In the first Great Depression, the government tried, for several years, between 1929 and 1933, to maintain a fiction that the U.S. dollar was still convertible and as “good as gold”, in spite of having irresponsibly printed more dollars than they had gold to back them. Back in the 1920s, just like during the last 22 years, the Federal Reserve had run its printing press overtime, and, as a result, it couldn’t deliver. The U.S. Treasury eventually ran out of the gold, in the face of overwhelming public demand, resulting in the infamous gold confiscation order, by President Franklin Roosevelt, in 1933. History may be repeating itself, except that the government no longer makes any pretension to maintaining a gold standard, or any standards at all. Instead, nowadays, the futures exchanges offer to trade gold for a floating number of dollars, and, it appears, they have printed more paper contracts than they can redeem, at least when it comes to 1 kilogram bars.
The NYSE-Liffe futures exchange has, it seems, run out of 1 kg bars of gold. Futures markets, like NYSE-Liffe and COMEX, try hard to maintain the fiction that they will deliver physical gold, in completion of executed contracts. Indeed, to prevent fraud, U.S. law requires clearing members to keep a stockpile, of one kind or another, consisting of a minimum of 90% of metal. Up until October, 2008, it didn’t matter. Only about 1% of long buyers of paper gold futures contracts typically took delivery. Now, the situation is very different. Demand has surged and, it appears, one major futures exchange, NYSE-Liffe, and by extension, the COMEX gold warehouses it shares with its larger cousin, are unable to meet the requirements of their contracts, vis-a-vis, delivery of 1 kg. bars.
As of December 31, 2008, the NYSE-Liffe mini-gold (YG) contract specifications were changed to read, in pertinent part, as follows:
33.2 fine troy ounces (+10%), no Less than 995 fineness. Seller’s discretion delivery of one vault receipt representing one bar or one Warehouse Depository Receipt (WDR) representing either 1/3 interest in one full size gold NYSE Liffe vault receipt or full interest in a NYSE Liffe Mini Gold vault receipt. Delivered to exchange approved vaults by exchange approved carriers.
But, before that, on August 26, 2008, it read as follows:
33.2 troy ounces (±5%) of refined gold, assaying not less than .995 fineness, contained in no more than one bar.
In summary, there is now so much demand for delivery of the mini-contracts that the exchange can no longer deliver 1 kg bars. When the wording was changed, a flurry of complaints resulted. Technically, in my opinion, if you bought a mini futures contract from an NYSE-Liffe clearing member, prior to December 31st, you could bind them to their legal contract with you, and force them to either deliver the 1 kg bar, or pay for you to obtain it on the open spot market. Based upon the original wording, NYSE-Liffe and its clearing members are legally obligated to deliver that 1 kg bar per contract, whether they want to or not, and regardless of the internal rules of the exchange. Whether anyone will force compliance, however, is an open question.
Absent legal action, clearing members are now being allowed to hand out little slips of paper, called “warehouse depository receipts” (WDR). These are being substituted for “vault receipts” (VR). The WDRs, in contrast to the VRs, merely promise the customer that he owns a 1/3 interest in a 100 ounce bar. The customer is not allowed to take delivery, unless he can accumulate 3 WDRs, which equals 1 VR. NYSE-Liffe shares its warehouses with COMEX. The warehouse is predominantly stocked with 100 ounce bars. The COMEX ETF also stores 100 ounce bars, and clearing members can withdraw baskets of them in order to meet delivery demands. But, the COMEX ETF doesn’t store any 1 kg. bars.
After a customer complaint, I contacted the head of regulatory compliance at NYSE-Liffe, and had a serious chat with him. He seemed like a nice enough fellow, but he wouldn’t admit that NYSE-Liffe had run out of 1 kilo bars. He said that the warehouse registrar has complete “discretion” to hand out paper WDRs, representing a 1/3rd interest in a 100 ounce bar, if the “circumstances warrant”. But, if the exchange has “complete discretion” to alter contracts as they see fit, what is the purpose of the advertised contract specifications? NYSE-Liffe claims that its clearing members can rely on Exchange Rule 1408. This obscure rule, however, was never communicated to customers. Nevertheless, it is now being relied upon by the exchange, in an attempt to “default” on the contracts without legal consequences. The rule says that clearing members can substitute delivery of a WDR, giving the customer a 1/3rd interest in a 100 ounce bar, instead of a physical 1 kg bar of gold. There is only one problem. In their eagerness to sell contracts, the exchange failed to communicate that to customers and failed to make it a part of the contract specifications. As a result, clearing members may be saved from claims by one against the other, but they are NOT immune to the just claims of aggrieved customers. The exchange clearly misled the public, intentionally or unintentionally, and allowed clearing members to sell huge numbers of 1 kg contracts, even though they did not have enough 1 kg. bars to fulfill the contracts.
There has been a lot of talk, over the past year, by bearish gold commentators, claiming that the shortage of gold and silver is merely a fluke of the retail market. However, 1 kg. bars of gold are NOT a retail denomination. They are the primary unit used in most commodity futures markets. Unlike the American exchanges, the 1 kg. bar dominates deliverable contracts, for example, on the Tokyo Commodities Exchange, as well as many other commodities exchanges around the world. They were also the primary unit of the mini-gold contracts (YG), offered by NYSE-Liffe, prior to the technical default. In other words, the retail gold shortage has spread into the wholesale market. What’s next? Will there be a shortage of 100 ounce bars? No exchange rule can be used to hide from a technical default on delivery of 100 ounce bars. But, vast numbers of 100 ounce bars are stored at the iShares COMEX gold trust (IAU). So, a default in delivery of 100 ounce bars will take a while.
All that said, however, given that the Fed printing press is running overtime, things are going to get tighter. It will take only a few months of delivery percentages similar to those seen in December, 2008, before all the 100 ounce gold bars are gone. What will the futures exchanges do? Hand out little slips of paper entitling contract holders to a ¼ interests in 400 ounce banker’s bars? There is no rule that allows that. What happens when people start taking mass delivery of the 400 ounce bars? Will they hand out fractional shares in gold mines, along with picks and shovels?
The only way that remaining supplies can be rationed is by a rise in price sufficient to deter some of the buying. For some reason, the supply and demand for gold on the futures market is significantly out of synchronization. This implies that those who claim that the price of gold is manipulated are probably correct, because the situation could not happen in a completely free market. But, even if the gold market is manipulated, the manipulators cannot stop this from happening if the demand for delivery continues. In a more practical sense, coupled with the nearly complete removal of all small retail denominations of gold from store shelves around the world, demand is clearly outstripping supply by a considerable measure.
With the U.S. and the U.K. now engaged in quantitative easing (printing new dollars and pounds), and other central banks ready to join, we can reasonably assume that the desire to exchange paper money for gold will get stronger. If the price does not rise significantly, and quickly, it is only a matter of time before these shortages reach the 100 ounce bars, and, then, on to the 400 ounce banker’s bars. That is what happened, back in the 1930s, and it is happening again. The main difference is that, in the 1930s, the price was fixed by the government, so the conversion of dollars to gold could not be controlled by a rise in price. Now, however, the price of gold can go up until, potentially, it is high enough to discourage more buying by the public. It is impossible to say whether or not this means a rise to $2,000 or $2,500 per ounce by the end of 2009, as some have predicted. But, it does mean that the price will surely rise, that the rise is going to be huge, and, probably, that it will be fast and furious, at some point in the near future.
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