As surely as day follows night, the world is slowly but inevitably inching towards a system of futures trading in diamonds. However, like the two opposite poles of a magnet, any push from speculators is met with resistance from the diamond traders fearing price transparency and an artificial price rise.

Although commodity derivatives are a reality, nowhere in the world is there futures trading in diamonds. Either because the government has not allowed it or it has not worked successfully, resulting in huge losses for the speculators.

Speculative Trading Without Stock :

Trading in futures is based on the speculative instinct. It tempts investors, with limited capital, to trade in commodities without having any physical stocks. Without buying or owning anything, one can bet on the future price of an asset. This kind of trading involves a contractual agreement to buy or sell an asset or a commodity at a future point in time at a specified price. For every trade there is a buyer and a seller.

Payment and delivery does not take place until this specified date. The speculator also has the option to offset his position at some time before the date set for future delivery. If the price has moved in the right direction, he will profit, if not, he loses.

Important Functions :

Futures trading performs two important functions of price discovery and price risk management.

For example, this can be useful to diamond exporters as it provides an advance indication of the price likely to prevail and thereby help the exporter in quoting a realistic price and secure an export contract in a competitive market.

Futures trade in rough diamonds would also help traders hedge against currency appreciation and the demand-supply position.

For instance, a diamond manufacturer can protect business from any fall in future rates by agreeing to sell a particular specified quantity and quality of polished stones for a certain price. On the other hand a diamond jewellery manufacturer could contract to buy a specific lot of stones at a certain price on a future date, thus hedging against a rise in future prices. In such a futures market, there could also be the speculators simply betting on the direction of price movement.

The Liquidity Angle :

According to Bruce Babcock, the trading guru, futures trading is meant to protect producers and consumers who need to hedge their risk from future price changes. The speculators, who do not actually deal in the physical commodities, are there to provide market liquidity. Without the speculator, futures markets could not function.

Thriving in India :

In India, commodity futures’ trading is presently permitted in 41 commodities. According to ministry figures, the trading volume and value have increased manifold after the three national level Exchanges were set up. During 2005-06, the total value of commodity futures trade was Rs. 21.34 lakh crore as compared with Rs. 5.71 lakh crore during 2004-05, an increase of 274 per cent. The volume of trade also went up by 244 per cent, to 6,685 lakh tonnes during 2005-06 as compared with 1942 lakh tonnes during 2004-05.

The Indian government has already permitted futures trading in agricultural commodities, metals, bullion, financial instruments and intangibles like currencies, stocks and bonds. But not in diamonds. Not yet. Primarily because ascertaining the quality of diamonds is a complex process and the trade is secretive about base diamond prices.

Diamonds to Follow ?

However, sources, on condition of anonymity reveal that “the government is seriously considering allowing futures trading in diamonds. All modalities are being worked out.” After all, diamond is a commodity. It is a natural resource with a limited supply. It is graded. It is certified and it can be bought and sold around the world.

Significantly, in the first week of October, India’s largest commodity bourse, the Multi Commodity Exchange of India, set up by Financial Technologies, launched the MCX Stock Exchange that has become the third bourse in the country to start trading in currency derivatives. The MCX is already into futures trading in bullion, silver, precious metals, copper, crude oil and carbon.

“It seems only a matter of time that trading in diamond futures is also permitted,” opined Suman Das Sharma, Vice-President, Business Communications, FTIL. “But the economy will first have to stabilize. The market is too volatile,” he added.

Bharat Diamond Bourse Eagerly Awaited :

He also felt that Mumbai’s Bharat Diamond Bourse, in the Bandra Kurla complex, that is about to become a new hub for diamond merchants, could be a big opportunity for futures trading in diamonds for those who want to open up.

Some diamond traders are eager, anticipating a market for bigger stones. Says Darshan Bhagat, Chairman, China Diamond Corporation, “Diamond is a commodity. The demand exceeds its limited supply and soon, there is going to be a diamond commodity fund in the market which will buy polished diamonds over 10 carats, and gem quality ones for trade.”

But before this can happen, the government of India would have to officially put diamonds on the approved list for futures trading. There is a slow but deliberate movement, even internationally, in this direction. Business needs avenues for speculation and the list of commodities available for futures trading is lengthening all around the world.

Ground Being Prepared Internationally :

Nowhere in the world are diamond futures being currently traded. But there is a move in this direction.

Rapaport, the New York-based company that provides the copyrighted monthly price index of diamonds, is neither in mining nor manufacturing of diamonds, has already sought permission from the US Commodity Futures Trading Commission (CFTC) to start the world’s first diamond-futures contracts, as reported in the Wall Street Journal last year. This is the second time such permission has been sought.

Closer home, the Dubai Gold & Commodity Exchange, set up by the Dubai Metals and Commodities Centre (DMCC), with functional and technological expertise from the Multi Commodity Exchange of India Ltd. (MCX) and Financial Technologies (India) Limited (FTIL), already facilitates futures trading in 60 commodities including gold, silver, steel and soon possibly diamonds.

Another ambitious project by the Dubai Diamond Exchange is International Diamond Laboratories, a new diamond certification service to be headquartered in Dubai, with branches in Antwerp and Mumbai. This will be the first attempt globally to commodify the diamond trade by bringing price transparency and creating a potential for the futures market.

Meanwhile, in India, diamond traders and retailers are reportedly waiting and watching the turn in the tide. Not without some trepidation.

Historically Disfavoured :

Some diamond traders recall that in the early 1970s, the West Coast Commodities Exchange in US had attempted to trade diamond contracts. But within a couple of weeks, prices crashed, speculators lost big money and the exchange ended diamond futures trading for several decades.

