Sunday, January 31, 2010

Who Owns Mobile Money?

By Ari Hyytinen and Tuomas Takalo [1]
The Lydian Payments Journal
November, 2009

It has long been predicted that the digital revolution will transform the way people pay at their point-of-sale transactions. The end of the cash era could indeed have dramatic consequences, not least since it might eventually even lead to the obsolescence of central banks.

While many digital payment media innovations have failed to take off and the paper form of cash has turned out to be surprisingly resilient, many commentators argue that mobile phones and other similar portable electronic devices finally enable digital cash to solve its chicken-and-egg problem.[2] For example, mobile phones can currently be easily equipped with payment features, and since almost all consumers in the developed countries carry mobile phones, shopkeepers are willing to install systems to handle mobile money. The prospects of mobile money are even greater in poorer countries where it often constitutes the only feasible digital payment medium. Moreover, mobile phones' display and ability to act as a mobile ATM add to mobile money's utility. But in contrast to the supply of paper cash, which is the monopoly of central banks, it is not clear who owns the property rights over mobile money.

Since the mid-1990s it has been clear that the emergence of new mobile technologies represents an untapped business opportunity. But who has tried to seize the opportunity and invested in the development of mobile payment technologies? What kinds of firms have tried to enter into this new, promising market? Where do these entrants come from?

At least two distinct industries should have had an incentive to innovate in and compete for the market for mobile payments. On the one hand, traditional incumbents in the market for payment media are financial institutions, such as banks and payment card companies, who obviously had a head start in capturing the emerging new market. On the other hand, ICT firms, equipment makers, and telecommunications operators, for example, are specialists of mobile communications technology and have been vying for new applications and revenue sources for their devices and services. Moreover, the economics of payment media markets is quite similar to that of the communications industry: both are two-sided markets characterized by network externalities and platform competition.

It is, of course, equally possible that new entrants could come outside these two main candidate industries. For example, Internet marketplaces and service providers, software and operating system producers (such as Microsoft and its rivals and collaborators), or completely new research-based entrants with unconventional business models could be interested in developing mobile payment media applications and entering the market.

The new mobile and digital payment media markets are emerging. While their eventual landscapes are yet unknown, patent statistics provide a window to the future and potential entry, characterizing innovative activities and intellectual property strategies of potential entrants at the birth of new mobile payment media.

Based on our own preliminary data analyses and Hall, Thoma, and Torrisi's research, some clear and interesting patterns seem to emerge from the patenting data.[3]

First, as Table 1 shows, patenting activity picked up late 1990s and accelerated after the millennium. This pattern emerges from the world-wide patent data on mobile payment technologies to which we have had access (covering publications from 42 patent offices and coming from Derwent World Patent Index -database). The same pattern can also be extracted from the European Patent Office (EPO) data on European financial patents compiled by Hall, Thoma, and Torrisi. While their study aims at covering a broad range of financial patenting, their data appear to cover a lot of payment methods and technologies. Hence their results could be seen as providing an upper bound for payment innovation patenting in Europe.

Table 1: Average Number of Patent Applications per Year

Second, U.S. firms are the most important source of mobile payment patent applications. In Hall, Thoma, and Torrisi's research, it is reported that 49.9% of EPO financial patents originate from the U.S. In our technologically targeted but geographically broad data, the U.S. innovators account for 31% of the (global) patent applications.

Third, the involvement of incumbents (financial institutions) is modest. Some payment card platforms figure in the statistics, but banks and other financial intermediaries are nearly absent. In our patent data on mobile payment technologies, traditional financial institutions are virtually entirely absent; among the top 20 patentees, none is coming from the traditional financial sector. From Hall, Thoma, and Torrisi's research, we can infer that out of 52 top financial patentees in EPO, nine (17%) come from the financial and insurance sector. These nine include four major payment card platforms and service providers (First Data, Mastercard, Visa, and American Express) but only few financial intermediaries.

In contrast, established ICT firms, device manufacturers, and operators in particular, seem to account for most of the mobile payment and European financial patents. In Hall, Thoma, and Torrisi's data, top five patentees include IMB, Citicorp, NCR, Fujitsu, and Siemens. In our (unweighted) data, they are Ericsson, Siemens, Nokia, Motorola and IBM. This suggests that ICT firms, which are entrants into the financial service sector, have begun to create and compete for a new market.

Interestingly, the patterns of patenting of mobile payment technologies are in stark contrast to some other areas of financial innovation, such as financial exchange systems and infrastructures. In this area, most innovations (according to the patent statistics) arise from the traditional incumbents, such as investment banks and financial exchanges.[4]

There are a couple of potential explanations for the absence of financial institutions and dominance of the ICT firms in the patenting of (mobile) payment technologies.

The first potential explanation is that the different industry backgrounds of the most likely entrants have repercussions for their innovative strategies. Investments in R&D and IPR management have long been the core competitive strategies in telecommunications industry, whereas financial institutions have hardly bothered to document their R&D investments. This view suggests that both incumbents and entrants may innovate equally but use different intellectual property strategies. It is possible that financial institutions waive patent protection, resorting to their traditional appropriability strategies (e.g., lead time and secrecy) to protect their mobile payment innovations, whereas ICT firms just follow their patent-based intellectual property management systems.

However, it is well documented that the Court of Appeals for the Federal Circuit's landmark 1998 decision in State Street Bank & Trust Co. v. Signature Financial Group, Inc[5] has raised the awareness of intellectual property issues not only in the U.S. but also in the global financial services sector. In some cases the State Street decision is also known to have drastically changed the management of financial innovations in financial services, prompting a large scale use of patents as an appropriability strategy. For instance, the active innovators and patentees in the field of financial exchange systems and infrastructures have been investment banks and exchanges themselves. It therefore seems a bit unlikely that different levels of awareness and interest would account for the difference in the patenting patterns over the past ten years, i.e., over the period when the most of mobile payment patent applications have been filed. Indeed, if one only looked at the overall patenting of payment inventions over time and across regions, one could easily make the misleading conclusion that the State Street decision prompted the U.S financial institutions to patent their payment method and technology innovations, too.

The State Street decision also implies that the research and innovations of financial institutions are hardly unsuitable for patenting. Moreover, many of the (mobile) payment innovations are inherently technological and as such have been always patentable. For example, according to the USPTO, one of the first U.S. patents was granted on March 19, 1799, for an invention used for "Detecting Counterfeit Notes".[6]

An alternative explanation for the lack of patenting by financial institutions in the area of mobile payment technologies is that they do not innovate. This fits well with the classic argument, associated with Kenneth Arrow, according to which incumbents generally may have weak incentives to innovate since they recognize that the new innovations cannibalize the revenues from their existing products.[7] More recently, Raghuram Rajan and Luigi Zingales emphasize that incumbents may prefer to conspire with the politicians to preserve the status quo and to prevent entry rather than to engage in innovative activities and competition for new markets. This could account for the cross-country variation in the pace of financial development over time.[8]

Whether some firms can eventually create and conquer the market for mobile payments and enforce effective property rights over the mobile money so created is a question on which existing data or research has little to say. Since this is an industry in which network externalities are crucial, it would be tempting to predict that the market will eventually "tip" towards a dominant solution. But politics and regulation creates a particular source of uncertainty, as the global financial industry and therefore a large part of the payment media markets (e.g., deposit services) still operate under extensive regulation. The limited prospects for further deregulation in this area suggest that potential entrants with the most radical mobile payment media innovations face a rocky road ahead.

If we had to bet a euro now on the future of mobile money, we would bet it on a rather fragmented market outcome, with different technological solutions and business models co-existing in different geographical and business areas.

Ari Hyytinen is Professor of Economics at University of Jyväskylä and Associate Research Fellow at the Research Institute of the Finnish Economy (ETLA), Finland. Tuomas Takalo is Research Supervisor at the Bank of Finland and Professor of Economics at University of Jyväskylä, Finland. This article has in part been prepared as part of ETLA-BRIE collaborative research program "Networks, Services and Global Competition." The underlying research has partially been funded by the Jenny and Antti Wihuri Foundation. Reprinted with permission.

