Saturday, December 26, 2009

Jewelry stores should be regulated by FINRA

My wife and I got engaged when I was an economics PhD student. As I recall, I was taking a class on principal agent problems (frankly, my favorite class from grad school, although the professor was ridiculously boring in class.) These are problems with asymmetric information. This area became very fashionable in the past two years, to say the least! I caved to peer pressure, and researched diamond buying. This seemed extremely interesting to a budding economist. Imagine a good which the buyer cannot value or even identify, that is purchased (more or less) once in a lifetime, from a semi-competitive middle man and a near perfect monopolist supplier. The possibilities are endless! After a little research, as best I recall, the only academic study of the diamond industry at the time was written by someone who mysteriously died. Very young.

One of the most striking features of the just passed Holiday Season, by which I mean Christmas, are the never ending jewelry store ads. Frequently the ones for diamonds feature a riff on the claim "...and [fill in the honorable retailer's name] will buy the stone back from you at any time for exactly what you paid!"

Think about this hypothetical transaction. This claim implies that the retailer stands ready, in the securities sense, to unwind every transaction they've ever made. The capital requirements to back this trade would be VERY large for the retailer. Why do our fine regulators allow these claims to continue??

In a technical sense, we could think about this as the retailer tying puts to every transaction. They are perpetual puts. There is a scenario where these perpetual puts work: A perfect monopoly. In a perfect monopoly, the monopolist controls supply to manage price fluctuations. There should be none because price fluctuations destroy value for the monopolist. Therefore, we can assume the monopolist manages supply to generate a stable real return, with no volatility. With no price volatility, and steady real return, the put has no value.

So, what's going on? My assumption is that the retailers, in conjunction with the near monopolist supplier of diamonds, wants to prevent (discourage??) owners of diamonds from selling them. To do this, they provide guarantees that they cannot possibly maintain, and the public accepts these guarantees at face value.

To me, this is financial fraud. Either the retailers don't have the capital to back the claim, or the retailer is a participant in a cartel. Bring on FINRA!

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