GIA: too big to fail: economic impact is concentration risk

Chaim Even-Zohar

Let’s get straight to the bottom line: at any given moment, the Gemological Institute of America (GIA) and other grading labs will have some $1.5 billion worth of diamonds in their possession that are not readily available for business. If annual polished diamond consumption is around $22 billion (at polished wholesale prices), this means that, at any given time, some 7-8 percent of annual sales and the equivalent of some 20 working days of the global polished-diamond working stocks are withdrawn from the business cycle.

At the GIA, we have seen recently that the turnover time for its certificates has lengthened dramatically – from a mere few weeks in November to about two months (and occasionally more) today. Especially in the smaller diamonds (the 0.20 carat-0.50 carat range), the sudden increase in the cycle time – at a very critical (holiday) demand period – has led to market shortages and upward pressures on polished prices. There also are concerns about what would happen if the GIA suddenly closed its grading backlogs, resulting in large amounts of goods entering the market too rapidly. (This is not likely to happen; it takes the GIA six months to train a new grader, so backlogs are worked down gradually.)

Certification

[two_third]Certification has become a must. One likes to forget what set off the trend. In the pre-certification age, there was a lot of ‘mis-selling’. The ascent of certification is the result of an diamond industry – including retailers – not being transparent about their product, much of which might have been deliberate. Initially, certification was mainly aimed at boosting consumer confidence – and some of us still see it that way. However, today, certification may mostly be for the confidence of traders inside the trade. It also enables the advent of ‘commodity trading’ based on paper only, but this is a by-product and was never the initial intent.[/two_third][one_third_last]

“Certification has become a must.”

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The enormous need for internal trade certification was recently exacerbated with the mixed selling of undisclosed natural and synthetic goods. Indeed, the fear of synthetics has driven both retailers and traders to reassert certification as the ultimate confidence document.

Grading  pays for itself – but hardly so…

polished_diamond_3The GIA is perceived as having money printing press power – but mostly for itself. A diamond going into the GIA lab may gain (market) value by anywhere between 3-5 percent when it gets out with a GIA certificate – although this hardly covers the added costs. The truth is that many stones simply cannot be sold or auctioned without GIA paper – or would not move as fast.

This raises questions about concentration risk. One wonders what would happen to the industry if something happened to the GIA. We’ll come back to this subject later. As already mentioned, diamond certification has become an integral phase in the diamond production process. In fact, the certification costs are already taken into account when one purchases the rough diamonds. It is just as essential as labor costs.

Generally, labor costs on the certifiable range of diamonds are viewed as anywhere between $80 and $120 per carat. GIA certification may cost that much as well, but it must be worth it, otherwise the GIA wouldn’t get such business. In fact, in many cases, the trader has no option – he simply must get that certificate, even if it requires weeks of waiting. It is even worth getting an “overnight” kind of express service at double the price.

There is another way to look at it. Last year’s GIA financial results are not yet publicly available, but we expect that they will show grading revenues of around $210 million. According to our calculations, the value of the total amounts of diamonds graded by the GIA would come to $27.5 million for each working day. Taking an average of 270 working days a year, this comes to $7.5 billion in diamond value a year. Thus, direct grading costs (i.e. the amounts paid by industry to the GIA) would be about 2.8-3 percent of merchandise value. To this, shipping, administration, insurance and interest costs need to be added. This gets the total quickly into the 4-5 percent range.

GIA intake: 14,000 stones per day

Globally, on any working day, the intake of the GIA is 14,000 stones, according to confirmed figures. We believe that some 9,500 submissions would be for dossiers, and 4,500 for certificates. Let’s assume that a stone for a dossier might have an average value (per stone) of ,$700 (and that is probably too low), and that a larger stone submitted for certification is valued ,$8,000 per carat. If we assume an average weight for certified goods of 0.7 carats, these 4,500 stones might have a value of ,$5,600 per stone.

Assume that two calendar months represent 45 working days. That would mean that the GIA would hold ,$1.6 billion (and maybe more, but not less) worth of polished at any given time. Following this arithmetic, on an annual basis, the GIA provides grades for some 34-35 percent (by value) of the world’s annual polished diamond sales.

[two_third]If we assume that the industry’s other, non-GIA labs, by value, will take in some ,$15 million a day (which might certainly be more in terms of number of stones), some ,$11.5 billion out of annual ,$22 billion polished sales would have a certificate. About half by value. Is that a reasonable hypothesis? (A theoretical exercise about the total certifiable goods gives a similar picture. It indicates, indeed, whatever is certifiable actually ends up getting certified.) The economic impact of certification and the role of the labs – including the inventory (depository) role of these laboratories require far more study and thought.[/two_third][one_third_last]

“On an annual basis, the GIA provides grades for some 34-35 percent (by value) of the world’s annual polished sales.”

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The certifiable part of world production

Let’s look at the world production from a potential certification perspective. According to Tacy Ltd. research, current annual polished production comes to 32 million carats.

