pay no attention to the man behind the curtain...

Good morning and welcome to a Terrific Tuesday! Don McLean greets me this morning with his 1972 hit, “American Pie.”

I thought today I’d do something a little different. Instead of offering up my thoughts on why the market is doing this or that, I’d instead explain how the market works. I mean, it’s a little more convoluted than the stock market and most people are shocked to see what actually happens behind the curtain.

So, to be able to make sense of what I’m about to explain, let’s first look at the stock market. This morning, you decide to buy 100 shares of Coca-Cola stock. So do you call the Coca-Cola Company Headquarters in Atlanta and ask for the “Stock” department? Nope, they can’t help because their stock is sold on the NYSE. So you have to call up a broker. He takes your money and buys you the stock. The price is based on how well the company is doing in relation to the number of outstanding shares. So when there is a finite number of shares available and more people want to buy than who want to sell, the price goes up. What we learned in first year economics as basic supply and demand. Easy enough.

The Precious Metals Market is different. Yes, you can buy 100 shares of SPDR® Gold Shares, but you aren’t actually involved in creating the value of gold like your buying of Coca-Cola stock. SPDR® is sort of a side bet. Precious metal prices are set on the COMEX and the players are actually what we call the Bullion Banks.

So first, let’s identify these market makers. These banks are: PNB Paribas, Citibank, Goldman Sachs, HSBC, JP Morgan Chase, Merrill Lynch, Morgan Stanley, Société Générale, Standard Chartered Bank, and the Bank of Nova Scotia. Additionally, there are a number of full member banks that include those in Australia, New Zealand, China, Switzerland, Japan, and Germany. Now we know who they are. But what do they do?

These banks act to physically hold segregated gold on its client’s behalf acting in the role of custodian. That gold is said to be set aside and the banks customer has full legal title to that specific gold. This is called an Allocated Gold Account.

They also, under their own regulations have what is termed as an Unallocated Gold Account. Unfortunately, over time, the definition has perverted to mean that the balance of the account simply represents the indebtedness between the two parties. There are no longer any bars set aside for the customers. This is where the term “paper gold” originated. These contracts represent a specific, yet fictitious amount of metal.

Important to note is that an unallocated account of paper gold can also be created by a Bullion Bank making a simple book-keeping entry. What I’m getting at is if a customer requests to purchase unallocated gold within the system as a means of achieving exposure to the gold price for speculative purposes, the bank simply credits the customer’s unallocated account with a “balance of gold.” The Bullion Bank then hedges its liability to the customer by creating a position on the opposite side of the trade and either holds it, sells it to another customer, or to another bank. The unallocated account customer thinks they hold a balance of gold, however, they merely hold a claim on the bank. The bank has offset the exposure to this claim by selling a counter claim elsewhere.

Okay, is this making sense? Tomorrow we’ll look at more perversions in this market.

Well, that’s it for today. Go out there and make a difference! See ya later!