Futures Volume Soars to Record Highs
futuresindustry.org
Total trading volume in exchange-traded derivatives hit record highs this year. Trading in futures and options on futures increased more than 50 percent this past year, and was more than four times greater than it was 10 years ago in 1991. Several exchanges (including the CME, LIFFE, and Eurex) enjoyed record high volumes and substantial percentage increases.
These record volumes, though, were due entirely to huge increases in financial trading. Interest rate and equity trading increased their shares of the exchange-traded business to the point where financial trading makes up about 85 percent of the total market. For non-financial commodities, 2001 was an off year. Energy, precious metals, and foreign currency trading were up somewhat, while trading in agricultural commodities was down a lot and in non-precious metals was down a little.
Further, chiefly because of the huge growth in European interest-rate trading and Korean stock index option trading, trading outside of the U.S. increased its share of the world market from 68 percent to 72 percent.
The Raging Eurodollar Bull (Bear?) Market
One morning recently on the north line train from Evanston to Chicago, I told Dick McDonald (chief economist of the CME) about Terry Belton’s and my efforts to rewrite The Treasury Bond Basis, our book on Treasury futures. He replied that I might well be working on the wrong book. Instead, he suggested, I should turn my attention again to Eurodollar futures and options, where trading volume was exploding. And he might be right, at least for U.S. markets.
It’s not that trading in Treasury futures didn’t grow this past year. It did, at least in 5-year and 10-year notes. But Eurodollar futures and options volumes went straight north. Eurodollar futures volume increased by more than 70 percent, while Eurodollar options volume more than tripled. One day in August, more than one million Eurodollar options changed hands.
The reason for this explosion in Eurodollar trading is not hard to find. The Federal Reserve has been cutting rates at a rapid clip and at unexpected times. One result of the Fed’s work is that U.S. interest rates have generally fallen over the past year, but with several large reversals along the way. But a more interesting result has been a Eurodollar yield curve that is as steep and concave as any in recent memory, and traders have taken huge curve bets in both futures and options to take advantage of the potential gains from rolling down the curve and from a return to a more normally shaped curve.
Eurodollar contracts are nearly ideal interest rate trading vehicles. While Treasury futures can be used to trade broad chunks of the yield curve, Eurodollar futures, which allow one to focus on individual 3-month segments of the forward curve, can be used to capture the subtle, or sometimes not so subtle, things that happen to forward rates from zero to four years.
Two Big Interest Rate Markets
As things now stand, if one views the world from the perspective of exchange-traded markets, the world now has two major interest rate markets—one for the dollar yield curve and one for the increasingly consolidated Euro yield curve. Both markets have very active money market futures contracts, and both have government note or bond contracts for key maturities along the curve.
The growth of trading in Euribor and Euribor options at LIFFE attests to the fact that an electronic trading medium can do a good job of handling complex markets. To be sure, the volume of trading that goes through the pit at the CME still dwarfs the Euribor market at LIFFE, but the CME can take some comfort from LIFFE’s experience.
The growth of trading in the Eurobund, bobl, and schatz complex at Eurex attests to the fact that one can erect a very large trading machine on top of a comparatively small and illiquid underlying market. It still is a mystery to me that the German debt market can bear the weight of all the futures trading that goes through Eurex, but it seems to work well enough, in spite of the periodic squeezes that plague this market. Eurex seems to have found a solution to the squeeze problem, however, and the market showed its approval with a surge in volume in September, October and November.
Equity Futures and Options
The real growth in equity option trading was abroad. Even without the KOSPI index options, equity option trading abroad increased roughly 60 percent. With the KOSPI options, options trading abroad more than doubled. In contrast, equity option trading in the U.S. was, on balance, flat. CBOE and AMEX showed modest declines, with PHLX the only U.S. options exchange in the plus column with a 32 percent increase. Trading in individual equity options fell somewhat, but trading in equity index options rose more than enough to offset this decline.
Another Fine Mess
The evaporation of Enron from the trading scene took far more people by surprise than perhaps it should have and wreaked a lot of havoc in financial markets. That’s the bad news. The good news for the exchange-traded market is that the failure of such a large trading enterprise serves to remind traders of one of the great virtues of exchange trading—credit. OTC derivatives may have a lot of advantages over exchange-traded contracts, but credit is not one of them.
With OTC derivatives, one is exposed to the credit risk of each and every counterparty. Moreover, it is nearly impossible, even for the most diligent credit teams to know the true condition of each and every company with which they trade.
In contrast, in the futures world, one can buy and sell with hundreds of other traders but have exposure to no more than one clearing member/clearing firm combination. Further, even though the futures market’s practices of requiring performance margins and of settling gains and losses every day in cash is a nuisance for many traders, these practices help to minimize counterparty exposure. No one ever really owes anyone else much money.
Although the OTC market can never achieve the level of credit quality offered by the exchange-traded market, I expect that it will continue to evolve in ways that make it look more like the exchange-traded markets. In particular, I imagine that more collateral will be required more often, and that one will find that gains and losses will be settled in cash more frequently and in smaller amounts of money.
