Traders Asked for This Futures Contract, But Aren't Using It

(Bloomberg) -- There was so much demand for Intercontinental Exchange Inc. to introduce a new global futures contract for cotton that the bourse successfully lobbied to change a century-old U.S. law. But almost 18 months later, it's contending with a flop.

The contract, launched in November 2015, has no open interest, data compiled by Bloomberg show. By contrast, the exchange's benchmark cotton contract, which represents just U.S. supply, currently has about 271,090 futures contracts that have yet to be closed out or delivered against. It also saw almost 39,000 lots changing hands on Thursday.

Cotton has been traded in New York since 1870, making it one of the oldest U.S. commodity markets. In all that time, the primary contracts have represented supplies with American origins. As the U.S. lost some of its dominance in global exports over the past decade, traders and investors began demanding a global contract, and ICE was eager to deliver. Standing in its way was the Cotton Futures Act of 1916.

The law required any cotton listed in America to be inspected and graded by the U.S. Department of Agriculture. But as a drought in Texas in 2011 drove the domestic cost of cotton prices to all-time highs -- and above international prices -- traders grew increasingly hungry for a global contract. ICE lobbied hard for a rule change, and by July 2015 the U.S. passed a law that would exclude certain futures contracts from the original legislation.

Global Origins

Four months later, the ICE global contract debuted. The instrument allowed for traders to deliver product from countries including India, Brazil, Ivory Coast and Mali, as well as from, the U.S., the world's top exporter. Delivery points were also expanded to include locations in Australia, Malaysia and Taiwan. But after all that effort and signals of pent-up demand, the new contract hasn't attracted any significant trading volume since June.

There were some missteps in the design, said Antonio Vidal Esteve, the chief executive officer for cotton operations at Ecom Agroindustrial Corp., an early enthusiast for the contract and one of the world's top traders of the fiber. Since the new contract also allows for American cotton, it inhibits possible arbitrage between cotton from different locations, he said.

“To trade two U.S. cotton contracts doesn't make sense; you are not going to migrate the open interest from one to the other one,” Esteve said in a telephone interview from Dallas, Texas. “In a normal market, the U.S. is always the most competitive. If you had a situation when prices went through the roof, then you could use it.”

ICE declined to comment on specifics about the instrument's design. The bourse “will continue to consult with the cotton industry to ensure that they have the appropriate tools to efficiently manage their price risk,” said exchange spokesman Damon Leavell.

No. 2 cotton futures for May delivery, the domestic contract, slid 0.6 percent to 74.1 cents a pound by 8:31 a.m. Friday on ICE Futures U.S. in New York. The world contract closed the previous day at 75.41 cents.

Low Volatility

Since the new derivative's introduction, the old one has traded between 55 cents to 79 cents as the impact of falling production was tempered by ample reserves from prior seasons, especially in China. The May delivery U.S. contract's 60-day historical volatility has stayed near an eight-month low reached in February.

“We haven't had the conditions for which the contract was created to avoid,” including high volatility amid supply shortages, said Peter Egli, the Chicago-based director of risk management for Plexus Cotton Ltd. “If you have a poor crop and strong demand,” then the contract would useful for hedging, he said in a telephone interview.

Introducing something new is never easy. The New York Cotton Exchange, which became part of ICE in 2007, listed a cash-settled world cotton contract in the 1990s that was eventually withdrawn amid low volumes. CME Group Inc.'s Black Sea wheat contract attracted little trading since starting in 2012, and the exchange had to suspend trading a European cocoa contract amid a lack of interest. Aluminum futures, now the most heavily traded on the London Metal Exchange, got a hostile reception from some quarters when they were introduced in 1978.

“If you look around the world, not many countries use futures,” Michael McDougall, senior director at Societe Generale in New York, said in a telephone interview.

For ICE's global cotton contract to succeed, it would have to pull liquidity out of the domestic one and attract players from places such as Pakistan or Bangladesh, the world's top cotton importer, where the derivatives are not widely used, McDougall said.

“The logistics probably aren't working for a lot of people in the trade,” Nick Gentile, a partner with NickJen Capital Management & Consulting in New York, said in a telephone interview. “If I am a U.S.-based mill, I don't want to have to pick up cotton in Malaysia. Speculators aren't going to trade until open interest grows.”

--With assistance from Fabiana Batista

To contact the reporter on this story: Marvin G. Perez in New York at mperez71@bloomberg.net.

To contact the editors responsible for this story: Simon Casey at scasey4@bloomberg.net, Millie Munshi