Exchange for Physical (EFP)
An Exchange For Physical (EFP) is an off market transaction between wholesale participants which involves the switching (or exchanging) of an OTC derivative for an exchange traded derivative.
For further information on EFP's please refer to the ASX 24 Operating Rules in conjunction with ASIC Market Integrity Rules (ASX 24 Market). In addition, please see the Energy Market Policy for further details.
An Exchange For Physical (EFP) is an off market transaction which involves the swapping (or exchanging) of an over-the-counter (OTC) position for a futures position. The OTC transaction must be for the same or similar quantity or amount of electricity, or a substantially similar commodity or instrument. The OTC side of the EFP can include electricity swaps, swap options, caps and other such instruments traded in the OTC market.
In order that an EFP transaction can take place, the OTC side and futures components must be “substantially similar” in terms of either value and or quantity.
EFP's may be negotiated either via ASX 24 Participants or direct, one counterparty to another. They must be registered through an ASX 24 Full Participant.
The net result is that the OTC position (and the inherent counterparty credit exposure) is transferred from the OTC market to the futures market. EFP's can also work in reverse i.e. a futures position can be reversed and transferred to the OTC market.
An EFP transaction has a number of uses and benefits for energy market participants:
- Counterparty credit exposure may be reduced when an existing swap position is reversed and replaced with a futures position. In so doing, an EFP allows counterparties to release “credit”, clearing the way for further OTC trading.
- Reduced balance sheet and margin requirements - by netting OTC positions against opposing futures positions margin and credit support requirements can be reduced. Note that an EFP transaction will result in a large negative variation margin call for an entity which transacts the futures leg of an EFP if the EFP futures price struck at an "out of market" price.
- Off-Market , EFP's are negotiated and traded between counterparties off-market with price and volume details not being reflected “on the screen”. EFP futures prices are not considered in the end of day price settlement process.
- 24-Hour Trading , EFP transactions can be negotiated around the clock but must be registered between 7 am to 5 pm during Exchange business days.
I. Parties to an EFP
An EFP can either be negotiated directly between two wholesale counterparties ("wholesale" for the purposes of Corporations Law) or facilitated by an ASX 24 Participant (broker). Under either circumstance the transaction must be registered with the Exchange through an ASX 24 Full Participant. ASX 24 Full Participants registering EFP transactions have the responsibility of confirming and maintaining records of details of the EFP transaction. The details of EFP transactions required for registration with the Exchange. Include:
1 The futures quantity
2 The futures price
3 Aknowledgment from the client that a materially similar OTC transaction has been transacted as part of the EFP
4 The identity of the counterparties' ASX 24 Clearing Participant
II. Pricing
The pricing of particular EFP transactions may depend on a number of key parameters including:
- The valuation of OTC credit exposures
- Cash-flow funding (cost-of carry) considerations. e.g. positive or negative variation margins and funding of initial margin requirement.
- The terms and conditions attached to the underlying OTC transaction, including the strike price
- The current futures price
Given the number of variables involved, EFP transactions will typically trade at a discount/premium to the original swap (OTC) price. Parties considering transacting an EFP should seek independent financial advice from a licensed financial advisor before doing so.
III. Documentation
Counterparties to an EFP transaction must have:
- Executed Client Agreement Forms and acknowledged Risk Disclosure Statements with organisations (brokers) licensed to deal in futures/ derivatives
- Opened an account with a ASX 24 Clearing Participant
ASX 24 Participants must obtain or have the right to access documentation confirming the details of the ‘OTC' component to an EFP transaction.
IV. Process Flow Diagram
V. Costs
The electricity futures contracts registered with ASX 24 via an EFP transaction will incur the standard per contract side Exchange fee.
In addition to the relevant Exchange fee, the counterparties to an EFP will typically incur brokerage and clearing fees.
The ASX 24 does not charge an EFP registration fee.
Worked hypothetical example of an EFP transaction scenario:
Party (A) is long a 20 MW base load Q3 2008 OTC contract with another OTC counterparty (B), originally traded at @ $38.75. The market is currently trading at $58.90 for this quarter. This position is now $889,824 in the money (20 MW x ($58.90-$38.75) x 2,208 hours*). Party (A) is exposed to the potential credit default risk of counterparty (B) and may be forced to pay $58.90 for a replacement contract if counterparty (B) defaulted on the OTC contract. Party (A) now wishes to exchange this position for an equivalent futures position to eliminate OTC credit default risk.
(*The number of hours in a Q3 2008 base load futures contract.)
Party (B) who sold the original OTC swap to Party (A) is short the 20 MW base load Q3 2008 OTC @ $38.75.
Party (A) has approached Party (B), who has agreed to transact an EFP (i.e. enter into an equivalent futures position while simultaneously transacting a new swap position which which is equal and opposite to the orginal swap position).
Step 1: Negotiation
Party (A) and Party (B) must negotiate to establish an appropriate price for both legs of the EFP transaction. This may be conducted through a broker or directly between the parties. Assume the parties agree on a price of $38.75 for both the futures and the new swap position in this case.
Step 2: Reversal of OTC Positions
Party (A) sells the 20 MW Q3 2008 to Party (B) at the original $38.75 price.
Party (B) buys the 20 MW Q3 2008 (back) from Party (A) at $38.75.
Party (A) will issue a standard ISDA confirmation to confirm the OTC sale to Party (B)
Step 3: Simultaneous Futures Execution
Having already agreed a price for the EFP transaction (Step 1), both parties will now execute (via their respective ASX 24 Full Participants) futures transactions which are opposite (buy versus sell) to the new swap transaction.
Party (A) buys 20 Q3 2008 futures at $38.75
Party (B) sells 20 Q3 2008 futures at $38.75
To complete this transaction, the parties ASX 24 brokers (or the parties themselves if no broker is involved) will provide all relevant information to an ASX 24 Full Participant who will in turn notify the Exchange that an EFP has taken place. Information furnished will include the price and full details of both sides of the transaction (i.e. both the futures and the physical legs). The details of the futures side of the transaction will be reported to the market via the ASX 24 message board.
Step 4: Cash Flows
Assume the end of day futures settlement price is $58.90.
Assume initial margin is $2,500.
At the end of day one, the Exchange will margin the parties as follows:
Note: In addition to the above cash flows, brokerage and Exchange fees will be payable.
After an EFP:
Neither party now has any credit exposure to the other (assuming that the equal and opposite OTC swap positions are legally netted) associated with the orginal swap deal. They have replaced (netted) an earlier swap agreement for an open futures position. Party (A) has the benefit of positive cash receipts through variation margins of $889,824 and Party (B) has had to pay $889,824 in negative variation margins. Both parties must also meet any additional initial margin requirements e.g. minimum $2,500 per futures contract (per party). Both parties now have freed-up OTC credit lines with each other to be able to conduct further OTC business as required.
Note: It is also possible to execute an EFP in the reverse direction of the above example. i.e. it is possible to reverse out of an existing futures position into an OTC position.
The Exchange for Physical trading mechanism is also available for Cap Futures and exchange traded Options.