Derivatives in the Polished Market

by Andrei Nikolashcenco
Economist and head of the FSUE Almazuvelirexport Market Research Office

From the end of 2006, the polished diamonds exchange trade has been under discussion in the market. Although this time, “packing” was more modern and “stuffing” has undergone some changes. So-called derivatives, i.e. derivative financial instruments, are proposed to become the hit of the season this year. Discussions of the problem of how to organize trade in standard contracts on polished diamonds has not disappeared from the agenda, but now regard the Over the Counter Market or OTC creation.
Consulting firm WWW International Diamond Consultants Ltd, which owns the site PolishedPrices.com (РР) acted as an initiator. Martin Rapaport sat down to develop a new idea at the June meeting of diamond bourse presidents in Amsterdam.

What is it? What is it for?

Before we start looking into the essence of proposals on diamond derivatives, let’s recollect what a derivate means. Derivative (read “derivative instrument”) is a financial instrument based on the other financial instrument. This definition is impressively detailed and thus difficult to argue with, but it is too general, and although it covers all kinds of derivatives, it does not describe peculiarities of derivatives — some of which are very special. A subject of a transaction can be practically anything: goods, currency, shares and other securities, and interest rates. In the case of diamonds, the idea of promptness lies in the basis of the discussed instruments, meaning that here we can speak about forward contracts, futures and options. “Mechanism of action” of all these instruments is analogous to: the price is fixed now, and the goods (or some other assets) are delivered later.
A forward contract is the least standardized declaration of intention of a seller and a buyer when they themselves act as the parties of the transaction. An option is a right for a certain payment to make an urgent operation (the technique of options trade is difficult, if not impossible, to set forth in a few words, thus its description will only distract from understanding of the process’ essence). And it turns out that the essence of the process reflects futures contracts or futures best of all.
Futures contract is a contract of sale or purchase of a certain quantity of goods of a certain quality at the price fixed at the moment of the contract conclusion, with delivery to be done at a certain moment in the future. Futures trade is strictly regulated and carried out on specialized trading platforms under the control of profile organizations (for example, Forward Market Commission in India). Value given to the control over futures operations can be testified by the fact that in the U.S., The Commodity Futures Trading Commission (CFTC) was established by Congress — the superior legislative authority in the country. CFTC is an independent agency authorized to regulate the U.S. market of commodity futures and options on a national scale.
Futures contacts have standardized conditions defined by a stock exchange, not participants of the market, as in case with forward contracts. The standardized conditions include: quantities of goods to be delivered (size of the contract), months of delivery, closing day of trade, place or places of delivery, and qualities or sorts of goods admissible to delivery.
To consider a concrete example will be most illustrative — the futures contract of wheat concluded by the Chicago Board of Trade (CBOT). It provides for the delivery of 5,000 bushels of any of several specified sorts of wheat within March, May, July, September or December (at that, the closing day of trade is underlined) to any of the specified places of delivery, namely: Chicago, St. Louis, Toledo, Ohio, Burns House (Indiana), where the stock exchange has its storehouses. The contract clearly defines different sorts of wheat, as well as discounts and the extra charges to the futures price.
Some words about technique. The purchase of a futures means that you have negotiated either a sale (short position) or a purchase (long position) of goods that are the subject of the contract (underlying asset). Sale of futures is an inverse operation: whereas you previously sold — now you buy, and whereas you previously bought — now you sell.
Futures transactions made at a stock exchange are accounted at a clearing organization which acts as a buyer for all sellers and as a seller for all buyers. When a futures contract is bought or sold, purchase or sale is technically made from a clearing organization, not from the party, with which you made a deal in a trading hall or over the Internet. As purchases and sales are finally made at one and the same contractor, if you first buy a futures contract and then sell it (most likely not to the person who sold it to you, but to the clearing organization), you “close” your position and the contract appears to be executed. Closing a contract at the stock exchange is called “offset”. You are obliged neither to buy, nor sell goods any longer. Compare it to the forward market: if you bought a forward contract and after that sold an identical forward contract to another person, you have obligations under the two contracts – the one short and the one long.
