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Exchange for Physical (EFPs)
An EFP (also referred to as "basis") involves simultaneous transactions in the cash and futures markets.
In an EFP, one party buys an acceptable cash market position and simultaneously sells the futures contract while the other party sells this acceptable cash market position and simultaneously buys this futures contract. Acceptable cash components are described in the procedure prescribed by MX.
The parties to an EFP privately negotiate the price of the futures position and the value of the cash commodity to be exchanged. Once the price and quantity of the futures have been set by the parties and an EFP has been accepted for clearing, the futures margin and delivery or settlement obligations of the parties arising from an EFP are not distinguishable from those executed competitively on the trading platform.
General reasons for the use of EFPs
- EFPs have traditionally been an integral part of the hedging and pricing practices of commercial entities.
- A means of pricing a cash transaction – an EFP preserves the basis relationship of a cash commodity trade. It permits both parties to complete their cash transaction and their futures hedge in one transaction at an agreed-upon basis (i.e. the price differential between the cash commodity and the futures contract). In the absence of an EFP, the basis might be altered by market forces moving the price during the time required to execute separate cash and futures transactions or by a change in the futures prices. Therefore, EFPs facilitate cash transaction.
- EFPs also permit the parties to choose the opposite party (just as they may in the cash market) and thereby reduce the risk of non-performance by the opposite party with respect to deliveries that are not guaranteed by the clearing house (most clearing houses guarantee only the payment/collection of futures profit or losses to the clearing members involved).
- A means to limit risk by doing a transaction after the regular trading hours of the futures market.
- EFPs have been employed by traders to allow them to avoid additional margin obligations or as a vehicle to cover market position against overnight price changes.
- EFPs and arbitrage transactions: If the spread between the cash and futures prices is out-of-line according to the break-even repo rate, arbitrageurs can use EFP transactions to keep the prices of futures continuously in line with the prices of cash bonds.
In summary, EFPs serve a variety of commercial needs and can contribute to the efficiency of the futures market. EFPs are employed in an expanding array of trading strategies.
What is an acceptable EFP transaction?
- There must be separate but integrally related cash and futures transactions.
The exchange transaction must be done between two separate accounts that must satisfy at least one of the following criteria:
- accounts have different beneficial ownership;
- accounts have the same beneficial ownership but are under separate control; or
- accounts are under a common control but involve separate legal entities which may or may not have the same beneficial ownership.
If the parties to an EFP transaction involve the same legal entity, same beneficial owner or separate legal entities under common control, the approved participant (or the parties themselves) must be able to demonstrate that the EFP transaction is a legitimate arm's length transaction.
- The cash market instrument leg of the EFP must provide for a transfer of ownership of the cash market instrument to the buyer of this instrument and delivery must take place within a reasonable period of time (in accordance with cash market practice).
- The relation between the prices of the futures and of the cash legs of the EFP and the relevant prices in either market must be established.
- The cash seller's ability to perform on his delivery obligation in the absence of prior possession of the cash commodity must be established.
Since EFPs are not required to be executed competitively on the trading platform of MX, the futures price is mutually agreed-upon by the parties to the transactions.
The futures contract leg of an EFP must be priced at a fair and reasonable level in light of factors such as, but not limited to, the size of the EFP transaction, currently traded prices, bid and ask prices in the same contract at the relevant time, volatility, liquidity of the relevant market, and general market conditions prevailing at the time the EFP transaction is executed.
The Montréal Exchange offers EFP facilities for the following futures contracts:
Share futures on canadian stocks
Long "basis": Long position on the underlying stock of the futures contract being exchanged and short futures.
Short "basis": Short position on the underlying stock of the futures contract being exchanged and long futures.
Interest rate futures
Long "basis": Long position on fixed income instruments that have a reasonable price correlation, maturities as well as risk characteristics that parallel the instrument underlying the futures contract being exchanged and short futures. Such instruments include, but are not necessarily limited to, money market instruments including asset backed commercial paper, Government of Canada and Federal Crown Corporation fixed income instruments, provincials fixed income instruments, investment grade corporates including Maple Bonds and mortgage instruments including collateralized mortgage obligations (CMOs). Fixed income instruments denominated in the currency of a G7 member country that satisfy these conditions are also acceptable.
