Understanding EFRP Transactions

  • 6 Oct 2017
  • By CME Group
  • Topics: FX

Exchange for Physical (“EFP”) transactions originated over a century ago in US markets for grains and grain futures.  Since then, the practice has been adopted in relation to other commodity futures as well as in financial futures markets, and it has been generalized as Exchange of Futures for Related Positions (“EFRP”), comprising Exchange for Risk (“EFR”) trades and Exchange of Options for Options (“EOO”) trades in addition to EFPs.1

This note provides an overview of EFRP practices on the CME Group designated contract markets (the “Exchange” or “CME Group Exchanges”), using CME foreign exchange (“FX”) futures to illustrate. 

What is an EFRP?

For futures, an EFRP trade is the simultaneous exchange of an Exchange futures position for a corresponding, economically offsetting position in:

  • a physical or cash-market asset, or an over-the-counter (“OTC”) forward contract on a physical or cash-market asset, in the case of an EFP, or
  • an OTC derivative contract position, in the case of an EFR.

Similarly, for options, an EOO trade comprises the simultaneous exchange of a position in an Exchange option (i.e., an Exchange-listed option on an Exchange-listed futures contract) for a corresponding, economically offsetting position in an OTC option contract.  (See Exhibit 1.) 2

Exhibit 1 – Schematic of an EFRP Trade

The hallmark of an EFRP is that the futures leg of the trade is not competitively executed in the Exchange’s centralized competitive market (i.e., neither the CME Globex electronic trading platform nor open outcry).  Rather, it is mediated through a privately-negotiated off-exchange transaction.

The futures leg of the EFRP is reported to the Exchange and is cleared by CME Clearing, like any Exchange-listed product.  Beyond this, the Exchange plays no direct role in facilitating the trade.  Notably, the two parties to the EFRP, and not the Exchange, remain responsible for subsequent maintenance and bookkeeping of the physical asset exposure or OTC derivative position entailed in the cash leg of the trade.

What Makes the Related Position Related?

An Exchange for Related Position transaction qualifies as such only if the two legs of the trade are in fact “related.”  The cash leg must be a legitimate economic offset to the futures leg in terms of its scale (Exchange Rule 538.E.) and its relation to the futures contract’s underlying commodity exposure (Exchange Rule 538.C.).  Specifically, the asset exposure represented by the cash leg must be (a) identical to that which underlies the futures leg, or (b) a by-product, related product, or OTC derivative of the futures underlying commodity, with a reasonable degree of price correlation to the future’s underlying commodity.  The Exchange’s Market Regulation unit identifies and publishes standards for acceptability of offsetting positions.

For CME FX futures, for instance, admissible offsetting positions include “spot [FX], forwards, non-deliverable forwards (“NDFs”), swaps and swaptions, cross-currency basis swaps, OTC FX options, non-deliverable options (“NDOs”), currency baskets, ETFs and ETNs.” 3

Entering an EFRP Trade

An EFRP may be transacted at any time, at any price that is both mutually agreeable to the counterparties and commercially reasonable.  For practical purposes, “commercial reasonability” means that the EFRP should be executed at or near the contract’s current prevailing competitive market price.  If it is not, the counterparties may be required to demonstrate that the trade was agreed and executed at an off-market price for legitimate purposes.

Upon agreement of the transaction’s terms, the resultant futures position must be reported to CME Clearing as soon as possible by the counterparties’ CME Clearing member firms via either CME Direct or CME ClearPort.4  Absent extenuating circumstances, submission is expected to be made on the same day the trade is executed.  In all events, an EFRP submitted to the Exchange is not considered to have been accepted by CME Clearing until (a) the transaction has cleared and (b) the first payment of settlement variation and performance bond has been confirmed.

The assets or OTC derivatives entailed in the EFRP’s cash leg are presumed to be held in suitable accounts established by the counterparties, and are not reported to the Exchange.  If a trade investigation or periodic audit by the Exchange’s Market Regulation unit calls for it, however, the CME Clearing member firms who serve the counterparties to the EFRP trade may be required to produce documentation evidencing that the cash leg was indeed transacted and that it meets Exchange standards as a valid offsetting position.

An EFRP often involves, on one side, a dealer who quotes bid and offered markets in such transactions and, on the other side, a customer of the dealer.  Where the dealer has an affiliated futures commission merchant, the dealer typically requires the customer to carry both a futures account in which the EFRP’s futures leg is booked and a securities account or bank account in which the cash leg is booked.  Although the Exchange does not post dealers’ indicative quotes for EFRP trades, it does provide to its market participants contact information for market makers who actively provide liquidity for EFRP transactions in CME FX products.5

What Do EFRPs Do?

