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The Risks of Gold and Silver ETF's vs. Physical Metals

Team GoldSilver 
JAN 25, 2024

On the surface, buying a bullion-backed exchanged-traded fund seems harmless. An ETF (or ETN, Exchange-Traded Note) is a security that tracks an index, sector, commodity, or other asset, but can be bought or sold just like a stock.

Gold ETFs are no different. They track the price of the metal, don’t require you to store any bullion, and even list the serial numbers of the bars they hold on their website. Sounds good, right?

But similar to the old joke about “waterfront” land in Florida that turns out to be swampland, these products are not as straightforward as they sound once you look closely. The reality is, bullion ETFs carry much greater risk than most investors realize. Further, a crisis of any serious nature may demand that you have not just price exposure, but actual metal in your possession.

  • Though ETF shares tend to track the price of gold or silver, owning ETF shares exposes you to many disadvantages vs. owning physical metal
  • The fine print in ETF prospectuses is riddled with loopholes and escape clauses that absolve the fund of responsibility in any number of situations that could prove disastrous to your holdings
  • The number one reason owning physical metal is vastly superior to owning shares in an ETF is zero counterparty risk: you own actual gold or silver instead of an unenforceable digital claim on gold or silver

This article examines the key structural defect inherent in all bullion ETFs, three specific risks you face with current ETF products, and the fundamental reason investors need a meaningful amount of physical gold and silver in their possession.

The One Sentence Every Bank Customer Fears

Imagine you log on to your bank account to withdraw some cash, and receive a notification that includes the following statement:

  • “We regret to inform investors that cash withdrawals are not permitted at this time.”

The things is, this is not fiction… it’s not some old reference to the Great Depression… and it didn’t occur in a third world country. It happened in Great Britain, in 2011.

The Risks of Gold and Silver ETFs vs. Physical Metals

Within 11 days after Britain voted to leave the EU (aka, Brexit), M&G Investments, Aviva Investors, and Standard Life all temporarily banned clients from withdrawing funds due to “extraordinary market conditions.”

These are not small, obscure funds in the UK. Each manages billions of British pounds. Because of the unexpected outcome on Brexit, however, it quickly became apparent that continued redemptions would cause a liquidity crisis and force management to dump assets at fire-sale prices. Executives at each fund felt they had no choice.

The result was that regular depositors couldn’t get their own money out.

What does this have to do with bullion-backed funds? Gold ETFs have the same risks as those funds. And those risks all center around two words…

Counterparty Risk

Counterparty risk is simple: it means you rely upon another party to make good on your investment. If they fail, for any reason, your investment is in jeopardy. Even a simple savings account relies on the bank to be in a position to honor paying out your savings at any time and in any amount.

The counterparty for the UK investors were the funds themselves. They were temporarily unable to return depositors’ money when they needed it (and consider that since it was a crisis at the time, it was precisely when customers needed access to that cash the most).

Every bullion-backed ETF also has counterparty risk. When you buy a gold ETF, you rely upon many factors, probably more than you realize…

  • Fund structure
  • Chain of custody
  • Management proficiency
  • Operational integrity
  • Delivery agreements
  • Regulatory oversight

If any of these break down, your investment could be at risk. Delays for redemptions could easily take place, just like with the UK funds above. More importantly, with the type of crises Mike Maloney sees ahead, it is highly likely that one or more of these counterparty risks will materialize with bullion ETFs. In fact, some already have, as you’ll see.

Here are three distinct counterparty risks of gold ETFs that every investor should be aware of…

Risk #1: Emergency Liability

A lot has been written about the pitfalls of GLD (SPDR Gold Trust), the largest gold bullion fund in the market. But what many investors don’t know is that it carries enormous counterparty risk.

The following statements are all buried deep within the most recent fund prospectus (May 8, 2017):

  • If the Trust’s gold bars are lost, damaged, stolen or destroyed under circumstances rendering a party liable to the Trust, the responsible party may not have the financial resources sufficient to satisfy the Trust’s claim.
  • If the Custodian becomes insolvent, its assets may not be adequate to satisfy a claim by the Trust or any Authorized Participant. In addition, in the event of the Custodian’s insolvency, there may be a delay and costs incurred in identifying the gold bars held in the Trust’s allocated gold account.
  • The gold bullion custody operations of the Custodian are not subject to specific governmental regulatory supervision.
  • The Trust’s obligation to reimburse the Marketing Agent and the Authorized Participants for certain liabilities in the event the Sponsor fails to indemnify such parties could adversely affect an investment in the Shares.

Does any of this sound like a reliable investment? Hardly. In a push-comes-to-shove environment, the risk is transferred to you. The fund is set up to protect itself before the investor. Worse, in the event any of these events take place the ETF may not even track the price of gold.

