Mind the Counter Party. Especially on route to gold and silver.

Mind the Counter-Party. Especially on route to gold and silver.

The failure of MF Global and Jon Corzine’s behemoth of a futures brokerage is a sharp reminder of the exposure investors and market participants have to their counter-parties. The rising to a head of problems in the Eurozone have brought renewed rises in LIBOR, the London Interbank Offered Rate. This key measure of interest rates is the average interest rate between banks in the London interbank market, and a widely used short-term interest rate benchmark since it is designed to reflect the cost of borrowing between some of the world’s largest, most reputable banks and institutions. As you can see from the graphic below from bankrate.com, LIBOR has risen 48% in a year.

LIBOR is a useful proxy for trust between the banks and institutions at the heart of our financial system. What the graphic above suggests is that these banks trust each other less than they did a month ago, and also less than they did a year ago. A source I cannot remember (and thus sadly not credit) presented an analogy I found useful with regard to LIBOR and trust within the financial world. The analyst urged people to think of a game of financial football, and then when LIBOR is rising the financial players are now less keen to pass the ball (liquidity) to the other players.

Even when investors are on the ‘right side’ of the markets they must be mindful of their counterparties who they might use to facilitate investments and positions. Whether you are an institutional investor like Goldman Sachs or a private individual these issues can affect you. Notable investor, entrepreneur and analyst, Bill Bonner, wrote of his colleagues’ concerns during the Credit Crunch with gold investments made using an exchange traded funds (ETFs). The concern was born from the fact that some of these funds were backed by AIG.

Even investors who have made renowned winning trades such as hedgie John Paulson of Paulson and Co. have to mind their counterparties. Paulson’s funds had to mind the exposure they had to the other side of their CDS bets against complex securities backed by sub-prime property assets. Heading such concerns, Paulo Pellegrini, Paulson’s head trader at the time, moved cash profits from these winning CDS positions to Institutional Treasury bond funds to protect it from reach of desperate investment banks. Paulson & Co. were worried about their counterparties, banks like Merrill Lynch, going bust and their profitable positions going down with them.

An increase in systemic risk over the last few decades has potentially increased investors’ exposure to counterparties. Whilst apparently spreading risk, derivatives have interlinked participants and institutions in a web that nobody fully understands. Given the leverage so often employed by institution’s today, one might think of an image of a group of people doing a complex dance, on their tip toes, whilst holding hands and tied together with differing forms of rope like material interlinking them all. No doubt you see where this homemade analogy is going. If one dancer falls the knowing and unknowingly interlinked fellow dancers experience this fall as well. Remember how the collapse of Lehman Brothers affected market participants.

Contemporary investors may need to consider if they have become relatively over-exposed to counterparties as leverage in the system has grown and the proliferation of derivatives and other financial products has helped increase systemic risk and the idea of ‘too big to fail’. Investors need to consider what is right for their individual situation. Paper investments and securities lack tangible value, and all the while you hold such an investment it is someone else’s simultaneous liability. Brokers, security providers, investment funds and the like are counterparties to many of us. Even if the investment is fit for your purposes, counterparties are difficult to avoid.

This is why the Swiss and Austrian investment traditions of ensuring a secure and ultimately liquid base to one’s net wealth has begun to appear especially prudent and appealing. An investment foundation built upon holdings that are your asset only, and no-body else’s liability, is something that Swiss bankers have advised for decades. An advised minimum allocation of 10% to gold and silver bullion has been traditionally suggested to form a solid basis to a portfolio and act like a financial insurance policy of last resort. One of our favourite analysts, Doug Casey of Casey Research, urges that gold and silver are some of the few assets that ‘are not simultaneously someone else’s liability’.

Is it worth having a higher percentage allocation to tangible assets free from counterparties? That would depend on one’s personal situation, but other notable analysts within the gold and silver markets do prefer a higher percentage for themselves. Eric Sprott, founder of Sprott Asset Management, has about 85% of his wealth in gold and silver related investments; Jim Sinclair, legendary trader and founder of The Sinclair Group, has a similar degree of exposure; whilst Mike Maloney has almost all of his net wealth invested in the precious metals. Austrian financial institution, Erste Group’s, Ronald Stoeferle put it succinctly when he wrote in his July 2011 research piece that: ‘the possession of gold is tantamount to pure ownership without liabilities’.

