Asked And Answered: Some Thoughts On Leverage In The Great Gold And Silver Frauds

The Story

Bloomberg (and The Financial Times et al.) are positing that the scandal in the contracts tied to the price of gold in China is depressing the price of gold now. Is this true?

China Finds $15 Billion of Loans Backed by Fake Gold Trades

By Bloomberg News

Jun 26, 2014

China’s chief auditor discovered 94.4 billion yuan ($15.2 billion) of loans backed by falsified gold transactions, adding to signs of possible fraud in commodities financing deals.

Twenty-five bullion processors in China, the biggest producer and consumer of gold, made a combined profit of more than 900 million yuan from the loans, according to a report on the National Audit Office’s website.

Public security authorities are also probing alleged fraud at Qingdao Port, where copper and aluminum stockpiles may have been pledged multiple times as collateral for loans. Steps by the Chinese government to rein in credit by raising borrowing costs in recent years created a surge in commodities financing deals that Goldman Sachs Group Inc. estimates to be worth as much as $160 billion…

 

The Question

Q:   If something is collateralised more than it exists, how does it become excess versus in short supply?

A:  It’s bearish because it’s convenient to certain parties who see an opportunity in it?  lol

In all seriousness, I do think one can get a temporary move in the paper price of a commodity like gold or anything else, because in their fear investors start dumping and unwinding their paper positions based on some question of fraud.

The question an objective inquiry must frame is, ‘Was the demand itself false, or the means of supplying the demand a false alternative? ‘  In other words, what is the essence of the demand, and what are the incidentals, or accidents.

In a situation where a fraud is exposed, you can get an excess of ‘supply’ of gold related instruments from those who wish to sell, against a deficit in ‘demand’ for that class of instruments because people doubt the veracity of the instruments themselves. You get a temporary break in demand from a disruption in market transactions. 

How do their liabilities match up against proven assets?   In a case like this any affect on the price of the assets is generally a very short term phenomenon, not unlike the withdrawal of the tide in advance of a tsunami. 

Perhaps an analogy would be if the integrity of some instruments such as GLD or SLV was brought into question. What if it was determined that due to counterparty claims and sloppy accounting the net asset value of GLD was called into question?  GLD would fall into a deficit against gold of course.  It would have an excess of liabilities over assets, and the market would adjust that.

There may even be an overadjustment, and ironically GLD might liquidate some of its real assets that had been in short supply.  And in the very short term a break in the demand for GLD might trigger a share liquidation that could also depress the price of the underlying commodity, at least temporarily, depending on how large a market force that GLD had been on marginal demand.