Diamond Futures Contracts Belong To A Traumatic Past
August 07, 03In some banking corners one can discern whispering about the inevitable ultimate next step in commoditizing the polished diamond market: trading in futures of parcels of polished on commodity exchanges. Past attempts to encourage the commodization of the diamond business through the introduction of trading in future contracts -- and the resultant encouragement of private and public investors to invest in diamond contracts -- has led to wild price speculation and, when ever-rising prices plunged all at once, they led to disastrous consequences. Those who were affected most were consumer/speculators cum investors from “outside” the diamond world – though, unfortunately, it affected the diamond industry just as badly. In the aftermath of the great fall in diamond prices, exacerbated by a world recession and high interest rates, dozens of diamond companies together with numerous “diamond investment companies” went bankrupt.
Those who are enthusiastically supporting the reintroduction of such schemes ought to examine the reasons of past failures – and determine whether conditions have sufficiently changed to expect faring better this time around. The reasons for past failures include broad from wall-to-wall condemnation of a diamond futures market scheme by the trade and industry and the fervent opposition by the world’s dominant rough supplier, De Beers, to such schemes. If anything, the current policies of producers will prove to be an even greater obstacle then they were in the past. Lest we forget, it is worthwhile to recall some of the traumatic memories of the past.
In 1972, the (now-defunct) West Coast Commodity Exchange began trading diamond contracts in the United States (the qualities of a polished diamond were described in a certificate, and the diamond itself was sealed in plastic wrappers to avoid switching). Price manipulation by dealers, however, doomed the contract. Traders went short en masse, driving down prices. Speculators with long positions, unable to meet margin calls, began to liquidate positions. The market closed within weeks. In the early 1980’s, following the development of grading systems, grading laboratories and price lists, the diamond futures markets were actively promoted by the New York Commodity Exchange (Comex), the Chicago Mercantile Exchange and the London Commodity Exchange. [The chief interested party from within the diamond industry promoting the Comex scheme was Martin Rapaport, who formally acted as consultant to the Exchange.] Our files even include a confidential business plan for Diamond Futures Contracts on a Geneva International Diamond Exchange (GIDEX). All existing schemes had different criteria for what constituted a trade-able parcel.
The London Commodity Exchange, for example, had developed some 85 different parcels of polished diamonds, with each parcel responding to a different description, with different size of diamonds (weight), color ranges and clarity. In the London contracts, polished diamonds (as in the Comex system) were based on parcels consisting of 10 polished diamonds, with a minimum contract size of 10.10 carats, with no individual diamond exceeding 1.2 carats. The minimum contract could be expanded to a maximum size of 12 carats, in which event, the contract price was adjusted accordingly. The proponents of contemporary schemes assume that, often, parcels will never actually change hands, but contracts “cashed in” or renewed, while serving an important hedging tool for the polished diamond traders. Don’t hold your breath – actual delivery is a complex, problematic and potentially costly exercise.
In the past elaborate systems were created for the “delivery” of physical parcels. These parcels (in the case of Comex) had to be submitted to a Comex representative (who will issue a temporary receipt), the party making physical delivery was required to pay a non-refundable verification fee. A lab would take five days to complete a verification procedure. Then the party making physical delivery was issued a warehouse receipt to be used to satisfy the delivery procedure. The way it was supposed to operate was that physical contract delivery would be accomplished by delivering a valid warehouse receipt to the appropriate Comex official. The holder of the warehouse receipt will be the sole owner of the diamonds in the depository and may at any time withdraw the diamonds from the depository.
In all fairness, from a technical, organizational, structural perspective, a futures market in diamonds in not an impossibility. Diamond grading has become far more sophisticated and precise. Whether the retail market or polished wholesalers need futures is a different matter: in fact, he gets financed by his supplier and large stocks are held on a memo basis. The need for hedging doesn’t seem urgent. In the 1980s futures schemes were developed when the commodization of diamonds was perceived as an opportunity to draw the investment community (and more liquidity) into the diamond world. Dozens of diamond investment companies were created in which the public would buy shares or certificates of ownership in diamond contracts – and, without a single exception, all these companies went bankrupt. The public lost vast amounts when diamond prices plunged by some 80 percent in the highest-grade categories. The confidence of the public in diamonds was greatly damaged. Ever since De Beers has fought to position diamonds as an asset representing lasting love and value and opposed any attempt to encourage investments in diamonds by the public, as these diamonds would be “returned” to the market at values and intervals not predictable in advance.
