Futurisation is a concept that incubated from the implementation of post-financial crisis regulatory reforms. The premise of futurisation concluded that market participants would turn away from traditional over-the-counter (OTC) derivatives and adopt Exchange Traded Derivatives (ETDs) due to lower clearing cost and regulatory simplicity.
The Derivatives Exchanges created products like MAC Swap futures, ERIS Standards and Swap Note futures in order to leverage the futurisation trend. While these products are seeing growth in volume and numbers of participants, adoption has been slow in terms of overall OTC derivatives usage. In the Foreign Exchange space (clearing is not mandated in FX products) the exchanges have increased the available number of delivery dates but overall volume in FX futures still accounts for less than 3 per cent of the $5+ trillion in daily volume.
The value case for futurisation is centred in the concept of standardisation. The standard specification of a futures contract makes it more capital and risk-efficient. Futures are also more transparent in terms of valuation and visibility. Futures operators have been highly successful in the creation of electronic Central Limit Order Books (CLOB), while the creation of scalable CLOBs within the OTC space has been elusive at best. The overall success of the electronic CLOB within futures markets makes a powerful argument for the superior liquidity footprint of a standardised product.
The drawback of a standardised product is a lack of flexibility. Hedging of bespoke risk dates is more complex when using a standardised contract as delivery or payment dates might not match. The user is forced to take on the basis risk between the standard listed product and the custom risk the user is looking to hedge. This is not an issue if the user that is taking on the basis risk is a market maker or proprietary trading firm.
However, if the participant is an end user or non-financial commercial, managing this basis risk becomes more difficult. The end user participant is forced to take on additional cost and risk in order to manage the basis exposure. This cost can easily exceed the additional margin, clearing and unwind cost of doing a custom OTC derivative exposure making the OTC hedge a better option. There have been attempts to design futures products that offer the flexibility of an OTC derivative but to date these products have seen sparse volume at best, limited take up and significant liquidity constraints.
There is a middle ground that effectively allows users to reap the benefits of both ETDs and custom OTC structures giving participants a process to swap between ecosystems when a specific need arises. The Exchange for Related Product (EFRP) is a transaction that allows a user to “toggle” between OTC and ETD exposure. The EFRP is an off exchange privately negotiated transaction with a mandated reporting requirement. EFRP’s comprise three different transaction types;
- Exchange for Physical (EFP) – A position in the underlying physical instrument for a corresponding futures position.
- Exchange for Risk (EFR) – A position in an OTC swap or other OTC derivative in the same or related instrument for a position in the corresponding futures contract.
- Exchange of Options for Options (EOO) - A position in an OTC option (or other OTC contract with similar characteristics) in the same or related instrument for an option position.
The largest percentages of EFRP transactions take place on the CME Group platform. These transactions take place in FX, Rates, Metals, Equities, Energy and Softs. The pivotal CME rule which is most applicable to EFRP transactions is Rule 538. Recently the CME made important changes to this rule in order to facilitate more EFRP transaction types (CME Rule 538 Webinar for more information), and I believe this rule clarification signals an important change at CME. It is likely that CME understands the need for the ETD space to operate alongside the OTC space. Making it easier for participants to transfer risk between these market pools will serve to increase volume and participation in both spaces.
At QTX Systems we have recognised the need and importance of the EFRP. We are currently developing multi asset class solutions specifically designed for all EFRP trade types. Our solutions fully automate workflows and reporting requirements for EFRPs. Once transactions have been executed trade details flow seamlessly downstream into legacy risk systems. If you are interested in finding out more regarding out solutions please feel free to contact us.