Security Futures: The New Game in Town
Will Acworth
December 2001
Everyone’s talking about single stock futures, but who’s really going to trade them? Traders, brokers and fund managers say it all depends on liquidity.
In an ideal world, it would work something like this: Take one part stock index future, add two parts common stock, mix in a little liquidity from the options business, and voila! You’ve created the biggest new product complex in the futures industry since the Treasury bond future. In this scenario, professional traders jump into the new market right from the start, quickly generating a healthy flow of activity in a handful of the most volatile names. Hedge funds will be watching closely as the market develops, waiting to see which of the three exchanges emerges with the deepest, most liquid market. Hedge funds, tempted by opportunities for arbitrage, are the next to arrive, but only after the market is deep enough to handle large trades. Volume picks up, open interest reaches a certain level, and then the rest of the crowd comes in—pension funds, mutual funds, maybe even the retail masses.
It’s a beautiful picture, and quite a few firms have staked a great deal of their resources on the belief that it will come true. But getting there won’t be easy. Even the most enthusiastic supporters of security futures say that there are many obstacles ahead.
For some, it’s the lack of details about the products themselves, which is handicapping their efforts to prepare for the launch of trading next spring. For others, it’s the complicated regulatory structure, which combines elements of futures and securities regulations in a way that is costly and confusing to both sides. And for still others, it’s the concern that liquidity will be split among the three exchanges that are planning to list these products, making it that much harder to reach critical mass.
No doubt there will be many institutions that choose to remain on the sidelines, watching and waiting to see how the new products will develop before committing themselves to the new market. But interviews with traders, brokers and money managers from both the securities and futures industries suggest that in the final analysis, the success of security futures is a question of when, and to what degree, rather than if.
The technology stocks in particular look to be the most likely candidates for the first round of contracts, although there are pockets of interest in other sectors as well.
Whichever way the market develops, the futures industry can be sure of one thing––there will be a lot of new faces in the business. Security futures by their very nature will continue the process of convergence among different types of markets, breaking down the walls between stocks, options and futures, and bringing new groups of traders and investors to the futures market. To succeed in this environment, broker-dealers and futures commission merchants will have to be familiar with both worlds. Many already are, and interestingly, they are among the most enthusiastic about the new products.
Why the enthusiasm? The reasons are many, but the most fundamental is the mix of equity and futures characteristics in these products. This creates a number of special challenges on the operations side, many of which have not yet been resolved, but it also means that there are large pools of liquidity in both the securities and futures worlds that can flow into these products. Of course, as with any product launch, much depends on ease of entry and the cost of trading.
Product Design: Still Under Development
All three exchanges that are planning to list security futures have agreed on some of the contract specifications. For single stock futures, the contract size will be 100 shares, and settlement will be through physical delivery. There will be at least 50 contracts listed at the start, possibly as many as 75, and probably with some overlap among the three exchanges. None of the exchanges has identified the target companies and indexes, but there is a consensus that they will parallel the most active names in the stock options market.
A quick look at the volume data points to some likely candidates. Cisco, Intel, Microsoft, IBM, GE, AOL Time Warner, Qualcomm, Oracle, Lucent—the same names come up month after month among the top 10 stock options contracts. However, certain events, such as takeover rumors or a surprise regulatory decision, can push a lesser-known name into the spotlight. The exchanges therefore will want to list a wide range of companies, even if the volume in some stays relatively dormant for awhile.
All three exchanges are planning to clear through the Options Clearing Corp. The Chicago joint venture––recently christened OneChicago––will also clear through the Chicago Mercantile Exchange’s clearinghouse, a gesture to firms that want to remain within the futures world.
There will be some significant differences among these exchanges. Two of the exchanges—the Nasdaq-LIFFE joint venture and the Chicago joint venture—will rely entirely on electronic trading systems, the former using Connect, the latter using both CBOE Direct and Globex. AMEX, on the other hand, will execute trades on its floor, through the traditional open outcry system.
While that would seem to put AMEX at a big disadvantage, the exchange’s officials argue that the flow of trade on their floor will give the new products a strong foundation.
“Our thought is that we can take the pre-existing pool of liquidity on the floor and leverage off that. Being floor-based sets us apart from the others,” said Mike Bickford, a senior vice president in the options department at AMEX who is responsible for security futures.