The signal feature of any futures contract is the centralized, competitive, all-to-all market in which it trades and in which price discovery occurs.  US law requires any organized futures exchange to “provide a competitive, open, and efficient market and mechanism for executing transactions that protects the price discovery process of trading in the centralized market.” 6  The corresponding regulatory requirement is that “all purchases and sales of any commodity for future delivery, and of any commodity option, on or subject to the rules of a contract market shall be executed openly and competitively” through the market’s central limit order book.7

Exceptions are permitted for transactions to be “executed non-competitively,” if such exceptional transactions are:

(a)   authorized by exchange rules that have been submitted to and approved by the CFTC,

(b)   “made in accordance with written rules of the contract market”, and

(c)   made for “bona fide business purposes.”

EFRPs exemplify such exceptions.  Since before the 1920s the Exchange’s rules have allowed noncompetitive, privately negotiated EFP trades as an accommodation to grain elevator operators, millers, and processors for whom the basis spread between the futures price and the spot price of grain at the location of business is a pivotal commercial concern.  More than a century later -- in a more general acknowledgement of the needs of commercial users of futures and options -- the Exchange’s rules permit a broader range of EFRP trades to be privately negotiated rather than competitively executed.

 

An EFRP transaction meets such needs in potentially several ways8 --

  1. Basis integrity – An EFRP serves to facilitate not only hedging but also arbitrage trading, because it ensures that the basis relationship between the futures contract price and the price of the contract’s underlying commodity is preserved, irrespective of the transaction’s size.
  2. Price uniformity -- The buyer and seller of the futures contract may use an EFRP trade to ensure they can execute a large transaction at a single price.
  3. Trade facilitation -- In a futures market that is historically illiquid -- or for a transaction that takes place at an hour of day when an otherwise liquid futures market is relatively inactive -- the buyer and seller of the futures contract might use an EFRP to ensure they can execute the trade at all.
  4. Risk management of trade certainty – An EFRP enables the parties to the futures transaction to choose their respective counterparties (just as they may in the corresponding underlying cash market) and thus to reduce the risk of counterparty nonperformance in fulfillment of futures delivery.9
  5. Temporal control of delivery – Where a futures contract’s terms permit physical delivery to occur at any time within a specified range of dates (e.g., a specified calendar month), an EFRP effectively allows the parties to perform “delivery” – certainly from the vantage of the party buying the commodity and selling futures, if not for both parties – at a mutually agreed time.  In this way, the EFRP eliminates uncertainty with respect to contract delivery date.
  6. General control of delivery – Like (5), reduction of uncertainty might motivate EFRP trades in futures contracts for which the delivery terms specify a range of eligible deliverable grades and qualities, or a variety of allowable delivery locations.
  7. Extension of delivery terms – Expanding upon the principle that underlies (5) and (6), the parties to an EFRP may enter the trade to effect “delivery” at locations, or with qualities or grades of the underlying commodity, that are different to those specified in the futures contract delivery terms, provided that the cash leg of the EFRP transaction evidences “reasonable degree of price correlation to the commodity underlying the Exchange contract” (in accord with Exchange Rule 538.C.).

EFRPs in CME FX Products

For users of CME FX futures and options, items (1) through (4) above are apt to be the most common and most compelling motives to enter EFRP transactions.  Consider a bank treasury dealer in spot FX who finds herself long FX and short futures, while a bank customer happens to be long futures and short spot FX.  The dealer and the customer could enter a bilaterally-negotiated EFRP, in which they exchange their positions at a single, mutually agreeable basis spread between the futures price and the spot FX rate.  Or they could make a bilaterally-negotiated sale and purchase of spot FX, and then go their separate ways, respectively buying and selling futures in the centralized and competitive CME Globex market.  Why would they opt to use an EFRP?

The answer lies partly in their sensitivity to the “mutually agreeable basis spread.”  As mentioned above, one of the attractions of an EFRP trade is that it ensures a uniform price spread between the cash leg and the futures leg, regardless of size of trade.  Buying or selling a futures position through the centralized competitive contract market provides no such guarantee.  Indeed, a single cash-futures price spread is an unlikely outcome in a competitive market trade, unless the size of the futures leg is less than the resting volume quoted at, respectively, the best offered price or the best bid price in the futures central limit order book.

Thus, the decision whether to trade via a bilaterally-negotiated EFRP also hinges in part upon an assessment of relative market liquidity.  To put the question concretely, how does the requisite size of the futures leg of a prospective EFRP compare to competitive market depth at the top of the futures central limit order book? 

On this point, Exhibit 2 summarizes evidence during the 12 months ending June 2017 for each of the six major FX futures listed for trading on CME. 

