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by Professor von Braun
October 23rd, 2005
The recent demise of Refco highlights the issue of custodial risk and more importantly, the issue of ownership when it comes to what people describe as 'their' assets. On average only a few people actually own 'their' assets and by 'own' I mean have actual possession and/or free and clear title. Obviously a house with a mortgage is 'owned' by the mortgagee until the last payment has been made and clear title recorded.
An investment portfolio generally requires the need for a third party to hold 'assets' -- as in stocks and bonds -- on behalf of the investor and such securities can be bought and sold upon instruction being received.
In the Refco situation clients no longer have the ability to access their accounts via an instruction to the executer of the trade -- and will not have that ability for some time.
Investors need to remember that custody is key, and without it one can do little to redeem ones asset, if needed.
Custodians, those that hold assets on behalf of other entities, either individual or corporate, take many different forms, including banks, stockbrokers, mutual funds and commodity traders to name a few.
Custodial risk along with its cousin, counter party risk, is unfortunately something that we are going to hear more about as the monetary debacle unfolds. Refco should be seen as a wake up call for those who have been paying attention to the unfolding. It's time to take very good look at what one calls an asset, or what some investment advisors call assets, in particular those that have been touting via various publications, 'safe' harbors, havens, cash and liquidity. One may wish to conquer the crash, but what crash, what form will it take and how will it unfold? Once again Refco provides an early clue by highlighting the potentially serious issue of custodial risk.
Most readers of this website have been aware for some time now that all is not well in La La land, that the monetary system is seriously flawed and that various wheels are starting to get very wobbly and are close to falling off. The obvious remedy has been to buy gold and silver, making sure that one takes delivery of ones purchase, thereby reducing the potential of custodial risk considerably.
Ownership of gold or silver via an exchange traded fund is not the same thing and it is important to understand this. You are relying on someone to tell you that the gold is there with no real means to check that that is indeed the case. Custodial risk increases when you are relying on a third party and increases again every time another third party becomes involved.
What needs to be closely looked at when it comes to an investment portfolio is direct ownership of assets. Physical possession of gold and silver fits that category, cash (the folding stuff as opposed to digits on a bank statement) fits that category, free and clear title to ones house and to other 'useful' assets also fits that category.
All else -- such as stocks, bonds, mutual funds, retirement plans, money on deposit, gold held on behalf, etc -- are subject to various degrees to both custodial and counter party risk.
Obviously it is difficult to avoid these risks, but it is possible to reduce them. The first step is to acknowledge that they do indeed exist. Once this is done then ones portfolio should be looked at from the point of view of direct ownership, followed by how safe is the custodian of ones other assets and what is the quality of the actual asset?
Equally relevant is how safe is the currency the assets are denominated in. Currency risk is the other risk investors face that is often overlooked. Given that the dollar is officially not redeemable by its issuer for anything other than more dollars, one may find that in the great fiat casino we call central banking the chips one is now using may become unwanted by other participants.
An understanding of the three C's of risk (custodial, counter party, and currency) should help determine what one owns that can be deemed 'safe'. The ownership of gold and silver certainly lessen the risk associated with all three.
Then there is the derivatives market, something we hear about but do not appreciate the size (now estimated to be in the trillions of dollars), the complexity or the implications associated with it. What effect will a blow up in this market have on the participants, the same participants who are acting as custodians of other peoples assets which, as Refco has clearly demonstrated, can become encumbered over night?
Refco has it seems caught some very astute investors by surprise, even those who I am told did their own due diligence at the time of the IPO and missed the dangers lurking within. What does this tell us? Whoever hid the ticking time bomb within the balance sheet did a very good job is what it tells us. How many others are out there ticking away?
Where is the complexity in an ounce of gold?
In recent conversations with some hedge fund managers I have been hearing about the need to increase due diligence on all 'investments' while at the same time I am hearing that the number of hedge funds is itself the problem, all trying to return a paper profit. Indeed 'investments' are now very difficult to find while 'speculations' are everywhere. But can a hedge fund manager actually discriminate between the two or does it matter at all? One would have thought that due diligence should start with the quality of the product and not the short term result it may or may not offer.
One can do as much due diligence as one cares to do on a craps table at a casino but at the end of the day the game of craps is still a gamble, always was and always will be. The amount of due diligence won't change this fact nor will it affect the outcome.
Perhaps there has been, over the last few years, a hidden role reversal, in the sense that investments have become 'speculations' and speculations are now offered up as 'investments'. Hedge fund managers may well be closet cross-dressers for all I know and their clients may very well be trying to do due diligence on something that is not what they think it to be, which might explain the difficulty they now appear to face.
Trying to obtain a return from the stock market has not been easy as it has on the most part traded sideways for 5 years, money on deposit offers little by way of return, while gold has nearly doubled since the low of 2001. Commodities certainly have increased in price while 'traditional' investments, apart from the over-inflated housing market, have done little.
Is the dramatic increase in hedge funds, along with the explosion of the derivatives market, a case of keeping alive a brain-dead entity that is slowly decaying anyway?
What else can be repackaged and sold as this week's special, as the next 'hot' market while the speculators continue to play a game that ended in 2000, mopping up the remaining cash credits held by the gullible?
One thing is for sure and that is that in light of the Refco debacle, most investors portfolios do need a closer inspection, one that takes into account custodial, counter party and currency risk issues, sooner rather than later. Perhaps one needs a distinction between a useful asset and a 'might be' useful asset.
The Prof can be contacted by email at firstname.lastname@example.org
Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.
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