And, finally, there is a point causing the greatest misunderstanding amongst people who have nothing to do with futures trade. Having made a delivery contract, conditionally speaking, in December, you do not have to necessarily wait for this term to transpire, worrying about the direction the market will take. The December futures contract is traded at the stock exchange constantly, before the closing day of trade specified in the contract. Transactions are made every second, especially, if it is a matter of a high-liquid contract with great volumes of the exchange tenders. Therefore, a futures contract with delivery to be made in some months can actually be closed already within minutes after its opening.
Upon opening the contract, a trader places the so-called initial margin to his account, the size of the margin usually making from 2 to 10 percent of the contract cost. Every day, on closing of the exchange trade, the change of price during the day is reflected on the trader’s account, the position “is corrected according to the market.” If the price rose, the seller bears losses, receiving a smaller part of the profit, this is reflected by a decrease in balance on his account. So, if a futures contract was opened at the price of .50 for a bushel and the price of closing made .60, the account will be reduced by ,000. Thereby it is supposed that in the case of the contract’s offset at the price of closing, the farmer will buy grain for .60, but will be compelled, according to conditions of the futures, to sell the grain for .50, thus bearing a loss. If the sum on the account becomes less than a certain size, the trader will be required to bring in an additional margin — the so-called variation margin, to restore the balance on the account up to the level of the initial margin. When the contract date comes, the dealer can realize a profit he received or a loss he bore by carrying out a delivery of physical goods to one of the stock exchange’s warehouses, or by doing an offset.
The practical value of futures is obvious. It is a way for a businessman to insure himself against all possible adverse changes of prices in the future. By fixing the price, both a manufacturer (in our example, a manufacturer of grain), and a buyer provide for themselves a known size of future receipts in advance. Actually, forward and futures contracts appeared as the means of such insurance — hedging. It is necessary to note that this “invention” is not so old. The surge of futures trade and the formation of the developed futures markets occurred in the 1970s in the U.S., and manufacturers of primary goods, firstly, agricultural, acted as pioneers in this area
Let's take another example to see how hedging is carried out. A farmer in Omaha (Nebraska) expects to collect 50,000 bushels of wheat. At the CBOT, a futures contract, with delivery in December, is traded for .5 for a bushel. The farmer buys ten futures sale contracts. Initial and supported (or guaranteed) margin under the contract (an established minimal sum, below which the balance on the account cannot fall) makes 0, thus, he must place ,500 to the account. Considering a “daily correction according to the market,” the farmer may be required to bring in additional sums, if the market goes against him.
At last, the crop is reaped. It appeared to be good and the price of futures contracts decreased to dollars for a bushel. As a result, the farmer’s futures account, which reflects the difference between the initial price of the futures (.5 for a bushel) and its current price ( for a bushel), multiplied by a quantity of goods (50,000 bushels) grew by ,000. The farmer has 50,000 bushels of grain in his granary and owes 50,000 bushels to the stock exchange.
There are two ways to fulfill hedging. The first is to carry out physical delivery of goods, i.e. simply sell the goods for .5, 50 cents higher than a current market price, what he actually counted upon when he made the futures contract. However, it will require a payment of transportation of wheat to one of the delivery points specified in the contract; that can be too expensive to do from Nebraska.
An overwhelming majority of the contracts are liquidated through an offset at the stock exchange, through purchase in this case. The farmer buys ten contracts at the price of for a bushel thereby closing ten contracts opened previously and receives ,000 of profit, which compensate a decrease in proceeds from selling the wheat at the price of for a bushel to a local granary. Though the price for wheat in the local market can differ a little from the price for wheat in Chicago, it is reasonable to assume that these prices are closely connected, otherwise, it would be possible to easily enrich oneself by just being engaged in price arbitration — to buy goods where the prices for them are lower and to sell where the goods cost more. This is actually what happens, leading to the fast adjustment of prices.
If the price for wheat increased up to , the farmer would lose ,000 in the futures market, but he would compensate these losses having sold his wheat at the price of for a bushel in the spot market.
