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15 october 2018

maxim_shkadov_xx3.jpgWhat is a diamond manufacturer’s margin composed of? What is the profession of diamond processing engineer about? How much time does it take to become a diamond cutter? How does a polishing factory work? The Russian Cut, is it alive? Lightbox from De Beers, what is it and why? Why do diamonds make banks feel edgy? What are the signs of a “diamond bubble” in the market? Maxim Shkadov, CEO of Kristall Production Corporation, Russia's oldest and largest diamond manufacturing business, sat with Rough&Polished to tell about all this and many other things.

What are the production results Smolensk’s Kristall is coming to the end of 2018 with?

Basically, we had a pretty good half year by all performance indicators, including the growth in sales of finished goods by 30% compared with last year. Online sales of both loose diamonds and diamond jewelry have also went up. This growth was due to the fact that demand for finished goods in the market was not bad in the first six months of the year and, in particular, for high-end goods in the sector in which we operate. The market began to slow down in July, as expected, and therefore the results of the third quarter somewhat influenced this overall picture, and we are anxiously awaiting the results of the fourth quarter, because the market situation today is very ambiguous.

Here we must take into account that 2017 was simply catastrophic for us - the export duty on diamonds was abolished, which led to a sharp rise in the cost of rough for Russian companies; there was also a sharp jump in the national currency exchange rate making it stronger, which was accompanied by a slump in demand for diamonds resulting in lower diamond prices. These three factors, of course, hit the business very hard.

In 2018, we see a certain upturn, but I repeat that we are still anxiously looking at the fourth quarter.

Many factors affect the profitability of diamond manufacturing, including rough, labor, production costs, market prices and so on. Which of them affect the margin of Kristall the most?

Undoubtedly, rough prices are the major factor, because the price of raw materials is the main component that is included in the cost of a future polished diamond. The cost of lending is the second key factor. And of course, the cost of labor and other production costs – these come as the third major aspect. The cost of rough is decisive, and it is determined not only by the price per carat, it is determined by many other factors - by the assortment of rough offered by a miner, by its mix, its sorting, its qualitative and quantitative composition, its color and presence of fluorescence in each box. This bunch of factors makes rough diamonds a rather unique material among other raw materials, since it is not a homogeneous product that could be brought to a single price denominator. Therefore, each company forms its own pricing policy.

If we talk about the cost of lending, it is important to understand that the process of manufacturing and selling finished goods and the availability of stock for efficient trading are all financially capacious things, and the cost of attracting loans or using own funds strongly affect the profitability of this business.

The cost of labor depends very much on a particular region. Even in Russia, we see a difference in the production costs between Moscow, Yakutia, the Far East and the central part of the country - the production costs in these regions are very different. Moreover, the differences exist not only in costs, but also in terms of specialization, qualification, skills.

What is the minimum size of rough diamonds cut by Kristall? And what is the average weight of polished goods belonging to the company’s major category of products?

To date, our processing technique is built in such a way that no one sets a minimum threshold. The main thing here is the calculation of the process engineer who puts the whole idea of added value in a future diamond. There are practically no uncut stones left - all stones we get are processed. A box of rough diamonds is carefully assessed by experts at the selection stage, when it is offered for purchase. After buying, they start working with it taking into account the needs of the market, the available demand for a particular product. Of course, some part of rough diamonds, if it is not requested in proper time, will be postponed and will wait in the wings. Some part of rough can be resold if it cannot be efficiently processed at the moment or it is processed with the participation of partner companies. But, as a rule, virtually all stones we buy are cut and polished.

Currently, the main stream of polished goods produced by our company and also requested by the Russian market consists of diamonds weighing twenty cents or more. And accordingly, the entire amount of rough and its assortment is processed at the level of two or three grainers and above. But the basis is made up of rough weighing four to six grainers, and accordingly, there is a sufficiently large number of stones weighing one carat and more.

How do process managers at Kristall view the Russian Cut standard at the present time? What do they favor more - the weight of diamonds or the play of light in diamonds?

These days, there is a rather common misconception prevailing in the semi-professional community that the high quality of the Soviet Cut was achieved due to the loss in diamond weight, in the yield, although this was practiced only at the initial stages of developing the cutting and polishing technique in the distant 1970-80s.

In reality, this ceased to happen long ago. Today, any process manager takes into account more than a hundred parameters when planning diamonds. The diamond processing technique has made such a great breakthrough that currently any process engineer has an array of computer marking systems to help in planning diamonds, which offer a number of different options for cutting stones based on market requirements. Still, whatever one may say, everything is determined by the market. Unfortunately, it should be said that the ‘Russian Cut’ concept lately has blurred and migrated to another category, which is classified as ‘Triple Excellent’ and is outlined by the standards of the Gemological Institute of America, being now the basic benchmarks in the market.

