Adrian Douglas: Price suppression follows inevitably from fractional-reserve gold banking

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By Adrian Douglas
Sunday, July 11, 2010

For 11 years the Gold Anti-Trust Action Committee has been amassing evidence that the prices of gold and silver are suppressed. The mechanisms by which this is achieved are complex and multi-faceted. Attempting to convince industry insiders and investors that such an intricate price suppression scheme is not only active but has been active for more than 15 years meets a lot of resistance.

In this article I am taking a different approach; I am going to find some common ground between what GATA says and what its critics say. I am going to define some facts about the gold market that are practically undisputed and show that those facts lead unequivocally to a conclusion that the gold price is suppressed. Given that these conclusions are based upon facts on which everyone agrees, then everyone should agree that the gold market is suppressed.

What everyone can agree upon is that through unallocated bullion accounts, gold certificates, and pooled accounts the bullion banks and gold brokers are operating a "fractional reserve" operation. This means that dealers who undertake to sell and store bullion for their customers on an "unallocated" basis can sell a lot more bullion than they actually have. Many investors will buy and sell their bullion without ever seeing it. This allows the dealers to keep in their vaults only enough bullion to meet the demands of the small percentage of investors who demand physical delivery.

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CPM Group executive Jeffrey Christian, a recognized precious metals expert, makes no bones about the fact that the gold market operates on a "fractional reserve" basis. He even goes as far as to confirm that this is well understood in the industry:

http://www.financialsense.com/editorials/2010/0423.html

Christian says GATA has "expressed shock" that gold held in unallocated accounts is "seen as deposits on the books of the banks and dealers holding those accounts, just like money deposited in a bank, and can be lent against. When they realized this, they began to rant against the fact that unallocated gold can be lent out by a bank holding it. They claimed I had admitted that gold in unallocated accounts was a form of fractional reserve banking. It is a form of fractional reserve banking, but I did not 'admit' that; it's a well understood fact in the industry, and was even the subject of a recent Financial Sense interview with another expert guest."

In 2000 Christian wrote a lengthy paper entitled "Bullion Banking Explained." I made a critical analysis of this document in an article entitled "Making Paper Bullion Explained":

http://www.gata.org/node/8627

In his paper Christian explained what a bullion bank does with an ounce of gold held on deposit for an unallocated account customer:

"Imagine, if you will, that the bank can line up three or more producers and others who want to borrow this gold. All of a sudden that one ounce of gold is now involved in half a dozen transactions. The physical volume involved has not changed, but the turnover has multiplied. This is the basic building block of bullion banking. This admittedly rudimentary outline of bullion banking holds the key to understanding how bullion banking allows for a multiple of trades to be based on one lot of metal. Many banks use factor loadings of five to 10 for their gold and silver, meaning that they will loan or sell five to 10 times as much metal as they have either purchased or committed to buy. One dealer we know uses a leverage factor of 40. (Long-Term Capital Management had a leverage factor of 100 when it nearly collapsed in 1998.)"

As a consequence of my article it appears that Christian has realized how damning his paper was, and while it was posted at the CPM Group Internet site for 10 years, it recently was removed mysteriously. However, you can still find a copy at the GATA Internet site here:

http://www.gata.org/files/CPMGroup-BullionBankingExplained.pdf

In 2003 Graham Tuckwell, chairman of Gold Bullion Securities, made a presentation to the annual London Bullion Market Association (LBMA) Precious Metals Conference. The transcript of his speech can be found here:

http://www.lbma.org.uk/docs/conf2003/2e.tuckwellLBMAConf2003.pdf

Tuckwell said:

"In fact, you could argue unallocated gold isn't gold; it's just a piece of paper issued by a bank, and in most cases, unsecured risk."

I think it is reasonable to infer that you can't stand up at an LBMA conference and say those sorts of things if they were not true. But we don't need to take it on faith because we can see for ourselves from the language of the bullion bank unallocated account agreements. The following definition of an "unallocated account" comes from an actual customer agreement issued by a bullion bank:

"'Unallocated account' means, in relation to a Precious Metal, the account(s) maintained by us in your name recording the amount of that Precious Metal which we have a contractual obligation to transfer to you (or, in the case of a negative balance, if so permitted by us, which you have a contractual obligation to transfer to us)."

Nowhere in the agreement does it require the bullion bank to hold the metal that it has an obligation to "transfer" to the customer. Under the liabilities section the only liability the bank accepts is to pay in cash for any failure of the bank to perform under the agreement.

It is reasonable to conclude that it can be taken as a fact that bullion banks operate on a fractional reserve basis. The bullion bank apologists don't dispute this but only argue that there is nothing wrong with such a system provided that customers receive bullion when they ask for it or get settlement in cash. But the bullion bank apologists do deny any notion that the gold market is suppressed or manipulated.

