An Exchange for Physical (EFP) is a particular type of Exchange for Related Position (EFRP) transaction that allows traders to simultaneously trade futures and cash securities as a package. U.S. Treasury futures EFPs most commonly involve the exchange of Treasury futures with cash Treasuries at an agreed-upon spread. In this transaction, one party buys Treasury futures and sells cash Treasuries and the other party takes an opposite position. While EFPs are privately negotiated transactions, they must be reported to the Exchange and are subject to CBOT Rule 538 and any associated advisories.1
Treasury futures EFPs are not restricted to Treasury securities but may also involve securities with a reasonable degree of price correlation to Treasuries. This flexibility expands the number of ways that market participants can use EFPs to manage their exposure between Treasury futures and cash securities.
While EFPs constitute a small share of Treasury futures volume, they are an important feature of the market and are used by a range of market participants.
Why trade EFPs?
EFPs allow a trader to easily transfer their exposure between Treasury futures and cash Treasuries without leg risk. A trader is exposed to leg risk when two legs of a transaction (e.g., buying Treasury futures and selling cash Treasuries) are executed as separate trades, since the price associated with the second leg may change in the time after the first leg is executed. Since an EFP involves the simultaneous trading of both legs, leg risk is eliminated.
This makes EFPs particularly useful for establishing a Treasury basis position, which consists of offsetting positions in Treasury futures and cash Treasuries. Securities dealers and other market participants use basis positions to hedge their basis risk, while arbitrageurs and proprietary traders may trade the basis to generate profit.
EFPs also allow market participants to utilize the liquidity of Treasury futures to establish interest rate risk exposure quickly and efficiently before shifting that exposure to cash Treasury positions. For example, a fixed income asset manager that receives a large inflow of funds can initially buy Treasury futures to establish their desired interest rate exposure and then use EFPs to gradually exchange those futures positions for cash Treasury positions. By using EFPs, asset managers are still able to establish their desired level of interest rate exposure once funds are received while optimizing the timing of their cash Treasury purchases.
EFPs may also be used by market participants to exchange Treasury futures positions for cash positions in other securities that are highly correlated with cash Treasuries, such as corporate bonds and mortgage-backed securities, depending on their needs.
Example: Using an EFP to execute a basis trade
The following hypothetical example illustrates how a trader may use EFPs to trade the Treasury basis.
Suppose that a trader expects the gross basis between the June 2023 10-Year Treasury futures and the 3-7/8% of Dec 2029 (the cheapest-to-deliver security in the futures basket) to increase. To profit from this view, the trader can use an EFP to buy the basis, which involves going short futures and long cash Treasuries.
The trader needs to hedge against parallel movements in futures and cash where the gross basis remains constant. For every $100M face value of Treasury notes purchased, the trader would need to sell futures with a notional amount of:
- DV01Cash is the dollar change in the price of the given a one basis point change in the note’s yield to maturity.
- DV01Futures is the dollar change in the futures price given a one basis point change in the CTD’s yield to maturity.
- CF is the Treasury note’s conversion factor and is equal to 0.887.
This implies that:
This relationship holds if the 3-7/8% of Dec 2029 is the CTD. However, the CTD could switch to another security in the deliverable basket, in which case the hedge would not perform as expected. For simplicity, we will assume that the trader is willing to accept this risk.
Since the notional value of the 10-Year Treasury futures contract is $100K, the trader would sell $100M × 0.887 / $100K = $88.7M / $100K = 887 futures contracts, where $100M represents the face value of the Treasury notes that need to be hedged and 0.887 represents the conversion factor.
The trader calls a broker and asks for an EFP market in 887 contracts of the June 2023 10-Year Treasury futures versus $100M of the 3-7/8% of Dec 2029. The broker provides a bid/ask quote of “-6.1685 / -4.7250” using a futures market of “114-27 / 114-27+”. This implies a cash market of “101-22 / 101-23” for the 3-7/8% of Dec 2029 in terms of the basis between the futures contract and the Treasury note (in 32nds). Using an EFP, the trader buys the basis at -4.725, which is equivalent to simultaneously:
- Buying $100M of 3-7/8% of Dec 2029 at the offer of 101-23
- Selling 887 TYM3 futures at the bid of 114-27
Table 1: EFP market when the trader buys the basis
|3-7/8% of 12/2029||101-22||101-23|
Once the trader and the broker agree to the terms of the EFP transaction it will need to be reported to the Exchange on the day of execution.
Suppose that a few days later, the basis has increased. To lock in their profit, the trader can use an EFP to sell the basis and close-out their long basis position. The trader calls a different broker who provides an EFP market of “-3.8945 / -2.4510” using a futures market of “114-25 / 114-25+”. This implies a cash market of “101-22+ / 101-23+” for the 3-7/8% of Dec 2029. Using an EFP, the trader sells the basis at -3.8945, which is equivalent to simultaneously:
- Selling $100M of 3-7/8% of Dec 2029 at the bid of 101-22+
- Buying 887 TYM3 futures at the offer of 114-25+
Table 2: EFP market when the trader sells the basis
|3-7/8% of 12/2029||101-22+||101-23+|
Using the futures and cash prices implied by the bases, the trader earns a profit of $25,953.13.
Table 3: Basis trade profit
Treasury futures EFPs provide market participants with a way to simultaneously trade Treasury futures and cash securities without leg risk. EFPs can help asset managers quickly establish interest rate exposure while they optimize the timing of their cash security purchases. They also help to facilitate arbitrage trading between Treasury futures and cash Treasuries. This helps ensure that the basis relationship between the futures price and the underlying spot price is preserved. While this article has covered some potential use cases, there may be others depending on the needs of market participants.
For more information, see:
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 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.