The given example is a little bit simplified in the sense that it does not take into account the so-called “basic risk” — that a difference in prices in the futures market and the spot market arises from time to time. As a rule, the prices for futures are a bit higher than the spot prices, a situation known as “contango.” This is some kind of a discount for charges on storage of the goods and discount income arising from a difference between the margin and the full cost of the contract. However, in case of change in market moods, for example, when there are expectations of growth of supply, backwardation can take place, when the spot prices are higher than the prices for futures. Negative market expectations can lead to impossibility for the farmer to completely insure himself against price risks.
However, some futures merchants, not being farmers, do not aspire to secure themselves against risks. Futures, as well as some other urgent derivatives, such as options, became convenient tools for speculation. This was promoted by both the “big financial arm” (parity between the cost of goods that are a subject of the contract and the initial margin) and volatility of prices for futures. The example with the agrarian shows how a rather small sum of investments, ,500, enabled him to receive almost fourfold profit of ,000, with the change of price being only about 15 percent. But as every stick has two ends, in the futures trade it is easy to bear losses, as shattering as the profit, which can considerably exceed the sum originally placed to the account. It is possible not only to lose everything, but also to remain indebted. That is why speculation in futures belongs to the most risky. The purpose of a daily “correction according to the market” and variation margin becomes clear — just to prevent the occurrence of such debtors.
Thus, derivative instruments pursue the most practical purposes. For subjects of the market, a use of urgent derivative instruments consists in price risks insurance (hedging), establishment of representative market-prices – “the market price finding”, and receipt of speculative income.
After such a wide consideration of various aspects of derivatives trade, it is possible to try to allocate the basic conditions necessary for their existence.
Standardization of the contract’s conditions and, first of all, requirements for quality of goods, excludes the need for additional coordination and allows for the conclusion of a contract without carrying out visual examination of the goods by the buyer. The goods, which are the basis for derivatives, should be homogeneous or have a precise and unequivocal system of quality gradation. Furthermore, parameters of futures goods quality are objective, i.e. can be measured (content of useful component, humidity, etc.). The only parameter that has to be coordinated is the price, but this process is also extremely formalized. As a result, transactions can be made long distance — by phone or over the Internet, and very rapidly — literally within a few seconds.
The main difference between polished diamonds and other exchange goods is that the key parameters of a diamond’s quality are subjective. Take, for example, the character and arrangement of inclusions — they are beyond any quantitative expression. Hence, the qualitative characteristics of a stone cannot be exhaustively defined within the limits of any classification of diamonds. Firstly, this leads to the case when one and the same description of quality can match diamonds having different prices in the market, and, secondly, in case of essential divergence of such prices the estimation of a diamond exclusively on the basis of “paper” characteristics becomes too risky for the dealer.
Moreover, visual examinations of goods and trade in standardized contracts are not compatible. In fact, the idea of over-the-counter or exchange trade consists only in the fact that a clearing center and not an individual contractor with his or her concrete goods act as a party of the transaction. This makes preliminary visual examination of goods senseless, because upon execution of the contract, the buyer will receive not those stones or the batch, which he has preliminary examined, but any stones casually chosen from the available stones in the stock exchange’s warehouse. Either the quality of goods in the standardized contract is defined unequivocally and does not leave space for uncertainty, or the quality of goods, which will be delivered after the contract closeout, turns into a subject of a lottery that deprives such a trade of economic sense.
Pricing. The process of pricing for futures is the most objective and transparent for participants of the market. In real time, a trader has an opportunity to see not only at what price transactions are made, but also what quantities and at what prices are announced for purchase (bids) and for sale (asks). Let’s assume that a trader wants to make 10 contracts to buy. The best bid makes 20 contracts, .98 for each, 4 contracts on “ask” for .01 each, and 23 contracts for .02 each. If a trader wants to make a contract as soon as possible, he can buy “on ask”, buying 4 contracts for .01 each and 6 contracts for .02 each. When a new and better bid is exposed on 10 contracts for .99 or .0 each, he expects to buy for a bit cheaper than the best ask, attach his contracts to one of the exposed bids, or make a new, but not the best, bid at the price he considers reasonable, and counting on the market to move in this direction.
