Over the last few years, the markets attracting the most attention are those in cryptocurrencies: cryptography-based, decentralised virtual currencies best exemplified by the industry’s torchbearer Bitcoin. However, the ride for these assets has been far from smooth for investors – Bitcoin went from $US1,000 at the start of 2017 to nearly $US18,000 by January 2018, before falling back to below $US3,500 in January 2019.
The volatility of Bitcoin is considered to be its primary weakness; the currency is driven purely by demand and supply and does not have an underlying value to it. Entrepreneurs saw an opportunity in this and focused their attention on creating cryptocurrency based on assets like diamonds, gold and other real currencies, such as the US Dollar, Chinese Yuan and Euro. Even oil, real estate and carbon credits have been used as the basis for cryptocurrencies.
As diamond-backed cryptocurrencies fire up, companies need to source diamonds from the real market. Diamantaires, who are traders by nature, have been tempted by these developments and it is critical for them to understand how these markets work and what to look for before investing.
Trust-less digital cash
Having an understanding of how some of the underlying cryptocurrency technologies work is necessary to appreciate the products. Traditional currencies – for example, the Australian Dollar – have moved from being backed by assets such as gold and are essentially an ‘IOU’ note issued by the government.
The currency’s value depends on whether the user trusts that the issuer will make good on the promise. Confidence enables individuals to freely exchange this cash.
The need for trust becomes more important in the digital realm, where mutual trust is required between financial entities – banks, credit card companies, clearing service providers, and so on – for electronic transactions. That is why these entities are regulated.
Fiat money issued by governments, which is stored electronically, can also be considered as digital currency. Digital currencies not issued by governments or regulators are known as virtual currencies. Good examples include loyalty-program ‘points’ or ‘in-game’ currencies in entertainment apps.
Cryptocurrencies are a kind of virtual currency designed to be decentralised, with no single issuer, and secured using cryptographic techniques. Cryptocurrencies do not have a central server but are hosted across many computers connected to each other on peer-to-peer systems.
Hence, this is also a trustless system where transactions can be made with the currency even when no party trusts the other, almost akin to cash transactions.
This cash-like capability also provides near anonymity, which endeared cryptocurrencies to early adopters.
Diamond backed scam
Diamond-backed cryptocurrencies aren’t always as they appear to be. In May this year, the US Securities and Exchange Commission (SEC) took out an emergency court order against Argyle Coin – which was billed as ‘the world’s first cryptocurrency backed by natural fancy colour diamonds’ – and its associated directors.
The Florida-based company was about to launch its ICO and had promised investors up to a 24 per cent annual return. They also claimed that an insurance bond guaranteed the offering.
However, the SEC alleged that Argyle Coin was actually a Ponzi scheme involving two other companies owned by Argyle Coin director Jose Angel Aman – Natural Diamonds Investment Co and Eagle Financial Diamond Group.
It was alleged that Aman and other associates of the business embezzled US$10 million (AU$14.5 million). They have been charged with securities registration violations and securities fraud. Assets have been frozen and the Argyle Coin website shut down.
Blockchain and Cryptocurrencies
Cryptocurrency systems need to maintain the balance for each account, like any bank account, and so they carry a copy of the entire transaction history. The technology that carries this digital ledger is commonly known as blockchain, and it does so in a manner that cannot be changed or tampered with.
In blockchains, valid transactions are processed in batches called blocks. Each block is processed through an algorithm to generate its unique code, which is called a hash – the algorithm is also known as the ‘hashing algorithm’. The hash of the previous block and the valid batch of transactions are passed through the hashing algorithm to generate the hash for the current block.
In turn, the hash generated for the current block is used for generating the hash of the next block. Hence, every block is linked to preceding and following blocks. This forms a chain, which is why it is called blockchain.
Transactions are not confirmed until they are written into a completed block. The computers that collect and combine these new transactions – doing the necessary mathematical calculations required for hashing, and creating new blocks – are called blockchain miners.
