Though the warning signs were on the wall – trust-based banking in the diamond sector seems all but dead. Three specifically named mammoth Indian diamond firms have apparently made some astonishingly brazen propositions to two of their leading lenders (ADB/KBC and Standard Chartered Bank). “We want an immediate haircut of 70% – and the remaining 30% we shall repay in a ten-year period. If you don’t take it, you won’t see any money.

For bald readers unfamiliar with barbershop language, a “haircut” in this sense means “forgive me 70% of the hundreds of millions that we owe you.” You don’t need to be a major borrower to qualify for this particular hair style; it seems that there are some players, realizing that their bank lacks meaningful and collectable collateral, who make similar demands – on top of a mutual desire not to continue the banking-client relationship.

How did a trust-based industry, wholly dependent on trust-based financing, get to such a calamitous reality?

How did this escalating deterioration of relations between the downstream industry and the banking sector happen? We believe it is largely attributable to the near catastrophic policies (and/or implementation) of the De Beers Supplier of Choice system that contaminated the integrity of the diamond pipeline and drove up the debt. The “missing” money for which haircuts are sought has mostly ended up in the pockets of the producers. The question we should all ask ourselves:  How are so many banks exiting (or downsizing exposure) all at once?

As disgraceful (or disgusting) as it may sound, haircuts have become a part of the Indian diamond business culture. As with the subprime junk-home mortgage scandals in the United States, which led to more than $1.5 trillion of loans, perhaps $200 billion of losses, thousands of families facing foreclosure, and umpteen politicians barking, the losses incurred in our industry are real and in some aspects too big to be fully understandable.

Mutual trust between the banker and client has widely disappeared, especially in India. In too many instances, the dialogue between banker and client seems more like a high-tension stand-off between fierce rivals – each side testing the other to see “who will blink  first.” And when the bank blinks  first, a further deterioration of the relationship becomes inevitable. Haircuts have become a part of this narrative.

The writing has been on the wall for more than a decade. The protracted lack of any meaningful profitability, and the unstable, if not long-term declining, polished diamond price trends have made the repayment of hundreds of millions of debts wishful thinking. Servicing the debt itself has become problematic. Is this the time for both banks and customers to throw in the towel? Is this a part of an “end-scenario” most of us believed would never materialize?

Trust-based business broken as a consequence of the ‘Supplier of Choice’ policy?

What I believe is that the diamond midstream (especially the past and present DTC sightholders) and the diamond banks are now paying for what many have seen as a “catastrophe-in-the-making,” called Supplier of Choice (SoC). SoC forced all DTC clients into a straightjacket, a kind of template, also setting certain financial criteria as preconditions to sight eligibility. Some of these criteria were outright counter-productive.

or the purpose of this article, we want to focus on SoC’s so-called “Criterion One: Financial Strength.” To measure a client’s performance, he was required (in the first question of the pro le questionnaire) to state gross turnover figures of rough and polished (carats and dollars), followed by: (question two) “please indicate the total amount of credit available to you from each of your banks.” The financial success of a company was measured by “credit utilization, turnover, and return on capital employed,” among some other criteria. Debt-to-equity ratios were also considered, but by maximizing the use of borrowed money, one’s own return on (limited) own equity could go sky high.

The DTC knew what it was doing. The larger the available credit, the easier it is to place the rough at ever higher prices. Without greater financing availability, it would be constrained in raising rough prices.

With SoC, the “real game” was – to put it bluntly – to allow DTC clients who were not making any meaningful margins to get access to banking finance.

trust-based

Trust and Integrity Were Lost

There are many causes for the unfortunate plight the “midstream” sector of the diamond industry finds itself in. Nevertheless, at the end of the day, one cannot help pointing a finger mostly at the diamond producers – the mining companies. They went from a straight cartel system to an oligopolistic operating model where a few suppliers continued to hold a sturdy grip over a fragmented downstream. De Beers, from an economic perspective, has remained the “price setter” of the industry.

