The Hybrid Zone: Who Holds the Key to Trading Single Stock Futures?
As rival all-electronic markets such as NQLX and OneChicago get prepared to launch, the American Stock Exchange defiantly remains committed to trading single-stock-futures contracts on its floor. But will the Amex's specialist-driven environment be able to match up with fully-electronic competitors, in terms of offering its customers liquidity, speed and best execution?
Do not adjust your eyes. Do not make a mad dash for another cup of coffee. You are about to take a journey into the unknown, into an unpredictable financial-markets landscape filled with controversial business models and sophisticated trading platforms. Be prepared. There is no turning back. You are now entering, The Hybrid Zone.
Our story begins with the pending launch of single-stock futures (SSF), hybrid contracts that have not seen the light of day in the United States in more than 20 years. The main character in our tale is the American Stock Exchange - a multi-faceted securities market that has defied conventional thinking in recent years.
SSF - futures based on individual stocks - have spawned the creation of four separate markets, including NQLX, OneChicago, the Island Futures Exchange and the Amex's SSF unit. Pending the expected resolution of a few regulatory issues, the exchanges will make their debut later this year. But while NQLX, OneChicago and Island all plan to trade SSF contracts electronically, on a full-time basis, the Amex has decided to swim against the current by trading the contracts in a specialist-driven, open-outcry environment.
Logically, you may ask, why would Amex shun the trend toward automation in favor of a model that could potentially have a hard time competing against all-electronic competitors in areas such as speed? The answer, in a word, is liquidity. Over the past two years, the Amex has been able to turn around its fortunes via the launch of exchange-traded funds, a new product line, and the enhancement of its incumbent equity-options business. Though they are supplemented by electronic-trading applications, both product lines are still traded in the Amex's open-outcry pits, and the exchange believes it can leverage its options success by trading SSF contracts on its floor.
"When you start talking about futures on individual stocks, we have a large captive audience of liquidity providers who already trade in virtually all of the names that we would trade futures on," says Michael T. Bickford, senior vice president in charge of options at the Amex. "Our plan is to put the (SSF contracts) in the same crowd with the options, so that Intel futures will trade at the same post and in the same pit as the Intel options will. And we think there are enormous synergies that will go on between the two - synergies that will provide extra trading and liquidity in both."
Today, options trading at the Amex is supplemented by technology. About 70 percent of options trades are electronically routed to specialists' order books, via the Amex's so-called common-message switch, says Bickford. Moreover, he says that between 13 and 15 percent of Amex's options volume is executed automatically via the exchange's trade-matching engine. Bickford refuses to say whether the Amex is projecting similar numbers for SSF trading, but asserts that the exchange expects to attract sufficient interest from independent software vendors (ISVs) that can electronically route customers' SSF orders to the Amex's floor. "It's my belief that a lot of these (vendors) already do business with us, and are coming into our system through CMS," he says.
However, three large ISVs currently have no intention of routing their customers' SSF orders to Amex. Sonic Trading, a direct-access broker focusing on equities; patsystems, an ISV specializing in derivatives; and Interactive Brokers, a direct-access vendor that provides access to a variety of equities, options and derivatives markets - all presently have no intention of building SSF interfaces to the Amex.
Sonic and patsystems cite a lack of customer demand as their primary reason for passing over access to Amex, while IB says that Amex's open-outcry model does not fit with its strategy. "We're not particularly interested in the Amex. Our model has always been electronic. We focus on being the cheapest and quickest, and offering customers best execution. And we don't feel that a floor-based model offers that," says Steve Sanders, vice president of business development at IB.
That said, Amex has attracted SSF interest from at least a few ISVs. Blackwood Trading, in contrast to its direct-access competitors, is leaning towards offering its customers immediate access to the Amex's SSF contracts. Craig Schlifstein, chief strategist and founder of Blackwood, says the vendor already routes listed-equity orders to Amex via CMS, and is optimistic about Amex's chances to succeed in the SSF market. "Our development philosophy is that we'll write to any pool of liquidity. So if the Amex is able to make a market in single-stock futures, and have some liquidity there, then we'll certainly write to it," he says.
OneChicago and NQLX: Speedier Alternatives?
Like Sonic, patsystems and IB, Blackwood plans to write interfaces to the trading engines employed by NQLX and OneChicago (see sidebar). NQLX, a joint venture between the Nasdaq Stock Market and the London International Financial Futures and Options Exchange, is going to be driven by a central-limit-order book, supplemented by market makers. Multiple market makers will be responsible for maintaining two-sided quotes in each SSF contract NQLX trades, and Liffe Connect, Liffe's matching engine, will be responsible for matching all of the buy and sell orders that are electronically delivered to the exchange.
Thomas Ascher, chief executive officer of NQLX, says that Liffe Connect's open architecture is one of the factors that should differentiate NQLX from its competitors. "We are not mandating that you must use this front end or that front end, and that comes from an architecture built around having an API and a community of ISVs."
Anthony Orantes, vice president of finance and brokerage operations at Sonic, says the vendor is impressed at the speed with which Liffe Connect turns around orders. Moreover, he says NQLX deserves credit for being the first SSF market to actively recruit ISVs. "They sought out liquidity providers, or anyone that could add liquidity to the market, as aggressively as possible. I received relentless phone calls from them, on a daily basis," he recalls.
However, though he gives NQLX the edge in technology, Orantes also describes OneChicago - a joint venture comprised of the Chicago Mercantile Exchange, Chicago Board Options Exchange and Chicago Board of Trade - as the SSF market with the most potential to attract immediate liquidity.