The hashing algorithm generates a unique value for a given input. Even making the smallest change in the input value will lead to a totally different hash value. The hashing algorithm used for a particular blockchain is public, making it extremely easy to check if the transactions in the block generate the hash value of the next block.
If any of the transactions have been changed, the hash value of the block will not match, immediately invalidating that block. This ensures the immutability of the transactions written into the blockchain.
While the above technique ensures that data in the ledger cannot be changed, making the system truly de-centralised requires two additional pieces.
Firstly, there needs to be multiple copies of the blockchain data to prevent manipulation, as well as a wide base of computers mining new blocks. Computers, also referred to as nodes, hold copies of the entire blockchain data and check the validity of all transactions before accepting every new block. They then transmit this valid data to other nodes.
“Compared to commodities, where prices fluctuate every second, diamond price movements seem glacial. This relative stability has led to launches of diamond-backed coins”
A majority of the nodes in the system need to accept the block before it’s accepted into the blockchain, ensuring that no individual node can corrupt the data – nodes are passive and do not need significant resources. Larger blockchains have over 10,000 nodes, making them more de-centralised.
In his 2008 paper, Bitcoin founder Satoshi Nakamoto brought the concept of competition into blockchain mining to ensure that the blockchain remains decentralised and everyone has a clear view of the entire blockchain landscape.
His system requires that the hash of every new block meets certain criteria. This meant adding additional code to the block. As the hashing algorithm output cannot be predicted, this additional code has to be determined using a brute-force computation method.
By varying the criteria for the output hash, the difficulty level can be varied to ensure that blocks are generated at a nearly steady pace. This entire process is then repeated with new transactions, leading to the addition of a new block. For Bitcoins, a new block is generated roughly every 10 minutes. Based on the hashing methods, mining can be power-intensive and make heavy use of a computer’s processor and memory.
In short, the system works like a production line where the miners are like machines, blindly producing goods, while the nodes act as the quality-control mechanism, allowing only the best blocks to be added to the chain. A system of majority acceptance ensures that the system cannot be gamed by collusion between a few miners and nodes.
While Bitcoin was the first blockchain cryptocurrency, later platforms were able to record and execute smart contracts. Products running on their own independent blockchain infrastructure are classified as coins.
Tokens, on the other hand, are basically smart contracts that run on another blockchain platform without creating their own infrastructure. Most asset-backed ‘coins’ are essentially tokens. Tokens require minimal programming and are surprisingly easy to create and sell to the public through events called Initial Coin Offerings (ICOs). Savvy programmers can launch a token in hours, which is why token companies usually have only a few technical experts.
There are currently between 2,000 and 2,500 coins being traded.
Bitcoins were created to serve as a medium of exchange; however, demand and supply fluctuations could cause sudden swings in price – fluctuations of up to 10 per cent in a day have been recorded. This scares potential users, which is why a slew of asset-backed coins have been launched where there are real assets underlying the coins.
Underlying assets are supposed to provide price stability to the coin, thereby making it more attractive for users. Diamonds are an asset in their own right. While prices might not have appreciated over the last five to seven years, many users and financial market participants view stability as a virtue. Compared to commodities, where prices fluctuate every second, diamond price movements seem glacial.
This relative stability has led to launches of diamond-backed coins. Israeli startup Carats.io launched Carat in the fourth quarter of 2018, which can also be used to purchase diamonds and jewellery. Natural fancy colour diamond-backed cryptocurrency PinkCoin uses trading profits to support charity organisations and non-profits. Latvia’s Certified Diamond Coin has also recently held its first public sale.
There are some other interesting releases too; one company has even proposed an ICO based on the price of synthetic diamonds, though they have not clarified details about the mechanics yet.
Combating money laundering
Money-laundering in cryptocurrencies is a known problem as entities can trade almost anonymously. In October 2018, the Financial Action Task Force (FATF), an inter-governmental body focused on anti-money laundering and countering the financing of terrorism, amended its recommendations to include ‘virtual asset service’ under the list of industries to be regulated.
