The Exchange of Futures for Physical (EFP)
By Anil Mishra:
The Exchange of Futures for Physical (EFP) is an alternative mechanism that is used to price any commodity whose derivatives trade on Commodity Futures Exchange. This enables participants to exchange their futures positions for a physical position thus separating the pricing from the physical supply.
The EFP trades as a differential between the futures market and the underlying physical market. The value of the differential will reflect the relative value of physical versus the futures at any given time. By transacting an EFP; a physical position is transferred from one participant to another, at the same accepting opposite futures positions. Both participants then advise their brokers to register their transactions with the Commodity Futures Exchange. It is important to note that when EFPs are registered with the exchange the volume is attributed to that trading day price has to be within that days price range but the price is not declared to the market.
EFPs can take place in respect of any contract month in any product listed on commodity exchanges. An EFP can be posted up to 1 hour after the relevant time of cessation of trading of the last day of trading on the Exchange platform.
Advantages of EFP:
Producers: Producers want to sell when the price is high but at that time producer may not have ready delivery hence he is unable to capture that price in physical market but he can capture that price in the futures market by selling the futures on the exchange where delivery becomes due only at future date chosen by the seller if the position remains open on settlement day. He is thus able to capture that high price even without commodity being ready for delivery. Once his produce (Rubber) is ready and he has his known set of buyers who pay premium for his superior quality goods he would not like to deliver the rubber to the exchange because exchange accepts standard FAQ quality and would not pay any premium, whereas his known buyer pays premium for his quality. In that case he exchanges his Sell Futures position with buyer’s opposite Buy Futures position on the exchange and then prices his underlying goods like rubber at the differential to Futures market that they had agreed. Thus final invoice value is arrived. This way he captures the best of both worlds, higher price through exchange and higher premium through his preferred buyer. In this case both are hedgers but they used commodity exchange for price risk management and getting better price without making delivery to the exchange.
Processors: Processors buy on the exchange when exchange price is very low but at that time producer doesn’t have ready delivery or is unwilling to sell at that low price, hence he is unable to capture that price in physical market but he can capture that low price in the futures market by buying the futures where delivery becomes due only if the position remains open on settlement day. Thus he is able to capture that low price. Once his preferred supplier has rubber ready he would buy from his supplier at differential to the exchange price. Differential would be arrived at based on prevailing spot price. Before taking delivery he would now price the contract by giving up his future buy position to the seller who would have taken sell position when the price was high. Thus both of them have squared the position on the exchange and have fulfilled the obligation on the exchange and do not have open position. The producer who had sold the future would now buy the future of his processor client. Thus future positions are being exchanged for the physical transaction.
Win -Win for both buyer and sellers: EFP helps both buyers and sellers benefit because it captures desirable price for both buyers and sellers but at different points in time and then marries them suitably before actual delivery is made.
Freedom from mark to market: When the buyers and sellers have their open position not for the speculation but for hedging even then they have to pay mark to market to the exchange as long as their position remains open. Once they price their contract through EFP they get freedom from paying mark to market even if they have to make or take actual delivery at future dates.
Any grade can be hedged: Since in EFP intention is to hedge to manage the price risk and capture better price, the stakeholders are not bound by the grade specification of the exchange. Any grade or even derivatives of the commodity can be hedged. The pricing for the superior or inferior grade could be adjusted through premium or discount. For example in case of rubber RSS4 is the standard grade on the exchange in India at NMCE. If one wants to hedge RSS3 or RSS1 which are premium grade he could arrive at the price by charging prevailing premium over RSS4. Similarly if one wants to hedge RSS 5 which is inferior grade to RSS4 he may buy at discount to the exchange price. Thus while on exchange only RSS 4 can be delivered through this kind of mechanism any grade can be hedged and traded.
Internationally popular: Internationally EFP is very popular way of trading and risk management between large buyers and large sellers of the commodity. Large multinational buyers and sellers use this method because they originate the commodity from various origins/geographies and sell to their clients all over the world. They are real players of commodity and are involved in the supply chain and do not have intention to give delivery to the exchange or take delivery from the exchange but give delivery only to their clients. They use exchange only to manage the price risk and price their commodity more favourable to them.
Useful even to smaller players: This can be used by smaller players also and many stakeholders who are away from the basis centre of the exchange, hence do not actively participate can use this tool. Through this method of EFP they can hedge any grade and even smaller quantity because NMCE has only 1 MT as a lot size. They can make or take delivery any where since they get freedom from delivery despite being hedgers. EFP was being practiced in India under FMC as regulator. SEBI the new regulator has to review it.