Exchange of Futures for Physical, or EFP, may sound like something reserved for seasoned traders, but at its core, it is a straightforward swap. One party hands over a futures contract, and the other delivers the actual commodity—be it oil, wheat, or gold. This method offers a smoother, more flexible alternative to the formal delivery process and is widely used in industries where physical delivery still matters.
In this blog we will break down how EFP works, why it is used, and where you will see it in action.
Understanding EFP
Simply put, an Exchange of Futures for Physical (EFP) is a sort of transaction in which a futures contract holder exchanges it with a person or party who holds the actual physical commodity, such as gold, wheat, or crude oil.
Think of it this way: your futures contract is like a coupon for a pizza, and your friend already has the pizza. Instead of waiting for the coupon to expire and going through the formal process to claim it, you simply swap the coupon for the pizza right away. Simple, quick, and no extra hassle.
EFP works the same way for major market participants. Instead of going through the official delivery process via the exchange, it allows them to privately negotiate and swap a futures position for the actual physical asset.
How Does it Work?
An Exchange of Futures for Physical (EFP) is like a private trade. A futures contract is an agreement to buy or sell something at a later date. The two parties agree to trade directly with each other instead of waiting for the formal delivery process through the exchange.
Here is what happens in order:
- One party has a long (buy) futures position and the other has a short (sell) position. One person wants to get rid of the contract, and the other person wants the goods.
- They talk about the amount, price, delivery terms, and other details in private, away from the trading floor of the exchange.
- Futures are traded for real goods: The futures positions are closed out, and the agreed-upon commodity is delivered.
- The deal is reported to the exchange. Even though it was made in private, the exchange still needs to be clear and record the deal to make sure everything is legal.
Key Features
Now that we have discussed what an EFP is, what separates it from a standard futures trade? The following are some characteristics that set EFPs apart,
1. Direct swap
Fundamentally, an EFP is simply a transaction in which one party surrenders a futures contract and the other delivers the actual commodity, such as wheat, gold, or oil.
2. The Deal Is Private
EFPs are negotiated privately between two parties, as opposed to standard trades that take place on a public exchange. They agree on terms privately.
3. The Exchange must be notified
The transaction is not confidential, despite taking place in the background. After everything has been decided upon, it is reported to the exchange, making it official.
4. Customise the Deal
What’s amazing about EFPs? Standard terms do not have to apply to you. Whatever works best, how much, where, when, and so forth, can be decided upon by the two parties.
5. Usually carried out by the major players
Casual traders are not the target audience for EFPs. Producers, manufacturers, and large organisations that need to move real goods or adjust their positions are more likely to use them.
Why do Traders use EFP?
You may be asking yourself, “Why put in all this work for a private swap when you can just continue trading futures normally?” EFP is simply much more convenient for many traders and businesses. They prefer it for the following reasons:
1. Avoid formal delivery processes
Futures traders occasionally do not wish to go through the entire formal delivery process through the exchange. They can get right to the point with an EFP, one party receives the goods, and the other party terminates the agreement.
2. Convert futures into physical commodities when needed.
Suppose a business used a futures contract to protect itself from fluctuations in wheat prices. EFP allows them to exchange that paper contract for the actual wheat now that they are in actual need of it. If they already have the wheat, they can also convert it into a futures position.
3. Choose delivery time, place, and quantity.
Where, when, and how much are all predetermined for standard exchange deliveries. EFP, however, gives both sides the opportunity to discuss what suits them best. Whatever works best for them, they can choose the delivery location, time, and amount.
4. Adjust positions privately without impacting the market.
EFPs are frequently used by large traders to adjust their positions or hedges without causing a stir in the open market. These transactions don’t affect prices or attract undue attention because they take place in private.
5. Maintain discretion for large or sensitive trades.
Not everyone wants the public trading screen to display their moves. EFPs provide some privacy because they are conducted behind the scenes, which is particularly helpful for large trades or delicate transactions.
Where are EFPs commonly used?
People use EFPs most often in markets where physical delivery is still important, like:
- The markets for crude oil and energy
- Gold, Silver, and Copper
- Agricultural Goods (Wheat, Corn, Soybean)
- Money and Financial Futures
Real World Examples
Let us look at an example from the market for crude oil.
- A refinery has bought futures for crude oil, but it now needs the actual crude oil to process at its plant.
- A producer or supplier with the opposite short futures position wants to get out of futures and deliver real oil.
- They come to an agreement on an EFP deal, in which they trade and the other party exchanges their futures positions for the same amount of crude oil.
- The oil is delivered to the refinery, and the futures positions are closed.
- EFPs are often used by companies that make, refine, or trade commodities to manage their exposure to real-world supply and price changes.
Regulatory & Exchange Needs
- EFPs require that a futures contract be exchanged for actual goods. It must be a legitimate business transaction; you cannot simply act as though you are trading something for show.
- The transaction must be reported to the exchange (such as CME, ICE, or MCX in India) after both parties have approved the swap. In this manner, the exchange can resolve it and ensure that everything is legal.
- The quantity, quality, and product type of the physical goods being exchanged should match those specified in the futures contract. A futures contract for 1,000 barrels of oil cannot be exchanged for 700 barrels.
- In the event that regulators wish to review the transaction later, the parties involved must maintain accurate records of the transaction, including the terms, the person they traded with, and the proof of delivery.
- Not all contracts in the futures market qualify for an EFP. Specific guidelines govern which contracts, usually those that are physically settled.
Conclusion
Exchange of Futures for Physical (EFP) may initially appear to be one of those jargon-heavy financial terms meant for experts. Once you know the basics, though, it is just a clever means for traders to exchange a futures contract for actual commodities such as wheat, gold, or oil.
Big players who deal in tangible goods and want greater control over delivery schedules of assets are the ones who use it the most. They negotiate terms directly with the other party, bypass the formal process, and keep transactions smooth.
Frequently Answered Questions (FAQs)
Can I use EFP as a small investor?
No. EFPs are mainly designed for large traders and organizations that deal in substantial futures positions or need the actual delivery of the underlying commodity.
Is EFP secure and legal?
Completely legal! All that is required to make it official is to report it to the exchange.
What distinguishes EFP from standard futures delivery?
EFP allows both parties to customise the deal according to their terms. Strict exchange regulations apply to regular futures deliveries.
What is being traded in reality?
The real commodity is delivered by one party while the other forfeits a futures contract.
Where does an EFP transaction take place?
Although it is a private agreement between two parties, the exchange is informed once it has been reached.
