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Physical Gold and the Blockchain

24 May 2017

The below is an edited extract from Gold for Australian Investors, published by ABC Bullion in 2016. The full book can be purchased here


One of the more fascinating developments of the post-GFC environment has been the introduction to the market of Blockchain technology. First popularized through the cryptocurrency Bitcoin, which was soon referred to as “digital gold” in some places and “Gold 2.0” in others, Blockchain technology is now a fast growing and rapidly evolving industry.

Indeed, in 2016, some several years since Bitcoin was created, so obvious is the potential in Blockchain technology that it has morphed well beyond its original monetary scope, with applications being developed across a variety of industries.

According to an article published in The Conversation on May 10th 2016, by Mark Stales, a principal researcher in software systems for the CSIRO, and an Associate Professor at the University of New South Wales; “Blockchains can be used for a wide variety of applications, such as tracking ownership or the provenance of documents, digital assets, physical assets or voting rights.”

As an example of its potential, whilst some still associate Blockchain with digital currency alone, there is no reason why title to property couldn’t be managed through a Blockchain, rather than relying on some centralized lands title office or official state registrar.

In Australia, in just the last year, we have seen a number of our largest banks, invest in the opportunities Blockchain could provide, with CBA, for example, conducting simulated trades with ten global banking peers. These trades were conducted on a Blockchain, rather than via a centralized third party.

The Australian Stock Exchange (ASX) is also interested, currently investigating the opportunities that Blockchain technology could offer, including the potential for much faster trade settlement.

Were it ever to replace the CHESS platform currently used for trade settlement, Blockchain could slash administration costs, with then CEO of the ASX, Elmer Funke Kupper, telling Fairfax Media in 2015 that successful development and deployment of a blockchain would allow the ASX to “get very close to real-time settlement”. Kupper went on to state that the end goal would be a scenario whereby “You should be able to sell shares at your desk right now and walk to the nearest ATM to get your money that is our mission, the moment we are able to do that, we remove a lot of risk from the system." 

We’ve also noted with interest that the government in Sweden is investigating the potential to use Blockchain technology to register and record land title, with the Swedish National Land Survey partnering with a number of vendors to test the concept. 

The potential for Blockchain technology

In our opinion, there is vast potential in Blockchain technology, evidence of which is everywhere, including in the tests and research currently being undertaken by some of the largest players in the Australian financial services landscape.

This potential, whilst obviously disruptive, is both an opportunity and a threat to existing business models and the companies that benefit from them.

Obviously, faster trade settlement can reduce costs and risks, whilst the technology also offers solutions that will aid in the compliance efforts financial services intermediaries are obliged to undertake.

Steve Wager, writing in Institutional Investor in April 2016, noted that analysts estimated compliance costs in the US could reach USD $10 billion in the aftermath of the Dodd-Frank Wall Street Reform and Consumer Protection Act. With trading revenue falling, the ability to reduce costs is of paramount importance to banks.

Blockchain can help reduce costs, minimizing the amount of capital banks have to allocate to protect against potential trade settlement issues. Rather than waiting one to three days for settlement, which is standard these days depending on which asset class we are referring to, instantaneous trade clearing would significantly reduce, if not outright remove, the risk of trade settlement issues arising.

As Wager noted; “a bank that knows the status of all its exposures can make better informed decisions about how to allocate its capital.” 

This is but one of the opportunities in the financial sphere alone, though the ability to reconcile and settle transactions will not only be of use to the “big end of town”.

In an article in EuroMoney in May 2016, Katie Houldsworth, audit partner and Head of Innovation for Audit at Deloitte UK, commented on the efficiency that Blockchain technology could offer businesses, reducing audit times and dual verification for transactions.

The ability to enter “smart contracts”, which self-execute provided relevant conditions have been met, will also be a benefit to businesses, irrespective of their size, allowing instant invoice generation, processing and payment, all in real time.

