The 100-ounce Gold futures contract listed on the COMEX in New York
can be traded in OTC market through which the contract can be “settled” with
anything that resembles the underlying asset, for example gold recorded as
eligible inventory in COMEX approved depositories.
Make sure you’ve read GOFO
And The Gold Wholesale Market before continuing.
It’s widely discussed COMEX gold futures contracts (GC) can only be physically
delivered with gold recorded as registered
inventory in COMEX approved depositories, which currently stands at
multi year lows. In the same spirit it’s discussed the ratio between the open
interest and registered inventory is at an all time high. I would say this is
technically true. However, essential to mention is that the COMEX facilitates
a mechanism through which trading in GC does not have to be “executed openly
and competitively on the Exchange”. Effectively, “settlement” of gold
futures contracts can be negotiated in the Over The
Counter (OTC) market, at a different price than floats on the
Exchange, and executed with anything that resembles the underlying asset;
example given, eligible inventory. This settlement in the OTC market
then circumvents normal physical delivery. In my opinion this insight is
significant for our approach to COMEX trading.
Conventionally COMEX gold
futures contracts are traded “on the Exchange” through CME’s electronic
trading platform Globex
or through the old fashion way of Open Outcry.
Roughly 95 % of total GC trading volume is executed on the Exchange. Market
takers can choose to sell short (or respectively buy long)
GC contracts by submitting bid (ask) quotes at the Exchange, in order to make
physical delivery (take delivery) of gold at a fixed date in the future, or
for hedging or speculative purposes. If one has no interest in making
(taking) delivery the short (long) position must be closed or rolled before
delivery date is reached. When traders open new positions (short or long) the
open interest is increased, when traders take opposite positions to existing
positions they hold, or when physical delivery is made, positions are closed
and the open interest is decreased.
The mechanism through which GC contracts can be traded in the OTC market
is called Exchange
For Physical (EFP). EFP can be seen as a forward swap whereby a
futures contract is opened combined with the reverse spot trade. I will
try to describe this phenomenon to the best of my abilities, supported by
quotes taken from official documents by CME Group (of which the COMEX is a
subsidiary). The sources that I used for this post are The
CME Group Risk Management Handbook, CME’s Market
Regulation Advisory Notice RA1311-5R, The
CME website, CME’s helpdesk (phone and email), the LBMA OTC
Guide and The
Gold Market by Grabbe.
To understand EFP trading in the OTC market and how it can increase or
decrease the open interest we must start by establishing some
nomenclature. All off-exchange negotiated trading in CME’s
contracts is what is referred to as Ex-Pit
trading or Privately
Negotiated Transactions (PNT). Ex-pit trades and PNTs can be
subdivided in more specific types of which we will only discuss Exchange
Of Futures For Related positions (EFRP) and EFP, as the rest is
insignificant for now. From The CME Group Risk Management Handbook we can
read:
EX-PIT TRADING
… there are some circumstances in which a privately negotiated or
‘‘ex-pit’’ trade may be warranted. The term ex-pit trade refers to any
transaction that is executed on a noncompetitive basis and outside of a
traditional open outcry or electronic trading environment. The several
varieties of ex-pit transactions serve slightly different purposes and may be
subject to somewhat different rules. These transactions are known by a
variety of names including exchange for physicals (EFPs), exchange for risk
(EFRs), block trades, and cleared-only, or ClearPort, contracts. Whatever the
nomenclature, they may collectively be referred to as ‘‘ex-pit’’
transactions.
…Although traditionalists in the futures industry are accustomed to
referring to EFPs, … Over the years, these practices have been adopted in the
context of futures markets and generalized as exchange of futures for related
positions (EFRPs).
Let’s say EFP is a form of an EFRP (which both are types of ex-pit/PNTs).
On the homepage
of GC at the CME website we can see it’s disclosed this contract can be
traded off-exchange (OTC) through CME
ClearPort.
What is ClearPort? Again, we’ll read a little in The CME Group Risk
Management Handbook to understand:
CME ClearPort should not be thought of as a trading platform or as a
clearing service. Rather it is best understood as an Internet or web-based
gateway. The CME ClearPort system currently provides traders a wide degree of
latitude to conduct transactions in literally hundreds of energy, metals, and
other contracts. These transactions are executed off exchange in a bilateral
transaction directly between buyer and seller. This is much like the
execution of any other OTC derivatives contract.
… By submitting OTC transactions to the CME ClearPort process, one enjoys
the financial sureties afforded by the Clearing House.
Ok, so ClearPort is a gateway through which market participants can use
EFP to trade GC contracts OTC style.
