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Exchange for Risk (EFRs)
An EFR is a transaction whereby two parties enter into an agreement in which one party purchases (sells) an over-the-counter derivative instrument and simultaneously sells (buys) a corresponding futures contract and the other party sells (buys) the over-the-counter derivative instrument and simultaneously purchases (sells) the corresponding futures contract.
General reasons for the use of EFRs
- An EFR transaction provides for quick and efficient execution of a futures transaction. Since the parties to an EFR transaction have to be the same parties to the OTC transaction, the timing and price are agreed upon without moving the market or being affected by intraday market volatility.
- EFR transactions can facilitate varying size futures transactions at a single price. An EFR can be transacted in any volume that equals the parties' OTC risk exposure at one price. However, all parties to an EFR transaction are subject to MX position limits unless, as bona fide hedgers, they have been granted positions limits exemptions pursuant to Policy C-1 of MX.
- EFR transactions improve the effectiveness of non-traditional hedging programs. Certain transactions which were previously limited to the OTC market are now able to benefit from reduced market exposure and slippage. Also, OTC positions associated with deferred months may be hedged more effectively.
- An EFR transaction enhances financial integrity of OTC hedging programs. Since the futures side of an EFR transaction is a futures contract listed on MX, it has the backing of the Canadian Derivatives Clearing Corporation (CDCC) thus reducing credit default risk.
Pricing the risk component of an EFR
- The risk component of an EFR is priced at such level that is agreed upon by the two parties to the transaction.
- The futures contract leg of an EFR must be priced at a fair and reasonable level in light of factors such as, but not limited to, the size of the EFR transaction, currently traded prices, bid and ask prices in the same contract at the relevant time, volatility, liquidity of the relevant market, and general market conditions prevailing at the time the EFR transaction is executed.
- The risk component of an EFR transaction must be the futures contract underlying interest, a by-product of this underlying interest or a similar product that is reasonably correlated to the futures contract being exchanged. Approved participants who are parties to an EFR transaction may be required to demonstrate that the risk component of such an EFR and the futures contract position are sufficiently correlated to make the transaction acceptable to MX. All correlation requirements are described further below.
- Also, the number of futures contracts exchanged must be approximately equivalent to the quantity or value of the cash market position being exchanged in the context of an EFR. Approved participants that are parties to an EFR transaction may be required to demonstrate such equivalency.
Acceptable EFR transactions
In order to have an EFR transaction accepted by MX, the transaction must satisfy the following conditions.
There must be separate but integrally related futures contracts and risk component for an EFR transaction.
The exchange transaction must be done between two separate accounts that must satisfy at least one of the following criteria:
- Accounts have different beneficial ownership.
- Accounts have the same beneficial ownership but are under separate control.
- Accounts are under a common control but involve separate legal entities which may or may not have the same beneficial ownership.
If the parties to an EFR transaction involve the same legal entity, same beneficial owner or separate legal entities under common control, the approved participant (or the parties themselves) must be able to demonstrate that the EFR transaction is a legitimate arm's length transaction.
The risk component leg of an EFR transaction must provide for a transfer of ownership of the over-the-counter derivative instrument of the EFR and the delivery of this instrument must take place within a reasonable period of time (in accordance with over-the-counter practice).
The relation between the prices of the futures contract and the risk component leg of the EFR transaction and the relevant prices in either market must be established.
If he does not have actual possession of the over-the-counter derivative instrument, in the case of an EFR transaction, before the execution of the transaction, the seller of this over-the-counter derivative instrument must be able to demonstrate his ability to satisfy his delivery obligation.
Permissible over-the-counter derivative instruments for an EFR transaction
As a guideline, the time period used to calculate the correlation coefficient must be based on daily price data for a period of at least six (6) months or, if weekly price data are used, for a period of at least one (1) year.
Please refer to the following list of permissible over-the-counter derivative instruments when effecting an EFR transaction:
|Bond futures||Short-term interest rate futures||Index futures /
|Vanilla interest rate swaps||X||X|
|Equity and index swaps||X|
|Commodity swaps or forwards||X|
|Forward rate agreement (FRAs)||X|
|OTC options and options strategies||X||X||X|
The following outlines the characteristics of OTC derivative instruments that would be acceptable for EFR transaction purposes.
- The standard plain vanilla OTC swap is written under the terms of an ISDA® Master Agreement and provides for regular fixed rate payments against regular floating rate payments.
- All swap payments must be denominated in the currency of a G7 member country.
- The OTC interest rate swap must be reasonably correlated with an R = 0.70 or greater so that the futures contract is a suitable instrument for hedging the OTC derivative instrument transactions. As a guideline, the time period used to calculate the correlation must be based on daily price data for a period of at least six (6) months or, if weekly price data are used, for a period of at least one (1) year.
Equities and indices
- The standard plain vanilla OTC swap is written under the terms of an ISDA® Master Agreement and provides for regular fixed rate payments or regular floating rate payments against the positive or negative performance of a basket of securities or a stock index.
- All swap payments must be denominated in the currency of a G7 member country.