Even central banks themselves are looking at Blockchain, with a 2016 International Conference on Policy Challenges for the Financial Sector, hosted by the Federal Reserve in Washington, featuring a key note presentation from Adam Ludwin, the CEO of Chain (a leading a Blockchain technology company).

The possibility of central banks engaging with Blockchain is not necessarily as far fetched as it might appear, as fears over the sophistication of cyber-criminals, some of whom have been able to manipulate the SWIFT system that underpins global financial transactions, continue to grow. Blockchain, owing to its decentralized nature (with no single point of failure), could be a more secure alternative, with the potential for central bank endorsed digital currency described as a “golden opportunity” by Ludwin.

As for the threat to existing business models, consider the table below, which comes from the Canstar 2014 Star Ratings report for International Money Transfers. It shows the average spread Australian banks charge to switch Australian dollars into a number of leading global currencies.


Source: Canstar International Money Transfer star ratings

As you can see, there is a more than 4% spread on average to switch a monetary deposit from one currency to the other, even though, in effect, transferring currency is nothing but a few computer entries today.

Bank A in Sydney or Melbourne definitely does not need to take all of your Australian dollars out of their vault and have a logistics company securely ship them to bank B in Paris in order for you to walk into bank B and pick up a handful of Euros so you can enjoy a café au lait, a stroll down the Champs- Élysées and a trip to The Louvre, for example. Note these are just the FX spreads, with sending, receiving, cancellation and amendment fees all potential charges to be aware of as well.

To grasp how expensive these fees are, it is worth pointing out that 4% is approximately double the spread it takes to switch Australian dollars for 1 troy ounce of physical gold with ABC Bullion either online, over the phone, or in our showrooms around the country.

Based on average ore grades these days, the better part of 30 tonnes of earth need to be mined to find that physical gold in the first place. From there, a dore bar needs to be made, and be shipped by a logistics company to ABC Refinery, where the bar will be melted down and turned into an investment grade gold bar of 999.9 purity. Finally, that bar will take up some of our shelf space until a client purchases it.

If the physical bullion industry can do all of that for a spread of circa 2%, is it really reasonable that banks can charge a circa 4% spread for what is in effect a couple of mouse clicks and computer entries?  Up until now, displeased as they may have been about the fees, consumers have had no choice but to accept them, as there was a clear need for a trusted middleman and counterparty to these types of transactions.

Blockchain technology changes the equation dramatically.

Going forward, consumers the world over may well be able to transfer money over these networks, for exceptionally low spreads, with instant settlement.

How about Cryptocurrency itself?

Whilst the potential for Blockchain technology in finance and a diverse range of other industries is clear, there remains a fascination regarding digital money itself. It is entirely understandable that this fascination exists, for, as we stated at the beginning of this chapter, it was Bitcoin that brought Blockchain to the world. 

The potential for digital money in the future is a debate with fans on both sides. On the one hand, as covered earlier, you have some claiming that cryptocurrencies such as Bitcoin are “Gold 2.0”, and that cryptocurrencies are the future of money.

Interestingly, those in this camp often state that the upper limit of the number of Bitcoins that can be mined into existence mimics the implicit supply constraints of physical gold, a recognition of the importance of limited supply to the long-term viability of any monetary medium.

On the other hand, you have many who argue that cryptocurrencies such as Bitcoin, are nothing more than Ponzi schemes that are doomed to fail, with many making the salient point that there are already more cryptocurrencies in existence than there are fiat currencies issued by sovereign states.

There are also those who are believers in neither Bitcoin and cryptocurrencies generally, nor physical gold.

This group, and their line of thinking, is perhaps best represented by Citigroup economist Willem Buiter, who derided gold as “shiny Bitcoin” back in late 2014, when he called gold a “six thousand year-old bubble”. 

One supposes that Buiter would have called gold a “5994 year-old bubble” back in 2008, around the height of the GFC, though that doesn’t have the same ring to it.

Of course, one can only speculate what Buiter would have compared this 5994 year old bubble to back in 2008, though it certainly would not, indeed could not, have been Bitcoin, for it did not exist at the time.

