Gold has historically been recognized as the premier hedge against market volatility. As a store of value, the commodity boasts global recognition – an entire industry has been formed to extract, provide services for, and invest in gold. The next generation of gold’s evolution is here today and being powered by a blockchain revolution just starting to climb the J-curve.
How and Why Retail Investors Participate in Gold Today
Gold has long been recognized as a premier hedging instrument against market volatility. Comparing LBMA benchmark prices for gold and the gold ETF (ticker GLD) with daily price returns of the S&P 500 over the last 20 years demonstrates the consistently uncorrelated nature of gold’s performance:
This performance has not required additional position-specific risk, as gold has been able to somewhat match the overall volatility of the S&P 500:
Examining the daily results, I observed how gold performed on days where the S&P 500 was in the red. Based on the last ~23 years of data, gold outperformed the S&P 500 greater than 75% of the time.
Participation in the value of this hedge, however, is not equal between institutional and retail investors. Today’s gold investment options for high net worth (HNW) and retail investors are starkly different, which contributes to unequal asset performance over time. HNW investors enjoy the luxuries of being able to afford custody fees for secure banks (such as those popular in Switzerland), discuss investment options with brokers that will not charge exorbitant fees (as a percentage of the total investment), and obtain liquidity without the use of complex derivative instruments. These abilities enable more direct exposure to gold’s actual performance over time.
Since November 2004, GLD was introduced as an efficient option for retail investors. While GLD enjoys benefits of being easy to access, hard to steal, live pricing, and the ability to garner leverage, many factors reveal inefficiencies in this ETF structure. Retail investors are not able to redeem GLD certificates for actual gold (this option is only available for investors with greater than ~$1,000,000 worth of shares), suffer from counterparty risk related to banks and sub-trustees of the physical supply, and experience performance drag as a result of management fees. Technically, even GLD’s live pricing is based on the trading of shares rather than that of actual gold.
Further, these inefficiencies are illustrated in actual performance data (daily returns). Observing trading performance since the introduction of the GLD ETF, the S&P 500 has been negative 45% of the time. Of these days, the LBMA gold index performed positive relative to the S&P on 73% of days while GLD was positive only 50% of the time. Moreover, average performance during those negative days were better for gold (almost 1% total) relative to GLD.
Looking at a more recent trade, we observe the latest performance of GLD and Gold during the most recent S&P 500 drawdown between 5/3/19 and 6/3/19. As a quick recap, many attribute this downturn to trade tensions between the US and China. Over that period, there were 7 days where gold and GLD were split between being positive and negative. The performance for GLD was ~25% greater than that of Gold during the same period. Although a positive for this specific period, the performance differential demonstrates that the true value of gold is not accurately reflected, especially in quick moving markets.
While certainly an improvement over legacy retail liquidity options for Gold, GLD will one day be a steppingstone to the more improved, tokenized version of the commodity. Tokenized gold enables investors to ‘own’ the index in a seamless manner.
Why Tokenization is Better
The use of blockchain to facilitate gold investments is significantly more efficient than our current system. Most of the questions pertaining to tokenized gold refer to the actual process of ‘tokenization’.
There are several competing systems that are just now coming to market. For example, DaVinci Token works with an LBMA accredited refinery in Switzerland. They have created a proprietary system where nano-lasers are utilized to engrave ID numbers in QR code format on each of the gold coins. New systems in the tokenization process are being created, but the overall idea is that the physical commodity requires a unique identifier to tie it to the digital version.
The benefits of the tokenization process are plentiful. Digital gold solves for the security element of physically owning the commodity and simultaneously the counterparty risk associated with publicly traded ETFs. Other benefits include the following:
- Access to premier gold offerings at a fraction of today’s cost of ownership;
- The ability to quickly leverage gold assets either to double down or generate portfolio liquidity;
- Redemption of tokens for actual gold (most platforms allow you to redeem in 1g units of gold and receive the physical commodity in a few weeks);
- Minimization of acquisition fees (in some cases it’s $0); and
- Real time, auditable pricing.
Gold has been the best store of value for as long as investors can remember; however, the trading strategies and liquidity options with tokenized gold will revolutionize the way we think about the commodity.
First, the following are structural improvements to liquidity with the use of blockchain technology:
- Easier access to loans – Historically, secured lending against gold has required a robust diligence process. With tokenized gold lending, the market will allow (i) a smaller dollar value loans due to the reduced marginal cost of lending and (ii) unify a fragmented market.
- Avoid High Currency Conversion Fees – Today’s fees for currency conversions typically exceed 5% for situations as simple as a vacation. Tokenized gold could be exchanged at real market prices for any currency in a frictionless manner. Currency stablecoins further reduce costs to the consumer.
- Access More Traders – With the global nature of the tokenized asset, GLD is unable to compete given the difficulty in accessing foreign investors.
- Conflict-Free Gold – As blockchain gets tied to the actual production process, it becomes easier to trace the history of each bar of gold and the ecological / humanitarian impact of each mining operation.
Second, with the improved liquidity, various investment strategies can be built in a customized fashion.
- Leveraged Lending Strategies – Investment funds can achieve better loan performance against an overcollateralized product without the red tape in setting up the appropriate infrastructure to lend against traditional gold. Gold is a liquid asset with no credit risk, adding blockchain-based liquidity creates an ideal secured lending platform for leveraged debt investors.
- Investment portfolio adjustments – Get liquidity for more divisible interest in Gold. ETFs must be purchased at an exact share count and coins suffer from other inefficiencies that prevent portfolio optimization.
- “Reverse the Hedge” – Gold’s cyclical movements resulting from supply/demand imbalances may also be a drag on portfolios in situations where there is downward pressure on prices. If investors feel an upcoming bear market (e.g., those resulting from an interest rate hike, newfound supply, etc.) for gold prices, leveraging their asset to invest in the market prevents a taxable event of selling one’s gold and arms investors with a valuable portfolio optimization tool.
The new generation of gold investors have a lot to be excited about, we can see a number of these platforms gaining significant interest over the next few months. For those excited about Bitcoin, tokenized gold presents institutions with a better form of something they already understand and a real use case. Finally, tokenized gold offers another path for retail investors to minimize gaps in their investment capabilities – i.e., blockchain can enable more and better access to the most widely used hedging commodity in the world.