South Korea recently announced plans to increase its gold reserves, but to date it has only acquired a different kind of paper.

According to a U.S. Securities and Exchange Commission filing, the Bank of Korea purchased 679,765 shares of the SPDR Gold Trust ETF during the second quarter. The central bank's ETF holdings were valued at ₩354.5 billion ($250.41 million) at the end of June. The purchase stands out because direct purchases of gold ETFs by central banks are uncommon; monetary authorities have historically preferred allocated physical bullion held in their own name.

ETFs offer a convenient way for investors to gain exposure to the gold market, but owning ETF shares is not the same as holding physical gold. An ETF represents a basket of investments that trades as a single entity on the market. It can track a single commodity, such as oil, or hold a wide range of assets such as tech stocks; the mix of securities in an ETF is limited only by one's imagination. Like stocks, ETFs are sold in shares on an exchange, with prices rising and falling throughout the trading day as they are bought and sold, just like a stock or bond.

A gold-backed ETF generally tracks the price of gold, but other dynamics come into play, so the correlation is not one-to-one. Most significantly, while a gold ETF is a convenient way to play gold's price, the holder does not possess any gold—only paper. Nor can one be certain that the fund holds all the gold it claims; investors are taking the fund's word for it. This is especially true when a fund experiences rapid inflows, a scenario in which there have been difficulties or delays in obtaining physical metal.

The SPDR ETF is the largest gold-backed fund in the world. The U.S.-based fund holds gold in New York and London.

"Amid heightened geopolitical risks, interest in gold as a safe-haven asset has grown, and we determined that the BOK needed to increase its relatively small gold holdings," Bank of Korea Reserve Management Group Director Jung Hee-sup said.

However, that is not what the central bank is doing. It is not buying gold; it is buying paper backed by gold—trading one set of counterparty risks for another.

Counterparty risk, in simple terms, is the possibility that the party on the other side of a transaction might not fulfill its obligation. For instance, if one loans a friend $200, there is always a chance the money will not be repaid; that possibility is the counterparty risk being taken on.

ETFs introduce a high level of counterparty risk. The ETF could have trouble sourcing metal and may not be backed to an appropriate level. The fund could be mismanaged or even closed down. Other parties could block access to the fund or confiscate shares. In other words, buying an ETF introduces many of the same risks central banks are trying to avoid by holding gold.

Central banks are accumulating gold to shield themselves from the counterparty risks inherent in the dollar. They are worried about America's fiscal malfeasance and its ever-increasing debt, as well as the weaponization of the dollar and the prospect of the U.S. using its currency as foreign policy leverage. Buying a U.S.-based gold ETF is, in this view, a little like jumping from the frying pan into the fire. The broader buying trend is well documented: according to World Gold Council data, central banks worldwide have been purchasing gold at historically elevated annual rates in recent years, including record annual volumes earlier this decade, driven largely by reserve diversification away from the dollar.

South Korea does have plans to increase its physical gold reserves. Earlier this month, it announced a framework to purchase gold from South Korean miners at international spot prices. The Korea Exchange and the Korea Securities Depository will facilitate the transactions, with domestic gold producer LS MnM and Korea Zinc supplying eligible gold. The two Korean gold miners produce 4 to 5 tonnes of gold annually. Officials say the Bank of Korea will purchase some of that output "when market and reserve management conditions are favorable."

The structure of the scheme will allow the Bank of Korea to settle transactions in Korean won, meaning it will not have to draw on its foreign exchange reserves. The gold will reportedly be stored in South Korea; most of the country's gold reserves are currently held in London vaults. Domestically stored, won-settled bullion would address precisely the jurisdictional and counterparty concerns raised about the ETF holding.

The last time the Bank of Korea expanded its gold reserves was 13 years ago. The country currently holds just over 104 tonnes of gold, about 1.1 percent of its total reserves—a share well below that of many peer central banks, where gold typically makes up a substantially larger portion of official reserves.

Korea Investment and Securities analyst Jung Hyun-jong said the central bank's renewed interest in gold is part of a broader trend in South Korea.

"In the past, jewelry demand accounted for more than half of the gold market, but the shares of investment and central bank demand have increased sharply in recent years. This suggests that gold is shifting in status from a simple consumer commodity to a financial asset and an alternative currency that can serve as a hedge against geopolitical risks, inflation, and currency depreciation."

The article was written by Mike Maharrey and published by GoldSeek.