Commodities ETF's Trading Freeze Due to AIG Fears

By: Mark_OByrne

Gold fell slightly yesterday with gold down $3.60 to $778.40 but silver again had sharper falls and was down 54 cents to $11.02. Gold has again traded sideways in Asian trading but has risen in early European trading to $780/oz.

Gold's wealth preservation qualities are being felt with the precious metal remaining resilient despite volatility and sharp sell offs in many other markets. Gold is only marginally negative(some -1%) in the last month despite sharp falls in the majority of stock markets. Thus the pattern seen in recent years when gold trades sideways to slightly down in the short term when equities sell off aggressively and then outperforms equities in the weeks following sell offs is being seen again.

Gold had clearly become overbought when it reached $1,030/oz in March as it had risen some 60% in 12 months (from $630 in March 2007 to $1,030 in March 2008). Thus it was overbought and due a healthy correction. Indeed it could be argued that gold actually forecast the financial meltdown we are currently experiencing and had priced it in as astute investors realized that macroeconomic and systemic risk was far higher than the authorities and bankers were letting on or aware of.

While the correction was steeper than many had expected it gold remains in a bull market as none of the fundamentals driving prices higher have abated.

From a position of being overbought, gold is now the most oversold it has been since the inception of the bull market and a sharp rally is likely in the coming weeks as the fundamentals reassert themselves and investors again seek gold's safe haven qualities.

AIG Fears Cause Trading to Halt in ETFs
It has been widely reported including by Reuters and the Daily Telegraph that  banks and brokerages ceased making markets in commodity securities backed by matching contracts from troubled insurer American International Group Inc on Monday afternoon. ETF Securities said on its website it was "actively working on possible ways of providing investors with liquidity" -- including arranging suitable collateral for market-makers.

ETF Securities, the leading provider of exchange-traded commodities (ETC) in Europe, is feeling the impact of the troubles facing the insurance company AIG, according to media reports. ETF Securities offers more than 100 ETCs listed in the U.K., Germany, France and other European markets. As of September 12, 2008, it had $7.65 billion in assets under management, making it one of the largest suppliers of exchange-traded commodities in the world.

According to reports, many of the products issued by ETF Securities are backed by credit agreements with AIG. They carry a credit risk similar to the one facing exchange-traded notes; i.e., if the party backing the ETCs goes bankrupt, shareholders become creditors of the firm.

AIG's collapse and quasi nationalisation is leading to concerns which are affecting ETF Securities' AIG-backed products.  According to a press release issued by the company, "a number of firms who were making markets in the [AIG-backed] Commodity Securities stopped doing so yesterday afternoon."

As a result, many of the ETCs did not track their underlying indexes during trading on September 16. Some products appeared to have stopped trading altogether, and there is no fully liquid market in the shares.  The company is working on alternate ways to provide investors with liquidity. For instance, it is trying to permit holders of the securities to redeem them directly from the issuer; typically, only large-scale authorized participants are allowed to do this. It is also trying to arrange suitable collateral to entice market-makers back into the market. 

It notes that, "we can give no assurance as to whether these or other alternatives can be implemented at this stage."

ETF Securities deny that their precious metal  ETFs will be affected
ETF Securities deny that their precious metal  ETFs will be affected ( such as Gold Bullion Securities) and say that the “credit risk from one group does not and cannot bleed over into the others.” They claim that as the precious metal funds are backed by physical bullion, they carry no credit risk.

However, it is important (now more than ever) to remember that all financial products involve counter parties and insurers and thus all financial products have credit risk. Indeed, gold bullion coins and bars are the only asset class that are not somebody else's liability.

Gold and Silver Investments Warned Regarding the Risks of ETFs in 2005
Since the launch of ETFs and ETCs, Gold and Silver Investments has warned that there were risks inherent in the exchange traded funds (ETFs) and exchange traded commodities (ETCs) that an investor is not exposed to if one invests in government gold certificates and actual physical bullion coins and bars.

These concerns were featured in the article ‘How to Invest in Gold' -   http://www.goldassets.co.uk/ How_to_Invest_in_Gold.htm .
In another article we examined the risks posed by storing bullion with third parties http://www.goldassets.co.uk/ How_to_Invest_in_Gold.htm  .

The significant risks involved include indemnification from many risks , intermediation (there are many parties, intermediaries, custodians and sub custodians between you and the ETF's gold holding) and nature of ownership – you do not own the underlying physical asset and do not own the physical gold. Also in the event of a systemic breakdown, you become a creditor of the ETF provider and cannot take possession of your gold assets or ship your bullion to a location of your choice (see articles above).

Thus, physical gold government certificates and physical gold have many advantages over ETFs for investors with a medium to long term horizon

- ETFs have an annual administration fee which make them uncompetitive for medium or long term investors
- ETFs are not direct ownership of physical gold
- ETFs like many financial products have indemnification, intermediation and counterparty and custodian risk

Gold is the only asset class that is not somebody else's liability
Gold is the only asset class that is not somebody else's liability. Deflationary depressions are characterised by many bankruptcies and defaults. The only assets you can count on are those in your own possession that are liquid, like cash or gold. Sound currencies such as gold become more valuable because so much is wiped out in defaults and wholesale wealth destruction. The price of gold can never go to zero unlike the value of multinational corporations and banks.

Gold is the ultimate safe haven asset and the only finite currency which cannot be printed or debased by desperate governments. Inflationary depressions, however, wipe out the fiat currency itself, which loses value rapidly, because the government creates so much more to bailout the financial system. Gold benefits from this brutal process.

By Mark O'Byrne, Executive Director

Gold and Silver Investments Ltd. have been awarded the MoneyMate and Investor Magazine Financial Analyst of 2006.

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