A few weeks ago, the ICE announced a new rule for the coffee market that made it explicitly forbidden to "recertify" coffee. There are numerous reasons why this is most likely a good change for the coffee market, but I have been trying to evaluate exactly what it would mean, if anything for coffee prices. My conclusion is that if anything, it's probably a little bit bearish, but I will outline my thinking, as well as what the other implications are in the article below.
Background:
The certified inventory is the backbone of a well-functioning commodity futures market. This is because the certified inventory keeps the futures prices "real" in other words it aims to create a one-to-one correlation between physical prices and futures prices. So physical coffee prices go up by 10c, then futures prices go up by 10c.
The certified inventory is key to this price correlation because it introduces an arbitrage opportunity between physical coffee and certified coffee. Every futures contract enters notice period towards the end of its life and during this period the holders of these futures contracts can magically turn their futures contracts into ownership of physical lots of coffee. If you are long futures contracts, you can accept delivery of certified coffee in a warehouse in Europe or the US to fulfill your contract. If you are short futures contracts, then you can tender certified coffee to fulfill your contract.
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This creates and arbitrage opportunity every notice period where if there is a divergence between physical prices, savvy traders will make a profit. For example, if physical coffee is cheaper than futures prices, a trader will sell expensive futures contracts and then buy cheap physical coffee, certify it and deliver it against his short futures for a profit.
Aging Penalties:
This is great, except that coffee is a food product. This means that old coffee is NOT good. If old, certified coffee i transferable for a future, then futures no longer reflect the price of coffee, it reflects the price of old coffee. This destroys the purpose of a futures contract because it would no longer have a 1 to 1 correlation with coffee prices, it would start to reflect the price of old, yucky coffee.
To combat this problem, the exchange has aging penalties. As coffee gets older, the exchange mandates a discount for the older coffees according to a set schedule. So, if you tender 2-year-old certified coffee vs your short futures, then you would receive less money (according to the aging penalties) then if you tendered fresh coffee. This ensures that the futures prices still reflect the price of fresh coffee.
Moreover, the steep aging penalties remove coffees from the exchange because it encourages participants to decertify old coffees and sell them on the open market or buyers to accept deliveries of these coffees as a cheap alternative.
Recerts:
This system works pretty well, except that a practice known as "recertification" arose. This practice (until recently) was not explicitly forbidden but appears to be against the spirit of the rules of the exchange. When a certified coffee was nearing the 1-year mark or so, the owner of that coffee could decertify it (take it out of the exchange circulation), and then resubmit the same coffee for certification again. If the coffee had maintained enough of its flavor and color, then it would pass as certified, and the aging clock would restart from that point.
The net effect of this is that even though a coffee was actually about 2 years old, it would only receive aging penalties as if it were about 1 year old.
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Implications of Recerts:
The implications of this practice were several:
First, it lowered the quality of the coffee in the certified inventory. The aging penalties were designed for new crop coffees (not past crop coffees), so if the coffee in inventory is recertified the aging penalties are not necessarily applying an appropriate discount, making the certified inventory overvalued. When you buy a future and receive certified coffee, you are receiving past crop coffee but paying current crop prices.
Second, it encourages churn and consumption of certified inventory. While the practice of recertification discourages holders of futures from accepting delivery for the purpose of consuming the coffee as a beverage (remember the recerts are old and overvalued), it encourages the owners of that certified coffee to decertify their own coffee. This causes drawdown on the certified inventory.
Moreover, when the coffee is resubmitted to the exchange it does not all pass. Some portion of it will fail certification and therefor that coffee is now removed from circulation and will have to be sold on the physical market as old coffee. This mean that the practice of recertification is actually creating an incentive to draw down inventories.
Think of it like this. If you own 100 lots of certified coffee and they reach 1 year old, you decertify and then recertify them. 60% of them pass certification and 40% fail grading, now there are only 40 less lots of certified coffee then there were before. Those 40 lots you sell as past crop coffee on the open market, but the 60 lots, now just gained 10-15 cents in value by essentially being "reset" as fresh crop coffee. (the exact amount that they gain will depend on mkt prices for new crop vs past crop coffee)
The final impact, recerts increase volatility (and potentially market manipulation) in the inventory levels. With the practice of recertification, the owners of certified coffee could conceivably decertify large swaths of coffee that they have no intention to consume. It is conceivable that a cert owner could decertify 200k bags of coffee, and then submit all 200k bags back for grading a few weeks later.
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If we want to be charitable, the cert owner may simply be looking to make some money by removing aging penalties, however if we want to be cynical, the decertifier may intend to be manipulating the market. They would know that a large decertification would be interpreted bullishly by the market and would thus likely be holding long futures positions. When the market rallies, they could sell those positions (and even go short) and then submit all 200k bags for regrading, knowing that the market would know interpret this bearishly.
The net effect of this would be that both the futures market and the certified inventory levels would be experiencing volatility that didn't really have anything to do with supply, demand nor a well-functioning market.
Implications of the Rule Change:
Given the implications of recertification and the potential for market manipulation it is not surprising that the rules were made more explicit. Going forward, starting Nov 30, it will be explicitly forbidden to recertify coffee that has been previously certified. While I think that this is probably a good thing for a well-functioning market, it may have a slightly bearish effect on coffee prices.
In the near term, it seems likely that if anyone has previously certified coffees that they were considering to recertify, now is the time to do it. By making it forbidden to recertify coffee after Nov 30, the exchange is implicitly making it permissible to recertify coffee before then. This could actually encourage people to participate in this practice if they weren't considering it before.
Any coffees that were decertified with the intention of recertification now have a deadline, and it will need to be submitted by that date.
Going forward, the practice of forbidding recertification may actually disincentivize certified stock consumption, which is bearish. If recertification has indeed been prevalent over the last several years, then it is conceivable that a good portion of the cert stock consumption was generated by de-certifying coffee and then when re-certifying it, some portion of it was failing grading.
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Let's use some numbers to illustrate the point. If 1,000,000k bags have been decertified and submitted for regrading over the last 2 years (just to use an arbitrary, round number), and only 70% of it has passed grading has been recertified, that means that 300k bags have failed grading and been removed from circulation. Those 300k bags would still be part of the certified inventory if re-certifying was forbidden. This could make a big difference in the quantity of certified inventory.
Now that the practice will be forbidden, it will remove one large incentive for consumption going forward.
The bullish argument is that now the certified inventory will more accurately reflect the price of newer fresher coffees and may perhaps incentivize real consumption of the certified inventory. This seems to fit the spirit of the purpose of a futures market more, where the prices reflect supply and demand, rather than jockeying the system to try and squeeze out a few more cents of profit.
Now don't get me wrong, I'm not judging anyone participated in recertification. The profit incentive exists to try and find every opportunity for efficiency and value that it can, if the rules allow for a way to make money that has a negative externality, it is not a moral failing to exploit those, competition means that it may be an economic necessity to participate. However, it is the job of the exchange to change the rules if those kinds of negative incentives exist. In this case, they have done so, and we believe that it will be a positive change for the market.
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