An appeal and a warning

Section:

10:30p EDT Monday, October 4, 1999

Dear Friend of GATA and Gold:

Vincent Cook offers this excellent essay warning of the
chance of default of the fractional gold banking system
operated by the London Bullion Market Association.

Please post this as seems useful.

CHRIS POWELL, Secretary
Gold Anti-Trust Action Committee Inc.

* * *

THE OTHER DEFAULT RISK

By Vincent Cook

October 4, 1999

With gold prices and gold lease rates soaring in the
aftermath of the announcement by a group of European
central banks that they would restrict gold sales and
gold leasing, short sellers in the futures markets are
facing a classic squeeze that threatens to propel them
into bankruptcy and rock the world's financial system
to its foundations.

But a short squeeze is only half the story. Gold is
not just a commodity that is traded on futures markets;
it is also a form of money. Like other types of money,
gold is used as the backing for a system of fractional
reserve banking.

Specifically, certain members of the London Bullion
Market Association (LBMA) issue deposit claims against
400-ounce good-delivery bars stored in London. Most of
these deposits are "unallocated metal accounts," which
means that the issuers and not the depositors have
legal title to the gold bars. In other words, these
accounts function just like ordinary bank accounts.

The significance of these metal accounts is that many
spot transactions in major gold markets around the
world are settled "in loco London" by mere bookkeeping
entries in these accounts, not by actual physical
delivery of gold (which incurs the expense of transport
and assaying). This gives bullion banks the opportunity
to lend some of their gold reserves, thus earning
interest by expanding the supply of gold claims beyond
its physical backing.

The rapid growth of these fractional reserve accounts
in recent years has had the effect of expanding the
supply of gold traded in spot markets much faster than
can be accounted for by new mine production and
mobilization of central bank reserves. Unlike non-
monetary commodities, the injection of new physical
supplies of gold into the market is subjected to a
multiplier effect, where each ounce of gold stored in
London creates several ounces worth of claims against
gold by successive deposits and loans. Undoubtedly this
leveraging of leased central bank gold via bullion
banking has been a major factor in depressing gold
prices.

As long as depositors don't simultaneously demand
redemption, bullion banks are free to expand the size
of unallocated metal account balances well beyond the
physical stock of gold held in their London vaults. But
when high interest rates create an incentive to draw
down these account balances instead of borrowing more
gold as a way of meeting the demand for physical
delivery, there is a danger that the fractional
reserves will be exhausted and the bullion banks will
default on their obligation to redeem unallocated metal
account balances.

The danger of mass redemption is further compounded by
the fact that gold depositors have no real knowledge of
the condition of the institutions they are dealing
with. The prospect of reserve exhaustion has a way of
becoming a self-fulfilling prophecy when depositors
lack solid information about the liquidity of their
bank, since the fear that others may redeem en masse in
the near future is a strong incentive for one to redeem
now. In other words, a short squeeze may very well turn
into a devastating bank run where every depositor
suddenly clamors for physical delivery.

The mere existence of market conditions such as we are
observing today may prompt the ordinary members of the
LBMA to lose confidence in the LBMA's market makers and
clearing members and demand redemption. If that
happens, the issuers of "paper gold" could be facing
ruin, and the unbacked "paper gold" itself will vanish.