For an overview of what was just discussed, let’s head over to CME’s
website and look at the volume
page of GC. We can see PNT/ClearPort volume (framed in red in
the screen shot below) is the sum of block trades, EFP, EFR, EFS and
TAS, and Total Volume (framed in green in the screen shot below) is
the sum of Globex, Open Outcry and PNT/ ClearPort volume. Have a look at the
headers and the numbers below.
The next step is to understand what EFP is. According to the most recent
formulation by CME Group (Market
Regulation Advisory Notice RA1311-5R, 2014):
An Exchange for Related Position (“EFRP”) transaction involves a privately
negotiated off-exchange execution of an Exchange futures … contract and, on
the opposite side of the market, the simultaneous execution of an equivalent
quantity of the … related product … corresponding to the asset underlying the
Exchange contract.
One party to the EFRP must be the buyer of the Exchange contract and the
seller of (or the holder of the short market exposure associated with) the
related position; the other party to the EFRP must be the seller of the
Exchange contract and the buyer of (or the holder of the long market exposure
associated with) the related position. …
(I will quote from the above paragraph later on.)
The related position component of an EFRP must be the cash commodity
underlying the Exchange contract or a by-product, a related product or an OTC
derivative instrument of such commodity that has a reasonable degree of price
correlation to the commodity underlying the Exchange contract. The related
position component of an EFRP may not be a futures contract or an option on a
futures contract.
Where the related position component of an EFRP is a physical transaction
… the transaction should be submitted for clearing as an EFP transaction
type.
For the sake of simplicity we won’t discuss all varieties of EFP
described by CME Group in the Market Regulation Advisory Notice RA1311-5R,
but only what I believe is the common denominator: a forward swap. In a previous
post I described what a forward swap is, how it’s executed in the London
Bullion Market and that it’s usually referred to in short as a
swap. When a (forward) swap is executed in the futures realm this is
done through EFP, as James Orlin Grabbe wrote
in the late nineties:
While forward gold is traded in the form of swaps, which combines a spot
trade (buy or sell) with the reverse forward trade (sell or buy), gold
futures can be traded in the form of EFPs (exchange for physicals), which
combine a futures trade with the reverse spot trade.
The CME Group Risk Management Handbook (2010) also describes EFP to
be a swap:
Technically, an EFP refers to a transaction in which a futures position is
assumed in juxtaposition to an offsetting … spot transaction.
So, we’ll focus on the swap characteristics of EFP.
In EFP two parties sign a futures contract (short and long) and simultaneously
make a spot transaction (buy and sell). One party sells short the futures
contract and buys spot gold (the spot leg is referred to as the related
position by CME), while the other party buys long the futures contract
and sells the spot related position. EFP trading can increase the
open interest, decrease the open interest or not change it, depending on the
existing GC positions held by both parties before they enter into an EFP
transaction.
Example given how EFP can increase the GC open interest: Suppose two
traders, Mister A and Mister B, have no existing GC positions. Mister A and B
connect through CME ClearPort and privately negotiate to enter into an EFP
transaction. Through EFP Mister A buys long 1 GC (the buyer of the
Exchange contract) and simultaneously sells spot gold (the seller of
… the related position). Mister B sells short the corresponding GC (the
seller of the Exchange contract) and simultaneously buys the
corresponding spot gold (the buyer of … the related position). In
this example the open interest is increased by 1, counted unilaterally, as
both Mister A and B open a new GC position (1 short, 1 long). The movement in
the related position (the spot leg) is irrelevant to the open interest.
Example given how EFP can decrease the GC open interest: Suppose, Mister A
is short 1 GC to be delivered in December 2016 and Mister B is long 1 GC to
be delivered in December 2016. Mister A and B connect through CME ClearPort
and privately negotiate to enter into an EFP transaction. Through EFP Mister
A buys long 1 GC December 2016 (the buyer of the Exchange contract)
and simultaneously sells spot gold (the seller of … the related position).
Mister B sells short 1 GC December 2016 (the seller of the Exchange
contract) and simultaneously buys the spot gold (the buyer of … the
related position). In this example the open interest is decreased by 1,
as the existing positions by Mister A and B before entering into the EFP
transaction have been offset by both taking an opposite futures position
through EFP and simultaneously exchanging spot gold. What happened
is that Mister A and B settled their existing GC December 2016 position
(short and long) through EFP. This settlement can only be performed if both
parties agree in EFP. No short or long GC position can be forced to settle
through EFP.
Naturally, EFP can leave the GC open interest unchanged if either Mister A
or B has an existing position and the other one not before both enter into an
EFP transaction.