Another crucial difference will come in market structure. Two of the exchanges—OneChicago and AMEX—will have a specialized class of market makers on hand to ensure continuous bids and offers. AMEX will have specialists obligated to make a two-sided market at all times in the new contracts. OneChicago plans to use a modified version of the CBOE’s designated primary market maker system.
“The end result will be a DPM system of some sort, so that each issue is assigned to a primary market maker. We’re going to follow the equity specialist model in some way, although the final policy has not been decided,” William Rainer, OneChicago’s chairman and CEO, told FI.
NQLX’s market structure, on the other hand, will more resemble a central limit order book, with all bids and offers matched in strict price-time priority and no special privileges for market makers. Robert Fitzsimmons, the exchange’s president and chief operating officer, said NQLX is negotiating with several firms about acting as market makers, but he stressed that unlike in the specialist environment, they will not be able to step ahead of customers and take out a percentage of an order.
The exchanges also differ on “fungibility,” the term used to describe the ability for customers to buy an IBM future on one exchange and sell the same contract on another. This is a vital issue for institutional customers, who fear that once they establish a large position on one exchange, they will not be able to unwind that position at another exchange, even if both exchanges are trading identical contracts.
AMEX and NQLX both support the idea, but OneChicago is adamantly opposed. What’s more, the contracts may not be similar enough for fungibility to happen. AMEX, aiming to make its futures contracts as similar as possible to its existing options business, has set the tick size at a nickel and intends each contract to have four expiration months. NQLX, on the other hand, will have a tick size of one penny and set the contract months at two serial months and five quarters.
“We always support fungibility. It’s good for the customers, for the industry and for the product,” said Robert Fitzsimmons, who ran the futures division at Nomura Securities before joining Nasdaq in 1999. “Unfortunately, one of our competitors is against it, and another competitor…we simply have different contract specs.”
“We support fungibility,” said Bickford. “The last thing this industry needs is three different contracts that don’t merge into each other. We don’t have an enormous number of people coming to us saying, ‘we’re here, ready to do this thing from day one.’”
More than Just Single Stock Futures
NQLX seems to be farther along in the contract selection process than the other two exchanges. It plans to list 50 to 75 contracts on broad and narrow indices as well as individual stocks. The exchange also intends to list a future on QQQ, the exchange-traded fund based on the Nasdaq 100. At first glance it may seem a bit far out to list an SSF on an ETF, but NQLX officials say there are two very good reasons for this contract to be a winner.
First, this instrument, commonly known as the “Q’s”, has become the single most heavily traded equity in the world, surpassing even the biggest tech stocks. Second, futures on the QQQ would have a lower margin than on the instrument itself, especially on the short side.
Fitzsimmons said the “Q’s” have not been approved for security futures, but said his exchange will seek an exemption. He also said NQLX will continue looking to broaden its offerings, and suggested that this will give firms a greater incentive to help his exchange succeed.
“Both the parent organizations are fully electronic exchanges, so we don’t really have the membership history or floor-based constituency that maybe some of our competitors will have to deal with,” he told FI. “We are looking at being much more than a single stock futures exchange. We intend to go beyond that and list other products. Depending on demand, we may go into interest rate futures.”
As for single stock futures, Fitzsimmons declined to be specific, but said his team has a database of historical volatility on more than 500 stocks to help it identify which stocks would work as the base for a futures contract. He added that NQLX is looking for stocks with “unhedgeable risks”, ie., with risks that cannot be hedged in any way but with futures.
The Game Begins, But Where Are the Players?
When the futures industry first began to see a possibility that Congress might lift the ban on single stock futures, many people believed that the greatest potential customer base lay in the retail side of the stock market.
In those days, the stock market was zooming higher, stock ownership was becoming more widespread, and retail investors were becoming increasingly confident about managing their investments themselves.
Much has changed since then. The bull market is over, many small investors have suffered big losses, and trading activity is way down. As a result, there’s now less agreement on the potential for ordinary retail investors to flock to the new contracts.
“I originally thought single stock futures would be a great play for the retail marketplace, but my view now is that they are pretty much an institutional play,” said Ira Krulik, director for equity listed derivatives at Credit Suisse First Boston. “Maybe high net worth people and corporate insiders with large positions in company stock [will participate], but not your Uncle Bob. I don’t see a certified financial planner, in the course of doing what he does, recommending single-stock futures to retail investors.”
