Paper Gold and Its Effect on the Gold PriceBy Bud Conrad, Chief Economist I explained in my October article in The Casey Report that the Comex futures market structure allows a few big banks to supply gold to keep its price contained. I call the gold futures market the paper gold market because very little gold actually changes hands. $360 billion of paper gold is traded per month, but only $279 million of physical gold is delivered. Thats a 1,000-to-1 ratio: Many argue that the net long-term effect of such orders is neutral, because every position taken must be removed before expiration. But thats actually not true. The big players can hold hundreds of contracts into expiration and deliver the gold instead of unwinding the trade. Net, big banks can drive down the price by delivering relatively small amounts of gold. A few large banks dominate the delivery process. I grouped the seven biggest players below to show that all the other sources are very small. Those seven banks have the opportunity to manage the gold price: The concentration was even worse on the other side of the tradethe side taking delivery. Barclays took 98% of all deliveries for customers. It could be all one customer, but its more likely that several customers used Barclays to clear their trades. Either way, notice that Barclays delivered 455 of those contracts from its house account to its own customers. The opportunity for distorting the price of gold in an environment with so few players is obvious. Barclays knows 98% of the buyers and is supplying 35% of the gold. Thats highly concentrated, to say the least. And the amounts of gold were talking about are smalla bank could tip the supply by 10% by adding just 100 contracts. That amounts to only 10,000 ounces, which is worth a little over $11 milliona rounding error to any of these banks. These numbers are trivial. Note that the big banks were delivering gold from their house accounts, meaning they were selling their own gold outright. In other words, they were not acting neutrally. These banks accounted for all but 19 of the contracts sold. Thats a position of complete dominance. Actually, its beyond dominance. These banks are the market. My point is that this market is much too easily rigged , and that the warnings about manipulation are valid. At some point, too many customers will demand physical delivery and there will be a big crash. Long contracts will be liquidated with cash payouts because there wont be enough gold to deliver. I saw a few squeezes in my 20 years trading futures, including gold. In my opinion, the futures market is not safe. The tougher question is: for how long will big banks dominance continue to pressure gold down? Unfortunately, I dont know the answer. Vigilant regulators would help, but futures market regulators is almost an oxymoron. The actions of the CFTC and the Comex, not to mention how MF Global was handled, suggest that there has been little pressure on regulators to fix this obvious problem. This quote from a recent Financial Times article does give some reason for optimism, however: UBS is expected to strike a settlement over alleged trader misbehaviour at its precious metals desks with at least one authority as part of a group deal over forex with multiple regulators this week, two people close to the situation said. The head of UBSs gold desk in Zurich, Andr Flotron, has been on leave since January for reasons unspecified by the lender. The FCA fined Barclays 26m in May after an options trader was found to have manipulated the London gold fix. Germanys financial regulator BaFin has launched a formal investigation into the gold market and is probing Deutsche Bank, one of the former members of a tarnished gold fix panel that will soon be replaced by an electronic fixing. The latter two banks are involved with the Comex. Eventually, the physical gold market could overwhelm the smaller but more closely watched US futures delivery market. Traders are already moving to other markets like Shanghai, which could accelerate that process. You might recall that I wrote about JP Morgan (JPM) exiting the commodities business, which I thought might help bring some normalcy back to the gold futures markets. Banks cant suppress gold forever. They need physical gold bullion to continue the scheme, and theres just not as much gold around as there used to be. Some big sources, like the Feds stash and the London Bullion Market, are not available. The GLD inventory is declining. The big banks arent stupid. They will see these problems coming and can probably induce some holders to add to the supplies, so Im not predicting a crisis from too many speculators taking delivery. But a short squeeze could definitely lead to huge price spikes. It could even lead to a collapse in the confidence in the futures system, which would drive gold much higher. Signs of high physical demand from China, India, and small investors buying coins from the mint indicate that gold prices should be rising. The GOFO rate (London Gold Forward Offered rate) went negative, indicating tightness in the gold market. Concerns about Chinas central bank wanting to de-dollarize its holdings should be adding to the interest in gold. In other words, it doesnt add up. I fully expect currency debasement to drive gold higher, and I continue to own gold. Im very confident that the fundamentals will drive gold much higher in the long term. But for now, I dont know when big banks will lose their ability to manage the futures market. Oddities in the gold market have been alleged by many for quite some time, but few know where to start looking, and even fewer have the patience to dig out the meaningful bits from the mountain of market data available. Casey Research Chief Economist Bud Conrad is one of those fewand he turns his keen eye to every sector in order to find the smart way to play it. This is the kind of analysis thats especially important in this period of uncertainty and volatility and you can put Buds expertisealong with the other skilled analysts talentsto work for you by taking a risk-free test-drive of The Casey Report right now. 