Adrian Douglas: If your gold is at an LBMA bank, you may be just an unsecured creditor

By Adrian Douglas

Monday, March 1, 2010

Recently I have written several articles that have discussed how much "paper gold" has been sold, principally through the unallocated accounts of the London Bullion Market Association, though there are other vehicles that achieve the same end, such as pool accounts, unbacked exchange-traded funds, futures, and derivatives, etc., but the LBMA dwarfs them all.

See:

http://www.gata.org/node/7911

And:

http://www.gata.org/node/7908

I estimate that as much as 50,000 tonnes of gold have been sold that do not exist. That is equivalent of all the gold reserves in the world that are yet to be mined -- or, put another way, 25 years of gold production.

That is the granddaddy of all short positions.

The fractional reserve operation of the LBMA is likely to be the next Madoff scandal, except multiplied by 100 -- a $5 trillion fraud as opposed to a $50 billion fraud.

Like all financial scandals before it, this one will be exposed just as surely as night follows day. Gold is unique among all commodities. It is the only commodity that is not bought to be consumed. Rather, it is purchased as a store of wealth. Because it is not consumed, the buyer does not need to take possession of his gold but can be persuaded to trust the seller to store his gold on his behalf.

This unique wrinkle allows bullion bankers to sell gold that does not exist. This allows them to make huge profits, since they have very little cost, as they don't have the inconvenience of actually having to purchase the gold before they sell it.

The consequence of this illegal activity is that it suppresses the price of gold because the "paper gold" supply has the same effect on prices that would happen if real gold had actually been supplied to the market.

Such racketeering is extremely beneficial to the central banks, which are hostile to gold because a free-market gold price would blow the whistle on their perpetual inflationary actions. A suppressed gold price makes fiat currencies appear to have higher purchasing power.

The central banks do not just turn a blind eye to the bullion banks' fraud but actively assist it; the central banks lease gold at a pittance of a lease rate to make sure there is always enough liquidity so the scam is not exposed from the bullion banks' inability to deliver real metal when asked.

There is nothing new about gold bankers selling gold they don't have. The goldsmiths invented the scheme in the 16th century. As recently as 2005 Morgan Stanley was sued for selling imaginary precious metals. Morgan Stanley even had the audacity to charge storage fees on metal that didn't exist. The firm settled the lawsuit out of court but no criminal charges were ever filed. Morgan Stanley maintained that it did nothing wrong because none of its clients had lost any money in the scam. That was innovative. I will try stealing a billion dollars from a bank and then I will pay it back the following day and see what the FBI thinks of that legal defense.

The LBMA operates a fractional reserve system. It sells much more gold than it has. The LBMA keeps on hand the amount of gold that it estimates, in the worst-case scenario, it will be called upon to deliver.

In a recent article I analyzed data from the LBMA's own Internet site that shows that a net of approximately 20 million ounces of gold are traded every day:

http://www.gata.org/node/8248"

This means that we are meant to believe that the equivalent of 25 percent of global annual gold production changes hands each day on the LBMA. On a gross trading basis this probably represents the whole of annual worldwide gold production traded every day. In dollar terms it represents $5.7 trillion of net trade annually. That is almost 60 percent of the entire U.S. economy or 10 percent of the entire global economy being traded through a handful of gold bullion banks.

It is simply mind boggling. You don't have to be a rocket scientist or a market regulator to smell something fishy. To back that level of trading on a 100 percent reserve ratio, the bullion banks would have to own almost 40 percent of all the gold ever mined. There are simply not enough London Good Delivery bars for that to be the case.

You don't have to rely on me to tell you that the LBMA is running a fractional reserve gold racket. This is from the LBMA's own Internet site:

http://www.lbma.org.uk/london/accounts"

"Unallocated Accounts

This is an account where specific bars are not set aside and the customer has a general entitlement to the metal. It is the most convenient, cheapest, and most commonly used method of holding metal.

"The units of these accounts are 1 fine ounce of gold and 1 ounce of silver based upon a .995 LGD (London Good Delivery) gold bar and a .999-fine LGD silver bar respectively. Transactions may be settled by credits or debits to the account while the balance represents the indebtedness between the two parties.

"Credit balances on the account do not entitle the creditor to specific bars of gold or silver, but are backed by the general stock of the bullion dealer with whom the account is held. The client is an unsecured creditor.

"Should the client wish to receive actual metal, this is done by 'allocating' specific bars or equivalent bullion product, the fine gold content of which is then debited from the allocated account."

There are some real peaches in this description. For example: "Credit balances on the account do not entitle the creditor to specific bars of gold or silver, but are backed by the general stock of the bullion dealer with whom the account is held."

They don't say that the bullion dealer has to hold the amount of gold he has sold, just that these unallocated accounts are backed by the bullion dealer's stock. His stock could be a thousand ounces or none at all.

Note the statement: "The client is an unsecured creditor." So this really spells out what "unallocated" means. It means that there is no gold allocated to the customer. The customer owns only an IOU for gold.

If the LBMA were running a system that had on hand 100 percent of all the gold being sold but just didn't want to assign specific bars and serial numbers, then all creditors would be secured. But the LBMA spells out that all clients are unsecured creditors. The buyers have no gold guaranteed against the IOU from the bullion dealers.