When the process engineer makes a decision, he or she naturally looks at a number of parameters that can be imparted to the stone to be cut. Then the process engineer gives the task to the computer and studies the stone with regard to its shape and internal inclusions. After all, the processing technique has always been focused on getting deep inside the diamond, almost to the level of its crystal lattice, and this was finally achieved by a number of devices that are working today. Then, using high-precision equipment the engineer marks the diamond to help in its further processing.

But when planning a diamond, we should consider the parameters dictated by the market. And this is the most interesting moment. Each parameter has its own price. Our work looks as follows: At Kristall, the price of a future diamond is managed through the internal price list system, which is changing quite often. If the market is changing dramatically, then our internal price list can change almost every ten days - in fact, like the Rapaport price list. This is being managed by our sales department and it happens quickly through an internal software application with a network access to all computers, with the result that both the marking computer and the process engineer receive ready-made basic characteristics of diamonds, which have their price in the market.

In this regard, the task of our sales managers is to track market prices very quickly, carefully and scrupulously, so that they can be translated into production targets.

Judging by what you say, Kristall has the most up-to-date information on the current pricing in the market, the quality of which is higher compared to the pricing data retrieved by diamond mining companies through their manufacturing arms probing the market. Do you share this information with anyone?

But nobody asks for it. And I will even explain why. The problem is that rough diamonds and polished diamonds live by their own laws, which absolutely do not intersect with each other. This is a serious problem for our market, which in itself, in our opinion, is a time bomb, that at some point may produce a very strong bang inflicting harm to the market. The current picture is similar to the crisis of 2008, but it is hidden in numerous diamond stocks. And we get evidence of this in particular from India, where there are frequent bankruptcies of companies. In the market, rough is traded according to its own laws. Each company offers its own system of selling rough diamonds it produces. This is understandable, because mining companies produce a variety of rough goods that need to be brought into some pattern convenient for customers. From time to time, it happens that some rough goods are in short supply in the market, and in this case rough prices start to outrun polished prices, sometimes significantly. It is necessary to understand that this is a speculative trend and sooner or later it will either disappear or will accumulate in the form of losses in the industry’s next segments at companies keeping rough stocks. This is the time bomb I mentioned above. Therefore, realizing that this is a serious risk banks began to busily leave the industry. And now we see that the industry is financed exclusively by Indian money, which represents a rather great danger.

The better the rough you get, the more you gain from finished goods. To what extent is Kristall provided with such rough and where do you take it from?

We have concluded a new agreement with ALROSA, taking into account all our previous wishes and bearing in mind the roadmap drawn up by the Russian government. This agreement is significantly different from the previous one. The supply of rough diamonds was coordinated to meet the specialization of the Russian market, and today we are provided with rough supplies to a complete extent and we have no questions. In addition, there is the secondary market in which, if there is a need, it is possible to get some types of rough additionally.

How did the shut-down of the Mir mine affect the assortment of rough you purchase from ALROSA?

We know that the Mir mine produced one of the highest quality types of rough. Today, ALROSA, apparently using its own stock, is coping with this problem by offering more or less equal boxes. But it is impossible to say that the Mir mine influenced the company’s assortment of rough diamonds in a significant way.

We are also pro-actively working through our subsidiary in Antwerp, and our specialists take part in almost all tenders. In addition, we can acquire almost any type of rough we lack through the brokerage system in Antwerp. Just currently, there is no such need.

With De Beers, the picture for Kristall was not very interesting, because one time the policy of this company was aimed at squeezing its customers dry and this forced us to refuse buying their sights. Being a state-owned company, we have no right to take excessive risks, and we officially said this to them. So, they transferred us, so to speak, to the status of second-round sightholders.

As for other mining companies, they offer their goods at tenders, and we participate in these tenders.

The talk about merging Kristall of Smolensk with ALROSA in one way or another has been going on for some time. How probable is it today and what will it give to both these companies, if this happens?

I would like to say it at once that these are the questions beyond our competence and they should be put to the owner, which is the Russian Federation, so from the point of view of the procedure and everything else, there is nothing to comment on. The only thing I can say is that there is a government decree that says that the prospect of such an association is obvious. From the point of view of whether this is necessary or not, there are many opinions arising on this topic, often diametrically opposed. My opinion is that in one form or another, an alliance between a diamond producer and a diamond manufacturer in Russia is simply inevitable and necessary. In the first place, it follows from the guidelines set by the government’s and the president’s economic policy aimed at deep processing of natural resources. Secondly, we have 55 years of experience under our belt in processing these resources, and most importantly in creating the diamond manufacturing system itself, which was implemented in the Soviet Union with the same task: to process this country’s own resources. Thirdly, from the market point of view, the niche that our colleagues from India now occupy is expanding very pro-actively and beginning to be controlled by them. In order to have our own independent access to the market, to the end consumer, in order to clearly understand everything that happens across the whole diamond pipeline, the mining company must have this channel through its own sales system. This is a market necessity. And I will explain why.

