Quick Answer
An exchange for physical (EFP) is a privately negotiated, off-exchange trade that simultaneously swaps a futures position for the matching cash position on opposite sides of the market. It is a permitted exception to open, competitive execution, not an illegal trade, and it must be reported to the exchange for clearing.
Almost every futures trade has to go through the exchange's open, competitive market. The EFP is one of the rare, legitimate exceptions, and the exam wants you to know it is permitted rather than prohibited.
What an EFP Is
An EFP pairs a futures trade with a cash trade between two parties who deal directly with each other.
- Exchange for physical (EFP): a privately negotiated, off-exchange transaction in which two parties simultaneously exchange a futures position for the corresponding cash or physical position, on opposite sides of the market. It is also called "ex-pit" or "against actuals."
- How the two legs move: the party who buys the cash commodity sells the matching futures (transferring the long futures to the other side); the party who sells the cash commodity buys the futures. The physical and the futures move together at a mutually agreed price, on opposite sides.
- Part of a larger family: an EFP is one form of the broader exchange for related position (EFRP) family, which also includes exchange-for-risk and exchange-of-options-for-options transactions.
Why an EFP Is a Permitted Exception
The point that matters most is that an EFP steps outside the normal execution rule on purpose, and that is allowed.
- The normal rule: futures and options on futures must normally be executed openly and competitively on the exchange's central market (the electronic order book).
- The exception: an EFP is one of the few permitted exceptions. The futures leg is not competitively executed on the central order book; it is negotiated privately, away from the exchange.
- Still reported: even though it is privately negotiated, the trade must be reported to the exchange afterward, for clearing and surveillance.
Exam Tip: Gotchas
- An EFP is a permitted exception, not an illegal off-exchange trade. The whole point is that it is a legitimate, reported way to trade the futures leg away from the central market. An answer calling an EFP a prohibited or non-reportable off-exchange deal is wrong.
- An EFP must still be reported to the exchange. Private negotiation does not mean it stays hidden. It clears through the exchange and is subject to surveillance like any other trade.
Who Uses EFPs and Why
EFPs are a hedging tool, which explains why commercials reach for them.
- Hedgers use them to swap positions at once: an EFP lets a commercial move into or out of a futures position and the matching physical position at the same time, at one agreed price, without legging the two markets separately.
- A clean bilateral swap: because both parties agree the price directly, an EFP lets a commercial trade a cash position for a futures position (or the reverse) cleanly. That is why it is a standard hedging tool rather than a speculative one.
Think of it this way: a hedger who wants to switch a cash position into a futures position (or back) would normally have to make two separate trades and hope the prices line up. An EFP lets both parties shake hands on one price and swap the two positions in a single move, no chasing two markets at once.