Fraudulent facets

Diamond fraudsters dupe consumers of all types, including savvy investors and collectors. The global diamond trade, like many other collectable markets, is at the mercy of the absence of transparency. Buyers must cautiously scrutinize gemstones and other low-utility/high-value objects. Here are practical ways for fraud examiners to avoid rip-offs.

Thanks to a brilliant 1940s marketing campaign by diamond conglomerate De Beers, buying a diamond engagement ring has become the symbol of love betrothed. Maybe you know something about the “4 Cs” of diamond shopping (clarity, cut, color and carat) so you can carry on a conversation with sales people at the jewelry counter. Maybe you saw the Leonardo DiCaprio movie, “Blood Diamond,” and you want to purchase a “conflict-free” stone. But what if you’re asked about shape and symmetry? Do you know about inclusion density and brilliance grades and how carat weight affects these parameters?

As your eyes glaze over, you realize you’re in over your head when it comes to such a large investment. There’s a lot to consider when buying diamonds (a $73 billion-a-year industry, according to the World Diamond Council) — not to mention how easy it is to be duped into purchasing an inferior stone, or a “cultured” (or lab-grown) diamond or worse: glass (especially if you shop for diamonds online from sketchy diamond houses). You worry about investing that “two months’ salary,” as the ads suggest, into something you just don’t know enough about.

And fraudsters in the global diamond trade want to keep it that way. It’s not just gemstone-quality diamonds that are subject to fraud. In 2004, De Beers was charged with colluding with General Electric to fix the price of industrial diamonds, which are used in a variety of applications. In the settlement, De Beers pleaded guilty and paid a $10 million fine to the U.S. Department of Justice. General Electric was acquitted of all charges. (See De Beers Agrees to Guilty Plea To Re-enter the U.S. Market, by Stephen Lebaton, The New York Times, July 10, 2004.)

The global diamond market faces many methods of large-scale fraud before the stones ever reach jewelry cases. This article briefly looks at three major types: conflict diamonds, diamond grading certificate fraud and color-enhanced diamond fraud. Also, I cover practical tips for fraud examiners to avoid diamond scams.

Artificial market shortage of diamonds

Prior to 1870, diamonds were rare, but that year the industry turned upside down with the discovery of vast amounts of diamonds in South African mines. European financiers soon realized that the diamond market would be saturated without implementing intervention strategies. By 1888, the Belgium-based De Beers Company controlled all diamond mining in South Africa. In the ’30s, it created a global wholesaler network with De Beers Consolidated Mines Inc. (See the academic paper, De Beers and Beyond: The History of the International Diamond Cartel, by Tobias Kretschmer, London Business School, 1998.)

De Beers captured the world’s diamond supply, but now it had to create the demand for diamonds worldwide. All it needed was a great narrative and marketing strategy, and a smart advertising agency, which they found in Philadelphia with N.W. Ayer in 1938. Europe at this time was concerned with the political instabilities that presaged the start of World War II, and De Beers saw the best potential for creating a demand for diamonds in the U.S.

Diamond inventory had declined by 50 percent after World War I, and people were just emerging from the Great Depression in the mid- to late-’30s. Diamonds were an extravagance for the wealthy; working Americans spent disposable income on bare essentials.

Celebrities often appeared in De Beers advertising to push the image of emotional value — joy, excitement, status — behind diamond jewelry at all price points without overtly selling diamonds. De Beers created a 55 percent increase in U.S. demand for diamonds between 1938 and 1941. (See The Engagement Ring Story: How De Beers Created a Multi-Billion Dollar Industry from the Ground Up, by Lindsay Kolowich, HubSpot.)

The “Diamonds are Forever” campaign began, which appeals to consumer emotions, social acceptance and status attached to love and marriage. Soon the “two months’ salary” investment for a diamond engagement ring (a completely arbitrary figure) became the standard investment guideline, according to Kolowich. That campaign endured for more than 70 years, and echoes of it still reverberate today in jewelry stores everywhere.

