"Bruce Lamar [name changed] was stunned when he read the one-sentence reply from his fund. His daughter was starting college, and he needed to withdraw currency from a real estate fund he’d invested in several years ago. He had plenty of cash in the account, so he went ahead and made the request online. But the response Bruce received stunned him. In big bold letters, he was told that due to the financial crisis…
We regret to inform investors that cash withdrawals are not permitted at this time.
This isn’t a fictional account. And it’s not from the 2008 financial crisis. It happened last week. Within 11 days after Britain voted to leave the EU, M&G Investments, Aviva Investors, and Standard Life all banned clients from withdrawing funds due to “extraordinary market conditions.” These are not small, obscure funds in the UK. Each manages billions of British pounds. Because of the crisis, however, it quickly became apparent that continued redemptions would crash the fund and force management to sell assets at fire-sale prices. Executives at each fund felt they had no choice. Bruce couldn’t get his own money out. What does this have to do with bullion-backed funds?
Gold ETFs have the same risks as these funds. And those risks all center around two words…
Counterparty Risk
Counterparty risk is simple: it means you are relying upon another party to make good on your investment. If they fail, for any reason, your investment is in jeopardy. Bruce’s counterparty was the fund itself. They could not make good on returning his money (at least temporarily, and who knows how long it’ll last). Every bullion-backed ETF also has counterparty risk. When you buy a gold ETF, you rely upon many factors, probably more than you realize…
Fund structure
Chain of custody
Management proficiency
Operational integrity
Delivery agreements
Regulatory oversight
If any of these break down, your investment is at risk. Delays for redemptions could easily take place, just like the UK funds above. And with the type of crises Mike and I see ahead, it is highly likely that one or more of these counterparty risks will materialize with bullion ETFs. In fact, some already have. Here are three distinct counterparty risks of gold ETFs that every investor should be aware of…
Who’s on First?
A lot has been written about the pitfalls of GLD (SPDR Gold Trust). But in my view, nothing screams counterparty risk! as much as this excerpt from the prospectus…
“In accordance with LBMA practices and customs, the Custodian does not have written custody agreements with the subcustodians it selects. The Custodian’s selected subcustodians may appoint further subcustodians. These further subcustodians are not expected to have written custody agreements with the Custodian’s subcustodians that selected them. The lack of such written contracts could affect the recourse of the Trust and the Custodian against any subcustodian in the event a subcustodian does not use due care in the safekeeping of the Trust’s gold. See ‘Risk Factors—the ability of the Trustee and the Custodian to take legal action against subcustodians may be limited’.”
So let’s get this straight: GLD’s custodian has subcustodians—and those subcustodians can have subcustodians? And these subcustodians can store gold without a written custody agreement? And this lack of documentation could affect the trust—and GLD has limited legal recourse? This doesn’t sound legal, let alone smart. It clearly makes GLD an accident waiting to happen. This “chain of custody” is so poorly structured that it makes the fund highly vulnerable to all kinds of mishaps. All it will take is for one supplier to knock over the first domino—“gee guys, we can’t get our hands on the gold we were holding for you,” for example—and the ripple effect could instantly cripple the fund and force management to freeze withdrawals. In that scenario, investors would not be able to cash out their position. And consider this: while the gold price would soar on this news, the price of the fund—and your investment—would plummet! These are obvious flaws with GLD, but it’s not the only counterparty risk gold ETFs face…
Paperwork? We Don’t Need No Stinkin’ Paperwork!
Now, if you think GLD carries risk, just wait... it gets worse.
Blackrock, the sponsor of the world's second most popular gold ETF, IAU (iShares Gold Trust), admitted in March that it had failed to register new shares with the SEC. Exchange traded commodity funds are required to do this, but BlackRock reported there was an “administrative oversight” and they sold shares that didn’t yet exist. Management claimed IAU shares continued to trade without interruption, but the reality is that management lost administrative control over the fund. They were fined by both the SEC and state securities agencies (not counting possible lawsuits from shareholders). At least the SEC was on the job, though. Just kidding… it turns out the “oversight” only came to light because the fund itself informed the SEC. In other words, regulators weren’t even aware of the violation! All told, IAU sold $296 million worth of unregistered shares. The problem for investors was that until those shares were registered, the price of the fund did not track the price of gold. Imagine logging on to your account and finding the price of gold rising but the price of your gold fund falling. Gold demand had spiked at the time, but certainly not more than what we’ve seen many times in the past. What happens if gold demand soars again? What if it doubles next time? Or if we have another mania like in 1979? And what does this say about how well equipped this management team is to handle these and other crisis-type events? This blunder shows that management proficiency of this fund is lacking. All ETFs are subject to managerial skill, or lack thereof. Most investors were completely unaware of this development. If a stampede for the exits had started, almost none would’ve got out intact. The next counterparty risk may be the biggest of them all…
Storing Gold on the Titanic
HSBC is Britain’s biggest bank. It is also the custodian for GLD, which means it buys and stores gold for the fund. Unbeknown to many GLD investors, HSBC has a history rife with unethical behavior. Check out some of their violations over the past couple years…
A $1.9 billion fine for money laundering and violating sanctions
Accused of allowing drug traffickers to launder billions of dollars in the US, and helping countries avoid sanctions by moving billions more across borders, including terror-ridden Libya!
Admitted to laundering $881 million for two drug cartels in Colombia and Mexico
Settled claims totaling $1.3 billion for foreign exchange rate manipulations
Charged with predatory lending practices in the mortgage market
On top of all this, HSBC stock has lost almost half its market value in the past two years… at a time the S&P has made new all-time highs!
Does this sound like a bank you want to be the custodian of your gold ETF? The answer is an obvious NO—and yet HSBC continues to be the cornerstone agency responsible for storing and supplying bullion for GLD. And it’s not just GLD… most bullion ETFs store their gold at a bank.
One reason we hold gold is to protect against the banking system—and most ETFs are part of that very system! This link between bullion ETFs and the banking system puts your investment at great risk during an economic or monetary crises. And since Mike believes the next banking upheaval will be one for the record books, bullion ETFs are vulnerable to all kinds of restrictions, emergency regulations, and even confiscation."
Three Reasons I Tell Everyone to Sell Their Gold ETFs By: Jeff Clark, Senior Precious Metals Analyst
