Are the underlying mechanics of the largest gold ETF a cause for concern?
Exchange-Traded Funds (ETFs) are an important element in the global gold market. The largest gold ETF is the “SPDR Gold Trust,” which is traded on the New York Stock Exchange Arca (NYSE Arca) under the symbol “GLD.” In this article, we will examine how GLD works to understand its role in the gold market and its impact on the gold price.
In general, ETFs are funds that hold and track the price of assets like a commodity or stock market index. But unlike normal funds, ETFs are conveniently traded on stock exchanges. ETF securities represent shares of ownership in the fund. In the case of GLD, shareholders own a segment of the Net Asset Value (NAV) of the fund, which mainly holds physical gold. So, owners of GLD shares don’t own the gold itself, but a slice of the fund. As with other derivatives, GLD provides exposure to the price of the underlying asset.
The stock exchange is referred to as the secondary market. Here, existing shares of an ETF can be traded by all types of investors. In the primary market, ETF shares are created and redeemed by “Participating Dealers.” It’s mainly through the creation and redemption process of shares that the ETF price tracks the price of the associated asset. Let us have a look at how this works with GLD.
Primary market participants for GLD include (from the prospectus dated August 9, 2019):
– The Trustee BNY Mellon Asset Servicing, which is responsible for the day-to-day administration of “the Trust” (the Fund).
– The Custodian HSBC Bank plc (there can be sub-custodians), which stores Good Delivery gold bars for the Trust in London.
– The Sponsor World Gold Trust Services, LLC, a subsidiary of the World Gold Council, which oversees the performance of the Trustee and the Custodian.
– The Authorized Participants, which are the institutions authorized to create and redeem GLD shares at the Trustee. (With other ETFs, these are called the Participating Dealers.) At this moment, the Authorized Participants are Credit Suisse Securities (USA) LLC, Goldman Sachs & Co., Goldman Sachs Execution & Clearing, L.P., HSBC Securities (USA) Inc., J.P. Morgan Securities LLC, Merrill Lynch Professional Clearing Corp., Morgan Stanley & Co. LLC, RBC Capital Markets, LLC, UBS Securities LLC, and Virtu Financial BD LLC.
One GLD share represents 0.1 ounce of gold. (Put differently, the value of one GLD share is equal to the value of 0.1 ounce of gold. And actually, at the time of writing, it’s a little less than 0.1 ounce, for reasons to be explained below.)
The price of GLD is set by supply and demand on the exchange where it’s traded (NYSE Arca), just like the gold price is set by supply and demand of gold in the London Bullion Market. For this article, when I mention the gold price, I refer to the spot gold price in London.
The GLD share price tracks the gold price, mainly through arbitrage. When, for example, the price of GLD trades at a premium to the gold price, an Authorised Participant (AP) can collect a profit. The AP can buy gold, deposit the gold at the Trustee, which creates shares in return for the AP, who can sell these on the stock market. This process will drive up the gold price and lower the price of GLD. APs will jump the arbitrage opportunity until the gap is closed. Naturally, the arbitrage works the other way around when GLD trades at a discount to the gold price. In this situation, APs will redeem shares at the Trustee to get gold out that they can sell in the London Bullion Market.
Below you can see a simplified graph I have made of the creation and redemption process of GLD shares.
GLD securities can only be created or redeemed in a “Basket” of 100,000 shares. Because one share represents 0.1 ounce, 10,000 fine troy ounces (about 25 Good Delivery bars) are required for creating 100,000 shares of the Trust. Vice versa, 100,000 shares are required for redeeming (withdrawing) 10,000 fine troy ounces from the Trust.
Over time small amounts of the Trust’s gold are sold to pay for the Custodian’s storage fees and the Trustee’s expenses. This gradual selling is the reason why one GLD share represents less than 0.1 ounce of gold, and this amount continuously declines. The day GLD was launched, one share represented 0.1 ounce; at the time of writing, one share represents 0.094 ounce. As a consequence, currently, APs need to deposit less than 10,000 ounces at the Trustee in order to create 100,000 shares and will receive less than 10,000 ounces when redeeming 100,000 shares.
