Is a Diamond ETF Forever?
In March, the exchange-traded fund company IndexIQ filed with the SEC to create the first diamonds ETF. The so-called IQ Physical Diamond Trust will hold a specified amount of one carat, gem-quality diamonds in a certain number of industry-recognized subcategories. The announcement immediately provoked speculation of a further commoditization of the diamond market and the potential flourishing of diamond-related financial instruments. Some project that diamonds could be the next gold – a safe haven investment with a liquid market. If approved by regulators, the introduction of the first diamond ETF may be a significant step toward greater openness and standardization in the diamond market with the potential for the formation of a large, liquid, diamond-specific futures market. However, there are numerous obstacles to further diamond commoditization, including the conservatism of many powerful market participants and standardization hurdles inherent in the diamond market.
Overview of the Diamond Market
Diamond market participants are most easily classified by value chain position. Four major players dominate the exploration, production and rough-diamond sales portion of the value chain: De Beers, ALROSA, Rio Tinto (RIO) and BHP Billiton (BHP). These companies sort, classify and sell the rough stones to middlemen through one of three different sales methods. The most common is the “sightholder system” through which buyers (“sightholders”) make regular purchases based on long-term contracts. This system fosters close working relationships between buyers and sellers and creates high barriers to entry for new participants. There are less than 100 sightholders in the world and only 10 to 15 major market participants, yet about 70% of all diamond sales occur within such systems. The diamonds are then shipped to manufacturing centers to be cut, polished, set in jewelry and sold in retail establishments. Antwerp hosts 80% of rough-diamond trades by volume and a vast majority of diamond cutting and polishing occurs in half a dozen municipalities around the world including Antwerp, New York, London, and Surat, India. Gem-quality diamonds constitute about 50% of total diamond volume annually yet account for approximately 95% of total value. Until very recent technological advances made the production of synthetic gem-quality stones feasible, synthetic diamonds were produced almost exclusively for industrial purposes. The encroachment of synthetic diamonds on the market could have a significant effect on supply and price or simply result in further industry segmentation between synthetic and natural gem-quality diamonds.
Demand for gem-quality diamonds is driven by consumer demand for jewelry, particularly in the relatively uniform low-end retail sector. Global economic growth rates have a substantial impact on demand. The United States accounts for about 50% of all diamond jewelry sales, making the diamond market particularly sensitive to economic conditions in the United States. Like many luxury goods, demand growth over the next decade will be stimulated almost entirely by growing middle class populations in developing countries. IndexIQ predicts demand growth rates will track global GDP growth rates in the medium term. On the other hand, supplies are expected to be static over the next decade, due to a lack of significant new discoveries and developments, high sector-specific barriers to entry, and depletion of existing deposits. In the medium term, market participants can expect inelastic supply and rising demand to contribute to buoyant diamond prices.
Industrial Grade Diamonds
Diamonds of less than gem-quality are classified as industrial-grade and are utilized in cutting, drilling, polishing and grinding applications as well as industrial lasers and surgical equipment. The line between gem-quality and industrial-quality is not succinctly defined; low- grade diamonds can be cut, polished, and sold on the lower end of the jewelry market or manufactured for industrial purposes at the discretion of the producer.
In recent years, several diamond producers, led by De Beers, have moved to vertically integrate the diamond pipeline by purchasing or partnering with dealers, cutters, manufacturers and retailers.
An Overview of the Diamond Market
Obstacles to the Commoditization of Diamonds
Increasing demand, static supplies, the recent opening of the diamond market to greater transparency and competition, and financial market demand for the type of safe haven investment offered by diamond-backed instruments, seem to indicate a strong trend toward greater commoditization of diamonds. However, there are a number of difficulties – many of which are inherent in the market – to be sorted out before diamond-related instruments can become as prevalent as gold or silver. The four most pressing issues are fungibility of the asset, pricing opacity and accuracy, vulnerability to market manipulation, and the increasing availability of synthetic, gem-quality stones.
First is the problem of standardization. By definition, commodities are ideally partially or completely fungible – that is, they are qualitatively indistinguishable across the market regardless of geographic origin, producer, etc. Thus, the commoditization of diamonds would require some mode of product standardization that substantially reduces product differentiation. However, diamonds are highly differentiable by cut, clarity, carat, color, and certification (or the 5 C’s of diamonds) and valuation varies accordingly. The Diamond Trading Company (a subsidiary of De Beers) classifies diamonds into 15,000 distinct categories. Additionally, diamonds lack many essential characteristics that make investment in gold popular. They cannot be reshaped and retain value, is feasible to mass-produce in lieu of sufficient natural deposits, and lacks historical precedent as either a medium of exchange or store of value. Unless investors can be confident in the fungibility of diamond financial products, such instruments are not feasible.
