Gold Trading and EFP — What you need to know

Most people who trade gold trade it either through an ETF or futures and probably have never heard the term EFP (which stands for exchange for physical). I’m here to shed some light and tell you what you need to know and why it’s important.

What exactly is EFP?

EFP stands for exchange for physical, which in the context of the gold market means the difference in price between gold spot and gold futures.

There are a lot of different instruments that are tied to the price of gold and it’s a bit tricky to just talk about ‘the price of gold’. Let’s sort out a few things first. Are we talking about the spot price, a gold ETF, or a gold futures contract?

The Spot Price

The spot price of gold is the price of one troy ounce of .999 purity gold. Sounds simple right? Wrong. There are a few different spot prices of gold which depend on the physical location of the gold being sold. Since we are talking about physical gold’s spot price, and because it costs money to move gold there are different prices for physical gold in Zurich, physical gold in London and physical gold in India. For the vast majority of trades done institutionally the prices of spot gold are quoted ‘loco ldn’ and ‘loco zur’ standing for gold in London and Zurich respectively. There also exist markets for gold that has a .9999 purity but this is mostly confined to gold trading in India.

Gold Futures

When the talking heads on Bloomberg or any other financial news channel talk about gold they are often referencing the active gold futures contract. Simple enough. This is traded on the COMEX exchange operated by CME.

Trading Gold and Trading EFP

When you or I trade gold we would usually only have access to an ETF or the futures contract. When banks trade gold they are often trading in the spot market but hedging with gold futures. Now trading one thing and hedging with a similar but not quite exact substitute leaves a basis differential. This basis is actually an additional risk factor to the bank’s trading desk and can be traded itself. This is where gold EFP trading comes into play. Banks will use brokers and other parties to reduce their risk by trading in EFP.

Let’s use an example to illustrate. A bank’s precious metals trading desk takes a 100,000 oz long position from a client who sold to the bank. The bank now has to hedge 100,000 oz of gold spot — the easiest and most liquid way to hedge is through gold futures contracts because the price of gold is too volatile to call up other clients and hedge with spot gold. The trading desk sells 1,000 futures contracts (a standard futures contract is 100 oz of gold) to offset their long 100,000 oz of spot they took in. Now the trading desk is net flat in terms of exposure to gold’s price movement but has exposure of 100,000 oz of gold EFP.

An EFP trade involves swapping a spot position with its specified location (could be loco ldn or loco zur) for an offsetting position in futures. In our example above our trading desk now needs to sell 100,000 oz of spot and buy 1,000 gold futures contracts in order to be truly flat in their risk exposure. Trading desks can go through brokers in order to find counter parties who are willing to trade at the indicated level of EFP.

Not to go into too much detail but EFP can both be positive and negative usually ranging between -1.00 and +1.00 meaning the spot price of gold could range between $1 lower or higher than the price of the corresponding future on a per ounce basis.

Contract Rolls

Because of the fact that gold futures expire consistently and gold spot does not (we will leave bank holding balances at custodial banks for another time) there are periods where gold futures can look like they are behaving erratically with no fundamental cause for change.

Let’s take another example and say a few banks have a combined position of 2.4 million oz of gold spot that they are long and short 24,000 future contracts as an offset. When the futures contract expiry comes the banks will need to flatten out their exposure since they don’t want to be called for delivery (very bad for trading desks). Banks are now buying 24,00 future contracts over a few days and selling spot against it.

If you only trade gold futures, then price action might look strange to you since you are wondering why there is massive pressure on moving gold futures higher off no underlying news! Well now you know!

Not crazy prices

I know a popular trope is to talk about gold conspiracies and while they are often alluring the vast majority of the time the price action of gold can be attributed to a simple EFP imbalance in the market.

EFP is just another market that is intertwined and yet often unseen to the average trader.

Let me know if you have any questions (I intentionally left out some low level details for readability)! And be sure to check out what we are doing at ZeroSum if you liked the article!

 Nothing here should be taken as financial advice, views are the opinion of the writer, please consult your financial adviser on investment strategies suitable for you.

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