In the chart above, you can see that the gold price and the level of GLD inventory are correlated. The chart suggests that buyers and sellers of GLD contribute to the directional trend of the gold price. Consider, for example, when the spot gold price went up and at the same time GLD inventory swelled. The APs must have been buying gold and creating shares. Their incentive for creating shares was likely that the GLD price (occasionally) was trading at a premium to the spot gold price.
However, the prospectus reads that the APs can also “act for their own accounts or as agents for broker-dealers, custodians and other securities market participants that wish to create or redeem Baskets.” And, “Shareholders who are not Authorized Participants will only be able to redeem their Shares through an Authorized Participant.” Implying, if you own less than 100,000 GLD shares, you can’t redeem for gold. But, if you are well connected to one of the APs, and you own a Basket of 100,000 shares or a multitude of that, you can redeem for gold.
In many countries, certain investment funds are not allowed to own commodities outright but are allowed to own regulated securities like GLD. These funds might be forced to buy GLD or a similar ETF if they want some exposure to the gold price. These funds can be sizable, and GLD’s secondary market might, therefore, be illiquid for them. On request, APs can buy or sell (create or redeem) shares for such clients in the primary market. To give you an idea of the gold trade’s extent, observe that in 2019 the average daily gold trading volume in the London Bullion Market was $45 billion. For comparison, the average daily trading volume in GLD at NYSE Arca was $1 billion.
Whether it’s arbitrage, or providing liquidity for institutional clients, when APs create (redeem) shares, this gives upward (downward) pressure on the spot gold price, and increases (decreases) GLD inventory.
There is always much hyperbole in the gold space, and when it comes to GLD, it’s no different. For years, rumors have been circulating that GLD isn’t backed by physical gold. Although the bar list of GLD is online, and twice a year, a highly respected auditor inspects the gold (click here to the view most recent audit report). Chances are very slim that the gold isn’t there.
Furthermore, the prospectus reads, “Creation of Baskets may only be made after the requisite gold is deposited in the allocated account of the Trust. … All of the Trust’s gold is fully allocated at the end of each business day.” According to my analysis, the gold is there.
Still, I wouldn’t buy GLD if I didn’t have to. When it comes to owning gold, one significant rationale is that gold is the only universally accepted financial asset without counterparty risk. Gold protects your purchasing power and offers insurance on your savings because it’s a physical element. As such, it can’t be printed out of thin air (inflate) or be late with its payments (default).
Gold is truly independent of the financial system. Every insurance product created by the financial system—whether that be a sovereign bond, a fiduciary currency, a futures contract, a credit default swap, etc.—has counterparty risk. Since all major financial institutions are nowadays connected, risk contagion is guaranteed. An insurance against the financial system is, therefore, ideally to be found outside the financial system, namely, in gold.
As financial expert Simon Mikhailovich puts it:
Buying an insurance policy against failure of the insurance industry from an insurance company is nonsense. If the insured event occurred, the company that sold the policy would fail and the policy would be worthless.
So why would you own GLD? Sure, it offers exposure to the spot gold price. But when things go haywire, GLD exposes you to many counterparties, which would be BNY Mellon Asset Servicing (Trustee), which is a division of The Bank of New York Mellon, HSBC (Custodian), potential sub-custodians (The Bank of England, ICBC Standard Bank, JPMorgan, Scotiabank, and UBS), NYSE Arca, and the Authorized Participants. Owning GLD is like owning a gold derivative with as much counterparty risk as possible.
Not surprisingly, the GLD prospectus reads like an endless disclaimer. On page 11, it states, “the Custodian will not be liable for any delay in performance ... of any of its obligations ... beyond its reasonable control, including acts of God...”. And on page 13, “In the event of the insolvency of the Custodian, a liquidator may seek to freeze access to the gold held in all of the accounts held by the Custodian, including the Trust Allocated Account.”
The problem with all the counterparties involved with GLD is that they don’t primarily deal with gold. These are the biggest banks in the world, and if any branch of these banks fails, it can have consequences for the entire entity, and GLD will potentially suffer too. In my view, it’s best to store gold outside of the financial system.
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