From Tulips to Diamonds – Fungibility

Some argue that diamonds cannot trade as a commodity because they lack fungibility – that they are not interchangeable with other individual diamonds like a gram of 24 karat gold is interchangeable with any other gram of 24 karat gold. Is that true?

According to Dictionary.com, fungible means “goods being of such nature or kind as to be freely exchangeable or replaceable, in whole or in part, for another of like nature or kind”. Investopedia gives it a somewhat more business-oriented definition. “Fungibility implies that two things are identical in specification, where individual units of the commodity or good can be mutually substituted. For example, specific grades of commodities, such as No. 2 yellow corn, are fungible because it does not matter where the corn was grown; all corn designated as No. 2 yellow corn is worth the same amount. Cross-listed stocks are also considered fungible because it does not matter if you purchased a share of XYZ stock in its home country or in a foreign country; the stock should be accepted at either location as XYZ stock”.

In the past four articles in this series on diamonds as an asset for wealth preservation, I detailed some of the requirements for establishing such a market. In the previous article, I showed that diamonds are rare  - a common need for an appreciating asset – stating that of the 127 million carats of rough diamonds mined in 2015, we got only 665,000 carats of diamonds fit for use as wealth preservation assets.

The week before, I discussed the need for transparency. Informing potential buyers of the characteristics of a diamond is essential. We start with the 4Cs and add information on irregularities, and how they can influence a diamond's price.  But before discussing irregularities, we need to begin by educating the public. Education gives the public a basic understanding of diamonds, and should start in science classes at elementary schools.

On top of this, we need to reach a critical mass of believers. These are people interested in the diamond as a tool for wealth preservation. They are confident that whichever diamond they buy, they will find a buyer who will purchase it from them.

The case for diamonds – fungibility

In my recent article on rarity, I stated that of the many millions of carats of diamonds mined annually, only a handful are fit for use as assets for wealth preservation purposes. Out of 127 million carats (25,400 kilos) worth about $14 billion mined in 2015, only 665,000 carats (133 kilos) of diamonds, worth a total of worth $8 billion, fit our needs. That is just 0.5% of total annual production by volume and 58% by value. This is, on one hand, a very small quantity, indicative of the rarity of this type of diamond, but, on the other hand, a large enough volume to support global trade in diamonds as an asset for wealth preservation. This is an unusual balance.

Truth be told, diamonds are not as standard as most other commodities. In addition to the 4Cs, which are commonly known to consumers and investors alike, diamonds have many more attributes that have an impact on their value. These attributes include: the quality of their polishing, fluorescence, location of inclusion and its color, and symmetry—more than 400 irregularities, each of which helps determine the value of a polished natural diamond. Comments on grading certificates can contribute to significant differences in prices between diamonds with the same 4C characteristics. Diamonds can only truly become a commodity if buyers understand the importance of these characteristics, and their role in the final price.

Therefore, the list of irregularities should include a discount or premium on the price, making the pricing of each and every diamond fully based on transaction prices. This will drive diamonds closer to fungibility. It will also bring greater transparency to pricing, and allow anyone to understand the value of any diamond - unlike the current situation, where only professional traders can determine price. That hurts fungibility. By making public a diamond’s full list of irregularities, we are leveling the playing field. A buyer will be able to find two diamonds with the exact same characteristics, which can therefore be sold at the same value.

Let’s consider another aspect of fungibility. If we would like to have a spot market, where diamonds are traded in large volumes, then one of the issues that needs to be addressed is that of fungibility. The current selling system, based on asking prices, makes finding two interchangeable diamonds challenging. This, according to the naysayers, stands in the way of turning high-end diamonds into a commodity. Combining an irregularities list with a spot market allows anyone to buy a diamond anywhere in the world at the same price without arbitrage. Today, if buyers go to Mumbai, they can buy a diamond for less than in New York City. A commodity must be sold without arbitrage.

A characteristic of commodities is their ability to be split in two or more and retain proportionate value. If, for example, one took a gram of 24-karat gold and divided it into two pieces of half a gram, then the value of each half will equal half the value of the whole ounce. The same is true for a barrel of oil, which can be divided into several equal parts, yet retain the same value per liter. This is not true of diamonds. If you cut a 1-carat diamond into two equal half-carat diamonds, the individual value of each half falls by more than 50 percent, and the collective value is reduced. After all, a diamond’s value rises exponentially with size.

However, this is a manageable issue. We at Mercury Diamond™ developed a special tool, the Mercury Exchange Converter™, which can match the current transaction price of any diamond, regardless of size, color, clarity, cut, shape or irregularities, to any other number of diamonds of equal value.

Which half-carat round, G color, IF clarity diamonds have the same value as a 1-carat, G color VS1 clarity diamond? The table below lists a number of such alternatives. As you go through the list, ask yourself about fungibility. If you can exchange one larger diamond with a few smaller diamonds that together have the same value, does this not demonstrate that fungibility of polished diamonds is possible? 

The options are nearly limitless, and the tool we developed (see more details here) translates the value of any diamond one could buy, for any size, shape and clarity, to an equal value diamond or diamonds.

Another way of finding fungibility for diamonds is by creating standardized parcels of polished diamonds. In large repeated volumes, almost any creation of nature can be equalized. When you look at two oranges, they may look very different, and therefore have different values. But what happens if you own an orange grove – would you sell oranges one by one to the orange juice manufacturer? Not at all – you would sell oranges by the truckload. All of a sudden, the specific traits of one orange seem less important. It is the collective goods that are valuated. This is true for the orange grower as well as for the juice maker. For some diamonds, such a path would work just as well: many diamonds with repeated similar characteristics, bundled together. That would also create fungibility.

Using my tools, such as the Mercury Exchange Converter™, we can reach fungibility of trade. If you can check the value of a diamond with a known weight, shape, color and clarity, and find that it has the equivalent value of another or several other diamonds, trading becomes a lot easier.

Mercury Diamond also has a list of about 400 irregularities with their discounts and premiums, as well as a diamond price tracker, known as MDGT™, shown below.

Mercury Diamond Tracker™

Source: Mercury Diamond™

With all of these options, plus the tools Mercury Diamond put together, a parcel of similar diamonds can be created and sold as a unit, with the possibility of becoming an asset for wealth preservation purposes.

Clearly, fungibility is not a farfetched idea for diamonds. The rarity of diamonds combined with a good number of diamonds fit for wealth preservation, transparency in diamond characteristics, the use of a list of irregularities that places a discount or a premium to every diamond, and the ability to find multiple diamond combinations that each carries the exact same value, provides the interchangeability needed for commodity trading, making fungibility attainable and useable. Together with education and marketing, we are getting closer to reaching a spot market for diamonds as an asset for wealth preservation. 

 The views expressed here are solely those of the author in his private capacity. No one should act upon any opinion or information in this website without consulting a professional qualified adviser.