Monday 17 October 2011

Is the gold "spot price" real?

I don't own gold I own the 'spot price' of gold

After taking a look at the prospectus for my ETFS Physical Gold (PHAU) shares I'm fairly sure that I'm not really the owner of gold. Yes the shares are backed by real lumps of the stuff in a vault but the chances are that I’ll never get my hands on it.

In reality the gold backing my PHAU shares is more like collateral - it’s what I have a right to if all else fails. Before that happens though, the prospectus for ETFS Physical Gold says my shares are valued at something called the “spot price” of gold (ETFS said that PHAU tracks the loco London spot market).

So what is this “spot price”?

On the face of it, the construction of the gold price appears a bit random. Adrian Ash at UK online gold and silver market BullionVault told me that the price is not standardised, which means it’s not like tracking the share price of Marks and Spencers for which there is a single price quoted through the London Stock Exchange.

So, in the case of gold, the source of the price is not set in stone. Ash says that the data feed that supplies the free online "spot" chart at BullionVault, where he is the head of research, is not likely to be the same as the data feed that supplies, say, the chart at Canadian bullion dealers Kitco and the prices may be slightly different.

This is because the companies that provide the data feeds can pick and choose the sources of the data. These will be dealers who have agreed to pass on their live buying and selling prices. However Ash points out that any difference in price will be minimal because a dealer who deviates far from the global price will either have everyone knocking on their door… or no one.

In general though, the prices that make up the core of the global spot price come from the big banks listed as the “market makers” for the London bullion Market Association – centre of the world's wholesale physical trade.

These include the likes of JPMorgan, HSBC and to be an official ‘market maker’ an institution promises to offer prices at which they will buy and sell gold at all times during the hours of London trading.

But these banks are global so when trading shuts in London it shifts over to New York.

Wherever the trading is going on, the prices offered are being fed to the likes of Bloomberg and Reuters and other data providers who then compile gold “spot prices” for their clients. To do this they take the mid points between the buying and selling prices offered by each market maker and find the average.

Ash said: “So take note – any "spot" price data you see will fail to show any widening of the spread between buying and selling prices during strong volatility.” So investors should look carefully at the difference between the price they are being offered and the gold spot price.

There are further complications to the foundations of the “spot price” and the extent to which it describes the price of physical gold. To start with, the London market makers are not the only sources of data or the only influence on the gold price.

But during London trading hours they are the biggest players and the deals being done in London are for metal and are supposed to be completed within two days. But that’s not the case in other markets that influence the gold price. Ash said that when trading shifts to the USA the biggest gold market open for business becomes the New York futures market – where promises to deliver gold at a specific date are traded, but the vast bulk of contracts are in fact settled for cash, not metal.

Influences like this are somehow factored into the data feeds for “spot gold” prices supplied to traders.

In contrast to the apparently laissez faire price setting – where there can be minor discrepancies – there is no flexibility about the gold that is bought and sold in the loco London spot market.

This is entirely standardised with approved refiners, vaults and traders. If the gold is in the system it is considered good for delivery and if it leaves the system it isn’t allowed back in without severe checks.

Conclusions: Supply and demand, investor fear, interest rates and the value of the dollar are the engines that drive the gold price. But the gold price itself is the speedometer and it seems sensible to check that it's actually measuring what you want it to measure.

The fact that it doesn’t include spreads - the difference between the price at which gold is bought by market makers and the price at which they sell it – essentially means that gold is will not change hands at this price.

It may be useful to find out more about when and why spreads widen and whether the changes are large enough to let them influence an investment decision.

Also, does anyone monitor the differences between gold price data feeds, particularly in times of crisis? Are there any technical dangers in terms of the gold price?