Paper Promises vs Physical Reality

Why the growing gap between derivative and physical precious metals prices matters for every Australian investor

Gold has just breached US$5,000 per ounce. Silver touched a record US$121 in January before a violent correction. Behind the headline numbers, a more important story is unfolding. The price you see on a screen is increasingly not the price you pay for real metal. Understanding why is essential for anyone holding, or considering, precious metals.

If you follow gold and silver markets, you are used to hearing about the “spot price”. That number, broadcast every second on trading terminals around the world, is in reality a derivative price. It is set in the paper markets: COMEX futures in New York, the LBMA in London, and other financial venues where hundreds of billions of dollars’ worth of notional metal trade every day without a single bar moving between vaults.

Physical bullion, the coins and bars you can actually hold, exists in a different world. It must be mined, refined, minted, shipped and insured. Right now, the gap between these two worlds is wider than at any point in modern history.

 

What Are Derivatives, and Why Do They Matter?

A futures contract is an agreement to buy or sell a specific quantity of metal at a set price on a future date. One standard COMEX gold futures contract represents 100 troy ounces, while a silver contract covers 5,000 ounces. These are binding obligations. If held to expiry, the contract requires delivery or acceptance of metal, though the vast majority are closed out or cash-settled beforehand. Futures require only a margin deposit, typically 5 to 10 per cent of the contract value, giving traders significant leverage.

Options sit one step further removed from the physical market. A call option gives the right, but not the obligation, to buy at a set price. A put option gives the right to sell. The buyer pays a premium upfront, and the maximum loss is capped at that premium. Pricing is governed by what traders call “the Greeks”: delta, theta, vega and gamma.

This matters because options lose value simply with the passage of time, even if the metal price does not move. They are, by definition, wasting assets.

The key distinction is straightforward. Futures provide price exposure. Physical metal provides possession. In calm markets, the two track closely. In stressed markets, they can diverge sharply.

 

The Divergence Is Real and Growing

In normal conditions, a one-ounce gold coin might trade 2 to 5 per cent above spot, and a silver coin perhaps 5 to 10 per cent above. These are reasonable allowances for fabrication, shipping and dealer margins. Those conditions no longer apply.

At the start of 2026, physical silver premiums in parts of Asia reached extraordinary levels. In Singapore, one-kilogram silver bars were reportedly priced around 14 per cent above spot. In Japan, secondary-market premiums surged to roughly 60 per cent. In the UAE, premiums approached 40 per cent. Even large “Good Delivery” bars, the institutional standard, were trading at premiums of 6 per cent or more. Only a few years ago, such levels would have been unthinkable.

On the Shanghai Gold Exchange, physical silver has traded at a persistent 12 to 13 per cent premium to LBMA and COMEX pricing. This signals that the physical market is increasingly asserting leadership over the paper benchmark.

Silver’s January 2026 spike to US$121, followed by a rapid fall into the low US$70s, a near 40 per cent decline in days, was itself a demonstration of paper-market volatility. The CME Group raised margin requirements multiple times to contain the move. Critically, physical prices did not fall nearly as fast. As paper silver dropped, physical premiums widened further because the underlying scarcity of metal had not changed.

The price you see on a screen might not be the price you pay for a coin in hand. When paper and physical diverge, it is the metal in your hand that tells the truth.

 

Why Is Physical Metal in Short Supply?

Five years of silver deficits

According to the Silver Institute, 2025 marked the fifth consecutive year of structural deficit in the silver market, with demand exceeding supply. The cumulative shortfall from 2021 to 2025 is estimated at nearly 820 million ounces, roughly equivalent to a full year of global mine production. That gap has been filled by drawing down above-ground inventories such as exchange warehouses, bank vaults and ETF holdings. Those buffers are now shrinking.

COMEX registered silver inventories have fallen by roughly 70 per cent since 2020. LBMA vault holdings are down around 40 per cent. Silver lease rates, the cost of borrowing physical metal, spiked from a typical 0.3 to 0.5 per cent per annum to as high as 35 per cent during periods of tightness in 2025. By January 2026, one-month lease rates were still around 8 per cent, signalling ongoing difficulty sourcing deliverable metal.

