Liquidity? What Liquidity?

So you have seen the Cocoa and Coffee markets in the news a lot in the past 2-3 years. Unprecedented volatility, record high prices, lots of money being made (supposedly) and yet the open interest in these futures contracts is collapsing.. Why?

The charts below are of ICE US listed Arabica coffee and Cocoa markets.

This is concerning.. For physical traders and consumers of cocoa and coffee this is not a good sign. Not only is the market more volatile and therefore requires more prudent risk management, you cannot effectively hedge your exposure in the futures markets. But hang on, isn’t there a cocoa and coffee market in London? Yes, also owned by the esteemed (cough) ICE exchange.

Now all the charts are out of the way.. you can see the story is the same. Prices seem to be inversely correlated to open interest. In some context that makes sense, as you need less futures contracts to the trade the same $ value of the commodity. However, that is a simple financial player perspective. Cocoa and coffee is not grown in fiat terms, it is grown in real world bags and weighed in grams, pounds, kilograms and tonnes.

The presence of system driven strategies in commodities and used to be something the much larger physical traders could take advantage of. Now the tables have turned. Whether it is traditional trend following CTA’s (go long or short depending on the trend under multiple time frames), systematic based on signals (momentum, trend, fundamental, curve structure, macro, FX, etc), high frequency (less so) or pure carry strategies, they are now an overwhelming part of the daily trading and open interest.

This works fine as long as their physical players that can keep the futures market trading within the realms of the cash market. Why is this important? You don’t eat cocoa futures or drink arabica call spreads, you need the reality in the cash market to converge with futures at most delivery periods. Today, with such low participation, using the futures market as a hedging tool is adding risk to your portfolio, not reducing it. Physical players are unwilling to post initial margins and keep up with the huge swings in variation margin. This leads to large portfolios of physical commodites that are financed by leverage, not having protection.

It also means the liquidity out the curve reduces, and the ability for producers to forward sell their production and lock in a price above their cost of production is greatly reduced. Not many merchants are going to want to sit on a futures hedge for coffee or cocoa to be deliver in 12-24 months time.

The consquence? For those that have capital, the opportunities in physical vs. future arbitrage are huge. Though not without risk thanks to the Trump tariff chocolate wheel..

As for ICE.. well it looks like their stock chart is inversely correlated to open interest in soft commodities as well..

As for ICE trying to fix the problem with the lack of open interest in soft commodity contracts…?

Good luck out there!