Physical vs. Paper Gold

Many people who want to diversify into precious metals buy something that isn’t real gold. Unfortunately, not only do these alternatives fall short in the benefits they offer when compared to physical gold, but they also come with added risk.

What are examples of paper gold?

Paper gold is different from physical gold in that any gold in question exists theoretically, on paper, often effectively serving as a promise of gold. You may think this means that there is an allocation of gold set aside to fulfill the promise if need be.

And yet, as many experts would warn, if tough times were to strike and everyone were to rush to cash in their promissory notes, there is a major chance that the promise will not be delivered. This is called counterparty risk, essentially the risk that the entity on the other side of a contract defaults on its contractual obligation, leaving you holding the bag.

There are three popular examples of paper gold that people commonly buy: gold futures, unallocated gold and “digital gold.”

Gold futures

A “future” is a kind of commodity contract agreement to buy (or sell) a specific quantity of a specific commodity at a set date in the future for a set price. Historically, such contracts evolved over time between producers and consumers of commodities to hedge against unexpected price movements. This makes sense if, say, you’re a farmer who wants to lock in profit on a harvest before the grain ripens in the field, or a commercial baker who needs to establish today how much flour will cost per ton a few months in the future. The farmer promises to deliver a certain number of bushels of wheat, at a specified future date, at a specified price. This agreement removes some of the uncertainties both parties must navigate, and as such, it can be quite beneficial.

We can think of that as a “pure futures” contract that directly connects a commodity seller to a commodity buyer.

Most futures contracts, however, aren’t written between producers and consumers of commodities. Instead, they’re bets on price movements. This is quite easy to determine… According to the Chicago Mercantile Exchange (COMEX), less than 2% of futures contracts are actually delivered. The value of the futures contract changes based on the market price of the underlying commodity. Profitable contracts get sold for cash, unprofitable contracts simply lapse.

Because there’s such a miniscule rate of actual delivery, clever traders quickly realized they don’t actually need to worry about whether or not there’s an actual commodity underlying the trade. After all, if no one ever asks for the wheat, does it really matter whether the wheat exists? In modern times, this has turned into a farce similar to the famous movie The Producers. For example, on the COMEX, there were 550 claims for every physical ounce of gold all the way back in 2016. In other words, every ounce of physical gold was promised to 550 different people.

Even earlier, in 2011, the volume of gold contracts traded was the equivalent of ten times the total quantity of all gold mined in history! 

For those using futures simply to speculate on price movements, this doesn’t matter. But what happens if the situation changes, and these speculators decide they want to take delivery of the gold underlying their contracts? Would one trader receive one ounce of gold, and 449 others receive nothing? Would everyone receive 1/550th oz of gold (less than the weight of a paperclip)?

The obvious risk here is that an individual could think they were diversifying their investments with real, physical gold, only to discover they’re in line with 500 other people who thought the same thing.

Unallocated gold

“Unallocated gold” is a financial term used to describe a claim sold by an institution, often a bank, to an investor promising to deliver a certain weight of gold. The institution claims to own a certain number of ounces of gold and offers to store it for you, and to redeem your claim for your gold at any time. It’s analogous to depositing dollars at a bank: you put a certain number of dollars into a bank, who promises you that you’ll have access to that same number of dollars in the future.

There are two concerns with this sort of asset.

First, unallocated gold isn’t segregated by customer account. Let’s say an investor deposits 20 1 oz gold American eagle coins into an unallocated account. Those coins go into a pool with other investors’ assets. When the investor decides they want their gold back, the institution might hand over a single 20 oz gold bullion bar. In an unallocated account, all gold is treated equally, as a commodity. (And both logic and Gresham’s Law tell us how unlikely the investor is to receive something better than they initially deposited.) So, even in the best case scenario, choosing an unallocated gold account means losing control over the specific form of your gold.

Second, unallocated gold bears counterparty risk (described above). Should the institution go bankrupt, the investor becomes a creditor with a claim on the bankrupt company’s assets. Leaving them waiting  in line, with a bunch of other angry creditors, hoping that bankruptcy courts will eventually deliver their assets.

(Note that Birch Gold Group exclusively works with allocated accounts. This is important because you remain the owner of your assets, even if you pay a depository to safely store your assets. Even if a depository were somehow to go bankrupt, your property would still be yours.)

Digital gold

In the last few years, in response to the rising price of gold and the popularity of cryptocurrencies, a number of institutions (including The Royal Mint in the UK and Australia’s Perth Mint) have developed a product usually called “digital gold” or “DigiGold” or gold tokens. These products are generally available in extremely small increments, as low as a single gram. Furthermore, digital gold-type accounts generally offer physical delivery of your metal.