Whilst we are obviously not in the Buiter camp, we do believe there are still unanswered questions regarding the monetary qualities of Blockchain and cryptocurrencies.

To help explain why these questions remain, we will explore briefly why, in our opinion, we believe Bitcoin was created, and how physical gold fits in with the cryptocurrency movement. 

Gold, Bitcoin and the Cryptocurrency movement!

Whilst the genesis and creator of Bitcoin, the first well-known example of Blockchain technology, will perhaps forever remain clouded in mystery, we believe there have been three main drivers behind the development of Bitcoin, the cryptocurrency movement, and Blockchain technology as a whole over the last few years.

The first of those is a genuine desire to harness the power of technology to develop new products and services, lower costs, and disrupt incumbent business models.

In this sense, Blockchain can be seen as a technology similar to Uber or Airbnb, which are causing havoc to the taxi and hotel industries while lowering costs and improving competition, with the obvious effect that they have changed the way citizens the world over travel and choose accommodation. 

The examples given earlier of Commonwealth Bank and the ASX would definitely fit in with this driver of technological innovation and progress.

The second driver behind Blockchain, and the development of cryptocurrency, is frustration with the monetary (as well as economic and political) status quo.

There are plenty of people working in this community who are distinctly uncomfortable with the economic and monetary developments that have taken place in the last decade.

The third driver behind Blockchain generally, and the cryptocurrency and Bitcoin movement specifically, is a question that many people are again asking in the aftermath of the GFC.

What is money?
For the first time in a generation there are serious questions being asked about the current monetary system, with increasing concern regarding the long-term viability of this current batch of fiat currencies.

This question is something that more and more people are asking every day in this era of skyrocketing public debt levels and seemingly perpetual quantitative easing, not to mention zero and, now, even negative interest rate policy in the world’s largest economies.

Whilst we can appreciate why this question is being asked, and think it is one of the reasons that demand for physical gold has risen as strongly as it has in the past few years, we are unconvinced that Bitcoin, or any stand-alone cryptocurrency, is a viable alternative to the current monetary order. The reasons for that go well beyond the fact they are not state-issued nor state- sponsored, as fiat currencies are.

The first of these issues is to do with competition. Whilst Bitcoin is the most famous, there are reportedly over 650 cryptocurrency alternatives in existence today, with new ones created on a daily basis.

There are even “cryptorials” online now which contain instructions on how to create your own cryptocurrency. In this sense, there are already far more cryptocurrencies than there are fiat currencies, with a much lower barrier to entry. Gold on the other hand is still just gold. 

The second question is related to the supposedly limited supply of a cryptocurrency, one of the arguments made in favour of Bitcoin is that there are supposedly only 21 million coins that can ever be mined into existence. There are two observations worth making here.

The first is that this feature (fixed supply) of Bitcoin is actually not like gold, despite what Bitcoin advocates say. As we discussed earlier in this book, the physical gold supply is not fixed, it is stable, and it grows ever so gradually on a year-to-year basis.

Furthermore, whilst Bitcoin is currently limited to 21 million coins, there is no guarantee that this will remain the case, with many pro-Bitcoin advocates admitting that there is no reason the supply of Bitcoin couldn’t be increased in the future, provided it didn’t lead to a decrease in value and a loss of confidence, that argument sounds very similar to the one that proponents of fiat currency make.

The final issue is to do with the potential for Bitcoin or cryptocurrencies to gain critical mass. Here we see a number of potential barriers, not least of which is the fact that the long arm of the state will not be entirely supportive of any potential competitors to government issued fiat currency.

There is also the inherent problem that most people will never know how a currency like Bitcoin really works, with terms such as “cryptography”, “open-source”, “distributed ledger” and even “blockchain” likely to remain a mystery to most.