That’s not all. You may be surprised to learn that GLD hires subcustodians to store some of their gold. But that relationship has glaring loopholes and potentially fatal flaws. Check out some of these statements from the same prospectus:

  • Under English law, neither the Trustee nor the Custodian would have a supportable breach of contract claim against a subcustodian for losses relating to the safekeeping of gold.
  • If the Trust’s gold bars are lost or damaged while in the custody of a subcustodian, the Trust may not be able to recover damages from the Custodian or the subcustodian.
  • Because neither the Trustee nor the Custodian oversees or monitors the activities of subcustodians who may temporarily hold the Trust’s gold bars until transported to the Custodian’s London vault, failure by the subcustodians to exercise due care in the safekeeping of the Trust’s gold bars could result in a loss to the Trust.
  • The Custodian is required under the Allocated Bullion Account Agreement to use reasonable care in appointing its subcustodians but otherwise has no other responsibility in relation to the subcustodians appointed by it. These subcustodians may in turn appoint further subcustodians, but the Custodian is not responsible for the appointment of these further subcustodians. The Custodian does not undertake to monitor the performance by subcustodians of their custody functions or their selection of further subcustodians. The Trustee does not undertake to monitor the performance of any subcustodian.
  • The Trustee may have no right to visit the premises of any subcustodian for the purposes of examining the Trust’s gold bars or any records maintained by the subcustodian, and no subcustodian will be obligated to cooperate in any review the Trustee may wish to conduct of the facilities, procedures, records or creditworthiness of such subcustodian. The ability of the Trustee and the Custodian to take legal action against subcustodians may be limited, which increases the possibility that the Trust may suffer a loss if a subcustodian does not use due care in the safekeeping of the Trust’s gold bars.

So let’s get this straight: GLD’s custodian has subcustodians… and those subcustodians can have subcustodians… and all these subcustodians can store gold without a written custody agreement… and GLD has no right to visit the storage facility… and the lack of documentation could affect the performance of the trust… and GLD has limited legal recourse?

This doesn’t sound legal, let alone smart. It clearly makes GLD an accident waiting to happen. This “chain of custody” is so poorly structured that it makes the fund highly vulnerable to all kinds of mishaps.

All it will take is for one supplier to knock over the first domino – “gee guys, we can’t get our hands on the gold we were holding in the fund,” for example – and the ripple effect could instantly cripple the fund and force management to freeze withdrawals. In that scenario, investors would not be able to cash out their position.

And consider this: while the gold price would soar on this news, the price of the fund – and your investment – would plummet!

These are obvious flaws with GLD, but it’s not the only risk gold ETFs face…

Risk #2: Administrative Oversights

If you already, rightfully, think GLD carries a lot of risk, wait until you see this…

Blackrock, the sponsor of the world's second most popular gold ETF, IAU (iShares Gold Trust), admitted in 2016 that it had failed to register new shares with the SEC. Exchange traded commodity funds are required to do this, but BlackRock reported there was an “administrative oversight” and they sold shares that didn’t yet exist.

Management claimed IAU shares continued to trade without interruption, but the reality is that management lost administrative control over the fund. They were fined by both the SEC and state securities agencies (not counting possible lawsuits from shareholders).

And per usual, the chronically overburdened and understaffed SEC totally missed it. It turns out the “oversight” only came to light because the fund itself informed the SEC. In other words, regulators weren’t even aware of the violation!

All told, IAU sold $296 million worth of unregistered shares. The problem for investors was that until those shares were registered, the price of the fund did not track the price of gold. Imagine logging on to your account and finding the price of gold rising but the price of your gold fund falling. That’s exactly what temporarily happened to IAU shareholders.

Management blamed a spike in demand at the time, but it was certainly no more than what we’ve seen many times in the past. What happens when (not if) gold demand soars again? What if we get some sort of gold mania? And what does this say about how well equipped this management team is to handle these and other crisis-type events?

This blunder shows that management proficiency of this fund is lacking. All ETFs are subject to managerial skill – or lack thereof.

Most investors were completely unaware of this development. If a stampede for the exits had started, almost none would’ve got out intact.

The next counterparty risk may be the biggest of them all…

Risk #3: Relying on Banks

HSBC is Britain’s biggest bank. It is also the custodian for GLD, which means it buys and stores gold for the fund.