[1] Hyytinen is Professor of Economics at University of Jyväskylä and Associate Research Fellow at the Research Institute of the Finnish Economy (ETLA), Finland. Takalo is Research Supervisor at the Bank of Finland and Professor of Economics at University of Jyväskylä, Finland. This article has in part been prepared as part of ETLA-BRIE collaborative research program "Networks, Services and Global Competition." The underlying research has partially been funded by the Jenny and Antti Wihuri Foundation.

[2] See, e.g., our own work (Ari Hyytinen and Tuomas Takalo, "Consumer Awareness and the Use of Payment Media: Evidence from Young Finnish Consumers," Review of Network Economics 8 (June 2009): 164-188), and the references therein.

[3] For details, see Bronwyn Hall, Grid Thoma, and Salvatore Torrisi, "Financial Patenting in Europe," NBER working paper no. 14714 (2009); Bronwyn Hall, Grid Thoma, and Salvatore Torrisi, "Financial Patenting in Europe," European Management Review 6 (2009): 45-63.

[4] See Mari Komulainen and Tuomas Takalo, "Does State Street Lead to Europe? The Case of Financial Exchange Innovations." Bank of Finland discussion papers 22/2009 (2009).

[5] 149 F.3d 1368.

[6] Patentability of payment media innovations is discussed further in Robert M. Hunt, Samuli Simojoki, and Tuomas Takalo, "Intellectual Property Rights and Standard Setting in Financial Services: The Case of the Single European Payment Area," in Financial Innovation in Retail and Corporate Banking, eds. L. Anderloni, D.T. Llewellyn, and R.H. Schmidt (Edward Elgar: Cheltenham, UK, 2009).

[7] Kenneth J. Arrow, "Economic Welfare and the Allocation of Resources for Inventions", in The Rate and Direction of Inventive Activity: Economic and Social Factors, ed. R.R. Nelson (Princeton University Press: Princeton, 1962).

[8] Raghuram Rajan and Luigi Zingales, Saving Capitalism From the Capitalists (Princeton University Press: Princeton, 2003). As also Rajan and Zingales point out, the notion that in particular (financial) intermediaries have an incentive to lobby for restrictions in competition goes back at least to Adam Smith (see Adam Smith, The Wealth of Nations, Book I, Chapter XI, ed. E. Cannan (1776; Chicago University Press: Chicago, 1976, p. 278).

How MMOs Decriminalize Real Money Trading

By AJ Glasser
Friday, January 29, 2010

GamePro investigates the hazy intersection between law, economics, and gameplay that many massively multiplayer online gamers cross so many times when they buy or sell virtual goods.

Real money trading (RMT) may not be something you read about in your high school economics class, but it’s something every massively multiplayer online gamer encounters every day. If the buying and selling of virtual goods using real money isn’t something actively encouraged by the game itself, you at least hear horror stories about gold farmers causing prices of in-game goods to go up, or find eBay auctions of in-game items for crazy-huge sums of money.

Earlier this month, the topic of real money trading in MMOs made some ink when a South Korean Supreme Court acquitted two Lineage gamers of criminal charges related to selling in-game currency for actual money. At issue in that case was whether or not the gamers had violated a South Korean law against unsanctioned gambling; but by clearing them of the charges, South Korea effectively legitimized RMT in MMOs.

Don't quit your day job to take up Epic Gear brokering in World of Warcraft just yet, though; RMT is still a sore point for many game developers. In particular, you'll find that games like WoW frown on RMT within their End User License Agreements (EULA) or Terms of Service documents. People who violate those pieces of paper may not go to jail – but Blizzard can sue the pants off them for breach of contract (not to mention ban your account altogether).

Rutgers University law professor Greg Lastowka explains the legal side of the RMT issue as a case where first, the game developers have to decide how vigorously they want to regulate RMT and second, where players might consider violating the game's EULA because RMT really pays off.

Greg Lastowka

"Most game companies are concerned about the trade of real money for virtual property because they see it as a potential way of creating liability for them," Lastowka tells GamePro. "If [fraud] occurs in a virtual world, the game is in the middle, the game company has to be dragged into litigation. So if players can have property rights and legal claims to their virtual property, I think that scares game companies for the most part."

However, as long as there is no criminal law on the books with a country's government – like the anti-gambling statute that sparked the South Korean case – it’s all on the game companies to go out and find people who violate their EULAs by engaging in RMT.

This is apparently quite the pain in the ass. Scan eBay auctions right now for Epic Gear in WoW (a game that explicitly bans the sale of in-game items for real money), and you'll find dozens of in-game things for sale, even fully leveled characters ready to be handed over to the highest bidder. Even without Blizzard responding to our request for comment on this story, we can just imagine how much of a headache it would be to keep track of every auction site and track back every contract violation to the actual perpetrator and then sue them for breach of contract in whatever country they’re based.

Lastowka sympathizes with game developers’ plight. "Many companies decided that they weren't going to vigorously go out and try to shut down people who are trading real money for virtual property," he said. "The can say 'we don't care whether or not you trade virtual goods for money' and in a way with Ultima Online, Electronic Arts basically turned a blind eye to those kinds of trades."

This attitude among game developers is where RMT turns into a gray area instead of a clear-cut contract violation. "If the company says you’re not allowed to do this while you're on our servers and then they do it, they're liable for contract violation, right?" Lastowka says. "But some lawyers think that breaching contract in some situations can be socially beneficial. That's called 'efficient breach.' Real money trading is not illegal in the same way that the government says you can't sneak into someone's house and steal their stuff. That's clearly illegal – but [RMT] is not criminal. It's only illegal in the sense that you could land in court if [game developers] decide to sue you and most of them won't."

Finding RMT's place within MMOs gets more complicated than EULAs and lawsuits, though. Game developers have to consider whether or not it might actually benefit their company to allow RMT – and then take a cut of the virtual transactions. Lastowka explains that this is what's going on with Live Gamer in all Sony Online Entertainment games. By moving in as a third party that operates like an online auction site behind the scenes within all microtransaction-based MMOs, Live Gamer is basically engaging in a one-way RMT exchange that benefits both it and SOE – and the user as well, because it's clearly stated that nobody will sue them or ban their account for paying money to own better items.

A game company could go even farther with RMT and build it directly into the game for users to control. This is how Second Life and Eve Online have always handled virtual transactions; and both companies are enormously proud of the economies that have grown up in-game around RMT.

Linden Labs sent us this statement when we requested comment on their reaction to the South Korea ruling: "Real money transfers have always been acceptable in Second Life. Linden Lab released this morning that Resident cash outs for 2009 were $55 million USD – an 11 percent growth over 2008. More than 50 people earned more than $100,000 USD each and the top 25 accounts earned a combined $12 million USD."

All that money is certainly nothing to sneer at; but it's also something a developer has to work hard to keep track of. We caught up with Eyjolfur Gudmundsson, Lead Economist at Eve Online developer CCP; as far as we can tell, he’s the only full-time economist whose job it is to monitor an in-game economy. Even before CCP brought Gudmundsson on in 2007, the Eve Online economy was growing at an amazing rate as users latched onto the RMT mechanics built into the game.

Eyjolfur Gudmundsson

"All that you needed to make [the economy] work was to get as many people as possible into the game world so that people could specialize," Gudmundsson explains. "They actually managed to do that early on. In 2004, they already had 50,000 people online. Today with more than 330,000 subscribers we can say with full confidence that this is an economy that is driven by the players. In economic terms, we can say that the players make the decision on what to produce, for whom to produce, and when to produce it. These are often stated as basic principles of economics and that decision is made by the players, not by CCP."

Gudmundsson says that the economy in Eve Online follows basic economic principles, even though there aren't real-life economic constraints like the need to buy food for your character to survive. For example, if the player base shoots up, but there aren't enough in-game resources to accommodate them, prices go up; if users get more efficient at mining resources to the point where there's plenty to go around, prices go down.

"The problem I have seen with real money trading to date is that it is often or in most cases it is related to using exploits, hacking, using illegal methods to acquire these items in games,” Gudmundsson explains. "Therefore, [RMT] has gotten a really bad reputation."