Liquidity. The owner of the futures should have an opportunity to buy or sell the futures at any moment. First of all, liquidity is defined by a quantity of goods circulated in the market. Rarity of goods obviously affects liquidity by reducing the number and frequency of transactions. Besides, there should not be a situation when the owner of the futures cannot find a contractor to make a transaction. In the developed markets, this problem is solved by technical “particulars,” the value of which is difficult to overestimate, such as market-makers (large companies), which are responsible for maintaining liquidity of a concrete underlying asset. For example, Russian investors that bought shares of some investment funds at the exchange tenders, have gone through many bright, memorable minutes while trying to get rid of them at falling of the market, as they could find no offers for purchase. A market-maker has to constantly hold both offers for purchase and offers for sale in the market; it is a different pair of shoes when their prices are not regulated (in other words, market-maker can propose to sell at a too high price and to buy at a too low price).
Last, but not least, and what was constantly mentioned above but not brought to a focus, is the presence of the developed spot market. In fact, all the above-mentioned conditions are characteristic for the exchange and over-the-counter trade which was born from sale and purchase of cash commodity by means of standardized contracts. Prices in the futures market are based on the prices in the spot market, because compulsion of a condition concerning a possibility of physical delivery in the futures contract consists in guaranteeing concurrence of prices for futures and prices in the spot market. If there is no possibility of physical delivery, contracts would simply be closed by offset, i.e. at the price of the futures market. As nothing in it interferes with a free game of supply and demand, nothing guarantees that the price for the futures and the spot price will be equal. If a supplier or a buyer has an opportunity to close the contract by offset or delivery/take-over of physical goods, then it is obvious that from the two alternatives he will choose a more favorable one, thereby price convergence will be provided.
Urgent contracts, i.e. futures and options, could arise only on the basis of strictly observed, precise rules of the exchange trade, but only later as means of realization of other functions —hedging and speculations. However, as we have seen above, hedging also requires the spot market. Without it, hedging will work only in half of cases — when a supplier will profit from purchase of the futures. In this case, he can “be closed”, after having delivered physical goods to the stock exchange (even if he bears additional charges for transportation). If he does not bear a loss from the futures, then after having closed by offset at the stock exchange, he cannot know for sure at what price and to whom he will sell his goods, if there is no spot market.

In search of underlying asset

All the abovementioned, concerns the already developed futures markets. In the world market of polished diamonds, not only do futures not exist, but there is even no elementary base for them — i.e. no trade under standardized contracts. How is a use of derivatives seen with an underlying asset such as diamonds? It is most systematically stated in the “Document for discussion of creation of derivatives contracts,” prepared by WWW International Diamond Consultants Ltd and published on PolishedPrices.com (PP).
PP specialists see the general direction of derivatives’ development in the manner of developing standardized contracts and procedures, which at the initial stage could be used to developing an over-the-counter market (OTC). If the spot market develops successfully, a development of futures trade is not excluded subsequently.
However, practical realization of these ideas is hampered by the same old problems. Namely, by what an underlying asset will be and how the prices for it will be defined. Authors mark that historically, the diamond industry did not show enthusiasm for the idea of derivatives, because it would cause damage to the image of the diamond. However, to a much greater degree, lack of enthusiasm has been connected with the principal difficulties connected with the assessment of diamonds done behind one’s back and only on the basis of quality parameters established by a standardized contract — a basic condition of the exchange and over-the-counter trade. Not seeing a stone (even if it has a certificate of a gemological laboratory) or a batch of diamonds, a diamantaire cannot precisely tell its price. The reason is in the subjectivity of the gradation of diamonds’ quality. “There are no two identical diamonds” — every diamantaire is ready to sign under this statement. From here, there is only one step to a, strictly speaking, not absolutely correct statement that “there are no two identical prices either.”
As a mechanism of price defining, РР suggest to use a system, analogous to the London gold fixing, concentrating basically on the technical side of the question: setting an independent organization (which could be РР), carrying out daily teleconferences, publishing the fixed price by the agencies Reuters, Bloomberg and РР themselves. In brief, the essence of the London fixing is that some participants — acting as representatives of numerous subjects of the market, declaring a number of transactions on purchase and sale at this or that price — try to achieve the price at which the volumes of applications for purchase and sale are equalized. This is the price of fixing. The procedure is fulfilled twice a day. РРs offer something analogous for diamond prices.
