Exchange of futures for physicals

Published on July 22, 2020 by Entrima

An exchange of futures for physicals (EFP) is a transaction process allowed by an exchange to enable market participants to manage their market risk with direct reference to the price of an underlying physical transaction. The EFP trade affords market participants the opportunity to separate pricing from supply by exchanging their physical price exposure for a futures price exposure. Hence, an EFP allows the exchange of a commodities position for a futures position.

An exchange of futures for physicals can be bought by a market participant or, alternatively, it is sold:

  • Buyer
    Buying an EFP implies buying a commodities futures contract and simultaneously selling (or making delivery of) the physical underlying commodity.
  • Seller
    Selling an EFP implies selling a futures contract and simultaneously buying (or taking delivery of) the physical underlying commodity.

Exchanging futures for physical trades work on the basis that counterparties agree with each other that they wish to complement their physical transaction with an accompanying futures transaction. An important reason for using an EFP is because of transaction efficiency. An EFP is used instead of multiple transactions, namely for the purchase or sale of a physical product and the opposite trade of a futures contract. Because of this combination, an EFP can be considered an integrated or implicit product. After all, one EFP replaces multiple other trades.

Furthermore, an EFP transaction can be used as some sort of block trade, for large volumes; hence, for ‘trading size’. Sometimes a market participant aims to execute orders that contain hundreds or thousands of contracts while market liquidity is limited. This would cause slippage to increase. However, with an EFP this can be avoided, as trading takes place outside the regular market. Counterparty credit exposure can be reduced by reversing and replacing (hence, swapping) an existing position of futures contracts with a physical position, or vice versa. By netting OTC positions against different futures positions, a reduced balance sheet and reduced margin requirements can be achieved. OTC trading allows market participants to negotiate price, as well as terms and conditions.