Why ‘digital gold’ could be the new flight to safety in market shocks

April 3, 2020
Louisa Bartoszek

As the impact of COVID-19 has rapidly unfurled, investors are moving from riskier investments into safer havens, like Gold. A phenomenon known as a ‘flight to safety’. We and Mozaic Markets have been watching gold with great interest as we believe it is an ideal candidate for tokenization.

Watching market turmoil in the last few weeks, I’m experiencing a serious case of déjà vu and haunting flashbacks to the pandemonium of the 2008–09 global financial crisis.

As the impact of the COVID-19 pandemic has rapidly unfurled, investors have scrambled to protect their wealth and transfer capital from riskier investments into safer havens; a phenomenon known as a ‘flight to safety’, or ‘flight to quality’.

Government-backed assets and precious metals, usually gold, historically being the preferred choice, along with perceived safer currencies such as the US Dollar, Swiss Franc or Japanese Yen.

The 2008–09 financial crisis is a case in point. Stocks and other risk assets tumbled in value. Gold by contrast, held its own and increased in price, rising 37% in pound sterling from December 2008 to December 2009 (Footnote 1).

March’s flight to safety was to be expected. But gold’s sudden sharp declines mid-month were a surprise to the many who perhaps had not analysed the unprecedented and fast-moving market conditions facing gold.

I’ve been watching gold with great interest, as we at Mozaic Markets and 2030 Group think it is an ideal candidate for tokenization.

How big is the gold market?

The gold market is enormous and one of the most important financial markets in the world.

According to the World Gold Council the best estimates available suggest that around 190,000 tonnes of physical gold has been mined throughout history, of which around two-thirds has been mined since 1950.

And since gold is virtually indestructible, this means that almost all of this metal is still around in one form or another.

If every single ounce of this gold were placed next to each other, the resulting cube of pure gold would only measure around 21 metres on each side.

This is just the ‘physical’ gold of course. We can also interpret and measure the size of the gold market in terms of its liquidity with average daily trading volumes indicating gold ranks among the largest financial assets in the world.

Every day, there are a whopping 5,500 tonnes ($212 billion) of gold traded in London alone, making it the largest wholesale and over-the-counter (OTC) market for gold in the world (Footnote 2).

Unprecedented market conditions for gold

Gold has been an attractive asset since ancient times and whilst no investment is risk-free, physical gold is seen as solid, real and always of value. Primarily due to the fact that it cannot be printed in unlimited amounts — unlike the globally traded government-issued currencies of today.

But as investors flock into gold, traders are already reporting a growing global shortage as the COVID-19 outbreak disrupts supply chains.

This is unlike the financial crisis in that the coronavirus pandemic impacts the trading of physical assets, like gold, which are mined, manufactured and transported.

Firstly, gold refineries have struggled to keep up because of the widening shutdown as the virus spreads and businesses are forced to close.

Argor-Heraeus, Pamp and Valcambi, for example, are all based in the Swiss region of Ticino, near the border with Italy. Local authorities announced on March 23 that production in the area was to be temporarily halted until April 5 at the earliest.

Secondly, banks and traders typically ship gold around the world on commercial flights, linking the trading hubs of London and New York with vaults and refineries in Hong Kong, Singapore and Switzerland.

Worldwide travel bans are grounding flights with many airports temporarily closing.

And this is just the physical delivery crunch. Add to the mix the expected inflation over the coming years, and it’s not surprising to see the extreme volatility in all precious metals.

But, let’s remember. Gold prices are likely to rise as soon as production recommences, and travel restrictions are eased.

The issue today is simply investors are unable to lay their hands on it. Regardless of the price. Their only alternative to gold exposure being:

  • Gold Mining Stocks — which are impacted by falling equity prices.
  • Gold ETFs (Exchange Traded Funds) — which are similar to individual stocks and trade on exchanges in the same manner and thus impacted by equity falls.
  • Gold Futures — which obligate the buyer/seller to trade at an agreed price at a predetermined future date, but this still involves the transportation of the physical gold. (However, 99% are cash settled)

Gold Tokens — the new safe haven?

