Financial Regulatory Forum

COLUMN-Cocoa’s rise and fall puts spotlight on FSA: John Kemp

By Reuters Staff
September 15, 2010

– John Kemp is a Reuters market analyst. The views expressed are his own –

By John Kemp

LONDON, Sept 15 (Reuters) – Cocoa’s stunning rally and equally spectacular bust over the last five months provides compelling evidence that large positions, especially in contracts close to delivery, influence futures prices, and that regulators should develop effective position limits to ensure market prices reflect supply-demand fundamentals and not the impact of dominant positions.

Britain’s Financial Services Authority (FSA), which regulates commodity markets, continues to insist there is no evidence large positions, either singly or collectively, influence futures prices, most recently in a position paper published in December 2009 (http://www.fsa.gov.uk/pubs/other/reform_otc_derivatives.pdf).

The FSA has rejected calls to follow the U.S. Commodity Futures Trading Commission (CFTC)’s lead in imposing position limits on commodity derivatives. It insists that London’s “position management” approach is more flexible and effective.

“Moving away from a regime which is flexible and established, to a different and more rigid system would imply there is an identifiable problem with the current regime. We have seen no evidence of this,” according to the FSA.

But the cocoa market’s performance over the last four months provides compelling evidence that large positions do influence both the level and structure of prices, particularly when they represent a substantial percentage of the deliverable cash commodity.

COCOA PRICES FALL LIKE A STONE

London cocoa prices have fallen almost continually since the controversial expiry of the July futures contract on NYSE Liffe. Prompt  and forward  cocoa prices are now at their lowest level for more than 12 months, as the nearest-to-deliver September futures contract expired today.

Prices for September delivery have fallen by a massive 609 pounds per tonne (25 percent) in the last two months, and the Sep-Dec spread has shifted from 166 pounds per tonne backwardation to 33 pounds per tonne contango .

Back in July, some commentators noted rising cocoa prices were not simply a temporary phenomenon reflecting low warehouse stocks, but were directly related to long-term structural factors such as diseased trees and rising demand from emerging markets. But those long-term problems do not seem to have been sufficient to hold the market up.

While favourable weather conditions in West African growing regions in recent weeks should ensure a favourable harvest later in the year, changes in fundamentals and expected fundamentals cannot explain the 572 pound (26 percent) run up in prompt cocoa prices between April and July, and subsequent 600 pound (25 percent) retracement.

Instead, the decisive factor appears to have been (informal) intervention by the NYSE Liffe and the FSA following complaints by cocoa processors and a string of high-profile stories in the media. [ID:nLDE66K1B2]

CASE FOR LIMITS STRENGTHENED

The FSA will probably argue that the pull back in cocoa prices vindicates its flexible position management approach. But in practice the gyrations in cocoa prices prove the opposite, and make an overwhelming case for a more formal system of position limits on contracts close to expiry:

(1) Strict limits would have avoided the extreme congestion and volatility witnessed in July, as well as preventing excessive concentration and ensured market prices reflected a range of views about the future.

(2) Formal limits would have made the regulatory framework more transparent and predictable, and reduced the enormous amount of uncertainty surrounding the current discretionary approach as market participants tried to guess whether the exchange or the regulator would intervene or not.

(3) Automatic limits would have avoided a high-profile and acrimonious lobbying campaign (conducted via the media) by holders of short positions in cocoa (and last year in tin) designed to force NYSE Liffe and the FSA to step in, arguably damaging the market in the process.

(4) By laying to rest suspicions that prices are being driven by dominant positions rather than fundamentals, limits would increase public and media confidence and acceptance that market prices are “legitimate.”

NOT AN ALTERNATIVE SPOT MARKET

Sometimes industry opposition to any form of limits seems to stem more from philosophical hostility to any form of intervention in “free markets” than clear evidence that limits would unnecessarily restrict reasonable trading and hedging.

Opponents rarely explain why market participants need to be able to run very large positions and take them all the way to expiry. Expiry limits have long been enforced on U.S. futures markets such as NYMEX oil and natural gas; no one has suggested that they have prevented those markets from working properly.

As the Eighth Circuit U.S. Court of Appeals observed in Cargill v Hardin (1971) the main economic functions of a futures market are to provide price discovery, stabilisation and hedging. Futures markets are not an alternative spot market for the commodity itself.

Some small volume of delivery may be needed to force convergence between futures and physical prices. But most parties who engage in futures transactions are hedgers and speculators in no position to make or take delivery. If they were always forced to make preparations for delivery, the market would become less useful, the number of effective participants would fall and liquidity would diminish.

Carefully designed limits on contracts close to expiry actually increase liquidity rather than reduce it. In the case of cocoa, the complainants threatened to remove their hedging business from NYSE Liffe, which allows unlimited delivery, and place it with the rival ICE exchange, which enforces limits, suggesting that well-regulated markets with effective limits can actually be more attractive and draw rather than repel hedging and other business.

Derivatives have warned the CFTC that enforcing strict limits in the United States will drive business into more lightly regulated markets in London. But the threat is probably an empty one, as former CFTC Chief Economist Jeffrey Harris observed yesterday, when he described some comments as “scaremongering.”

The cocoa market’s recent stunning rise and fall is likely to reinforce the CFTC’s determination to apply comprehensive limits to all commodity derivatives markets. (Editing by James Jukwey)

((john.kemp@thomsonreuters.com; Reuters messaging: john.kemp.thomsonreuters.com@reuters.net; +44 207 542 9726))

Comments
One comment so far | RSS Comments RSS

Although the article is focused on the FSA, even the CFTC’s powers and policies are far from a preventative measure against excessive positions on futures markets, including cocoa. Fundamentally, it is index traders which are behind the upward pressure on prices. Index traders predominately enter swap agreements with swap dealers such as investment banks, and these swap dealers then hedge their risks in futures markets – and are exempt from positions limits in both the US and the UK. Swap dealers remain bona fide commercial hedgers, and the speculators behind the swap deals effectively escape regulation.

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