Saturday, September 6, 2008

3rd-Party Coin Grading: The Race to the Bottom

The grading of coins has always been more of an art than a science. Each coin presents a unique set of attributes (both positive & negative), which together embody its desirability. However, for circulated coins, it should be possible (at least in theory) to derive objective measures of the amount of wear visible on the surfaces. The original idea of coin grading involved making the distinction between uncirculated (eg. no wear) and varying degrees of circulation.
Dr. William Sheldon devised a numerical system of grades, from 1 to 70, which he proposed to use as a shorthand expression for a coin's value. Using Sheldon's system, a higher numerical grade translated literally into a higher value.

Time passed, and the value of uncirculated coins escalated to the point where it became important to distinguish between "typical" uncirculated, "choice" uncirculated, and "gem" uncirculated coins. The factors involved in making the distinction between typical, choice, and gem included: Sharpness of strike, Quality of lustre, Number of marks, and Overall Eye Appeal. A gem uncirculated specimen might be worth 2X, or 5X, or 10X the value of a typical uncirculated coin of the same date & mint. The economic implications of a 1 or 2-point difference in grade became enormous in some cases. Problems arose in the rare coin market when the buyer & seller could not agree upon the appropriate grade for a particular coin.

3rd-party grading services arose recently (about 20 years ago) with the stated goal of "solving the coin grading problem". This seemed theoretically possible: The basic proposition was for the owner of a coin to send it to the grader, who would assign an independent grade (for a fee), and then return the coin in a sonically sealed plastic holder. After that, the coin could be bought & sold with no further arguments about its grade. Presto!

The Evolution of The Slab:
3rd-party grading was immediately successful. The initial success of the pioneering firm led to the creation of other grading services. For some time, there were plenty of “raw” coins to go around, and graded coins began to be called "slabs". A market for slabbed coins developed, and the Coin Dealer Newsletter even created a separate pricing guide (The Certified Coin Dealer Newsletter) to assist market participants. The grading of coins was a strong growth industry. The grading services competed on the basis of price, service, and reputation (ie. the perceived value of the 3rd-party grade).

Savvy market participants began to take note of subtle differences between the way each service graded particular types of coins (since grading is an art more than a science, the assigned grade will depend upon a number of subjective factors, as mentioned above). The art of "cracking" coins out of one service's holder for re-submission to a different service (with hopes of a higher grade) was born. Furthermore, it was observed that although the assigned numerical grades were integer numbers, the distribution of the coins themselves was "analog" in nature, so that within a particular grade, there were average coins, strong coins, and weak coins. Some talented market participants began seeking high-end coins with exceptional profit potential at the next higher grade level. These strong coins could be cracked out and re-submitted with the chance that they would make the next higher grade (the graders were human, and the grading process was subjective). Eventually, the percentage of uncirculated coins in slabs became significant when compared to the entire available population, and the growth in grading submissions began to slow. A few problems began to surface.

The 21st Century and the Race to the Bottom:
I suppose that at this point, I should point out that the perceptions that I am about to share with you are purely my own. I have not mustered any objective data or other proof to support my assertions - therefore, you should take this all with a grain of salt.

The dawn of the 21st century brought a disaster (on Sept. 11, 2001) along with an economic recession (the recession was actually already underway before Sept. 11). The recovery from this recession coincided with the start of one of the great coin booms of our time. This boom began slowly, but gathered strength along with the U.S. economy, and really kicked into high gear with the acceleration in the price of oil and other commodities. Boom coin markets are often associated with the relaxation of grading standards. The reasons are somewhat complex, but I can invoke a simple supply & demand argument to explain the phenomenon. More people are seeking high-grade coins (higher demand). The number of high-grade coins is strictly limited (in an ideal world), but is somewhat "flexible" in the marketplace. Relaxation of grading standards permits an increase in the supply of high-grade coins. Grading services are capable of maintaining tight grading standards (at least, within the inherent limitations of a group of human graders), but they are also for-profit businesses. As such, they need to be responsive to the needs of their customers (the people submitting coins & paying fees). The profit motive works to everyone's benefit during a boom coin cycle. However, there is a dark side to this phenomenon. As the 3rd-party graders compete for submissions, one service could relax their standards (just a little), to encourage business. Market participants (attempting to maximize their own profits) crack coins out of old slabs and pay another fee, in the hope (ie. expectation) of a higher grade. Buyers continue to pay (after all, the coins have been graded, and the grading services are there to maintain the standards, aren't they?). Not only that, but prices have been rising, so any “error” in judgment (ie. grade) will be eclipsed by the error of NOT buying NOW! Pressure mounts on the other grading services to follow the first service to a looser grading standard. I believe that the coin market’s long Bull Run initiated the slide in grading standards, which I call the “Race to the Bottom”.

