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Many of the proposed diamond backed Cryptocurrency schemes simply risk repeating the mistakes of history

29 march 2021

By Richard Chetwode. 24th March 2021.
E-mail: richard.chetwode@btinternet.com

Not many people are still in the diamond industry who will remember the boom and bust of diamonds in the 1970’s, when diamonds ceased to be a luxury purchase, and instead became an investment vehicle, a decade at the end of which De Beers lost control of the diamond market, where the Israeli banking system had to be rescued from bankruptcy because of bad lending into the diamond sector, and where the price of a 1 carat D/IF went from USD1,650 in 1971 to a peak of around USD66,000 in 1980. When the crash came… the 1 carat D/IF fell back to USD6,000 in the space of a month. In light of the many diamond backed crypto schemes which purport to have discovered once again a way to make investment diamonds exciting, it’s a story worth remembering, lest we repeat the mistakes. Interestingly in inflation adjusted terms that 1 carat DIF diamond which cost USD1,650 in 1971 should today cost you USD10,717, whereas following the recent run up in prices this year, the equivalent stone costs around USD15,000, so over 50 years you’ve made a 40% profit i.e., an inflation hedge: (at cost) yes… a real return: very small. If you inflation adjust the peak price of 1980… a 1 carat DIF should be USD210,666 today… ouch!

Now the diamond trade is awash with stories of new “diamond backed” crypto schemes. Maybe crypto today is what was for us the tech boom of the late 1990’s; ignore it and you miss making a fortune. But basing a crypto product on diamonds risks creating the same underlying problems we had when diamonds became The Investment of choice in the 1970s. Even if high inflation (the root cause of the move into hard assets in the 1970’s) isn’t the same threat today, using diamonds to back a crypto product has great potential to cause lasting harm to the diamond market, just as the events of the 1970s did then.

Without breaking down the different functionality of each crypto scheme, once the glitz is removed, it may be easier to compare them to mainstream existing financial schemes. Where the diamonds that back the crypto scheme sit in a vault, the investment thesis is not dissimilar from an investment trust, so let me start there. Investment Trusts are “closed-end” investment companies (the “Company”) with a fixed pool of capital. A newly created Investment Trust issues a set number of shares in an IPO to raise capital to invest in a specific physical market (shares, property or bonds…diamonds…etc). The investors who provide that capital now own shares in the Company, and investors can buy or sell shares in that Company, but while the price of the shares may rise or fall, the number of shares in the Company remain the same. The Net Asset Value of the Company’s investments should reflect the market value of those investments, but the shareholders of the Investment Trust are unable to get their hands on that capital (dividends aside) until the Company is wound up (most Investments Trusts are created for a set time). The result is that with no way to immediately realise the underlying value of the investments, almost every Investment Trust trades at a discount to its NAV until it nears the time when it is wound up and the value of the underlying investments is returned to the Company’s shareholders. But when a Company invests in diamonds, especially when these diamonds are kept in a vault, they may well have a purchase price… but they don’t have a selling price. Even where polished diamond price lists exist… they list the price it costs for you to buy a diamond, not to sell it, and most of those lists are based on algorithms around asking prices, not transactions themselves and so much polished diamond trading is done on credit not cash. You want to know what happens when you sell a diamond… just ask any jewellery consumer who has tried (with mounting horror) to sell their diamond they purchased at retail and expected to get fair value for. There is no transparent sellers’ market for diamonds, which will become especially apparent in a downturn.  

In a normal market, any schemes which are structured like an Investment Trust are likely over the long-term to trade at a discount to their NAV. And unlike in the equity markets there is no fundamental reason why that discount between a crypto diamond currency and actually achievable diamond prices (if you can access them) should close other than sentiment because you cannot realise the value of the assets (worth recalling the reason that Long Term Capital Management went bust).

A classic example of the discount to NAV in the diamond space was an Investment Trust called “Diamond Circle Capital” (DCC) launched in London in 2008 with the intention of investing in a selection of exceptional white and coloured diamonds. By March 2012 DCC owned 11 diamonds, (including a fancy red and a vivid blue), with an estimated value of USD48 million (Total Assets of DCC more like USD52 million equal to over USD7 a share). Except the actual shares in DCC were trading at a 50% discount to its asset value, so in 2012 Lebanese millionaire Abdallah Chatila (made a fortune from diamonds and real estate) joined up with Pavlo Protopapa (CFO of Benny Steinmetz Group) and Evermay Global Inc (Pavlo was also its CEO) and because they together held over 30%, they were forced to make an offer for the company at the last price they had paid for DCC shares… USD3.50 a share; their plan was to buy it ridiculously cheaply, break it up and sell the diamonds at market value… and make a fortune. In the end the DCC trustees liquidated DCC in July that year and returned the money to all shareholders to ensure Abdullah and Pavlo couldn’t get the sole benefit… but they still made a lot of money. i.e., DCC traded at a massive discount to its asset value until someone decided to liquidate the assets. Now here’s a really important point; DCC had invested in larger top colour diamonds and in their defense if any part of the diamond market that leads itself to investment, it would be top colour top quality larger diamonds bought from trade or auction by professional investors who understood (or took professional advice on) the diamond market. And the final sale of DDC’s diamond inventory also took place after a three-year bull market in polished diamond prices.

