Comment Text:
Dear Sirs
I am a 30 year + veteran of the commodity markets and have traded physical cocoa, sugar and coffee during the span of my career which has included periods working for Cargill, Sucres et Denrees, Louis Dreyfus and Phibro. Cocoa has been the focus of my work for most of the last 20 years. I currently work as a portfolio manager for a fund handling investments in agricultural commodities. I have a long track record of membership of the NYBOT/ICE Cocoa Committee and believe staff will generally confirm that I have always put the health of the market ahead of the narrow interests of my employers. This comment is a personal view and does not necessarily represent the view of my employers.
Much of my time has been, and continues to be, spent travelling at origin so I have a deep understanding of the mentality of growers and farmers, and their expectations of markets. I believe that although the US and the UK have emerged as the dominant marketplaces, in terms of provision of exchanges, they are effectively custodians of global marketplaces and should therefore be taking into account the positions and views of all their stakeholders not just the American consumer, or even consumers at large, when they enact legislation pertaining to these markets. This aspect should be particularly emphasized when we are dealing with commodities that are not grown in the same domicile as the marketplace and therefore there are no national farm policy issues that might pose conflicts.
Going one step further, enforcing rules that sometimes artificially dampen prices would almost certainly run counter to a wide variety of other government initiatives. For example, the US government via USAID and other agencies is seeking to alleviate poverty in many cocoa producing countries and there is widespread recognition that current conditions for cocoa farmers in W. Africa – especially the price of a cash commodity that growers cannot use themselves - maintains them in a state of perpetual poverty. Until the recent market rally, the same can be said to apply to coffee (see recent riots by farmers in Colombia and Honduras) and sugar. I believe it is necessary to represent the “invisible” users of the markets – those whose goods are traded and hedged on these markets – but who do not have representation or lobbying power. Absent their voice, proposed rules are designed to effectively choke off involvement by “outsiders” who provide liquidity and leave the final price to be essentially dictated by US end-user commercial interests. I am therefore appealing to the CFTC to consider carefully when it imposes position limits and other rules, such as the elimination of cash and carry exemptions, which distort free market prices.
There is a fundamental mis-match between the needs of producers and end-users. The former like to sell when prices are high and the latter when they are low. In agricultural markets there is also seasonality to take into account. Farmers generally have to sell when crops come in, especially if they are perishable due to climatic conditions or an absence of acceptable warehousing. Conversely, roasters, chocolate manufacturers and end-users generally consume on a regular monthly timetable. In fact, with the advent of computerization and just in time inventories, industry have cut back their purchases of actuals and are now carrying historically low levels of physical inventory. Traders and investors, both at origin and in consumer nations, are therefore tasked with holding the balance, pending final sale or use.
The role of the investor or speculator is to fund or bridge this gap, and provide liquidity to markets as a whole, as and when needed. They have a broad but single aim-to obtain a financial return for the risks they assume. Historically, this principle has always been accepted and acknowledged as reasonable ,and explains why exchanges and markets have tended to flourish in places where the sanctity of this right to potentially make money, in return for assumption of risk, is enshrined.
If they believe crops are poor, or late, or inadequate to meet demand speculators might retain positions for longer periods of time in an attempt to maximize their profits. Against this backdrop I believe cutting , or more vigorously enforcing position limits, and eliminating the cash and carry exemption as a bona fide trade, runs a serious risk of interfering with and damaging the existing pricing environment for these tropical soft commodities. While I believe many of the market characteristics described above also apply to domestically produced crops, I believe that at a minimum these tropicals (sugar/coffee/cocoa) should be examined and considered separately from those agricultural crops produced in the US domestic market. Global markets need to do their job for a broader constituency than the US taxpayer and this requires :
1) Spot month position limits should be expanded to ensure rough or approximate convergence of futures and underlying cash at expiration. Without this, the price transparency associated with the highly visible futures prices is in fact a myth.
