GoldMoney Alert - 16 March 2008

Counterparty Risk Is Escalating

Counterparty risk has moved to centre stage. Financial assets are being scrutinized. Promises are being called into question. People are waiting for the next shoe to drop.

The financial crisis that began nearly a year ago continues to deepen. What's worse, there is no solid or even reasonable evidence to suggest that the worse is behind us. According to yesterday's The Telegraph in the UK: "In the coming few weeks, financial markets face their biggest test since the 1930s. This is not hyperbole."

Whether we reach the depths of the 1930s or not, only time will tell. But this past week adds more support to my view that 2008 is shaping up like 1974 (see my alert on February 1, 2008). I noted in that alert:

"Given what happened in 1974, there is one piece of advice that I can recommend. If history is any guide - and I really do believe that it is - then the current banking and counterparty crisis is going to get much worse before it gets better. Years of imprudent reckless lending is taking its toll on the global banking system. There is one last point worth noting. In 1974 gold rose 72.8%, while silver jumped 84.1%."

Why did gold and silver soar in 1974? There are two reasons. First, they both did what was expected of them, acting as a hedge against the inflation scourge that was egregiously eroding with much harm the purchasing power of national currencies. But everyone who owned the precious metals back then also benefitted in another way - they avoided counterparty risk.

When you own physical gold or silver, you own a tangible asset. In contrast when you own a financial asset, the value of that asset is ultimately tied to someone's promise and their financial capacity to fulfil that promise. In other words, wealth takes two forms, and they are fundamentally different. Financial assets have counterparty risk, but tangible assets do not. That important difference between these two types of assets explains why Bear Stearns had a difficult time this past week.

As questions arose about the quality of its $395 billion of assets that were carried on only $12 billion of equity, Bear's customers and other brokers became unwilling to accept the counterparty risk that arises from transacting with Bear, while its lenders began worrying about repayment. Being leveraged to that extent, even a small decline in the value of its assets can significantly erode Bear's equity base, and as every accountant knows, when the losses become greater that the firm's equity, it becomes insolvent - making its promises not worth the paper they are printed on. Gold and silver, being tangible assets, do not have this risk.

But what about GoldMoney, I am often asked. Doesn't it have counterparty risk? The answer is no, but our customers do have performance risk. Namely, they accept our promise that we will complete our tasks as expected.

To explain the difference between counterparty and performance risk, there are two ways to own physical metal - either store it yourself, or work with someone to store it for you. GoldMoney is the latter. We perform a custodial function, and customers need to rely upon our ability to perform as promised

When you store metal with GoldMoney there is no counterparty risk because no debt (i.e., no liability on GoldMoney's balance sheet) is created. In other words, we do not "owe metal" to you. Rather, we simply store metal "you own".

All too often people say they "own gold" and then start talking about their "Gold Certificates" with XYZ Bank. The reality is that they do not own gold. They only own the bank's promise to pay gold to them. That is the nature of a "certificate".

From both a legal and an accounting point of view, a "Gold Certificate" is akin to a "Certificate of Deposit". When you deposit dollars in a bank, you give up the ownership of those dollars to the bank, which becomes their new owner and can therefore lend those dollars to other customers. To evidence its debt to you, the bank issues a "Certificate of Deposit". Similarly, a "Gold Certificate" evidences the bank's debt to pay gold to you. To be clear on this important point, with a "Gold Certificate" you own the bank's debt, which is denominated in gold (in contrast to a Certificate of Deposit denominated in dollars, euros, pounds or some other currency).

That change of ownership of the dollars from the customer to the bank or gold from the customer to the bank does not happen with the gold and silver in GoldMoney. Our customers always own the gold and silver we store for them, which also contrasts with the gold and silver Exchange Traded Funds.

If you own one of these ETFs, it is not accurate to say that you own gold or silver. In reality, you own an equity that tracks the gold price or the silver price; the ETF owner does not actually own any physical gold or silver that may be owned by the ETF.

I say "may be owned" purposefully. These ETFs still do not audit the gold and silver supposedly stored in the vaults to prove that it actually exists. In contrast, one of the key components of GoldMoney's governance procedures is the periodic audits of metal owned by its customers. Furthermore, these audits are available to GoldMoney's customers upon request.

This omission by these ETFs seems inexplicable given the small cost of obtaining an audit relative to the millions of dollars in annual fees being paid by the ETFs to its managers and other service providers. Without this independent third-party confirmation to prove that the gold and silver really exists, ETF shareholders must therefore assume that the ETF has counterparty risk. So while these ETFs may be viewed to be an inflation hedge, they do not offer the other advantage that one receives by owning physical gold or silver - these ETFs are not a hedge for financial catastrophe like the one now brewing.

So to confirm this important point, GoldMoney's customers are not reliant upon the creditworthiness of GoldMoney; they are not a counterparty of GoldMoney. Their only reliance on GoldMoney is that we perform as expected, accurately keeping the record of how many goldgrams and silver ounces each user owns and just as importantly, making sure that the gold and silver in the vault always exactly equals the gold and silver owned by our customers. Keeping accurate records is one of the cornerstones of our governance procedures, which are designed to provide assurances of integrity that performance risk is well controlled.

So in summary, there is a big difference between counterparty risk and performance risk. And in today's uncertain financial environment, it is essential to avoid counterparty risk wherever possible. We can expect more Bear Stearns 'events', and only time will tell whether or not they will end in 'soft landings'.

As the US dollar continues to plumb new depths, financial strains will build, and counterparty risk is almost certain to increase. It is therefore important to note that the US Dollar Index made another record low this past week.

In contrast to the dollar, the precious metals remain in uptrends. This past week gold breached $1,000 per ounce ($32.151 per goldgram) for the first time.

Breaking $1,000 is a significant development in gold's ongoing bull market. It is a newsworthy event that is being broadcast around the world. The result will be that more people will be watching - and eventually buying - gold, in time driving its price higher still.

Importantly, gold is in a bull market when its price is measured in terms of all the world's currencies. As we can see from the following charts, gold is not only rising against the US dollar.

Lastly, silver continues to climb relentlessly higher too.

To conclude, there is now more reason than ever to own gold and silver. They are continuing to fulfil their function as an inflation hedge, but those who own physical gold and silver are also benefiting in another way - they are protected from counterparty risk. In other words, gold and silver are a hedge against financial catastrophe, and more of that is probably on the way.

Published by GoldMoney
Copyright © 2008. All rights reserved.
Edited by James Turk

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