Storing gold safely
The majority of investors who buy gold do so in the belief that it is "the one asset which is no-one else's liability". But there is a nasty legal subtlety which causes many of them hold it in such a way as to achieve the exact opposite, and they expose themselves to a hidden risk which may in many cases be exactly the risk they were trying to avoid.
Property and Liability
- Property and Liability
- The Gold Account
- Allocated gold
- Unallocated gold
- How banks manage allocated and unallocated gold
- The success of unallocated gold
- The effect of custody on the Spot gold market
- The long term consequence of unallocated agreement
- What to look for in an allocated agreement
- The downside of unallocated gold deposit
- The safe deposit box
- The importance of offshore custody
Money can't easily belong to a saver and his bank at the same time, so in well established law money deposited in a bank becomes the bank's property and its liability. Simultaneously it stops being the saver's property and becomes his asset, so if a bank fails the saver must stand in line with the other creditors and maybe accept a few cents on the dollar (although governments in many countries offer depositor protection, which might reduce the loss).
But there is a different way to put money in the bank such that it remains the private property of the saver. Western law generally recognises the fundamental difference between a deposit in a bank (banking law) and a safekeeping relationship (custody law). With a custody arrangement the saver expects safety, and no other benefit, such as the free payment services associated with current accounts, or interest associated with deposit accounts. Instead the bank is paid a fee for looking after the property, and may not put it to its own use.
The technical legal difference is that when you open a current or deposit account you transfer your property to the bank and expect them to utilise your property for your benefit. Under a custody arrangement private property is not transferred to the working capital of the bank, and may not be used by the bank. It is there only to be kept safe, and it will be returned in its entirety to the owner, even if the bank fails.
Even cash can be placed in a bank so as not to become that bank's liability (for example in a safe deposit box). So in fact it is not the form of the money handed to the bank that defines whether or not it is the bank's liability but the terms under which it was placed there. Anything tangible - bank notes, diamonds, teddy bears - can be put in a bank vault or a deposit box in a way which avoids it becoming the bank's liability, and this is exactly the same for gold.
The Gold Account
But the flip side is that depositing gold into an account is legally like depositing money into an account. It stops being private property and becomes the bank's liability and the investor's asset. It is important that gold investors fully understand the consequences as there is a critical difference in how they are treated as account holders if the future becomes difficult - as many gold investors expect it to.
The two types of treatment - custody and account - have very similar sounding names in the gold industry. They are called 'allocated' and 'unallocated' storage.
Allocated gold is gold deposited under a safekeeping or custody arrangement. It is held as numbered bars, on labelled shelves, and it is the property of the individual owner. Even though it is held in a vault it is neither the property of the bank nor the liability of the bank. As such it is safe from bank insolvency.
Investors have to pay for the storage of allocated gold. Arranging for the physical security of bullion bars requires strong vaults, wise use of technology, carefully constructed systems for security, and the monitoring and control of human factors. There is no point in arranging for all of this and then not charging for it, and all institutions which offer allocated storage must charge. In fact the charge is an important part of establishing the custodial nature of the relationship. The courts accept that payment of a fee to the custodian is powerful evidence that the relationship is a custodial one, and not a deposit into an account.
Fortunately gold is a remarkably compact store of value. A tonne of gold bullion is worth about $14.5m (November 2004) yet needs only a 14 inch block of space for storage. For this reason allocated storage is not very expensive compared to - for example - typical investment management fees. It can be found for as little is 0.1% per annum for volume buyers.
You should note that with allocated gold cover against theft is important. The gold is the owners property and is not the legal liability of the bank. Instead the bank has a duty of care over the security of the gold, but if it were the victim of a supremely well organised theft which it would not have been reasonable to defend the investor from then the loss is a loss of the owner's property, and the bank is not technically liable. Therefore your allocated gold needs to be specifically covered against theft.
In practice, theft of bullion from vaults is extremely rare. The result is that cover against theft is exceptionally low cost, and is usually included in the storage charge - which is a vote of confidence in the security of the vault.
Unallocated gold (frequently held in accounts referred to as "pool", or "metal" accounts) is simply the provider's liability. It forms part of the working capital of the bank and it can be legally used by the bank for profit. The gold investor is therefore exposed to the insolvency of the bank.
But not being a depositor of currency the saver is not ordinarily subject to any degree of depositor protection. This means the 'owner' of unallocated gold in a gold account is more dependent on the financial system's robustness than even the straightforward depositor of cash, a situation which for many gold buyers would be considered upside-down.