Issuing a blanket ban on RMT, however, isn't something Gudmundsson sees as entirely practical for an MMO developer or even a government to enforce. Not only is it "one hell of a monitoring problem" to keep up with every transaction that goes on both inside and outside of a game, he says, but RMT is sort of something that comes with the MMO territory.

"In general, players tend to exchange items between them," Gudmundsson says. "If you design a game that has at least two individuals within that game and those individuals can exchange items – I give you this and you give me that – you can rest assured there will be a market developed whether you like it or not."

Instead of RMT being a legal issue or a financial incentive for MMOs, Gudmundsson says it should be a game design issue. "You have to think about it if your world is supposed to be an open world or a closed world," he says. "In an open world, you exchange and [trade] items but since it's an open world, you are restricted [by] real life regulation."

A closed world game, however, doesn’t have to use real life rules because it’s not supposed to be real life. “It’s like going to a theater,” Gudmundsson explains. "You're living in an alternate universe. And therefore it's important that those worlds be kept apart, that they can work and function by themselves. The restrictions would then be that those games cannot exchange the items outside of the game, even though players can still exchange with in the game – this is completely different. So when people are thinking about these game transactions, they have to make a distinction between open world on the one hand and closed world on the other."

Ultimately, defining and regulating RMT all comes down to the game developer on the legal side, the financial side, and the gameplay side. With rulings like the one in South Korea this month attracting the attention even of gamers who can't balance a checkbook, turning a blind eye to RMT might not be an option anymore.

AJ Glasser is a writer for GamePro. Reprinted with permission.

For further reading:
"The Most Efficient Way To Acquiring Gold In A MMORPG", We Fly Spitfires, December 8, 2009
"Click to Agree: Virtual Currency and RMT Provisions in Virtual Worlds and MMO Games", Jay Moffitt, Virtually Blind, October 31, 2007
"Xfire 'Virtual Gold & Real Money' Debate Today", Benjamin Duranske, Virtually Blind, August 21, 2007
"Virtual Worlds Draw Real World Lawyers", BusinessWeek, May 15, 2007
"How big is the RMT market anyway?", Tuukka Lehtiniemi, Virtual Economy Research Network, March 2, 2007
"The New New Economy: Earning Real Money in the Virtual World", Knowledge@Wharton, November 2, 2005

Saturday, January 30, 2010

Dubai's Dark Side Targeted by International Finance Police

By Nick Mathiason
The Observer
Sunday, January 24, 2010

Fears are intensifying that the emirate has become a global centre for terror funding, money-laundering, drug money and mafia cash

Naresh Kumar Jain, an Indian multimillionaire suspected of being one of the world's biggest money launderers, ran from the law, but last month it became obvious that he couldn't hide.

Having skipped bail in Dubai – where much of his vast empire was based – 18 months ago, Jain was finally arrested in Delhi by India's Narcotic Controls Board for allegedly moving hundreds of millions of dollars for drug dealers. It had taken an international manhunt involving law enforcement agencies spanning three continents to catch him.

The 50-year-old is suspected by the UK's Serious Organised Crime Agency of being at the heart of a drug money-laundering network shifting up to £1.35bn a year across jurisdictions. Jain has reportedly admitted to Indian police that he has laundered cash, but denies being involved in the drugs trade.

However, investigators believe that his businesses are based on huge sums of cash originating in Africa and passed on to him by diamond smugglers and drug dealers – and that most of that illicit cash flows into Dubai. But the allegations against him do not make him unique in the emirate. "[Jain's arrest] was an important incident, but many wanted men reside in Dubai," says Dr Christopher Davidson, an expert on Gulf economics at the University of ­Durham.

To many, Jain is the latest, perhaps the biggest, example that proves the United Arab Emirates is not so much awash with vast oil wealth but built on a toxic tide of illicit cash: a place where Russian mafia and drug cartels clean their dirty cash and al‑Qaida finances terror atrocities. And at its heart is Dubai, a world financial centre that in the past 15 years has grown exponentially.

As Dubai's ruling elite pick through the wreckage of its bombed-out economy, which exploded under the weight of $60bn of debt last year, an equally pressing issue threatens to undermine not just Dubai but the UAE as a whole.

Next month, a meeting of the Financial Action Task Force (FATF), the powerful intergovernmental body responsible for combating money laundering and the financing of terrorist networks, will meet in Abu Dhabi. The meeting is expected to establish which countries to put on a high-risk jurisdiction list following a request by G20 finance ministers last year. It is thought likely that the UAE will feature on the list. Such a development would be a serious blow to the money men of Dubai, but would confirm many people's fears that it remains a port of choice for dirty cash.

The notion is causing renewed concerns among senior US officials. Last month an American ambassador to Afghanistan, E Anthony Wayne, said that every day $10m in cash was being smuggled from Kabul to Dubai in briefcases, much of it from the Afghan heroin trade, which has boomed since the US invasion. Wayne said a US investigation found that $190m in cash was smuggled in just 18 sample days.

Insiders say that obtaining a UAE passport, which allows the bearer to open a bank account, is still relatively easy. Experts suggest that airport customs in some of the UAE states provide easy routes to move goods and cash around. In addition, Dubai real estate has a notorious reputation as a front for laundering, where apartments are bought up by unknown entities who never live there. "After 9/11, there was a crackdown on corruption, but they're careful not to talk about money-laundering because it is part of the lifeblood," says Davidson at the University of Durham.

"The place is built on it," insists one seasoned Dubai businessman. "It's a commercial port. There's a free trade zone. That's what made its livelihood."

Expatriate UK financiers say that new rules have not had any appreciable effect: "Russians are still coming with suitcases of cash to buy flats which they never live in," says one. "It's easy to get resident permits. These sort of stories are rife. Russia is the biggest source. A lot of it is mafia."

"There are weak links in every country," says Bryan Stirewalt, director of supervision at the Dubai Financial Services Authority. "There are weak links in the US, but they are different types. Money launderers choose the US because of [its] size… they don't stick out. There's an inherent conflict between the ease of doing business and the potential for money laundering. Unfortunately, they work contrary to each other. The easier it is to open a business, the easier it is for money launderers."

So easy, in fact, that the latest FATF evaluation of the UAE's efforts to combat financial crime is a devastating critique of its laws and agencies. The report, ­published in November 2008, points to the low number of suspicious transaction reports (STRs) submitted in a region where so much wealth is banked.

The FATF also criticises the low number of staff in the UAE central bank's anti-money laundering unit, as well as an inadequate legal framework that places few obligations on the region's authorities to ensure customer due diligence checks are made and monitored.

The task force also points out that standards vary on the identification of the true owners and beneficiaries of companies in the UAE, and expresses concern about the region's securities and insurance sectors, which adopt less onerous regulations than even its banking sector.

Alarmingly, regulations on wire transfers still "fall well short" of FATF requirements, the report says – an observation that will shock many, since six-figure sums were wired from Dubai to bank accounts in America to finance the 9/11 suicide bombers. The FATF also states that lawyers and accountants face no specific due diligence requirements under UAE money-laundering law.

To be fair, the FATF spares the Dubai International Finance Centre – the 110- acre Middle East and North Africa capital markets hub – from some of its fire. In fact, the Dubai Financial Services Authority, which regulates the centre, says that last year it posted a 20% rise in STRs, though it admits the overall number recorded was still not as high as might be expected. Much of the increase, it says, came in the wake of the Lehman Brothers bank collapse, when huge amounts of money came looking for new safe havens.

Stirewalt, who has been in charge of fighting money laundering and terrorism finance in the Dubai International Finance Centre for more than a year, has set up systems that are going a long way to identify illicit flows. As well as turning up a "significant" increase in STRs, he is focusing on accountants and lawyers, and has stepped up inspections of banks as well as improving links with the UAE Central Bank, which has overall control of money laundering issues.

Stirewalt points out that Dubai, which is close to a number of conflict zones, is vulnerable to criminal penetration, made easier because of its role as a port. He has still not completely come to terms with the region's long-established informal money-transfer network known as hawala, suggesting that reform in this area still has "further to go".

When it comes to claims that Dubai is a destination of Afghan heroin cash, Stirewalt is candid: "I don't disagree with it. I can't say it's not true."

