Many introductory economics texts and lectures surmise that fractional reserve banking began with goldsmiths and the like who kept gold on deposit for people but lent some of it out, knowing/expecting that not all of the gold would ever be redeemed at once. This story, whether apocryphal or not, forms the basis of our explanations for how fractional reserve banking works. Banks have reserves, but because depositors do not all redeem their deposits at once, these reserves can support multiples of deposits. What percentage of deposits should the banks keep on hand (or on deposit with a central bank) is often a policy choice affecting the perceived soundness of the banks as well as the overall size of the money supply (for more, see this; note that in Canada there is no required reserve ratio for the chartered banks.).
It seems that today's gold dealers, like the goldsmiths of old, are redeploying a fractional reserve strategy [h/t TomL]:
JP Morgan is employing the traditional Wall Street/banking business model of fractional gold ownership. This is not new, as Morgan Stanley was successfully prosecuted for this same scheme several years ago when the firm was exposed for selling physical silver to high net worth clients - and "safekeeping" it for a fee. The scheme was exposed when a few of them demanded delivery and Morgan Stanley was unable to deliver the actual silver on a timely basis.
... Here's how it works. JP Morgan sells Comex gold to hedge funds, who then opt to safekeep it at JP Morgan's Comex depository for a 15 basis point fee. It makes the purchase very simple, the "storage" inexpensive and enables the hedge fund to seemingly have possession of physical gold. But in reality all the hedge fund gains is a "security interest" - or paper documentation - in the gold rather than the actual gold. Here's why: how many of those hedge funds will actually ever ask for delivery of the gold into a private depository or go visit the vault to make sure that the gold it purchased is physically sitting in a separate, allocated bin? JP Morgan is "banking" on the fact that none of them will. This enables JP Morgan to make an electronic ledger entry and create an account statement showing the market value of the gold purchased, but it never has to actually produce the physical bars and deliver them. This dynamic permits JP Morgan to sell gold that the bank is never held accountable for. This is exactly the scheme Morgan Stanley used with their silver fraud on a much smaller scale, that GLD and SLV use and that the Comex and the LBMA bullion banks use for their futures/forwards business.
I had two reactions when I read this piece.
- Selling gold that doesn't exist should have dramatically increased the perceived supply of gold on the market and thus kept the price from rising even faster than it has; and
- I have no idea how widespread this phenomenon is, but even if it is legal (and well-covered in various prospecti), it could well lead to yet another bubble/crash if there is a run on these gold dealers, a run in which people expect to receive their gold. TomL suggested to me that some of the dealers have reserve ratios of as low as 1%, which could lead to "interesting" developments if/when redemption is sought.
At the same time, it appears to me from what little I've read on this topic, that the gold dealers have worded the current prospecti in such a way that they might be exempt from redemption demands. [addendum: for example see this]. But if that's the case, why are people paying them anything for "storage" of gold that possibly doesn't exist?
At the very least, I sure hope folks buying into these certificates and instruments are doing a thorough due diligence!