Allocated and Non-Allocated Bullion
Bullion bought and sold on bullion markets are either allocated or non-allocated. Allocated bullion is assigned and segregated to the purchaser, where non-allocated is simply a general claim for a precious metal from storage.
With allocated bullion, the precious metal is identified and uniquely identified and segregated to represent the physical property of the bullion holder, which is held in storage for their benefit.
Most bullion is unallocated though and this represents the seller’s owing the buyer a certain amount of bullion. Some suspect that this may be based upon a fractional reserve system, the way banks treat money, with enough on hand to satisfy demand but not enough to satisfy all of it.
The volume of bullion trading, especially with gold, would lead us to believe that a fractional reserve system does exist, and this is a bigger deal than doing this with currency.
Given the limited quantity of precious metals in existence, trading bullion on credit could end up with a run on the metal so to speak. Bullion dealers have been paid for the bullion, so would probably have the funds to purchase the bullion on the spot market and deliver it, at today’s prices.
Since these funds aren’t segregated, they become subject to business performance, and if the organization which holds the non-segregated bullion has financial difficulties, they may not be able to meet their obligations to deliver all of the bullion on their books if required.
More significantly, if there was a run on physical gold, the sheer amount of increased demand on the spot markets could drive up the price of the metals very significantly. Given that the contracts for the bullion were settled at the market price at the time, this could mean that the bullion holder could not afford to buy the bullion they are obligated to deliver.
Bullion Really Doesn’t Serve Any Other Purpose than a Store of Value Though
With all this said though, this fractional system is far less likely to be exposed than with currency, because people really have no need to possess the gold versus having it stored unallocated.
With currency, people withdraw money to allocate it toward something else, to convert it to another asset or to store it elsewhere. With bullion, when they do this, they sell it, and the contract becomes fulfilled, even though the gold in question may not have been stored or may not even exist in physical form.
What happens with a bullion contract on the spot market is that ownership is transferred at a certain price, and then when the bullion is sold, the seller receives the difference between the buy price and the sell price.
So, no bullion changes hands here anyway in these transactions, and this would operate much like contracts for difference work with commodities and indexes. With contracts for difference, there’s no need for anyone to actually ever possess the asset that is traded, and what are placed are essentially bets on the future changes in price of the assets.
This is what is termed derivative trading, bets placed upon the value of an underlying asset which get settled when the positions are closed out. This would function just as well with bullion, provided that a small enough proportion of it never needs to be physically delivered.
Of course, there’s a fair percentage of bullion that does get delivered, although most end users do not insist on it being delivered. Dealers who sell to the public do require physically delivery, although this is much more the case with coins than with bars, and therefore coins are not subject to a fractional system based upon credit.
Some investors do buy bullion bars of different sizes, and do take possession, and bullion bought from dealers often does get delivered, although some does remain in storage with the dealer. However, sufficient inventory is maintained to satisfy the day to day demands of this, and shortfalls can be easily remedied by simply buying more bullion on the spot market.
The Bullion Retail Market
Unlike securities markets, where individuals can purchase just about anything on their own, they do not trade in high enough volumes to buy bullion or any other commodity on the spot market.
Therefore, their bullion purchases must go through a third-party intermediary, which may be banks or other institutions that offer bullion for sale to the public.
This of course involves a markup by the dealers, and this is not unlike foreign exchange transactions, where the price on forex exchanges will differ from the rate that people get at banks or other financial institutions, due to the markup involved.
Physical currency doesn’t change hands in these transactions though, so the cost of conversion is lower than it would be with a physical asset such as bullion. Still though, the markup for retail bullion is pretty modest compared to the difference in wholesale and retail prices that is typical in the marketplace.
In fact, retail gold only costs a bit more than the spot price on the market, which is pretty amazing. This isn’t the sort of thing that you would really want to hold for a very short period of time to speculate on the price of the metal, but would suit medium to long term holding for those who are looking to take advantage of future price increases.
For those who are looking to trade bullion, the futures market offers all the opportunity you could wish for, without ever having to take possession of the asset. The underlying assets can be only held for a matter of seconds if one wishes.
There are other ways to speculate on bullion as well, buying shares in companies that produce bullion for instance, or buying ETFs which hold bullion or bullion backed securities.
Precious metals are also supplied to industrial users as business inputs, but this market does not involve the delivery of bullion, precious metals cast for long term investment purposes. This usage does involve a significant amount of the overall precious metals market, but most production is allocated to investment use.
What is rather unique about the retail bullion market is that, unlike other retail markets, it is not based upon end user supply and demand. It is instead based wholly on the wholesale price on the bullion market, and whether or not a dealer sells a certain amount of it, this in itself does not affect the price. So, you won’t see any bullion sales due to excess inventory, or the price rise if a dealer or even the retail market is in short supply.
Retail demand does affect the price of bullion indirectly though, to some degree anyway, as if retail customers desire gold more, this will increase the demand at the wholesale level. Large users of bullion still drive prices though primarily.
Bullion markets are very well developed in spite of a lack of transparency and a limited number of market participants, and the overall supply and demand for precious metals does result in a market that is reasonably efficient.