OneChicago plans to trade SSF contracts in an electronic-auction environment, employing so-called Lead Market Makers (LMMs) to maintain two-sided quotes. Each LMM will serve as the primary liquidity provider for the SSF contract (or contracts) he or she is assigned.
From a technology point of view, OneChicago will rely on CBOEdirect - the CBOE's electronic-trading platform - as its matching engine. Participants in OneChicago will have a choice of either routing an SSF order directly to CBOEdirect or entering a trade into Globex - the CME's trading platform.
SSF orders entered into Globex will be routed, immediately and electronically, to CBOEdirect for matching. This process, which will add an extra millisecond to an order's turnaround time, could potentially be a cause of concern for speed-driven SSF traders. "It could be an issue, depending on what kind of customer you are. If you're just a plain old market taker, you probably don't care. But because you're routing first though the CME's order-routing infrastructure and then getting into CBOEdirect, there definitely is another hop that you have to go through," explains CME chief information officer Scott Johnston. "What we've told people is that if speed is the most important thing to you, then you should write directly to CBOEdirect, so that you'll circumvent that extra hop."
The Amex's Bickford, while acknowledging that speed is the most important criteria for some investors, says that price improvement and size are usually the determining factors in best execution for large institutions. "What we find, as a primary floor-based market, is that people come to our marketplace doing price discovery. They want to come and find out at what price a particular order trades, and I think our system is best suited to do that," he says.
The Amex will be able to provide automatic executions, Bickford says, for some smaller SSF orders. But larger orders could take a little time. "Should you try to execute something larger than our automatic-execution size, turnaround time probably goes up to somewhere between 30 and 60 seconds on an electronically-delivered order," Bickford explains.
SSF investors who crave speed will have one other enticing option: the Island Futures Exchange. Currently, there are very few details available about the Island Futures Exchange. It will be a designated-contract market, and it will undoubtedly market the speed of its SSF executions. But it may face an uphill battle in its efforts to snag liquidity away from larger players, such as NQLX and OneChicago. "Island certainly has a track record and reputation for speedy technology ... but the flip side of it is, are the other exchanges better positioned to bring in the type of liquidity that is going to be required to make (SSF) a successful venture?" Schlifstein asks.
But whether you are a proponent of NQLX, Island, Amex or OneChicago, one burning question remains: will SSF contracts succeed? There are some exchanges that are not high on the prospects of SSF. Most notably, Eurex, the New York Mercantile Exchange and the International Securities Exchange have chosen to take a wait-and-see approach, rather than just jump right into the SSF arena. "From a liquidity-provider perspective, there are any number of (ISE member) firms that would be interested in providing liquidity for this product. But from a (customer) perspective, we have not seen the demand for this product," says ISE executive Gary Katz.
Sonic's Orantes retorts that it's a question of when, not if, single-stock futures succeed. The failure or success of each individual SSF market, he says, will ultimately be decided by a market's ability to generate liquidity. "It does not matter how good your technology is if you can't generate enough liquidity. If the liquidity isn't there, then it does not matter how fast your technology is, because the fact is that (your) order is not going to be filled," Orantes concludes.
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A Front-End Forecast
The imminent launch of single-stock futures, in addition to creating new exchanges, will also provide significant opportunities for front-end-workstation software vendors. Brokers and institutions that need electronic access, to the likes of NQLX, OneChicago, Island Futures Exchange and Amex, can either build internal systems or choose from an array of vendor offerings.
As the launch of the SSF exchanges draws nearer, undoubtedly, more and more front-end suppliers will jump into the market. But today, the SSF charge is being led by a quartet of vendors: patsystems, Sonic, Interactive Brokers (IB) and Blackwood Trading.
Blackwood, a direct-access broker, has already written an interface to Globex - an order-routing component of OneChicago - and is in the process of writing to the application-programming interface (API) for NQLX's Liffe Connect trading engine. Moreover, in order to offer its clients access to the Island Futures Exchange, Blackwood will only have to make some slight modifications to the electronic interface it has built to the Island ECN, says Blackwood founder and chief strategist Craig Schlifstein.
IB - a direct-access broker that provides access to a wide range of equities, options and derivatives markets across the world - also plans to offer its clients access to the SSF markets run by NQLX, OneChicago and Island. Steve Sanders, vice president of business development of IB, says the broker has been approved as an NQLX member and is awaiting approval on the membership application it filed with OneChicago. A link to the Island SSF market, he says, is also on the horizon.
Like IB and Blackwood, patsystems expects to provide its clients with access to NQLX and OneChicago. However, in contrast to its SSF competitors, patsystems presently has no plans to build an electronic bridge to the Island Futures Exchange. Citing the fact that there is a "substantial cost involved" in writing to the API of any given exchange, patsystems Chief Executive Officer David Jones says that there is currently not enough customer interest in Island's futures market to warrant such a development. "We're not in this for the sake of developing technology and then trying to find a customer to sell our product to .... But if our customers demanded access to the Island exchange, we'd provide it," he says.
Sonic, meanwhile, is eager to build an interface to the Island Futures Exchange - but is not yet sure how to go about that process. "Island has not been too forthcoming," says Sonic vice president of finance and operations Anthony Orantes. "We have really hounded them for their (SSF) API, but they have yet to give us any information." Sonic has had, however, more success establishing links to both NQLX and OneChicago. Orantes says Sonic has been approved as a member of NQLX and is awaiting approval of its membership application with OneChicago. Sonic expects to write to the trading engine APIs of both exchanges before they go live. |
