Worst case gold ETF scenarios
Posted: Sun Sep 02, 2012 11:45 pm
The notion that GLD (or IAU or SGOL) intrinsically corresponds to some amount of gold seems fundamentally incorrect to me. In this thread, lets collect some plausible nightmare scenarios. Be creative. Think "worst case".
The potential vulnerabilities seem to be that since a share of GLD is not the same as 1/10th of an oz of gold, GLD's price can vary independently of the actual price of gold, trading in GLD can be suspended for indefinitely long periods of time while trading in actual gold continues, the monetary value of a share of GLD can ultimately be decided by a court, one or more of the authorized participants might engage in a massive fraud (this one's easy - an AP exchanges a tonne of gold plated tungsten for shares, sells the shares and then goes belly up - the "backing percentage" is now off by a tonne), etc etc.
Here's a nightmare scenario I'll freely admit I'm not entirely sure is actually feasible:
1) Gold explodes to the upside.
2) JP Morgan acts to control the upside explosion (because they're so short gold, movement up is bad for them) by taking an even larger short position on COMEX, and by madly borrowing shares of GLD/IAU (same mechanism as shorting GLD/IAU) which shares they trade for actual gold from GLD/IAU, which gold they sell on the open market hoping to control the price explosion. This effectively amounts to shorting GLD/IAU - but in a way that no one has to openly report (!).
3) Prices KEEP going up, and eventually even JP Morgan runs out of money (effectively a short squeeze).
Now what?
They obtained actual gold (which has already been sold on the open market) from GLD with borrowed shares and the "backing percentage" quoted by GLD reflects the "borrowing" as SALES. Anyone holding GLD in such a way that it can be lent (think very very hard about whether your shares of GLD can be lent by anyone) suddenly realizes their "shares of GLD" don't correspond to gold, but to an amount of "cash" somebody put up as collateral. The market panics. Perhaps everyone dumps GLD and AFTER its price collapses the government finally steps in and freezes trading (which, not coincidentally, helps JP Morgan). The actual price of gold KEEPS going up.
The net result might be physical gold trading at $5,000/oz and shares of GLD frozen reflecting a gold price of $500/oz. After several months winding through the courts (during which time the price of gold KEEPS going up), the court decides the only "fair" solution is to liquidate the ETF at its frozen value (affecting ALL shareholders, not just those whose shares were lent) and sell the actual gold to help pay for the obligatory JP Morgan bailout (because they are, of course, too big to fail). Another possibility is the court dilutes the shares by an amount corresponding to how many shares JP Morgan "borrowed". I don't think it's inconceivable that they could borrow 50% of the total outstanding shares, meaning all shareholders would take a 1/3 hit. In the first case you're getting less than 10% of what you think is the value of your GLD. In the second, you're getting 2/3. The point here is the value you receive might be, somewhat arbitrarily, decided by a court - not by the gold market!
Anyone else have a nightmare scenario?
The potential vulnerabilities seem to be that since a share of GLD is not the same as 1/10th of an oz of gold, GLD's price can vary independently of the actual price of gold, trading in GLD can be suspended for indefinitely long periods of time while trading in actual gold continues, the monetary value of a share of GLD can ultimately be decided by a court, one or more of the authorized participants might engage in a massive fraud (this one's easy - an AP exchanges a tonne of gold plated tungsten for shares, sells the shares and then goes belly up - the "backing percentage" is now off by a tonne), etc etc.
Here's a nightmare scenario I'll freely admit I'm not entirely sure is actually feasible:
1) Gold explodes to the upside.
2) JP Morgan acts to control the upside explosion (because they're so short gold, movement up is bad for them) by taking an even larger short position on COMEX, and by madly borrowing shares of GLD/IAU (same mechanism as shorting GLD/IAU) which shares they trade for actual gold from GLD/IAU, which gold they sell on the open market hoping to control the price explosion. This effectively amounts to shorting GLD/IAU - but in a way that no one has to openly report (!).
3) Prices KEEP going up, and eventually even JP Morgan runs out of money (effectively a short squeeze).
Now what?
They obtained actual gold (which has already been sold on the open market) from GLD with borrowed shares and the "backing percentage" quoted by GLD reflects the "borrowing" as SALES. Anyone holding GLD in such a way that it can be lent (think very very hard about whether your shares of GLD can be lent by anyone) suddenly realizes their "shares of GLD" don't correspond to gold, but to an amount of "cash" somebody put up as collateral. The market panics. Perhaps everyone dumps GLD and AFTER its price collapses the government finally steps in and freezes trading (which, not coincidentally, helps JP Morgan). The actual price of gold KEEPS going up.
The net result might be physical gold trading at $5,000/oz and shares of GLD frozen reflecting a gold price of $500/oz. After several months winding through the courts (during which time the price of gold KEEPS going up), the court decides the only "fair" solution is to liquidate the ETF at its frozen value (affecting ALL shareholders, not just those whose shares were lent) and sell the actual gold to help pay for the obligatory JP Morgan bailout (because they are, of course, too big to fail). Another possibility is the court dilutes the shares by an amount corresponding to how many shares JP Morgan "borrowed". I don't think it's inconceivable that they could borrow 50% of the total outstanding shares, meaning all shareholders would take a 1/3 hit. In the first case you're getting less than 10% of what you think is the value of your GLD. In the second, you're getting 2/3. The point here is the value you receive might be, somewhat arbitrarily, decided by a court - not by the gold market!
Anyone else have a nightmare scenario?