Monty Python gold ETF

[rickb]

A recently discovered, but never filmed, Monty Python script ...

Scene: John Cleese is sitting at a desk on a busy street in front of what appears to be an open-air warehouse under a large sign that says "Gold". We can see in the background a stream of trucks pulling up to the warehouse from all sides loading gold bricks from a large pile or delivering gold to the pile. Graham Chapman walks up.

Chapman: I'd like to buy some gold.

Cleese: Right. See that fellow over there? [pointing to Eric Idle, sitting at another desk under a large sign that says "Stock broker"] Go talk to him and tell him you want to buy shares of "Gold ETF". You can buy as much as you'd like.

Chapman: But I said I'd like to buy some gold.

Cleese: Right. Like I said, go talk to him. [pointing to Idle again]

Chapman: But I don't want shares, I want gold.

Cleese: Right. It's exactly the same thing. See, we've issued 1,000,000 shares so each share is exactly 1/1,000,000th of the gold in our warehouse. [a truck driver comes up and gives Cleese a stack of papers - Cleese makes an entry in a ledger] Strike that. We have 1,020,000 shares and each share is 1/1,020,000th of the gold in our warehouse. When you buy a share, you're buying exactly that much gold.

Chapman: So I go to him and give him money and he brings it to you and you buy gold and store it in your warehouse?

Cleese: Oh no, not at all. We never talk.

Chapman: But I thought you said he sells shares of the gold you have in your warehouse.

Cleese: (exasperated) No, no, no. He just finds someone else who already owns shares willing to sell them to you. But trust me, the shares are exactly the same thing as gold. [another truck driver comes up and gives Cleese a stack of papers - he makes another entry in the ledger]

Chapman: So what am I actually buying if I a buy a share?

Cleese: Like I said. You're buying 1/1,020,000th [looks at the ledger] - no strike that - 1/1,040,000th of the gold in our warehouse.

Chapman: So you're saying if I buy a share it costs me 1/1,040,000th of the current total value of the gold in your warehouse?

Cleese: No. You buy a share for whatever anyone is willing to sell it to you. [Cleese walks over to the pile, picks up a gold bar from the pile, walks back and puts it in what appears to be his briefcase that he takes out and returns from under the desk - making another ledger entry]

Chapman: [sputtering] What are you doing?

Cleese: Oh, that's our fee for managing this operation.

Chapman: Look, I'd just like to buy some gold. I can see people driving up to your warehouse and taking gold. I'm saying I'd like some.

Cleese: [more exasperated] Those people are Authorized Participants. They're trading gold for shares, or shares for gold. We let them trade whenever they want. That's what keeps the price of the shares the same as the price of the gold in the warehouse.

Chapman: How does that work?

Cleese: It's very simple. You see gold costs whatever it costs per ounce, let's say $X. We have as many ounces as we have, let's say Y ounces. So the total value of our gold is X*Y. We keep careful track of how many shares we've issued [another truck driver comes up with a stack of papers, ledger entries are made] - currently [looking at the ledger] we have 950,000 shares outstanding. Let's say the price of our shares is $Z/share. The authorized participants can trade as many shares as they'd like for precisely the same portion of our gold, so if the total price of the shares (currently Z*950,000, minus our fees of course) is more than the total value of our gold, the authorized participants can buy shares, trade shares for gold, sell the gold, and make money! Likewise if the total price of the shares is less than the total value of our gold, the authorized participants can buy gold, trade the gold for shares, sell the shares and make money! What could be simpler? That fellow just leaving traded 90,000 shares for gold which will tend to make our share price go up relative to the price of gold.

Chapman: So your current price was a little less than it should be?

Cleese: I really don't have any idea why the authorized participants make the trades they do. I just work here.

Chapman: And that fellow just leaving bought shares, and traded them for gold?

Cleese: [looking around, a little worried] Yes, of course!

Chapman; [clearly pondering] Wait a minute. I've heard people who short shares on the stock market borrow them from, say, mutual funds or even individual brokerage accounts that own the shares. What happens if the shares he just traded were borrowed?

Cleese: [uncomfortable] Well, ah, [a pretty woman is walking down the street] - Isn't she gorgeous?

Chapman: [still pondering] If the authorized participant borrows shares rather than buying them, and trades them for gold, your share count is too low until the borrowed shares are recreated. It looks like there are less outstanding shares, and you'll have less gold than you should. Hmmm. How many shares are borrowed?

Cleese: [extremely uncomfortable] Well, ah, we don't really track that so I don't actually know.