Unallocated gold is always likely to be put to use by the bank in one way or another. Although it is sometimes believed that there is a non-specific pile of gold somewhere in the bank which the customer has a share of this is not reliably true. There need be no physical pile - pooled or otherwise. And even if there is a pile of gold it is legally the bank's property, not the account holders, and would be sold for the benefit of all classes of creditor (not just the gold holders) in the event of bank insolvency.
So unallocated gold's free 'storage' is a bit of a misnomer because it is quite likely that there will not be anything tangible to store. This should not be surprising, after all banks do not store the money in our bank accounts; they put it to use. With gold accounts they are just doing the same with your bullion, and the bank makes more money out of unallocated gold accounts than out of allocated storage, just as it makes more out of its current accounts than out of safety deposit boxes.
This is why unallocated gold is more aggressively marketed, and being generally free for 'storage', is more popular than allocated.
How do banks manage allocated and unallocated gold?
Relatively few banks make allocated gold available. The reason is that nowadays banks operate the wrong kind of business to be willing and reliable custodians of gold bullion.
Modern banks make their money by providing credit and by executing transactions. They operate in a world of exceptional competition where they cannot afford to allow their working capital not to be put to profitable use. Unfortunately this means there is hardly any enthusiasm for a low margin role as physical custodians of a lump of gold. But many of them will - nevertheless - be pleased to provide customers with 'unallocated' gold.
An unallocated gold holding will entitle you to physical gold if you ever ask for it, while in the meantime it will remain as a liability to you on the bank's balance sheet. You can expect your bank to charge you with fabrication and custody charges should you ever demand your gold entitlement in physical form. This is because your bank too has to pay to get the physical gold delivered to itself.
But if you don't require physical gold it continues to exist only as a promise, and there are many efficient ways your purchase of unallocated gold can be managed by your bank.
One of the simplest is for the bank to buy a gold futures contract to balance its position, and remove its exposure to a rising price.
A future is only a contractual promise where the payment and delivery of the traded goods has been postponed. In that respect it is very like unallocated gold. But not quite, because your bank will probably not be allowed to trust your promise to pay, so you will have paid for gold without receiving it. Banks - on the other hand - are allowed to trust each other to keep their promises. So your bank doesn't yet have to pay for future gold which it has agreed to buy on your behalf but not yet take delivery of. As a result the real money they receive from you, the customer, can be put to good use financing things which the bank considers make a better return on capital than storing bullion.
In this way your bank could enjoy (i) a balanced gold position, (ii) an apparently very small risk that the futures clearer might fail, (iii) a big saving on the costs of maintaining and operating a secure vault, and (iv) all your money to be lent elsewhere for profit. It can even say - in all honesty - that it doesn't lend your unallocated gold, which is true up to a point.
Futures are not the only gold credit device bankers can use. Options, swaps, loans and leases are alternative mechanisms which can remove the price risk to the bank of your unallocated gold position. All ultimately depend on your first extension of credit to the bank, and each puts the bank in an extremely attractive position : having your money at no cost to the bank, so long as all the various credit risk monitoring systems in the financial world continue to operate smoothly.
The success of unallocated gold
It should now be clear why most banks offer and successfully encourage gold buying customers to remain permanently unallocated and not opt for delivery. Customers save money, banks save money, and it all works so long as the banks are safe, which they honestly regard themselves as being.
This permanently 'unallocated' system has been so successful that daily 500,000 ounces of gold are traded inter-bank in London on an exclusively unallocated basis. Most of the banks involved no longer offer any convenient route to physical gold storage and have almost completely withdrawn from gold vaulting.
So this highly liquid professional gold market now operates on credit, i.e. on the belief that exists between banks that each is good for the promises it makes - and of course they usually are.
The effect of the custody issue on the 'Spot' gold market
The success of unallocated has undermined allocated gold. When you buy aluminium, or corn, or foreign currency on their respective spot markets the seller undertakes to make delivery within a few days, and you will go to an agreed location and get what you have bought in return for your payment.
You will not have that privilege with your spot gold purchase on the world's spot gold markets. When you turn up with your bank draft you will receive nothing. This is because spot market gold is now by convention 'unallocated'.
This really is quite neat. Banks realised that with gold many new buyers really just wanted to put it straight back, safely in the bank. So they can save the cost of delivery and security for themselves and their customers if they can get the customers to put it back in the bank in the form of a deposit (unallocated), rather than under a custody agreement (allocated). The result is that the cheapest gold to trade is unallocated, and this has made it the most popular.
The popularity of unallocated has caused it to become the de-facto standard for gold. Now the internationally quoted 'spot' price for gold is on an unallocated basis, and investors need to pay extra for delivery. With almost any other commodity they would not tolerate a surcharge for taking delivery of what they have already agreed to buy. But that's just how gold works. The spot price you see quoted all over the world is the price exclusive of delivery in physical form.