He is keen to stress that Dubai is just one place through which dirty cash flows. When the emirate was cited as being part of an international £60bn carousel fraud five years ago, it was among a host of other countries including Switzerland and the UK. "We have to think about the whole globe," he says. "No one is perfect; no one is bulletproof. The UAE is taking the issue seriously post-9/11 to strengthen the system."

But it is not just Dubai's reputation that is at stake if the authorities fail: the apprehension of international crime and terror gangs dep­ends on its ability to stem the tide of illicit cash washing through the emirates.

For further reading:
"Underground Banker", Little India, January 9, 2010
"'Hawala King' Naresh Jain arrested in India", The Telegraph, December 9, 2009
"Suspected Hawala Kingpin Naresh Jain says he is being trapped", Thaindian News, September 25, 2009
"Anti-money laundering expert warns of dangers facing UAE financial services firms",, June 14, 2007
"Informal Value Transfer Systems Report", Nikos Passas, U.S. Department of Justice, January 2005

Friday, January 29, 2010

Hunt Brothers Demanded Physical Delivery Too

By Jon Matonis

"A billion dollars isn't what it used to be."
--Bunker Hunt on the Sunday after Black Thursday when confronted with a significant payment demand from Engelhard.

If you want to know what happens when multiple long positions demand physical delivery of a commodity all at once, you need look no further than the Hunt brothers silver saga of 1979-1980. They did nothing illegal, the Chicago Board of Trade (CBOT) and COMEX changed the rules in the middle of the game, the Commodity Futures Trading Commission (CFTC) implemented new regulations, and the Hunts were bankrupted, unjustly. All they really did was simply request the delivery of the physical metal for which they held valid, legal contracts. The shorts were unable to meet the delivery at any price because enough deliverable silver did not exist - a classic short squeeze and the panic was on.

This is their story. In conjunction with wealthy investment partners from Saudi Arabia, the Hunt brothers, Bunker and Herbert initially, amassed a legendary silver hoard that had supported itself with ever-increasing prices propelled along the way by their continued margin buying on the exchanges.

Beginning in 1973 and continuing into 1974, they slowly began purchasing silver futures contracts totaling 55 million oz and then took physical delivery of all the contracts. Since Bunker was concerned with impending inflation and the potential confiscation of precious metals following Nixon's closing of the gold window, he arranged for transfer of the bullion to Switzerland. Larry LaBorde summed it up best:
"Meanwhile, back at the ranch, (the Circle K Ranch in Texas) brother in law Randy Kreiling and his brother Tilmon held a shooting contest amongst the cowboys to find the best marksmen. The dozen best marksmen were hired for a special assignment to ride shotgun on one of the largest private silver transfers in history. The Circle K cowboys flew on 3 specially chartered 707 jets to Chicago and New York where they were met by a convoy of armored trucks during the middle of the night. Forty million oz of silver was loaded onto the planes and they immediately flew to Zurich where they were met by another convoy of armored trucks. The cowboys loaded the trucks and silver was dispersed to six different storage locations in Switzerland. The transfer cost Bunker and Herbert $200,000. The storage costs for the 40 million oz in Switzerland and the 15 million oz still in the US amounted to $3 million/year." (from "H.L. Hunt's Boys and the Circle K Cowboys", January 26, 2004)
By the spring of 1974, the markets started to get worried about the amount of silver out in private hands, because annual demand was 450 million oz but annual production was just 245 million oz. Of the estimated 700 million oz. above ground, only 200 million of that was deliverable against futures contracts. Silver had risen to above $6 per oz during this time and then settled back to the $3 to $4 range for several years.

The Arabian Connection

Then, in 1978, a significant development occurred. John Connally, former governor of Texas, introduced Bunker to a Saudi sheik at the Mayflower hotel in Washington. Sheik Khalid bin Mahfouz was staying at the same hotel as Bunker and John Connally, and they met in bin Mahfouz's suite, which consisted of the entire hotel floor, complete with 30 or 40 security guards. The goal was to get the Hunts in the front door with these very wealthy Arab sheikhs, and the Hunts would sell the Saudis on the value of silver over the worthless U.S. dollar with the hope of enlisting them for coordinated joint purchases.

Khalid bin Mahfouz became intrigued, but since he had close ties to the Saudi royal family, Crown Prince Fahd and Prince Abdullah, and since the plan involved the potential elevation of silver to reserve asset status within the Saudi Arabian Monetary Authority, bin Mahfouz wished to be discreet. The operation was to be organized so that his name would not appear in public. Then on July 15, 1979, the company was formally established in Bermuda and registered under the name International Metals Investment Company, or IMIC for short. The stated object was dealing in precious metals and its shares were divided equally between Nelson Bunker Hunt, W. Herbert Hunt, and the two designated Saudi Arabian money men, Ali bin Mussalem and Mohammed Aboud al-Amoudi. The primary silver accumulation would now occur through the IMIC vehicle and two other well-connected middlemen, the Lebanese Naji Nahas and the Palestinian Mahmoud Fustok.

The Accumulation Phase

On August 1, 1979, a new name showed up on the CFTC's daily reports of silver purchasers. The buyer was International Metals Investment Company through an account at Merrill Lynch's Dallas office opened by Herbert Hunt just seven days earlier. Other buying syndicates, including Naji Nahas and the Banque Populaire Suisse, with big money behind them entered the silver market in the first week of August without being noticed.

In all during that period, over 43 million oz of silver contracts were purchased through the Comex and the CBOT with delivery to be taken that fall. In the fall of 1979 the silver price doubled from $8 to $16/oz in only two months and the COMEX and the CBOT started to panic. The warehouses of the two exchanges only held 120 million oz of silver and that amount was traded in October alone. Many buyers, including the Hunts through their International Metal Investment Company were taking delivery on all their contracts. As disorienting as the price escalation was, even more of a concern was the exact identity of IMIC since the CFTC only had a post-office box number located in Hamilton, Bermuda.

The Hunts continued to accumulate silver throughout 1979. Again from Larry LaBorde:
"Late in 1979 the CBOT changed the rules and stated that no investor could hold over 3 million oz of silver contracts and the margin requirement were raised. All contracts over 3 million oz per trader must be liquidated by February of 1980. Bunker accused the COMEX and CBOT board members of having a financial interest in the silver market themselves. Investigations later found that many had substantial silver short positions. Bunker knew that a shortage now existed or they would not be screaming so loudly. He bought even more. The price on the last day of 1979 was $34.45/oz. At this point Bunker and Herbert held 40 million oz in Switzerland and 90 million oz of bullion they jointly owned through International Metals Investment Company. In addition to all that, IMIC had contracts on another 90 million oz due for delivery that March from the Comex, bringing the grand total to 235 million oz. The younger brother, Lamar, had even entered the arena and had taken a $300 million dollar, 10 million oz, silver position by the end of 1979."
Changing the Rules

In early January, it became evident that COMEX intended to change the rules of the game. And then finally on January 7th of 1980, the COMEX changed their rules to only allow 10 million/oz of contracts per trader and that all contracts over that amount must be liquidated before February 18th. Of course, the CFTC promptly backed up the ruling. The escape hatch for the Hunts and some of the other large longs was simply to convert their futures contracts into physicals, lease the physicals abroad at interest rates, which were tax deductions, and shift their future forward buying to the London Metal Exchange. On January 17th silver hit $50/oz, Bunker had continued to buy. At that point in time the Hunt's silver position was worth $4.5 billion dollars bringing their profits in silver to $3.5 billion dollars. The chart below illustrates the great Silver Spike of early 1980.

The "Silver Spike"

On January 21st, the COMEX announced that it was suspending trading in silver and that they would only accept liquidation orders. Predictably with trading suspended and only liquidation orders going through, the price of silver dropped $10/oz and stayed around $39/oz until the end of January. Long lines formed outside of metal dealer shops and scrap silver, old silver coin collections, and family silverware came into the market - about 22 million oz in all. In early February the Hunt group took delivery of another 26 million oz from Chicago. The Hunt's North Sea oil through Placid Oil was coming on line and generating $200 million /year from that venture alone. There was talk of a takeover of Texaco Oil. Bunker was also talking to other Middle Eastern rulers about putting together another silver buying group.