Whilst one could make an argument that most people don’t understand how the current monetary system works either, it does have the benefit of incumbency, and the imprimatur of government supporting it. If concerns regarding potential state over-issuance of this fiat currency cause more and more people to look for alternatives, it is not at all clear that the end result would be a rush to a man made solution (Bitcoin or other cryptocurrencies) which are barely used in society today, have no real track record to speak of, and remain well beyond the comprehension of the average citizen.

For as Matthew McLennan, the highly successful fund manager we quoted earlier in this book, put it, if you want “a potential hedge against frailties of the manmade system you have to own something that occurs in nature”.

He was of course talking about physical gold.

For all of these reasons, whilst we are excited by Blockchain technology, and think one could profit from speculating in the potential price appreciation of Bitcoin and other cryptocurrencies in the future, we remain highly sceptical about the potential for cryptocurrencies to gain critical mass and unseat either fiat currencies or gold as the most widely used form of money across the globe.

Indeed, for Bitcoin, or any cryptocurrency for that matter, to become money, and widely accepted as money, it is our belief that it will have to wed itself at the hilt with physical gold.
The reason for that is that without physical gold, Bitcoin, and Blockchain as a technology solution for money transfers, is merely another (admittedly large) step forward in payment technology.

After all, the credit card is an infinitely more efficient form of money transfer than the bank cheque ever was, whilst Paypass is more efficient still. Be that as it may, the actual money itself that is transferred using these mediums remains the same.

Therefore, whilst Blockchain and Bitcoin technology can make the transferring of money more efficient, that doesn’t make it money in and of itself.

It is also worth re-iterating our earlier point regarding the fact that Bitcoin and Blockchain are created by man, as is fiat currency. And just as humanity has periods of crisis in which our faith in fiat currency is tested, so too could we have a crisis of faith in any man made monetary creation, which Bitcoin and any cryptocurrency will forever be, no matter how elegant and potentially ground breaking they are.

The best way to ensure that that doesn’t happen, and to give Bitcoin or any cryptocurrency stability so as to ensure that everyday people will trust it, is by linking it to physical gold, just as the architects of the current international monetary system did some seventy years ago.

The reasons for that are simple.

As covered earlier in this book, physical gold as a monetary medium and store of wealth has a 6,000-year track record. It is a zero credit risk asset, it has exceptional liquidity, and it is intrinsically trusted. It is also accepted and recognized everywhere on this planet, with Harley Bassman of PIMCO wisely observing that; “global consumers are more familiar with gold than the banking system”.

Physical gold was a form of money well before any of the fiat currencies that are in use today were invented, and certainly well before anyone had heard of Blockchain and Bitcoin. It will remain a monetary asset irrespective of what happens to the USD, the Euro or the YEN, and regardless of the success or otherwise of Bitcoin and any other cryptocurrency in the coming years.

In our opinion, this is actually well understood and accepted by many of the pioneers in the Blockchain space. For evidence of this, consider a simple Google image search of the word Bitcoin (see below) that generates picture after picture of what sure does look like physical gold, or gold-like coins.


Source: Google image search, May 2016

It is also evidenced through the evolution of companies such as BitGold, who’ve tried to harness the best of Blockchain and cryptocurrency technology, and tie it to physical precious metals.

These companies, and many others like them, are using the image of physical gold coins to project value and trust for the very same reason governments, including the Australian government, to this day mint the one-dollar and the two-dollar coin so that they look like a gold coin. 

Everyone on this planet knows what physical gold is, recognizes it as an item of beauty, and instinctively trusts that it will continue to maintain its value.

Therefore, whilst Blockchain technology has massive potential, and there exists the opportunity for a symbiotic relationship between physical gold and the cryptocurrency movement, there is no contest as to which is the superior form of money.

Gold’s six thousand year reign as societies premiere monetary asset, or ‘six thousand year bubble’ if that’s how one chooses to see it, will survive this latest challenge, as it has all prior ones. 

Until next time 
Jordan Eliseo

Disclaimer
This publication is for educational purposes only and should not be considered either general or personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, and past performance is not necessarily indicative of future performance. Any prices, quotes, or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.