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Hedge funds' exit from cocoa futures fueled by high

volatility

and trading costs

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Cocoa prices hit record highs amid supply issues in West

Africa

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Liquidity drop led to wider spreads and trading challenges

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Some traders seek alternatives to futures for hedging

By Nell Mackenzie, Tom Wilson, Maytaal Angel

LONDON, Dec 20 (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 - a class of

investors that use privately pooled money to make speculative

bets - started pulling back from trading cocoa futures because

price swings in the market were raising their cost of trading

and making it harder to make profits.

They accelerated their retreat in the first half of this

year as cocoa prices hit a record in April, driven by supply

issues in West Africa, according to Reuters calculations based

on data from the U.S. Commodity Trading Futures Commission

(CFTC), which oversees the New York market, and ICE Futures

Europe, an exchange that compiles figures for trading in London.

"This market became increasingly volatile," said Razvan

Remsing, director of investment solutions at Aspect Capital, a

$9.3 billion London-based fund that uses coding and algorithms

to find trades. "Our system's response was to trim our

positions."

Aspect slashed the exposure to cocoa in its Diversified Fund

from nearly 5% of its net asset value in January to less than

one percent after April, according to a presentation reviewed by

Reuters.

The departure of hedge funds and other speculators caused

liquidity in the market to slump, making it harder to buy and

sell, stoking volatility to record highs and fueling the price

spike still further.

Reuters spoke to a dozen fund executives, cocoa market

brokers and traders who said the retreat - described here in

detail for the first time - has left lasting strains on the

market. That has resulted in greater gaps between the price at

which cocoa can be bought and sold, and has prompted some

industry players to seek alternative instruments, leaving a

lasting impact on the sector.

This month, the number of futures contracts held globally at

the end of a given trading day - a key indicator of market

health known as "open interest" - hit its lowest since at least

2014, the global figures show, a sign the futures market overall

has shrunk significantly. Data prior to 2014 was not available.

On Wednesday, New York cocoa futures prices topped their April

peak.

The futures market is a crucial cog in the cocoa industry,

allowing producers and chocolate companies to hedge their

exposure to swings in the price of beans.

Futures dictate income for the farmers and low-income

nations that produce the world's cocoa - the majority of which

comes from Ghana and Ivory Coast in West Africa.

Hedge funds and speculators have become bigger players in

commodity markets over the past two decades as the value of

their overall assets has grown. But, as purely financial

investors, they have no need to remain in the market at times of

stress.

The impact of hedge funds' exit illustrates how reliant trading

has become on these lightly regulated funds that increasingly

shape financial markets. Reuters has reported this year on how

hedge funds are piling into the euro zone's $10 trillion

government bond market, drawing regulatory scrutiny, and on

their growing sway in European stock trading.

Contacted by Reuters, the CFTC declined to comment. A

representative for Britain's regulator, the Financial Conduct

Authority, said that, in line with its market supervision

practice, "we have been working with trading venues and

participants to monitor the orderliness of the market."

Bernhard Tröster, an economist at the Austrian Foundation

for Development Research (ÖFSE) in Vienna, who last year

co-authored a paper on the growing role of financial actors in

commodities derivatives markets, said the withdrawal of hedge

funds had helped fuel the crisis in cocoa markets.

"When markets became so volatile this year, it was clear how

hedge funds  and other financial actors have become so

important," he said.

SUPPLY ISSUES HIT PRICES

Hedge funds and other speculators' share of the market

peaked at 36% in May 2023, the highest in at least a decade,

after which their retreat began, the global data calculated by

Reuters show.

Then, at the start of this year, global cocoa prices soared

after top producer Ivory Coast was hit by adverse weather and

disease. Number two producer Ghana fared even worse, with

smuggling, illegal gold mining on cocoa farms and sector

mismanagement added to the mix.

In early February, cocoa prices surpassed a previous record

high set in 1977. Executives at five hedge funds told Reuters

they began to withdraw as volatility grew and the cost of

trading increased.

When markets become too hot, exchanges require speculators

to increase the amount of collateral they put down per futures

contract, raising their costs. Lawrence Abrams, president of

Absolute Return Capital Management in Chicago, said the cost of

trading a single cocoa futures contract soared from $1,980 in

January to $25,971 by June.