It is difficult to agree that the price should be defined by a group of specially authorized traders. The ground is too fertile for conflict of interests. To define the price, traders should act either as sellers or buyers that generate their interest in certain developments of the price. A direct interest combined with an opportunity to influence the price (under a special position of such dealers) is not the best condition for objective pricing.
There is one question that arises immediately: prices for what goods? РР suggest to use some standard set of diamonds as underlying assets (a batch of standard assortment and weight) and a diamond index based on its prices.
Each standard batch offered by РР for discussion contains one 1-carater of each position in the range of colors H, I, J and qualities SI1, SI2, SI3, i.e. nine stones overall. The main reason for which 1-carat diamonds of the specified colors and qualities were chosen is the popularity of 1-caraters among the public at large and the prevalence of the specified colors and qualities in global diamond extraction, the two reasons raising liquidity. Apparently, a circumstance that РР foresee as a possibility of incomplete delivery of a standard party at execution of the contract is explained by fears of physical shortages of goods. Variants of delivery of any six or one to two stones from an assortment of the standard batch (at the discretion of a seller) are offered. A difference in cost arising at incomplete delivery is proposed to be compensated for in cash, proceeding from the market price of the standard basket on the date of performance of the contract.
As in practice, a situation when a diamond weighs exactly 1 carat is extremely rare; it is therefore provided that a difference between a contractual and actual weight of the standard batch is compensated for in cash at the price of performance of the contract.
Tendering and fixing a price for the standard basket of diamonds are kept within a general scheme of trade in standardized contracts. However, questions of principle remain open: a prospect of the standard batch absent appraisal, liquidity, and the main question connected with the first two — a degree of quality specification.
The last point should be observed in more detail, because an increase in detailed quality description  generates fundamental contradiction. It is clear that the more precisely the quality of a diamond is defined, the narrower the price range for which it can be sold. Therefore, on the one hand, the more detailed the diamond’s specification, the more real the possibility of its correspondence appraisal. Though, as indicated above, subjectivity of definition of some quality parameters of a stone can make it essentially impossible to have an unambiguous appraisal. On the other hand, the more precisely qualitative characteristics are defined, the more difficult it is to find diamonds precisely corresponding to them, which reduces the number of stones suitable for a complete set of the standard batch.
РР’s attempt to raise liquidity by the possibility of incomplete delivery of the standard batch only complicates the situation. They say that “The devil is in details” — when something that is insignificant at first glance leads the dance, ignoring such circumstances can destroy the entire construction.
While a price for the standard basket “is defined” by the market, prices for diamonds sold to cover an incomplete delivery of the basket are proposed to be defined by calculation, proceeding from the market price of the basket. The application of calculated discounts and extra charges to the price in derivatives on other original goods is based on the idea of “a useful component” (for example, content of gold in the alloy, gluten or fiber in grain, etc.), and arithmetic calculation is justified in similar cases. Strictly speaking, prices for diamonds of certain categories do not depend on the prices of the neighboring categories and parities of the prices can and will vary depending on supply and demand fluctuations. In fact, to state that the price for a 1 carat, I, VS1 diamond is strictly on five percent (or some other strictly defined number) higher than the price for a diamond of the same size, but J, VS1, would be a blatant mistake. In practice, there will always be a divergence between a market and calculated price for a diamond from the basket, and when the market price is lower, a stock exchange warehouse will turn into a garbage bin where overpriced diamonds will be thrown.
Maybe, a possibility of incomplete delivery does not break the interests of the supplier, but is completely unfavorable to the buyer, who will remain with unmarketable overpriced goods or will not even receive the stones he wished. This makes the participation of dealers interested in deliveries of physical goods in derivatives trade senseless, creates the most serious threat for over-the-counter market, and leaves only speculators in the market of futures. Certainly, in practice, it is not the buyer who will lose, because under such conditions he will close by offset, but a clearing center of the stock exchange. In turn, instead of possessing certain, strictly considered quantities of standard baskets, the stock exchange soon remains with a heap of diamonds from which it will probably not be possible to make any basket.