The Impact of September 11th
A glance at the monthly ratios of 2001 volume to 2000 volume for futures markets suggests that the terrorist attack on the World Trade Center had no appreciable effect on our markets. Instead, it seems that things really began to pick up steam in July and August both at home and abroad. Fewer trading days in September as trading halted in the aftermath of the attacks was not reflected in the volume figures for most of the U.S. exchanges. Despite shortened trading sessions, the New York Board of Trade managed to retain most of its volume, experiencing only an 11 percent decline.
Last Year’s Check List
Most of the active questions about our industry are pretty much the same as they were last year when I touched on:
• market consolidation in Europe;
• the shrinking Treasury market;
• the emergence of LIBOR as a benchmark;
• mini equity contracts;
• exchange consolidations; and
• single stock futures.
As I noted above, the Euro yield curve has firmly established itself in the form of Euribor and the various Eurobund, bobl, and schatz contracts. Of the remaining items, here is how things stand.
Bye, bye long bond. The Treasury market has continued to shrink, and the Treasury did in fact suspend the 30-year bond as part of its financial tool kit. The consequences of this decision for U.S. financial markets in general and the futures market in particular will take a long time to unfold. An active long-term Treasury market has been a hallmark of U.S. interest rate markets. It has improved the market for 30-year residential mortgages and has served as a foundation for longer-term corporate borrowings.
Its disappearance, though, may not be such a bad thing. As a practical matter, cash flows dated 10 years or less into the future represent more than 90 percent of outstanding debt in the U.S. 10-year government markets are the norm in most parts of the world. And our own Treasury market has been gravitating toward the 10-year sector for a number of years now.
As far as the Treasury bond contract goes, issues with maturities of 20 to 25 years have dominated the cheapest to deliver list for the past couple of years, and it would take 10 years without a new 30-year auction for this part of the curve to disappear altogether. Thus, it seems likely that the Treasury bond contract will die a slow death rather than expire outright.
Emergence of LIBOR as a benchmark. I still think this is the way of the future, especially in the dollar market. For that matter, I think that the swap curve in one form or another will become the standard against which other fixed income instruments are gauged. Just how this will affect futures markets is hard to judge. The Eurodollar and Euribor markets already provide the financial building blocks for the swap curve.
For those who would prefer to trade term LIBOR exposure, the exchange-traded market offers two possibilities in the dollar market. One is the market for 10-year agency futures, which are based on the 10-year notes issued by Fannie Mae and Freddie Mac. A close look at the yields on agency debt reveal a reasonably close correspondence between the agency curve and the swap curve. And so, as long as this relationship holds, agency yields can be a good proxy for swap yields. As it is, though, these contracts have plugged along at about 3,000 a day, but have shown no real tendency to grow. A better alternative would be the new 10-year swapnote contract listed recently by the Chicago Board of Trade, but it is far too early to tell if it will get off the ground.
In the Euro market, LIFFE’s 2-year, 5-year, and 10-year swapnote contracts have begun to show some promise. Collectively, total trading in these contracts was about 4.2 million contracts, which is nothing to threaten the Eurex complex yet, but which is worth keeping an eye on.
Mini equity contracts. Every year it seems that some exchange or other has a small contract that inflates the trading data. This year it was the really small option contract on the KOSPI index that traded more than 820 million contracts in 2001. In its wake, the similarly small CAC40 options traded more than 100 million contracts. Thus, nearly a fourth of exchange-traded volume was in mini equity contracts.
Exchange consolidations. One big piece of news is Euronext’s purchase of LIFFE, a transaction that was made possible because of LIFFE’s conversion from a membership structure to a corporation. Had the merger been in effect during all of 2001, the Euronext/LIFFE combined volume would have launched them into the number two spot above the Chicago Mercantile Exchange, but still 126 million contracts behind Eurex.
Regulatory Shambles Over Single Stock Futures
I think the Futures Industry Association allows me one tirade a year in this review article. I would like to exercise that privilege with a bitter complaint about U.S. financial regulation and the way it has arrested the development of single stock futures in this country.
At last count, 10 exchanges offer futures contracts on the shares of individual companies, and total trading in these contracts grew from 2.2 million contracts in 2000 to 13.4 million contracts in 2001. The fact that not one of these exchanges is in the U.S. is a shameful burden that must be borne by U.S. financial regulators. At one time, not so long ago, the U.S. was the great fount of innovation in financial markets. Now it seems that we have ossified to the point where financial innovation is beyond our reach.
We should remember that futures have contributed as much as any single financial instrument could to improving the efficiency of financial markets in the U.S. It was Treasury futures that broke up the oligopoly enjoyed by what was once a tightly knit group of primary government securities dealers. It was Eurodollar futures that reduced the costs of borrowing and lending in the banking market by giving banks the flexible tool they needed to be able to manage their interest rate exposure. And it was S&P 500 futures that greatly expanded the ability of the cash market for individual shares to achieve the volume of trading we see today. Futures have been fantastic engines of competition in financial markets.
Instead of standing in the way of the kind of financial innovation that has done nothing but make life better in this country, our regulators should be striving to find ways to open these markets up. Or perhaps we have done enough for one country and can hand the baton over to the European exchanges. |
