Monday, September 28, 2020

Adopting a clean gold standard


Last month I wrote an article about banning gold mining. It received plenty of feedback from different parts of the internet. Some loved it, some didn't. [ GATA | Boing Boing | Hackernews ]

In this follow-up post, I want to outline a less draconian and more market-friendly alternative to banning gold mining.

But first, let me quickly reprise the original blog post. Unlike coal or oil or wheat, gold never gets consumed. We mostly "use" gold by holding it in vaults where it is kept safe from wear and tear. If people collectively want to hold more of the yellow metal, then a simple rise in price will suffice. After all, if the price of gold jumps to $4000/oz from $2000/oz then the world's gold hoards will have doubled. Voila, demand satisfied.

With price doing all the work of responding to higher societal demand, no new metal from mines is required. That's a good thing. The problem with gold mining is that it causes all sorts of environmental damage. That's why El Salvador, for instance, chose to ban gold mining back in 2017. Extending this ban to the entire globe would reduce all of the damage caused by mining without hurting gold's main consumers: investors, speculators, and hoarders.  

So that was the gist of last month's post.

In today's post I want to outline an alternative way to move in the same direction as a mining ban. The idea would be for a standards board, perhaps the London Bullion Market Association or the International Standards Organization, to create a new industry standard for gold called "clean gold." Unlike "dirty gold," clean gold would not be implicated in the environmentally damaging effects of mining. Environmentally-conscious gold investors would be able to migrate from their dirty gold to clean gold, which would likely trade at a premium to the dirty stuff.

Clean gold would be defined as all gold in existence before a fixed cutoff date, say December 31, 2023. Any gold produced after that would not be granted clean status. It would be dirty.

By committing to only buy and hold clean gold (i.e. the legacy already-mined stuff) a woke gold investor is choosing to avoid contributing to any additional mining-linked environmental degradation. These investors' collective choice to only buy pre-2023 gold would be a substitute for a gold mining ban. Together, they would be acting as-if gold mining had been banned by governments.


One institution that could champion clean gold would be the London Bullion Market Association, or LBMA. The LBMA already maintains a set of standards that define London "good delivery" gold bars, including rules concerning permitted bar dimensions and purity. There are currently 8,790 tonnes of London good delivery gold, worth around $555 billion and accounting for about 5% of all gold ever mined. So the LBMA’s standards have a major influence on what sort of gold is considered legitimate for investment purposes.

The LBMA has already instituted some woke standards for good delivery bars. LBMA responsible gold guidance prohibits bars from qualifying as good delivery if they have been involved in financing conflict and the abuse of human rights. It also sets some environmental standards. For instance, the LBMA requires refiners who buy gold from artisanal miners to assist them in establishing processes to better use mercury.

How would the LBMA introduce a clean gold standard?

The LBMA could redefine its good delivery standard to be a clean standard by only allowing bars produced prior to the December 31, 2023 cutoff date to qualify. Alternatively, it could set up a second delivery standard, a "good & clean delivery standard," and anyone participating in the London gold market could choose their preferred standard.

Exchange-traded funds, say like the State Street's SPDR Gold Shares ETF, the world's largest gold ETF, would also be a natural set of institutions that could champion clean gold. Either in conjunction with an LBMA clean standard, or on it own, the SPDR Gold Shares ETF could commit to only holding gold bars produced prior to December 31, 2023.

Finally, major gold coin-producing mints like the Royal Canadian Mint and the US Mint could also apply a clean gold standard to the coins they produce.


As I mentioned earlier on, clean gold would trade at a premium to dirty gold. Likewise, a clean gold ETF would trade at a premium to a dirty gold ETF and clean gold bullion coins would trade at a premium to regular bullion coin.

The reason for a premium is that the supply of clean gold would be fixed at the amount of gold in existence prior to December 31, 2023. But the amount of dirty gold is not fixed. Dirty gold includes not only all gold mined after 2023 but all pre-2023 gold. After all, an owner of a 1995 gold bar needn't seek clean status if they don't care for that designation.

If dirty gold were to ever rise to a premium to clean gold, then arbitrageurs would convert clean gold into dirty until the premium disappeared. There are no rules prohibiting movement from the clean to dirty designation. But careful, once dirty always dirty! There is no way to do the opposite, to convert dirty gold into clean in order to reduce the clean premium. The clean gold rules and standards prevent dirty gold conversions.

How large might the premium get? If the gold investment world were to completely migrate over to clean gold, quite high. Most existing gold is currently being held for hoarding purposes. By taking the totality of this demand and refocusing it on pre-2023 gold, the price of clean gold might trade at, say, $3,000 while the price of dirty gold trades at just $300.

On the other hand, the premium would remain low if the clean gold standards are poorly managed and lack credibility.


