As previously proposed, ICE Futures U.S. updated its block trading Frequently Asked Questions as of today to authorize the pre- or anticipatory hedging of futures and related options block trades by principal counterparties prior to a transaction’s execution under limited circumstance. Parties to a block trade may now “engage in transactions to hedge positions which they believe in good faith will result from the consummation of the block trade which is under negotiation.” (Click here for background on IFUS’s proposal in the article “IFUS and ICE Futures Europe Update Block Trade Guidance” in the June 5, 2016 edition of Bridging the Week.) However, such authority is not available to intermediaries (i.e., agents) that take the opposite side of a customer’s order. If an intermediary takes a customer’s order for a block trade neither it, nor any affiliate may enter into a hedging trade until after the block trade is formally executed. Last week, CME Group also updated its Market Regulation Advisory Notice regarding block trades to parallel IFUS’s new guidance. Absent CFTC objection, CME Group’s proposed guidance will be effective November 8.
Compliance Weeds1: IFUS and CME Group will likely be requested to provide additional clarifications of their new block trade guidance. However, in a nutshell, there seems to be at least three scenarios covered by the exchanges’ new interpretations:
Assume that “A” is an eligible contract participant. It maintains a brokerage relationship with “B,” a registered futures commission merchant. B also maintains a proprietary trading desk, “C.” “D” is an affiliate of B that engages solely in proprietary trading.
- If an employee for D initiates or receives a solicitation from A to enter into a futures or related options block trade, D may pre-hedge its block trade as soon as it reasonably believes in good faith that it will enter into the relevant block trade. D will not be acting as an intermediary (i.e., agent) for A but solely as a counterparty.
- If an employee for B receives a solicitation from A to execute a block trade, and the employee facilitates the execution of the block either by C or D, neither C or D may pre-hedge the block trade. Each entity must wait until the block trade is executed before hedging it. This is because B is acting as an intermediary for A.
- An employee for B receives a solicitation from A to execute a block trade. The employee declines the solicitation; however the employee advises A it may contact C or D directly to execute the block. After receiving a solicitation from A directly, C (which is also part of B) or D may pre-hedge its block trade as soon as it reasonably believes in good faith that it will enter into the relevant block trade. C or D will not be acting as an intermediary for A but solely as a counterparty. B is also not acting as an intermediary for A in this transaction.
Compliance Weeds2: In the United States, block trades are an exception to the CFTC’s requirement that all futures contracts be executed on a derivatives contract market. Block trades may be executed off the marketplace by eligible contract participants subject to CFTC-approved DCM rules. These rules typically state which DCM products are subject to block trades (and sometimes, during which times); minimum thresholds; what constitutes a fair and reasonable price; and reporting requirements. The rules also typically address the use of nonpublic information regarding block trades. Notwithstanding IFUS’s and CME Group’s new guidance, as before, solicited parties to a block trade that decline to enter into the transaction may not trade on such information until after a public report of the relevant transaction. Recently, JSC VTB Bank (VTB), a Russia-based bank, and VTB Capital PLC (VTB Capital), a UK-based bank that is ultimately 94% owned by VTB, were sued by the CFTC for engaging in block trades with each other contrary to CME Group rules because the prices of their block trades were not fair and reasonable. This was despite the block trades' prices reflecting the midpoint between the prevailing bid-ask spread of related swap contracts at the time when relevant Chicago Mercantile Exchange futures contracts were illiquid. (Click here for details in the article, “Futures Block Trades' Prices at Midpoint of Related Swaps Bid-Ask Were Not Fair and Reasonable Says CFTC in Enforcement Action” in the September 25, 2016 edition of Bridging the Week.)