Gold 'paper' markets at breaking point as analysts warn of threat to US dollar stability

For years, advocates of gold and silver have argued that derivatives are being used to suppress the prices of precious metals. Today, however, conditions are emerging that could end this practice, as imbalances in the "paper gold" markets continue to accumulate.

The fundamental flaw of gold derivatives

At its core, there is a simple reason why derivatives used for speculation or hedging in the gold market suffer from a structural problem. In the common law of nearly all nations, gold is recognized as money, while state currencies are considered a lower form of credit—where the real counterparty risk lies. The fact that the Western financial establishment ignores this distinction does not negate its validity. There is a serious reason why this matters: gold has been maintained as legal money, while credit was recognized as a deferred payment in money as far back as Roman law. Since then, many governments have attempted to substitute gold with their national currencies, denying this fundamental principle—historically, such choices have ended in monetary collapses.

In every price relationship involving a medium of exchange, there is objective and subjective value. Objective value is found in the medium of exchange itself, while subjective value lies in the goods or services being traded. Buyer and seller value money in the same way, but the buyer attributes greater value to the good than the seller—otherwise, the transaction would not occur. But if gold is the money, where does a fiat currency stand? If a currency is not a reliable substitute for gold, it should carry subjective value relative to it. The fact that it is not treated this way is partly due to state propaganda against gold, but mainly due to the accounting and tax valuation performed in the state currency itself.

Furthermore, while the "gold standard" is defined as the exchangeability of a currency for a specific weight of gold, for convenience, it is expressed as a number of monetary units per gram or ounce—creating the false impression that gold is "priced" in the inferior currency. However, given that fiat currencies historically fail while gold as money does not, recognizing this reality could eventually lead to the collapse of derivatives when these currencies weaken. If any derivatives survive, they should express fiat currencies in terms of grams of gold or, ideally, in a reliable substitute—should one exist. Fundamentally, gold derivatives should not exist, with the possible exception of seasonal agricultural products—the original function of futures contracts.

The plan to weaken gold as money

Following the inflationary crisis of the 1970s, which nearly dismantled the dollar’s fiat system after the collapse of the Bretton Woods Agreement in 1971, US Treasury strategists reportedly formed a three-pronged strategy:

• Reform of the financial system so that banks would dominate the securities markets. London's "Big Bang" in the 1980s spectacularly boosted the industry's capital power.

• Revision of key statistical indicators, such as inflation and unemployment, to create an image of monetary stability and contain the cost of pensions and benefits.

• Encouragement of derivative growth, aiming to shift speculative demand from the physical gold market to the "paper" markets.

This formed the basis for the explosive growth of trading in the London Bullion Market Association and COMEX gold contracts, where major US banks play a dominant role. In the late 1990s, 44 million ounces were settled daily in London. Last December, that number had dropped to 17 million, yet the value of transactions had multiplied. At COMEX, gross and net short positions in the "swaps" category—dominated by bullion banks—have ballooned dramatically compared to the 2010–2018 period.

Liquidity, geopolitics, and crisis risk

At the same time, physical gold is being withdrawn from London and New York, directly or indirectly, due to strong demand from central banks and Asian investors. London faces an emerging liquidity crisis in available gold, while at COMEX, positions are becoming increasingly difficult to maintain without rising capital requirements. The expectation that physical demand will decrease is proving baseless, as geopolitical risks and increasing credit risk for the dollar strengthen the shift toward the precious metal. Simply put, the gold derivative markets are approaching a dangerous turning point.

Gold in physical possession carries no counterparty risk. Conversely, the fiat dollar carries increasing uncertainty regarding its future value. Central banks and Asian investors accumulating gold seek to limit this uncertainty, avoiding the exchange of dollars for other currencies that are ultimately linked to the credibility of the dollar itself. The relationship between the dollar and gold has remained a puzzle since the suspension of Bretton Woods. The pricing of commodities and energy in gold appears historically more stable than in dollars. If paper hedges are curtailed, the adjustment will shift to commodity prices in dollar terms—with gold itself as the likely catalyst.

The contraction of derivatives will not be without consequences: large losses for banks, potential bailouts, and the risk of contagion to other markets, such as interest rate swaps and forex, due to counterparty interconnectedness. The rise in the value of gold and commodities is equivalent to a fall in the value of the dollar for commodity transactions. Foreign holders of dollars may accelerate their shift into tangible goods. Based on this analysis, the distortions of the last 55 years seem to be heading toward a violent financial end—with gold returning to the spotlight as the timeless measure of value.

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