Second, pricing information is opaque, imprecise and poorly understood. Proponents of commoditization argue that diamonds can be standardized and sold at easily defined and understood prices. Implementation of this has only been moderately successful. The Rapaport Diamond Report, first issued in 1978, was the first attempt to establish a standardized pricing system for diamonds. The report is available by paid subscription only and bases price differences on variation in the 5 C’s of diamonds. IDEX Online developed a competing price index in the early 2000s. Critics argue that the information is regularly inaccurate or unrepresentative of market movements. Once again, diamonds are at a disadvantage compared to silver and gold, which are measured by weight, due to the lack of a direct and objective valuation method. To date, no comprehensive spot market for rough or polished diamonds exists due to the high proportion of long-term, private sales contracts, which are the primary method of transaction. Thus, diamond instruments will have no regular price movement data to reference until price information is better reported. And if such pricing data was accurate and readily available, without proper standardization the information would be virtually useless.
Third, the highly centralized and secretive nature of the market makes it incredibly vulnerable to manipulation. Even in the absence of collusion among firms, the top two rough diamond producers – De Beers and ALROSA – each have sufficient market power to heavily distort prices by influencing the number and value of diamonds brought to market. De Beers itself (though no longer the monopoly it once was) still has market power (by total sales value) approximately proportional to that of OPEC in the global oil market. Moreover, the insular nature of the diamond market would compound risks of fraud and price manipulation by market participants. Thus, the market would have to be subject to considerable regulatory oversight – a prospect that is surely an anathema to conservative market participants who profit from the insularity of market conditions.
A final major obstacle is the potential threat posed by greater production of synthetic gem-quality diamonds. The means to produce such high quality stones through industrial processes recently became feasible. Market participants could defang this threat by differentiating between natural and synthetic stones and marketing natural stones as higher quality diamonds. Differentiation between stones of natural and industrial origin is already taking place among investors; synthetic diamonds are presently not considered investment grade, regardless of quality.
The Proposed Diamond ETF
IndexIQ’s proposed diamond ETF would hold a given quantity of diamonds in a vault in Antwerp (in much the same manner as gold ETFs that are backed by physical holdings) and issue shares in the fund for public exchange based on the net asset value of the diamonds held in the vault. The shares in the fund must be backed by physical quantities of diamonds due to the constraints imposed by the absence of a liquid diamonds futures market. (Many commodity ETFs invest in futures contracts rather than hold physical quantities of a given commodity and simply roll over expiring contracts at the end of each period, never taking physical delivery of the underlying asset.) Crucially, the fund has taken an initial step toward standardized diamond investing by specifying that the fund will only hold one carat, gem-quality diamonds. However, the fund has yet to specify a spot market upon which it will base its net asset value or further narrow the types of stones it will hold.
Too Soon to Tell
The movement toward commoditization of the diamond market and availability of diamond-related financial instruments is in its relative infancy and faces numerous hurdles. Three crucial developments must come about before diamonds can challenge silver or gold as safe haven investments in liquid commodity markets. First and foremost, diamonds need to be sufficiently standardized in order to trade on an exchange through futures contracts. Even if this cannot be done based solely on natural characteristics and must restrict which stones are deemed to be of investment-grade, price standardization is essential. Second, the industry needs to develop a coherent and readily available pricing mechanism on which to base spot prices. The mechanism should be open, transparent, and well regulated to discourage participants from indulging in price manipulation. Third, diamond-backed instruments will need regulatory approval – which is far from assured given high differentiation and the closed, centralized nature of the market. Conservative forces in the existing diamond market structure are likely to resist commoditization to a certain extent unless presented with adequate incentives to participate in the market. Current market participants may be wary of possibly subjecting themselves to greater price volatility and market speculation as well as sacrificing the famous industry claim that every diamond is unique. Moreover, the centralized nature of the diamond market will make any trading regime highly vulnerable to price manipulation. Despite these obstacles, if there’s one indomitable force in financial markets, it’s the seemingly endless capacity of financiers to create innovative products in response to sufficient demand. IndexIQ may not succeed in its bid to create a diamond ETF but, if sufficient demand for such products exists, the trend toward commoditization may culminate in the formation of large, liquid market in diamond futures.
Disclosure: The author has no holdings in the stocks mentioned in this article and has no plans to initiate any positions within the next 72 hours. He does, however, have the intention of rating these stocks on WealthLift.com, a social media website where investment ideas are shared openly and free.