Complementary Markets
36 Pages Posted: 5 May 1999
Date Written: March 1999
Abstract
With the growth of OTC markets, concerns arise that alternative markets remove volume and liquidity from centralized exchanges. This article investigates by examining the exchange-traded futures market and its OTC alternative, Exchange of Futures for Physicals contracts, or EFPs. EFPs provide a means to obtain futures positions, coupled with offsetting cash position(s), off the trading floor. The ability of traders to obtain a desired price on bundled or complex packages of trades helps traders avoid transactional risk associated with pit execution. Analysis of EFPs establishes their effect on the exchange-traded market depends on the level of transparency. Transparent EFP trading improves market quality of the exchange, increasing total volume, increasing liquidity, lowering transactional risk, and lowering hedging costs. If EFP trading can attract more volume to the futures market overall, then market quality is also improved. An empirical analysis confirms that EFP trading is motivated by transactional risk, showing increased levels during periods of increased trading volume and volatility. Consistent with the notion that OTC 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.
JEL Classification: G13, L1
Suggested Citation: Suggested Citation
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