Block Trades, EFRPs And Assorted Other Trade Practice Issues: A Practical Guide Of Current Status

• Published date: 27 July 2022
• Subject Matter: Finance and Banking, International Law, Financial Services, Commodities/Derivatives/Stock Exchanges, International Trade & Investment
• Law Firm: Katten Muchin Rosenman LLP
• Author: Gary DeWaal, Carl E. Kennedy, Stephen R. Morris and Alexander C. Kim

With some frequency, Katten attorneys field questions from clients about exchange rules on off-exchange execution of futures and options on futures.¹ This Advisory provides a high-level overview on this topic in connection with four principal derivatives exchange organizations: Chicago Mercantile Exchange Group (CME), ICE Futures U.S. (IFUS), ICE Futures Europe (IFEU) and Cboe Futures Exchange (CFE). In addition, it offers some perspective on other futures trade practice issues that have been recent focus areas for US regulators.

Block Trades and EFRPs in Futures

Commodity Futures Trading Commission (CFTC) Rule 1.38 requires futures and options on futures to be executed by "open and competitive methods" - except where transactions are executed in a "noncompetitive" manner in compliance with designated contract market rules specifically providing for such noncompetitive execution.²

Exchange rules provide for two kinds of noncompetitive execution of futures: block trades and exchange of futures for related positions,³ or EFRPs (another type of commonly exchange approved noncompetitive transaction is the so-called "office trade" or "transfer trade" - e.g., transfers of cleared trades from one clearing member to another).

Block Trades⁴

In futures, a block trade:

• is a privately negotiated transaction in an eligible contract that meets certain quantity thresholds (as prescribed under exchange rules);
• is executed apart from the public auction market (that is, not on the central limit order book or in the trading pit or ring);
• cannot be transacted anonymously on an exchange or trading venue, but can be executed on electronic trading facilities - such as the Clearport or ICE Block platforms - which allow counterparties to interact directly;
• must be transacted at a price that is fair and reasonable in light of the size of transaction and comparable prices and sizes in related markets;
• must be submitted to the Exchange once consummated - generally within five to 15 minutes, depending on the contract (for blocks done outside of exchange business hours that clock starts when the exchange reopens).

Exchange for Related Positions⁵

EFRPs involve a privately negotiated futures transaction and the simultaneous execution of an equivalent quantity in a related cash product or OTC derivative instrument corresponding to the asset underlying the exchange contract - that is, an EFRP enables market participants to post a futures contract to the clearing house against a negotiated and executed cash, physical or OTC transaction or agreement.

Generally:

• An EFRP involves two legs: one party to the EFRP is the buyer of the exchange contract and the seller of the related position and the other party is the seller of the Exchange contract and the buyer of the related position.
• The related position component of an EFRP may not be a futures contract or option on a futures contract, a listed equity option or a swap executed on a swaps execution facility or subject to a swap facility's rules.
• EFRPs must be transacted at commercially reasonable prices market participants may be required to demonstrate that EFRPs executed at prices away from the prevailing market were executed for legitimate purposes (that is, not as pretext for moving assets from one account to another without the incurrence of market risk - sometimes referred to as a "money pass").
• The quantity of the related position component must be approximately equivalent to the quantity of the exchange component - although this is not to say quantities need to be identical, since appropriate hedge ratios may be used to establish equivalency. This is often another area that exchange market regulatory staff may scrutinize in inquiries after the fact.
• "Transitory" EFRPs are prohibited - that is the execution of one EFRP may not be contingent upon the execution of another EFRP between the same parties (or the offset solely of one of the legs of the EFRP), resulting in the offset of the related positions without incurrence of material market risk. Some exchanges, however, do permit "immediately offsetting" EFRPs in FX transactions.⁶
• As for block trades, EFRPs must be submitted to the exchange for clearing, as soon as possible following execution (generally the time at which the deal is priced) but no later than end of the day.

Fair and Reasonable Pricing versus Commercially Reasonable Pricing

Fair and Reasonable

Block trades must be transacted at prices that are fair and reasonable, considering (i) the size of the transaction; (ii) the prices and sizes of other transactions in the same contract at the relevant time; (iii) the prices and sizes of transactions in other relevant markets including the underlying cash market and related futures market, at the relevant time; and (iv) the circumstances of the markets or the parties to the block trade. The policy concern underlying the "fair and reasonable" pricing requirement for blocks is that block trade prices are publicly reported to the market (separately from trades done on the order book or in the trading pit or ring).⁷

Commercially Reasonable

By contrast, the pricing standard for EFRPs is that they be transacted at commercially reasonable prices as are mutually agreed to by the parties to the transaction (in most cases, provided that the price conforms with applicable futures price...