Further on, РР speak about derivatives, an underlying asset for which there is an index. Derivatives trade to index implies use of futures and options. Taking into account that contracts on such derivatives are closed by monetary offsets (no wonder considering that physically, index cannot be delivered by the seller to the buyer), it is emphasized that index should be simple enough and clear. As a basis for its calculation, it is suggested to use both a price of the standard batch and a price of separate categories of diamonds constituting it. It should be noted that the use of prices for separate diamonds can be justified only in the case where the diamonds are also tendered. Usage of a calculated prices’ index as a basis only creates a vicious circle when calculated prices are calculated through the price of the basket, which itself is used for the calculation of index.
Other proposals of РР are not specific to the diamond market and describe the most standard moments of the international practice of trade in derivatives and, in particular, in futures, such as questions of place of delivery, storage, sizes and ways of financing the margin (the proposed size of the initial margin makes 15 percent of the contract’s value), hedging, operation of authorized members of clearing organizations (stockbrokers), and features of taxation.

Impulse and impact

Unlike the cautious approach of PolishedPrices, Martin Rapaport has already started receiving market prices for calculating the price index for diamonds, having organized the first auction especially devoted to it, in September 2007. Laid out for sale were 210 polished diamonds, the quality of which were described by the following parameters (all the exposed diamonds had a round form of cut, therefore, the form of cut is not given further special mention): weight (1.01-2.9), color (D-K), quality (IF-VS2), proportions (EX, VG), quality of polishing (EX, VG), symmetry (EX, VG), fluorescence (F, N).
Thus, three questions were solved at once: what will be the underlying asset, how prices will be set and what will form a base for diamond index.
An attempt to describe the quality of diamonds as precisely as possible resulted in the allocation of 6 parameters, each of which has from 2 (excellent, very good) up to 8 values (color of diamond). As a result, even within the limits of one size, for example 1.00-1.99 carats, in the narrow niche of colors and qualities chosen for auction, diamonds are usually divided into 320 categories of quality and consequently, there are, at least, the same quantity of prices corresponding to these categories.
This is not so far from the earlier drawn conclusion: “so many diamonds, so many prices.” At the auction, 37 groups of diamonds with absolutely identical qualitative characteristics, weighing 1.00-1.99 carats each, were displayed, each group counted from 2 up to 11 stones. But diamonds within a group were appraised differently. At that, a divergence of up to 45 percent in appraisal of identical diamonds, according to the specification, cannot be considered negligibly small. Below are the data on four of these groups accumulated the greatest number of diamonds.

Size (carat)	1,00-1,99	1,00-1,99	1,00-1,99	1,00-1,99
Color	G	G	G	G
Quality	VVS2	VS2	VS1	VS2
Proportions	EX	EX	EX	EX
Quality of polishing	EX	EX	EX	EX
Symmetry	EX	EX	EX	VG
Fluorescence	N	N	N	N
Number stones in the given gradation of quality	11	9	6	6
Min from the best bids (USD for one carat)	6 336	4 512	5 120	4 500
Max from the best bids (USD for one carat)	7 411	6 530	6 350	4 850
Excess of max over min	17%	45%	24%	8%

The results seem to be a master card in favor of the impossibility of “correspondence trade” in separate diamonds. Usage of a separate diamond as an underlying asset showed the insolvability of the contradiction between a necessity of a detailed description of quality gradation and the liquidity of the market. A nontrivial problem will probably be to provide regular availability of any significant amounts of diamonds with identical descriptions of quality at auction.
An attempt to “rough” the parameters of quality, for example, by reducing their number, will even more increase dispersion of prices for “identical” (if to judge according to such rough descriptions) goods, making their appraisal by paper descriptions impossible. Take, for example, a polished diamond of round cut, weighing 1.00-1.99 carats, G color, and VS2 cleanliness. There were 30 such stones at the auction, but they differed by the parameters of quality skipped by us: fluorescence and quality of cut; and a certain maximum price was offered for each of the stones. By results of the auction, an average price for these 30 stones was ,521 per carat, with a standard deviation of ,143 per carat or 9.3 percent of the average price. The received maximal offers were in the range of ,407 to ,498 per carat – the difference almost double. We shall emphasize that “a round carater of color G, quality VS2” is a characteristic, widely spread among businessmen and perceived by them as sufficient to begin negotiations.
