The Comex Will Not Go Bankrupt!

September 21 2015

There is a lot of nonsense being written about the gold market. One myth is persistent:  the Comex — London’s 'paper gold market' — is thought to be on the brink of collapse. For example, Zero Hedge, in one of their articles, stated that “there is now an unprecedented 228 ounces of paper claims” (futures contracts) in circulation for every troy ounce of physical gold 'in the Comex vaults." Myth or reality?

The Myth

They call it a "crime," a fraudulent gold market. The so-called paper gold market in London is rigged. The largest gold exchange in the world also has gold in its vaults and issues "paper certificates."

Every buyer on the Comex is a complete fool, and as soon as he finally realizes that he doesn’t actually own gold he will panic and buy physical gold elsewhere. What are the consequences? The gold price will skyrocket, and this will mark the end of an era of gold price manipulation. Those who defend this myth will argue that "investing in gold makes no sense as long as the gold market is manipulated."

What’s Really Going On

First of all, it is important to understand that the Comex — the gold futures exchange — doesn’t own or store gold itself. The traders trading on the Comex do hold gold. In many cases, they trade through a bank that has a commodities division (and a dealing desk). In other words, the Comex doesn’t hold any gold, nor do major banks (in principle). It is the customers of major banks who store their gold with these banks. They have access to the gold, and they make the decisions.

There’s also a difference between eligible and registered gold. The claim that Comex’s vaults are 'getting empty' is based on statistics published about registered gold. But converting gold from to actual registered stock will only take a couple of seconds; you’ll need only one press on a button to register gold. Beyond that, nothing changes.

It’s ironic that when we look at how much registered and eligible gold is held by Comex-traders, we can see that the ratio of  'outstanding futures' to 'stored gold' has only become smaller and smaller over the years.

Furthermore, it is important to understand that futures contracts are not 'certificates' or warehouse receipts. A futures contract is an agreement between two parties about a future delivery of gold at a certain price. Only a small portion of outstanding futures will actually be delivered at any given time.  In practice, only 2 to 4 percent of futures contracts actually lead to a delivery of physical gold.

THE TOTAL AMOUNT OF GOLD STORED BY COMEX RELATIVE TO THE AMOUNT OF OUTSTANDING FUTURES CONTRACTS TO THE COMEX (1 ON 4.9 IS "COVERED").

How Does It Work?

So, how does it exactly work?

Someone who is short on a gold future sells a promise to deliver gold at an agreed price at a later point in time. He has two options:

  • He owns gold which is held by a Comex approved depository
    If this is the case, there is no default risk. It doesn’t matter whether the gold is eligible or registered. In this case the most common option to exit the short position is an 'exchange for physical,' meaning that physical gold is exchanged for a futures contract and money.
  • He doesn’t own gold held at a Comex approved depository
    In this case, there are multiple alternatives:
    - He can offset his own contract before the term expires;
    - He can postpone delivery by 'rolling over' his futures contract;
    - He can postpone delivery by leasing physical gold from another party, enabling him to deliver it. The lease can be settled later (either with cash or physical gold).

In sum:

  • The gold market is a futures market: futures contracts are agreements between two parties about a future  delivery of gold
  • Gold held by Comex approved holding depositories can be converted from eligible to registered easily
  • Only a small portion of the outstanding futures contracts is close to the delivery date , and there is more than enough gold available 'in the vaults' (either eligible or registered) to execute these deliveries
  • Physical deliveries can be prevented in several ways

Regarding the Alleged Shortages

Just about every month I am bombarded with another article arguing that coin and bullion traders have large shortages.

And this should somehow show us that the gold price is being manipulated. After all, 'we are running out of gold (or silver) and yet the price hasn’t changed!'

There’s a mistake in this logic: the shortage of one specific product (take for example, the Australian silver Koala coin) is interpreted as a more general shortage in the entire precious metals market.

It’s very well possible that there’s a shortage of Koala coins. Its producer, Perth Mint, has limited capacity to mint Koala’s from silver. So it’s possible that there are no longer any Koala’s in stock at a certain point in time. But that doesn’t mean there’s a shortage of silver; it only means that the production capacity of Perth Mint is lagging behind the demand for this specific product. More so, Perth Mint does have plenty of ways to acquire silver bullion. It just isn’t minting fast enough to keep up with the demand for Koala’s.

This shortage results in a premium on Koala coins compared to the silver spot price. .

And what is true for Koala’s, also goes for other gold and silver coins, as well as smaller bar sizes.

Only when there a shortage of silver bullion arises (you know: the standard size bars they sell on the London exchange), will it have an impact on the price in the futures market. Until we see that the prices of bullion rise, we do not need to worry about a shortage. I can assure you that there currently are no bullion shortages and, as a result, no price premiums have to be paid for precious metals.

Why All the Commotion?

Often, there are other interests at stake. A lot of people who choose to scare others with horror stories have a commercial interest to do so.

Marketing specialists know that a 'sense of urgency' sells well. An example can be drawn from booking.com: they offer hotel rooms, and when you scan their website looking at rooms they will notify you with messages expressing urgency: "There’s 1 room left," "15 People are looking at this hotel," "Last booking: 11 minutes ago," etcetera.

The Comex myth is abused to function as an equivalent of Booking.com’s 'now-or-never' marketing tactic.

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