Forever the optimist, Bunker faithfully believed that he could maintain the silver spike if only he had cooperative fresh buying. From Larry LaBorde:
"By March 14th silver was down to $21/oz, Paul Volcker had raised interest rates, and the dollar had firmed up. International Metals still held 60 million oz of futures contracts. Their margin calls on those contracts amounted to $10 million dollars a day! Bunker still believed the price would go back up if only he could promote more buying. He scrambled around Europe looking for a buying partner but the more the price dropped the harder it was to borrow more money against his silver holdings to buy even more silver to hold up the price."
The Hunt's brokerage connection in New York and London, Bache Halsey Stuart Shields, sent the Hunts a margin call for $100 million on March 26th of 1980. Since the Hunts had also purchased vast quantities of Bache stock (more than 5% of issued and outstanding shares), they were technically "insiders" required to adhere to the rules of only fractional stock selling permitted on a monthly basis. With their Bache stock illiquid and silver in free fall, the Hunt brothers had run out of cash. Bunker was in Paris that day so he called Herbert and simply said, "Shut it down". Herbert promptly told his broker the following morning that they could not meet their total $135 million dollar margin call.

The Hunt's brokers immediately sold $100 million dollars worth of silver on that day. Their account only had $90 million dollars worth of equity and they were expected to lose all that the next day. The CFTC chairman, the Chairman of the Federal Reserve, and the US Treasury Secretary began an around the clock silver monitoring session. Whoever could have foreseen the day when a change in the price of silver would cause tremors through the entire stock market and adversely affect the reputations of leading brokerage and commodity firms. Wall Street was on edge.

Silver Thursday

On March 27th (Silver Thursday), silver opened at $15.80 and closed at $10.80. The stock market crashed on rumors of Hunt Brother liquidations of stocks in order to cover his silver losses, but the market then rallied to close roughly at the same level. The Hunt's bullion purchases were all averaged around $10/oz, but their futures contracts were purchased at or about $35/oz. When it was all over the Hunts owed approximately $1.5 billion dollars.

Fearing a financial disaster, Federal Reserve Chairman Paul Volker gave approval for an emergency bailout plan for the brothers and a group of banks agreed to loan the brothers $1.1 billion with the family posting $8 billion in collateral. With this final act the brother's older sister, Margaret, finally put her foot down and demanded to know just what Bunker had intended to accomplish in the silver market? Bunker sheepishly replied, "I was just trying to make some money" (see Larry LaBorde).

Nelson Bunker Hunt filed for personal bankruptcy in September of 1988. Within one year he exited bankruptcy with a net worth of $5 to 10 million dollars and a debt to the IRS of $90 million dollars which had to be repaid in 15 years. In a 1989 settlement with the United States Commodity Futures Trading Commission, Nelson Bunker Hunt was also fined US$10 million and banned from trading in the commodity markets as a result of charges of conspiring to manipulate the silver market stemming from his attempt to corner the market in silver. Bunker's trusts, set up by his father H.L. Hunt, were valued at approximately $200 million dollars. The payments to the IRS finally stopped in 2003.

For further reading:
"The Art of Silver Manipulation", Ed Zimmer, November 13, 2009
"Once world's richest man, Bunker Hunt has 'no regrets' 29 years after silver collapse"
, Doug J. Swanson, The Dallas Morning News , March 22, 2009
"Let's Be Hunts", David Bond, August 17, 2008
"H.L. Hunt's Boys and the Circle K Cowboys", Larry LaBorde, January 26, 2004
"Move Over Fisk and Gould", James Turk, Free Gold Money Report, August 16, 1999
"Hunts are Ruled Part of a Scheme to Control Silver", The New York Times, August 21, 1988
"Trial of Hunt Brothers In Silver Case Begins", The New York Times, February 25, 1988
"The Hunt Brothers; Battling a Billion-Dollar Debt", The New York Times, September 27, 1987
Beyond Greed: The Hunt Family's Bold Attempt to Corner the Silver Market, Stephen Fay, 1982
Silver Bulls: The Great Silver Boom and Bust, Paul Sarnoff, 1980
"Silverfinger: The Hunt Brothers Story", Harry Hurt III, Playboy, September 1980
"Bunker's Busted Silver Bubble", Time, May 12, 1980
"He Has a Passion for Silver", Time, April 7, 1980

Tuesday, January 26, 2010

Facebook's Virtual Currency and the Exchange Rates

By Eric Eldon
Inside Facebook
Monday, January 25, 2010

Facebook has slowly introduced its virtual currency, Credits, to third parties over the last few years. But it has been planning to make Credits a more central part of its platform for third-party developers, and we’ve been hearing that a bigger launch is planned soon.
So here’s a look at how much Credits currently cost Facebook users around the world. A lot more people are going to care about these numbers if and when Credits becomes a way to buy virtual goods in Facebook apps and games.
The table you see shows how each of the 15 currencies that Facebook supports currently converts to Credits. We convert to 10 Facebook Credits because that’s the lowest denomination available (you can’t just buy a single credit). We also compare the conversion to how each currency converts to the US dollar based on numbers from Yahoo Finance — clearly, Facebook is benchmarking the value of Credits on the dollar for the time being, as the two sets of numbers almost exactly line up. The difference is likely due to Facebok updating the dollar conversion slightly later than real-world market changes.
Despite the dollar parity, Facebook has been making a few moves to make Credits more distinct. The virtual currency appeared in its earliest form as a means to by virtual gifts in the company’s Gift Shop, years ago — it only moved from US Dollars to Credits in November of 2008. Then, last May, it adjusted the exchange rate from 100 Credits per $1 to 10 Credits per $1. In June, it followed this move by introducing the 14 additional currencies you see listed in the table.
We’ll be watching to see how Facebook handles Credits pricing. In order to make virtual gifts more affordable to more of its users, the company may choose to unpeg Credits from the Dollar, and allow users to purchase Credits for a range of prices aimed at local (and often poorer) markets. This is important because around 70% of Facebook’s more than 350 million monthly active users are outside of the US, with many of them in developing countries.
The Credits Timeline
The more users Facebook can get paying at all for Credits, the more money it can make. In May, the company also began letting third-parties sell goods in the virtual shop using Credits. Facebook has long planned to take an Apple-style 30% cut from transactions that go through Credits, as we first reported in May and then in November.
Facebook has been planning some sort of major launch with big developers since last fall; at one point, we heard that the company was aiming for a launch in time for Christmas virtual good sales. Happy Islands, a social game by CrowdStar, launched last month using Credits as the sole means for virtual goods purchases. This month, the company has already made a push to hire for a new payments operation team, tested a payments resolution interface, and released Credits in more apps.
Credits might squeeze out payment services providers who currently provide currency support and other features to developers. We’ve heard unconfirmed rumors that Facebook will offer incentives or regulations that favor Credits over third-party virtual currency systems.
Yet many developers themselves have told us that Credits could them make more money. The reasons are that users will have a more seamless interface for purchasing and spending the virtual currency, all using Facebook’s own brand.
For further reading:
"Facebook Credits - Part I: The Story So Far", Neil Vidyarthi, All Facebook, January 25, 2010
"Facebook Credits - Part II: What's Here and What's Next", Neil Vidyarthi, All Facebook, January 26, 2010
"Revealed! Facebook's Plan To Double Its Revenues", Nicholas Carlson, Silicon Alley Insider, January 25, 2010
"Developers Would Pay 'Whatever Cut Facebook Desires' For Payments Platform", Nicholas Carlson, Silicon Alley Insider, January 12, 2010
"A Running Summary of Facebook’s Virtual Currency Tests", Justin Smith, Inside Facebook, August 26, 2009

Monday, January 25, 2010

The Universal Currency Wars Are Coming

By Lisa Rutherford
Friday, May 29, 2009

We’ve seen much speculation in the past month about Facebook’s impending virtual currency tests. Its initial forays will be, by all accounts, relatively simple and small. But it’s the potential of “what Facebook could do” that has everyone talking. Yes, it’s cool that in the short-term, application developers will be able to use its “credits” currency to make money, and it’s nice to see Facebook making a smart business decision, but there’s a larger and more serious question:

Can Facebook introduce a universal virtual currency that makes it easier and cheaper to buy/sell virtual and real goods?