Unbeknownst to many GLD investors, HSBC has a history rife with scandals that include predatory lending, tax evasion, and even accusations that their lack of controls helped terrorist groups and drug traffickers. Their “rap sheet” is pretty long…

  • In January 2013 HSBC paid $249 million to settle charges of foreclosure abuse
  • In March 2013 the government of Argentina filed criminal charges against the local subsidiary for helping businesses evade taxes and launder money.
  • In April 2014 the US Justice Department warned the bank needed to do more to improve its safeguards against money laundering.
  • In July 2014 the US Attorney for New York reported that HSBC would pay $10 million and admit to misconduct to settle civil fraud charges for failing to monitor reimbursement claims submitted to the federal government in connection with foreclosures on government-insured mortgages.
  • In November 2014 HSBC was fined $275 million by then CFTC and $343 million by Britain's Financial Conduct Authority for manipulating the foreign exchange market.
  • In the same month, a unit of HSBC paid $12.5 million to settle SEC charges that it failed to register with the agency before offering cross-border brokerage and investment advisory services to US clients.
  • In 2015 HSBC it was reported that on HSBC helped wealthy customers of its Swiss private banking unit evade taxes.
  • In February 2016 HSBC paid $470 million to settle abuses related to mortgage origination, servicing, and foreclosure.
  • In July 2016 one HSBC executive and a former colleague were charged with conspiracy to commit wire fraud for foreign exchange manipulation.
  • In January 2017 HSBC was fined $32.5 million for failing to comply with a 2011 order that directed the bank to overhaul its foreclosure practices.
  • In October 2018 HSBC agreed to pay $765 million to settle allegations it had covered up risks associated with mortgage-backed securities.
  • In December 2018, when Chinese telecom giant Huawei Technologies’ CEO was arrested for allegedly evading US sanctions against Iran, the probe included whether HSBC conducted illegal transactions.

Does this sound like a bank you want to be the custodian of your gold ETF?

The answer is an obvious and resounding NO. And yet HSBC continues to be the cornerstone agency responsible for storing and supplying bullion for the GLD fund.

The thing is, most bullion ETFs also store their gold at a bank. And that is the bigger problem for investors:

  • One reason we hold gold is to protect against the banking system – and most ETFs are part of that very system!

This link between bullion ETFs and the banking system puts your investment at risk during an economic or monetary crisis. Bullion ETFs are vulnerable to all kinds of restrictions, emergency regulations, and even bank closures.

What About Taxes?

If you don’t know, there’s an archaic US law still on the books about gold taxes. Basically, gold is taxed as a “collectible,” which for most investors is currently 28%.

And since bullion ETFs only hold gold, the tax rate is the same. They’re generally divided into three categories: physical-backed ETFs structured as grantor trusts, such as the popular GLD. These ETFs are generally taxed as collectibles. Second are closed-end funds, also trusts that are also generally treated as collectibles. Last are securities “tied to” precious metals, such as mining stocks, mutual funds and mining ETFs and Exchange Traded Notes. These are generally taxed as securities.

In other words, there’s no current tax advantage to buying a gold ETF in lieu of gold itself. You can get lots more info on taxes here. And if you’re interested in tax-advantage precious metals, consider opening a Precious Metals IRA.

The #1 Reason to Hold PHYSICAL Gold

As an investor, you don’t want to experience delays selling your bullion ETF or in getting proceeds paid out… or to find out the fund doesn’t have the gold it thought it had… or to watch your fund fall while the gold price rises.

All these and more can impact the #1 reason you want to have physical gold:

  • In a crisis, it’s important to be liquid.

In a crisis situation, you could be subject to restrictions ranging from inconvenient to disastrous:

  • Temporary bank closures and/or limited access to physical cash
  • An interruption in the electrical grid, no internet connection, or a security breach.
  • A bank bail-in, where depositor money is frozen and used to keep the bank afloat (this has already occurred in Greece).

If any of these or other actions take place, physical gold will give you a ready form of money to meet any financial need or emergency. You can’t do these things with a gold ETF, because most don’t permit delivery of bullion to retail investors (and the few that do are costly and slow). You will also have to wait on settlement, and then for a check to be mailed or funds to be wired, and that assumes the system is still functioning smoothly and can process your request exactly when you need it. And those funds will end up in the banking system anyway, which could pose another barrier to access. And all along you were merely “renting” a paper product that gave you little to no ability to get real gold delivered to you.

So, the primary reason to buy physical metal instead of a paper product is because the nature of a crisis could demand it, at least for a short time. You need more than just price exposure: you want gold in your possession to get through a crisis.

Is Your Gold Investment a True Safe Haven?

Bullion ETFs are a nice idea, but the risks are a very real and present danger. Worse, the reason you own gold is to protect against financial and economic uncertainty – and you could lose that advantage if you own a paper form of gold that comes with all kinds of counterparty risks.

Yes, holding physical gold isn’t risk free, either. But, if you hold gold Eagles and other popular bullion coins, you hold a tangible asset that has virtually no counterparty risk.

  • Physical gold, in your possession, is the most crisis-proof asset you can hold.

Any type of crisis could put gold ETFs under greater and greater pressure, making them unable to offer safety from the very events they are supposed to protect us against.

Buy real gold, and not a paper proxy, promise, or pawn.