Cocoa Market Volatility and Hedge Fund Exodus

By Nell Mackenzie, Tom Wilson, and Maytaal Angel

LONDON (Reuters) – Behind a record surge in cocoa prices this year, a corner of financial markets that drives the cost of chocolate underwent a seismic shift: the hedge funds that oiled its workings headed for the exit.

Confectionery prices, from candy bars to hot chocolate, are heavily influenced by futures contracts for cocoa beans. These financial instruments, traded in London and New York, allow cocoa buyers and sellers to determine a price for the commodity, forming a benchmark for sales across the world.

In the middle of last year, hedge funds—investors that use privately pooled money to make speculative bets—started pulling back from trading cocoa futures due to increasing price swings that were raising their trading costs and making it harder to generate profits.

Their withdrawal accelerated in the first half of this year as cocoa prices hit record levels in April, driven by supply issues in West Africa, according to calculations based on data from the U.S. Commodity Trading Futures Commission (CFTC) and ICE Futures Europe.

> "This market became increasingly volatile," said Razvan Remsing, director of investment solutions at Aspect Capital, a $9.3 billion London-based fund. "Our system's response was to trim our positions."

Aspect reduced its exposure to cocoa in its Diversified Fund from nearly 5% of its net asset value in January to less than 1% after April.

The retreat of hedge funds and other speculators led to a slump in market liquidity, complicating buying and selling, which in turn fueled even more volatility and spurred price increases.

Reuters gathered insights from a dozen fund executives, cocoa market brokers, and traders who explained how this retreat has left lasting impacts on the market. This has led to greater gaps between buying and selling prices in cocoa trading. Some industry players are now exploring alternative instruments, signaling a long-term effect on the sector.

This month, the global number of futures contracts held at the end of a trading day—a key market health indicator known as "open interest"—has hit its lowest since at least 2014, indicating significant shrinkage in the futures market. On Wednesday, New York cocoa futures prices surpassed their April peak.

The futures market is critical for the cocoa industry, as it allows producers and chocolate companies to hedge against price swings, impacting income for farmers primarily in Ghana and Ivory Coast.

Hedge funds have become significant participants in commodity markets over the last two decades as their total assets increased. However, they lack the need to remain in volatile markets.

The CFTC did not provide a comment when contacted by Reuters, while a representative for the UK's Financial Conduct Authority mentioned ongoing monitoring of market orderliness.

Bernhard Tröster, an economist at the Austrian Foundation for Development Research (ÖFSE), stated that the hedge fund withdrawal catalyzed the cocoa market crisis, highlighting how financial actors have grown increasingly central.

Supply Issues Impact Prices
Hedge funds' participation peaked at 36% in May 2023 before they began exiting, coinciding with soaring global cocoa prices due to adverse conditions in major producing countries.

By February, cocoa prices rose past their all-time high from 1977. As volatility and trading costs increased, hedge funds started pulling back.

Increased collateral requirements due to heightened market activity caused the cost of trading a single cocoa futures contract to skyrocket from $1,980 in January to $25,971 by June, impacting trading decisions.

The widening bid-ask spread following hedge funds' exit complicated trading, limiting liquidity and leading to erratic price movements. By mid-April, cocoa futures reached over $12,000, tripling from January’s levels.

Hedge fund market share plummeted to 7% in late May, the lowest in a decade. A European broker reported heightened market panic as liquidity drained.

Cocoa futures volatility hit an unprecedented level in May, with daily price swings averaging nearly $800, significantly more volatile than in the past year.

For major trading firms like Olam, Barry Callebaut, and Cargill, the lack of liquidity and price volatility compounded losses exceeding $1 billion on futures positions after Ghana delayed bean deliveries earlier this year by almost 50%.

The delivery delays forced traders to liquidate positions at substantial losses, undermining their hedging strategies.

As a result, some traders are now considering alternatives to traditional futures contracts.

Macquarie Bank told Reuters it started selling over-the-counter products amid heightened cocoa volatility, responding to ongoing high demand.

Some hedge funds have returned to the cocoa market, with their share now at 22% of futures trading. Nevertheless, trading has become more difficult due to changing market dynamics.

The growing role of day traders cannot fulfill the liquidity needs traditionally covered by hedge funds. A trading associate referred to such participants as "cocoa tourists" for their short-term commitments to the market.

Conclusion
The cocoa market’s recent turmoil, driven by hedge funds' exits and ongoing supply chain issues, presents ongoing challenges for all market stakeholders, from traders to chocolate manufacturers.