What Is Exchange of Futures for Physical?
An exchange of futures for physical (EFP) is a private agreement between two parties to trade a futures position for the basket of underlying actuals. An exchange of futures for physicals can be used to open a futures position, close a futures position, or switch a futures position for the underlying asset.
- An exchange of futures for physical (EFP) allows for one party to swap a futures contract for the actual underlying asset.
- EFPs are traded over-the-counter (OTC) and are often used by commodities producers to hedge positions or regulate production.
- EFPs are especially useful when a large transaction takes place so the market price is not artificially altered by a non-speculative trade.
Understanding Exchange of Futures for Physical (EFP)
Exchange of futures for physical (EFP) is one of a few types of privately negotiated agreements that can then be registered with the exchange. The volume involved in the transaction is shown in the days’ trading when the transaction is registered, but the price at which the transaction was completed (the privately agreed upon price between the parties) is not revealed.
When two parties have agreed to an exchange of futures for physicals, they then register the transaction with the relevant exchange. Exchange of futures for physical is also referred to as exchange of futures for product and exchange of futures for cash (as in cash commodity). The term exchange of futures for physical is generally used to describe transactions of this nature even when the underlying are financial products rather than cash commodities. Exchange of futures for swap (EFS) can be used if the futures position is being traded for a swap contract.
Example of Exchange of Futures for Physical
The most common examples of the exchange of futures for physical is in the oil and gas sector. This makes sense, as these types of transactions are not done by small traders and speculators. EFPs will usually involve large commercial and non-commercial traders. Imagine an oil and gas producer is sitting on an inventory of one million barrels on the assumption that prices are trending up. A refiner who is worried about prices going up wants to secure barrels of oil in the future, so they buy 1,000 contracts representing a contract unit of 1,000 barrels, each for a total of one million barrels.
The refiner and the producer get to talking and they realize that a) they are both bullish on the price of oil and b) they can switch positions to fulfill each other’s needs. They agree to a price and delivery date in the future where the producer hands over the physical oil to the refiner—locking in the refiner’s supply—and receives the futures in return, allowing the producer to continue the bullish position on oil prices. This large transaction is registered with the exchange, but it doesn't impact the price of oil because pricing information is not disclosed. So the refiner has closed out a futures position and the producer has opened one.
Advantages of Exchange of Futures for Physical
The obvious question is why not just do the transaction through the market? The answer is simply for the sake of efficiency. Large transactions impact the market as they are executed. This is why large traders sometimes break up transaction over time to reduce the impact of slippage. Doing the exchange for futures outside the market pricing mechanism allows large, offsetting transactions to take place at a decided price. EFP is also used when the market depth is not able to absorb the transaction—for example, a transaction involving thousands of contracts.