Who exactly are the members of the LBMA? The clearing members are as follows:

-- HSBC Bank USA National Association

-- JP Morgan Chase Bank

-- The Bank of Nova Scotia

-- Barclays Bank

-- Deutsche Bank

-- UBS AG

HSBC and JPMorgan Chase are the biggest short sellers on the New York Commodity Exchange. Together they own 95 percent of the over-the-counter precious metals derivatives. They are also custodians of the bullion supposedly held by the GLD and SLV exchange-traded funds, respectively, and they are clearing agents for the LBMA.

That is one fine set of credentials. These banks are so arrogant and confident that their racketeering will not be exposed that the quarterly publication of the LBMA is titled "The Alchemist."

Unlike the alchemists of the middle ages who tried to turn lead into gold, the alchemists at the LBMA turn paper into gold. (Well, gold IOUs, to be exact.)

In 2003 Graham Tuckwell, chairman of Gold Bullion Securities, made a presentation to the annual LBMA precious metals conference about his firm's new gold-backed ETF that today trades on the American Stock Exchange under the ticker symbol "GOLD." The transcript of his speech can be found here:

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

In that speech Tuckwell said:

"There are three essential components of [a] listed security, in our opinion. Firstly, ownership of the gold; investors want allocated gold, not a third-party credit risk, which is what unallocated gold is. 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."

You have to remember that this is a speech being made in front of all the members of the LBMA. You simply can't make such a statement in front of such a crowd if it isn't true. And we know it is true because the LBMA says the same thing on its Internet site. They say their clients are "unsecured creditors."

The LBMA peddles gold promises to those gullible enough to trade off convenience against title.

Many people do not understand what fractional reserve accounting means. I will give you an example of a less important real-life case.

Commercial airlines routinely sell more seats on a flight than the airplane has. If the plane holds 200 passengers but from statistics the airline knows that on average only half the passengers with ticket show up for check-in, the airline can sell 400 seats and be confident that the plane will fly full, which increases the airline's profitability. If the airline sold only 200 tickets, the plane would fly half empty. Occasionally the airline gets caught when, say, 210 passengers check in. In such circumstances the airline offers a free night in a hotel, a first-class upgrade, and some cash for any 10 passengers volunteering to fly later or the next day. But all the people who purchased tickets believed that they were buying actual available seats, not unallocated virtual seats.

This is exactly the same situation with the LBMA; the LBMA sells more gold than it has. It knows from statistics on average how many clients will ask for delivery and that determines the LBMA's minimum stock level.

But just like the case of the airlines, this scheme is destined to be discovered. When more gold is demanded than the bullion banks can deliver, they try to lease or buy gold from central banks. If this can be done in a timely fashion, the bullion banks' clients are none the wiser. If the central banks cannot provide supply, then the bullion banks are obliged to offer premiums over the spot gold price to encourage clients to accept cash in lieu of metal.

We are hearing anecdotal stories that recently there have been cases of premiums of up to 25 percent being offered for gold buyers to settle in cash instead of metal. It would seem that the bullion banks have pushed the game too far and are on a collision course with default. In addition the central banks have dishoarded a large proportion of their gold and are not in a position to come to the rescue of the bullion banks as much as in the past.

I recently made an analysis of the Comex warehouse inventory of gold and silver in an article entitled "Alarming Trend in Comex Gold and Silver Inventory Data":

http://www.gata.org/node/8373

One of my conclusions is that in the last six months there has been a dramatic decline in the inventory held by the dealers on the Comex (the registered category), while over the same period the open interest has increased. This essentially means that each open contract has less warehouse gold or silver backing today than it did six months ago.

This is a classic reduction in reserve ratio. It is a sign that the gold cartel is running out of physical gold and silver.

This observation is supported by other data. During the last two years the U.S. mint has periodically suspended production of gold and silver coins due to shortages of bullion, and the Comex futures have displayed contracting contango and/or mild backwardation, which is indicative of physical market stress.

There is anecdotal evidence that the LBMA OTC market in London has been having difficulties in making deliveries and requiring central bank gold to do so.

There are also rumors of large premiums being offered for cash settlement in lieu of the bullion.

Sources active in the London market tell us it is difficult to find large amounts of bullion.

The central banks have stopped selling and have become net buyers of gold. Further, at the end of last year the politically connected miner Barrick Gold announced a panicked buying back of its hedges.

The clients of the LBMA are not speculators or gamblers. They have bought gold that they believe is being held in a vault for them by the LBMA members. As the suspicions about the LBMA rise, more clients will ask for delivery, which will expose this fraudulent operation.

As I wrote here earlier, I estimate that as much as 50,000 tonnes of gold have been sold that do not exist. That is equivalent to all the gold in the world that is yet to be mined, or, put another way, 25 years of gold production, the granddaddy of all short positions.

The fractional reserve operation of the LBMA is likely to be the next Madoff scandal, except multiplied by 100 -- a $5 trillion dollar fraud as opposed to a $50 billion fraud. Those holding real bullion will see the price multiply many times as the price adjusts to the supply and demand fundamentals of real metal.

There is only one way to protect yourself and to profit. You should own physical bullion. Simply don't trust intermediaries like the LBMA that purportedly sell you gold but label you an "unsecured creditor." Anyone who thinks he holds gold at the LBMA should demand delivery.

The major desirable and unique characteristic of gold is that it is no one else's liability, unlike almost every other financial asset. If you own a credit risk, like IOU gold, you have not achieved the principle objective of owning gold.

Are you a gold owner or an "unsecured creditor"?

You cannot be both.

-----

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

* * *