What is Paper Gold? Understand Here!

5 mins read
by Angel One

What is Paper Gold?

Paper gold is a kind of asset that represents the price of gold but isn’t truly gold; it’s not backed by real metal, thus it’s just worth paper. Holding paper gold allows you to acquire exposure to the price of gold without having to own real bullion, and it’s more beneficial for trading than long-term investing. Gold certificates, pool accounts, gold futures accounts, and most exchange-traded funds are examples of paper gold.

Why is Paper Gold used instead of Physical Gold?

The initial response is that you may wish to save money on storage. You may not want to store your metal at home if you spend a significant portion of your wealth in real bullion (you’ll need a safe and perhaps other supplementary equipment). In this instance, a custodian — an entity that keeps your metal for you – would be a better option. This storage service is not free (neither is transportation to the storage facility, nor is insurance), therefore you must include this expense into your calculations, which reduces your gold returns. When you purchase paper gold, you receive a piece of paper that roughly matches the price of gold and saves you the expense and hassle of storing it.

Furthermore, paper gold allows you to invest in gold even if you don’t have enough money to purchase an ounce. This is due to the fact that ETF shares, or similar investment vehicles, often represent less than one ounce of gold — most generally, they track the price of a tenth of an ounce. ETFs may be a good option if you don’t have enough money to purchase a whole ounce of gold. Another factor for the popularity of ETFs among individual investors is their low cost.

Is Paper Gold a Safe Investment?

You may wonder whether it’s sensible or safe to invest in paper gold if you don’t own the metal. This is a crucial issue since purchasing paper gold exposes you to counterparty risk (the risk that your transaction partner will fail to fulfill their promises).

In brief, this is okay if you just spend a tiny fraction of your cash to buy paper gold (for example, by gambling on price movements), but it might be troublesome if a substantial sum of money is at risk (long-term investments). When you purchase a gold ETF share, for example, you receive a piece of paper that trades in the same way as gold. You may sell it to any other investor and get money, just like a stock. Please keep in mind that most ETFs do not accept gold redemptions. In other words, you won’t be able to swap your ETF shares for gold if you wish to sell them.

The ETF attempts to make the price of its shares move in a manner that is unrelated to the demand for those shares. If a large number of investors want to acquire shares of a certain ETF, the price of those shares will almost certainly rise. In such a case, an ETF (together with its partners) issues extra shares to relieve price pressure, and the new shares are backed by actual gold or a gold derivative (like futures contracts). As a consequence, higher demand for ETF shares will result in an increase in the number of shares available rather than a price rise. If demand for these shares is limited and the price falls, the ETF (and its business partners) will sell some of its actual assets and use the proceeds to redeem existing shares. This step restricts the supply of shares and raises the price.

The aforementioned process is essential since there have been fears that ETFs’ shares may not all be backed by actual gold. This means that the total value of the shares issued by a certain ETF surpasses the total value of gold held by the ETF. It may seem insignificant at first since you can’t normally swap your shares for gold using an ETF. However, after some thought, such a circumstance seems to be disturbing.

The fundamental reason for this is that when you wish to swap an ETF share for cash, the ETF (and its partners) must first collect this cash. If the ETF contains real bullion, it may simply sell a portion of its holdings to get the required funds. However, if it does not own real bullion and runs out of funds (for example, due to a futures market failure), it may be unable to pay you for your share, resulting in an ETF default. In this situation, instead of making money by selling gold at a high price, you would lose it.

Even ETFs with insufficient actual gold will be profitable as long as demand for ETF shares is strong and you can sell them to other investors (rather than the ETF). However, if the gold derivatives fail, gold falls in value, and/or demand for these shares decreases dramatically, such ETFs may find themselves unable to redeem all of their shares. The less real gold the fund actually has, the more likely you are to find yourself on a precarious limb in an emergency.

The Golden Rule

If you invest in gold ETFs, make sure you pick either ones that allow for gold redemptions (which are limited) or those that have their shares entirely backed by gold. Aside from that, ensure to balance your possessions, which in this case implies possessing both physical and non-physical gold for small, quick transactions. If the derivatives market crashed, the price of your actual gold assets would skyrocket, more than compensating for the losses on the speculative paper gold. This is why, in this scenario, diversity is critical.