However, it is vital to consider how this precious metal investment is achieved. By moving towards gold and silver bullion the investor is often opting for something free of counterparties. What then seems illogical is then why such an inclined investor would opt to facilitate their precious metals investments using a financial product, like an ETF, and once more be open themselves up to counterparty risk. Granted, some ETFs have grown large and highly liquid, such as State Street’s ETF known by the ticker GLD. The need for such professional market depths of liquidity might have made such ETFs favourable to funds and institutions which their potential regulatory requirements. Interestingly, some of the high-profile interviewees on King World News believe these ETFs to represent some of the largest inventories of available bullion for large Asian buyers to use to access the gold and silver bullion markets. But are these products the most suitable for an individual who is looking to gold and silver for the reasons discussed above? We believe not, and will seek to articulate why below.

Why are gold and silver ETFs potentially not the optimal investment solution for individuals? The distilled answer is: counterparties! Even if some of these counterparties are large established institutions such as HSBC or JP Morgan, the counterparty risk is still attendant. Further arguments then rage about the structural integrity of ETFs, and the best research we have seen in this space comes from Hinde Capital and Jeff Neilsen of Bullion Bulls. Both sources are indeed ‘interested’ parties, as are we, but this does not invalidate their potential conclusions. We would challenge any reader to look at Hinde Capital’s research piece from August 2010, ‘ Precious Metals ETF Alchemy: GLD – the new CDO in disguise?’, and not come away with significant concerns about the suitability of ETFs for gold and silver investors. Hinde’s 52 page research piece is substantial and not an easy read but is likely to leave the reader with not only concerns about ETF providers’ counterparty risk, but the actual legitimacy of these particular ETF products as proxies for gold and silver investment. Whatever the true realities are, making a gold investment using an ETF still exposes the investor to a range of counter-parties (usually about three to five). Such analysis and concerns are echoed by notable precious metals analyst , James Turk, who at Monday’s ‘Gold and Silver’ summit told the audience that when reading the prospectus to the original gold ETF back in 2005 he found the investment structure to be ‘full of holes’. It does not matter that these may be large reputable firms such as HSBC or JP Morgan. Lehman Brothers and Barings were once similarly large and apparently reputable firms before they went the way of the Dodo. So were AIG, RBS and Lloyds before they narrowly avoided a similar fate.

To add an interesting anecdote to this ETF debate we should mention part of fund manager Ned Naylor Leyland’s speech, also from November’s ‘Gold and Silver’ summit. Ned reminded us of State Street and HSBC’s efforts earlier this year to dispel concerns about the gold backed nature of the SPDR Gold Trust (GLD). CNBC’s Bob Pissani went to HSBC’s vault to be shown some of the gold, and famously showed the camera the gold bar shown below.

This bar was then shown to not be part of GLD’s bar list by an immediate follow up by ZeroHedge. How could such an apparently reputable custodian bank make such a blunder? To prove the integrity of the investment product you help provide, you have invited a journalist to come and look at some gold; at least guide him to look at gold you know is on GLD’s bar list. What gets more interesting about this story is that when Ned Naylor Leyland met with ETF Securities (another provider of ETFs) a while later and recalled this story and apparent PR own goal, he sent ETF Securities the picture above showing a specific bar number. Ned was amazed to hear that this bar was in fact on the bar list of one of ETF Securities’s own ETFs, and that ETF Securities were quite relaxed about this. This raises a few concerning questions.

Investors are exposed to counterparties at many junctures. Keeping money in a bank account exposes one to the operational success of that bank. Holding financial assets in a brokerage account exposes an investor to similar risks. These issues came home to roost in the Credit Crunch when investors remembered to first be concerned with the return of their capital, before seeking returns on their capital. When you invest in gold or silver you are usually keen to ensure security of investment, and the above example of a custodian bank potentially mismanaging the gold belonging to the trust structures that ETFs employ could be a representative example of why counterparties are a problem.

If you can buy allocated bullion (that you hold legal title to) more efficiently than you can purchase an ETF, and can store this bullion at costs lower than ETF management fees, we struggle to see why investors would opt for the ETF.

Regards and good investing,

Will Bancroft

of The Real Asset Company.

Please Note: All articles and information published here are to inform and aid your thinking and investment decisions, not lead them. You must independently decide the best place for your money, and any investment decision you make using The Real Asset Company is made at your own risk. Information or data included here within may already be out of date or touch, and must be verified by you elsewhere, should you choose to act on it.

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