the Persian Gulf.

    Jeff Christian said in some interview (Financial Sense?) that gold lending used to be done by CBs (we now know it used to be the European CBs before 1997), but today this had shifted to lending by private entities. I speculated that this must be whoever acts as the front of the Gulf Arabs because they seemed the obvious candidates to benefit from keeping the paper gold market alive (apart from the U.S. most of whose gold is tied up though).

    Of course, China is a candidate, too.

    Finally, how does this fit with the paper gold support 2002 to 2012 which we suspect came from Europe? Did the Europeans just make sure the price is high enough and the physical supply lasts long enough for them to close out all the remaining lease positions that they didn’t want to sell? Now the Europeans are done, they have closed the leases, and gold is ready to drop again?

    Does this mean Europe and Big Entity have been talking to each other?


    • Piripi says:

      Bearing in mind that this is all pure speculation based upon a theory for which there has been no attempt on my part to empirically test…

      Victor said: “Big Entity would be net short “gold” because their paper gold short would be bigger than their physical long position, no?”

      Yes. Ideally this “gold” short is hedged in dollars or a highly liquid dollar denominated instrument like T-bonds and bills, because “gold” is ultimately not actual gold but dollars. So BE is net short “gold”, but at least net neutral or, better, long dollars, requiring a big and ongoing surplus or alternative source of dollars to finance this.

      My initial point was simply that if an entity was willing to take such a position then they are not only creating an actual synthetic supply of “gold”, but additionally acquiring that monetary holy grail (even if only temporarily) of controlling gold. Control gold via “gold”.

      As to why an entity may wish to employ such a strategy, well there are many conceivable reasons because there are many side-effects, any of which in themselves or in some combination may be reason enough.

      Stated differently, the BE strategy could be viable for any entity (with the means to fund it) who expects the strategy to be net profitable to them, with that profit being realised in either:

      1. the higher future value of their thusly accumulated actual gold reserve (they are acting upon what they consider a “hidden arbitrage” opportunity);

      2. the utility of enabling another party/s to accumulate more gold reserves than would otherwise be possible;

      3. maximising the profit found in a current circumstance which would end if “gold” were no longer at parity with actual gold;

      4. the utility of one or more of any other corollaries of “gold” being artificially cheap;

      5. or some combination thereof.

      The Big Entity strategy is based upon said BE expecting/anticipating an eventual shift to an AG higher-valued gold paradigm/international monetary system upon the breakdown of parity of “gold” with gold.

      The maximisation of the accumulation of a reserve of actual gold is just one possible motive of the theoretical BE; another is delaying this shift; there are potentially many others, particularly when we consider that there appears to be a number of potential candidates for the role of BE, should BE in fact exist, including that of a co-operative (for which there are precedents, one example being the London Gold Pool).

      As always, cui bono?

      • FOFOA would probably say that the structure of the paper gold market was engineered in a fashion such that the behaviour you are describing, appears naturally, without any need for any conspiracy, plot, cooperation or even secret international agreement.

        We know that GATA, Sprott, Turk and friends claim is it the U.S. or the banks who are behind the short position in gold (they usually don’t know of unallocated accounts, and so they think this would need to involve physical gold, but this is not the case).

        I’d like to add the Gulf Arabs to the list of beneficiaries (they profit from dollar settlement for oil in combination with cheap gold in dollar terms) as well as China (who need to accumulate more gold).

        On the other hand, who lifted the gold price sixfold between 2002 and 2012 and why? Are the alleged shorts that “weak”?

        Also on the other hand, we have FOFOA’s and my point of view on the stability of the gold market. There is an inflow from mining and scrap that is roughly constant in terms of weight per year. But there is an outflow that is constant in terms of dollars per year (people and countries who have a surplus accumulating reserves instead of dollars). So the lower the London gold price the more likely that the London market runs out of reserves. The higher the price the longer the market will survive.

        Does BE know this?


  5. Piripi says:

    “…the structure of the paper gold market was engineered in a fashion such that the behaviour you are describing, appears naturally, without any need for any conspiracy…”

    Was said behaviour an intention of this engineering?

    I agree 100% that dilution of the price of “gold” (and by extension the price of actual gold) is intrinsic to the structure of today’s gold market. It follows that in such a market the price will always be lower than it otherwise would be, in, for example, a fully allocated/physical only market, all else being equal.

    When some portion of gold demand is satisfied without actual gold being supplied, the price has then not necessarily risen to the level at which that demand would have been satisfied by a holder parting with real gold. But as gold’s function is its price, so gold is now malfunctioning, not sending the actual signal that that gold demand should have sent to the market. As a result of this malfunction, the marginal preferences of all potential gold buyers and sellers have been affected, and this in turn affects their marginal preferences for all other marketable goods, and this the marginal preferences of all other participants in all other markets. The entire market pricing structure has been affected and capital is misallocated as a result. This may appear innocuous in and of itself, but it compounds.

