Exchange for Physical (EFP) Transactions

Flexible Tools for Achieving Equity Index Exposure

An Exchange for Physical (EFP) is a particular type of Exchange for Related Position (EFRP) transaction and may be executed in any CME equity index future in accordance with Rule 538 and any associated advisories.1

EFP transactions allow investors to convert between futures and either ETFs or baskets of the underlying index constituent stocks, without exposure to intraday market execution. This not only allows investors to optimize their holdings to meet their leverage, capital, tax and liquidity needs but to also differentiate between the tool they use for trading and how they want to hold their exposure.

In an EFP transaction, two parties exchange equivalent but offsetting positions in an equity index futures contract and an underlying physical equity (either a related ETF or basket of shares). One party is the buyer of futures and the seller of the physical shares, and the other party takes the opposite position. The EFP is a privately-negotiated transaction between the two parties to the trade, where the consummated transaction must be reported to the Exchange.

Because both sides of the trade track the same benchmark, an EFP is market-neutral. As such, the pricing of the EFP is quoted in terms of the basis between the price of the futures contract and the level of the underlying index.

Example: Asset Manager Moving From a Long ETF Position to a Long Futures Position

  1. Consider an investor who is long 1.4 million shares of XLY (Consumer Discretionary Select Sector ETF), worth approximately $100m. The investor wishes to benefit from futures’ broad-based index margin of roughly 4.5% versus the Reg T (50%) or Prime Broker (15-20%) margining available on a cash position. By exchanging the ETF position for futures, the investor can free up between $20- and $50 million of cash.
  2. The investor calls a broker and asks for an EFP market in 1,400 contracts of the Consumer Discretionary Select Sector futures expiring in June 2015 (ticker XAYM5) versus the XLY. The broker provides the client with a bid/ask quote in terms of the basis between the futures and the underlying cash index. The quote in this case is “-1.30 / -1.10” using the prior night’s closing index level of 711.66 as reference. The investor wants to buy futures and agrees to pay the offer side price for the futures – in this case, a basis of -1.10 which corresponding to a futures level of 710.56. Additionally, the investor and dealer agree to the equivalent price at which to exchange the related position – the XLY ETF.
  3. The broker and client have agreed to execute the EFP at a futures level of 710.56. However, futures can only be crossed in tick increments of $0.10. The futures are therefore reported in two separate entries 840 lots at 710.60, and 560 lots at 710.50, the weighted average of these two trades matching the agreed price of 710.56.
  4. The broker reports the client sale / broker purchase of 1.4m XLY at the prior night’s ETF NAV of 70.9456 to ACT. The EFP must be reported reported to the Exchange within the time period and in the manner specified by the Exchange.
  5. Upon completion of the EFP, the investor and broker have different positions but the same exposure:
    • The investor was long $100m of exposure to the Consumer Discretionary Select Sector index via ETFs and has now converted this exposure into an equivalent notional of the futures contract.
    • The broker had no position and now holds equal and offsetting positions, long the ETF and short the futures contract.

The figure below illustrates the flow of these transactions.

Why Do Investors Trade the EFP?

Banks and broker-dealers are active in the EFP market for a variety of reasons. The EFP between futures and ETFs or stock baskets is a key ingredient in the management of inventory street-wide as well as the index arbitrage mechanisms that keep both futures, ETFs and the cash constituents trading in line with their fair value. For example:

  • Inventory management / stock loan: If demand increases to borrow an ETF or the component stocks of the associated index, a broker can source additional lendable supply via the EFP market. By lowering his offer (i.e. the price at which he would sell the future to buy physical shares) he can encourage long holders of the ETF or stock to exchange those for futures, giving the broker additional shares to lend out. This process allows long holders who cannot lend shares directly, to benefit from the increased stock loan value of their inventory.
  • Index arbitrage: Index arbitrageurs buy and sell baskets of shares, ETFs and futures throughout the day to capture mispricings. Many of these firms are small and cannot carry large inventory positions overnight. If intraday trading has resulted in large stock balances (with offsetting short futures) on the arbitrageurs’ books, the EFP allows them to collapse these positions and exit the arbitrage so that they may continue to transact.
The EFP market for futures is analogous to the creation / redemption mechanism for ETFs. Despite their very different mechanics and regulatory frameworks, the role of these two transactions is similar: they both allow for a riskless conversion between different tools for index tracking. In the inventory management example above, even if the demand is for the component shares, the broker can still benefit from an EFP executed versus the ETF because the ETF can then be redeemed through the issuer to receive the underlying shares.

Did you know: OTC S&P 500 index options are eligible for an EFRP transaction?

An EFRP is a very flexible tool and comports well of OTC swaps and options trading. For example, when trading OTC S&P 500 index options, a CME E-mini S&P 500 index futures or S&P 500 index futures trade can be consummated to exchange the offsetting delta in the transaction, and reported to CME Clearing as an EFRP trade. The E-mini S&P 500 index futures or S&P 500 index futures are considered the listed instrument, while the OTC index option(s) is considered the related position. Please note that only bona fide OTC options trades can be used as the related position. Products listed at another securities or futures exchange are not eligible for inclusion as the related position is an EFRP transaction. Other requirements for EFRP transactions remain applicable.

Pricing and Trading Details

EFP versus a basket of shares: When executing an EFP versus a basket of shares, the replicating basket is usually a perfect slice of the index. In some cases an imperfect basket may be used (e.g. if the broker is restricted from trading a particular security). The requirement is that the resulting basket of shares is highly correlated with the underlying index and at least a 50% overlap of either the weighting or number of securities.

Tailing futures: When determining the appropriate number of futures contracts to exchange for a given notional of ETFs or underlying cash baskets, brokers may apply a “tail” adjustment whereby the number of futures contracts is reduced slightly. Conversely, the size of the related position, the ETF or basket can also be adjusted if the client wants to trade a set number of futures. This results in slightly different notional values for the two legs of the EFP, but more precisely matches their market exposures (i.e. sensitivity to change). This tail adjustment will be agreed during the private negotiation and is a function of the days to maturity and the level of interest rates. (At the time of writing, due to low rates, this adjustment is very small – on the order of one contract per 1,500.)

NAV pricing: It is market convention to price and trade EFPs with reference to the prior night’s closing share prices (for a cash basket) or NAV (for an ETF). Because the NAV reflects not only the prices of the underlying shares but also the accrued dividends and cash held in the fund, the NAV price may be adjusted by a small amount to reflect any changes that have occurred since the previous day (e.g. underlying stock going ex-dividend). It is also possible to execute the EFP after the market close versus the closing NAV on trade date. In this case, the agreed upon basis (which referenced the prior night’s closing level) may be adjusted slightly (called a “delta adjustment”) to reflect the change in market level since that time.

Ready to start using EFP transactions? Contact your broker for a quote.

Need more information? Contact your dedicated CME Group Sales representative.


1View the Market Regulation Advisory Notice regarding rule 538.

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