First of all, the game played by our colleagues from India is extremely dangerous, because it resembles a financial pyramid. On the other hand, one should not forget that the active penetration of a parallel product into the market in the form of synthetic rough diamonds and polished diamonds made from them is a serious challenge to the entire market and the future of diamonds. In addition, our industry, unfortunately, does not perform sufficiently thorough marketing studies to assess and track the preferences of modern customers and, most importantly, the preferences of future generations of customers. Meanwhile, the fashion for diamonds, fashion for beautiful products with diamonds, fashion for the transparent supply of these diamonds - all this will very soon reach another quality level, and those who will have this system will gain a foothold in the market.

Some time has passed since the establishment of the Eurasian Diamond Center in Vladivostok, where, among other things, a diamond manufacturing business was put into operation. As the CEO of the country's oldest and largest diamond manufacturing enterprise, how successful do you consider this project?

If we say that large-scale diamond manufacturing programs are being implemented in the Far East, then we need to understand that these involve not only machine tools. First of all, they should involve a very powerful system of personnel training. Technologically, the processing of diamonds has gone so far ahead that to work on the most sophisticated computer systems used in production, we need highly qualified personnel, as well as solid experience in stone processing to match all this. After all, the most scrupulous work to prepare a diamond to be polished by a diamond cutter is the basis of the entire manufacturing industry. If you do not organize everything properly, the cutter will not do anything. We have no educational institutions to train diamond processing engineers, there is even no such a speciality, except for one institution of higher education - the Smolensk branch of the Moscow Power Engineering Institute, which at one time introduced the speciality of diamond processing engineer with the pro-active assistance of Kristall. Such a specialist studies there at the department of optical electronics and after that specializes at our company. At one time, we had all our technological personnel study at this department. Solving our company’s personnel problem in this way made it possible to have a reserve of properly trained people for a period of 15 years.

And how long does it take for a graduate of this institute to gain steady production skills?

For a process engineer it is enough to be involved in production from one and a half to two years in order to start working independently on a sufficiently serious level. What is a process engineer? This is a person who understands all modern techniques of diamond cutting, is able to operate all modern types of technological equipment, is excellently versed in special computer equipment and application programs, as well as commands good English, because the software environment and the equipment itself require it. A top-notch process engineer is a person who can go to any international tender in Africa or Antwerp, look at the package of rough and say what kind of polished goods can be made of it in terms of quality and price, and then do it in practice. It takes at least five to seven years to train a process engineer. After six months of training, diamond cutters mostly learn only the basics and they will begin to work independently only in one year. Only a year later a diamond cutter will be able to fulfill the production norms in terms of quality and quantity. Judging by our experience, it will take him from three to five years to become a true master of diamond cutting and polishing. It should be noted that more than 50% of diamond cutters drop out in the process of learning.

As for the diamond manufacturing enterprise in the Far East, everything will work there in the right way after a certain time and with the advent of trained personnel. We envy them in a good way from our region, because it was our idea to establish the first territory of priority development for diamond manufacturing, and we still believe that this should be done in Smolensk as the diamond manufacturing center of the Russian Federation with a 55-year-old history.

After De Beers rolled out its Lightbox diamonds to the market and the US Federal Trade Commission released its Guidelines for the jewelry industry, the attitudes towards laboratory diamonds began to change. What is your view on this problem?

The market situation has certainly changed and changed in a positive way. The positive fact is that De Beers has quite firmly shifted the price bar. If earlier it was believed that lab-grown diamonds cost 30-40% cheaper than natural ones, based on the same Rapaport price list, today De Beers drew a rather hard line and said: “You will not have any Rapaport. You will not have any diamond grades, you will have a one-carat stone priced at $800. End of story". This is a very serious step. After all, reducing the price tenfold means putting this product on the same level as a Swarovski crystal. “That's where lab-grown diamond makers will compete with each other, and we will lead this process,” De Beers said. It should not be forgotten that, having a business worth $6 billion, De Beers will always take care of it first and foremost, rather than of a business worth around $200-300 million. It should also not be forgotten that De Beers has already spent a lot of money and will spend more on developing its own retail jewelry brand, “De Beers”. So, the company is engaged in serious and powerful activities in the field of retail. In terms of profit, this is a very significant market, and De Beers is maintaining quite a vigorous presence there.