One of the new schemes proposes using diamonds as small as 0.05 carats… that’s not investment grade: that’s mass market lower value non-bridal. And it’s also worth noting that with some of the proposed crypto schemes, the intention is not to sell the diamonds. Ironically that’s actually quite clever, but because a liquid, transparent market to sell them into doesn’t currently exist. If they are tokenised, then of course the token can be traded; with rising diamond prices, investors can make money… just as long as no one actually tries to realise the value of the underlying assets in a flat market or worse, a downturn.

But if you want to eliminate the discount to NAV, then it would be better to structure the scheme more akin a diamond Unit Trust rather than an Investment Trust. A Unit Trust is an “open-ended” Trust. When an investor decides to buy a Unit, a new Unit is created and the investment manager simply takes the money and invests it into the relevant market; when an investor sells a Unit, a Unit is cancelled, and the investment manager sells some investments to pay out the seller. The market value of each Unit is simply the market value of the underlying investments divided by the number of Units in issue. The number of Units in issue (and therefore the capital available to invest in the market) is simply based on demand for the Units. Unit Trusts don’t trade at a discount because you are buying or selling the underlying assets.

Except there are two challenges. Firstly the spread between Bid and Offer on Unit Trusts can be over 5% which makes outperforming the relevant sector extremely difficult (and there are of course juicy fees to pay on most crypto schemes), and in a downturn, when people redeem units in a Unit Trust, the investment manager is often forced to sell the better performing, larger, more liquid investments, which means the remaining portfolio get more and more concentrated in less liquid, worse performing smaller assets, and therefore downside risk increases and the performance worsens. Imagine that in diamonds… it’s not just how you price each diamond, though that of course is a major issue, but which diamond you sell when you need to raise capital to pay out an investor who wants to redeem their investment, and the increased risk and downside in the remaining portfolio. And this wouldn’t be like selling shares or ounces of gold; … which both have quoted prices for what are fungible assets, in the diamond trade… and it’s the trade you will be selling the individual diamonds to, the 4 C’s’ are only the start of pricing a diamond; it’s also about the Make, the sparkle, the feathers, the fluorescence… and no established, transparent liquid market to sell into. And worse if one had tried to sell polished diamonds in late 2008 / early 2009, or in March last year; you’d have only got a fraction of their pre-crisis’s prices.

Most people in the industry are all too aware that the diamond market could benefit hugely from financial products than add liquidity, transparency and accurate two-way pricing. Maybe it’s hidden in the small print, or maybe I just missed it, but the schemes I looked at fall flat on their back when it comes to the underlying value of the product. We’ve seen on a ten-year decline in polished prices, partly the result of structural flaws in the diamond industry, partly because of the increased commoditisation of polished pricing at retail. Tokenising a polished diamond doesn’t so much create new demand as commoditises a non-fungible product without providing transparent pricing for the selling price of that product.   

Will a Crypto diamond-backed fund work as the various proponents believe? In a normal market where price equates to fundamental value, I would argue “No” until someone finds a way to provide actual selling prices for the diamond held. But then if people are willing to invest in Bitcoin, which seems to have no intrinsic value other than the greater fool theory (“someone will pay more for it than I did”), but each one of which has used appalling amounts of carbon emitting energy to create, anything is possible, and investors are nothing if they are not sometimes sheep.

From a diamond market perspective, there is an additional point worth considering. What impact would the performance of a publicly traded diamond backed crypto currency in a downturn have access on the thousands of years old perception that diamonds are a store of value… but that may not be important for those setting up these schemes. Like most new products, it is possible that there will be considerable interest from investors who don’t fully understand the diamond business and New Toys always have their day. Possibly counter intuitively, the diamond business has survived the worst of the dreaded Covid in better health than it went into it. The mining companies cut production and held back sales, the midstream had to stop manufacturing for months at a time. But the diamond jewellery retail environment has continued to improve; the result - rising polished prices. But diamonds are a luxury purchase; try to turn them into an investment market and without a transparent pricing mechanism for selling them and we risk ignoring the lessons of history. Caveat Emptor.

 

Richard Chetwode runs a diamond consultancy business. He is also Chairman of Namibian Diamond Mining Company Trustco Resources, is Chairman of the Advisory Board of Australian technology company Fine Arts Bourse as well as consulting to a number of diamond (and other) businesses. All the opinions in this article are his own.