Truth about conflict-free diamonds

The United Nations defines “conflict diamonds” as those “… that originate from areas controlled by forces or factions opposed to legitimate and internationally recognized governments.” For example, a country in an African conflict area that’s embroiled in civil or religious fighting, ethnic cleansing, forced tribal relocations or genocide might contain rebels or terrorists who trade their mined conflict stones to a more-stable African state in exchange for weapons. (See How the African Diamond Trade Works, by Alia Hoyt, HowStuffWorks.)

A more-stable African state — the Republic of Congo, for example — can then export those stones as “conflict-free” diamonds even if there was no history of diamonds being mined in that country. In 1998, the U.N. banned Sierra Leone from exporting diamonds because it traded illegal diamonds in exchange for weapons with neighboring Liberia. (See Inside the ‘conflict-free’ diamond scam costing online buyers millions, by Bryan Clark, TNW, June 16, 2017.)

Some diamond companies provide chain-of-custody certifications that state they’ve tracked and documented diamonds from the ground to cutting labs and they’re conflict-free in origin. However, some believe it’s impossible for companies with only paperwork to certify with 100 percent certainty that diamonds are sourced from conflict-free areas.

In their travels from dirt to display case, some diamonds might have been bought and sold as many as 30 times with or without legitimate accompanying certifications.

The diamond industry recognizes that some unethically sourced diamonds (termed “mixage”) become a small part of the legitimate supply. (See Clark’s TNW article.) Without stricter enforcement by the diamond trade itself, legitimate companies that buy and sell diamonds consider this mixage as the cost of doing business.

Another big problem lies with the number of contractors and intermediaries between the “rough” — the uncut stone sourced from South Africa, for example — and the “cut” — cut and sized for final finish, often in processing facilities in India, Israel or Belgium. (See Clark's TNW article.)

Paperwork must accompany all shipments at every transfer point plus many “assurances” along the line that the shipment doesn’t contain conflict diamonds. However, some believe the process is overweight in paper and promises, and ultra-light on oversight via industry regulations and inspections thus making for fertile ground for all types of fraudulent transactions.

When a rough leaves a mine, a wholesaler buys it and affixes a “Kimberley Process Certification Scheme” (KPCS) certificate on it before it sends it to a cutting center for processing. The wholesaler must take out a bond that attests to the legitimacy of the stone’s source from KPCS member states in the shipment, according to Clark in the TNW article. Clark writes that Global Witness, an anti-corruption NGO, outlined the 2003 KPCS process, and the U.N. enacted it.

Once the cutting center receives the legitimate KPCS-certified stones, they convert the rough into hundreds or thousands of cut, faceted and polished gemstones that one day end up in expensive jewelry. Yet, it’s virtually impossible to ensure the finished cut stones have direct provenance to the KPCS-certified wholesale shipment. Many of the accompanying “certifications of provenance” are worth their weight in paper only.

According to Global Witness, loopholes in the Kimberley Process “and the failure to effectively adapt to address a broader range of human rights concerns means that diamonds associated with abuses are still contaminating global markets.” (See The Kimberley Process, April 1, 2013, Global Witness.) Global Witness said that “persistent and unresolved concerns” about certification of stones led the group to resign as an official observer of the Kimberley Process in 2011.

India has more diamond cutters than any other country, which creates fierce competition among other cutters and an environment that eases the path of conflict diamonds as they enter the legitimate export supply from cutting centers. In their travels from dirt to display case, some diamonds might have been bought and sold as many as 30 times with or without legitimate accompanying certifications, which increases the opportunity for fraud with each exchange, according to Clark.

Anti-fraud professionals look for suspicious “kinks in the links” in inflection (or turning) points where significant changes can occur throughout the distribution chain.

Until the diamond industry takes the problem of conflict stones seriously, some believe diamond purchasers have two available options: 1) Purchase stones that have been laser-etched with certification numbers to ensure the stones are sourced from conflict-free states or countries or 2) opt for synthetic, lab-created diamonds that are practically identical to the natural stones and inform purchasers of the origins.

