On May 23, the CME is implementing new functionality under its block trade rule permitting dealers to trade “derived blocks” in certain equity index futures contracts. A derived block trade is a block trade the price and quantity of which depends on hedging transactions by the dealer that take place after the block trade has been agreed, but prior to its being submitted to the exchange. Derived block trades are available solely in CME E-mini Select Sector futures and CBOT Dow Jones US Real Estate Index futures, at the existing block trade minimum thresholds applicable to those contracts.
Ordinarily under CME rules a block trade must be submitted to the exchange within 5 or 15 minutes of being “consummated.” Derived blocks are an exception to that rule – a derived block is not required to be submitted to the exchange until 5:45 p.m. (Central Time) on the business day it is agreed and priced.
The derived block functionality introduces nuance to the CME’s existing guidance on pre-hedging. For block trades other than derived blocks, a dealer may (with prior disclosure to its counterparty) engage in pre-hedging or anticipatory hedging of the position that it believes in good faith will result from the consummation of the block trade. However, a dealer that acts as an “intermediary” is prohibited from engaging in such pre-hedging, and may only commence hedging of a position established by a block trade after the block trade has been consummated. As of May 23, a dealer trading derived blocks may commence hedging activity upon having reached agreement with its counterparty on (i) the quantity of futures or the notional value of the block trade (which must meet or exceed the applicable block trade minimum quantity threshold for the contract); (ii) the execution methodology for the dealer’s hedging transactions; (iii) the markets in which the dealer’s hedging transactions will take place; and (iv) the basis (expressed in index points) to be used by the dealer in determining the price of the block trade after the hedging transactions have been concluded.
Permissible hedging vehicles include stock baskets, other cash market instruments such as ETFs, ETNs, and/or equity index futures or options on futures contracts. The hedging vehicles must evidence a reasonable degree of price correlation to the equity index futures product underlying the derived block trade. Permissible execution methodologies governing the execution of the hedges may include VWAP, TWAP, POV, limit price, or other hedge types as determined by the dealer and the client at the time the block trade terms (other than price) are agreed. Hedge methodologies must be identified when submitting the block trade to CME.
If the dealer is unable to execute the full quantity of hedges necessary to support the originally agreed quantity of the block trade, the dealer may, in consultation with its client, elect to submit the block trade (i) at the quantity corresponding to the quantity of hedges executed; or (ii) up to the full quantity originally agreed. If the quantity of hedges does not meet the block trade minimum threshold, the dealer may, with the client’s consent, submit the block trade at any quantity at or in excess of the block trade minimum threshold. Alternatively, the dealer may notify the client that no block trade can be submitted due to the lack of sufficient hedges to meet the block trade minimum quantity threshold. If no block trade is submitted, the dealer must retain a record evidencing that the block trade could not be submitted.
Dealers looking to use the new derived block functionality should fully explain to their clients how the trade works under the CME’s regulatory guidance. It’s important that clients understand going into a derived block trade that there is a risk, assumed by the client, that the trade as originally agreed will not be consummated if the dealer is unable to establish a sufficient hedge. The text of the CME’s regulatory guidance on block trades, including derived block guidance, is available here: https://www.cmegroup.com/rulebook/files/cme-group-Rule-526-pending.pdf