The long term consequence of an unallocated gold agreement
The long term consequence of the probable physical non-existence of unallocated gold is hard to believe for those who are unfamiliar with finance. People who put money in bank accounts occasionally find out a few years later that it isn't there any more. As unfortunate victims they find it very hard to accept that the loss of their money - by the bank - is treated in law as their own commercial error for investing in a bank account.
It is easy to understand why they protest so loudly that a bank has taken their money, but it doesn't make it any easier to pay anything back after the money has been lost. That is a conceivable prospect for the unallocated gold depositor. It is why there is a strong case for storing gold in a good vault, and under a sound allocated agreement.
What to look for in an allocated agreement
An allocated storage agreement should be a legal document executed by both the vault operator (custodian) and the customer, which should make clear that the gold remains the property of the investor at all times. It should also make it clear that the placing of the gold with the custodian is performed in order to benefit the owner from the secure storage of the gold, for which the custodian is provided with a fee. Remember, in law the payment of a fee for the custody service is one of the critical markers for assuring the liquidator, and any court, that the property was not transferred to the balance sheet of the custodian, but was placed there for safe custody. The payment of the fee marks the gold as the owners property.
With terms like this in place any banker or vault operator will segregate the gold, store it safely, and not use it. They know the rules! You should also make sure your allocated gold is covered against theft, because allocated gold is your property and not the bank's liability. The theft of gold from a vault is incredibly rare, which makes this one of the cheapest forms of insurance you can find. For that reason it is often included within the allocated storage charge. Indeed this is effectively a certification of any vault you choose.
The downside of unallocated gold deposit
The alternative gold storage strategy is to save the fabrication and custody fee and take the risk of a loss of capital which could arise with unallocated storage, in the event of the insolvency of the provider. Most of the time you will be perfectly safe, but - in terms of risk - you should remember that major waves of bank failures are a regular feature of financial history. They have occurred several times in the last 100 years.
The downside risk in unallocated gold deposits may be more marked than is yet widely appreciated.At the smaller end of the scale there are risks from some potentially disreputable providers of unallocated gold outside the main banking sector:
Most countries make banking a heavily regulated business; a banking licence is difficult to come by and requires a lot of capital to underpin the bank's solvency, and both the supervision of banks and their capital act to protect their customers.
But because gold has lost its formal monetary status it can now be bought, sold and lent outside the scope of banking. It is now possible to set up a commercial business on very limited capital and sell gold on an unallocated basis, by which means some comparatively insubstantial and undercapitalised businesses could get hold of a great deal of investors' money "on account".
Then the business of using gold can be legally performed by people who have no banking licence, who are inexperienced in banking type operations, and who are short on capital.
Moreover there is nothing which obstructs the commercial lending of unallocated gold to the highest payer of interest (possibly a weaker organisation which banks and other respectable businesses won't lend gold to). The disreputable unallocated provider can then receive extra interest for taking that extra risk. This extra income will not remunerate their unallocated gold account holders for that extra credit risk - because their gold account pays no interest.
Instead that extra money can for a long time finance salaries and dividends out of the interest received on customers' gold, and this remuneration to the provider's staff and directors is legal provided the gold appears to have been lent to generate income in good faith - even if a little riskily.
Following a default, any gold loans will probably be found to have been made in good faith - but rather stupidly. This would be scant consolation to those customers who had lost their whole account balance of gold.
Meanwhile at the larger end there is the material risk of general financial instability: Just as unallocated gold is a form of credit so is the modern financial derivative. The increase in size of the world's derivative markets is beyond the numerical comprehension of most people. It has expanded from about $1 trillion in 1986 to about $300 trillion in 2003.
Through these instruments banks have taken to underwriting financial insurance where the potential for claims - if the world's credit system falters - is of the order of $1m per head for the world's richest 300 million people. To put that number in perspective there are only about 7 million dollar millionaires in the United States, and maybe 20 million worldwide. By another comparison the US national debt - widely regarded as unsustainably large - is about $7 trillion. Meanwhile all the gold ever produced in the world is worth about $2 trillion. So $300 trillion is a large overhang, whichever way you look at it.
Derivatives - just like unallocated gold - are credit based promises to deliver future value. The original contract remains open, or unsettled, because settlement involves shipping, transfer, administration and other expenses and sometimes even tax. By avoiding payment, transfer and delivery, and by holding settlement liabilities open, derivatives reduce trading cost. But they extend credit which is underpinned by the financial assets in bank balance sheets, and by the ability of a bank's counterparties to pay. The risk in unsettled derivative positions ultimately rests against exactly the same pot of bank capital as unallocated gold.
