Fragmentation and complementarity: The case of EFPs

✍ Scribed by Sharon Brown-Hruska; Paul A. Laux

• Publisher: John Wiley and Sons
• Year: 2002
• Tongue: English
• Weight: 220 KB
• Volume: 22
• Category: Article
• ISSN: 0270-7314
• DOI: 10.1002/fut.10029

✦ Synopsis

Abstract

With the proliferation of alternative markets, concerns have arisen that they may induce lower liquidity on
centralized exchanges. In futures markets, the use of an alternative trading mechanism known as exchange of
futures for physicals (EFPs) has increased sharply in recent years. EFPs provide a means to obtain
futures positions, coupled with offsetting cash positions, away from the centralized exchange. Traders use EFPs
to ensure a desired price on complex packages of trades, thus avoiding the transactional risk
(slippage) that is inherent in the centralized market. Theoretical analysis establishes that any
detrimental effects of fragmenting the centralized market can be offset by traders' knowledge of another
opportunity to trade without transactional risk. If EFPs attract more risk‐bearing capacity, there could
even be a net benefit to the central market. An empirical analysis suggests that EFP trading is motivated by
transactional risk because it represents a larger portion of total trading during periods of unusually high
volatility when slippage is apt to be more of a problem. Consistent with the notion that alternative markets can
be complementary to centralized exchanges, we find that EFP trading is not associated with reductions in market
quality and may act as an outlet for extra volume when markets are under the most stress. © 2002 Wiley
Periodicals, Inc. Jrl Fut Mark 22:697–727, 2002