By Turnkey Trading Partners:

An increasing number of Introducing Brokers (“IB”) are entering the block futures space. A surprising number of these firms don’t have a strong understanding of their obligations when getting started. What are block futures? What is required to get set up to execute these orders? What compliance obligations are there for this space? Turnkey takes a look at these questions and more in this month’s feature article.

What are Block Futures?

Simply put a block trade is a large privately negotiated transaction for futures contracts which fall under the oversight and regulation of the Commodity Futures Trading Commission (“CFTC”). Block trades are also referred to as Block Futures or in some cases “Cleared Swaps”. These transactions are not swaps under CFTC regulations. Rather they are referred to as swaps based on how they were marketed and transacted prior to Dodd Frank.

The specific size that qualifies as a “block” may vary depending upon the market and exchange rules where the block is traded. Block trades are however typically much larger than standard futures contract sizes.  For example, CME Group offers block trades in products on the following exchanges: CME, CBOT, NYMEX, and COMEX. ICE Futures US offers a comprehensive block trade FAQ here.

Block trades are also privately negotiated. This makes them unique relative to traditional screen traded commodity futures contracts. They are considered over-the-counter (“OTC”) in this regard as the two parties to a block transaction must independently agree on both price and volume. Unlike traditional futures trades which are executed via a central order book, block trades are arranged directly most often by a broker who must be registered with the CFTC and a member of the National Futures Association (“NFA”) as an IB.

Due to the large size of block trades transactions in this space they have an outsized impact on the underlying futures market. Commercial buyers and sellers of commodity futures often utilize blocks to mitigate the immediate price impact which may occur if such large volume were to be placed into a central order book at one time. Brokers working within this sector must have strong institutional relationships. A great deal of trust is required to broker blocks as the stakes are high given the significant volumes transacted in this space.

Who Can Enter into A Block Trade?

Introducing brokers within the block futures industry typically do not assist customers to open an account with a Futures Commission Merchant (“FCM”). In most instances commercial end users of block futures already have in place a relationship with a clearing firm. In addition to this, in order to transact in block trades customers must meet certain eligibility requirements. Of particular note is that all block futures transactions must be negotiated between parties that meet the definition of an eligible contract participant or (“ECP”).

Briefly, an ECP is an entity or individual that meets certain financial or professional qualifications which are greater than a typical retail investor. Block trades are only available to ECPs to ensure that only sophisticated and financially suitable market participants enter into these highly complex and potentially higher risk transactions. As a rule, to be deemed an ECP typically a customer must have at least $10 million in assets. This threshold can be lower for certain types of entities or when using block trades for bona-fide hedging purposes. To learn more about ECP qualifications please read further here.

Account Opening Obligations

Since customers transacting in block trades typically have a relationship in place with an FCM, the account opening process is usually easier. Introducing Brokers are required to follow NFA Compliance Rule 2-30 as applicable. Rule 2-30 however is typically referenced for retail brokerage as many of its provisions do not apply to large commercial accounts that qualify as ECPs. While this is the case certain elements of NFA Rule 2-30 and other NFA membership obligations will still apply.

At a minimum, the following information must be obtained and kept on file by IB’s intending to broker block trades:

  • Customer name
  • Customer address and contact information
  • Transactional contact information (billing, confirms, compliance, brokerage etc.)
  • Business identifying info (LEI,CICI,SEF #, Tax ID, FCM Name and Account etc.)
  • Authorized traders and broker contact information
  • Fee schedule and terms
  • Conflict of interest disclosure as applicable
  • ECP qualification verification
  • NFA Bylaw 1101 Attestation/Qualification

Many of an introducing broker’s account opening obligations with respect to Anti-Money Laundering (“AML”) are not applicable when executing block trades. In fact, the Financial Crimes Enforcement Network (“FINCEN”) published guidance in this area specific to execution and give-up business in this area. Specifically, interested parties should consider FIN-2007-G001 for more information. The CFTC has also published a position on this type of business. Specifically, CFTC letter No 19-18 from July 22, 2019 should be revisited by IB’s working in this sector.

Many IBs are mistakenly under the impression that when conducting OTC business, such as block trading, no obligations exist for account opening. This is simply not true. Turnkey has assisted dozens of firms to clean up their onboarding process for this type of business. Firms struggling or unclear of their obligations in this area should feel free to contact Turnkey today for assistance.

Reporting and Record Keeping Obligations

Brokering block trades can be very lucrative, it is however a very difficult business. Compliance obligations for account opening and AML may be reduced in this area of the market. On the other hand, supervision and record keeping obligations for OTC business are immense. IBs intending to broker either block trades or swaps which are privately negotiated must be well aware of their obligations.

When brokering block trades, the various participating exchanges have rules which apply to this type of negotiated transaction. Of particular concern is the brokers obligation to report block transactions to the exchange within a specified period of time after they occur. Block trade reporting is monitored very closely by regulated futures exchanges and is frequently audited. Introducing brokers that are not familiar with the trade reporting process should contact Turnkey for assistance in developing best practice processes.

In addition to block trade reporting, record keeping obligations for brokers executing block futures transactions are typically higher than other registration categories. Turnkey has written about electronic communication record keeping obligations in the past. We have also written about trade reconstruction audits. For those who are unfamiliar with these obligations please review the aforementioned articles for more information. Firms struggling with electronic communication, voice, chat, or text message record keeping obligations should also consider Turnkey’s electronic communication supervision offerings.

Introducing brokers working to execute OTC transactions whether blocking trades, negotiating swaps, or brokering physical commodities should consider this article in detail. Turnkey stands available for any questions or outsourced support needs you may have.