WATERS TECHNOLOGY – Going for Gold: Tech Answers Demand for Physical Holdings
By Timothy Bourgaize Murray
September 7, 2012
The world’s oldest asset has enjoyed renewed popularity, with prices hitting contemporary highs. But wealth managers are beginning to demand more than ETP shares—investors and institutions want the real deal. As Tim Bourgaize Murray explains, technology is proving crucial in delivering physically allocated gold—in a way, making ‘old’ new again.
Rise of ETPs
Short of kingly handouts, holding gold has not been an easy process for modern investors. “Before gold ETFs were first listed, the only ways to really invest in gold were to buy shares in gold mining companies, futures, or coins and bars that are subject to premiums to the spot price of gold, and were inefficient and costly to store,” says Will Rhind, managing director with ETF Securities, an exchange-traded product provider.
In the past, those means have proven fraught with risk. Mining companies’ stocks are priced indirectly and subject to bad bets. “Very aggressive, far-forward gold hedging by global gold producers was a major factor in the decline of gold prices throughout the 1990s,” says Colin Griffith, a precious metals consultant at the London Metals Exchange (LME). And private bank offerings of physical gold would be subject to those institutions’ credit risk—essentially a certificate backed by the bank’s balance sheet, says Stefan Garcia, executive director and head of commodities at Source, a European ETP provider.
The first exchange-traded commodities, launched in 2003, changed the game. Gold ETPs, or ETFs in the US, are valued at approximately $140 billion, with State Street’s SPDR GLD, the oldest of them, now one of the largest ETFs of any kind by assets under management.
Owing to scalability and low technology costs, the array of gold ETPs has also rapidly expanded. “As the ease of operation has been perfected over the past years, we now see products competing in different ways, whether on cost, trading volume, geography—as in where the gold is stored—and whether they can be ‘passported’ for cross-border trading,” says Garcia. Source’s physical gold ETPs, for example, are traded in three currencies at the London Stock Exchange (LSE), Deutshce Börse’s commodities platform Xetra in Frankfurt, and the SIX Swiss Exchange in Zurich.
Yet even as they remain highly popular, gold ETPs are not without their challenges—or detractors.
Price is where the debate starts. Because traders can move in and out of the products frequently, much as they would with equities, their price doesn’t tend to precisely mirror their benchmark’s actual value. One market expert familiar with upstream gold operations describes these products as “devilish” for obscuring a market where prices were once only subject to the “natural” order of the production chain.
Laura Morrison, head of US ETP listing and trading at NYSE Arca, says a large percentage of ETP volume is not executed on exchange anymore. “Fragmentation, particularly within the dark pool and internalization models, has caused the market to be less transparent,” she says.
Large brokers with significant supply of ETFs in their system benefit from in-house matching, friendly price discovery and lesser transaction fees. “There is also an element of certainty, where you’re not being potentially broken up on the secondary market,” she says. Today, the exchanges are often left to mop up the more difficult transactions.
Increased regulatory scrutiny, lengthening the approval process for new ETFs that do not meet exchange generic listing standards from eight months to as much as two years, has also come in response to another challenge: greater scrutiny of unique ETPs’ intricacies. “It is critical that investors understand all the characteristics of these products, really delving into the details,” Morrison says.
Some products, for example, employ a synthetic swap mechanism that produces physical replication and, with it, counterparty risk. As a result, more wealth managers and funds now believe that holding a stake in a trust—as most gold ETFs are structured—is not exactly what their hold-and-hedge and institutional clients require. Rather, they are after investment in the genuine hard asset—something which, by its nature, is physically redeemable.
“We are in the very early stages of the rebirth of gold as a respected world asset, as a currency, as a store of value, as a hedge against negative real interest rates, as a proxy for income growth in the fastest growing part of the world—the emerging markets—and as a hedge against financial system turbulence,” says Dan Tapiero, head of global macro investment at Stamford, Connecticut-based SAC Capital Advisors. He offers as an example the University of Texas’ recent foray into physical bullion, investing a full 5 percent of its $1 billion endowment in the metal.
Enter the alternative venues, which have made their gains through being tech-savvy as well as timely. Compared to the crowded gold ETP space, the precious metals direct trading space is an open one. Of the venues in question, “a few have good liquidity while the majority suffers to meet that requirement,” says the LME’s Griffith.
