London became the gold trading hub of the world entirely by accident. The Coin Act of 1696 was an attempt to move away from the silver coins that were slowly losing their value as people “clipped” the edges off them.

The problem was the Crown accidently overvalued gold with this Act, and the Royal Mint didn’t have enough silver to meet the market. Gold flowed to the London’s refineries but there was not enough money in circulation to sustain the economy.

The monetary chaos of uneven weights and prices lead to Sir Isaac Newton formalising the bi-metallic standard in 1717. Newton devalued silver when fixed its weight, to protect the Crown’s position. But the set purities and weights were appealing to many. In the early 18th century, several gold refineries were set up. Nearly 60% of the world’s gold was flowing through London.

The influx of gold needed to be stored and the Bank of England opened its first purpose-built gold vaults in 1732.

Three hundred years later, London remains the epicentre of the gold markets. The Bank of England vaults are now an eight-vault system spread over two floors deep under Threadneedle Street, where some £200 billion – or 8,000 odd tonnes – worth of gold is stored.

The Bank of England’s vaults are the prime choice for major central banks, bullion banks and gold-backed exchanged-traded funds (ETFs). London remains the deepest and most liquid gold market in the world, with the London over the counter (OTC) market responsible for 70% of all notional trading.

Aside from the city’s multi-century role as a gold hub, the UK’s stable rule of law continues to support London’s dominance in the gold market.

Missing gold makes for great headlines

Never let the truth get in the way of a good story, as my pop told me a couple of decades ago. This was a motto he lived by when it came to the retelling of his old copper and sailing stories. Fact and fiction often merged into his loud and enthusiastic tales.

These ripping yarns, therefore, were much like the gold industry.

While people who buy physical gold are naturally sceptical of governments, there are pockets of gold buyers that are a little more passionate than some. Fanatical even. They are convinced the entire sector is manipulated tick by tick…

… and nothing brings out the best (or worst) in them, like discussing where gold is stored.

Australia’s gold was shipped to London in the 1990s, and this has been a fire for gold bug conspiracy theories since the start of this century. And every now then, someone goes and pours petrol on it.

The week before Easter that petrol was confirmation from the Reserve Bank of Australia (RBA – the country’s central bank) confirming that it was sending two officials to London to complete an audit on Australia’s gold bullion stored with the Bank of England.

“Only 10% being counted? Outrageous,” they tweeted. “Bring it home” others demand. “What took them so long?” another commented. The first two are typical of gold bugs – although the latter question is valid.

A decade ago an Australian blogger noticed that the RBA wasn’t keeping an eye on Australia’s gold reserve. A couple of freedom of information requests later, the blogger wrote that the RBA had been leaving the auditing of Australia’s gold to the Bank of England. That seems pretty slack given that the metal had been shipped over 30 years ago.

The RBA now claims that it audits the gold reserves every six years. Any accountant would say that’s not often enough. That said, at least the RBA does appear to be getting its together. People should be outraged, though, that the RBA takes so long in-between counts.

Yet the anger at a 10% sample is misdirected. In fact, anyone latching on to this “10%” is proving how little they know about standard auditing procedures.

Sure, they’ll they’ll rack up some more social media followers, but raging about 10% proves they’ve got no clue on how firms are audited annually… let alone how the gold markets work.

How the bean counters do it

No auditor audits everything a company has. Rather they take a percentage sample size, then determine the acceptable margin of error based on the population being sampled. Ten per cent in any audit is generally the upper limit.

Then, the auditors will decide the confidence level – the degree at which the sample size will reflect the true value of the population.

The higher the confidence level needed, the bigger the sample size needs to be. The confidence level varies between 90% and 99%. Exactly which end of the range used is assessed by the controls of the environment, interviews and procedural walkthroughs. The more confidence an auditor has, the more likely he/she is to opt for the lower end of the range.

If the auditors find the error rate is higher than past audits, they’ll increase the sample size. Fails again, and more is sampled and so on, until the error rate begins to drop and reach past confidence levels.

Traditionally when the auditors come in, they take over a meeting room for a few weeks. They fill it with boxes. They nod at each other, drink coffee and stay late. That’s typical of a paper audit.

The RBA is doing a physical audit and that’s a whole different beast…

Vaults aren’t designed for ease of access

Have you been inside a gold vault? I have. It was one that’s a lot smaller than the Bank of England’s eight-vault system.

Let me tell you something about my tiny vault experience: they aren’t designed for ease of access. You’ve got multiple check points, body scans, clothing scans and hundreds of cameras on you that you can’t see.

They’re squishy and require discretion and most of all, patience. Lugging big heavy bars around takes time and hydraulic equipment.

Knowing this, now let’s assess the audit of Australia’s physical gold.

The RBA is coming in person, with a list of roughly 640 random bar numbers (10% of the total bars held in London) to check up on the 80 tonnes we keep there.

Assuming they are all 400 troy ounce bars, that’s 80 bars to a pallet. Each pallet holds one tonne, that means there’s 80 possible pallets where these random serial numbers might be found.

The Bank of England doesn’t know in advance what serial numbers the RBA will want. Plus, for security reasons, the RBA’s serial numbers are different to the internal serial numbers the Bank of England uses.

For the Bank of England, this is a needle in a haystack search. This is logistical nightmare for an operating vault that stores over 8,000 tonnes of gold from third parties all over the world.

Gold bugs may be demanding that every bar be audited, yet that’s nearly impossible inside an operating vault with constant inflows and outflows of gold. Oh, it’s also wildly out of touch with standard auditing procedures.

And the whole time, there’ll be two government bureaucrats sitting around on the taxpayers’ expense waiting for each bar to be located…

Don’t believe the memes

People should be critical of how the RBA has managed Australia’s gold reserves. Much further overnight is needed.

But the outrage at the size of the audit, or gold being stored in London is misplaced.

The real frustration is wasting the taxpayers’ dollar as two government boffins scored an all-expenses paid trip to the UK (business class, no doubt).

You see, most of the precious metal industry’s use independent third parties to audit their precious metal accounts.

Alex Stewart International and Bureau Veritas are the go-to gurus for the gold market. Both are used by gold-backed ETFs, bullion banks and other central banks to take stock of gold.

Both firms have offices in all the major metal hubs, including London.

Did anyone in the RBA think to get a quote from both and them compare it to the cost of sending two Aussies over to old Blighty for two weeks, maybe longer?

Clearly not. Because the economics favour using third parties that have offices just around the corner from the Bank of England.

More to the point, Alex Stewart and Bureau Veritas are probably more qualified to be carrying out the audit than two central bank boffins.

The real crime here isn’t the audit or the sample size. It’s the two central bank members on an international junket that Australians’ taxes paid for while ignoring the international industry standard of using a locally independent third party.

Of course, perhaps the real question is: what is the benefit of keeping gold in London and should Australia bring it back?

Let’s get into that one next time.

Until next time,

Shae Russell
Contributing Editor, Fortune & Freedom