 

China’s export controls

From January 2026, China introduced strict new export controls on refined silver, reclassifying it as a strategic resource. Only large, state-approved producers with at least 80 tonnes of annual capacity are permitted to export, and only under special licence. Hundreds of smaller exporters, previously key suppliers to the global market, are effectively shut out. As the world’s largest silver refiner, China’s move has tightened supply at precisely the wrong time.

Insatiable industrial demand

Unlike gold, which is primarily held for investment and jewellery, silver is a critical industrial input. Solar photovoltaics, electric vehicles, 5G infrastructure, defence systems and AI hardware all consume silver in volume, with limited substitution options. Industrial demand accounts for roughly 60 per cent of total silver usage, and these sectors are receiving substantial government investment worldwide. This demand profile does not moderate simply because prices rise.

 

Central banks hoarding gold

On the gold side, central banks purchased 863 tonnes in 2025, according to the World Gold Council. While down from the 1,000-plus tonne pace of 2022 to 2024, this still represents the fourth-largest annual accumulation on record and remains well above the 2010 to 2021 average of 473 tonnes. Poland alone added 102 tonnes, with Brazil, Kazakhstan, Turkey and the Czech Republic also notable buyers.

Perhaps most tellingly, gold overtook US Treasuries in late 2025 to become the world’s largest reserve asset by value. When the institutions issuing the world’s currencies favour physical gold over paper instruments, it says a great deal about where we are in the cycle.

 

Backwardation: The Market’s Distress Signal

Under normal conditions, futures prices trade slightly above spot to reflect storage and financing costs. This structure is known as contango. When that relationship inverts and spot trades above futures, a condition called backwardation, it signals that immediately deliverable metal is scarce.

Silver has repeatedly entered backwardation since late 2025. The message is clear. Metal available now is worth more than a promise of delivery months down the track.

 

What This Means for the Paper Market

Derivative markets rely on an implicit assumption that most participants will never demand physical delivery. Contracts are rolled, offset or cash-settled. The system functions smoothly until confidence begins to falter.

Estimates vary, but the ratio of paper claims to physical metal in some venues has historically been extremely high. As long as only a small fraction of holders stand for delivery, the structure holds. When more participants do so, strain emerges. The dynamic closely resembles a slow-moving bank run.

For bullion banks, the institutions acting as market makers and often carrying large short positions, a severe physical shortage is particularly dangerous. If clients demand metal that cannot be sourced, outcomes range from expensive buy-ins to outright default. The Financial Stability Board has previously noted that precious metals derivatives are highly concentrated among a small number of dealers, amplifying systemic risk if disruptions occur.

If the gap between paper and physical prices continues to widen, one of two outcomes becomes likely. Either paper prices surge to meet physical reality, inflicting heavy losses on short sellers, or physical markets increasingly abandon paper benchmarks altogether, with miners, refiners and dealers pricing directly off physical exchange data. Both scenarios would be highly disruptive.

 

What Australian Investors Should Consider

None of this suggests futures and options lack value. They remain useful tools for hedging, trading and price discovery. Understanding their mechanics, from leverage in futures to time decay in options, is important for any market participant.

But current conditions reinforce a principle that has held across centuries. There is no substitute for owning the real thing.

Physical bullion carries no counterparty risk. It cannot be diluted through leverage or fractional-reserve practices. It does not expire, decay, or depend on the solvency of a broker, exchange or custodian. It exists outside the digital financial system, and that independence is precisely what gives it value when confidence in that system weakens.

The trade-offs are real. Physical metal requires secure storage, insurance and a buyer when you wish to sell. It is less convenient than an ETF and less liquid than a futures contract. But as 2025 and early 2026 have shown, when paper markets seize, it is the investor holding real metal who tends to sleep more easily.

The old saying still applies. If you do not hold it, you do not own it. In a world of US$5,000 gold, structural silver deficits and physical premiums that would have seemed implausible five years ago, that maxim has rarely felt more relevant.

For a deeper exploration of these dynamics, including what the current supply crunch means specifically for Australian investors and how to think about balancing paper and physical exposure, tune into our upcoming podcast episode, where we unpack these issues in detail.