Exchange for Risk (EFR) for OTC SPX Options and S&P 500 Futures

OTC SPX option trades are often negotiated in a delta-neutral manner, where the trade involves both an option component (individual leg or a spread) and the associated delta covering component. One way to transact the delta of the option trade is through an OTC synthetic options combo. But another – and perhaps more efficient – way to exchange the associated delta of an OTC SPX options trade is with S&P 500 Index futures. Exchanging futures as the related delta of an OTC index option is permissible as part of the Exchange for Risk (EFR) mechanism at CME and is addressed in CME Rule 538^1.

OTC Index options trades are permitted as the related position component of an EFR transaction involving listed futures – including E-mini S&P 500 index futures – at CME Group. The futures transaction should be approximately equal in size to the notional value of the delta of the OTC Index options trade and in the inverse direction between the two counterparties.

Initially, executing an EFR in lieu of an OTC combo may seem unnecessary. Since the two OTC counterparties would likely already have the necessary ISDA documentation in place, adding an OTC combo may not substantively increase the administrative burden. And while OTC trades could be subject to a 5-day risk margin versus exchange listed futures enjoying 1- or 2-day risk margin treatment, the margin impact will vary across each OTC transaction and is dependent upon whether a dealer is extending credit or collecting initial margin via a Credit Support Annex (CSA). Therefore, one cannot unilaterally claim that utilizing futures as the delta hedge instead of using an OTC combo will introduce margin efficiencies; however, margin efficiencies are possible depending on the construction of a participant’s portfolio. Examining the index option business more holistically may reveal other capital efficiencies presented by trading EFRs. Setting aside any potential margin impact, transacting an EFR instead of an OTC combo as the delta hedge of an index option might improve the capital requirement under which banks and participants must operate.

While the capital requirement for a single trade might be similar, regardless of whether a counterparty uses an OTC synthetic combo or listed E-mini S&P 500 index futures contract to delta hedge, the more efficient trading vehicle changes when one considers the entire book of option combo trades entered into across a disparate group of counterparties over time.

With OTC combos, each options combo stays in the portfolio and factors separately into the capital requirement calculation. Even if the combos net down to insignificant directional risk, the capital requirement continues to scale with the raw notional size of the positions – the combos do not net down across counterparties.

However, if a counterparty uses listed futures at CME, these positions do net out, therefore reducing the associated capital requirement of the portfolio. Further, if the desk is already using listed futures for other risk management purposes, the futures position from the EFR will net against the existing E-mini S&P 500 index futures positions already in place, reducing line items and keeping the overall portfolio tractable and operationally efficient.       

1. Please consult the Market Regulation Advisory Notice associated with EFRP transactions.  The current notice can be found here.