By Alexander Osipovich

CME Group Inc. and Intercontinental Exchange Inc. are loosening their rules on trades that involve large blocks of futures executed off exchanges.

Block trades are big futures transactions negotiated between two companies. They are crucial to U.S. energy markets, where a significant portion of trading in recent years has shifted away from over-the-counter swaps into block trades. Both are private deals often agreed over the phone, but in block trades, the two companies doing the deal allow a futures exchange to step in as a middleman.

The rule changes being adopted by ICE and CME will allow a company that is considering doing a block deal to buy or sell futures in anticipation of the trade -- a practice called pre-hedging. ICE's change took effect Monday, while CME's rules are set to shift on Nov. 8. Energy firms say the moves will make it easier for them to use block trades to protect themselves against volatile prices.

"The ability to pre-hedge likely will improve liquidity across a large number of energy futures contracts that are essential hedging tools for many energy companies," said Alex Holtan, a lawyer at Sutherland Asbill & Brennan LLP who advises energy companies on regulation. Liquidity is the ability to put on a trade in a market without moving the price.

In a scenario where an electric utility approaches a commodity trading firm to buy a block of natural gas futures, the latter would find itself "short" natural gas if it agreed to the deal.

In other words, the commodity trading firmwould be exposed to losses if the price of gas increased. Therefore, it might choose to pre-hedge, or buy natural gas futures to offset that short position and keep the firm neutral as to whether gas prices go up or down.

Veterans of the futures market often say block trades are executed "upstairs," a description that dates back to the era before electronic trading, since such deals were made outside the hurly-burly of open-outcry trading pits.

Until now, CME rules would have banned the commodity trading firm from pre-hedging until the trade had been finalized. ICE didn't explicitly ban pre-hedging, but many firms shied away from the practice because it fell into a regulatory gray area. To avoid sanctions, firms typically waited until immediately after a block deal was executed to carry out offsetting futures trades.

Energy traders have gotten into trouble for pre-hedging. Last year, the trading unit of Koch Industries Inc. agreed to pay more than $100,000 to settle accusations that a trader had pre-hedged a block trade. The unit, called Koch Supply & Trading, didn't admit violating the rules. A Koch spokesman declined to comment.

Starting this week, ICE's U.S. futures exchange allows pre-hedging of block trades once the two parties believe "in good faith" that the transaction will be executed. CME is set to adopt a practically identical rule change next week.

In both cases, the rule changes don't apply to brokers that have a fiduciary duty to their customers. Brokers that act on knowledge of customers' incoming orders and trade against them can be punished for front running.

Block trades are an exception to standard futures regulations that require trades to be executed in the open markets where other participants can see them. They are subject to limitations such as minimum sizes, and they must be reported to the exchange typically within five to 15 minutes after being agreed upon.

Write to Alexander Osipovich at alexander.osipovich@dowjones.com

(END) Dow Jones Newswires

November 02, 2016 13:01 ET (17:01 GMT)

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