Short "basis": Short position on fixed income instruments that have a reasonable price correlation, maturities as well as risk characteristics that parallel the instrument underlying the futures contract being exchanged and long futures. Such instruments include, but are not necessarily limited to, money market instruments including asset backed commercial paper, Government of Canada and Federal Crown Corporation fixed income instruments, provincials fixed income instruments, investment grade corporates including Maple Bonds and mortgage instruments including collateralized mortgage obligations (CMOs). Fixed income instruments denominated in the currency of a G7 member country that satisfy these conditions are also acceptable.
Futures contracts on S&P/TSX indices
Long "basis": Long futures and short position on stock baskets that must be reasonably correlated to the underlying index with a correlation coefficient (R) of 0.90 or more. Furthermore, these stock baskets must represent a weight of at least 50% of the underlying index or must include at least 50% of the securities of the underlying index. The notional value of the basket must be fairly equal to the value of the futures contract component of the exchange transaction. Exchanged-traded funds are also acceptable, provided they mirror the index futures contract against which the EFP transaction is made.
Short "basis": Short futures and long position on stock baskets that must be reasonably correlated to the underlying index with a correlation coefficient (R) of 0.90 or more. Furthermore, these stock baskets must represent a weight of at least 50% of the underlying index or must include at least 50% of the securities of the underlying index. The notional value of the basket must be fairly equal to the value of the futures contract component of the exchange transaction. Exchanged-traded funds are also acceptable, provided they mirror the index futures contract against which the EFP transaction is made.
Reporting an EFP transaction to MX
To report an EFP transaction, the approved participant for either the seller or the buyer must complete and submit MX's Special Terms Transaction Reporting Form (STTRF). If the approved participant is acting for both the seller and buyer, the STTRF goes directly to the Market Operations Department (MOD) for approval and subsequent input into SAM (the Montréal Automated System). If not, the approved participant for the other party then validates, completes that which concerns them and approves the STTRF, at which point it is transmitted to the MOD.
For an EFP executed before the close of the relevant contract's trading session, the STTRF must be submitted immediately upon the execution of the transaction. For an EFP executed after the close, the STTRF must be submitted no later than 10:00 a.m. (Montreal time) on the next trading day.
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 the transaction is not in compliance with the requirements of article 6815 of the Rules, or of the related procedures. In case of refusal, the MOD will ensure that the approved participants involved in the EFP transaction are promptly informed of such refusal and of the reasons for it.
Once an EFP has been validated and entered into SAM by the MOD, MX will disseminate the following information on its Web page Transaction Report:
- Date and time of transaction
- Product description (code)
- Contract month(s)
- Volume of the transaction, in contracts
- Transaction price
Trade validation and market dissemination by MX of an EFP 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 6815 of the Rules, or of the related procedures.
Audit trail requirements EFP transactions
Approved participants who enter into an EFP transaction must maintain all documents relevant to the futures contracts as well as to the corresponding over-the-counter derivative instrument transactions and must be able to promptly provide copies of such documents to the Regulatory Division of MX upon request. Documents that may be requested include, but are not limited to, the following:
- Futures contracts' order tickets;
- Futures contracts' account statements;
- Documentation customarily generated in accordance with the over-the-counter or other relevant market practices such as cash account statements, trade confirmation statements or other documents of title;
- Third party documentation to support proof of payment or allowing to verify that the ownership title of the related over-the-counter derivative instrument position was transferred from the seller to the buyer. This may include, but is not limited to cancel checks, bank statements; cash account statements and cash instruments clearing corporation documents (e.g.: CDS Depository and Clearing Services Inc.).
All futures contracts order tickets must clearly indicate the time of execution of the EFP transactions.
For more EFP information, please contact our Market Monitoring Department at 1-888-693-6366.