Also what is unusual in PP is that those companies that give data have to sign contracts and in return are given equity in proportion to the volume of data that they provide according to a predetermined formula. PP is in essence creating a JV with those that provide the data. Finally no one in PP trades in rough or polished stones, mitigating any risk of conflicts of interest.

To fix the price and pay off of a derivative it is necessary to establish certain price points where there is a pre-determined mechanism to determine the price point.

Examples are closing prices established by a closing auction on an exchange, or a daily price fixing as has been used for Loco London gold for many years.

On the one hand Price Transparency can lead to margin reduction for diamantaires as bid/offer spreads tend to narrow as prices become more transparent as diamantaires compete with one another; but on the other hand greater price transparency tends to attract new capital to a market that would not have previously considered investing since previously the investing institution was not able to prove that they have provided best execution to their clients. To prove best execution they need a verifiable benchmark price to compare their trading price against.

If a new investable asset class like diamonds becomes available to financial institutions it will spawn innovation in the creation of products by Investment Banks. Examples are diamonds would start to be included in asset allocations by Discretionary Fund Managers within their Alternative Asset Classes, currently including hedge funds and commodities.

To do this they will need research to back up their investment choices on behalf of their clients. Other innovations will be the creation of structured products for different types of investors, an example would be issuing structured products to retail investors that are eventually convertible into physical diamonds.

In many cases the derivative market size is greater than the physical underlying market it is derived from. The growth of the derivative market increases the volume of transactions in the physical market through the need to hedge the derivatives exposures. So although bid/offer spreads may narrow through the increased price transparency, the volume of trades will increase on the back of the development of the derivative market, that the increased price transparency will enable to develop.
Daily Price Fixing
In order to establish a daily price fixing for diamantaires to be confident in it will be necessary to have a group of respected traders contributing to the process. There are two established daily fixing mechanisms that could be copied in the Diamond market:

For either fixing methodology a centrally appointed independent organisation such as an existing diamond price vendor like PP collects prices from the contributors or chairs the conference call at a given time every day. It may be possible to collect prices electronically in advance of the fixing on either the basket of stones or individual stones. The resulting Fix Price from the procedure will be published by Bloomberg, Reuters and PP.

Each price contributor will decide on the price they supply based off their own portfolio of stones or from the orders they have received from the clients to be executed at the fix price.

Use of Indices
Derivatives based on indices are normally cash settled and when exchanges create indices with derivative contracts in mind they are normally based on a small number of constituents to assist market participants to move from the underlying to the derivative relatively easily. Applying the same analogy to diamonds means that any indices would need to have a range of diamonds in them that are both liquid and reflect polished diamond supply and demand. By limiting the number of stones to say 20 or less it should be possible to develop an Exchange for Physical (“EFP”) market as well.

EFPs. EFPs work by two parties with opposite requirements exchanging the physical basket vs the derivative. A price is agreed between the parties and the physical is delivered between them and the futures crossed on the exchange by a broker. The motivation is each party’s calculation of fair value of the future which will be governed by their own valuations of the diamond basket and their internal funding rate and expectation of future interest rates.

Establishing a benchmark basket
Likewise choosing a basket that can have the most universal application for stake holders that is deliverable from the derivative will be important in building liquidity and open interest in the contract. An example of a benchmark basket could be a basket consisting of one stone in each category of one carat stones.

India’s major commodity bourses haven’t taken the initiative so far to develop diamond Futures, perhaps, in view of the complexities involved in executing the idea and getting approval from Forward Markets Commission and later on the confidence of investors and diamond industry.