Then in the 1980s, Martin Rapaport had proposed the creation of a futures market for diamonds but the New York Commodities Exchange rejected the proposal because “the diamond industry didn’t want price transparency,” he was then quoted as saying.

More recently, a diamond fund was introduced in London as an alternative investment. But even that did not generate investor confidence and failed.

Currently, the market is volatile. Credit systems in the US are crumbling with a rippling impact around the world. There is financial uncertainty. Yet, around the world, diamonds are big business that is always looking for new avenues for expansion like diamond futures trading.

Big Players Could Push Up Prices :

Although, diamond prices are normally linked to crude oil prices and dollar fluctuations, recent speculative tendencies have led to a spike in diamond prices. According to Amit Bumb, Director, Avenue Montaigne, Gold Souk, Gurgaon, “Diamond prices have been steadily climbing. There is an increase of nearly 50 per cent in diamond prices over the last two years, as reported by Rapaport.

Agrees Anil Shah, Partner, Venus Jewels. “The price of rough and polished diamonds has risen in the last six months, especially in the large sizes. Prices of better quality diamonds have increased drastically without any rationale or logic. Apart from the overall economic slowdown and impact of recession in US; the major reason for the price rise is speculation in the diamond business,” he said.

Traders also fear that futures trading in such a huge, speculative market could only make the rich richer. Volumes will be high. Only the big players would play and possibly lead to an artificial rise in diamond prices, badly affecting the smaller players. Moreover, to make matters worse, smaller diamond traders do not understand the complex marketing mechanism of futures trading and would keep away.

Informs Pranav Bhargava of Shrenuj & Co., “Futures trading would allow traders to bet on future diamond prices with an option to purchase or pay the difference. It could be a good platform for realisation of better prices if backed by delivery. But if the trade does not culminate in delivery, speculation could push up prices unrealistically.’

Only Big Players to Benefit :

‘As volumes will be high, any futures trading will attract the larger players, not the smaller ones. Only the few big players who have the money and the knowhow will play the market,” he adds.

This is exactly what has happened when the government threw open futures trading in gold. Prices of gold are ruling unnaturally high.

Anil Shah, observes “Futures trading in gold has made the market highly volatile and there are continuous price oscillations. Similarly with the commencement of futures trading in diamonds, the financially powerful people will mould the direction of the market. Regular trading and routine flow of business could be hampered.”

Bhargava also cautions that rise in diamond prices is inevitable. “If those, not in diamond mining or manufacturing, drive speculative trade, prices are bound to shoot up. Cartelization at the level of availability of diamond roughs is breaking up due to fragmentation of the mining market, but not at the level of prices,” he states.

“This is because while prices of other commodities are driven by tangible market conditions like weather, rainfall, soil, raw material availability and demand, diamond prices are based on the Rapaport price index, which is not comprehensive enough to cover every diamond, each of which is unique and needs to be separately priced,” Bhargava adds.

Price Transparency :

It is true that the whole system of futures trading is driven by price standardization that is based on the quality and quantity of the commodity. Although the world has moved to a better and more comprehensive system of grading diamonds, diamond purchase is not like buying potatoes or tomatoes or even gold. These commodities have a standardized quality on which the price is based. But diamonds are different.

While gold may be priced according to its purity, diamond prices are impacted by imperfections.

Today, there is a relatively comprehensive system of diamond grading considering more than 20 parameters for imperfections. But pricing of a diamond does not quite depend entirely on its quality. Price and grading are two parallel tracks. “Even though two diamonds may be similarly graded, each retailer would sell them at a different price,” says Bhagat.

“When prices are high and margins are being squeezed, not many retailers want price transparency,” states Bumb. Consumers don’t ask and retailers don’t tell. Faced with competition, some retailers offer discounts and schemes on diamonds that vary from stone to stone. There are no fixed prices for diamonds.

Buyback Experiment :

Some jewellers have introduced buyback arrangements for their diamonds. Ddamas, among a few others, offers to buyback the diamond jewellery for 80 per cent of the value. This is 80 per cent of the invoice value and not the prevailing price at the time of resale!

But diamond pricing scenarios are turning around. More standardization is coming in. Probably in preparation for futures trading in diamonds.

Says Anil Shah,” We price a stone according to 16 grading parameters and we can easily justify any pricing differences between stones with similar grades.”

Biggest Challenge :

However, fixing the diamond price is one of the biggest challenges for futures trading in diamonds. According to the Forward Markets Commission, that regulates commodity markets, “small changes in cuts and polish changes the standard of diamonds and thereby the price. This makes it difficult to arrive at a uniform standard.

Roughs or Polished ?

Therefore the Forward Markets Commission is debating on index futures in rough diamonds. Although the industry would accept futures trading in polished stones.

Informs Bhagat, “Any futures trading in diamonds would always involve polished stones and not roughs or uncut stones, whose true value is yet to be realised.”

Whether futures trading would be permitted in diamond roughs or polished stones or whether it shall be permitted at all is a development of the future.

As Professor Richard Teweles explains in his book, ‘The Futures Game,’ “Futures markets can help markets to reduce the costs of production, marketing and processing while maintaining well-publicized price information and liquid markets.”

To be or Not to Be ?

On one hand, futures trading offers a diversification of portfolios from shares, bonds and real estate. On the other it can disturb the market and those who want to do serious business. Whether the time for diamond futures has arrived or not, the debate is on and the diamond industry is on the brink of an array of changes to tackle the whole new ballgame of diamond derivatives.- Aasha Gulrajani Swarup