Understanding EFRP Transactions

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. There, and in what follows, we use “futures” or “futures leg” as shorthand reference to either the Exchange-listed futures component of an EFP or EFR or 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 the OTC derivative position in an EFR, or the OTC option position in an EOO.)

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.

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 futures underlying commodity. The Exchange’s Market Regulation Department identifies and publishes standards for acceptability of offsetting positions.

For CME FX futures, for instance, permissible 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.” ²

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 if the price agreed for the futures leg of an EFRP is away from prevailing market levels, then the counterparties may be required to demonstrate that the price is indeed legitimate.

The Exchange component of the EFRP transaction must be priced in accordance with the applicable futures price increments or option premium increments as set forth in the rules governing the Exchange contract. The applicable price increments can be found here. Unlike block trades, EFRP transactions are not subject to a minimum transaction size requirement and therefore an EFRP may be transacted at any size.

Upon agreement to 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.³ Absent extenuating circumstances, submission is expected to be made on the same day the trade is executed by the end of the business day unlike block trades which must be submitted within 15 minutes for CME FX products. 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 Department 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.⁴

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.” ⁵ 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.⁶

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

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

(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 privately negotiated rather than competitively executed.

An EFRP transaction meets such needs in potentially several ways⁷ ‒

(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 as a means 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.⁸

(5)   Margin optimization – An EFRP enables parties to consolidate their risk at the Exchange rather than being split between the Exchange and the OTC. An EFRP also enables parties to transition their risk to a netted position versus the Exchange rather than having multiple OTC counterparties and margin requirements.

(6)   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.

(7)   General control of delivery – Similar to (6), 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.

(8)   Extension of delivery terms – Expanding upon the principle that underlies (6) and (7), 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.).

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.

(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.

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.

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. With this in mind, 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.

Exchange rules forbid what is commonly known as the “transitory EFRP” ‒ any EFRP trade that is contingent upon the execution of another transaction between the parties (either a second EFRP or a cash-market trade), such that the EFRP’s cash leg is offset without the incurrence of cash-market price risk (Exchange Rule 538.C.).

The Exchange, however, does permit “immediately offsetting EFPs” solely for use in connection with CME FX futures. In an immediately offsetting EFP trade, the parties may immediately unwind the cash leg of the EFP, on condition that they fully document all physical transactions entailed in the trade (with one physical transaction for the EFP and a second physical transaction, or set of transactions, to achieve immediate offset of the first):

“[T]he 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.).

CME Rule 538.K. establishes that the component trades in the immediately offsetting FX EFP – the FX EFP transaction itself, and the offsetting stand-alone physical transaction ‒ may occur simultaneously without being prohibited as a transitory EFRP. The crucial feature of the immediately offsetting FX EFP, distinguishing it from a prohibited transitory EFRP, is that the offsetting physical transaction is not contingent upon the FX EFP transaction in any way. To see this, consider an example: if the futures leg of an immediately offsetting FX EFP were not accepted for clearing, then the futures transaction would be void, and the counterparties would be left with the stand-alone physical transaction.

An EFRP is a convenient mechanism to transact futures and option in combination with related products in a compliant manner and enable the parties to the futures transaction to choose their respective counterparties to reduce the risk of counterparty nonperformance and manage their risk with CME Clearing. CME Group expects the majority of FX trading will be conducted in the centralized and competitive market on CME Globex, but EFRP transactions are a useful and convenient outlet for some traders who find this a convenient and expeditious way of conducting business. 

For more information, please contact:

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. EFRPs are subject to CME Rule 538 and the associated CME Group Market Regulation Advisory Notice.

² What’s permissible as an offsetting position may change from time to time at the discretion of the Exchange. The roster quoted here is as set forth in CME Group Advisory Notice RA1716-5, Exchange for Related Positions, 18 October 2017.

³ 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

⁴ Market-making firms who have agreed to accept customer enquiries 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

⁵ 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.

⁶ 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.

⁷ 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.

⁸ 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.