London, 22 July 2010

NYSE Liffe may have already intervened, at least informally, in the cocoa market this month to ensure smooth expiry of the July 2010 contract, if recent trading activity and price movements are anything to go by.

The exchange has declined to comment. In a reply to European cocoa processors and traders, who earlier this month complained about trading patterns on the exchange, Liffe insists it has simply "[engaged] with open position holders about their intentions, to ensure business is conducted in an orderly manner" as is normal practice.

Liffe wrote "From our investigations there is no evidence of abusive behaviour or that any market participant is trading with the specific purpose of distorting the price of the July 2010 delivery month".

Possible Signs of Intervention?

We may never know for certain, and the exchange has good reason to keep any interventions confidential until well after the event. It must not prejudice the interests of any one market participant or encourage more clamour for intervention in future. But there are a couple of things that point to possible intervention:

(1) On July 8 and again on July 12, large numbers of open positions were closed with little or no movement in either outright prices or the spread with the next open month . The number of contracts traded both days was unusually high (in the top 4 percent of daily trading volumes since the start of 2005). Normally such intense activity would be accompanied by a significant movement in prices yet market was actually very calm both days. Is it an indication the long or longs decided to allow, or were instructed, to let some shorts close positions at current prices or roll them forward to September or even December at a steady spread of around 230 pounds per tonne for the Jul/Sep switch?

(2) Some 24,100 contracts (representing 240,100 tonnes of physical cocoa) were taken to physical delivery according to the delivery notice published by the exchange. It represented almost all physical stocks registered with the exchange, and around 7 percent of world production. News reports circulating at the weekend suggest most was delivered to one firm.

In theory, with almost all the free cocoa in one trader's hands the market should now feel tight, at least until the new crop starts to become available in the autumn. There is little free cocoa to deliver against open short positions in the next-to-delivery September futures contract. But prices for the September contract peaked on July 16 at 2,445 pounds per tonne and have since eased to around 2,300 pounds (a drop of 6%).

Prices for December cocoa are off around 4 percent from 2,276 pounds to just 2,182. December prices have been steadily declining since reaching a recent high of 2,341 pounds all the way back on June 3. As the above figures imply, there is no "tightness" in the front month Sep/Dec spread either. Having closed at 313 pounds per tonne on July 15, it has fallen more than half to 127 pounds in early trading today.

Given what has been written about an imminent supply crunch or shortfall, market participants with open short positions appear remarkably insouciant about their ability to pay, roll or deliver. Is there a secret cocoa mountain somewhere waiting for delivery? Or do they think the massive delivery seen in the July contract is unlikely to be repeated in two months time?

And if the world is facing a prolonged, structural cocoa shortage as a result of aging, diseased trees in the Ivory Coast and growing demand from emerging markets, why have forward prices, such as the December 2011 contract been steadily declining more than two months?

Prices for Dec 2011 cocoa (currently around 2177 pounds per tonne) have fallen 6.5% from their peak in early May (2329 pounds) and are scarcely changed from where they were trading back in December 2009. The lack of tension in the nearby spreads or upward momentum in Sep and Dec contracts suggests most participants do not envisage another big delivery in September.

Is it possible the exchange has cautioned one or more of the position holders not to increase their positions in the nearby contract(s) or seek to make or take delivery of more than a set amount, given the vulnerable state of the physical market until the new crop becomes available? We may never know. But it would certainly be consistent with the pricing behaviour we have seen in recent sessions.

Of course the current lull might simply be a trap for the unwary and complacent, or evidence the longs are now working down their positions to take profits from the earlier rally.

But it would also be consistent with the more flexible "position management" approach endorsed by Britain's Financial Services Authority (FSA) which exchanges are required to implement.

More Transparency Needed, Promised

Hopefully the next few weeks will allow frayed tempers to cool. All market participants, as well as regulators, need to step back and contemplate what changes (if any) need to be made to boost confidence in the market and its supervision, silence the critics, and take the issue back out of the headlines.

But perhaps the key lesson is the need for much more transparency. There is much less data on positioning in London commodity markets than on exchanges in the United States and in other markets such as Shanghai. Liffe has already promised to publish its own version of the commitments of traders (COT) report which has been a staple of U.S. commodity exchanges for decades.

Hopefully, Liffe's report will follow the example of the U.S. Commodity Futures Trading Commission (CFTC) which last year overhauled the COT report. Following the overhaul, the CFTC replaced the old 2-way distinction between commercial and non-commercial traders (which was not terribly informative) with a more informative 4-way categorisation (producers/consumers/merchants; hedge funds; swap dealers; and other reporting entities).

If it emulates the U.S. version, Liffe's COT report will provide useful data on the share of open interest attributable to the largest 4 and 8 longs and shorts. Alternatively it could adopt the practice of the London Metal Exchange ( LME) and provide data on the number of "dominant positions" in contracts close to expiry, perhaps in bands as percentage of open interest or graded warehouse cocoa.

More transparency would help give everyone (producers, consumers, traders, investors and the media) confidence the market is working effectively and is free from distortions.

Finally, the regulators themselves, both at exchange level and at the FSA, need to be more open about their regulatory activities. There are good reasons why interventions cannot be revealed in real time, and there is a good case for keeping the identity of market participants confidential even in retrospect.

But the current official silence about regulatory activities means that it is hard for outsiders (and even market users) to distinguish between inactivity and quiet effective regulation.

That matters and will matter even more in future because Britain's quiet position management approach will stand in increasing contrast to beefed up position limits applied in the United States as a result of the Wall Street Reform and Consumer Protection Act.

If the exchanges and the FSA do not want commentators to draw "adverse inferences" from their silence on the subject, and both appear to feel that much of the recent criticism and comment is deeply unfair, they need to start discussing regulation more openly. It is a matter of public interest. A good start would be for both the exchanges and the FSA itself to publish an annual report on their regulatory activities discussing any interventions or other emerging matters of concern retrospectively and with appropriate discretion.

That would convince even the doubters that the FSA and the exchanges were on the case.

Ends --

John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.