The overwhelming bulk of polished natural diamond output is in diamonds of sizes smaller than 0.18 carats. Out of 32 million carats polished, some 18.5 million carats consist of goods below seven pointers (0.07 carat), with a further 6.9 million carats falling into the range of 0.08-0.17 carats. The total annual polished production from 0.18 carats and up totals 6.6 million carats.

Let’s take a closer look at this: The rule of thumb that we have followed is that in rough diamond production, some 35-36 percent of the production represents some 85 percent of the value. A typical mine – if there still is such a thing – would produce 7-8 percent of its rough carats in >2 carat sizes, with some 29 percent in +11/-2.0 carat range.

[two_third]Looking at polished, we would estimate that less than 7 million carats of the 32 million polished represent well over 80 percent of polished value, i.e., some $18 billion in polished wholesale values (PWP). The smaller goods, i.e., some 25 million carats, would account for $4-5 billion of polished values. So our earlier mentioned hypothesis, that annually some $11.5 billion worth of diamonds would be graded (including dossiers), seems defendable.[/two_third][one_third_last]

“The overwhelming bulk of polished natural diamond output is in diamonds of sizes smaller than 0.18 carats.”

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Labs grade stones – not carats

polished_diamond_loupe_1But let’s look at stones – not carats. The GIA grades some 4.2-4.5 million diamonds a year – but that includes dossiers. The 32 million carats represent some 1.0-1.1 billion (!) stones. (This is based on calculations and estimates of the net polished yield out of each category of rough, after removing, of course, the industrial diamonds from the rough output.) It is not a precise absolute number since along with changes in technologies, yield outputs also improve. Also, the overlap between, and shifting from, industrial to near-gem cuttables is changing as well.

Annually, some 1 billion stones of polished diamonds of less than 0.07 carats each enter into the diamond value chain. There is no commercial or economic justification for grading these billion stones. Some may argue that these need to be checked as to whether they are synthetic or not, but that’s an esoteric issue that is not relevant here.

Assuming a polished output in the range of 1 billion stones, we get the following breakdown:

For certification purposes, the theoretical limit would be some 14 million stones – but this figure represents all colors and clarities and, obviously, not all these goods will be traded with certificates.

Out of the theoretical 14 million stones figure, the GIA certainly will get some 4.3 million stones this year. That’s enormous! It is so enormous because of the value it represents. The impact of the GIA on the market is believed to be far greater than its proportional share of certification.

Risk concentration: is the industry prepared?

[two_third]The numbers tell only part of the story. The dependency of the diamond industry on the GIA has gradually also become one of the industry’s major vulnerabilities. A few years ago, we had the certificate upgrade fraud scandal, which has now been largely forgotten. With great risk management and survival skills, this potential catastrophic industry shock was contained – no one went to jail, a consumer outcry was avoided, and the confidence in our product remained unscathed. In fact, if anything, the GIA emerged from this period with greater public and industry trust.

Some large retail chains have drawn their own conclusions and are replacing the GIA guarantee with their own corporate certificates. The De Beers downstream aspirations (Forevermark, etc.) are also following a GIA bypass route to the market. The GIA’s response, a stepped-up globalization of its services and its brand, makes it clear that De Beers won’t have an easy ride for its own certificates. But the vulnerabilities for the GIA grow as well. The greater the number of stones, the greater becomes the challenge of consistency in the grading.[/two_third][one_third_last]

“The dependency of the industry on the GIA has gradually also become one of the industry’s major vulnerabilities.”

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The GIA is not omnipotent and it isn’t alone in the field. However, rightly or wrongly, none of the other grading labs have obtained the prestige of a GIA certificate. The GIA is a charitable institution. Its non-profit status, which allows it to earn some $50 million a year without any tax burden, will continue to give it an (unfair?) competitive edge. But, as an industry, have we ever paused and reflected on our own industry risk associated with relying too heavily on the GIA?

Risk, defined as the uncertainty surrounding the outcome of an event, is an integral and inevitable part of business. What would happen if, for whatever reason, the GIA ceased to function for a prolonged period of time? (Due to a global grader’s prolonged strike or something to that effect.) What if another Certifigate happened with Arthur Andersen/Enron type results? Would this be unthinkable? Maybe, but that’s the nature of catastrophic events – they are low frequency and often unpredictable. Just imagine an ‘impossible’ scenario in which a Tiffany-type of prestigious brand discovered that it sold synthetic stones with a natural GIA certificate. “Impossible,” we would all shout in unison.

The fact remains that, at the start of 2014, we must realize that it is the industry’s own conduct that has given rise to its dependence on certificates in general – and on the GIA in particular. In the old days, the industry had a Custodian, a Godfather, a Protector – whatever you call it – until the antitrust authorities forced its demise. The GIA comes closer than any other institution to these roles. Fortunately, under the leadership of Susan Jacques and Tom Moses, there are no signs that suggest that one day there might be a problem. That is precisely the reason that this is a good time to also think about the unthinkable.

The diamond industry has simply invested too much into the business to allow the GIA to fail – and that’s possibly a good reason why, periodically, all relevant stakeholders should think of the vulnerabilities presented by this concentration risk. Never before has there been so much at stake.

Source Idexonline