    Being the good whose price is its function, gold acts as the reference point for the entire market pricing system, whether market participants are aware of this fact or not. The system evolved prior to 1922 without this distortion (though with another handicap), and as you pointed out elsewhere recently, despite no one fully understanding how, it worked, as gold’s price transmitted accurate signals which directly affected all markets and all their participants. If only that price hadn’t have been fixed in currency terms inflation/deflation could have been significantly reduced.

    Back to today, and, as you say, no ” conspiracy, plot, cooperation or even secret international agreement” is required for this “gold” price dilution to occur: “gold”‘s just structured that way.

    However, when structures exist which can be used as means to an end, it is not unreasonable to expect that, whether visible or not, some entity with appropriate motive and awareness will attempt to exercise that utility. This doesn’t mean any actually are, and I’m not positing that any actually are. I’m wondering if any could, and, if so, who has the capability, and, if any entity does, what possible motivations they might have.

    The BE strategy is simply a theoretical arrangement which so far appears to be technically feasible. It would require access to vast and continuous financial reserves (which is why it requires a BIG Entity), suitable motivation(s) to pursue it, and an expectation that eventually gold will function once more.

    Were the BE strategy being exercised, it should be producing observable effects consistent with possible motivations of capable entities. From my point of view, the purpose here is not to prove, but to disprove. This exercise is purely speculative; I’m only interested in narrowing possibilities.

    So, if you are still interested after all that, who is capable; who is motivated; what real world evidence can be seen that is consistent with these? What inconsistencies? You’ve already mentioned the movement of the price and the flow of physical. These obviously need to not be inconsistent with suspects and their motives, but there is likely more too.

    That’s all I have time for currently.

  6. Piripi says:

    Right now, I can’t be bothered sticking with the logical parameters I’ve outlined above. Things to do, etc etc.

    VtC said: “On the other hand, who lifted the gold price sixfold between 2002 and 2012 and why? Are the alleged shorts that “weak”?

    Also on the other hand, we have FOFOA’s and my point of view on the stability of the gold market. There is an inflow from mining and scrap that is roughly constant in terms of weight per year. But there is an outflow that is constant in terms of dollars per year (people and countries who have a surplus accumulating reserves instead of dollars). So the lower the London gold price the more likely that the London market runs out of reserves. The higher the price the longer the market will survive.

    Does BE know this?”

    Of course, since at least the late ’90s.

    “The higher the price the longer the market will survive.”

    The sleeping giant was late to the game. BE keeps market on life support while building foundations for future: gold reserves, ramping up mining industry, building domestic infrastructure, industrial capacity, stockpiling durable resources, restructuring financial and political systems, adopting best aspects of the west (observe the euro closely and take lots of notes), and completely realigning itself with ROW. The world’s biggest makeover, at breakneck speed.

    “Who lifted gold price sixfold… Are the alleged shorts that “weak”?”

    Classic Sun Tzu.

    “… the lower the London gold price the more likely that the London market runs out of reserves.”

    At some point, Big Trader, erhm Big Entity, having built his future foundations as well as conditions permitted makes his move by launching a bear market in gold, shaking out as many weak physical hands and running London as close to dry as possible before it locks up. Stability in the gold market allows the rest of the strategy to be executed, and you just milk what you can. At the end, when most other aspects of the strategy are as far along as you can reasonably get them, you pump out what more gold you can while you can before it’s all over. That’s happening now. The last cheap ton is pure gravy. Others will probably help hold that door open as long as possible too, with an eye to the future.

    With all this occurring on borrowed time, the emphasis is on bang for the buck, the same buck that hedges the entire process and becomes practically worthless in the end.

    The exorbitant privilege has a sting in its tail, and there’s no way anyone ever wants to get stuck managing a “reserve currency” again.

    I think it most likely BE is an informal co-operative, if only in as much as no one interferes with China, who is absolutely the prime mover. Loads of motive, loads of means and, increasingly, loads of friends. Emerging markets have been net buyers of gold since 2009.

    Putting aside the gold and the money and the power for a minute… there is a large, highly visible, and accelerating (from my point of view) movement of credibility from West to East. That’s what it all turns on. The US will be off their perch faster than most would expect when the time comes. They’ve already lost the moral high ground they’ve had almost by default globally for most of a century. Much of the late 20C will be revised, historically, and the US won’t look the better for it.

    When China has a good measure of the credibility, it has many friends (including the Middle East, whoever’s running it), it has respect, and, in an equitable world, a solid share of the equity (gold).

    All with the blessing of the BIS, whose model I think they are adopting. Stability of currency’s purchasing power paramount, floating gold exchange reserves to defend this, let markets reassume responsibility for themselves. Severed links, in other words.

    With such a late start, China needed to force extra time while committing to an audacious all or nothing type gambit.

    That’s one narrative, anyway.

    • Piripi says:

      Between 2002-2011, I’m of the opinion that for at least part of this time (prob later part) the price was likely contained, rather than supported. Can’t have the market bifurcate before you’ve squeezed as much phys out as possible, but you can’t do this in earnest until the end, and there’s plenty of other fish need frying before then.

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