Our analysis has shown that, year after year, even the primary distributors (dealers) have a problem in getting an acceptable return on their efforts, on their capital employed, or for the risks they are taking. After all, it’s these dealers that have to sell mostly on credit – they accept the risks which the producers themselves don’t want to take.

As an industry leader stated in an e-mail: “Most of the profit from the unlimited bank credits to the diamond industry went to the producers, but also to the banks and DTC brokers themselves who pro ted from commissions on all purchases. They all worked together to make it possible for the sightholders to get credit to ‘feed the monster’.

Producers, such as Alrosa, Rio Tinto, BHP and others were maybe unwittingly “used” by diamantaires seeking banking funds. It’s enough to show a bank that one holds a contract to purchase goods from a prominent producer to get a “red carpet” treatment. “If you are good enough for that producer, you must be good for our credit.” It is evident that none of the producers had any incentive to cut off this credit dance.

No bank or banker can claim that they “didn’t know” what they were financing. As one Indian diamantaire succinctly and candidly put it: “I am not making money in diamonds; I make money from diamonds.” It is a small step from this to an even more disturbing statement: “With a few noted exceptions (for those working in specific niche areas), a decent honest diamantaire cannot compete with those who are less scrupulous. The latter will always win.

Producers Could Provide Credit

So, what would be the risk to producers extending credit to suppliers? They could charge for the service (just as banks do) and make money on top of it, as their own borrowing terms would undoubtedly be better than those extended to midstream companies. Another downstream pro t center. They will probably refuse. They have said so already…

In some instances, one may wonder “where is the money?” The answer is, in a general way, with the producers! The main beneficiaries for the high banking debt were the producers; they could sell less rough (carats) at higher prices. The manufacturers, however, have not seen an increase in their added value. The “added value” went straight into the pockets of producers.

Besides restoring downstream profitability or extending credit, De Beers has an additional option. The company is making huge investments in its own downstream activities. It is trading in polished, it is issuing grading certificates, it buys and sells recycled polished on the market, it owns an important jewelry chain, it has its own Forevermark brand, it conducts polished auctions, it seems to be doing everything except for cutting and polishing. Maybe, just maybe, they don’t really care whether the midstream “goes bust” – and will simply subcontract some major manufacturers and outsource the cutting and polishing of some or all of their rough – or do it all by themselves. During the negotiations with the competition authorities, the “do it all by ourselves option” was certainly favorably viewed by De Beers, but it was rejected by the anti-trust people. They could be thinking about the option again.

In conclusion about the future of a trust-based business: Back to the Haircuts

Diamond bankers only have themselves to blame. They have created “fictitious” instruments – such as taking specific pledges on rough parcels for collateral purposes, knowing full well that when converted into polished, it’s hard to establish which diamonds are pledged goods and which are not. They would hand back the collateral “in trust” – knowing full well that, in practice, it can never match a remittance for a diamond sale to a specific trust receipt. Basically, it has always been trust-based banking.

Most of them didn’t hold real tangible collateral – but they knew this. No banker can claim “he didn’t know.” Diamond bankers have also tacitly condoned corruption. When one bank has good reasons to make executives redundant, and another bank is eager to hire such persons, one really wonders what happened to old-time sanity or common sense. There are ample examples of such games of musical chairs. The outcome was predictable. When the music stopped, when the mutual trust fell away – and one betrayed the other – the legal troubles started.

As for the haircuts – the financial crisis of 2008-2009 has shown that the banks have an enormous capacity to absorb shocks and to make spectacular comebacks. Let them explain to their boards and shareholders that losses in the diamond sector are all because of market contingencies, because of unavoidable commercial realities, because of the cyclical nature of the business. This narrative worked rather well in India – so why wouldn’t it work elsewhere?

There will always be young, enthusiastic, well-educated, and honest manufacturers and bankers that will create their version of a diamond dream. The mega defaults will come, if not in 2017, then in 2018. This is not a pleasant thought – but it’s not the end of the world either. The question remains if the trust-based era in the diamond business is about to disappear forever.