The short answer is yes.

But they’re not the only ones eyeing the market. From startups like Jambool and SpareChange to behemoths like Apple and PayPal, companies of all sizes are preparing to chase the modern alchemist’s dream of turning virtual coal into real dollars.

Virtual Currencies

For those of you reading this who aren’t sure what a virtual currency is (love you, Mom), let’s do a quick primer. In the real world, we’re used to sovereign/fiat currencies, which serve as a standard unit of account and representation of value within a given economy, facilitating all types of trade. Virtual currencies do the same thing, except that the economy is online, and they are backed by private companies (here’s a more in-depth discussion of how we define virtual currencies).

Virtual currencies have gained popularity because they reduce two major points of friction – consumer inconvenience and merchant cost. A user enjoying a social or gaming experience doesn’t want to be pulled away to enter payment info, and the seller doesn’t want to pay transaction processing fees that were scaled for more expensive purchases. As transactions have gotten smaller and more frequent, reducing friction has become a key driver for increasing overall revenue.

Enter virtual currencies, which allow customers to buy a chunk of virtual money with real world money. It’s one processing fee, and then the consumer can spend the virtual currency over time for no additional fees (essentially lowering effective transaction costs) and without leaving the application.

A universal virtual currency extends across a host of applications. Instead of each application having its own micro-economy, they puddle up onto a shared currency system. Vertical examples include Microsoft Points, SparkCash, and Hi5 Coins.

Why You Can’t Buy Lisa Dollars from Twofish

I have a pretty unique view on the space, simply because my company, Twofish, markets a virtual economy data platform that was actually built to manage and optimize exactly these types of universal currencies. Sitting here with a world-class infrastructure and watching the market evolve relatively slowly, we’ve stopped several times to (re)assess whether or not we should launch our own Twofish-branded currency.

I’m not going to lie, I really love the idea of having everyone spending Lisa Dollars all over the internet, but at the end of the day, we’ve chosen to white label for brand partners and not launch a Twofish currency for a fundamental reason: We’re a startup, and a universal currency should come from a trusted consumer brand that has the resources to promise—and provide—customer support, stability, and security, as well as the scale to attract an appropriately diverse set of economic partners.

No matter how great your technology or how much you want to be the central bank for all of the virtual coins of the world, it’s just unrealistic to think that mass consumers will be willing to entrust a significant portion of their income to a startup tech company (note that I do not consider the people who invested in Second Life’s Ginko Financial to be representatives of the mass market).

Importance of Brand and Scale

When virtual currencies were just a fanciful piece of game play, the need for that brand promise was low. But now that we’ve started thinking about universal virtual currencies that carry real world value across the Internet…well, they’ve become tangibly important, and a new level of care is expected. The brand needs to be trusted and recognized.

A large brand can also attract a more diverse and plentiful set of partners, which is important from an economic theory perspective. At the risk of glazing over some eyes, consider what’s called the Optimum Currency Area (OCA), the optimal geographic domain of either a single currency or several that are permanently pegged together. An optimal area has labor mobility, price and wage flexibility, open trade, diversification in resources/production and consumption, and fiscal integration, so that when the global economy shifts, the region has the flexibility to optimize its monetary power through different resources.

Following OCA theory, a small, land-locked country, like Luxembourg, or even Austria, doesn’t have enough flexibility to optimally support its own currency. But if you put it together with the surrounding 26 nations, take away trade barriers, and build a great rail system… well, now you understand the EU.

My point is that the same principle applies to online economies—let’s call it the Optimal Virtual Currency Area (OVCA). For a shared virtual currency to take hold and maintain its long-term stability, it needs to be accepted across multiple verticals (i.e., not just games or SNS apps), it should have open trade and dynamic pricing (so that users can buy or earn a currency in one app or platform and sell in another), and it needs to have some loose infrastructure or clearinghouse to step in and balance when needed.

So who can succeed?

Remember, were not talking about a small gaming currency here. We’re talking about the potential to create a global virtual wallet system that extends and simplifies all types of commerce.

It’s just not going to come from a startup. But there are several companies that I think could make a massive and transformational shift, though they each have very different motivations:

I don’t think Facebook sits around thinking about virtual currency domination. Rather, the mantle has been thrust on them by demand and the evolving nature of their application developers. Time will tell if they decide to embrace and run with it, but if they do, they can continue to diversify their business outside of the core social network and start leveraging the power of the transactional graph.

PayPal’s motivation should be much different. They need to think about blocking someone else from coming into their space and replacing their “e-wallet” with a “v-wallet,” which would be designed to essentially circumvent existing fee structures. PayPal used to be at the forefront of lower-friction commerce, but now they’re risking becoming one of the old boy network if they don’t innovate. If I were them, I’d start here.

Apple has the best interface (iTunes) and the most goodwill, and they’ve expertly managed expectations around their mobile micro-transactions, so that people love them even when they’re late to the game. What’s interesting about Apple is that an iPhone-friendly virtual currency can wreck the carriers, who are still charging exorbitant fees for mobile payments.

I also think that Amazon is well-positioned to outflank PayPal and start consolidating v-commerce into their existing e-commerce model. It’s also a great fit for some of their long-term ideas for the Kindle.
Then there’s that most ubiquitous web company of all… Google. Why wouldn’t they move to beat PayPal in the v-wallet space? Particularly since they are so focused on analytics and understanding massive amounts of information.

The War is Coming

All of this is not to say that there will be only one currency. There will always be places for specialized currencies, as well as tools to clear/exchange different virtual currencies.

But the domination that would come from a consumer-embraced universal virtual currency is just a massive opportunity. And while right now it’s just startups, game-centric portals, and minor social networks who are playing with shared currencies, Facebook’s impending tests are going to escalate the current skirmishes to-all out battle.

The universal currency wars are coming. It’s going to be interesting to watch.

Lisa Rutherford is President at Twofish, based in Palo Alto, California. Twofish was acquired by Live Gamer, Inc. on August 24, 2009.

For further reading:
"The Ramp Up To Facebook Credits Continues", Nick O'Neill, January 14, 2010
"Reasonings for virtual currency implementations in business models of free-to-play worlds", Juho Hamari, Virtual Economy Research Network, December 5, 2008
"Death to Paper Money: Virtual Currency is the Future", Kelly Spies, June 4, 2008
"'Human-Currency Interaction': Learning from Virtual Currency Use in China", Yang Wang and Scott D. Mainwaring, CHI 2008, Florence, Italy, April 5–10, 2008

Saturday, January 23, 2010

Cellphone Encryption Code Is Divulged

By Kevin J. O’Brien

BERLIN — A German computer engineer said Monday that he had deciphered and published the secret code used to encrypt most of the world’s digital mobile phone calls, saying it was his attempt to expose weaknesses in the security of global wireless systems.

The action by the encryption expert, Karsten Nohl, aimed to question the effectiveness of the 21-year-old G.S.M. algorithm, a code developed in 1988 and still used to protect the privacy of 80 percent of mobile calls worldwide. (The abbreviation stands for global system for mobile communication.)

For further reading:
"Encryption gets a Battering", Nigel Stanley, Bloor Research, January 18, 2010
"Experts Break Mobile Phone Security", MIT Technology Review, December 29, 2009
"Mobile phone security codes cracked", The Telegraph, December 29, 2009
"Secret code protecting cellphone calls set loose", The Register, December 28, 2009

Ron Paul Testifies on Behalf of Free Competition in Currency Act

On December 9, 2009, Ron Paul introduced the Free Competition in Currency Act. Watch a January 20, 2010 video of Ron Paul testifying on behalf of his proposed legislation.

HR 4248 would abolish the legal tender laws, allow the establishment of private mints, and repeal capital gains taxes on gold and silver, allowing them to compete effectively as currencies. From Ron Paul:

"Because of legal tender laws that force acceptance of the dollar, the Fed has absolute power over the currency. This absolute power is leading to the absolute corruption of our currency. The money supply has doubled in the last year or so, which is extremely dangerous. The banks seem to be hoarding liquidity now but once these dollars make their way into the economy, hyperinflation and economic chaos will be a real possibility."

