Since their launch, about five years back, Gold Exchange Traded Funds (ETFs) have been a preferred form of investing for many investors. This is reflected from the fact that the assets under management (AUM) for gold ETFs have crossed Rs 100 bn mark over the last five years. However, it seems that there are some hindrances in the current structure for the instrument to prosper further. Thus, some reforms are required to gain further market acceptance.
Let us have a look at the problem area's first. It may be noted that gold ETFs are required by regulation to hold physical gold only with no lending clause attached to it. And this results in opportunity cost foregone from loaning out the asset. True, that by the virtue of it, ETFs are structured to give investors exposure to gold without any undue risk. But when the ETFs hold gold in their vault they lose out on possible income arising from lending out the same. It also increases the storage cost. So, without any additional income investors actually lose out on some proportion of their gold return.
So, what could be the solution for this? It is simple. Allow ETFs to lend gold to credit worthy borrowers in a safe manner. There is a huge market for this in India. The potential borrowers of gold could be jewellers who have to stock huge amount of inventory. They can pledge rupee fixed deposits (FD) as collateral.
However, the said mechanism is exposed to the risk of default by the borrower. This can happen if the FDs are not of a sufficient amount to cover up as collateral. Hence, the lending norms have to be extremely stringent. One solution could be that the ETFs lend only to bullion banks who in turn can lend to these jewellers. Another option is to lend gold through stock exchanges. While the exact mechanics of the same may take some time to evolve it reduces the concentration risk of lending gold to a few banks.
Thus, it can be seen that the lending risk can be curbed to a certain extent though various measures. Also, if lending is allowed the ETFs could earn extra income which could eventually be given to the investors as dividends. If not, the storage cost would hurt investors' returns and the market acceptability of the instrument may eventually fade.