As for any further development of synthetics, everything will depend on how strong the role of marketing and promotion of natural diamonds will be, and on how much the market fight – or one might even say, market war - for buyers will escalate between synthetic and natural stones in jewelry, competing by design. Buyers will be offered to choose. But they should choose from a prepared ground. To do this, the industry should literally bombard the mass consciousness instilling the idea of ​​real value intrinsic to natural diamonds as such. This is the only way, which remains, since it is not yet possible to make a widely used investment product out of diamonds, a product based on an understandable value chain. To do this, we need to have a certain market, a stock exchange, where trading is going on and everyone is able to see the price movement for this product. Currently, apart from the Rapaport, IDEX or Mercury websites and some other websites run by individual companies, there is no such global exchange. Right now, we say that diamonds should be sold in the form of jewelry, be presented accordingly, have the appropriate brand, value, attractiveness, as it was – I can’t get used to saying this - in the twentieth century. And here it should be noted that no one has yet invested so much in the development of fashion for diamonds as De Beers, including the idea of ​​engagement rings, let alone the fact that quite recently they managed to introduce the fashion for wedding diamond rings in China. At the same time, it must be said that all these efforts are at the level of individual companies, and not the entire industry. The attempt of the Diamond Producers Association to give all this to the world is not very visible yet, to be honest. All companies pursue their own interests. And in this sense, among other things, Russia will need a symbiosis between its mining and processing assets enabling them to jointly present goods of appropriate quality and brand on the international market.

How does Kristall promote its diamonds in the market? How often do you participate in international exhibitions and what do you get from them?

We constantly take part in exhibitions and other events where we present our goods. But you can get the maximum value from your goods only if you reach the final consumer. However, getting on to the final consumer involves a rather strong financial flow accompanying this process. In order to sell our goods to jewelry companies, it is necessary to have, so to speak, a large supermarket offering a whole array of goods, and this means a big amount of frozen money. We simply do not have enough funds for this, as they are needed to purchase rough, manufacture diamonds and maintain the stock of finished goods. At one time, we tried to create our own brand, including overseas, and it began to work quite well in America before the 2008 downturn. But then this topic was closed for a long time. I want to say that, despite the political and economic confrontation, if we speak of jewelry art and diamonds, the market responds very well to everything connected with Russian goods.

What do you think can be improved in the area of ​​legislation in terms of regulating the turnover of rough and polished diamonds?

Of course, arising issues in this area are being dealt with and removed, but the system of moving goods across the border still does not work properly. Therefore, we have to use our subsidiaries based abroad to carry this out. In terms of exporting polished diamonds, there are no problems. The problem is with moving goods across the border back and forth. If we take our goods abroad to exhibitions, sell some part of them there and then take them back across the border, we have to fill in a whole array of documents. Since we have our own distribution network, we cope with this problem in an easier way.

How do you assess the situation in the market this year? Is it better or worse than in 2017? How stable is the demand for diamonds?

There are a number of factors - both positive and negative - that always affect the market. This year marked a good sales season driven by North America. Sales of diamond jewelry increased and demand for it was very good. The holiday season, which lasts from the end of November to Saint Valentine's Day, has a very strong impact on sales and this period in the end of 2017 and in the beginning of 2018 was quite good. Due to this, diamond inventories thinned out and it was necessary to replenish them, which caused movement in the market. This movement has been active for six months. The upcoming holiday season, too, in principle, promises to be quite good. But we must understand that all goods for this season are usually briskly bought until July. Then customers are partially buying what they lack during July, August and September, but there is already a decline in purchases. The exhibitions held this year, including the Hong Kong show in September, point to this trend, which suggests that the upcoming season will be no worse than last year.

Now about the negative aspects. There are always concerns about the volumes of rough that mining companies unload onto the market during the period of diamond market growth. There is no one to quantify how much rough the market really needs. The market can consume as much as money can buy. These funds on the market, which can be spent to buy certain amounts of rough, have been strongly reduced since the beginning of this year. This process started with a bank fraud in India worth two billion dollars involving a number of diamond companies, which, of course, does not speak well for our Indian colleagues, but clearly shows the essence of what is happening in the diamond industry to the whole world. This story seriously scared major players in the financial sector, so we see a significant outflow of banks from this business. As a result, financial flows are increasingly being concentrated in single hands, which is always dangerous. Further, taking into account the enormous amount of rough that has been released to the market, it is possible to calculate with a high degree of confidence the amount of resulting polished diamonds put on the market in the second half of this year and now exerting pressure on prices and demand. The supply of polished goods has grown significantly, and this negative trend will continue until the end of the year. In parallel, there is a decrease in funding and a slump in demand for rough. Another negative trend is that rough prices are outpacing polished prices. Margins in the middle part of the diamond pipeline turned to be again under heavy pressure and reduced. When rough will become a more convenient tool for manufacturing diamonds and not for speculation, then the market will begin to stabilize. This is the real picture today, and our company’s arms in Antwerp, Hong Kong and America are reporting this quite clearly. And if the sightholders of diamond mining companies start reselling their boxes at a loss, this is usually the first sign of such situations rising in the market.

Vladimir Malakhov, Rough&Polished