South Korea goes for Gold, gets paper

South Korea recently announced plans to increase its gold reserves, but so far, it’s only bought a different kind of paper.

According to a U.S. Securities and Exchange Commission filing, the Bank of Korea purchased 679,765 shares of the SPDR Gold Trust ETF in the second quarter. The central bank's ETF holdings were valued at ₩354.5 billion ($250.41 million) at the end of June.

ETFs are a convenient way for investors to play the gold market, but owning ETF shares is not the same as holding physical gold.

An ETF represents a basket of investments that trades on the market as a single entity. An ETF can track a single commodity, such as oil, or hold a wide range of assets such as tech stocks. The mix of securities held in an ETF is limited only by your imagination.

Like stocks, ETFs are sold in shares on an exchange. The price rises and falls throughout the trading day as they are bought and sold on the market just like a stock or bond.

A gold-backed ETF generally tracks the price of gold, but other dynamics are in play, so it's not a one-to-one correlation.

Most significantly, while a gold ETF is a convenient way to play gold's price, you don’t possess any gold. You have paper. And you don’t know for sure that the fund has all the gold either. You’re taking their word for it. This is especially true when a fund sees rapid inflows. In such a scenario, there have been difficulties or delays in obtaining physical metal.

SPDR ETF is the largest gold-backed fund in the world. The U.S.-based fund holds gold in New York and London.

 “Amid heightened geopolitical risks, interest in gold as a safe-haven asset has grown, and we determined that the BOK needed to increase its relatively small gold holdings," Bank of Korea Reserve Management Group Director Jung Hee-sup said.

But that’s not what the central bank is doing. It isn’t buying gold. It’s buying paper backed by gold. This is nothing more than trading one set of counterparty risks for another.

What exactly is counterparty risk?

In simple terms, it is the possibility that the party on the other side of a transaction might not fulfill its obligation.

For instance, if I loan you $200, there is always a chance that you won’t pay me back. That possibility represents the counterparty risk that I’m taking on.

ETFs introduce a high level of counterparty risk. The ETF could have trouble sourcing metal and may not be backed to an appropriate level. The fund could be mismanaged or even closed down. Other parties could block your access to the fund or confiscate your shares.

In other words, buying an ETF introduces many of the same risks central banks are trying to avoid with gold.

Central banks are piling up gold to shield themselves from the counterparty risks inherent in the dollar. They are worried about America’s fiscal malfeasance and its ever-increasing debt. They are also concerned about the weaponization of the dollar and the prospect of the U.S. using its currency as foreign policy leverage.

Buying a U.S. based gold ETF is a little like jumping from the frying pan into the fire.

South Korea does have plans to increase its physical gold reserves. Earlier this month, it announced a framework to purchase gold from South Korean miners at international spot prices.

The Korea Exchange and the Korea Securities Depository will facilitate the transactions, with domestic gold producer LS MnM and Korea Zinc supplying eligible gold.

The two Korean gold miners produce 4 to 5 tonnes of gold annually. Officials say the Bank of Korea will purchase some of that output “when market and reserve management conditions are favorable.”

The structure of the scheme will allow the Bank of Korea to settle transactions in Korean won, meaning it will not have to dip into its foreign exchange reserves.

The gold will reportedly be stored in South Korea. Most of the country’s gold reserves are held in London vaults.

The last time the Bank of Korea expanded its gold reserves was 13 years ago. The country currently holds just over 104 tonnes of gold, about 1.1 percent of the country’s total reserves.

Korea Investment and Securities analyst Jung Hyun-jong said the central bank's renewed interest in gold is part of a broader trend in South Korea.

"In the past, jewelry demand accounted for more than half of the gold market, but the shares of investment and central bank demand have increased sharply in recent years. This suggests that gold is shifting in status from a simple consumer commodity to a financial asset and an alternative currency that can serve as a hedge against geopolitical risks, inflation, and currency depreciation.”