Exhibit 2 – CME FX Futures: EFRP Trading Activity, July 2016 through June 2017

 

FX Pair

Total Volume (Contracts/Yr)

EFRP Volume (Contracts/Yr)

EFRP Volume (Pct of Total)

EFRP Trades per Year

Average EFRP Trade Size (Contracts)

Average Resting Quantity at CME Globex Best Bid/Offered Price Levels (Contracts)

Average EFRP Trade Size as Multiple of Average Resting Quantity at Best Bid/Offered Price Levels

EUR/USD

50,123,160

155,984

0.31

665

235

19

12.4

JPY/USD

38,245,995

158,453

0.41

598

265

15

17.7

GBP/USD

29,700,529

103,531

0.35

380

272

17

16.0

AUD/USD

23,396,991

72,091

0.31

412

175

54

3.2

CAD/USD

18,242,364

57,938

0.32

385

150

15

10.0

CHF/USD

6,147,314

64,411

1.05

307

210

16

13.1

Source: CME Group

Several features of these data merit comment –

(a)   The average size of an EFRP lately ranges from 150 contracts (for Canadian dollar/US dollar (CAD/USD) futures) to nearly 275 contracts (for British Pound Sterling/US dollar (GBP/USD) futures).

(b)   For all but one currency pair, the average size of an EFRP is an order of magnitude larger than the average resting quantity quoted at the best bid or best offered price levels in the CME Globex central limit order book.  Specifically, the number of contracts that change hands in the typical privately-negotiated EFRP transaction exceeds the average number of contracts that could be bought or sold competitively, at a single offered or bid market price, by a multiple ranging from 10x (for CAD/USD futures) to nearly 18x (for Japanese yen/US dollar (JPY/USD) futures).

(c)   The exception is Australian dollar/US dollar (AUD/USD) futures, for which the average EFRP is only 3x larger than the resting best-bid or best-offered quantities in the competitive central limit order book.  Interestingly, this is not because the typical EFRP trade size in AUD/USD futures is small relative to other currency pairs, but because the resting amounts quoted at the top of the CME Globex order book tend to be relatively large.

(d)   For most currency pairs, EFRP trading signifies less than one half of one percent of total trading volume.  The exception is Swiss franc/US dollar (CHF/USD) futures, for which EFRPs account for slightly more than one percent of total trade flow.  For all six futures products examined here, the proportions are small enough to suggest that market practitioners are accustomed to reserving EFRP trade capability for exceptional circumstances, generally preferring the centralized competitive market.  

Transitory EFRPs and CME FX Products

Exchange rules generally forbid what are known as “transitory EFRPs.”  That is, “the execution of an EFRP transaction may not be contingent upon the execution of another EFRP or related position transaction between the parties where the transactions result in the offset of the related position without the incurrence of market risk that is material in the context of the related position transactions” (Exchange Rule 538.C.).

The rules, however, permit an exception to this structure that applies solely to CME FX futures.10  Transitory EFRPs in such futures are allowed, on condition that the Exchange must receive explicit documentation of the physical transactions entailed in any such transitory EFRP (with one physical transaction for the EFRP itself and a second physical transaction (or set of transactions) to achieve immediate offset of the first):

“With respect to EFPs in foreign currency futures wherein the parties immediately offset the cash transaction (“transitory EFPs”), the Exchange would expect to see confirmation statements issued by the bank/foreign exchange dealer party to the Transaction.  These confirmation statements should be the type normally produced by the bank/foreign exchange dealer for confirmation of currency deals and should indicate, by name, the identity of the counter party principal to the Transaction.  However, in circumstances where the EFP Transaction is between a bank/foreign exchange dealer and a [commodity trade advisor], account controller, or other Person acting on behalf of a third party (such as a commodity pool or fund), the cash side confirmation statement must identify, at minimum, the name of the third party’s Carrying Clearing Member and the third party’s account number (or other account specific designation), but need not identify the third party by name” (CME Rule 538.K.).

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1 For EFRP trades involving futures or option contracts listed on the CME Group Exchanges, the authoritative reference is the CME Group Market Regulation Advisory Notice (“MRAN”) entitled Exchange for Related Positions, which is found at http://www.cmegroup.com/rulebook/rulebook-harmonization.html.  The Exchange periodically publishes revisions to this MRAN.  The latest edition of the MRAN, as of the date of this publication, is CME Group Advisory Notice RA1710-5, Exchange for Related Positions, 31 July 2017, which is available at:  http://www.cmegroup.com/rulebook/files/cme-group-ra1710-5.pdf

2 In what follows, we use “futures” or “futures leg” as shorthand reference to both the futures component of an EFP or an EFR and the Exchange-listed option component of an EOO.  Similarly, we use “cash” or “cash leg” or “related position” when referring to the obverse component of the EFRP – the physical, cash-market asset position in an EFP or EFR and the OTC derivative or option position in an EOO.

