Deciphering the Complex World of Precious Metal Derivatives: UCITS and the Shift from Physical to Paper Gold & Silver

Why and How Does the Physical Gold and Silver Market Continue to Be Engulfed by the Enormous World of Paper Gold and Silver Derivatives?


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This disparity has persisted for decades. Why is there such a significant outflow of ounces from SLV and GLD, yet the price has barely been impacted?

Graph showing a significant outflow of ounces from SLV and GLD, yet the price has barely been impacted?

And why has there been a notable increase in derivatives on precious metals in recent years, as reported by the OCC?

Graph showing the notional amounts of precious metals by maturity

To quote Bob Dylan, “The answer, my friend, is blowin’ in the wind.” This article will not focus on the Comex but rather on a lesser-known investment scheme that attracts vast sums of money, in the trillions of dollars, diverting it away from physical assets such as gold and silver.

A recent article titled, “BlackRock warns investor disdain for mining threatens green transition” highlights that the world’s largest asset manager criticizes complacency over the supply of transition metals.

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Understanding the regulatory environment and the flow of money, which disincentivizes owning actual physical assets, will shed light on what this article overlooks.

After diving into the following details, one might wonder: Why not invest directly in real assets, having legal ownership that is straightforward? Possibly, the vast amount of money created over the past 50 years would have driven commodities like gold and silver prices through the roof a long time ago. The derivatives market acts as a buffer, ensuring large capital investments have a minimal impact on the underlying commodities.

This phenomenon began in Europe in the 1980s with the introduction of a new investment directive called UCITS (Undertakings for Collective Investment in Transferable Securities). While UCITS can represent commodities, they can’t have direct exposure. Commodities, such as gold and silver, are accessed using derivatives. This might sound absurd, but an entire regulatory framework addresses the risks associated with these sophisticated derivatives compared to investing in the tangible asset. UCITS can employ both regulated and over-the-counter (OTC) derivatives, encompassing commodities, financial indices, credit default swaps (CDS), total return swaps, and more.

A UCITS fund must be diversified with no single asset exceeding 10% of the fund’s net asset value (NAV). Moreover, these funds should offer liquidity, allowing investors to sell their shares at any moment. The assets within a UCITS ETF are kept separate from the fund provider’s assets, safeguarded by an independent custodian, to protect investors in case the provider faces financial difficulties.

Various conditions, such as maintaining derivative counterparty concentrations below 10%, necessitate ongoing monitoring of derivative positions. The tools supporting these risk calculations need to be transparent and widely accepted.

Significantly, a fund or ETF meeting UCITS requirements cannot allow for the delivery of a physical commodity, even if the fund or ETF possesses the genuine asset. For instance, the prospectus of Sprott’s Physical Silver Trust (PSLV) mentions that UCITS unit holders, or those with specific restrictions, can only redeem trust units for cash.

In some scenarios, if a UCITS unit holder redeems PSLV units for cash, they might only receive 95% of the lesser of two values: the volume-weighted average trading price of the trust units over the past five trading days or the NAV of the redeemed trust units at the end of the month.

There are numerous eligible and non-eligible Commodity UCITS ETFs, such as the WisdomTree Enhanced Commodity UCITS ETF, iShares Physical Gold ETC, and SPDR Gold Shares – GLD, among others.

While UCITS mainly targets European investors, many US fund companies and ETFs cater to this capital pool. Approximately 12.4 trillion euros are held in UCITS assets, with over 5 trillion in equity assets.

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The majority, if not all, of the prominent asset management firms have created products for this asset class using derivatives, diverting the vast money supply increments over the years from real commodities.

By encapsulating these UCITS within derivatives, laden with risks such as leverage, counterparty risks, and systemic risks, the system effectively diminishes the demand for actual commodities like gold and silver. Consider the scenario where all the capital seeking gold and silver wasn’t diverted by derivatives such as UCITS, CFDs, futures, and more. Although many investors might not intend to take physical delivery and simply want price representation, these instruments absorb capital from the foundational asset. This impacts the mining industry, price discovery, and the overall volatility of the asset class.

Basel 3 might have been designed to reduce bank leverage and distribute risk among financial system counterparts. In an era of surging debts and increasing uncertainties, the significance of directly held, unleveraged real assets for portfolio diversification cannot be overstated. Yet, major asset firms might not find profitability in such a simplistic model.

image showing many logos of the precious metal trading industry

Sadly, many entities, from individuals to institutions and pension funds, might be obliviously banking on commodities that, during significant risk-off events, turn out to be mere mirages. Commodity prices can be volatile, but owning tangible assets like gold and silver mitigates some of the profound risks that paper instruments weren’t crafted to address.

Before opting for a passive investment strategy in gold and silver, thoroughly read user agreements, prospectuses, and offering documents. Compare the outlined schemes to outright ownership in gold and silver. Evaluate all factors and, most importantly, understand your counterparty before investing.


Bob Coleman



About Author

Bob Coleman has been in the Investment management industry since 1992 to provide intelligent research, consulting, and portfolio management services to high-net-worth investors and institutions.

Bob Coleman standing in front of gray background wearing a suit.

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