Let us move further to the essence of this post. The COMEX publishes
the amount of gold stock in its approved depositories in two categories:
eligible and registered inventory. Factually, gold stock recorded as eligible
or registered is required to respect exactly the same
specifications and are both stored in vaults “within a 150-mile
radius of the City of New York“. The only difference between the two is
that registered gold has a warrant
attached to it. From the COMEX rulebook we can
read:
Eligible metal shall mean all such metal that is acceptable for delivery
against the applicable metal futures contract for which a warrant has not
been issued. Registered metal shall mean an eligible metal for which a
warrant has been issued.
…A warrant shall mean a document of title … demonstrating that the
referenced quantity of the covered metal, stored in the facility referenced
thereon, meets the specifications of the applicable metal futures contract.
Through the conventional process – without OTC trading – GC is physically
delivered with “either one (1) 100
troy ounce bar, or three (3) one (1) kilo bars, … with a weight tolerance of
5% either higher or lower, … [assaying] to a minimum of 995 fineness”,
which is located in a COMEX approved depository in New York and has a warrant
attached to the gold. On the warrant the
serial numbers of the bar(s) are written, and it is this warrant that
changes hands when the gold is delivered from a short to a long. Because
physical delivery is done with warrants, often only registered inventory
is presented by analysts when comparing COMEX gold stock to the open
interest or other economic parameters.
But, as we just learned GC can also be settled through EFP. The punch line
of EFP is that the related position (the spot leg) can be anything that
resembles 100 ounces of gold. Through EFP “the quantity of
the related position component … must be approximately equivalent to the
quantity of the Exchange component”. Therefor, the related position is
allowed to be gold recorded as eligible inventory in New York, but it
can also be Good
Delivery bars or a bag of gold coins located anywhere on this
planet. Yes, CME confirmed to me in black and white the related position in
EFP has no geographical limitations. The physical gold used in EFP for
settlement of GC does not have to be located in New York.
Does CME generally inspect what these related positions are? Well, CME can
ask EFP parties to show their offsetting (/related positions)
accounts. From The CME Group Risk Management Handbook we can read [brackets
added by me]:
The … spot … position that is traded opposite to the futures contract must
be a product that represents a legitimate economic offset.
After the two counterparties consummate the [EFP] transaction, the futures
position is reported to the CH [CME Clearing House] through a clearing member
via electronic systems. The cash position [/related position] continues to be
held in appropriate accounts established by the EFP counterparties and is not
reported to the exchange upon execution. If called on during the course of a
periodic audit, however, clearing members may be required to produce
statements that show the offsetting position was transacted and meets
exchange standards as a valid offsetting position.
What about the price at which EFP is executed? Again, these trades are OTC
so the price is privately negotiated between the EFP participants – and are
not likely to be in line with prevailing prices on CME’s Globex. A CME representative
told me over the phone that EFPs are usually quoted by brokers in dollars
that reflect the difference in price between the spot (related position) and
the futures leg. From the Market Regulation Advisory Notice RA1311-5R we can
read:
EFRPs may be transacted at such commercially reasonable prices as are
mutually agreed upon by the parties to the transaction.
… The price of the Exchange leg of an EFRP transaction is not publicly
reported. EFRP volumes are reported daily, by instrument, on the CME Group
website.
From The CME Group Risk Management Handbook we can read:
An EFP may be transacted at any time and at any price agreed on by the two
counterparties. Two customers may transact an EFRP among themselves provided
that the resulting futures position is subsequently submitted to the CME
Clearing House (CH) through the facilities of a clearing member.
Last but not least; below is a chart showing EFP volume, clearly
this concept is not something unusual. On average 4 % of total daily trading
volume in GC is performed through EFP. If EFP volume is 8,000 a day the lower
bound is that the open interest is decreased by 8,000 contracts, the
upper bound is that the open interest is increased by 8,000 contracts.
This concludes the introduction of EFP. More will be discussed in
forthcoming posts.
Addendum
Btw, this is helpful as wel. From CME:
113102.E. Termination of Trading
No trades in Gold futures deliverable in the current month shall be made
after the third last business day of that month. Any contracts remaining open
after the last trade date must be either:
(A) Settled by delivery which shall take place on any business day
beginning on the first business day of the delivery month or any subsequent
business day of the delivery month, but no later than the last business day
of the delivery month.
(B) Liquidated by means of a bona fide Exchange for Related Position
(“EFRP”) pursuant to Rule 538. An EFRP is permitted in an expired futures
contract until 12:00 p.m. on the business day following termination of
trading in the expired futures contract.