Who would want to buy dirty gold?

Investors who are less concerned about the environment might be content to keep holding dirty gold kilo bars and 400-ounce bars. People who buy gold jewellery might not mind holding dirty gold either, since dirty gold necklaces will be cheaper than certified clean necklaces.

I suspect the main buyers of dirty gold would be manufacturers that use it for industrial purposes, like circuitry. Gold has excellent conductivity. It is also the most non-reactive of all metals, which means that unlike copper and silver it is resistant to corrosion & oxidization.

Given these advantages, manufacturers would love to use more of the yellow metal in their products. However, gold's high price prevents broader industrial usage of gold. The dominant group of buyers—hoarders & investors—keep gold's price perpetually high, thus pushing manufacturers out of the market. And so copper has become the most important metal in electronics. By diverting a large chunk of hoarding demand to a certain type of gold, clean gold, chip makers could finally get access to low-priced gold. Gold would displace copper and the overall quality of electronics products would improve.

Certain manufacturers that want to demonstrate a commitment to having sustainable supply chains (i.e. Apple?) would probably purchase clean gold, and so their products would be more expensive than those without clean gold.


What about coins?

As I suggested earlier, mints such as the US Mint and Royal Canadian Mint would produce two streams of gold coins: clean coins and regular ones. They would buy clean gold feedstock from the LBMA's certified clean gold inventories. The mints would include branding on clean coins to certify their clean status. As for their regular coins, mints would continue to buy newly mined gold from miners.

I suspect that many gold coin buyers would default to the woke alternative. Say that Jack has $10,000 to invest in gold. He can either buy 4 clean Maples for $2500 each or 40 dirty Maples for $250 per ounce. At least with the clean option Jack can feel good he's doing the right thing. Either way, he ends up with the same nominal $10,000 in metal, and it's the nominal amount of metal that most gold investors care about, not the actual quantity of ounces. 

Of course, there are gold coin buyers who like to consume their gold (say like Scrooge McDuck) and prefer to get more bulk for their dollar. They will be happy to buy the dirty stuff.


Gold laundering would be a big issue.

With clean gold trading at a premium to dirty gold, fraudsters would try to profit by converting gold mined in 2025 or 2026 into counterfeit gold bars with a 2016 or 2017 date, and then try to sneak the counterfeit bars through the LBMA's (or State Street's) verification process. These institutions would have to set up effective mechanisms for stopping counterfeit gold bars.

At the same time, the LBMA and State Street would have to find ways to ensure that they are not preventing legitimate pre-2023 bars from entering their systems. Central banks would probably account for a large proportion of pre-2023 bars. Going forward, their holdings would be a key source of clean gold.

Rogue gold coin manufacturers would buy mined gold at $250 an ounce and manufacture fake Maples or Eagles for $2500. Mints such as the Royal Canadian Mint and US Mint would have to introduce additional anti-counterfeiting measures into their manufacturing processes to guard against fake clean coins.


There are plenty of other things that can be said about clean gold, but for now that's probably enough.

In sum, if a clean gold standard was carefully implemented and became popular with investors, it would synthesize many of the same effects of an outright ban on mining. By herding the gold investment community away from the newly-mined gold market, the amount of gold mining would fall, and so would associated environmental damage.

It would also correct a major defect of the gold market. Manufacturers who actually buy gold by the gram for use in their products have always had to compete with investors/speculators who aren't beholden to the same profit and loss calculation as a business. This is just silly. Disaggregating gold into two types corrects this. Investors & speculators can continue with their bets as before by focusing on the first type of gold, and it's clean to boot. And manufacturers finally get access to cheap type 2 gold. It's win-win.

Wednesday, September 2, 2020

Different bitcoins different prices

Not all bitcoins are the same. If someone steals 100 bitcoins from a cryptocurrency exchange and tries to sell them, they'll have to price them at a discount to the market price in order to compensate the buyer for the risk of laundering them. Different bitcoins different prices.

This isn't just a bitcoin phenomenon. There are two wholesale markets for banknotes, too. The legitimate one is comprised of banks, retailers, and cash-in-transit companies like Brinks that exchange notes at par. And the illegitimate one is made up of mob lawyers, drug dealers, and note brokers exchanging dirty notes at 20 or 30 cents on the dollar. Different dollars different prices.

You can find this same fractionalization everywhere: in electronics or prescription medicine or used cars. There is a licit and illicit price in each market.

But the difference between dirty and clean prices isn't the dichotomy that interests me in this post. Could we see a two-tiered market develop for clean bitcoins? In other words, could a situation arise in which Jerry's 100% legitimate bitcoin's are worth more than Elaine's 100% legitimate bitcoins?

