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China’s Rising Gold ETF Market: A Hybrid

by Koos Jansen, Bullion Star:

In 2013 we’ve witnessed the inception of the Chinese gold ETF market. At first demand for the gold ETFs was neglectable, as investors mostly preferred to buy the physical gold directly at the Shanghai Gold Exchange (SGE) or buy jewelry or investment bars through retail channels. This year, however, there has been a major shift in gold ETF demand in China.

The physical holdings of Chinese gold ETFs have surged five-fold from 7 tonnes at the end of January, to 35 tonnes at end of August. The Huaán Yifu Gold ETF, which was holding 23 tonnes in August, entered the global top 15 list.    

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chinese-gold-etf-physical-holdings
Exhibit 1. All physical holdings of Chinese gold ETFs are stored within SGE designated vaults.

The interest in China’s nascent gold ETF market was even mentioned by the World Gold Council in a recent Gold Demand Trends report. In this post, we’ll add some texture to China’s gold ETF market; how are the gold ETFs constructed and how can they be compared to the largest Western gold ETF, the SPDR Gold Trust. At this moment the market share of Chinese gold ETFs is still small – within China as well as globally, but knowledge about the workings of these ETFs will be valuable when they acquire significant market share in the future.

Kindly note, all mechanics and examples presented in this post are simplified.

What Is A Gold ETF?

ETF is short for Exchange Traded Fund. ETFs trade like stocks and its price usually tracks an underlying asset or index. Like stocks, ETFs have a primary market and a secondary market. The secondary market is the stock exchange where most ETF investors trade. What makes ETFs special is the primary market where ETF shares are created and redeemed. Let us use the SPDR Gold Trust (symbol: GLD) to illustrate how the primary market works. Mainly through the creation and redemption process of shares, the GLD share price tracks the gold price.

Primary GLD market participants include (from the prospectus):

  • The Sponsor (World Gold Trust Services, LLC, which oversees the performance of the Trustee and the Custodian)
  • The Trustee (BNY Mellon Asset Servicing, which is responsible for the day-to-day administration of GLD)
  • The Custodian (HSBC Bank plc, which holds the gold bars in custody, there can be sub custodians)
  • The Authorised Participants (the institutions which are authorised to create and redeem GLD shares, at this moment the Authorised Participants are Barclays Capital, Inc., Credit Suisse Securities (USA) LLC, Goldman Sachs & Co., Goldman Sachs Execution & Clearing, L.P., HSBC Securities (USA) Inc., P. Morgan Securities Inc., Merrill Lynch Professional Clearing Corp., Morgan Stanley & Co. LLC, RBC Capital Markets, LLC, Scotia Capital (USA) Inc., UBS Securities LLC and Virtu Financial BD LLC).

GLD is traded on the New York Stock Exchange Arca (NYSE Arca)

gld-creation
Exhibit 2. The (simplified) process of creation and redemption of GLD shares by an Authorised Participant through the Trustee.

If an Authorised Participant (AP) wants to create GLD shares, it needs to deposit gold into the account of the Trust and subsequently the Trustee will provide the AP with GLD shares. The creation application must be made in multiples of 100,000 shares (a block of 100,000 shares is called a basket). Since every GLD share represents approximately 0.1 ounce of gold, in order to create 100,000 GLD shares the AP needs to deposit 10,000 ounces of gold into the account of the Trust. (In reality, 1 GLD share actually represents a little less than 0.1 ounce of gold, the reason for this will be explained later on in this post.)

The redemption process works the other way round. If an AP wants to redeem GLD shares, it deposits 100,000 GLD shares at the Trust and subsequently the AP receives 10,000 ounces of gold.

The purpose of APs creating and redeeming GLD shares is usually arbitrage. As previously mentioned the gold equivalent of 1 GLD share is roughly 0.1 ounce, nevertheless GLD shares and actual gold are traded in two different markets. As a consequence, the price of 1 GLD share can differ from the price of 0.1 ounce of gold. If the price of GLD and the price of gold diverge, this is where arbitrage comes into play for the APs. Accordingly, the arbitrage by APs through creation and redemption of shares contributes to GLD’s price tracking the gold price.

Suppose (simplified), the price of 1 GLD share is $110 – caused by supply and demand for GLD shares at the NYSE Arca – while the price of 0.1 ounce of gold is $100 in the gold market. An AP can grasp this opportunity by buying (or first leasing) 10,000 ounces of gold to deposit in the GLD Trust account after which the Trustee will create 100,000 GLD shares for the AP. The new shares created are then sold by the AP on the stock market, which will cause the price of GLD to go down. The arbitrage opportunity will be used by APs until it’s closed.

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1 comment to China’s Rising Gold ETF Market: A Hybrid

  • Geo

    “The Custodian (HSBC Bank plc, which holds the gold bars in custody, there can be sub custodians)”

    With regards to this part of GLD, why is there a clause in the GLD prospectus that states GLD has no right to audit subcustodial gold holdings? Why would the organizations behind GLD forfeit this right and create this massive audit loophole? I haven’t heard of a single good reason for the existence of this loophole so far. In addition to the audit loophole, GLD claims to be fully backed by physical gold bullion but yet it refuses to give retail investors the right to redeem for any of these ‘claimed’ gold bullion. I’ve read about and verified a number of other red flags as well:

    “I remember CNBC’s Bob Pisani visiting GLD’s vault in a well documented segment. GLD’s administration arranged this visit to disprove everyone claiming that GLD’s gold did not exist. However, Mr. Pisani held up a gold bar with the following serial number – ZJ6752. This serial number did not appear on the most recent bar list during that time period. Cheviot Asset Management’s Ned Naylor-Leyland later found out that this “GLD” bar actually belonged to ETF Securities.”

    “Did anyone try calling the GLD hotline at (866) 320 4053 in search of numerical details on GLD’s insurance? The prospectus vaguely states “The Custodian maintains insurance with regard to its business on such terms and conditions as it considers appropriate which does not cover the full amount of gold held in custody.” When I asked about how much of the gold was insured, the representative proceeded to act as if he didn’t know and said they were just the “marketing agent” for GLD. What kind of marketing agent would not know such basic information about a product they are marketing? It seems like they are deliberately hiding information from investors.”

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