Others are more optimistic.
“The retail product side has the potential to be very large,” said Bill Russell, director for equity derivatives at Schroder Salomon Smith Barney in London. “Partly because they will be able to short the stock in a way that is easier, with no uptick rule to worry about.”
“Right now it’s an uncertain environment and people are less willing to make big trades. But if we can provide the same access [as the stock market] then there is huge potential on the retail side,” he added.
Paul Finnegan, vice president for marketing and business development at Man Financial, is even more upbeat. “Fifty percent of all retail accounts on the futures side trade the E-mini. Why wouldn’t they trade a futures contract on Qualcomm?” he asked rhetorically.
What will attract people to this market? In addition to all the classic advantages of a futures contract, single-stock futures will also have two particular advantages over the stock market.
First, they will make it easier for traders and investors to short their positions. Currently, to short a stock, a trader has to borrow the securities from someone else. The trader also has to conform to the “uptick rule,” which prevents short-selling when the price is going down. Neither condition will apply to single stock futures.
Second, a buy-and-hold investor can get more leverage out of single stock futures than owning the shares outright. As proposed by the Commodity Futures Trading Commission and the Securities and Exchange Commission, the margin requirement will be 20 percent. That’s well above the normal level of margin in the futures industry, but still lower than the 50 percent margin that ordinary retail investors need to post for long positions in stock.
The one thing that everyone agrees with is that education will be essential to bringing ordinary retail investors into this market. Some firms have already begun this process; Refco has launched a Web site dedicated to single stock futures, and Man Financial plans to do the same in a few weeks. But the process is still in the early stages.
“I worry that the industry has not completed enough of an education program,” said OneChicago’s Rainer. “If the retail comes in, it will not come in significantly at the outset, and that’s not a bad thing. I think these instruments will have utility for some individuals, but the goal around here is that the widespread education program has to be embarked upon first.”
“This is not a customer-driven product yet,” said Bickford, the AMEX official responsible for security futures. “It will need education. Remember, this came about because Congress passed legislation, not because customers were beating down our doors.”
Turning to the other part of the security futures product line, people also have different views on the potential for narrow-based index futures. Single stock futures have grabbed most of the attention so far, but several industry sources said they view “the narrows” as having a very powerful appeal.
CSFB’s Krulik said he thought sector futures could have the same appeal to the public as exchange-traded funds, which have become enormously popular in the last few years. And Joe Murphy, chief executive officer of Refco Global Futures, said he actually sees more interest in “the narrows” than in the single stock futures.
“What the professional traders in equityland are telling us is that the narrow index is something new,” Murphy told FI. “The narrow index allows you to create a small portfolio. It’s easy to get in and get out, it’s capital efficient. You can use it to neutralize larger indexes. It’s a great asset allocation tool.
“That’s where the action is going to be,” Murphy added. “We have 175,000 customers—hedge funds, CTAs, retail—and that’s the feedback that I’m getting.”
Institutional Investors: Watching and Waiting
Even the skeptics agree that there is strong interest in the new products among institutional investors, but there appears to be a wide range of opinions on which groups of institutions will participate and when.
Hedge funds are everyone’s pick to be the first to take the plunge. They are already familiar with the futures markets, they have the capacity to arbitrage between the futures and the underlying, and they would welcome a more efficient way to short the stock market.
However, industry sources familiar with the way that the London market for single stock futures has developed stressed the importance of having enough liquidity to attract the hedge funds.
“In theory these contracts trade away from fair value quite regularly, but there hasn’t been the critical mass of open interest to take advantage of it,” said one futures analyst who talks regularly with hedge fund clients. “Open interest is hovering around 250,000 for the whole complex, which is clearly a success, but it’s not deep enough to attract the big arbitrage players.”
Harvey White, a director in the equity derivatives sales team at UBS Warburg, expressed a similar view, but added that there has been activity by other types of institutions.
“LIFFE’s USF contracts have been quite successful, but volume has been sporadic and regular two-way flows have not yet emerged,” said White. “The main users have been institutions, such as indexers looking to enhance performance, rather than hedge funds.”
