Leverage is an obvious two-edged sword when used in investment portfolios. The credit obligation incurred enables you to acquire a larger position, which adds tremendous upside profit potential, but only with considerable risk. Therefore, leverage is not for everyone.
If you are one of those intrepid individuals seeking to use leverage to build your portfolio, there are different ways to do it. These are well known and varied and used in just about every market imaginable, but regardless of how and where they are applied, they all boil down into four basic types: futures contracts, forward contracts, options and swaps. These four are popularly referred to as derivatives.
The risks associated with derivatives have never been better stated than by Warren Buffett in his 2002 letter to Berkshire Hathaway shareholders:
“The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear…derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
That warning is clear and well stated, but what makes derivatives so dangerous? The answer lies in the following quote also from Mr Buffett’s 2002 letter:
“We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside.”
What he is saying here is very important. His warning about derivatives is not directed toward the leverage they make possible. After all, leverage is a tool, and like any tool, it has a use and can be helpful when used properly.
Instead, Mr Buffett’s words of warning are directed at the counterparty risk arising from the “uncollateralized receivables” that is created by derivatives. This counterparty risk caused the 2008 financial collapse when banks and other financial firms could not fulfil their promises arising from the derivative contracts for which they were obligated, which reminds me of another adage from Mr Buffett:
“Only when the tide goes out do you discover who's been swimming naked.”
So, let’s apply Mr Buffett’s insight to a Comex gold futures contract for 100 ounces of gold with a face value of $130,000 and the $10,000 of margin you deposit with your broker to demonstrate your financial capacity and commitment. If the gold price were to rise to $1400, the contract’s value rises by $10,000, and you have doubled your money*. But what if the tide goes out and your broker gets swallowed up in a financial catastrophe like happened to Lehman Brothers?
You have the uncollateralized receivable that Mr Buffett warns against.
So, the term “derivatives” is well chosen. A futures contract on gold is not gold. An option contract on silver is not silver. Derivatives derive from the underlying asset, but they are not the asset themselves, and when you use them, you have counterparty risk. Importantly, this risk can be avoided, yet still provide the means to leverage your gold and silver portfolio. This is where Lend & Borrow Trust Company Ltd. (“LBT”) can help.
I created LBT as a peer-to-peer online lender to enable investors to leverage their gold and silver without using derivatives and without incurring the counterparty risk that comes from them. It is a very simple process in which transactions are made only with physical gold and physical silver.
Your precious metal in Goldmoney is pledged as collateral, and you can borrow up to 65% of the market value of that metal. Here’s an example of how it works.
Let’s assume you have five kilobars of gold stored with Goldmoney in London or Hong Kong (other vaults will be added over time). Those bars have a current market value of $208,980, and you want to borrow $100,000, which is 47.9% of their value. You enter a proposal to borrow in an online auction stating your preferred interest rate and maturity.
The loan is advanced if a lender agrees to lend, and why wouldn't they, knowing that the pledged gold provides them with security if the borrower defaults. LBT controls the gold as agent for the lender, and will sell the amount needed to make sure the lender receives the interest and repayment of capital that is due. Thus, the lender earns interest income outside the banking system.
So, the lender avoids counterparty risk as well. It is the risk that comes from depositing your money in a bank.
More information about using physical gold and silver to borrow and lend in five national currencies (GBP, USD, CAD, EUR and CHF) outside the banking system is available here: www.lendborrowtrust.com
Endnote: To learn more about using leverage with your gold and silver, please read: “Leveraging Your Gold & Silver”
*If the gold price fell, you would incur a loss. To point out the risk of leverage, you would lose $10,000 if the gold price fell to $1200.