This year marks the fifth anniversary of the ALROSA’s project to start exchange trading in investment diamonds. Of course, this attempt, like all the previous ones, was a failure. A number of similar foreign initiatives also failed almost at the same time. This gave reason for intellectually solvent analysts to insist again that it is impossible to use polished diamonds - and even more so rough diamonds - as an underlying asset for creating investment instruments. Rough or polished diamonds are not an exchange-traded commodity and never will be such, as the practice has shown. It seems to be an axiom. However, over the past five years, interesting trends have emerged in the industry, making us to look at the problem not so categorically.
However, let’s start with ... coffee. It may seem strange, but in our opinion, the market for this tasty product allows us to formulate a couple of useful and constructive analogies.
For many decades, coffee has been a full-fledged exchange commodity. Coffee beans are grown on four continents, but only five countries control 75% of their world production. The basic asset is green coffee beans of two varieties - Arabica and Robusta. The Arabica futures contracts are traded on the NYSE (New York), and the Robusta futures ones are traded on the European branch of the ICE (Intercontinental Exchange). The contracts are deliverable ones and traded by the coffee bean manufacturers, wholesale customers, importers, exporters, investment funds, and private investors. Some regional exchanges also participate in coffee trading, the spot market is significant as well, but the core of the market, the mechanism that sets price targets is the trade on the NYSE and ICE.
So, the underlying asset is the raw material, the green coffee beans. A priori, it is clear that Robusta beans grown, for example, in Vietnam, has some differences from the Brazilian Robusta beans, but the market players consider these differences insignificant. In other words, the underlying asset is standardized, and all the fluctuations in quality associated with the different climate of the producing country, its soil composition, agricultural technology used, etc., are recognized just as the standard’s tolerances. The intergovernmental International Coffee Organization (ICO) plays an important role in arranging such agreements. Elite coffee varieties that do not belong to the standardized Arabica and Robusta are not traded on the exchanges; however, this market is relatively small. Thus, the standardization of the underlying asset and sufficient market liquidity has made coffee an exchange commodity, and are two essential and sufficient prerequisites.
Now let’s move aside the cup with a fragrant drink and return to rough and polished diamonds. Unfortunately, standardization is, in principle, impossible. Over the past half a century, many attempts were made to develop “standardized polished diamond baskets” as the underlying asset for “diamond” derivatives, but they have all failed. The expression “there are no two identical polished diamonds” turned out to be quite true, to say nothing of rough diamonds. Unfortunately, the market has the liquidity required, and the standardization of the underlying asset is obviously impossible - and dreams of creating the “investment polished diamonds” regularly dissolve in the air like steam over a coffee cup. And we would like to make the dream come true! After all, this could ensure additional investments, pricing transparency, and accuracy, faster turnover, ample opportunities for speculative transactions, in the long run ...
But these remarks apply exclusively to natural rough and polished diamonds. As for synthetic diamonds, the situation is quite different. Can synthetic diamonds be standardized? No problem, today increasingly more lab-grown diamond manufacturers offer the jewelry market sets of stones ideally calibrated (standardized) in size, shape, color, and clarity. And the categorical words “there are no two identical polished diamonds” are easily replaced by “there are as many identical standard polished diamonds as you want”! But if we continue to draw the analogy with the coffee market, polished diamonds are the packs of coffee on supermarket shelves, a huge selection of different brands made using different roasting methods, with different caffeine content, etc. And this endless variety is made from only two types of standard exchange commodities. Could synthetic rough diamonds be an exchange commodity?
There are two methods to grow man-made rough diamonds: HPHT and CVD, one might say, the “Arabica” and “Robusta” of the diamond industry. The methods are competitive, the ratio of the respective goods on the market is about 3 to 1. The prime cost of the rough diamonds obtained by these methods is practically the same, but the yield (when cut and polished, KP57) differs by 10 percent in favor of the HPHT method. Aren’t these the two varieties of an exchange commodity? Really, each lab-grown diamond manufacturer has its own production know-how that gives some individual characteristics to the finished product, but since the methodological basis of the production is identical, the standardization is, in principle, possible, and the issue can be discussed by the major manufacturers. The manufactures based in five countries account for over 80% of the global production of gem-quality lab-grown rough diamonds. The International Grown Diamond Association (IGDA) is a platform for discussions and agreements - like the International Coffee Organization (ICO). Does anything prevent the lab-grown diamond manufacturers from agreeing on an exchange standard (maybe, several standards) for rough diamonds that are potentially most in-demand in the jewelry market? Moreover, the mechanism of the standardization of such an underlying asset presents no problems. (By the way, the pricing mechanism used at Lightbox is vivid evidence of the possible standardizing the synthetic diamonds). Like elite coffee varieties, large-sized diamonds need not be taken into consideration, as their amount is small, and the profitability is low. And today’s mass production (4-carat and 5-carat stones with a margin of about 50%) is quite suitable to be the basis for the exchange standard.
If such standards are created, the market for gem-quality lab-grown rough diamonds can get a tremendous development, since there will be no need for expert evaluation, and the speed of the goods movement in the “exchange diamond pipeline” will increase significantly. It is obvious that turning the rough diamonds into an exchange commodity also solves the issues of financing the industry - the banks will make their decisions based not on a complex (and often subjective) expert evaluation, but on the price of futures contracts.
However, a lack of liquidity hampers the attractive prospect. The gem-quality synthetic rough diamond market is still too small to become an exchange participant. For the same reason, gem-quality synthetic rubies and emeralds did not become exchange commodities. For example, pomegranate juice did not become an exchange commodity, either, but the orange juice futures contracts have been traded since the middle of the 20th century as the market volumes for these goods differ by several orders of magnitude. Today, about 10-12 mn carats of gem-quality synthetic rough diamonds enter the market annually. This is not enough. Perhaps, 30-40 mn carats is the volume of a market for the idea of exchange trading in synthetic rough diamond contracts to become a reality.
The critical question for the industry as a whole is whether the synthetic diamond market will grow due to the substitution of natural polished diamonds with lab-grown ones, or whether it will develop in a “parallel space”. As you know, there are two opposite points of view on this problem. Well, the coffee market did not immediately become an exchange one, either; it took rather long to “gain liquidity” or, to put it simply, to squeeze out the competitors. This process still continues today; for example, over the last five years, the coffee sales in China have increased by 2.5 times due to a decrease, of course, in the tea sales (and this happens in a country with a traditional tea culture!). The analogy, I think, is quite clear.
No matter, how the problem of competition is solved, the potential for the exchange standardization of the underlying asset is a significant advantage of the gem-quality synthetic rough diamonds over the natural ones. If there is a way to create “investment polished diamonds”, most likely, it should be looked for in this.
Sergey Goryainov, Rough&Polished