Fund managers have found a number of uses for these products, White said. For example, some managers cannot operate within guidelines that don’t permit them to buy more stock if it goes above a 10 percent weighting in an index, but the guidelines might not apply to futures or other derivative products. Another aspect that institutions have looked at is asset allocation, such as balancing cash flows.
White thinks running overlays is one of the most overlooked potential uses of the USF contracts. There are situations where it may be more efficient to transfer exposure through a futures contract rather than by disposing of the entire position. For example, an institutional investor with a large long-term holding in a particular stock might want to temporarily take a position in another stock. Rather than selling out of the existing holding, and incurring all the costs associated with such a sale, the investor could sell the future on the first stock and buy the future on the second.
White added that at MEFF, the Spanish futures market, the situation has been quite different. Only five single stock futures have been listed, but both volume and open interest have been very strong. In this market, hedge funds have been the main users of single stock futures, White said, primarily because they had no other way to short the underlying stocks.
Turning back to the States, one of the challenges facing the industry will be convincing the more conservative institutional investors to use the product. In thinking about the potential demand for single stock futures among pension funds for example, it is important to remember that most managers run long-only portfolios and use derivatives only to a limited degree, such as to change the duration of their bond portfolios or to convert cash into an equity exposure, according to Todd Petzel, president and chief investment officer, Commonfund Asset Management Company.
Running through all the different reasons why one would trade a single stock future, Petzel said he has a hard time finding any that are compelling for that type of money manager. "What is it that would make single stock futures attractive to that manager? I have trouble finding a positive answer," Petzel told FI.
An index future, for example, has the attraction that it can be bought or sold faster than the underlying basket of stocks, but buying a future on Microsoft is not going to be faster than buying the stock, he said. Buying a single stock future would require less margin than buying the stock, but these investors don't use leverage, he said. In fact, most have strict prohibitions on leverage. Can a single stock future help these investors get around the short sale rules? Yes, but most long-only funds don't sell stock short. Will single stock futures have more liquidity than the underlying stock? There again Petzel is doubtful.
It's a different matter with hedge funds, Petzel said. "There I think the prospects are brighter. The hedge fund manager typically has experience using many different types of instruments to achieve exposure. You also have recognized clearinghouses sitting behind positions [in security futures], so you don't have to look for a specific counterparty to offset a trade. And there are fewer problems with the short-selling rules, or with the probability of getting caught in a squeeze if you have to borrow the securities."
The lack of interest may be partly because they have not yet turned their full attention to these products and considered all the possible trading strategies. But even if that is the case, it means the exchanges and firms that support these products need to market them more effectively.
Mike Sobel, head of U.S. equities trading at Barclays Global Investors, said it is not clear yet how single stock futures will fit into BGI’s investment philosophy and trading practices.
BGI is a heavy user of index futures because they provide exposure to many underlying names in a single contract, superior liquidity, and financial leverage “when and where we need it,” he said. But single stock futures offer little operational or delivery advantages for BGI, and it doesn’t seem likely that they will be more liquid than the underlying security, he said.
He also said he did not see much use for single stock futures as a hedging vehicle, at least not for his firm.
The one reason why BGI might enter this market is if the futures contracts get out of line with the underlying securities contracts. “Where I get interested is if there is any mispricing,” Sobel said, adding that would create opportunities for cash and carry arbitrage as well as an opportunity to pick up the single stock exposure cheaper than doing so in the underlying security.
Another possible attraction would be in narrow index futures based on indices that BGI uses as a benchmark for its funds, such as the MSCI country and regional indices. “We could be enormous users of any derivative product that allows BGI to achieve our investment objectives at a low cost,” he said.
On the other end of the scale are the commodity trading advisors. Here as well, there is some hesitation about using the new products.
Jonathan Matte, president and principal trader at Defender Capital Management, a commodity trading advisor focused mainly on fixed income products, said he will probably wait a year or two to see how the market develops.
“From my perspective, I view single stock futures as just another asset class, another market to trade,” said Matte, who manages $5 million in customer assets. “What would concern me, especially in the early days, would be the simple question of liquidity. If there are just a few hundred trades per day, I would not want to put that into my portfolio.”
On the other hand, single stock futures will have a marketing advantage over other futures. “A lot of individuals are more comfortable on the stocks side,” said Matte. “To be able to offer a product that sounds familiar would be helpful.”
Louis Lukac, director of futures research at Prudential Securities, said he sees the market for security futures developing in three broad phases.