- The OTC equity or index swap must be reasonably correlated with an R = 0.90 or greater so that the futures contract is a suitable instrument for hedging the OTC derivative instrument transaction. As a guideline, the time period used to calculate the correlation must be based on daily price data for a period of at least six (6) months or, if weekly price data are used, for a period of at least one (1) year.
Swaps or forwards on commodities
- The OTC commodity swap or forward is written under the terms of an ISDA® Master Agreement.
- The OTC commodity swap or forward must be reasonably correlated with an R = 0.80 or greater so that the futures contract is a suitable instrument for hedging the OTC derivative instrument transaction. As a guideline, the time period used to calculate the correlation must be based on daily price data for a period of at least six (6) months or, if weekly price data are used, for a period of at least one (1) year.
Forward rate agreements (FRAs)
- The conventional FRA is written under the terms of an ISDA® Master Agreement.
- The interest rate is predetermined.
- The start/end date is agreed.
- The conventional FRA has a defined interest (repo) rate.
OTC options and OTC option strategies
- Any individual or combination of OTC equity or stock index option positions can form the risk transaction component of an EFR transaction against any of MX's stock index or single stock futures contracts.
- Any individual or combination of OTC bond, interest rate swap or FRA options (e.g. caps, floors and collars) can form the risk component of an EFR transaction against any of MX's interest rate futures contracts.
Bonds (as part of the OTC leg) used in an EFR transaction must have the following characteristics:
- The coupon rate must be fixed.
- Bonds are defined as bullet maturity issues (a coupon paying bond with no repayment of principal until maturity)
- Bonds have no embedded optionality or early redemption features.
- An ISIN code is required.
- The principal amount is fixed.
- Bonds are denominated in the currency of a G7 member country.
Stock baskets used in an EFR transaction must have the following characteristics:
- They must be reasonably correlated to the index underlying the futures contract with an R = 0.90 or greater and the time period used to calculate the correlation must be based on daily price data for a period of at least six (6) months or, if weekly price data is used, for a period of at least one (1) year.
- They represent at least 50% of the weight of the index underlying the futures contract or include at least 50% of the stocks comprised in the index underlying the futures contract.
- The have a notional value equivalent to the value of the futures contract component of the EFR transaction.
- Exchange-traded funds (ETFs) are acceptable provided that they mirror stock index products traded on MX.
Reporting an EFR transaction to MX
To report an EFR transaction, the approved participant for either the seller or the buyer must complete and submit MX's Special Terms Transaction Reporting Form (STTRF). If the approved participant is acting for both the seller and buyer, the STTRF goes directly to the Market Operations Department (MOD) for approval and subsequent input into SAM (the Montréal Automated System). If not, the approved participant for the other party then validates, completes that which concerns them and approves the STTRF, at which point it is transmitted to the MOD.
For an EFR executed before the close of the relevant contract's trading session, the STTRF must be submitted immediately upon the execution of the transaction. For an EFR executed after the close, the STTRF must be submitted no later than 10:00 a.m. (Montreal time) on the next trading day.
If the STTRF is not fully and accurately completed, it will be refused by the MOD and the approved participant who completed it will need to amend and resubmit a correctly completed STTRF. The second approved participant must then validate and approve the revised STTRF, at which point it is once again transmitted to the MOD.
Once the correctly completed STTRF has been received, the MOD will validate the transaction. MX has the discretion to refuse any such transaction, should it deem that the transaction is not in compliance with the requirements of article 6.208 of the Rules, or of the related procedures. In case of refusal, the MOD will ensure that the approved participants involved in the EFR transaction are promptly informed of such refusal and of the reasons for it.
Once an EFR has been validated and entered into SAM by the MOD, MX will disseminate the following information on its Web page Transaction Report:
- Date and time of transaction
- Product description (code)
- Contract month(s)
- Volume of the transaction, in contracts
- Transaction price
Trade validation and market dissemination by MX of an EFR transaction will not preclude MX from initiating any investigation and, as the case may be, disciplinary procedures in the event that the transaction is subsequently found to have been made other than in accordance with the requirements of article 6.208 of the Rules, or of the related procedures.
Audit trail requirements EFR transactions
Approved participants who enter into an EFR transaction must maintain all documents relevant to the futures contracts as well as to the corresponding over-the-counter derivative instrument transactions and must be able to promptly provide copies of such documents to the Regulatory Division of MX upon request. Documents that may be requested include, but are not limited to, the following:
- Futures contracts' order tickets;
- Futures contracts' account statements;
- Documentation customarily generated in accordance with the over-the-counter or other relevant market practices such as cash account statements, trade confirmation statements, ISDA® Master Agreements or other documents of title.
- Third party documentation to support proof of payment or allowing to verify that the ownership title of the related over-the-counter derivative instrument position was transferred from the seller to the buyer. This may include, but is not limited to cancel checks, bank statements; cash account statements and cash instruments clearing corporation documents (e.g.: CDS Depository and Clearing Services Inc.).
All futures contracts order tickets must clearly indicate the time of execution of the EFR transactions.
For more EFR information, please contact our Market Monitoring Department at 1-888-693-6366.