Certification fraud: Gemological Institute of America grading reports

The Gemological Institute of America (GIA) is one of several organizations that grade and measure physical parameters of a variety of gemstones, including diamonds. Customers submit diamonds for grading, and the resulting GIA Diamond Grading Report provides a full assessment of the 4Cs with a plotted clarity diagram and other features. (See Figure 1 below.) Diamond companies use GIA grading reports to certify properties that add to gemstone quality.

Figure 1: Sample of a Gemological Institute of America grading report

I recently spoke with a representative from Signet Jewelers, the world’s largest retailer of diamond jewelry, about the value of grading certificates. “Most consumers purchasing either large or small carat-weight diamonds want a certified stone, and some don’t care, depending on the jewelry piece or the price, so it’s a mix of both,” the Signet Jewelers’ rep says.

In 2015, the GIA was forced to invalidate more than 1,000 diamond grading reports from one of its labs in India. An unauthorized party had access to the grading parameters and doctored grading reports to make inferior stones appear more valuable. Fortunately, the GIA was alerted to the tampered reports through its internal controls. (See: GIA invalidates more than 1,000 reports because of hacking, by Rob Bates, Oct. 26, 2015, Rubel & Ménasché Diamantaires.)

In a 2016 fraud involving GIA Grading Reports, Alibaba — the online wholesale portal — blacklisted and removed a New Delhi-based supplier of synthetic diamonds and simulated gems for trying to pass off lab-grown synthetic diamonds with fraudulent GIA natural-diamond certificates. International Trading Corporation had offered, via Alibaba, to supply buyers 10,000 carats at wholesale — at $100 or more per carat — of synthetic chemical vapor deposition diamonds a week with fake individual GIA certificates. (See Firm passing off artificial gems as natural, banned, by Melvyn Reggie Thomas, The Times of India, Feb. 18, 2016.) The International Diamond Exchange, an online international diamond trading platform, exposed the attempted fraud.

Coloration fraud: chemically enhanced diamonds

Fraudsters increase the wealth of diamonds prior to the grading process by applying extremely thin chemical coatings — often only visible at 500x magnification — that give them a whiter appearance and hence higher value. Suspicious grading labs can clean the stones with alcohol or acetone or boil the diamonds with acid to remove the coatings.

Client behavior often signals fraud. For example, a legitimate client would be upset and demand a revaluation if the grading process reveals a color reversal of three to four lower levels. However, a fraudulent client would probably keep quiet.

In one recent incident in Antwerp, Belgium, the International Gemological Institute (IGI) received a large diamond along with several smaller carat-weight stones, all of which appeared to be coated. Several IGI employees recognized the large stone as one that had been analyzed a few months earlier. So, they called in court bailiffs to observe the grading process, which demonstrated that the fraudulent enhancement of just the large diamond would’ve yielded an estimated excessive value of $40,000. The same pre-enhanced stone was four grades lower when the client had evaluated it months earlier. (See: Antwerp Lab Discovers and Reverses Undisclosed Temporary Color Enhancements, by Chaim Even-Zohar, Diamond Intelligence Briefing, June 16, 2015.)

Digging into the ‘diamond/water paradox’ or the ‘paradox of value’

As of press time, the parched city of Cape Town, South Africa, has delayed “Day Zero” at least until 2019 — when it  supposedly has to turn off its dwindling water supply because of a multi-year drought and a population explosion since 1994. (See Cape Town drought: South African city may avoid ‘Day Zero,’ BBC, March 7.)

In a country that produces one of the most desired gemstones, life-giving water could become more valuable than diamonds. That would be a reversal of the basic economics principle, “diamond/water paradox,” which says that although water is more useful and plentiful than diamonds, diamonds command a higher price.

The more rare and marginally useful an item or service is the higher the happiness factor associated with possessing it and the higher its price tag.

Adam Smith, an 18th-century economist, described this principle, also called the “paradox of value,” in “The Wealth of Nations.” (See Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, University of Chicago Press, 1976.)