Let me demonstrate that once it is accepted that there is a fractional reserve operation in the gold market, then there is de-facto gold price suppression. They are flip sides of the same coin.

Imagine if you had heard about the great Colorado River and how fast it flows. If you were to go to the mouth of the river in Yuma, Arizona you would be astonished to see what a small river the Colorado is. But perhaps what you wouldn't know is that the river is dammed upstream, which has reduced the flow from its native condition of the early 1900s by 90 percent. The water is diverted from these dams for irrigation and municipal water supplies. For each 10 gallons of water that flows into the reservoirs created by the river dams, only 1 gallon reaches the river mouth.

In exactly the same way the bullion banks act as dams to the capital that flows into their coffers to purchase bullion. For each 10 or maybe as much as 100 ounces of gold that are requested to be purchased and fully paid for by investors, only one real physical ounce is purchased.

What will happen to the price of gold if only a fraction of investors' money is being used to purchase bullion and the rest is siphoned off to "irrigate" the bank's balance sheet to be channeled into entirely different investments?

Any price rise will necessarily be muted.

This is gold price suppression.

Make no mistake about it; gold price suppression is an absolutely guaranteed outcome of fractional reserve bullion banking.

In a thought experiment we could imagine a world where all investors are content to hold paper gold in an unallocated account and never ask for delivery. The bullion bank could then purchase no real gold whatsoever. There could then be massive demand of billions of dollars flowing into the bullion banks to purchase "paper gold" while the price of real physical gold plummeted because no one was buying the mine output of the gold mines. In our Colorado River analogy you could have record rain fall upstream in the Rockies and the river could dry up in Yuma.

In 2007 Morgan Stanley settled out of court a class-action suit by precious metals investors. The complaint alleged that Morgan Stanley told clients it was selling them precious metals that they would own in full and that the company would store. But Morgan Stanley either made no investment specifically on behalf of those clients or it made entirely different investments of lesser value and security.

If Morgan Stanley was the only one operating in this way, the price suppression would be small. But we know from the London Bullion Market Association that their member bullion banks collectively trade 24 million ounces of gold each day on a net basis. This is $7.5 trillion annually. When a vast majority of this capital never goes to purchase real physical metal, the suppressive effect on the price is monumental.

The dangers of owning "paper gold" have mainly been discussed as the risks of receiving a cash settlement or the risks of losing an investment entirely. These are certainly risks that everyone should take seriously. But in addition to those risks one should add the contribution made to price suppression. By allowing your investment to be channeled away from augmenting the demand for physical metal, you are handicapping your own investment.

The good news is that the tide is turning. More fund managers and institutional investors are becoming aware of the difference between "paper gold" and real bullion. This was highlighted brilliantly and eloquently by Ben Davies, CEO of Hinde Capital in London, in his recent interviews on CNBC Europe and King World News. (See http://www.gata.org/node/8683, http://www.gata.org/node/8805, and http://www.gata.org/node/8809.)

Imagine what will happen when the proverbial dam bursts. As more investors who already believe they own gold demand delivery of physical bullion in place of their paper substitutes there will be a run on the bullion banks. The suppressive effect of holding back demand from the physical bullion market will be reversed with force and fury.

There are already signs of massive cracks in the dam. Last week I wrote an article analyzing the BIS gold swaps in which I concluded that the transaction had the hallmarks of a bullion bank bailout. (See http://www.gata.org/node/8803.) It appears that the bullion banks needed desperately 380 tonnes of gold. When coupled with recent surreptitious monthly gold sales by the International Monetary Fund, this BIS gold swaps are indications that gold supply is drying up -- or, more appropriately, that demand is becoming insatiable.

The impending massive and rapid upward revaluation of gold and silver, or conversely, massive and rapid devaluation of fiat currency will make any discussions of deflation entirely moot.

Investors should do their own due diligence to ensure that their bullion investments are either held in their own custody or in the custody of institutions that guarantee allocated storage that is verifiable and audited. Why hold an investment that will be used by the dealer to prevent it from performing as you anticipate?

The process by which only a portion of an investment is used to purchase bullion -- what is politely called "fractional reserve bullion banking" -- is fraudulent because it acts against the investor's interests. CPM Group's Jeffrey Christian said of fractional reserve bullion banking, "It's a well-understood fact in the industry." If so, then gold price suppression should also be a well-understood fact, because the consequence of fractional-reserve bullion banking is undeniably price suppression.

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Adrian Douglas is editor of the Market Force Analysis letter (www.MarketForceAnalysis.com) and a member of GATA's Board of Directors.

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