So unbeknown to many owners of unallocated gold they are full participants in the stockpile of global derivatives. This is one of the ironies of modern financial practice.
No-one knows when a major financial collapse might occur. Not even pessimists can claim to understand the very considerable increase - thanks to modern computers - in our powers to monitor and manage thousands of complex and inter-related financial situations at once, and this might mean we can safely manage a derivative marketplace at 10 or 100 times its current size.
But whatever the limiting size is it is likely that unallocated gold and modern derivative finance will eventually fail together under dramatic circumstances. Can there be many serious buyers of gold who intended to run that risk?
The safe deposit box
The safe deposit box is often used as a way of circumventing on the one hand the custody charges of allocated gold and, on the other, the notional status of unallocated gold. The problem with the safety deposit box is the loss of integrity of the gold which is stored in it.
A bullion bar bought in the professional bullion markets has been refined by an accredited bullion refiner, and stamped with a serial number, its purity (at least 99.5%), and the official bar weight (about 400 Troy Ounces).
The original verification process is called assaying. Bars which pass the strict scrutiny rules of bullion assaying are classified as Good Delivery Bars by their local professional bullion dealing community. They retain this status as long as they are kept in vaults within the recognised gold bullion dealing community.
Within that community a record is made of every movement of a bar between recognised vaults. This builds what is called the "chain of integrity" which is broken if the bar leaves the custody of the bullion community, for example when it is withdrawn to be placed in a deposit box (from which it could conceivably be tampered with).
Gold kept within the recognised bullion dealing community gets a better price when it is sold, because professional market buyers will accept it at face value - without assay - when it is delivered to them in settlement of a sale.
If - on the other hand - a bar has been outside the system of recognised vaults it is instantly devalued. A future buyer of such a bar within the recognised bullion dealing community (where sale prices are highest) has to begin a new chain, with himself as the ultimate guarantor of the bar's quality. If a subsequent spot check of that bar shows it to have been tampered with it will be the original acceptor who takes a hit, because he was the first link in the new chain.
This additional risk diminishes the value of the bar delivered from outside the recognised bullion dealing community. In fact your buyer will probably decide to re-refine the bar, which will eventually re-emerge from the melting pot with the refiner as its new guarantor. This way there is a new certified bar containing your gold, and your buyer is not left with a bar circulating around the community for a long period, with him as its possibly nervous long term guarantor.
Melting down and re-assaying costs money, and even if your bar is perfect someone - usually you - will pay for that work one way or the other. It is this cost of re-asserting the gold's integrity that makes the deposit box option not as good value as might at first be thought.
The importance of offshore custody
There are practical constraints on keeping gold in your own country, because just as the use of unallocated gold accounts is risky so too is the storage of bullion too close to home.
If investors choose to live in the same country as their capital then in the event that it becomes truly valuable, during a crisis which impoverishes many others, it is very likely that their government will choose to deprive them of most of it.
Being rich when no-one can find any money at all is rapidly deemed by everyone else to be selfish and highly anti-social. The common view generally develops that 'hoarders' are at the heart of the problem, and are preventing money from circulating for the general economic good. Governments find the pressure to legislate against hoarders to be very convenient - both in terms of populism and fiscal necessity.
The US government did exactly that in April 1933 and anyone found hoarding over $100 in gold or gold certificates was made subject to two years imprisonment and a $10,000 fine (at a time when $10,000 would have bought you several excellent properties). Not surprisingly the US banks were not keen to assist individuals in breaking the law, so holding assets in domestic banks turned out to be pointless.
Withdrawing gold into personal possession is equally useless. It cannot be safely used in a country where ownership of it is illegal, and few would risk carrying it through an airport. Doubters should ask themselves if they currently have the courage to smuggle or deal in illicit drugs, a contraband with a fine marketable value reaped only by the brave, wicked or foolhardy - depending on your point of view.
So perhaps the best way to store gold is to make use of a country which you are not too keen to live in, which benefits from the robust rule of property law, and which has an enormous vested interest in retaining its international reputation as a discreet haven for international money. This leaves you free to quit wherever you live - temporarily or permanently - without the asset transfer problem.
A practical solution is to follow the rest of the world's rich and preserve your wealth in Switzerland (though even this will at some stage become the wrong place). Note however that a Swiss bank account is unlikely to be available instantaneously. Setting up a secure custody arrangement in Switzerland takes time. The Swiss too are concerned with money laundering, and they are keen not to consort with criminals, so they want the chance to know something about their customers. If Switzerland is the path investors select then they need to plan a month or two ahead to set up a sound custody arrangement. For reasons which should now be plainly obvious a custody facility at a Swiss bank costs money.