3 CME Group Advisory Notice RA1710-5, Exchange for Related Positions, 31 July 2017.

4 For information on various means of registration for access to CME Direct, visit:  http://www.cmegroup.com/trading/cme-direct/registration.html#newFirmUserRegistration  For general information about CME Direct, please visit:  http://www.cmegroup.com/trading/cme-direct.html

Information on means of registration for access to CME ClearPort is available at:  http://www.cmegroup.com/clearport/registration.html  For general information about CME ClearPort, please visit:  http://www.cmegroup.com/clearport.html

5 Market-making firms who have agreed to accept customer calls in respect of either EFRP trades or block trades in CME FX futures are listed at:  http://www.cmegroup.com/trading/fx/fx-futures-blocks-and-efps-market-makers.html  To register to receive market maker contact information, please visit:  http://www.cmegroup.com/education/events/forms/rfq-followup-registration.html

6 See US Commodity Exchange Act Core Principle 9 for Designated Contract Markets (17 USC 38.500):

The board of trade shall provide a competitive, open, and efficient market and mechanism for executing transactions that protects the price discovery process of trading in the centralized market of the board of trade. The rules of the board of trade may authorize, for bona fide business purposes:

(a)    Transfer trades or office trades;

(b)    An exchange of:

(1) Futures in connection with a cash commodity transaction;

(2) Futures for cash commodities; or

(3) Futures for swaps; or

(c)    A futures commission merchant, acting as principal or agent, to enter into or confirm the execution of a contract for the purchase or sale of a commodity for future delivery if the contract is reported, recorded, or cleared in accordance with the rules of the contract market or a derivatives clearing organization.

7 See 17 CFR 1.38 (“Execution of transactions”):

(a)    Competitive execution required; exceptions. All purchases and sales of any commodity for future delivery, and of any commodity option, on or subject to the rules of a contract market shall be executed openly and competitively by open outcry or posting of bids and offers or by other equally open and competitive methods, in the trading pit or ring or similar place provided by the contract market, during the regular hours prescribed by the contract market for trading in such commodity or commodity option: Provided, however, That this requirement shall not apply to transactions which are executed non-competitively in accordance with written rules of the contract market which have been submitted to and approved by the Commission, specifically providing for the non-competitive execution of such transactions.

(b)    Noncompetitive trades; exchange of futures, etc.; requirements. Every person handling, executing, clearing, or carrying trades, transactions or positions which are not competitively executed, including transfer trades or office trades, or trades involving the exchange of futures for cash commodities or the exchange of futures in connection with cash commodity transactions, shall identify and mark by appropriate symbol or designation all such transactions or contracts and all orders, records, and memoranda pertaining thereto.

8 The following builds upon the discussion in Division of Trading and Markets, Report on Exchanges of Futures for Physicals, pp 17-20 and pp 253-6, Commodity Futures Trading Commission, 1 October 1987.

9 If the futures contract is cleared and guaranteed by a central counterparty, like CME Clearing, then why should “nonperformance of futures delivery” be a concern?  The answer lies in how the needs of the futures contract user compare to the scope of the central counterparty’s guarantee.

For any futures contract for physical delivery that is listed for trading on any CME Group Exchange, delivery is facilitated by and occurs between CME clearing member firms, who act as agents for those who hold accounts with them.  To be clear, deliveries on expiring futures contracts do not occur directly between account holders themselves.  Instead, each clearing member firm is responsible to the Exchange and to CME Clearing for guaranteeing the performance of its account holders in meeting the obligations of delivery.  If a CME clearing member fails to fulfill its delivery obligations in respect of an expiring futures contract, the sole obligation of CME Clearing “is to pay reasonable damages proximately caused by the delivery obligation failure…”  (See Chapter 7 of the Exchange Rulebook, especially Rule 714 (“Failure to Deliver”).)

For the question at hand, the key feature in this arrangement is that CME Clearing (like most futures clearing houses) does not guarantee actual delivery of the expiring futures contract’s underlying commodity in fulfillment of the parties’ contractual obligations.  It guarantees only that the parties to the contract will be made financially whole, via payment (or collection) of futures contract profits to (or losses from) the clearing members involved in the delivery and, in the event of delivery failure, payment of “reasonable damages proximately caused” by such failure.

For most futures contract users, this arrangement is perfectly adequate.  For others – a nonfinancial commercial user for whom actual physical delivery of the contract’s underlying commodity is of paramount importance, for example – any outcome other than actual physical delivery might be viewed as an inconvenient and potentially costly instance of nonperformance.

10 A second exception pertains specifically to pairs of EFPs entered in connection with financing of inventories in storable commodities, in which one EFP may be explicitly contingent upon the other:  “A party providing inventory financing for a storable agricultural, energy or metals commodity may, through the execution of an EFP, purchase the commodity and sell the equivalent quantity of futures contracts to a counterparty, and grant to the counterparty the non-transferable right, but not the obligation, to execute a second EFP during a specified time period in the future which will have the effect of reversing the original EFP” (Exchange Rule 538.D.).


 

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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