The first phase will be dominated by professional traders, such as those who trade the CME’s E-mini contract, with “cross pollination” from day-traders in the stock market. As liquidity grows, there will be opportunities for arbitrage trading, especially for the firms that are committed to both the cash and futures markets.
“Once we reach a certain level of volume and open interest—and volume has to reach 5,000 per day at least—then the market will attract the two primary users: smaller hedge funds and the CTA community,” he said.
“For the CTAs, this is purely a diversification play,” Lukac added. “They are accustomed to trading futures, and these products are either not correlated or loosely correlated with their existing portfolios. And the beauty is that you can go short and make money when the market goes down, unlike many traditional stock investments such as mutual funds.
“As for hedge funds, once we hit critical mass, this will be a big market for both hedging and speculation,” he added. “I attended an annual meeting a few weeks ago of a major hedge fund group and I went around and asked several hedge fund managers if they intended to use single stock futures. Most said sure they would, but only if there’s enough liquidity to do size. So I see them coming in at stage two, unless they are very aggressive and small.”
Traditional mutual funds could arrive at the third phase, Lukac said. These products could help the mutual funds reduce the volatility of their returns and hedge their market risk, he said.
Other industry sources pointed to options traders as another group of users that would very likely come into the security futures market at the early stages. Tim Biggam, chief options strategist at Man Financial, said having single stock futures available will give him many more ways to get his customers into the right trades.
Instead of combining puts and calls into a synthetic future, customers will now have the alternative of using the futures contract and having one less transaction to pay for. Having a single stock future available to short the stock will also help conversion and reversal trades. And at the most basic level, there are a large number of traders out there “who simply want to be in something that is moving,” he said, whether it be stocks, options or futures.
Tom Ascher, executive vice president at Interactive Brokers and a former CBOE vice chairman, also said he sees the security futures market as something that will draw participants from the options markets.
“You will regularly see single stock futures conversations on U.S. equity options desks at big firms,” he said. “A lot of options participants are looking at this as something that might complement their business, or take business away. And some are scratching their heads, they don’t know if this will work or not, but they know they will have to do something.”
“I personally don’t think this will be a zero sum game,” he added. “I don’t think the volume comes contract-for-contract out of existing vehicle volumes. I think it’s highly probable that it will be additive.”
Ascher said that Timber Hill, the market maker subsidiary of Interactive Brokers, is ready to serve that function at the new security futures exchanges. “We will definitely participate as a market-maker,” he told FI. “We are among the largest market makers and specialists in the business, and we are particularly well-qualified in electronic arenas that some people are still expending a lot of effort opposing.”
Patience Has Its Rewards
One feature that comes through in almost every conversation about security futures is the sharpening of attention as the launch date approaches. Inevitably, as the vision moves to reality, hard issues come to the fore, but so do the real opportunities.
The terrorist attacks of Sept. 11 were a huge blow to both the securities and futures industry, and preparations for security futures had to take a back seat while people focused on disaster recovery. But even before those attacks, the degree of preparation varied widely across the industry, and it was clear that many firms were uncertain about whether there would be enough customer demand to justify the labor involved in getting ready to offer these products.
One reason was the absence of final regulations governing security futures, a problem that is still affecting the industry as this issue of FI goes to press. Equally important, however, were and are the operational challenges. To give just one example, the price of single stock futures will have to reflect stock splits, special dividends and other corporate actions. Futures firms with options desks already in place have developed procedures for explaining this type of issue to their customers, but more traditional futures firms may find themselves in unfamiliar territory.
For these and other reasons, the effective launch was moved from late December to the end of the first quarter. This may turn out to be a blessing in disguise, because the firms see that more and more of their competitors are preparing to enter this market, and the interest among customers and firms is picking up.
“If we had had this conversation a year ago, I would have said that the whole concept in the U.S. was ice cold,” said CSFB’s Krulik. “Today, we’re not at full boil, but we are somewhere between lukewarm and hot.”
“Since day one, the main crux has been liquidity,” Krulik continued. “That’s the big abyss. With each passing day, more and more people are asking questions and thinking about possible uses. The more that we as an industry publicize these products, as more of the index guys come up with ideas, the more that will create liquidity.”
Will Acworth is editor of Futures Industry magazine. |
