Improving Prospects for Cocoa Price Convergence - Article 2

CME Europe’s Cocoa Futures Improve Prospects for Price Convergence with the Underlying Market

Cocoa futures are not primarily used to secure a supply of cocoa beans, but rather to offset the risk of adverse price movements for those with exposure to cocoa beans.

The gain or loss from the futures hedge should offset the gain or loss from the physical transaction, providing the environment is such that the futures price converges with the cash price on expiration. Convergence of futures prices with those of the underlying physicals shows the relevance of the futures to the physical.

In recent years, a number of factors have led to complaints over convergence between cocoa futures and the cash price so in drafting the new cocoa futures contract, CME Europe set out to create the conditions wherein the likelihood of price convergence is improved. CME Europe’s cocoa futures contract is designed to track the underlying cocoa cash market more closely than any other futures alternative.

Price convergence is subject to many factors, some of which are:

  • The location of the goods and the relevance of the location to the trade
  • The true availability of the goods
  • The quality of the goods and how that is determined, together with the associated allowances
  • The age of the goods

In essence, good convergence relies on the delivery mechanism mirroring that used in the physical market; from location of the goods, their sampling and grading, through to their movement out of the warehouse. The CME cocoa futures’ enhanced delivery systems is designed to improve the conditions for convergence between the futures contract and the cash market offering participants a more effective risk management vehicle.

The key points of the CME Europe cocoa futures contract, where it relates to price convergence, are detailed below. 

Location of the goods

The specified delivery locations are concentrated in northern Europe, at just three of the main trade-relevant ports to provide a clear pricing basis for the contract. Physical delivery will be made at exchange registered warehouses in or nearby to Antwerp, Amsterdam and Hamburg.

True availability of the goods

Stocks registered and complying with Exchange specifications back the futures contract. There can be a disconnect between the futures and  physical markets when only a small amount of commercially traded cocoa is truly available for sale or delivery at the exchange, which may cause significant price swings. 

The CME contract addresses this in two ways:

Bulk deliveries

Currently 70% of the cocoa beans shipped into Europe are shipped in bulk. The existing futures contract allows for delivery of just one size of bulk cocoa, 1,000 tonnes, at a £20 per tonne discount in price. This, together with difficulties in re-grading,  is a strong disincentive to deliver bulk cocoa against exchange traded positions, which means that bulk Exchange-registered cocoa currently represents less than 20% of the total.

The CME Europe cocoa futures contract provides for bulk deliveries in five sizes without a financial disincentive and the Exchange has taken measures to ensure bulk cocoa is prepared, stored and sampled in a sympathetic manner for long term storage.

Delivered out

Under the CME Europe Cocoa Futures contract, delivery out of goods is free, subject to certain conditions, and if required, will occur within 21 business days from request thereby ensuring true availability.

What does this mean?

First, CME Europe believes that an improvement of the environment for futures price convergence with the underlying is likely by changing the basis of delivery of warehoused cocoa from an ‘in store’ system, where the receiver pays the delivery out charges, to a delivered out contract, whereby the party storing the cocoa (so choosing the warehousekeeper) pre-pays the delivery out charges to the warehousekeeper.

Second, a 21 business day delivery out period will help to resolve any issues of long queues for delivered beans at exchange warehouses without recourse to an exchange led load out rate in terms of tonnage per day or per week.

Together these measures address complaints over steep charges for withdrawal of certified cocoa beans from registered warehouses, high rents and long delays for removal of beans, which all translate into extra costs for traders and end users.

Long waiting times at official commodity exchange warehouses, especially acute and controversial in the metals industry for some time, have been highlighted as an issue in some European coffee and cocoa warehouses over the past few years and therefore are not considered as providing true free availability of goods.

Such a system, whereby the party storing the cocoa in the first place also pre-pays the delivery out charge, means that there is no need for the Exchange to publish movement out or rent rates.  Unless specific delivery out methods are asked for, charges to the receiver are zero and, because of that, excessive rents cannot be applied, otherwise the owner has the option to remove the stock at no cost.  The market will regulate the prices to be charged without Exchange intervention.

The quality of the goods, how that is determined and associated allowances

Sampling

Sampling and grading go hand in hand; the grader can only grade what has been drawn so if a sample has not been drawn well it will not be a true representation of the cocoa parcel. CME Europe has introduced a cocoa bean sampling process which is in line with physical market procedures and which is always overseen by an independent supervisor appointed by the exchange to ensure contract integrity.

The new CME Europe procedure for sampling bagged and bulk lots will be explained in another article. For the purposes of price convergence, the market needs to be certain that a sample truly reflects the cocoa it represents.

Grading

Under the CME Europe cocoa futures contract, grading of cocoa beans is based on physical market practices, as specified by the Federation of Cocoa Commerce Ltd (FCC), to be conducted by independent analysts under exchange supervision. Grading may only occur with a CME Europe representative in the room so CME Europe remains responsible.

By following the physical market specifications, grading in the CME Europe contract adheres more closely to the arbitration process specified in the physical market.  This starts from the use of 5mm round-holed screens to sieve the sample, as specified in the FCC Quality Rules, through to employing the chocolate manufacturers’ specified method of assessing homogeneity on bean size, used only if graders think a sample is mixed.   It should be mentioned that the period of validity of grading results is equally pragmatic and reflects the change expected in the deterioration of quality over time.

An explanation of the grading procedure for the CME Europe cocoa futures contract and its increased relevance to the physical market will be made in another article but overall, with grading practices based upon the standards established by the FCC, CME Europe expects the value from grading results will be brought closer to that of the underlying physical market.

The age of the goods

Finally, another barrier to price convergence is the old age of current stocks in exchange registered warehouses, with some cocoa dating back to the 1980s. The age allowances built into the CME Europe cocoa futures contract are intended to promote the replacement of older cocoa with fresher material, helping to ensure convergence of price with the underlying. 

CME Europe believes the new contract will respond to demand from the cocoa market for an improved hedging mechanism that better reflects the underlying physical markets. Some of the improvements outlined here will be developed further in future articles, the next of which will detail how the specifications of the CME Europe cocoa futures contract will reduce conflicts of interest. 

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