Existing Markets for Gold

Before recent securities markets and the globalization of financial services, markets for physical gold have a history that stretches to antiquity. When gold was used as money, the price of gold was expressed in other goods, e.g. food items, other metals, etc. However, in the recent financial system, the price of physical gold is most commonly expressed in fiat money value, particularly U.S. dollars. As such, whether gold is held as a safe-haven asset, is traded for speculative purposes, or is made part of a well-diversified investment portfolio, it is exposure to the fiat money price change of gold that is sought. As the global financial system matured, new financial products were designed that could provide economic exposure to the fiat money price change of gold, without having to hold the physical gold itself. There are currently three primary ways to gain economic exposure to the price of gold:

i. Physical Gold

The global standard for investing physical gold is the London bullion market, a wholesale over-the-counter (OTC) market for trading gold and silver. Trading is conducted amongst members of the London Bullion Market Association (LBMA), and is loosely overseen by the Bank of England. The physical characteristics of gold and silver bars used in settlement in market is described by the Good Delivery specification which is a set of rules issued by the LBMA. With most of the members being major international bullion dealers and refiners, the public can typically only access this market indirectly, through a third-party.

ii. Gold Exchange-Traded Products

Gold exchange-traded products include exchange-traded funds (ETFs), closed-end funds (CEFs), and exchange-traded notes (ETNs), which are all traded like shares on the major stock exchanges. Gold ETFs have come to represent a large share of the market for gold, as they allow investors to put small amounts of capital to work more effectively. Within this category there are a range of products to choose from, with some designed to track the price of physical gold itself, and others designed to invest in companies that specialize in gold. These products provide only varying levels of indirect exposure to the price of gold, but they save investors the burden of storage and verification of physical gold.

iii. Derivatives

Financial derivatives, such as gold futures, forwards, and options, are a third primary way for investors to gain exposure to the fiat price changes of physical gold. These products currently trade on various public exchanges around the world, as well as in various OTC private markets. Gold futures are used as hedging tools by commercial producers and users of gold, to manage and minimize the price risk associated with commodities. Derivatives enable purchasers to tailor their economic exposure to physical gold to suit their specific situation, e.g. strike price, duration.

Each of the above three ways to gain economic exposure to the price of gold has pros and cons. Holding physical gold provides direct economic exposure to a highly liquid market for physical gold, but the costs of storage, transfer, and verification can be prohibitive, particularly for smaller investors. Exchange traded products largely overcome these high expenses, but can only provide indirect exposure to the price of physical gold. Although many ETFs hold large volumes of physical gold, investors are not entitled to any specific allocation, meaning that some counterparty risk is baked into the product. Gold derivatives are free of such counterparty risks, but their use requires fine tuning and sophistication. They are not generally a cost-effective way for typical investors to gain economic exposure to gold prices.