On January 27, 2015 CME Europe announced the launch of two cocoa futures contracts to be cleared in London. First a Euro-denominated cocoa futures contract with delivery in certain northern European ports and second, a cash-settled US Dollar denominated contract to be settled on the basis of the close of cocoa in New York. Trading in these contracts, which have been drafted in response to consultation with the international cocoa trade and industry, will begin at the end of March 2015.
In designing the Euro-denominated cocoa futures contract, CME Europe aimed to address the main causes of conflict in the cocoa market and so offer participants not only a choice of where to place their hedges but also a relevant and effective hedging and pricing mechanism.
Futures markets exist to aid price discovery, where the price of a transaction between buyer and seller in a competitive market place signals the value of the goods concerned, and to help participants take protection against their price risk exposure, where the gain or loss resulting from a hedged position should offset the gain or loss of the physical position. This is true providing, and here is the essence of a delivered futures contract, that the futures price converges with the cash price at expiration. And here, changing trends have caused some concerns.
Over the coming weeks, we will explore how CME Europe has encompassed these long term trends in order to draft a contract that meets the needs of the international cocoa industry.
Historically, the relationship between Great Britain and its cocoa producing colonies of Ghana and Nigeria resulted in a sterling based European cocoa market. Times have changed and now the Euro is both the accounting currency for most of the cocoa industry in Europe and the currency base for those exporting cocoa from countries using the CFA Franc, significantly key growers Cote d’Ivoire and Cameroon, which have seen their share of world cocoa production grow from 15% in the period of 1960/65 to 45% in 2013/14, according to International Cocoa Organisation (ICCO) figures. Nearly 38% of the world’s cocoa beans are ground in Europe, according to ICCO data, whilst the major European processors have also increased the amount of cocoa they grind at origin.
Participants in both regions might expect to see some alleviation of currency risk with a Euro-based contract. CME Europe will not offer a Sterling denominated cocoa contract which would only divide liquidity in the European-based market.
On the subject of currency, CME Europe will list a cash-settled US Dollar cocoa contract, regulated and cleared in London. This will afford those who wish to trade the arbitrage between London and New York cocoa, (which accounts for a significant amount of business,) a cheaper alternative, as there will be margin offsets between the two CME Europe cocoa contracts both of which will be cleared by CME Clearing Europe in London. This is a good example of how CME Europe will offer the market a relevant and cost efficient alternative method of trading.
Over the past few years, complaints over excessive speculation, different sampling and grading procedures compared with the physical market, disincentives to deliver bulk cocoa and with regard to practices in some registered warehouses have numbered among the grievances of those participants trying to hedge their physical cocoa positions. In response, CME Europe made use of the physical contract terms in drafting the delivery requirements in the futures contract, the most relevant of which are those published by The Federation of Cocoa Commerce Ltd. (FCC), of which CME Group is a member. The intention is to offer physical market participants the ability to hedge their physical positions on an exchange where the delivery terms are based on those used in the physical contracts and there is therefore likely to be price convergence between futures and physical at the time of delivery.
While currency and compatibility with the physical market terms are important, there are other deep underlying issues faced by the cocoa community over the hedging medium. CME Europe has had the opportunity to draft a contract and procedures from the ground up and without the legacy of an existing contract.
In designing the contract, CME Europe’s approach put those who need the contract for hedging at the centre of the whole process and in particular with regards to the delivery requirements, in other words, the needs of the receiver.
These differences will be explored in more depth in the forthcoming series of articles, a brief summary of which is made here.
To start with, good price convergence relies in part on an efficient delivery system; the location of the cocoa; and the origin, age and grading allowances. Without these the futures offer little relevance to the physical market.
As such, CME Europe has set the basis of delivery of warehoused cocoa to a ‘delivered out’ contract, whereby the party storing the cocoa, not the receiver, pre-pays the delivery out charges to the warehousekeeper. On expiration the receiver has no choice in what he is allocated; he has to accept the cocoa irrespective of origin, age, where and with whom it is stored, which naturally includes the rates that the warehousekeeper storing the cocoa will charge. Over the past few years there have been long queues for loading out and high storage charges (even for beans scheduled to be moved) at some registered European coffee and cocoa warehouses, which impeded a receiver’s ability to access beans and increased his costs.
By making the basis of the delivery process ‘delivered out,’ CME Europe anticipates the market will organise loading out rates and storage costs in a market-led way, avoiding the need for the Exchange to set minimum load rates and maximum rental rates at its registered warehouses. This, and other measures to be explored in another article, should reduce conflicts of interest between parties involved in the current delivery process.
The CME Europe cocoa futures contract includes a novel process for electronically lodging physical warehouse warrants in ”in-house” depository , which will result in significant savings for the market participants.
Improved sampling procedures that reduce both costs to the owner and damage to the cocoa and bags, together with the more relevant grading process, overseen by the Exchange, will help align the futures prices with those in the physicals.
The FCC physical contract calls for shipment of cocoa in new jute bags or in bulk. The amount of cocoa shipped in bulk has grown since the first cargo of bulk in the hold docked in Europe in 1995. Shipment this way reduces handling costs and can be up to one third cheaper than conventional bagged shipments. It is especially increasingly popular from Côte d’Ivoire, the world’s biggest cocoa producer, and amongst the large processors in Europe.
Discounts for bulk shipments are a disincentive to tender bulk cocoa leading to a disconnect with the physical market and instead, CME Europe’s contract includes flexible use of bulk deliveries to help the deliverer prepare bulk cocoa whilst also incorporating appropriate safeguards for those receiving cocoa.
The specifications of the CME Europe cocoa contract recognise the need by end-users of beans to value certified cocoa and the associated requirement of traceability of all stock. Some of the biggest traders and processors, supported by the World Bank via its IFC investment arm, are lobbyists for certification to ensure the identity of a product from a particular origin, to convey an assurance of quality and distinctiveness and to enable farmers to receive a better price.
Some of these items are interconnected, for example having the ability to offer a premium for certified cocoa is meaningless if traceability is not placed at the heart of the process of identification of the cocoa. Likewise, the identification has to be clear to the owner and the specific details will be included on the warehouse warrant to ensure clarity of ownership. Similarly the basis of the contract could not be meaningfully changed without the CME Europe having reached an agreement with the warehousekeepers over the delivery out of the cocoa, which in turn has meant the necessary removal of conflicts of interest between parties.
Where possible the CME Europe deliverable cocoa contract has been designed to correlate with the current physical market and to address the issues in a market-led way, by reducing conflicts of interest while retaining the integrity of the process via the appropriate regulatory control and exchange oversight. The following series of articles will explore the choices CME Europe made in drafting the contract and demonstrate why it best suits the current environment.
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