The form of auction chosen by Rapaport differs in principle from traditional exchange tenders, because only buyers compete with one another during the auction. Besides, it turned out that there is the seller’s so-called “reserve price,” unknown to buyers, and only its achievement or excess results in the conclusion of a transaction. If tenders are organized in this way, a situation may arise whereby a buyer offers a higher price for a diamond than the one at which a seller was ready to sell. As a result, auction prices can be overstated compared to the market prices formed in conditions of free competition among buyers and sellers.
At tenders like these — when only bids are exposed and there is a reserve price unknown to the market, it is impossible to guarantee that all goods exposed for auction or even any certain and constant part of the assortment will be sold. As sets of diamonds sold by auction will always be different, a diamond index supposed to be calculated on the basis of the prices reached during the auction will not have a stable base.
We think the fact that at the auction held in September 2007, only 27 stones were sold from the exposed 210 diamonds, i.e. not more than 10 percent of the total number, may serve as a confirmation of the expressed apprehension.
Of course, practice makes perfect. Probably, in the process of accumulating experience from organizing regular auctions, the market will receive a source of rather objective information on prices. However, the first auction has already made it possibly to reveal some principle issues.
Separate diamonds cannot be the underlying asset. The subjectivity of diamonds’ qualitative characteristics leads to a necessity of its visual examination for the purpose of price fixing (at least, for large-size diamonds weighing 1 carat and more). It, in turn, undermines the foundation of the whole construction with standardized contracts and futures.
Stones with all six absolutely concurring parameters of quality will meet rarely. A consequence of this will be low liquidity of spot trade in separate stones.
Rapaport’s plans to use prices received during auctions to calculate a monthly diamond index can meet with difficulties, as was mentioned above. Such an index, if calculated by a reasonable method, could certainly become a useful indicator of price dynamics for the diamond market. However, such a monthly index certainly could not become the underlying asset for a derivative. Or it would be an extremely specific derivative instrument. Now, all, without exception, indexes used as underlying assets for derivatives are derivatives of prices of the exchange tenders and have constantly changing values, absolutely similar to the prices of the exchange goods. Futures contract on a diamond index, the value of which will be set once a month, and in periods of recalculations a “price” of the futures will remain constant, will be the first futures of such a kind in the world.

Who needs it?

Apparently, attempts to invent a wheel of a particularly complex construction will not bring any results. Simple decisions checked by practice seem more vital. In particular, it seems that a price for a derivative should be a traditional exchange price established during open tenders by balancing between bids and asks. And the underlying asset should most likely be some kinds of standard baskets. There are ideas concerning the possibilities to avoid “a trap of detailed specification of quality,” simultaneously providing liquidity. Exchange quotations of these standard baskets can, in turn, be a good base for diamond index. However, what can all these instruments give to the market?
The importance of the “finding the price” function carried out by modern commodity exchanges and over-the-counter trade in derivatives cannot be underestimated. Although rather insignificant quantities of physical goods circulate in stock exchanges, exchange prices are, nevertheless, an objective base used everywhere in the commercial practice of contract prices fixing. The industry on the whole can be interested in receiving reliable price information. Still, it will be insufficient if individual participants of the market will not benefit from derivatives trade.
What benefits can diamond manufacturers make from it? On the one hand, realization of standard contracts allows them to make transactions quickly, even without having direct contact with a buyer. To tell the truth, there are rests of diamonds which “did not fit in” standardized assortments of the standard basket and which a manufacturer will have to realize in the normal way. It is clear that the wider the assortment of the standard basket, the less “rests” are formed at the manufacturer and the higher his interest in trade under standard contracts.
