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.