From the WSJ, November 19, 2009

By Carolyn Cui

Electronic trading was supposed to bring improvements to the insular world of cocoa-futures trading, where candy companies and cocoa dealers spent decades jostling in trading pits at the New York Board of Trade.

Two years into the electronic era, the cocoa market is in disarray. Market makers have disappeared. Overall volume has shrunk 20%.

Prices have swung sharply for months, creating headaches for chocolate makers, many of whom no longer use the exchange to hedge costs.

The problems in this obscure corner of the financial markets have hit consumers. Cadbury PLC has shrunk its Dairy Milk candy bars, while Mars Inc. reduced its Galaxy chocolate bars. Many candy companies have raised prices, too.

Previously, the New York Board of Trade’s cocoa trading pit opened at 8 a.m. New York time and closed at 11:50 a.m. It was populated by a group of roughly 50 floor brokers, who acted as middlemen between big buyers and sellers of cocoa. Known in the pits as “locals,” the group gleaned informational tidbits that they believed made them smarter traders.

“It was a fantastic time,” said Paul Dapolito, president of Dapco Brokerage, which was the largest cocoa broker by trading volume. An average floor trader made $250,000 a year, and some could make as much as $1 million. Young traders usually went for beers after the market closed.

Then, IntercontinentalExchange Inc. purchased the New York Board of Trade in 2007, and converted it to an all-electronic exchange.

The move to all-electronic trading meant that virtually any one could get involved in the cocoa markets, buying and selling futures contracts online. The hope was to make the cocoa markets more like other commodities, such as oil, where contracts are traded almost around the clock.

But the move had the opposite effect on commodities like cocoa: Many cocoa floor traders and brokers, who made up about 40% of the market, have quit. Dapco Brokerage, which used to handle 30% of the cocoa trading on the floor, went out of business a year ago.

Its departure scared off other electronic-commodities traders, who have stayed out of the $4.3 billion market because of high volatility and thin liquidity.

The liquidity crunch became more pronounced as the exchange extended the trading hours in 2007 in an effort to attract traders in Europe and Asia.

Trading now begins at 4 a.m. New York time and ends at 2 p.m. About 80% of trading still is concentrated between 8 a.m. and noon, when U.S. traders are awake. Sometimes, fewer than 100 contracts change hands each hour in the early mornings.

That has made the market for cocoa a highly volatile one. Cocoa surged 65% in the first half of 2008, to a 28-year high of $3,360 a ton on July 1, then tanked 43% in four months before recovering 77% to hit $3,392 in late October, the highest since June 1979. On Wednesday, cocoa settled at $3,199, up 3.7%.

Soaring prices of cocoa drove chocolate makers to raise prices and cut the size of candy bars since mid-2007.

In August 2008, Hershey Co. raised prices an average of 11% to offset “significant increases” in the cost of raw materials such as cocoa, sugar and peanuts, said Hershey Chief Executive David West in a statement at the time. Andrew Bonfield, Cadbury’s chief financial officer, said on a September analysts’ call that reducing bar sizes enabled the company to avoid raising prices.

During the first 10 months of 2009, cocoa’s daily trading volumes fell 14% to a level not seen since 2005.

People who depend on the market are looking for changes, including a reduction in trading hours. Wednesday, a group including Mars, Hershey, Nestlé SA, Archer Daniels Midland Co., Cargill Inc., and hedge funds Armajaro (USA) Inc. and Perennial Capital pushed the exchange at a meeting to shorten the trading hours from 8 a.m. to 1 p.m., a time when most transactions occur.

ICE has resisted calls to reduce trading hours. The exchange brands itself as a global marketplace and wants to keep hours long enough to compete with NYSE Liffe, which has a similar cocoa contract in London trading during similar hours.

The exchange is careful to “balance the concerns of the market where we think we can improve the markets, be it hours or contract sizes,” ICE spokeswoman Kelly Loeffler said.

ICE declined to comment on the meeting.

Nicholas Gentile, who started in the cocoa pit as a broker in 1992, trades far less cocoa than he once did. Instead of rubbing shoulders with other traders in the pits, looking to pick up pieces of information that may give him an advantage, Mr. Gentile spends his days in his office, staring at screens and reading research reports.

Now that he is confined to an office, Mr. Gentile sees no incentive to trade cocoa exclusively. Without the floor buzz, “you trade everything the same way,” said Mr. Gentile, who trades about 5% of the cocoa contracts than he used to.

The thinning market, he said, has limited his ability to trade “spreads,” or bets on the differential between two contracts. Mr. Gentile said he now trades more grains.

Mr. Gentile gets up at 3:50 a.m. every day and sometimes doesn’t brush his teeth or shower until the afternoon. “I know we were spoiled working on the floor,” he said.