Andrew Maguire's revelations and subsequent testimony at the CFTC hearing, which basically conceded that 100 times more gold is traded than actually exists, will eventually produce a massive short squeeze in physical gold. A short squeeze means that players who are 'short', i.e. those that owe gold to someone else but don't actually have any, will be forced to buy gold on the spot market to honour their contracts. Either that or default. We think there will at some point be a scramble for physical metal and the price will surge higher. This will happen because gold is like no other asset. The whole reason you own it is to avoid counterparty risk. Gold is a store of wealth and by owning physical gold you are not relying on the solvency of any other party. So while some might think that $100 of outstanding claims on gold versus $1 of actual gold availability is ok because that's how other markets operate miss the point completely. They say the leverage inherent in the gold market is ok because if short sellers cannot deliver, 'cash' settlement is always available. But gold is the ultimate form of cash, and those owning physical gold do so because they want to diversify away from paper currencies. Why would they settle for a paper cash settlement? Up until now, hedge funds have been predominant in the gold futures market and they have been willing to settle for cash. They have simply been playing the theme that increasing monetary disorder will be good for gold. In other words they have participated in the gold bull market without actually owning bullion itself. But that might be about to change. Recent revelations have highlighted a weakness in the market structure. In financial markets, weaknesses eventually get exploited.

We believe more and more large gold investors will begin to take delivery of their bullion to ensure that they actually possess what they own. The benefits of having 'exposure' to gold (via the futures markets or in unallocated accounts) without the costs of storage, insurance etc will soon be outweighed by the risk of not actually owning gold when its most needed. This move to take possession or have gold securely stored has already begun on a small scale but it will intensify. Physical gold will slowly diminish in circulation, producing the short squeeze discussed above. This process is known as Gresham's Law, named after 16th century English financier Sir Thomas Gresham. Its basic premise is that bad money drives out good money. It's happening right now and will continue to do so.

Greg Canavan
for The Daily Reckoning Australia