The issue today is the scarcity of physical gold on the market and its ability to be transported.

What if there was a digital twin available as an alternative? A digital twin which is immune to disruption in supply chains — from mining to transportation? And one which is also immune to being over-leveraged too?

Tokenization uses distributed ledger technology (DLT) to turn a real-world asset, such as gold, real estate or even forests, into a verifiably digital asset (digital twin) called a Security Token.

A gold token, or any other commodity, is structured as a security or is deemed to be an investment contract that sits on a distributed ledger and is run by a smart contract. It represents the tangible assets that can be traded in a security token exchange anytime and anywhere in the world, in a fully regulated environment.

Security Tokens can represent an underlying real asset and pay dividends, share profits, pay interest, or invest in other Tokens or Assets to generate profits for the Security Token holders.

A gold token offers the same defensive-asset-class traits as bonds or gold ETFs, which also track and reflect the price of gold. While the assets in an ETF are backed by the commodity, the intent is not for the investor to own the gold — indeed most ETF’s, are highly leveraged and physical delivery of gold to the end investor is not always possible.

Why Gold Tokens are attractive

Speaking to commodities traders, I’m told Gold Futures can be leveraged by as much as 100:1 (paper:physical) on the Commodity Exchange (better known as COMEX). Giving this some perspective, Lehman Brothers was leveraged at 33:1 when it finally blew.

Ultimately, the main reason for an investor to hold gold is as a store of value in times of crisis. In that, I can physically touch it, melt it down and sell it if needed. ETFs and shares do not allow for this physical delivery/exposure to the actual metal.

A gold token would be a digital twin of the real asset and would allow for an investor to request physical delivery of the gold, in the event of a default. With the gold acting as a form of collateral.

A digital ‘twin’ is exactly that — one to one. One physical and one digital. They are effectively the same in a sense. A smart contract, imbedded into the token, can specify that it cannot be leveraged.

The biggest opportunities for gold tokens are that they:

  • Open up the market to fractional ownership. A new investor base that previously could not access the asset due to high ticket requirements and closed nature of the gold investor base. Creating a new revenue stream for real asset gold owners.
  • Can be included in institutional and pension funds. If the tokens are regulated, institutional investors and pension funds can incorporate gold tokens into their asset allocation strategies. The liquidity of gold tokens, vis-a-vis physical gold is attractive from an active portfolio management perspective.
  • Low cost opportunity for individual retirees. If the tokens are regulated, they can be an alternative for the average individual retiree who may want to hold gold in their personal retirement account and is not able to easily do so today. As the population ages and we demand more accountability and direct control over our investments, particularly with more people on Defined Contribution pension schemes, the Gold digital twin can provide a low-cost opportunity to balance a typical equity/debt portfolio.
  • Substantially increase liquidity. Unlocking value from illiquid real assets and effectively doubling the market if every asset has a digital twin in the form of a token. One which is unaffected by physical headwinds should production and transportation be impacted.
  • Enable faster, simpler and cheaper trading. Clearing and settlement of traded tokens are faster as they are fully digital with less intermediaries; costs are therefore reduced as intermediaries (brokers, bankers etc) are not required, and trading is able to take place 24/7 anywhere in the world by anyone.
  • Single Source of Truth. Trust is vital for markets to function and through using distributed ledger technology, such as blockchain and decentralised identity, transactions have immutable proof of ownership as a verified digital ledger cannot be altered. Both of the physical gold asset and that of its digital twin. Securing transactions, verifying that a token is a twin and not leveraged and facilitating trust between buyers and sellers. DLT will also provide an immutable record of the mining source and supply chain of the gold. This is increasingly important in our ESG friendly world where we have many illegally / improperly sourced precious metals.

The COVID-19 crisis is unprecedented in many ways and the outcome remains unknown.

But for capital markets, it could be considered by financial historians a watershed moment with 2020 the year the true potential of tokenisation was realised, and a new token economy born.

1 https://www.gold.org/goldhub/research/relevance-gold-strategic-asset-uk-edition-2020#footnote-11

2 https://www.visualcapitalist.com/inside-look-worlds-biggest-paper-gold-market/ (LBMA)