The key is having a clever plan—and robust technology.
Gold Bullion International (GBI), as one particular example, set out in 2009 to build a platform that could integrate directly into wealth managers’ portfolio management systems, just as the financial crisis began to see radical monetary policy, particularly in Europe, accelerate. The firm’s CTO, Peter Custer, says what began as a flexible FIX Protocol-like specification has now developed into a customizable web-based application programming interface (API), providing access for wealth managers to real-time prices from 14 different dealers and refiners. The firm’s back office then bundles daily logistics and shipping information for one of five vaults across the US, Europe, and Australia—with a sixth soon to come in Singapore—while also achieving T+2 settlement.
“The metals business has a lot of old school and antiquated notions for a business that has been around for 5,000 years—we simply asked, where was technology 2.0 for gold?” says Steven Feldman, GBI’s CEO and founder, adding that the tremendous upfront cost of developing the platform has created a high barrier to entry in the space. That spend includes a pricing algorithm, which ties an exchange-for-physical (EFP) base rate to futures pricing data for contracts initiated on a particular day.
Custer says an agency model—coupled with GBI’s trading blotter, intentionally designed to keep “buy” and “sell” order flows discrete—ensures integrity in the process.
“When you have a match, it might be really tempting to invent your own price with a cross-trade,” Custer says. “But we want the model to be based on market best execution, and be able to justify and document that whenever necessary. This is one of the first questions asked when we’re arranging new institutional business.” SAC Capital’s Tapiero, who advises GBI, calls it a “specific safety” that dealing in exchange-traded products can’t provide.
The other attraction to such platforms isn’t only in getting a hard asset with physical access, but high-touch service and back-end technical expertise facilitated by the firm’s custom application layer. That, after beginning with only a single, albeit very large, North American wealth management client, has helped GBI gain market share on its ETF rivals.
“State Street’s GLD is obviously bigger than we are, but first isn’t always best,” says Feldman, who, like many of the firm’s leadership, comes from a wealth management and an institutional products background, rather than having previous gold expertise. “If you’re looking to buy a safe-haven asset, to hedge a portfolio rather than trade in and out, buy it in its safest form. That means a product with no credit, counterparty, or default risk; with no fear of a glitch at an exchange affecting pricing; and one that is audited, insured, and never re-hypothecated.”
Will wealth managers continue to buy that proposition? ETPs and physical gold can live in mutual coexistence as managers become more acutely aware of their clients’ needs and allocation options. But nimble alternative venues like GBI entering the fray, combined with lost market share due to internal ETF matching, only serve to heighten the impetus for technology innovation at the exchanges. Observers say the squeeze has already begun to effect some changes.
In one sign, says Garcia, SIX Swiss Exchange recently implemented a new trading system from Nasdaq OMX to specifically service expanded ETP volume by next January. “That’s where the technology aspect kicks in,” he says. “Market-makers want to be able to send more quotes faster to exchange, and in Europe, regional exchanges are catching up to established centers of power like the LSE. They are competing for market-makers, to put up tighter spreads and see more flow.”
At Arca, Morrison says NYSE is working on expanding its retail liquidity program, which helps retail order -sending firms connect directly with dedicated liquidity providers, into its broader ETF listings. And some gold ETF issuers have begun to react to alternative competition with “spot” products that are physically redeemable on a monthly basis, including ETF Securities’ Asian Gold Trust and Physical Swiss Gold Shares. With the exception of Ucits funds, Source also provides delivery to investors large enough to hold an account with the London Bullion Market Association (LBMA). But options like these are otherwise few.
GBI’s platform, in the meantime, continues to evolve. With its Enterprise 6.0 platform upgrades, the firm is tackling fractional allocation, building connectivity with Asian venues in order to cover all OTC trading hours, and most of all, deconstructing the platform into “Lego blocks,” as Custer describes it, to enable current and future distribution projects. Those include servicing the physical allocation dividend program for a gold mining firm, and even talks with sovereign mints around their coin management.
Still, Feldman insists that wealth management, providing an ancient asset for contemporary investors with a seamless process, will remain the firm’s prime objective.
“What we’re all about is truly expanding the gold ownership pie,” he says, adding that the firm is enthusiastic about its position, while welcoming future competition.. “They just have the privilege of competing with us.”
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