What interest does the buyer have? It can be a diamond dealer or a jewelry manufacturer. Considering the fragmentation of diamond manufacture — trade in mass categories of diamonds is almost always “the market of the buyer.” Now the buyer has an opportunity to get the assortment which interests him, using long-term credits at that. Basically, he also can be interested in fast and effortless diamond purchases; however, he will be captious in questions of assortment, wishing to receive the maximum of what he needs. It is better for the buyer to purchase several batches, each of which contains a narrow assortment of what he needs, than a batch in which a share of low-liquid categories is essential. At this point, the assortment of the standard batch will be narrowed down.
So, on the one hand, buyers are interested in a rather narrow assortment of the standard batch, but with a wide range of different batches. On the other hand, it increases risk when a situation arises whereby some standard batches, which are not currently in demand, become illiquid, i.e. they are in no demand at any prices. A secret or art of the diamond trade is actually in the skill of selling illiquid goods coupled with tradable categories and avoid accumulation of sticky stocks. Assortment of the standard batch should be a result of the compromise between “narrowness” and “width,” and the accuracy of its choice will play an important part in the general success or failure of trade in derivative instruments.
The next stage in the derivatives market development is trade in futures by the standard basket (or some kinds of standard baskets). For the diamond market this trade can have the following value: it will slightly increase a demand for physical goods for maintenance of transactions within the limits of exchange or over-the-trade. Costs of using financial resources will be reduced. And, of course, manufacturers and consumers will be able to insure themselves against price risks. That is why the first group of consumers of futures is both suppliers and buyers of diamonds interested in hedging.
However, is the manufacture and realization of diamonds connected with such serious price risks that their realization is impossible without hedging as a whole and futures as an instrument of its realization in particular? If the question is put in such a way, the answer seems obvious: the industry has been functioning for centuries, coping with price shocks. But it should not be forgotten that the cost of rough makes the lion's share of the cost of diamonds; besides, prices for diamonds were rigidly regulated up to 2000, thus reducing to a minimum or completely eliminating price risks. From this point of view, recent years’ events in the sphere of the global rough diamond trade have objectively promoted a growth of price volatility in the industry and interest in insurance against price risks.
On the other hand, unlike agricultural and raw goods where a production cycle is long (from planting to cropping) or current costs are significant, a cycle of diamond manufacture takes only several months, i.e. it is rather short, thus preventing the negative movement of prices from taking on a menacing character. The impression is created that a diamond manufacturer is to a greater degree interested in the spot market on which he can quickly and for transparent prices realize the goods, than in the urgent  market.
Without the spot market, with its inherent objective, “exchange” quotations, the degree of price risk in the diamond market is not clear. For the moment, commercial practice, in particular the fact that diamonds are sold in batches of rather broad assortments, testifies in favor of the fact that diamond prices are not subject to sharp changes.
Another category of diamond futures consumers are speculators. Here it is necessary to note that a diamantaire and a diamond futures speculator have little in common. Subjects of the diamond industry will hardly start receiving significant additional incomes from operations with futures. Diamantaires wishing to speculate with futures could have long ago realized their wish in other markets. Therefore, the hypothetical prize for the diamond industry can consist in a certain growth of demand for diamonds for maintenance of exchange stocks. But the effect from speculations will not necessarily be positive for the global diamond market. Speculation can increase volatility of diamond prices playing not only against manufacturers, but also against jewelry consumers.
Another purely speculative instrument – futures – has no relation either to the growth of the diamond market, or to diamantaires’ interests, being entirely a prerogative of sophisticated financiers. Though РР specify that diamantaires can have diamond index as an instrument of hedging diamond stocks, considering all possible varieties of assortments of stocks and differences in tendencies of prices for separate groups of diamonds, futures for goods can be successfully used as an instrument of hedging diamonds stocks and the price movement for them is just like the dynamics of prices for diamonds, i.e. goods like precious metals. In this case, the spot market of diamonds is more necessary for hedging. If such a market existed, hedging by index would already be possible to do.
In conclusion, we would like to emphasize that a purpose of this article is to give the Russian participants of the rough and polished diamond market additional information on trade in derivative instruments and some new ideas in the market of polished, which can serve as food for thought. Success of diamond derivative instruments will finally depend not on analytics’ reasoning, but on the interests and actions of the market participants, each of whom will decide for themselves whether diamond derivatives have a future.