Gold Manipulation Receives Official Recognition

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Market manipulation has been a hot topic over the past couple of years. Not only are market participants suspicious of high-frequency trading, but several allegations of market manipulation in all sorts of markets have been made against large financial institutions.

Gold market manipulation is the latest story in this saga, with Barclay’s (NYSE:BCS) recently being fined $44 million by British regulators for alleged manipulation of the gold market in 2012.

But allegations of gold market manipulation go way back depending on how one defines “manipulation.” In fact, manipulation of the gold market was once official central bank policy in the 1960s, during which time the price of gold was fixed at $35 per ounce. As the market started to creep higher in the late 1950s and early 1960s, the Federal Reserve and seven other European central banks got together in order to ensure that the $35 per ounce level was fixed.

More recent instances of manipulation of the gold market dating back to the early to mid-1990s are the result of a tactic known as “gold leasing.” This is when central banks lease gold or, rather, lend it to financial institutions called bullion banks in exchange for a small interest consideration. Central banks would justify this by arguing that the gold price was going nowhere and that they were better off earning interest on this “dead” asset than let it it simply sit in their vaults gathering dust.

This created an excellent short-selling opportunity for the banks that knew leasing was going on. While central banks were putting gold out into the market — thereby increasing the supply — they were reporting constant gold holdings because they didn’t differentiate between gold in their vaults and gold owed to them by the bullion banks. This created the veneer of a greater supply on the market, and it dissuaded investors from owning gold. This in turn exacerbated the gold bear market of the 1980s and 1990s, and the bullion banks could make a profit so long as the price declined at a faster rate than the interest they owed to the central banks.

Of course, market forces necessitated an end to the bear market, which happened in 1999. But there was a problem: Bullion banks were short a lot of gold, and if the price rose, then they would lose money. In order to stymie the rise in gold prices, bullion banks turned to using derivative contracts such as futures and options in order to put pressure on the gold market and to dissuade investors from owning it.

At around the same time, we began to see more serious allegations of manipulation. An organization called the Gold Anti-Trust Action Committee, or GATA, was formed in order to expose this foul play in the gold market. They alleged that several interested parties were colluding in order to keep gold prices from reaching a realistic market price, which its lead members and supporters argued was several times the prevailing price at the time — about $300 per ounce.

With the gold price trading at several multiples of the 1999 price, it seems as if GATA proponents were right about gold being an undervalued asset. However, there was little evidence that GATA was correct about market manipulation. While the group came up with several convincing arguments and while it was able to cherry-pick quotes from bankers and aberrant market activity, the claims were largely circumstantial.

With the acknowledgement of an act of manipulation by the British authorities, GATA’s position has much more credibility. Of course, we also live in a time period during which market manipulation appears to be the norm. Recall the Libor scandal that became public a couple of years ago. We learned that bankers from several institutions were colluding in order to manipulate Libor rates, which have a significant impact on global interest rates and by extension the global economy.

Also recall the “flash-] crash” from 2010. This was a situation in which machine-driven trading pushed the Dow Jones down 1,000 points in a matter of minutes. I don’t think that anyone believes that this is a case of manipulation whereby a few billionaires sat in a room planning to tank the market 1,000 points, but the fact remains that market fundamentals were trumped by extremely unusual trading activity.

These events make the idea that the gold market is manipulated less absurd and more acceptable even from a relatively mainstream perspective.

As investors, we have to accept the fact that there are certain things about markets that we simply cannot control. We also have to accept that certain market outcomes have political significance. For instance, a rising gold price makes the dollar and other currencies look weak, and it follows that interested parties such as the federal government or the Federal Reserve have a vested interest in a low gold price.

Are they manipulating prices? Maybe they are. But that shouldn’t matter. You need to focus on fundamental value. You cannot justify buying or selling an asset solely on the basis that a market is manipulated. You also cannot blame losses on a manipulated market. Markets may be manipulated, but no one entity can control a market indefinitely. Fundamental value will ultimately be recognized, and finding it before others do should be your priority as an investor.

Disclosure: Ben Kramer-Miller owns gold coins and shares in select gold miners.

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