New "token" technology that comes from the same sort of stable as Bitcoin can change how investors treat diamonds, the author of this article claims.

Is there anything modern distributed ledgers and associated cyber-“tokens” cannot do? For all some of the scepticism around such technology, innovation proceeds apace. There have been moves to connect gold with crypto-technology, and now it appears the diamonds market is in for the same treatment. As is often stated, diamonds differ in one crucial respect from gold in that each diamond is unique – one cannot melt them down and reconstitute them. So for a long time the ability to arrive at a standardised way of pricing and trading diamonds has faced a certain set of hurdles. But modern financial capitalism is nothing if not a fertile creature, and the development of crypto-currencies and associated technology, so its cheerleaders say, offers new opportunities.

In this article, Hogi Hyun, an asset manager by trade and founder of D1 Coin, an asset-backed token linked to diamonds, argues for the potential of such tech in making diamonds a new asset class. 

The editors of this publication are pleased to share these views and invite readers to respond with views and questions. The editors don’t necessarily endorse the opinions of guest contributors. Email tom.burroughes@wealthbriefing.com
 

For millennia diamonds have represented the epitome of luxury, populating the realms of royalty and romance. Their history dates back to the first diamond mines in 4th Century BC India, which produced diamonds for Indian royalty; subsequently European royalty developed a taste for the gems, and in the 13th Century under Saint Louis IX their ownership was limited by sumptuary laws to kings. With the discovery of diamond mines in South Africa in 1867 and the rise of both production and the De Beers monopoly in the 20th Century, diamonds were brought to the mass market and became an essential part of every betrothal.  But despite the elevated status and social ubiquity, they have so far failed to become an investable asset class.

Diamonds take literally billions of years to form naturally in the earth’s mantle, where extreme heat and pressure turn carbon into gems, which are then pushed to the surface by volcanic eruptions, making these precious stones extremely rare and difficult to find and to mine. Once mined, approximately 80 per cent of diamonds are destined for industrial use, such as grinding, cutting and drilling, and the remaining gem-quality diamonds are then cut and polished, producing a fair quantity of small decorative diamonds, and a small quantity of precious diamonds.  It is this last category that would qualify as investable diamonds, and can form the basis for diamonds as a future asset class.

There are an estimated 26 million carats of gem-quality cut diamonds worth $25 billion produced annually, and an estimated cumulative produced stock of existing investable diamonds equal to 1 billion carats worth approximately $1 trillion. This is no small number, equal to the total M1 money supply of Spain, which begs the question of why diamonds have not developed as an asset class on their own.  Actually, both Pedigree Diamonds and large and rare diamonds have been actively acquired and collected by royals and wealthy individuals for centuries, and this activity has picked up in the past few decades with the growth of new wealth and the globalisation of the diamond industry. However, it remains a largely secretive bilateral brokered market, with some high profile auction sales shedding precious little light on transactions and pricing.  

Despite these drawbacks, Pedigree Diamonds have offered returns of 2 per cent to over 40 per cent per annum, with an estimated weighted internal rate of return of 5.5 per cent for their fortunate owners.  Outside of Pedigreed Diamonds, Investible Polished Diamonds have also increased in value over time – since the end of De Beer’s monopoly in 2003, diamonds have appreciated by about 5 per cent per annum, accordingly to the Rapaport Diamond Index.  So diamonds have offered a return of about 5 per cent per annum, making them a very attractive inflation-beating asset class. However, the previous monopolistic structure of the production and distribution system has been an impediment to making diamonds investible, but this has changed dramatically in the past two decades.

Up to the end of the 20th Century De Beers had a stranglehold on the diamond mining and wholesale industry, with a peak market share of almost 90 per cent, thus enabling the company to control diamond prices and effectively scaring off investors. However, today De Beers mines roughly one third of the world’s diamonds, with Alrosa mining about the same and Rio Tinto and Dominion trailing behind, thus eliminating the previous monopoly player in the industry. Currently the main obstacle keeping diamonds from becoming an asset class has been a combination of the lack of fungibility and a wide bid-offer spread in the secondary market.  

Fungible
Diamonds are not fungible because each diamond is unique - diamonds originate from different volcanic pipes in diverse geographies, and thus have varying natural characteristics of colour and clarity. Each diamond is then individually cut and polished, further differentiating them by man-made characteristics of cut and carat.  As a result, each diamond will have a different price, depending on the aforementioned four “C”s, and these prices are subjective, as each dealer may have a different value for each diamond. The end result is a very wide bid-offer spread that can range from 10 per cent to over 40 per cent, depending on the diamond, making trading of diamonds very expensive, and thereby reducing their liquidity.

