Futures Exchanges Shift Rules on Block Trades in Win for Energy Companies
November 02 2016 - 1:16PM
Dow Jones News
By Alexander Osipovich
CME Group Inc. and Intercontinental Exchange Inc. are loosening
their rules on trades that involve large blocks of futures executed
off exchanges.
Block trades are big futures transactions negotiated between two
companies. They are crucial to U.S. energy markets, where a
significant portion of trading in recent years has shifted away
from over-the-counter swaps into block trades. Both are private
deals often agreed over the phone, but in block trades, the two
companies doing the deal allow a futures exchange to step in as a
middleman.
The rule changes being adopted by ICE and CME will allow a
company that is considering doing a block deal to buy or sell
futures in anticipation of the trade -- a practice called
pre-hedging. ICE's change took effect Monday, while CME's rules are
set to shift on Nov. 8. Energy firms say the moves will make it
easier for them to use block trades to protect themselves against
volatile prices.
"The ability to pre-hedge likely will improve liquidity across a
large number of energy futures contracts that are essential hedging
tools for many energy companies," said Alex Holtan, a lawyer at
Sutherland Asbill & Brennan LLP who advises energy companies on
regulation. Liquidity is the ability to put on a trade in a market
without moving the price.
In a scenario where an electric utility approaches a commodity
trading firm to buy a block of natural gas futures, the latter
would find itself "short" natural gas if it agreed to the deal.
In other words, the commodity trading firm would be exposed to
losses if the price of gas increased. Therefore, it might choose to
pre-hedge, or buy natural gas futures to offset that short position
and keep the firm neutral as to whether gas prices go up or
down.
Veterans of the futures market often say block trades are
executed "upstairs," a description that dates back to the era
before electronic trading, since such deals were made outside the
hurly-burly of open-outcry trading pits.
Until now, CME rules would have banned the commodity trading
firm from pre-hedging until the trade had been finalized. ICE
didn't explicitly ban pre-hedging, but many firms shied away from
the practice because it fell into a regulatory gray area. To avoid
sanctions, firms typically waited until immediately after a block
deal was executed to carry out offsetting futures trades.
Energy traders have gotten into trouble for pre-hedging. Last
year, the trading unit of Koch Industries Inc. agreed to pay more
than $100,000 to settle accusations that a trader had pre-hedged a
block trade. The unit, called Koch Supply & Trading, didn't
admit violating the rules. A Koch spokesman declined to
comment.
Starting this week, ICE's U.S. futures exchange allows
pre-hedging of block trades once the two parties believe "in good
faith" that the transaction will be executed. CME is set to adopt a
practically identical rule change next week.
In both cases, the rule changes don't apply to brokers that have
a fiduciary duty to their customers. Brokers that act on knowledge
of customers' incoming orders and trade against them can be
punished for front running.
Block trades are an exception to standard futures regulations
that require trades to be executed in the open markets where other
participants can see them. They are subject to limitations such as
minimum sizes, and they must be reported to the exchange typically
within five to 15 minutes after being agreed upon.
Write to Alexander Osipovich at
alexander.osipovich@dowjones.com
(END) Dow Jones Newswires
November 02, 2016 13:01 ET (17:01 GMT)
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