Paper gold (Part 3): When trust erodes, physical gold gains prominence

In the first two parts of this series, “paper gold” is described as a product that meets market demand. From domestic over-the-counter transactions to derivatives contracts in international markets, the common thread is that the exchange no longer relies on physical assets at present, but on future commitments.

These systems can operate stably for long periods because many participants do not require delivery of physical assets. They buy and sell contracts to hedge risk or seek profits from price fluctuations, and close out positions before any delivery obligation arises.

This creates a fragile equilibrium. When the amount of “paper gold” far exceeds real gold, the system can still function normally as long as demand for converting into physical gold does not spike—meaning stability depends on participant behavior.

The key question is what happens if human behavior changes and the assumption about how many people want to deliver physical assets is no longer valid.

When trust is gone, the state must intervene

The answer can be found by looking at the history of finance. In the early 20th century, the US banking system operated on the gold standard. Depositors could demand conversion of fiat money into physical gold at a fixed price. However, banks kept only part of their gold reserves and used the rest to lend, reflecting the fractional reserve principle.

This structure supported credit expansion and economic growth when withdrawals were modest, but it became fragile when confidence waned. During the Great Depression, confidence in the banking system and fiat money collapsed, and people withdrew gold en masse. Because banks held only a fraction of reserves, they could not meet demand, triggering a cascade of bankruptcies that froze the economy from 1929 to 1933.

Under the gold standard, money creation required gold first. To address this, President Franklin D. Roosevelt signed Executive Order 6102 on April 5, 1933, just a month after taking office. The order prohibited American citizens from holding gold valued above $100. People had to surrender gold holdings exceeding $100 to the Federal Reserve by May 1, 1933, in exchange for paper money at a fixed price of $20.67 per ounce.

The $20.67 per ounce figure had been fixed since the Gold Standard Act of 1900, far below the market price in 1933. People had no right to bargain or negotiate: they either sold gold at the fixed price or faced penalties up to $10,000 (equivalent to more than six years’ average wages at the time) and up to 10 years in prison.

After the government amassed gold from the public at the low price, it revalued gold from $20.67 to $35 per ounce. On August 9, 1934, Roosevelt followed with Executive Order 6814, requiring individuals and organizations holding silver bars to deliver them to national mints within 90 days. Those who defied faced penalties equal to twice the value of the silver held, along with up to six months in prison.

Within 90 days, the Treasury collected 109 million ounces (about 3,100 tons) of silver from private hands. The Silver Purchase Act of 1934 then allowed the Treasury to buy silver on the world market to raise reserve ratios, and the Treasury’s large purchases pushed global silver prices higher.

The objective of these policies was to recover gold and silver and restore control over the monetary system. Concentrating gold and silver at a single point enabled authorities to expand the money supply more actively and stabilize the financial system. The 1933 confiscation illustrates that when trust is broken, markets cannot operate smoothly and administrative intervention becomes a last resort.

In modern times, financial systems have developed sophisticated risk-management mechanisms, yet “paper gold” models continue to appear in various forms.

Modern examples of “paper gold” risk

In India, gold mobilization programs and gold savings expanded during the 2010s. Customers could deposit money and receive gold after a certain period. However, some businesses struggled when gold prices moved sharply or cash flow was insufficient to meet obligations, leading to delivery delays or failure to fulfill commitments.

In the Middle East, especially Dubai, gold forward transactions are common in the retail sector. During periods of major volatility—such as the 2008–2009 financial crisis or the 2020 supply-chain disruption—some traders had to extend delivery times or adjust contract terms due to uncertain supply.

These cases did not trigger systemic crises, but they reflect a shared theme: when trading is detached from physical gold and silver, risks can surface when obligations come due.

Three layers of risk under “paper gold”

Trading “paper gold” hides three core risks.

• Liquidity risk: Assets may exist on the books but cannot be converted into physical gold quickly when demand surges.
• Counterparty risk: When trading is based on a promise, the other party’s ability to fulfill the obligation becomes decisive.
• Risk of trust: When participants begin to doubt the ability to fulfill commitments, behavior can shift en masse, turning latent risk into an actual event.

These risks interact and can amplify each other. A liquidity shock can erode trust, and loss of trust can increase liquidity pressure.

Three policy choices: ban, laissez-faire, or regulate?

Returning to the domestic market, trades of “paper gold” are described as not yet large enough to pose a systemic risk. The central issue is how to manage risk when it arises.

In spontaneous trades, there is no margin mechanism to cover losses over time, no intermediary to guarantee settlement, and no explicit procedures for handling defaults. If a problem occurs, the current system lacks “safety valves” to mitigate impact.

Regulators typically have three options:

• Ban all forms of derivative-like trading: This can reduce short-term risk but does not eliminate market demand; activity may move to informal channels where risk is harder to control.
• Let markets self-adjust: This allows flexibility and innovation but risks accumulating in an under-supervised environment.
• Create a regulatory framework: Trades would occur within a controlled system, including standardized contracts, margin requirements, and an intermediary to ensure settlement.

In Vietnam, proposals to list and trade silver on the Vietnam Commodity Exchange are presented as a step toward the third option. Rather than eliminating “paper gold” entirely, the goal is to bring trading into a framework that can be managed.

Bottom line

The overarching message across the three parts of this series is that “paper gold” is a natural consequence of market development: as trading demand grows, new financial instruments appear to meet that demand. The issue is how risk is allocated and managed. In developed markets, risk is spread, diversified, and continuously managed through financial mechanisms. In developing markets, risk can accumulate and only become visible when obligations come due. Regulators’ choices will determine market stability.