2) The creation of a level playing field in the markets - thereby accepting that a broader universe of long position holders than that currently allowed ,should be able to take up delivery provided that there is a reasonable expectation that by doing so they will economically profit (effectively retaining and expanding the concept of cash and carry that underpins all physical commodity markets)
3) Market participants remain under the jurisdiction of the Exchange for position management purposes. Overall reporting position limits could remain effectively unchanged though the single month limits should be abolished in favor of an “all months” or gross position that would effectively allow the player to adapt their position to the realities of an agricultural crop that doesn’t flow in equal monthly chunks. The exchange will approve and monitor applications to take delivery of the spot month on a fair basis taking into account that markets do get naturally disruptive if there are crop failures or weather risks present. While respecting the desire for an orderly liquidation, price inverses or excessive cash and carries are not inherently bad but are the result of inequalities in supply/demand. They are needed to bring about the necessary conditions to restore balance by stimulating increased supply or choking off demand
Let us look at the background for exchange traded commodities and how and why futures markets developed and evolved. Exchanges were voluntary associations of members who represented all parts of the supply/demand equation. Middlemen bought production of metals or grains and financed them until end-users could be identified. The markets that grew were those based on commodities that were fairly homogenous, simple to describe, reasonably durable and storable and could be easily divisible as the trader sold lots off. Other key criteria were an abundant supply of the underlying material, open availability or easy access to the marketplace, transparent pricing information and prices that were unfettered by interference of governments or other powerful blocs .Clearing houses emerged to avoid counterparty risk and strengthen the financial integrity of the marketplace by introducing the concept of margining.
But exchanges and futures markets were not designed to generate stocks for a limited range of “qualified” end-users or consumers to partake of at their whim, which is almost what the proposed legislation seems set to accomplish. Exchanges were financial at heart, engineered to foster and encourage trade. They enabled traders to hedge or shift “price risk” in return for taking on “basis risk”, the “basis” being the difference between the actual cash crop value and the “standardized” version represented by the exchange. As basis risk is generally less than price risk, exchanges were believed to be important components of a stable financial system, providing an important risk mitigation tool. Exchanges provided a forum for all market users to trade thus enabling the clearest possible price signals to emerge.
However this was/is contingent upon markets being efficient and unbiased. Putting artificial ceilings upon entities’ ability to trade damages this efficiency. Driving willing market participants out of the market interferes with the concept of efficiency especially if manufacturers or end-users (who are natural shorts) or physical traders, are not similarly constrained by ceilings. Limiting who is able to take delivery and of what quantities has the identical effect. Longs and shorts should both be subject to the same laws. If you sell, you have an obligation to close out your contract or the right to deliver. If you buy, you have an obligation to close out your contract or the right to take up the goods. These rights and obligations are embodied in the concept of convergence whereby the gap between the real value of the physical underlying commodity and the exchange traded price moves towards (but not necessarily at) zero . This gap closing creates a true “market” with genuine price discovery.(One might note that the LIFFE markets moved away from the concept of convergence in 2011 but are now re-considering whether this has had an extremely detrimental impact upon the role of the markets both as a means of price discovery and as a hedge for surplus stocks. Robusta coffee stocks ,as a result of the disconnect between physical prices and futures values, have dwindled to almost nothing with cash trading at a large premium to futures yet limits on take-up precluding willing users from using the exchange as a source of supply).
Another aspect of functioning futures markets is their role in helping commodity markets attract/obtain financing. Capital is required to fund the extensive stock-holding that accumulates along the various stages of an international supply chain, and from one crop year to another, especially with a tree crop(like cocoa and coffee). Loans, both short and long-term in nature, are much more easily facilitated if it is possible to hedge both in the spot month and forward. The existence of the hedge acts as a form of collateral but the cost (original and variation margins) is but a fraction of the total inventory value. Allowing one to benchmark the value at the future delivery point by either hedging forward, or rolling spot month hedges, enables banks and importers to gauge their risk more accurately and move to re-position themselves if holding stock becomes an unattractive use of their capital. It is not enough to claim that cash and carry exists if entities who might want to do it, and have the resources to do it, are actually precluded from it on the grounds that they do not have a physical need for the material.
