Riskless Basis Cross Transactions

Description

A riskless basis cross transaction is a trade where an approved participant and a client engage in prenegotiation discussions to agree upon the terms of a transaction on index futures contracts and on share futures to take place outside MX's electronic trading system.

The trade must include the acquisition of a cash market position by the approved participant. The terms agreed upon also include the required amount of index (in the case of index futures) or underlying cash instrument (in the case of share futures) exposure and the basis spread between the average price of the cash exposure acquired by the approved participant and the index or share futures contracts that will be crossed to the client.

General reasons for the use of riskless basis cross transactions

Approved participants receiving requests from clients who cannot or do not want to hold cash securities in their accounts but who wish to acquire market exposure in the most efficient way possible (either on the cash or ETF markets) are authorized to do a riskless basis cross. The sole purpose of the riskless basis cross is to allow market participants to use the attributes of the underlying cash market to take the market position requested by the client and then to replicate it through the use of futures contracts—leaving the approved participant with no resulting market position and the client with a futures position.

Once the terms of the riskless basis cross are agreed upon by the client, the approved participant takes a position in the cash instrument in its own account on behalf of the client. The approved participant then executes the riskless basis cross and allocates the futures position, functionally equivalent to the cash market exposure (as initially requested by the client), into the client's account.

Riskless nature of the transaction

MX allows the use of a riskless basis cross to trade index futures (SXF, SXM, SMJ, SCF, SXA, SXB, SXH and SXY) and share futures provided that the approved participant's final position is riskless and does not impact the cash market. A long (short) position in the cash market will be offset by a short (long) position in the futures contract. The risk offsetting features of this transaction will transform the net position of the approved participant into the equivalent of a short-term money market instrument maturing at the futures contract expiry.

The provisions that 1) the exposure is acquired at an average cash market price and 2) the riskless nature of the position on the approved participant's book, ensure that these trades will not disrupt or displace the exchange-traded markets.

While the approved participant must acquire the cash market position before executing the futures leg, MX does not impose any time limit for the retention or liquidation of the cash market position by the approved participant. Once the riskless basis cross has been completed, the approved participant may manage the positions on its book as it sees fit. This will further harmonize the transaction with the TSX Basis Trade facility, which similarly does not impose any retention or liquidation requirements.

Pricing of the futures contract transaction vis-à-vis the cash market

The price that the client pays for an index futures contract or a share futures contract has two components: the cash market average price and the basis. This price is obtained in the following manner:

1. Basis: The client and the broker agree on the basis that the client will pay above and beyond the cash market average price. This basis is negotiated between the broker and the client.
2. The client and the broker agree on the time period during which the broker will acquire exposure to the index or the underlying cash instrument. The average price of the cash instruments is calculated for this period.
3. The client's final price for the futures contracts is the average price of the cash market plus the pre-negotiated basis.

The price of an index futures contract (or share futures contract) reflects very closely the price of the index (or the underlying instrument) on the cash market, the difference between the two being the basis (futures price = cash price + basis). While the price of the futures contracts transaction that forms part of the riskless basis cross may be outside the posted market, the acquisition of this exposure through transactions on the cash market firmly sets the price of the transaction in the prevailing market.

Reporting a riskless basis cross to MX

To report a riskless basis cross (RBC), the approved participant must provide the details of the concluded transaction by completing and submitting MX's Special Terms Transaction Reporting Form (STTRF). The STTRF is transmitted to the MOD for approval and subsequent input into SAM (the Montréal Automated System). The RBC need not be displayed prior to execution.

If the STTRF is not fully and accurately completed, it will be refused by the MOD and the approved participant who completed it will need to amend and resubmit a correctly completed STTRF. The second approved participant must then validate and approve the revised STTRF, at which point it is once again transmitted to the MOD.

Once the correctly completed STTRF has been received, the MOD will validate the transaction. MX has the discretion to refuse any such transaction, should it deem that it is not in compliance with the requirements of article 6380 of the Rules, or of the related procedures. In case of refusal, the MOD will ensure that the approved participant is promptly informed of such refusal and of the reasons for it.

The RBC will be specially marked and displayed at the post trade recap level, on both the trading platform and data feeds, and will appear on its Web page Daily Special Terms Transactions.

The RBC is excluded from the daily settlement price procedures but included in trading volumes.

Trade validation and market dissemination by MX of an RBC transaction will not preclude MX from initiating any investigation and, as the case may be, disciplinary procedures in the event that the transaction is subsequently found to have been made other than in accordance with the requirements of article 6380 of the Rules, or of the related procedures.

Audit trail requirements for riskless basis cross transactions

Approved participants involved in a riskless basis cross may be required to demonstrate to MX:

For index futures

• that the transaction is comprised of at least 80% of the components constituting the underlying index;
• that the futures portion of the transaction replicates the underlying index and that components of the underlying index that are not included in the riskless basis cross were justifiably excluded (as described above) from the transaction;
• that the cash portion of the riskless basis cross has a minimum correlation of 90% to the underlying index;
• whether the transaction's pre-negotiated basis was fixed and established prior to the execution of the transaction or resulted from a guaranteed closing or executed price of the cash component;
• that the cash position and the futures contracts position (resulting from the riskless basis cross transaction) are properly recorded in both the approved participant's and client's accounts.

For share futures

• whether the transaction's pre-negotiated basis was fixed and established prior to the execution of the transaction or resulted from a guaranteed closing or executed price of the cash component;
• that the cash position and the futures position (resulting from the riskless basis cross transaction) are properly recorded in both the approved participant's and client's accounts.

While the approved participant must acquire the cash market position before executing the futures contract leg, MX does not impose any time limit for the retention or liquidation by the approved participant of the cash market position. Once the riskless basis cross has been completed, the approved participant may manage the positions on its book as it sees fit.

For more riskless basis cross information, please contact our Market Monitoring Department at 1-888-693-6366.