Smith noted that the everyday practical items we use often have little or no value in commerce or other transactions. Items such as plates, cups, buttons and combs (and water) are just a few examples. However, the impractical, rare item is often far more expensive. For example, a bottle of 1787 Chateau-Lafite Rothschild, pesos de ocho (“pieces of eight”) silver coin minted in the early 1600s or a five-carat diamond have far greater market value but very little or no practical value.

Our impulsive desires and overly optimistic assumptions often sway our assessment of potential risks of low-utility/high-value commodities. We can cast aside the discerning mind of an unabashed skeptic.

Paradox of value leads to scarcity and marginal utility

Scarcity and marginal utility can explain our seemingly irrational purchases. Scarcity is simply the unavailability of a product, skill or service. Marginal utility is how economists measure the personal gain or satisfaction that meets an emotional want or need from using or purchasing an additional unit of a good or service.

The more rare and marginally useful an item or service is, the higher the happiness factor associated with possessing it and the higher its price tag. For example, one afternoon of batting practice with Baseball Hall of Fame pitcher Nolan Ryan (a rare, marginally useful and expensive service) would be appreciated more than three afternoons of batting practice with him. The emotional want or excitement decreases slightly on the second afternoon and more on the third afternoon, especially if others are invited to participate with you. The experience now isn’t unique.

The “emotional want or need” is the Achilles heel of many ordinary consumers and wealthy investors who answer the siren call for “one of a kind,” marginally useful, expensive collectibles or opportunities. Fraudsters, of course, know this.

If water and diamonds were available in equal quantities, what would happen to their relative value? What if the supply of water could be controlled artificially as De Beers did with diamonds? What would that do to the values of both? Which is the marginally useful item? It’s a paradox.

Let’s add a second variable in the pursuit of and desire to possess rare objects: “information asymmetry” — that’s when the seller has more knowledge than the buyer about a product or service. (See What is information asymmetry? The Economist, Sept. 5, 2016.)

Diamond fraudsters take advantage of buyers’ obsession and fragility by applying persuasion psychology and outright market manipulation as De Beers did. As in most such pursuits, consumers usually are on the wrong side of the information asymmetry equation.

A third variable is “diffusion” — the extent of a seller’s influence in an investor social network that includes direct or indirect social ties to the seller or other investors plus the seller’s extent of influence through advertising and marketing campaigns. (See Diffusion of Fraud: Intermediate Economic Crime and Investor Dynamics, by Wayne E. Baker and Robert R. Faulkner, Criminology, Volume 41, No. 4, 2003.)

The power of social networks to distribute information is well documented. Charles Ponzi’s scheme duped many Italians living in Boston’s South End as the close-knit ethnic social network spread via word of mouth his promise of extreme rates of return. Investors’ emotional want of such high returns exceeded their due diligence for considering the offer’s validity.

Taken together, the paradox of value, information asymmetry and diffusion suggest an equation I devised that I call a “fraud susceptibility index” for those who participate in transactions involving “rare” (low-utility/high-value) objects. See the fraud susceptibility Figure 2 below. (I haven’t yet tested my theory, but I offer it as a plausible understanding of how victims could succumb to this fraud.)

Figure 2: Fraud susceptibility index (the lower the score, the lower the susceptibility to fraud)

Here’s an example for a Ponzi scheme: low utility, high value, high emotion for the buyer = 1; information asymmetry (seller knows more than the buyer) = 1; direct and indirect diffusion (rapid spread by word-of-mouth brings in additional buyers/investors) = 1. So, the fraud susceptibility index = 3, which is quite high.

Onus is on consumers because of lack of controls

Why are diamonds valuable? Because people believe they’re valuable. The global diamond trade, like many other collectable markets, is at the mercy of the widespread absence of transparency. Buyers must cautiously scrutinize gemstones and other low-utility/high-value objects.

The diamond industry and governmental agencies don’t police all the actors in the supply/distribution chain. So, investors, collectors and everyday consumers must educate themselves so they don’t purchase bogus certificates, conflict diamonds, chemically enhanced diamonds and diamond-like substitutes. Anti-fraud professionals can help their communities avoid the pitfalls. Buyers must beware.