Old-fashioned run on gold could hit London market, ADM analyst warns

The Shanghai Gold Exchange launched its groundbreaking yuan-denominated price fix last month, and in doing so set the stage for China to potentially displace London as the global epicenter for the gold trade, among other far-reaching implications. Now, ADM Investor Services Paul Mylchreest has issued a new analysis that spells out exactly why Londons dominance is so vulnerable.

Sensationally titled Death of the gold market: Reforming the LBMA and the true price of gold, the thesis of Mylchreests paper is simple: The London Bullion Market Association (LBMA) simply does not have all the gold needed to back up paper and electronic claims on the metal particularly if Western investment in gold suddenly increases.

Based on his calculations, Mylchreest argues that the LBMA is running into a problem and is facing the biggest challenge since it collapsed from an insufficient supply of physical gold in March 1968.

Growing risk of market failure: According to Mylchreest, investors shouldnt make the mistake of thinking that much physical metal actually changes hands over the course of a given trading day in London. Rather, most transactions are just paper and electronic receipts that represent quantities of bullion.

The assumption that the London-based LBMA members are primarily trading physical gold is inaccurate, he writes. In reality, LESS THAN 5% of gold traded on the LBMA is settled by the delivery of physical metal into what are known as allocated gold accounts.

The opposite of allocated is unallocated. The problem is epitomized by the practice of gold leasing, in which central banks and other institutions loan out gold or claims to their gold without the bullion actually ever leaving their vaults. The end result is multiple counterparty claims to the same bar of gold. The only force sustaining the arrangement is blind faith that the system can deliver actual gold if its ever called upon to do so. In other words, its a fractional reserve system.

Stressing the unsustainable market structure of paper gold instruments versus physical gold bullion, Mylchreest warns of the growing risk of market failure.

Western surge could be game changer: Increasing demand for physical gold from a variety of consumers is putting pressure on the system and raising the odds of a delivery failure. Central-bank buying, Chinese consumption, and the rebound of gold ETFs are all straining the system.

The structural flaws in London leave the gold markets integrity vulnerable to increasing offtake of physical gold. In other words, an old fashioned run, writes Mylchreest. A shift in the balance in gold trading from paper instruments towards physical could quickly destabilise the market.

The explosive element in this picture is Western demand. Western investors, both individually and institutionally, are drastically underinvested in gold. Should a crisis occur that stokes a renewed run into gold, then the London system could implode.

The vast pools of Western capital are not underweight gold, they are almost zero-weighted, Mylchreest notes. Ultimately, gold is a bet on financial system mismanagement in many guises such as inflation, deflation, rising credit risk, declining confidence in policy makers, etc. The fact that mainstream investors and commentators have started to have doubt about central bank policies has been positive for gold. An increase in the current tiny allocation of the vast pools of Western capital into physical gold would have a disproportionate impact on the market. Could the physical gold market accommodate even a modest allocation of Western capital near the current gold price? We doubt it.

Two-tiered system emerging: And now, with yields on trillions of dollars of bonds now turning negative, the age-old rap against gold that it doesnt pay any interest is starting to lose its weight.

And waiting in the wings to take over where London falls short is the Shanghai Gold Exchange, which unlike London is a 100% physically traded and allocated bullion market. Its launch this year is part of China's long-term plan to elevate its yuan currency to world-reserve status.

Mylchreest sees the potential for a two-tiered gold market emerging, in which the yuan-denominated price (with its assurances of physical backing) carries more weight than the London price, which he argues carries little to no guarantee.

Most investors holding flimsy paper: Mylchreests paper is a clarion call for investors who have settled for gold ETFs instead of physical gold. The vast majority of gold investors are holding paper gold instruments. While their investment rationale might be because they dont trust the financial system or require portfolio diversification, their counterparties are banks in which they are on the lowest rung of creditors. The irony.

Its a tale of two exchanges, one in the West, the other in the East. Without drastic reforms, the sun is setting on London while Shanghai is in its early ascendancy. Its also a tale of two currencies, the U.S. dollar and the Chinese yuan (or renminbi). Though the dollar still dominates, China and Russia are madly scrambling to anoint alternatives, and the yuan has now been tapped for reserve status in the International Monetary Funds SDR (or special drawing rights) system.

The main message of Mylchreests paper is: Dont be left holding the bag. Dont settle for a paper promise of gold when you can still get your hands on the physical metal. And dont denominate all your wealth in U.S. dollars when you can still diversify into alternatives like physical gold.

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