There are some possible solutions to these barriers, most of which would involve the pooling and securitisation of a large selection of diamonds and a fractional ownership arrangement that would allow assignment and therefor secondary market trading. There have been some attempts at this, in the form of diamond funds and securities: for example, the Thomson McKinnon Diamond Investment Trust, incorporated in 1981) and a diamond exchange traded fund, Diamond Circle Cap, listed in 2008. Both of these approaches failed – the diamond fund collapsed because of a combination of poor market timing and the open-ended nature of the fund, which give investors the ability to redeem fund units for cash, thus obliging the fund to sell diamonds to meet redemptions and thus face the very wide bid-offer spread.  The ETF did not get launched largely because of concerns about the same issues, coupled with issues surrounding pricing, both for the purchase and sale of diamonds, as well as for mark-to-market purposes.   

So it appears that to create a successful diamond investment in the form of a pool of diamonds with fractional ownership, a few key points need to be addressed, namely (i) open-ended redemptions, (ii) pricing, and (iii) market timing.  

Open-ended redemptions are a challenge because they enable investors to redeem their investment for cash, which normally would cause a sale of some of the diamond investments, and thus exposure to losses due to a wide bid-offer spread. An alternative would be a closed-ended investment vehicle, which would preclude redemption and limit exits to a sale of units in the secondary market. However, closed-ended vehicles are often unpopular because of the inherent redemptions restrictions, which often result in their trading at a discount to Net Asset Value and thereby limit the upside potential for investors. A solution to this problem is to establish an open-ended investment vehicle with an “in-kind” redemption feature, with redemptions being in the form of diamonds. In this structure, investors can exit from their investment either in the form of a secondary market sale of units for cash, or a redemption in the form of diamonds, which they could then chose to either keep or on-sell. Diamond market participants would be able to monitor the price of the vehicle, and when the price trades below the fair market value of the diamonds there would be an arbitrage opportunity, and they could then buy units and redeem for diamonds at a discount to the prevailing market price. This open-ended feature would thus lend demand for the units and thus offer price support, limiting the risk of the units trading at a discount.

Pricing remains a big issue in the diamond industry, since diamonds have a complex ecosystem that runs from mining companies producing and selling rough diamonds to cutters and polishers who on-sell to wholesalers and retailers, who finally sell to consumers. The result is a variety of rising price points along the production and sales chain. For a large scale investment in diamonds it would make sense to purchase diamonds at the lowest possible price for gem-quality diamonds in the cycle, which would be just after the cutting and polishing stage. Prices at this level are generally quoted at a discount to a reference price, which is usually the Rapaport Diamond Report price.  

There are alternative prices available, generally provided by diamond exchanges and some diamond merchants, but Rapaport remains the principal reference price for the industry. However, since each diamond is unique and thus has different characteristics, pricing of any single diamond involves an approximation based on index pricing provided by sources such as Rapaport. To find the actual price of a specific diamond requires a pricing model, which can now be programmed with a high level of accuracy using approaches such as multiple linear regression, decision trees, random forests, neural networks, cluster analysis, and principle component analysis.

Market timing is always hard to predict, but good timing can have a very big impact on the market acceptance and thus growth of any investment. It goes without saying that issuing an investment in a rising market and the resulting track record of capital gains will make the investment more attractive than issuing in a falling market. The next question to ask then is are diamond prices in the future likely to rise or fall. The rough diamond and polished diamond sectors don’t trade exactly in tandem but are obviously related. Since 2008 rough diamond prices have grown by about 35 per cent according to the Rapaport Research Report 2018; while polished diamond prices have grown by 16 per cent.

Research by Frost and Sullivan predicts that supply of rough diamonds will contract from 147 million carats per annum in 2018 to 62 million carats in 2030, and demand will increase from 155 million carats in 2018 to 221 million carats in 2030. The resulting deficit of 159 million carats in 2030 portends a rising price environment for diamonds, making this a good time to launch a diamond investment. 
In summary, there is an open challenge to find a solution to making diamonds an accepted and successful investible asset class. The parameters are likely to involve a large and diverse pool of diamonds that is unitized and thereby offers fractional ownership.

The units will have to have a form of open-ended redemption to enable arbitrage, and thus price support, but preferably redemption “in kind” and not in cash, to avoid having to face wide bid-offer spreads.  The solution will also have to tackle the pricing issue and will need to incorporate a non-discretionary and index-linked pricing model to accurately price both individual diamond transactions as well as mark-to-market prices for the purpose of calculating an accurate and objective NAV. Finally, it doesn’t hurt to have some luck on your side and time the launch of diamond investment with a rising market, as we are likely to see in the coming years.