Fragmentation and complementarity: The case of EFPs

With the proliferation of alternative markets, concerns have arisen that they may induce lower liquidity on centralized exchanges. In futures markets, the use of an alternative trading mechanism known as exchange of futures for physicals (EFPs) has increased sharply in recent years. EFPs provide a means to obtain futures positions, coupled with offsetting cash positions, away from the centralized exchange. Traders use EFPs to ensure a desired price on complex packages of trades, thus avoiding the transactional risk (slippage) that is inherent in the centralized market. Theoretical analysis establishes that any detrimental effects of fragmenting the centralized market can be offset by traders' knowledge of another opportunity to trade without transactional risk. If EFPs attract more risk‐bearing capacity, there could even be a net benefit to the central market. An empirical analysis suggests that EFP trading is motivated by transactional risk because it represents a larger portion of total trading during periods of unusually high volatility when slippage is apt to be more of a problem. Consistent with the notion that alternative 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. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:697–727, 2002