Gold investments: how liquid is the crisis metal?

Gold facts & figures Arnulf Hinkel, financial journalist – 31.03.2021

Learn why liquidity is especially important when it comes to gold, in trading as well as with regard to its function as an investment reserve.

© Umicore

Investors are familiar with the term liquidity, which refers to how easily, quickly and cheaply a financial product can be traded. If a financial product is highly liquid, it has many potential buyers as well as numerous potential sellers. The higher the number of investors interested in trading a financial product, the more closely the desired buying and selling prices converge. The trading margin, or spread, narrows, with the favourable effect of lowering transaction costs. This applies to shares as well as bonds, certificates, funds, ETCs, and of course to gold. The Germans’ favourite precious metal plays a special role here, as Gold trading is not only highly liquid; it also constitutes the ultimate liquidity reserve. 

Gold: symbol of prosperity and crisis-proof investment  

In high-growth economies with rapidly rising wages such as China and India, demand for gold is high. In investor portfolios, the precious metal is popular across different economic cycles as a proven instrument for generating long-term returns and an important factor in portfolio diversification. In turbulent phases on the stock markets or in times of economic crisis, the gold price often moves conversely to the market and can thus provide stability to investors’ portfolios. Gold is also a valuable inflation hedge and store of value.   

During the financial crisis 2008/2009, many investors still relied on currencies such as the US dollar. This has changed in recent years, as evidenced by the extremely high global demand for gold in 2019 during the US-Chinese trade war and – even more so – since the start of the Coronavirus pandemic in 2020. After all, gold, as one of the oldest means of payment, is also the hardest currency in the world. The purchasing power development of gold from 2000 to 2020 compared to important currencies such as the US dollar or the euro shows that the latter has depreciated by nearly 81 per cent against gold, the former by 82 percent. It is therefore no wonder that gold is considered a superior liquidity reserve. 

How liquid is gold as a liquidity reserve?

To use a liquidity or investment reserve in times of crisis, it must be made “liquid”. It is important that transaction costs are as low as possible when selling, as they have a reductive effect on value. This is especially true for gold, as it does not yield interest or other returns such as dividends. The fact that gold is among the most heavily traded instruments is beneficial. As substantiated in the World Gold Council study “Relevance of gold as a strategic asset 2021: European Edition”, the average daily trading volume of gold worldwide amounts to €149.8 billion. By comparison, the European benchmark index EURO STOXX 50 only has a trading volume of €8.6 billion, and even the extremely liquid currency pairs euro/yen and euro/pound sterling lag far behind gold, trading at €93.32 billion and €97 billion, respectively. Only the S&P 500, composed of stocks of the 500 US companies with the highest market capitalisation, has an even higher daily average trading volume at €186.16 billion. 
Gold trading liquidity is, in fact, extremely liquid. In 2020, 88 per cent of the total annual production changed hands every day. It is hardly possible to imagine a higher degree of liquidity. However, these figures refer entirely to gold traded wholesale or on-exchange. For private investors, the situation may be different under certain circumstances, for example if they intend to buy physical gold from commodity traders or their house bank.  

Physical gold as investment reserve ranks highest in terms of flexibility and cost

© PantherMedia /strelok
© PantherMedia /strelok

Private investors can access gold bars or coins directly in times of extreme crisis and thus hold a liquidity reserve outside the financial system. This can be a decisive advantage in the event of a system crash. However, this ultimate liquidity reserve comes at a high price. Private investors only benefit to a limited extent from the advantage of the precious metal’s enormous trading volumes, as price transparency is low when trading gold through a jeweller, trader or bank. Investors must thus rely on their own comprehensive price comparison to avoid paying unnecessarily high prices for physical gold, because high spreads immediately devour part of the gold value. In addition, relatively small denominations, such as 10 grams or one ounce, can serve as a sensible preparation for a system crash. Although they come with significantly higher transaction costs, they are easier to sell or exchange than large bullions. 

Seller integrity is an extremely important factor to be noted. There may be cheaper offers on the Internet, but the risk of acquiring counterfeit gold is real. Bars and coins should only be purchased if they are certified as genuine, which also facilitates later resale, when the authenticity of the gold must be proven. Moreover, the costs do not end with the purchase. Bars and coins should be stored safely, which in turn necessitates a security system, entailing additional costs. 

Alternatives: central storage or safe deposit box 

Private investors may also store their physical gold at their bank. However, safe deposit boxes and additional theft insurance also incur additional costs.
Another option is to invest directly in centrally stored gold, with the advantage that investors can usually buy or sell gold around the clock, even on weekends. However, this option does not allow for direct access to the gold investment, which limits its function as a liquidity reserve. The same applies to bank storage. In the event of an extreme crisis, it may be difficult to get hold of the gold.

ETCs are the closest alternative to direct gold investments

Of all the securities that indirectly back gold, such as gold indices, shares or certificates, physically-backed gold ETCs (exchange-traded commodities) are the next best thing to a direct investment. This is especially true if, like Xetra-Gold, they securitise the delivery of physical gold in the amount of the respective ETC investment at any time. Legally, ETCs are bearer bonds, which means that the issued units are not insured in the event of insolvency on the part of the issuer. For each ETC unit issued for trading, a corresponding amount of physical gold is therefore purchased as collateral and held in safe custody. The extremely low transaction costs are a major advantage of gold ETCs. Equally liquid as blue chips, gold ETCs are traded on the stock exchange and in an entirely transparent process. ETCs allow investors to benefit from the fact that they directly track the performance of gold without requiring costly direct investments in physical gold.   

Conclusion: independence from the financial system has its price

The great advantage of minimal transaction costs when trading gold ETCs is contrasted by a certain disadvantage: they are securities, and those who fear a complete collapse of the financial system will not feel any safer with gold ETCs than with an investment in ETFs (exchange-traded funds). For reliable inflation protection and as a safe haven within a functioning financial system, gold ETCs are definitely a reliable and cost-effective alternative to a direct investment in gold. However, investors looking for the ultimate investment reserve for extreme times of crisis that may even threaten the financial system will be unable to avoid costly direct investments. 

Arnulf Hinkel

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