Comex abandoned all its ambitious plans in early 1989, in light of the vocal opposition by the large dealers and, more importantly, because of the active opposition against all these schemes by De Beers. The then vice-president of the International Diamond Manufacturers Association, discussing the Comex scheme in 1988, said at the time: “We remember the speculative horrors of 1979 and 1980, when diamond prices soared to the skies and then plummeted in an uncontrolled free fall. It took us seven years to recover from the miserable publicity the diamond industry suffered during this period. Diamond investment schemes folded like houses of cards. They were sued, they disappeared without leaving a trace, and they went broke.”
Any contemporary consideration of futures market must take into account that such contracts would again focus on polished diamonds of >1 carats – which is derived from rough of >2 carats. This rough constitutes some 6%-7% of world production in carats, but, at today’s prices, represents some 45%-48% of the value of the diamond market. In this particular category of rough, De Beers, the dominant producer, controls more than 60% of the world supply of rough. It shouldn’t be difficult to recognize that through its marketing control, De Beers could “torpedo” any futures markets, if not through its price-setting ability, or its allocation mechanism, then through its control over the downstream programs of its clients.
Any futures contract requires the selling and buying parties to have conflicting assessments and anticipation of future price developments. Those who expect the prices of diamonds to rise are willing to lock in a future delivery at today’s prices; the seller, however, is likely to think that prices will decline, why he would otherwise lock in the price he would get on future delivery. There is an assumption here of a totally freely competitively operating market, complete and transparent information on supplies and the presence of a sufficiently large target public out there that will hold, at any given times, strongly conflicting views on price developments. We don’t share these assumptions. Except for occasional short-term shocks, in the long term, prices of diamonds have always risen – which only confirms the strength of the price-setting ability of the dominant producer. Supporters of the reintroduction of these schemes should ask themselves whether there are, within the industry, really dramatically conflicting expectations of future price trends. The acquisition of future contracts to secure availability of one’s future inventory requirements is, in theory, very well plausible – but this seems rather inconsistent with the present development of the market away from “spot” purchases from middlemen, towards the entering of long-terms supply agreements with diamond manufactures. It is necessary to stress again that the concept of diamond futures in itself is quite feasible; in reality, however, we expect that the producer policies and the self-interest of the major industry players will cause these efforts to fail. And if consumers pay the price of failure, the resulting bad publicity, loss of confidence, etc., will cancel all the positive effects of marketing programs, branding and other innovations aimed at increasing consumer demand.
The futures contract concept does address a valid concern. Volatility in commodity prices cannot be eliminated – and price volatility in diamonds has, indeed, intensified in recent years. The latter is partly a result of the decision by De Beers to cease market intervention through the use of buffer stocks. However, it must recognized that De Beers “compensated itself” for the loss of one major intervention tool by creating Supplier of Choice, which gives it a much stringer grip over its clients and their clients’ downstream business then in the past. If anything, it has strengthened its ability to control the market. De Beers would certainly not approve of any of its clients participating in futures contract hedging schemes. On paper, the futures schemes of the 1970s and 1980s were launched to share with (outside, non-business) speculators in the risks of volatile price movements (although these prices were then still underpinned by the price support offered by De Beers). It is our belief that as long as De Beers dominates the supply of diamonds they can never successfully be traded through futures contracts. De Beers and other producers will be able to frustrate any attempt by the seller of the contract to purchase and deliver the underlying commodity when a contract falls due. We are all in favor of new and exciting marketing schemes to advance the diamond business, using all technologies available today. However, we ought to think twice before bringing back schemes or concepts that are associated with some of the most miserable times in our industry’s history.