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Solved: The Mystery Gold Deals

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In July, the Bank of International Settlements (BIS) revealed in a note in its annual report that it had entered into gold swaps with a number of commercial banks. These highly unusual transactions unsettled the market, pushing gold prices down to what was then a six-week low. However, details regarding these deals have now surfaced, highlighting some of the risks investors must be aware of before buying gold.

This was no banking bailout
At the time of the initial reports, there were rumors that the gold swaps amounted to a support measure for the European banking system on behalf of the BIS – the central bank of central banks. However, according to the Financial Times, the transactions were initiated by the BIS simply in order to earn a return on its dollar holdings by lending them out to commercial banks, which banks put up the gold as collateral on the loans.

Indeed, during the fiscal year ended March 31, the BIS took in three times the amount of currency deposits it took in during the prior year. In loaning these deposits out, the BIS is using its balance sheet as any ordinary bank would.

Gold is perceived as a safe, but...
On the one hand, these operations demonstrate that gold is perceived as a safe store of value at a time when banks are more cautious about lending to each other. However, the gold that is being pledged as collateral doesn't belong to the banks, but rather to investors. With the surge in demand for physical gold, banks are looking for ways to use the bullion that is swelling their coffers. Banks have quite a bit of freedom with regard to gold deposits held in "unallocated" accounts (this is comparable to stocks that are held "in street name," which can be loaned out to short-sellers); that's a source of risk for investors.

If you own gold via the hugely popular SPDR Gold Shares ETF (NYSE: GLD  ) , I urge you to read the prospectus in order to understand the nature and extent of your ownership rights. This advice holds for the COMEX Gold Trust ETF (NYSE: IAU  ) and for any other commodity ETF, for that matter.

Alternatives to gold bullion ETFs
Finally, physical bullion isn't the only way to take on exposure to the yellow metal. Think gold miners -- for broad exposure to this sector, there is the Market Vectors Gold Miners ETF (NYSE: GDX  ) . If you are interested in individual stocks, my colleague Chris Barker likes Goldcorp (NYSE: GG  ) best among the major miners, but he has started to focus on junior miners instead.

If you're concerned about the impact of slowing growth and ballooning government debt on U.S. stocks, there are alternatives for your money. Tim Hanson explains how to make more in 2010.

Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

Read/Post Comments (3) | Recommend This Article (4)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 02, 2010, at 8:22 PM, Clint1010 wrote:

    About Junior Gold Mining, why don't you mention GDXJ?

    It is including New Gold (Great (Jr.) (?) stock.

    If Gold stocks will move, GDXJ will surpass easy the GDX.

  • Report this Comment On August 03, 2010, at 4:17 PM, SundayRider wrote:

    This is total BS. The fact that is constantly repeated by Gold Bugs does not make it non-BS. It is one thing to "loan out" stocks, bonds, or gold for short-selling (for which both the short-sellers and you are responsible for replacement). It is totally another thing to deliver your investors' stocks, bonds, or gold to someone else as collaterial for a loan. People have gone to prison for this, as far back as the 1930s when a very public and famous Wall Street figure went to prison for just that (using his clients' bonds for collaterial for loans).

    Yes, please read the prospectuses of the gold ETFs. You should be reading these for anything you invest in. (People also go to prison for violating the published rules in a prospectus.) You'll see they require "allocated" gold to be kept except for a small percentage in futures etc. which is necessary to manage the day-to-day transactions to keep them square. I don't even think they allow loaning out for short-selling. If you're really concerned about this then buy SGOL, which is audited twice a year and requires all gold to be "allocated and segregated". Currently both bullion coins and CEF are running at a 10-20% premium, so if you want to take the hit for what you get, go ahead.

  • Report this Comment On August 04, 2010, at 12:47 AM, techperson wrote:

    I have read the GLD prospectus as you suggested. All the gold is allocated to the Trust, with specific serial numbers. It is both audited and, separately, counted twice a year by an outside agency. It is not lent out. Thank you for the jab to read the prospectus on this point, as it has given me great peace of mind regarding my gold holdings.

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