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| Exchange of Futures for Swaps (EFS) |
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An exchange of futures for swaps (EFS) transaction works similarly to exchange of futures for physicals (EFP) transactions, long used by Exchange market participants as an additional instrument to add flexibility to their trading and risk management portfolios.
An EFS allows market participants to exchange a position in the Henry Hub natural gas futures contract for a cash-settled position instead of physical gas. An EFS also gives market participants the ability to liquidate a swaps position in a market which may have limited liquidity. As has been evident from recent industry headlines, it can be extremely risky to transact business over-the-counter (OTC) no matter how well established the counterparty, and one of the principal advantages of trading on the Exchange is the absorption of counterparty risk by the clearinghouse.
The parties to an EFS are allowed to privately negotiate the execution of an OTC swap and related futures transaction on their own pricing terms. The transaction must involve approximately equal but opposite side-of-market quantities of futures and swap exposures in the same or related commodities.
EFS transactions are permitted until two hours after trading terminates in the underlying Henry Hub natural gas futures contract. There is an Exchange fee of $2.50 per side for each EFS transaction.
The clearing member representing each party is responsible to notify the Exchange of the amount and type of futures contracts involved, the price at which the futures transaction should be cleared, and the identity of the parties involved.
An EFS allows market participants involved in the transaction to liquidate, initiate, and transfer futures market positions between them. For example:
- A natural gas marketer buys a swap fixing his cost of gas.
- A swaps dealer buys NYMEX Division natural gas futures to hedge his short position related to the swap.
- At some point in the future:
* The marketer prefers to acquire a position in the natural gas futures market because the liquidity of the futures market allows him to liquidate his position at any time. Using EFS also enables a party who is at his credit limits with OTC counterparties to free his credit lines by moving his positions onto the Exchange.
- The parties, by executing an EFS, liquidate their swap exposure and create futures positions. In this example, the dealer ends up flat and the marketer assumes the open interest obligation created when the dealer hedge the original swap.
The EFS can also be used to liquidate a hedge. A natural gas marketer who buys natural gas for resale at a fixed price would fix his purchase price through a long swaps position, hedging the obligation by going short an equivalent number of futures contracts on the Exchange.
Likewise, a gas marketer who sells gas to a customer at a fixed price would hedge his commitment with an equivalent long futures contract.
When trading terminates in the futures contracts at the end of the month, both marketers want to offset their swaps and futures positions at the final settlement price without incurring other obligations.
The marketers seek each other out where they exchange futures and swaps, in effect offsetting their respective market positions while preserving the desired profit margin they had originally hedged. A summary of the hedge transaction follows:
Hedge example:
Marketer No.1 agrees to supply gas to a customer for a fixed price of $3 per mmBtu, and sells a swap that obligates him to supply gas at that price. He then hedges this position by buying the equivalent number of futures contracts at the prevailing price, $2.98 per mmBtu, locking in a profit of 2¢ per mmBtu.
Independently, Marketer No. 2 agrees to buy a wellhead producer's gas for $2.98 per mmBtu, which he then arranges to sell for $3, or a 2¢ profit. He fixes his cost by entering into a long swaps position for $2.98, and hedges with a short futures position for the current price of $3 per mmBtu, yielding a 2¢ profit.
Both marketers want to liquidate the hedges at the end-of-the-month natural gas settlement price on the Exchange.
On the last day of trading, natural gas futures settle at $3.05 per mmBtu.
A broker brings the two parties together: Marketer No. 1, with his short swap and long futures position, and Marketer No. 2 with his long swap and short futures position. The two parties post their EFS to the Exchange, effectively exchanging positions.
Marketer No. 1, with a short $3 swap, effectively assumes the other party's long swap at $3.05, incurring a loss of 5¢. At the same time, his long futures position, opened at $2.98, is exchanged for the other parties short futures position at $3.05, for a 7¢ gain, leaving a net profit of 2¢, the desired margin.
Marketer No. 2, with a long swap purchased at $2.98, assumes the short swap at the settlement, $3.05, generating a 7¢ gain, while his short futures position, sold at $3, is exchanged for the other parties long futures position at $3.05, incurring a 5¢ loss, for a net margin of 2¢, the original position.
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