Individual governments that are part of FATF – including Australia, which is a founding member – would be expected to make the necessary changes to their respective laws. Virtual asset service providers like wallets and coin issuers will now need to be licensed and/or registered and subject to the same monitoring and compliance practices as other financial institutions.
Going forward, the anonymity provided by cryptocurrencies will be lost; however, this might be for the good as only the persons who are genuine traders or investors in the virtual assets or currencies will remain.
Old fund in a new bottle
When analysing a couple of serious diamond-backed ICOs, the structure looks like an asset-backed fund. The funds promise the usual ability to invest in smaller units – an ability gained from the overall value appreciation by investing in the underlying portfolio of certified diamonds – and have reputable diamond-industry partners.
As in the past, the primary investor concern is confidence in the value of the portfolio of diamonds; this leads to regular third-party audits, separate depository holding, sealed diamond inventory and the facility for investors to redeem coins by buying diamonds.
Valuation mechanisms usually have complex-sounding algorithms with ‘artificial intelligence’ thrown in for good measure. The aim is to attract buyers for the ICO. Everyone in the industry knows that most large diamond companies have had similar pricing algorithms in place for the last eight to 10 years – without artificial intelligence, of course!
Regular asset-backed funds and financial products like diamond futures contracts are highly regulated. Governments have a history of regulating and monitoring these products, with clear rules to be followed and disclosures to be made to investors.
In fact, some diamond-backed fund products would have to be sold only to institutional buyers and high net-worth individuals who have the capacity to understand and analyse the products.
In contrast, ICOs can be launched on the basis of a simple white paper. Marketing these fund-like products as ‘coins’ may allow the promoters to indulge in regulatory arbitrage and escape detailed scrutiny. This greatly increases the chances of hidden costs and inadequate disclosures as well as mis-selling of the product.
Show me the money
When analysing any financial product, be it a fund or a coin, understanding the business model of the promoter is a good indication of whether it is sustainable. ICOs are clearly trying to cash in on the current speculation in cryptocurrency – investors hope to get in early and benefit from the appreciation as the usage of the product takes off and promoters usually allocate a significant portion of the coins for themselves.
Liquidity is the life-blood of any financial product, including coins. Liquidity gives investors the confidence that they can exit the investment without a heavy penalty, which in turn will sustain the coin infrastructure. Hence, coins are hesitant to levy any charges on transactions or for maintenance of the coins, unlike asset-backed funds.
In asset-backed cryptocurrency, coins can only be issued against assets. Hence, if no coins can be issued to promoters in the ICO, other innovative options are used, many of which are also drawn from funds. These include charging fees, either for buying the coins or on redemption, and having a coverage ratio less than coins issued – i.e. the assets held is a fraction of the total money invested in the coin.
Coins can also have restrictive redemption options, including only allowing redemption through delivery of physical diamonds.
At times, even the purchase of diamonds into these coins is through associate companies. These coins imply that their prices are at near wholesale level; however, a quick check by the author indicated that prices seem to be 15 to 30 per cent above wholesale. This would not be possible with regulated funds.
While the reported information on charges is vague, it indicates that coin issuers are incentivised only to encourage investors to enter and exit notethe scheme rather than hold and transact in coins – what’s known as ‘the churn’. The sustainability of such a model is debatable and in the long term would lead to disenchantment among users of diamond-backed coins.
The diamond industry needs diamond-backed financial assets in order to successfully channel the latent demand for investment diamonds; however, in their current form, diamond-backed coins look far too flawed to become a sustainable and healthy product.
For a diamantaire or an industry service provider, selling diamonds into these products should be similar to any other customer, as long as the payment is in normal currencies – in India it would be prudent to check whether RBI regulations will allow US Dollar payments from coin companies. For diamantaires looking to sell their diamonds for cryptocurrencies, all one can say is caveat venditor – seller beware!