High prices and volatility, combined with falling liquidity,

began to affect "our system's trading and risk management

decisions," Abrams said, whose fund sold out before prices

peaked in April. He declined to detail how much his fund

managed, citing regulatory reasons.

Many hedge funds promise investors they will not exceed a

certain amount of risk, meaning that if a certain market becomes

too volatile they have to reduce their exposure.

The difference between prices offered and sought for

futures, the so-called "bid-ask spread", soared following the

hedge funds' withdrawal. That has made trading harder: lower

liquidity and wider spreads mean traders struggle to execute

large trades without moving overall prices.

"You need speculators," said Vladimir Zientek, a trading

associate at brokerage firm StoneX, referring to hedge funds,

which are not among his clients. "Without speculators in the

market, you lose a lot of liquidity, which allows for these very

wide and erratic market swings."

By mid-April, New York contracts hit a then-record

above $12,000, up three-fold from January, prompting hedge funds

to sell down their positions.

"Trends don't last forever," said Remsing at Aspect Capital.

"Stay too long in size and you stand to give back all your

gains."

Hedge funds' share of the cocoa futures market dropped to 7%

in late May, its lowest in at least a decade, the global data

show.

One European broker, who requested anonymity to discuss

clients' trades, said that panic in the market increased in

March and April as liquidity drained away.

Volatility in cocoa futures hit an all-time high in May, up

five-fold from a year earlier, according to data from the London

Stock Exchange Group (LSEG).

Daily average price swings that month neared $800, some 15

times the levels of a year earlier, according to a Reuters

analysis of figures from market data provider PortaraCQG.

RISKIER MARKETS

For major trading houses that buy and sell cocoa beans - a group

that includes Singapore's Olam, Switzerland's Barry

Callebaut, and U.S.-based Cargill - the liquidity drain

and associated price surge exacerbated the more than-$1 billion

dollar hit they took on their futures positions.

The losses came earlier this year after Ghana, following a

disastrous harvest in the October 2023 to September 2024 season,

delayed delivery on nearly half the beans the nation had pledged

to sell, upsetting cocoa traders' futures market strategies.

These traders typically use futures to lock in prices

achieved for cocoa beans, or to hedge against the risk of

falling prices.

But that strategy unraveled as Ghana delayed its deliveries.

Traders were forced to liquidate, at steep losses, short

positions for the month of expected delivery, and take new short

positions.

The market turmoil has prompted some trading houses and

producers to seek alternatives to futures.

Australian investment bank Macquarie, a big player in

commodity markets, told Reuters it sold over-the-counter

products to trading houses, processors and chocolate makers when

cocoa volatility hit record levels this year, and demand remains

high.

One major agri-commodities trader is now using such bespoke

contracts, according to a source who requested anonymity citing

sensitive commercial relationships. They declined to comment on

the magnitude of the business.

Such products typically protect buyers against narrower

price swings than is possible with futures, limiting their use,

a European broker said, declining to be identified to freely

discuss clients' activity.

'COCOA TOURISTS'

Some hedge funds have returned to the market. Along with

other speculators that trade using investors' cash, they

accounted for 22% of futures trading this month, according to

the global data. But buying and selling in the cocoa market's

altered landscape has become harder.

Zientek, the trading associate at StoneX, said bid-ask

spreads can now top 20 "ticks" - $200 per contract - compared to

about 2-4 ticks before cocoa's rally to record highs.

"This makes larger orders tougher to execute without seeing

an immediate distortion in the market," he said.

Daniel Mackenzie, managing director of Cocoa Hub, a UK-based

company that sources and sells cocoa beans to artisan chocolate

makers, said higher and more volatile prices were forcing small

and medium-sized makers to decide between passing costs to

clients or reducing product sizes.

One chocolate maker he worked with has been shuttered and

another sold, he said, without providing further details.

As hedge funds exited, short-term investors such as

day-traders - which buy and sell assets within a single trading

day - have stayed in the market, the European broker and the

broker at the agri-commodities bank said.

The cohort that includes day-traders this month accounted

for 5% of the market, about the same as the start of the year,

the global data show.

Day-traders cannot fulfill the liquidity-provision role

traditionally played by hedge funds, the two brokers said.

"I like to call them 'cocoa tourists' - they move in, hold a

position for a day or two, then move out," the European broker

said.

(Editing by Tommy Reggiori Wilkes, Elisa Martinuzzi and Daniel

Flynn)