"I introduced the Free Competition in Currency Act last week to free the people from these governmental threats. HR 4248 would repeal legal tender laws, prohibit taxation on certain coins and bullion, and repeal certain laws related to coinage. The prospect of people turning away from the dollar towards alternate currencies should provide incentive for Congress to regain control of the dollar and halt its downward spiral. Restoring soundness to the dollar will remove the government's ability and incentive to inflate the currency and keep us from launching unconstitutional wars that burden our economy to excess. With a sound currency, everyone is better off, not just those who control the monetary system."
For further reading:
"Real Banking Reform? End the Federal Reserve", Richard M. Ebeling, January 22, 2010
"Judicial Terrorism: The State vs. Robert and Danille Kahre", William Norman Grigg, December 3, 2009
"Prosecuting Robert Kahre for Embarrassing the Federal Reserve", Jacob G. Hornberger, June 3, 2009
"Employer's gold, silver payroll standard may bring hard time", Las Vegas Review-Journal, May 26, 2009

Thursday, January 21, 2010

Is There Gold in Fort Knox?

By Constance Gustke
CBS MoneyWatch
Wednesday, January 20, 2010

Buried inside a 109,000-acre U.S. Army post in Kentucky sits one of the Federal Reserve's most secure assets and its only gold depository: the 73-year-old Fort Knox vault. Its glittering gold bricks, totaling 147.3 million ounces (that's about $168 billion at current prices), are stacked inside massive granite walls topped with a bombproof roof. Or are they?

It's hard to know for sure. Few people have been inside Fort Knox, a highly classified bunker ringed by fences and multiple alarms and guarded by Apache helicopter gunships. When the U.S. finished building Fort Knox in 1937, the gold was shipped in on a special nine-car train manned by machine gunners and loaded onto Army trucks protected by a U.S. Calvary brigade. And the fort has been pretty much off limits since then. A U.S. Mint spokesman said in an email statement to MoneyWatch that the accounting firm KPMG, which audits the Mint, "has been present in the vault at Fort Knox." The Mint won't comment on exactly how much gold is in there, though.

That's why U.S. Rep. Ron Paul, R-Texas, a 2008 presidential candidate known for his libertarian streak, wants to have a look around. Paul introduced a bill to audit the Federal Reserve, which includes Fort Knox's gold. "My attitude is: Let's just find out what's there," he says.

Despite conspiracy theories to the contrary, no serious Fed watcher thinks Fort Knox is wholly goldless — not even Paul. The push by Paul and a conspiracy-theorist group known as Gold Anti-Trust Action Committee (GATA) to open Fort Knox's 22-ton door is more about their loathing of the Federal Reserve and its purported growing powers. "The gold market is being manipulated by the Fed," says GATA spokesman Chris Powell. "It's involved in gold swap agreements with foreign banks. Gold is a major determinant of interest rates."

The bad news for "Goldfinger" buffs, say gold analysts, is that Fort Knox doesn't really matter much anymore.

Fort Knox began losing its luster when the United States went off the gold standard in 1971. Before that, gold bars packed into a secure vault gave people faith in the country's currency. Today, however, Fort Knox's gold is now an asset on the Federal Reserve’s balance sheet, not a key part of our monetary system.

Though Fort Knox's security overkill may seem a quaint relic of bygone days -- like the Beefeaters guarding Buckingham Palace -- the gold there and at U.S. Mint facilities adds up to one of the world's largest bullion holdings. Still, it's a tiny part of the nation's total assets. In a $13.8 trillion GDP economy, 147.3 million troy ounces of gold barely registers.

"It may lend some confidence to investors that we have large gold reserves," says Mark Zandi, chief economist at Moody's "But it's more symbolic than substantive."

The Fed’s gold is valued at a tremendously low figure -- just $42.22 an ounce. The rock-bottom figure was set in 1973, two years after we left the gold standard, primarily to avoid wild accounting swings. "What would happen if the price of gold drops dramatically?" asks Dimitri Papadimitriou, president of the Levy Economics Institute at Bard College. "The Fed balance sheet would be dramatically lower."

The Fed won't be unloading large stashes from Fort Knox any time soon. Doing so would flood the market and send the price of gold spiraling downward. "A small, vocal group of gold bugs would be against it," says John Irons, research and policy director at the Economic Policy Institute, a liberal think tank. "The Fed wouldn't want to stir things up."

But Irons and some other economists would like to see the U.S. gold reserves thinned out. "The Fed could sell a lot of the gold," says Irons. "It's better used in jewelry or electronics. It can be useful to the private economy rather than buried in a vault."

The sale could make a small dent in the $12.1 trillion national debt and, with the price of gold near its all-time high, this is a particularly good time to sell.

The reason Fort Knox will remain a mighty fortress, however, may come down to something Alan Greenspan once told Paul. When Paul asked the former Fed Chairman why the Fed hangs onto its hefty gold reserves, "Greenspan said, 'Just in case we need it,'" says Paul. "You hold onto it because it's the ultimate in money."

For further reading:
"Gold all there when Ft. Knox opened doors", David L. Ganz, September 15, 2009

Monday, January 18, 2010

ECB Prepares Legal Ground for Euro Rupture as Greek Crisis Escalates

By Ambrose Evans-Pritchard
The Telegraph, London
Sunday, January 17, 2010

Fears of a euro break-up have reached the point where the European Central Bank feels compelled to issue a legal analysis of what would happen if a country tried to leave monetary union.

“Recent developments have, perhaps, increased the risk of secession (however modestly), as well as the urgency of addressing it as a possible scenario,” said the document, entitled Withdrawal and expulsion from the EU and EMU: some reflections.

The author makes a string of vaulting, Jesuitical, and mischievous claims, as EU lawyers often do. Half a century of ever-closer union has created a “new legal order” that transcends a “largely obsolete concept of sovereignty” and imposes a “permanent limitation” on the states’ rights.

Crucially, he argues that eurozone exit entails expulsion from the European Union as well. All EU members must take part in EMU (except Britain and Denmark, with opt-outs).

This is a warning shot for Greece, Portugal, Ireland and Spain. If they fail to marshal public support for draconian austerity, they risk being cast into Icelandic oblivion. Or for Greece, back into the clammy embrace of Asia Minor.

ECB chief Jean-Claude Trichet upped the ante, warning that the bank would not bend its collateral rules to support Greek debt. “No state can expect any special treatment,” he said. He might as well daub a death’s cross on the door of Greece’s debt management office.

This euro-brinkmanship must be unnerving for the Hellenic Socialists (PASOK). Last week’s €1.6bn (£1.4bn) auction of Greek debt did not go well. The interest rate on six-month notes rose to 1.38pc, compared to 0.59pc a month ago. The yield on 10-year bonds has touched 6pc, the spreads ballooning to 270 basis points above German Bunds.

Greece cannot afford such a premium for long. The country must raise €54bn this year – front-loaded in the first half. Unless the spreads fall sharply, the deficit cannot be cut from 12.7pc of GDP to 3pc of GDP within three years. As Moody’s put it, Greece (and Portugal) faces the risk of “slow death” from rising interest costs.

Stephen Jen from BlueGold Capital said the design flaws of monetary union are becoming clearer. “I don’t believe Euroland will break up: too much political capital has been spent in the past half century for Euroland to allow an outright breakage. However, severe 'stress-fractures’ are quite likely in the years ahead.”

As Portugal, Italy, Ireland, Greece, and Spain (PIIGS) slide into deflation, their “real” interest rates will rise even higher. “It is tantamount to hiking rates in the already weak PIIGS,” he said. This is the crux. ECB policy will become “pro-cyclical”, too tight for the South, too loose for the North.

The City view is that the North-South split may cause trouble, but that there will always be a bail-out to prevent a domino effect. “If a rescue turns out to be necessary, a rescue will be mounted,” said Marco Annunziata from Unicredit.

It comes down to a bet that Berlin will do for Club Med what it did for East Germany: subsidise forever. It is a judgement on whether EMU is the binding coin of sacred solidarity, or just a fixed exchange rate system like others before it.

