The Indian government is considering tighter regulation of “digital gold,” including requiring that all digital products be backed one-to-one with physical metal.
The fact that this isn’t already a requirement should give you pause.
With digital gold products, investors can buy and sell ownership of physical metal electronically. The digital gold provider stores physical gold in a vault on the owner's behalf. You technically own the gold, but you don't physically possess it. Digital gold allows quick transfers between accounts and facilitates fractional gold purchases. Some digital products allow investors to take physical possession of gold under certain circumstances. Others do not.
The downside is you don't have physical possession of the metal, and there's no guarantee the provider has all the gold either.
Last year, the Securities and Exchange Board of India (SEBI) warned that digital gold products fall into a regulatory crack since they are “neither notified as securities nor classified as commodity derivatives.”
“Such digital gold products may entail significant risks for investors and may expose investors to counterparty and operational risks."
And SEBI emphasized, “They operate entirely outside the purview of SEBI."
That may soon change with a regulatory structure run jointly by SEBI and the Reserve Bank of India.
A bank official who asked not to be named told the Times of India, “There is a consensus among all stakeholders that digital gold has gained acceptance among investors, and currently it is an unregulated segment which should be brought under the supervision of regulatory authorities.”
According to the Times, "The government is considering stricter regulations for digital gold, including a requirement that every unit be backed by physical bullion."
Stop and think about what that means. Currently, Indian law doesn't require digital gold providers to back their product with actual metal. That means they could run a fractional reserve system with only a small amount of gold on hand. That’s all well and good until everybody wants to take physical possession of their gold at the same time.
The situation isn’t much different in the U.S.
The United States has no uniform federal requirement that all digital gold products be backed ounce-for-ounce by physical bullion. However, individual products may provide that backing and operate under regulatory oversight, depending on the product's structure and jurisdiction.
Interestingly, digital gold platforms in India have already created a self-regulatory organization called the Digital Precious Metals Assurance Council of India. According to the Times, several of the largest platforms have joined.
MMTC-PAMP ranks as one of the largest digital gold companies in India and has joined the DPMAC. Managing Director Samit Guha conceded “the digital gold and silver ecosystem in India needs some regulatory oversight urgently.”
He said the council will help standardize processes for purchasing, selling, and storing gold.
This underscores that while digital gold products are convenient, they come with significant counterparty risk.
In simple terms, it is the possibility that the party on the other side of a transaction might not fulfill its obligation. Specifically, it means the digital gold custodian might not actually have all the gold it claims.
Government and private regulation can minimize counterparty risk to some degree, but it can’t eliminate it. As long as there is a party on the other side of a transaction, you’re taking on risk.
On the other hand, physical gold and silver carry no counterparty risk, as no party stands on the other side of a gold or silver bar. You only take on counterparty risk if you store your bullion in an outside depository.
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