The markets need to operate on the basis that all participants are efficient and seeking rational economic objectives. If one is not allowed to do something that is rational eg take up the cheapest form of supply for future delivery then one undermines the whole basis of a physical market. Sometimes markets need backwardations to encourage a more rapid flow of supply in terms of shortage or potential shortage. Conversely, an excess supply will push the market out to “carry”- carry being the cost at which the most efficient “carriers” can finance, store and insure the available inventory and make it available to end-users when they need it in the future.
The agricultural commodity markets have performed perfectly in recent years. The clearing house mechanism ensured that as other financial markets melted down there were no problems of non-performance. Prices for many agricultural commodities rose sharply but they largely reflected a serious shortfall in the stocks of many. Companies who did their homework, and predicted shortages, started accumulating long positions. In doing so, prices rallied giving the signal to producers that they could profitably plant more. Across the board in grains, sugar, coffee and cotton we saw a massive expansion in production. Not just in the US but globally. As the supply has come on stream prices have dipped, in many cases dramatically. Markets have moved from inverses (backwardations with the highest price paid nearby illustrating tight supply) to contangos (cash and carry markets with cheap nearby prices and more expensive forwards, reflecting that owners of the underlying stocks need a financial incentive not to dump stocks but rather to hold them for delivery at a later date. As prices have dropped, production is being adjusted downward and so it goes on. These movements in prices are normal for commodity markets that are dependent upon seasonal factors such as rainfall and temperature but also erratic components such as wars, disease, changes in buying habits.
Trying to arbitrate how much of anything is allowed becomes a judgment call by regulators who are not equipped to measure market forces. Should the price of corn be lowered to keep food prices low so that people can eat more corn-based foods or should energy companies be allowed to use the corn to provide cheaper fuel for people to heat their homes? Is this the role of government to decide? If astute analysts determine that disease and poor weather in W Africa makes for a poor cocoa crop should they not be allowed to signal that shortage by bidding up prices and mopping up cheap available supply? Why should poor farmers in W Africa not be the beneficiaries of price rises that induce them to grow more? This is especially the case when one is dealing with crops that are effectively handled/processed by a small group of very large multi - national companies who exert a dominant influence upon price eg cocoa -Nestle/Mars/Kraft/Hershey/Ferrero.
Quoting from the 2008 UNCTAD Cocoa Study – Industry Structures and Competition
“there seems to be a structural imbalance, upstream in the cocoa chain, between cocoa
producers (with a structure of production characterized by the predominance of small-scale
producers) and buyers (highly concentrated, with the emergence of oligopsonistic or even – in
remote locations – monopsonistic market structures). This asymmetry gives rise to the
potential for the exercise of oligopsonistic or monopsonistic power in cocoa purchasing, both at the farmgate and at the international level.”
We must not allow this power to dominate our futures markets by eliminating hedging exemptions, forbidding the provision of cash and carry and subjecting non-commercial players to position limits that preclude them from competing with end-users.
We should be seeking to ensure correct execution of customer orders, preventing unlawful manipulation, eliminating fictitious trades, outlawing the mis-use of customer funds and punishing all evidence of cheating or fraud rather than blaming speculative funds for all manner of woes and seeking to drive them out of the market. For every unhappy consumer who wishes that prices were lower there is a happy farmer who is glad prices are firm. We cannot take sides in this debate. We can best help the world community by ensuring that we provide fair and open market places where ,over the long-term, agricultural futures markets approximate very closely to the value of the underlying physical commodity. At that point markets are doing what they should –fostering price transparency, providing a risk mitigation tool, allowing market users to secure financing and collateral against their stocks and sending signals to the world that more or less supply is needed in the future. To achieve this, all market players should be eligible to play on the same terms.
Yours sincerely
Pam Thornton