Politics will decide, and in Greece it is already proving messy as teams of “inspectors” ruffle feathers. The Orthodox LAOS party is not happy that an EU crew dared to demand an accounting from the colonels. “The Ministry of Defence is sacrosanct,” it said.

Greece alone in Western Europe treats the military budget as a state secret. Rating agencies guess it is a ruinous 5pc of GDP. Does the country really need 1,700 battle tanks, 420 combat jets, and eight submarines? To fight NATO ally Turkey? Merely to pose the question is to enter dangerous waters.

Who knows what the IMF surveillance team made of their mission in Athens. The Fund’s formula for boom-bust countries that squander their competitiveness is to retrench AND devalue. But devaluation is ruled out. Greece must take the pain, without the cure.

The policy is conceptually foolish and arguably cynical. It is to bleed a society in order to uphold the ideology of the European Project. Greece’s national debt will be 120pc of GDP this year. S&P says it will reach 138pc by 2012. A fiscal squeeze – without any offsetting monetary or exchange stimulus – will cause tax revenues to collapse. Debt will rise higher on a shrinking economic base.

Even if Greece can cut wages without setting off mass protest, it lacks the open economy and export sector that may yet save Ireland in similar circumstances. Greece is caught in a textbook deflation trap.

Labour minister Andreas Loverdos says unemployment would reach a million this year – or 22pc, equal to 30m in the US. He broadcast the fact with a hint of menace, as if he wanted Europe to squirm. Two can play brinkmanship.

For further reading:
"Chaotic Greek Economy Spells Trouble For Eurozone", Radio Free Europe/Radio Liberty, January 15, 2010

LBMA Operates a Fractional Reserve Gold System

By Adrian Douglas
Gold Anti-Trust Action Committee
Monday, January 18, 2010

Here are some Trivial Pursuit questions for you:

1) What is the biggest market in the world for a physical commodity?

2) Is the gold market one of the smallest markets in the world for a physical commodity?

I would guess that you answered:

1) Crude oil.

2) Yes. Gold is one of the smallest commodity markets in the world.

If those were your answers, you are wrong. What everybody believes to be the "tiny gold market" is in fact the world's biggest physically traded commodity market.

Let's have a look at some facts.

The London Bullion Market Association (LBMA) "over-the-counter" (OTC) gold market trades approximately 90 percent of the world's physical gold trade. The amount of gold sold each day is given at the LBMA's Internet site here:

The LBMA reports the net gold traded, which is termed "ounces transferred." This is not the gross trading volume. For example, if an investor were to sell 1 million ounces in the day and then buy 1.1 million ounces, the trade would be counted as 0.1 million ounces, the net difference between the purchase and the sale and the amount of gold "transferred" to the investor's account. Therefore the numbers are the amount of gold that changes ownership each day.

The value of the daily trading for November 2009 is given as $22 billion.

From looking at the data you might think that the trade amounts are for the entire month. But they are actually average daily figures for the month. This is clear from another page of the LBMA Internet site, which states:

"Gold ounces transferred rose from a daily average of 20.6 million in September to 20.8 million, an increase of 1.2%. There was a 4.7% increase in the average price to $1,043.16, resulting in a 6.0% rise in value to a daily average of $21.8 billion. The number of transfers dropped by 0.8% to a daily average of 1,908."

The world consumes 82 million barrels of crude oil each day. At $77 per barrel the physical trade of crude oil is worth $6.3 billion each day. This means that the amount of gold that changes ownership each day is, in dollar terms, 3.5 times the dollar value of crude oil that is consumed each day.

In a GATA dispatch in October 2009 the market analyst Paul Mylchreest estimated that the gross volume of gold traded on the LBMA each day was about 2,100 metric tonnes:

That equates to $77 billion each day at 1,150 per ounce. The NYMEX WTI crude oil contract trades 400,000 contracts each day, which is 400 million barrels. At $77 per barrel, the gross value traded is $30.8 billion, which is only 40 percent of the value of the gross trade in gold.

There is a myth among even knowledgeable gold investors and analysts that the gold market is tiny, but in reality it is the biggest physically traded commodity market in the world. The perception of gold being a tiny market comes from the tiny annual production of gold. Global gold production is only 2,200 metric tonnes per year, which is equivalent to the gross trade in gold on the LBMA in just one day.

In a previous article I analyzed the LBMA market numbers and deduced that it was impossible for the LBMA to have enough gold in its vaults to trade such large daily volumes. The inescapable inference is that the LBMA is operating a fractional reserve system and has sold much more gold than it has or could ever have. The amount of gold that has been sold is estimated to be around 65,000 metric tonnes, while the maximum amount of London Good Delivery bars that exist in the world is around 15,000 metric tonnes. So even if the LBMA possesses the world's entire stock of LGD bars there are 50,000 metric tonnes of obligations that cannot be met if the owners ask for delivery.

To put that quantity of gold into perspective, it is equal to all the gold reserves that remain to be mined in the earth.

Gold is unique among all commodities because its very nature and function enable such a fraud to be perpetrated. Gold has very few uses that consume gold. Its main function is to store wealth, and gold can perform that function while in your house, in your vault, or even on the other side of the world in someone else's vault. When it is acting as a store of wealth in someone else's vault, you have to trust that someone else that there is any gold at all in his vault.

Many wealthy individuals, institutions, and sovereign states buy gold through the LBMA in unallocated accounts and leave the gold they supposedly own in the custody of the LBMA.

That people are buying and selling gold without ever taking delivery means that there is the opportunity for the bullion houses to sell gold that doesn't exist. The bullion houses probably don't view this as illegal or dishonest, because they will operate a fractional reserve type of system just as the banks do with fiat currency and will make sure that they have enough gold on hand for what would be the maximum estimated volume of gold that could be called for delivery at any one time.

For this fraud to continue without being exposed, no requested delivery of gold by an LBMA customer must ever be defaulted upon or else a massive "run on the bank" would be triggered. When the bullion banks get into trouble and don't have enough gold on hand to meet delivery demands, central banks lease or sell them gold to cover the shortfall. The central banks are willing to aid and abet the crime because the selling of "paper gold" has the same suppressive effect on the gold price as selling real gold. Suppressing the gold price accommodates the central banks in masking their promiscuous fiat currency creation. In this way the traditional inflation "canary in the coal mine" is muted.

This is the basis of the "strong dollar policy" that allows interest rates to be lower than they should be, and in turn it lowers the price of commodities and imports as it artificially enhances the dollar's buying power. Further, the central banks are able to earn a lease rate on their gold hoards.

If commission fees are 3 percent, then the annual commission earned by the LBMA is approximately $585 billion on only $500 billion of assets. A 100 percent return on investment is certainly a handsome profit.

The much-heralded public auction by the Bank of England of half of its gold stock was open only to members of the LBMA.

From the thesis presented here it can be seen that the suppression of the gold price suits the central banks and that running a fractional reserve gold inventory is extremely lucrative for the LBMA, especially when it is backstopped by the central banks.

Mobilizing central bank gold to maintain liquidity in the market is essential. Maintaining secrecy of such gold activities is equally essential. Over the last 10 years GATA has amassed a large amount of evidence that more than half of central bank gold has been sold, leased, or swapped into the market. This is what lies at the core of the federal Freedom of Information Act lawsuit GATA has filed against the Federal Reserve. The Fed is denying access to hundreds of pages of documents pertaining to the U.S. gold reserves because they are deemed to be exempt from disclosure as "trade secrets." GATA believes that the Fed is trying to cover up its involvement in the suppression of the gold price as part of the implementation of the "strong dollar policy," which necessarily involved mobilizing or encumbering the U.S. gold reserve in some way. GATA intends to find the truth.

Investors in precious metals should take delivery of their bullion. No matter what the outcome of GATA's lawsuit, the fraud will be exposed by customers of the LBMA asking for their gold. When it becomes clear that there isn't enough gold to meet demanded delivery, the gold price must rise in accordance with the new market reality of a much smaller supply than previously was apparent. If you don't take delivery of your bullion, you might discover that investments you thought you had in gold are just promissory notes.

Adrian Douglas is publisher of the Market Force Analysis financial letter and a member of GATA's Board of Directors. Reprinted with permission.