The primary drawbacks we see to these digital gold-type accounts combine the negatives of both gold futures and unallocated gold.

First, there’s the issue of trust. How do you know the seller really has the gold? It’s in an allocated vault in Zurich, they say? Maybe it is, maybe it isn’t. Can you visit the Swiss vault and see the gold for yourself? Of course not!

Second, there’s the issue of supply. How many times has the same ounce of gold been promised to different investors? If everyone wanted to claim the physical version of their digital gold all at once, would there be enough for everyone? Let’s hope so!

Third, there’s the physical form of the gold. Gold bullion bars or Canadian maple leaf coins? Do you get a choice? Most likely, you do not (if you’re lucky enough to get your gold in the first place!). Then of course there are insurance, shipping and sometimes even fabrication costs associated with physically claiming your digital gold.

Why invest in physical gold over paper gold?

Paper gold has a number of risks that simply cannot be ignored, including:

  • Counterparty risk – Counterparty risk is the likelihood that someone in a transaction could default on fulfilling their obligation. Although this is a risk with any investment, as we’ve seen in particular when it comes to gold, there are an awful lot of claims on every single ounce.
  • Zero liability – Institutions selling unallocated gold often include a note in their paperwork that exempts them from liability for most things that could happen to your gold. This includes terms that can be somewhat loose in interpretation, such as “loss” or “damage.”
  • Volatility risk – Note that this is a debatable point. Essentially, we believe that when you own a tangible gold coin, you benefit not only from its beauty and historic safe-haven asset reputation, you also own a commodity that has a large number of practical applications in electronics manufacturing, jewelry creation, medical device development and so on. The types of paper gold described above shift in value at the whim of market forces. Thus, it seems that the price of a specific gold coin, say a 1994 American gold buffalo, would be more stable over time.
  • Insurance coverage – When you own gold and place it with a custodian — even when working through a precious metals dealer — that gold is directly protected by their insurance in a contract between you and the custodian. But with situations like an unallocated gold account, the contract with the custodian can get hairy. Because the institution is not a direct beneficiary of the insurance policy, it claims no ability to control the terms of the insurance; the custodian, then, may pick a token insurance policy intended to cover the bare minimum while still being able to claim that they offer “insurance.” This means that the full value of your gold may not be covered in the event of a catastrophe.
  • No choice of what gold you buy ­– Gold can come in many forms, including bars, bullion, proof and numismatic coins, and more. You might see different returns depending on the specific items you you choose to buy; this might be an area you choose to explore and maybe even become fascinated with. With paper gold, you lose this option completely.

Physical gold, on the other hand, does not carry these same risks.

Six keys reasons to buy physical gold

    1. Physical ownership – Sure, experts recommend placing gold in a secure, insured depository versus, say, storing it in your basement. However, even when placed in a depository, you are the owner of physical gold that you can claim at any time—which is more than most paper gold ownership offers.
    2. Purchasing an asset with intrinsic value – Unlike a piece of paper promising a share of a company or some amount of currency that is actually prone to fluctuation, gold is valued and in-demand for reasons beyond its investment potential with applications that include electronics through jewelry. It has intrinsic value.
    3. Growth potential backed by historical performance – While no investment comes with any certainty, gold’s track record is longer than just about everything else and it has proven a steady, long-term store of value or better — even when the dollar has suffered. Even when the Roman empire collapsed.
    4. Limited supplies could lead to future gains – While a central bank like the Federal Reserve could always print more dollars, or a commodities exchange could always write more futures contracts, there is a finite amount of gold in the world. Gold’s scarcity in the face of sustained demand across a variety of industries means that there is potential for future gains for anyone holding gold.
    5. Diversify your savings – Instead of limiting purchases to currency-based assets, buying gold gives you access to a market that operates following different performance trends. By diversifying your holdings, you reduce the overall negative impact to your portfolio that any one asset may have.
    6. Hedge against inflation or economic downturn – One recent example of this in action came during the 2007-2009 economic meltdown. Gold not only maintained its value, but the price of gold actually continued to rise even as this crisis was playing out. Even during the 2020 coronavirus pandemic and resulting recession, gold continued the rally it started in Fall 2018. Over the course of two years, its price surged 72% and it actually went on to pass $2,000 for the first time in August 2020.

Once you buy it, physical gold is yours, in the form you chose, to hold and store wherever you prefer. And while gold can be used as a currency, it also serves as a very liquid asset that is highly desired in markets around the world.

Best of all, gold’s historical performance has seen it persist or even grow in value even during times of plunging dollar value and economic downturn. In fact, crises that cause breakdowns in the economy and widespread financial disruptions may actually increase the value of your physical gold.