I'd argue that the precedent already exists in the gold market.

Last month I wrote a quick explainer on the London Bullion Market Association, or LBMA, for CoinDesk. The LBMA is a standards-setting body for the gold market. It defines what constitutes a London "good delivery" gold bar and what doesn't. These standards include physical details like purity, weight, height, and appearance. Increasingly, the LBMA's standards are being stretched to include details about sourcing. Has the miner extracted the metal in an environmentally friendly and ethical way? Are they laundering money for Mexican drug lords?

Good delivery bars can only be stored in a handful of London-based vaults. A strict paper trail is maintained to ensure that nothing gets in (or out) of this walled-garden. The moment a bar is withdrawn from a London vault, it loses it's good delivery status.

This has the effect of creating a two-tiered licit gold market, one in which London gold is worth more than non-London gold.

Consider that the world's largest buyers congregate in London to trade gold. A 400-ounce gold bar fabricated by a refiner that doesn't have the LBMA's stamp of approval can't access the incredibly liquid London market. And so it won't be worth as much as an LBMA-approved 400-ounce bar. (No one wants to buy your metal if it can't be immediately on-sold in London.)

To be granted London "good delivery" status, an unapproved bar must go through a process of being anointed. That means bringing the bar to a refiner on the LBMA's approved refiner list. The refiner vets the bar owner to check for money laundering, much like a banker would. Only then can the bar be melted down and reformed into an entirely new and approved bar. But all of these steps are costly.

As my CoinDesk article suggests, we might one day see the same sort of fractionalization emerge in the bitcoin market. A core group of exchanges and custodians would begin to define what qualifies as a "good delivery" bitcoin. Standards would mostly apply to the provenance of bitcoins. Since the history of bitcoin transactions can be easily monitored, it is relatively easy to cast aspersions on certain flows of bitcoins, perhaps because they happen to pass through suspicious addresses or are  mixed by coin tumblers. (As Izabella Kaminska suggested a while back, bitcoin has a lien problem. Tim Swanson has been writing about this for a while, for instance in A Kimberly Process for Cryptocurrency.)

Should a bitcoin be withdrawn from this "walled garden" of approved exchanges and custodians it would fall out of the Bitcoin Marketing Association's "chain of custody" and, as such, would no longer have access to core liquid markets. And so unapproved bitcoins would be forced to trade in lower quality venues with lax vetting standards, and less liquidity.

An online retailer might not want to take the risk of selling their products for unapproved bitcoins (i.e. ones that come from non-vetted personal wallets). Sure, it might be possible for the retailer to accept non-approved flows with the intention of re-depositing them into the Bitcoin Marketing Association's system in order to get the Bitcoin Marketing Association price. But there would always be the risk of an unexpected blockade or freeze of a customer's unapproved bitcoins. And so retailers would ask their customers to only spend approved bitcoins straight from their Coinbase wallets.

By the way, the sort of LBMA-driven dichotomy that exists in gold (and could one day exist in bitcoin) does not exist in banknote markets. There is no such thing as a good & expensive $20 bill and a good but cheap $20 bill. Cash, as we say in the monetary biz, is pretty much fungible.

Why do we see a two-tiered gold market but just a single-tiered banknote market?

There are probably many reasons for this, but a big difference is the sorts of people that occupy each market. The gold market is populated by investors, the most dominant of which are large institutional investors and central banks. These big players do not want the risk of having their gold being tarnished in any way. They don't want their $50 million in gold bars to end up being fake, or subject to a court dispute, or frozen by law enforcement due to money laundering concerns. That's why the LBMA standards exist; to make gold safe for big institutional buyers.

But cash is different. Warren Buffett and Ray Dalio don't occupy this particular market. The market for coins and notes is dominated by regular people. Furthermore, banknotes are primarily used in small day-to-day retail purchases, not financial speculation. This sort of activity is not conducive to the emergence of a centralized marketing association. Cash transfers are done too quickly, and in small amounts, and by folks who don't have deep enough pockets to pay for verification.

The market for banknotes is literally everywhere (each corner store in town will accept them), whereas the market for gold tends to clump up in a certain specific physical locations. This centralization makes standardization easier.

Bitcoins are more like a gold bars than a banknotes. Let's face it, it's been ten years since bitcoin appeared on the scene and no one really use bitcoin it as money (just like they don't use gold as money). The majority of bitcoin demand is a demand to hoard the stuff for price exposure, much like the yellow metal. And like gold, the market for bitcoins has coagulated around exchanges. It's not an everywhere market, not like the market for banknotes.

So to sum up, the market for bitcoins is very much like that for gold. Given that a standardized gold market has evolved, I wouldn't be surprised to see the same happen to the bitcoin market, especially if big financial institutions start arriving.