Block trades are privately negotiated futures, options, or combination transactions that meet certain quantity thresholds and are permitted to be executed apart from the public auction market. Requirements that must be met for a block trade include the minimum block size threshold along with the reporting time. However, sometimes the block quantity may be too large and require a longer reporting period to allow the counterparties to hedge their exposure.
Introducing derived block trades
This can be addressed by using a derived block trade available on select CME Group Equity Index futures. A derived block trade is a block trade consummated by eligible contract participants, in which the price and quantity of the trade depends on hedging transactions in an eligible related market. Parties agree to the pre-defined notional or number of contracts and the markets in which the hedging transaction will take place. Additionally, a basis price will be agreed to and added to the index price of the resultant delta hedge in the related market.
Permitted hedging instruments include stock baskets and other eligible related market instruments such as ETFs. Pre-defined hedging methods are volume weighted average price (VWAP), time weighted average price (TWAP), percentage of volume (POV), and limit price (LP).
Example
A dealer has received instruction from their customer for $450 million dollars of exposure to Financial Select Sector Index futures. The dealer knows a standard block trade could potentially move the market. Additionally, they would like to hedge the exposure in a related market throughout the remainder of the day, so that would not conform with the block reporting period.
Based on current pricing, the dealer calculates a need to buy an exposure equivalent to 4,000 XAF contracts. It is determined that the position will be hedged with IXM Index constituent stocks using V-WAP.
Once the final hedged index price is known, the pre-agreed basis is added to this, resulting in the final futures price. The trade is reported.
Derived block trades must be submitted to the exchange through CME Direct. Additional details will need to be entered including the block hedge type, hedging price, reference hedge product, and basis. Derived block trade details will be available on cmegroup.com and will be clearly differentiated from standard block trades.
Summary
Derived block trades provide greater liquidity and execution flexibility to eligible listed futures contracts by allowing liquidity to be sourced from related markets.
