An asset that reflects the price of silver while not being silver itself; it’s not backed by real metal, so it’s considered to exist only on paper.
Holding paper silver enables one to get exposure to the price of silver without having to possess the physical metal and is considered more useful for trading purposes than for long-term investments. Examples of paper silver include: silver certificates, pool accounts, silver futures accounts, and most exchange traded funds (ETFs).
Paper Silver Instead of Physical Silver - Why?
The first answer is that you might want to avoid storage costs. If you invest a sizeable part of your capital in physical bullion, you might not want to keep your metal at home (you’ll need a safe and perhaps other additional equipment). In this case, you might prefer to choose a custodian – an institution that stores your metal for you. This storage service is not free of charge (neither is transportation to the storage facility, nor its insurance), so you need to take this cost into account, and it diminishes your returns on silver. By buying paper silver, you get a paper that more or less reflects the price of silver and allows you to avoid the cost and headache of storage.
Is Paper Silver Safe?
You might ask yourself whether it is reasonable or safe to invest in paper silver if you do not actually possess the metal you bought. This is an important question, because by buying paper silver you get exposed to counterparty risk (the risk that your transaction partner will fail to fulfill their promises).
In short, that’s OK if you use only a small portion of your capital for purchasing paper silver (for instance by speculating on its price moves), but it may become problematic if a large amount of capital is at stake (long-term investments). For example, if you buy a silver ETF share, you get a paper that trades roughly in the same direction as silver does. You may sell it to any other investor just like a stock and receive money. Please note, however, that most ETFs do not allow redemptions in silver. In other words, if you want to sell your ETF shares, you will not be able to exchange them for silver.
The ETF tries to make the price of its shares trade without direct connection to the demand for these shares. If many investors are willing to buy shares of a particular ETF, the price of these shares will most likely go up. In such a situation, an ETF (along with its partners) issues more shares to weaken the price pressure and backs the new shares with physical silver or some kind of derivative on silver (like futures contracts). As a result, an increased demand for the shares of an ETF will result rather in an increase in share numbers than in the surge in the price of a share. Conversely, if the demand for these shares is low and pulls the price down, then the ETF (and its business partners) will sell a part of its physical holdings and use the acquired cash to redeem existing shares. Such an action limits the supply of shares and pushes the price back up.
The above mechanism is important, as concerns have been raised that ETFs may not have all of their shares backed with physical silver. This would mean that the overall value of shares issued by a given ETF exceeds the value of silver this ETF holds. At first, it may seem of little relevance, as you usually cannot exchange your shares for silver with the ETF. However, after a short consideration, such a situation begins to look unsettling.
The main reason is that when you want to exchange an ETF share for cash, the ETF (and its partners) has to obtain this cash to redeem your share. If the ETF holds physical bullion, it may simply sell an appropriate part of its holdings to get the desired amount of money. On the other hand, if it does not hold physical bullion and runs out of cash (for example because of a default on the futures market), it may not be able to pay you for your share – and this would be a default of the ETF. In this case you would lose your money instead of gaining it by selling silver at a very high price.
As long as the demand for ETF shares is sound and you are able to sell them to other investors (and not to the ETF), even ETFs without enough physical silver will manage to make good business. However, if there is a default in the silver derivatives and/or silver declines and/or the demand for these shares falls significantly, it may turn out that such ETFs are unable to redeem all of their shares. The less physical silver the fund actually holds, the higher the probability that in an extreme situation you may find yourself out on a fragile limb.
The Golden Rule for Silver Investing
If you invest in silver ETFs it is crucial to choose either the funds that allow redemptions in silver (there are only a few such ETFs) or those that have their shares fully backed by silver. Apart from that, you should always remember about diversification – in this case it would mean holding both physical silver for long-term investments and non-physical (futures, options, ETFs, pool accounts, certificates) for small, quick trades. If the derivatives market collapsed, then the rocketing price of your physical holdings would more than compensate for the losses on the speculative paper silver. This is why diversification is important in this case.