Chapman: [incredulous] You don't know? Would http://sharesshort.com/ know?

Cleese: I suppose.

Chapman: [looking at what appears to be an iPhone] Would it surprise you to know the total number of your shares that are borrowed is currently nearly 4%. Doesn't this mean that the total number of shares is under counted, by about 4%?

Cleese: [looking around, very nervously - almost whispering] Look, if you really want gold, go talk to that guy over there [pointing to Michael Palin, in a very old fashioned looking shop]. He'll sell you as many gold coins as you want, but you'll have to pay in cash.

Chapman: BRILLIANT!

[stone]

I thought that the physical gold etfs were much less risky than the bond and stock etfs because they didn't lend out holdings. The authorized participant method for expanding and shrinking the size of the etf in line with the amount of money invested in the etf seems on the face of it to be a good system to me. I think it is great that the gold etfs are kept under so much scrutiny but I just think spreading some of that scrutiny over to bond and stock etfs etc would be a good thing.

[rickb]

I thought that the physical gold etfs were much less risky than the bond and stock etfs because they didn't lend out holdings. The authorized participant method for expanding and shrinking the size of the etf in line with the amount of money invested in the etf seems on the face of it to be a good system to me. I think it is great that the gold etfs are kept under so much scrutiny but I just think spreading some of that scrutiny over to bond and stock etfs etc would be a good thing.

As far as I know, the gold ETFs don't directly lend their holdings - but this is really only a technicality since their shares are fungible with gold.  The shares can be (and are) lent, so there are more shares "owned" than the ETFs report as available and the ETFs hold less gold than the amount required to back all the shares apparently in circulation - by the amount of shares that are currently sold short.  For more on this, see http://www.silverseek.com/commentary/sl ... ion-update.

Any stock or bond ETF (or mutual fund) who loans out their assets can get screwed under the right circumstances (for example the loaned asset explodes in value and the borrower defaults).  Vanguard, for one, is very conservative with what they loan out.  I don't know about iShares/BlackRock or other ETF vendors.

[MachineGhost]

Are you saying these ETF's directly create new shares specifically to lend them out to short sellers and unbacked by any hard assets?  If so, that is a different model than normal short selling which borrows shares already in existence.  I'm a little skeptical as this would be fraud on a massive scale.

MG

As far as I know, the gold ETFs don't directly lend their holdings - but this is really only a technicality since their shares are fungible with gold.  The shares can be (and are) lent, so there are more shares "owned" than the ETFs report as available and the ETFs hold less gold than the amount required to back all the shares apparently in circulation - by the amount of shares that are currently sold short.  For more on this, see http://www.silverseek.com/commentary/sl ... ion-update.

[bronsuchecki]

Loaning shares can be risky if the collateral supplied is not good, but loaning does not create unbacked shares as the lender no longer holds the shares, just a right to get them back and thus has a counterparty exposure. Therefore it is not correct to say "so there are more shares "owned" than the ETFs report as available and the ETFs hold less gold than the amount required".

That example is a total misrepresentation of the Authorised Participant market making process that underlies all ETFs, not just the precious metal ones.

[rickb]

Are you saying these ETF's directly create new shares specifically to lend them out to short sellers and unbacked by any hard assets? 

No.  I'm saying if/when these shares are borrowed (from, say, a mutual fund that invests in the ETF), both whoever the borrower sells the borrowed shares to (the real owner) as well as the owners of the mutual fund (who now actually own an IOU, not shares of the ETF) think their investment is backed by gold.  Since the collateral the mutual fund accepts is cash (again, I think it's typically 100% of the current value, marked to market every day), the risk is an upside price explosion so presumably the folks doing the borrowing are pretty convinced the price won't go up.

Therefore it is not correct to say "so there are more shares "owned" than the ETFs report as available and the ETFs hold less gold than the amount required".

Yes - I agree.  That's why I put quotes around "owned".  There is only one actual owner, with shares backed by gold held by the ETF - but (per just above) there's somebody else who in all likelihood thinks they still own the borrowed shares and that these (borrowed) shares are also backed by gold the ETF holds.  You could argue that since the ETF itself is not loaning the shares (or the gold) that they have no culpability whatsoever here.  However, since their shares are fungible with an actual commodity, I think there's a pretty good argument that they're intentionally structured as "stock-like" investments at least partly to get around pesky commodity trading rules.  In particular, unlike actual commodities where shorts and longs must be balanced, short sales of gold ETFs don't have to be balanced by anything.