There is ample evidence that these things are going on. This is why the term "OGH" (old green holder) has crept into so many auction & fixed-price coin listings. The implication is that “new” grading standards are looser than “old” standards, and therefore the OGH coin could be a higher grade today (even from the same service!). Dealer wholesale prices (quoted in the Coin Dealer Newsletter) have lagged the retail market significantly. Some of this lag is natural, since the CDN must (by definition) follow the market, but another factor in the lag is the reluctance on the part of knowledgeable buyers (ie. coin dealers) to pay market rate for coins that simply do not meet their personal grading standards. Now, a group of entrepreneurial individuals have formed a new service that will (for a fee) examine a slabbed coin, and ratify the grade assigned to the coin, if the assigned grade meets their standards. A holographic-style green sticker will then be affixed to the slab, to certify it. In other words, they have created a grading service for the grading services!

Over the past four years I have examined tens of thousands of coins of all types in slabs. All of the major services exhibit variability in their grading standards, although I would say that the top two services maintain the tightest control over variance. All of the services make grading errors (both under-grading & over-grading). However, under-graded coins are quickly absorbed by the crack-out specialists, who re-submit until the higher grade is obtained. The result of this activity is that, the distribution of coins at any particular grade level must (over time) tilt toward average and below-average coins. It is my observation that one of the major services (not #1) began to loosen their standards early in this boom cycle, as a way to increase their market share. Auction after auction, I could examine two coins side-by-side of the same type, date, and mint-mark, but graded by these two services – in more than 90% of the cases, the coin from the service with the looser standards had a grade at least 1 point higher (often more). In spite of this clear visual difference, their strategy succeeded well enough to force the other grading service to also grade more loosely, in defense of their market share.

More recently, I have begun to observe an even more alarming trend in slab grading – coins with obvious problems (like large scratches, corrosion, cleaning, or damage) encased in holders that state the sharpness grade with absolutely NO mention of these problems. A couple of the major services have offered grading & encapsulation (ie. slabbing) for “problem” coins for some time – these slabs state the sharpness grade and then the problem immediately below. Occasionally there is even a “net” grade on the slab, to assist with determination of value. This service (slabbing for problem coins) was not perfect, but it provided some protection to the buyer (by guaranteeing authenticity, and pointing out the problem, which could at times be subtle). One major service typically rejected problem coins (returning them in a “body bag”, to use the parlance of the coin market). Early in the current coin boom, minor problems began to be accepted, with a lower “net” grade assigned in order to account for the lower market value of the coin with a problem. In this bold new world of slab grading it is “Buyer Beware” (which, by the way, is exactly how it has always been when purchasing raw coins).

In conclusion, I would argue that the grading services have enriched themselves at the expense of the very market they intended to serve. Their mission ("solving the coin grading problem") has been an abject failure. It is high time to tell the people purchasing slabbed coins in today’s market that "The Emperor is NOT wearing any Clothes”. The grade on that slab you are considering is probably not the same grade the same coin would have obtained from the same service 10 years ago. Knowledge is the buyer’s only protection. It is imperative to know how to grade the coins that you collect, and approach certified coins with an appropriate sense of skepticism.