London, 6 July 2010

Sixteen cocoa consumers, processors and traders have written to Liffe to complain about lack of transparency and control in the London futures market, and threatened to transfer their hedging business to the more tightly regulated and transparent New York market run by ICE instead. It provides unexpected support for U.S. Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler's bid to tighten position limits and force more disclosure in commodity markets. In the past year, swap dealers and commentators have issued dire warnings about the threat to U.S. dominance if the CFTC presses ahead with proposals to impose strict limits on major energy contracts. But the cocoa letter indicates tough regulations are not necessarily a competitive disadvantage. Disclosure and limits provide vital assurance to market participants that price movements are the result of physical fundamentals, legitimate hedging and moderate speculation, rather than "excessive speculation" or an attempt to manipulate, corner or squeeze the market.

A substantial gap has opened up between the level of transparency and regulation applied in New York and London, reflecting different philosophical approaches. The gap is set to widen further if derivatives reform legislation currently before the U.S. Congress is enacted.

Until now, the debate has assumed market participants prefer less regulation to more. But that may not be true for all participants. Physical hedgers and merchants in particular may opt to conduct their business on a more regulated and transparent market if that convinces them gains and especially losses are "fair" and they will not be unwitting victims of a squeeze or other distortions.

Like Caesar's unfortunate wife, who protested her innocence but was nonetheless divorced, futures markets must be seen to operate fairly if they are to retain legitimacy and support from interested parties and the public.

Breakdown of Trust

In their letter, the cocoa market participants make four specific complaints:

(1) Why did open interest reported by the exchange not change following the expiry of the July 2010 options contract?

(2) Why are there more than 50,000 lots (equivalent to 500,000 tonnes of physical cocoa) outstanding in the nearest-to-expiry July contract when it has only two weeks left to run?

(3) Why is Liffe still not publishing a commitments of traders report showing the aggregate positions of various types of traders as is done for ICE cocoa and other U.S. futures contracts?

(4) Why did the first-to-deliver and second-to-deliver spreads shift so abruptly (increasing almost 50 percent) on July 1 on turnover of less than 500 lots, when the open position is supposed to be more than 54,000 lots?

The complainants note bitterly "This type of action would never [have] been allowed on ICE, where they have position limits in order to avoid big players from cornering the market".

Liffe refused to comment on reports, but on its website said that as a regulated market it operates a fair and orderly market.

Challenge to the FSA

In the United Kingdom, the Financial Services Authority (FSA) set its face resolutely against the use of limits in a paper on "Reforming OTC Derivative Markets" published in December 2009.

The regulator acknowledged "a common concern of potentially abusive behaviour relates to market manipulation, and specifically that effected from the holding of, and abusing, a large position". While this risk can occur at any time in the life of a contract there is particular risk in the run up to expiry of physically settled contracts (paragraph 9.7).

In other jurisdictions "Position limits were originally imposed in exchange-traded commodity derivatives markets as a tool for ensuring that large positions were not amassed as the expiry of physically delivered contract approached" to reduce the risk of a market squeeze or settlement failure (para 9.9).

In contrast, the United Kingdom does not require exchanges to set limits. Instead it has adopted a broader "position management approach". This gives exchanges the power to manage positions at any point in the contract lifecycle, including the power to instruct a member to reduce or close them out, though it is not clear how often the powers have been used in practice.

In its 2009 paper, the FSA makes clear it sees no reason to change a successful system and is sceptical about whether position limits reduce volatility (para 9.22).

The FSA has also decided against publishing a UK-version of the widely used CFTC commitments of traders reports. The FSA consulted market participants about compiling and publishing similar data, but decided against after "market participants" said such a report would not be useful, though it is not clear which ones the FSA asked and who replied.

Flying in the Dark

Unfortunately, without either position limits or public data, market users and the public at large have almost no visibility about what is happening on UK commodity exchanges.

Besides data on time and sales, as well as some highly aggregated numbers on open interest and turnover, most FSA-regulated exchanges publish little information that would enable participants or researchers to understand why prices move in the way they do.

There is no way to assess if there is any merit in the Liffe cocoa consumers' and traders' complaint. Ironically, research studies cited by the FSA, other regulators and swap dealers to claim there is "no evidence" speculators affect prices, rather than supply and demand, are all based on studies utilising CFTC traders data from the United States.

No such studies have been, or ever could be, performed on London commodity markets because neither the regulator nor the exchanges publish comparable information. Outsiders must trust the FSA and exchanges when they claim there is no manipulation and no unintentional distortion resulting from large positions. There is no way to verify this independently. Unfortunately, trust is thin on the ground, as the letter to Liffe indicates.

This is not the first time consumers and traders have complained about dominant positions and price setting in London. Copper consumers have raised repeated objections with the London Metal Exchange ( LME) in recent years, and members of the LME's tin committee reportedly complained in 2009.

What makes the cocoa complaint unusual is that the complainants have the option of switching to an alternative contract. Neither copper consumers nor tin participants had any real choice so they could not credibly threaten to take their business elsewhere. Their complaints were dismissed by many as gripes from firms on the wrong side of the price movement.

Transparency Not Wrong

The futures industry is rather too fond of anonymity. But confidence would be strengthened by greater transparency. We don't expect courts, legislatures and governments to operate behind a veil of secrecy, and nor should we expect commodity markets to rely on a doctrine of "trust us". As President Ronald Reagan wisely warned: Trust but verify.

Some level of confidentiality for individual positions is vital, but the blanket confidentiality currently thrown across London trading is not helpful, and will not be sustainable. For example, on ICE, hedge funds and other managed money firms are currently running a net long position of 23,264 contracts, which is not especially large by past standards. It mostly offsets a net short of 38,661 contracts among producers, consumers, merchants and processors, according to CFTC data.

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The question is why couldn't the FSA and Liffe produce something similar? Then we could all see what was driving prices. Plenty of criticisms can be levelled at the CFTC reporting regime. But the Commission has addressed some of them with the publication of data on disaggregated positions and regular data on positions held by index traders. Pointing to limits on the usefulness of U.S. data will not take the pressure off the FSA and London exchanges to improve their own transparency and make sure the markets they oversee are seen to be fair.

Ends --

By John Kemp, Reuters - for Commodities Now

Attachments:

COCOA-COT.pdf

240 Kb