SSFs - a Product in Search of a Market?
Sooner or later they will get round to launching single stock futures (SSFs) in the US. Judging by the repeated delays, and the response to those delays, a lot of people evidently think this is a very big deal. But is the fuss justified? God did not create SSFs; was there any need to invent them?
The big test of viability for the SSF as a product is the US market. If they can't work there, then surely they will not work anywhere. Despite their current Luddite reputation for open outcry and other anachronisms, the US derivatives markets have been incredibly innovative and if anybody can make SSFs work, then surely it is they.
But I don't think they will work and here's why.
The history of SSFs is not a happy one. Many markets have introduced them, more often than not without much success. My own experience with them is one example. I was at the Stock Exchange of Hong Kong in around 1994, working on the development of their stock options market, when the Hong Kong Futures Exchange - an independent exchange - made the dramatic announcement that they were going to launch stock futures. It was front-page news (yes, in Hong Kong, at least in those days, the stock market was a branch of the entertainment industry, arousing the same passions as "normal" places reserve for their national soccer teams).
The typical stock-broker at the stock exchange saw this as the equivalent of somebody coming and pitching a tent on his front lawn. How dare they do this? But the move had the full support of the local Securities and Futures Commission and it was a done deal. At the time, I thought the stockbrokers were justified in their fear. This seemed like a magnificent product and I admired the HKFE for launching it - just the thing to exploit the existing inefficiencies in the underlying stock market such as:
* Exchange-mandated bid/offer spreads you could drive a bus through (the minimum tick size was sometimes as much as 1% of the stock price).
* Minimum Commission of 50 basis points per round-trip
* Stamp duty of 25 basis points per round trip
* Short-selling banned or severely restricted
A stock needed to move as much as 2% before you could even sniff a profit. In contrast, these stock futures seemed to represent the sweet smell of freedom for beleaguered traders. The SSF tick size was one basis point, there was no minimum commission and no stamp duty and you could short them all day if you wanted. How could they fail?
Well they did. They failed in a big way. After the initial congratulatory trades, volumes fell away to zero after a few weeks and, to this day, it is a moribund market (but the stock exchange spreads are still wide and the minimum commission is still there and so is the stamp duty - though much reduced).
Who can really say why they failed in such promising circumstances? It was not that the HKFE itself was the wrong forum, their Hang Seng index futures and options were quite successful and there was nothing obviously wrong with the product design, except maybe the failure to have market makers (which they did fix later, but to no avail).
My view is that they failed because there was no demand for the product. Not because people in Hong Kong didn't understand the product (people in Hong Kong understand anything if it involves trading profits). Single stock options were launched successfully in Hong Kong and, after a while, became quite popular, often trading tens of thousands of contracts per day so it was not that investors were uninterested in derivative contracts. It seems users just did not have faith that, when it came to the crunch, there would be liquidity in the SSFs.
No doubt this experience jaundiced my view but, since then, I have had the time to think about why SSFs may be such difficult products to launch successfully. To understand why, we need to go back to the basics.
What is it about futures that make them so wonderful? A successful futures contract has one core defining characteristic: it meets a need that nothing else can satisfy quite as well. That need may vary from one market to another but is always there. In a single transaction, commodity producers can hedge their forward production for years ahead; portfolio managers can use index futures to alter their entire risk profile and money managers can smooth out their 10 year interest rate exposure using bond or interest rate futures. Until futures came along, there was just no quick way to substantially modify your risk profile in asset classes that were as complex as commodities, benchmarked equities and debt.
Futures are also excellent at circumventing regulatory or other inefficiencies. The whole currency futures concept at the Merc brilliantly exploited the currency controls imposed in Europe. Singapore's various Asian index contracts provided a service that the market wanted but had been denied by their neighbours' regulatory aversion to derivatives.
And I haven't even mentioned the role of futures in price discovery (especially in commodity markets). So I'll mention it now: futures are really good at enabling price discovery when the physical market is opaque.
So there you have it - efficient risk transfer, circumvention of market inefficiencies, price discovery: futures can play many useful roles and when they meet a need, they can become very successful.
Now take a look at stock futures in the US. What need will they be satisfying? First risk transfer: for very liquid stocks (which are the only ones where it can possibly make sense to have futures contracts in the first place), the market depth and price competitiveness of the US markets are unparalleled. Anybody who can't alter their risk profile by executing their orders in that environment is not really trying and it is hard to see how a stock future trading alongside is going to make that big a difference.
I know the argument that says the stock futures provide an additional avenue to trade through - a kind of HOV lane where you can pass all the congestion in the underlying market. But unless you have strong buy-and-sell interest in the SSF market and have it all the time, somebody is going to have to make markets. And where are those price makers going to hedge? Mostly in the underlying market i.e. on the existing stock exchanges. In which case, the prices they make on the futures markets are not going to be any better than the hedges they can execute in the cash market, unless they are operating some kind of day-trader benevolent society. I realise that most price makers today also hedge on a portfolio basis and could use index futures and other derivatives to improve their competitive quoting in the SSF market - but why should they bother? If they are that competitive, why not send the quote to the cash market where there is a pre-existing pool of liquidity for what is essentially the same instrument. This is the problem. SSFs are just a slightly different way of trading the same thing. They meet a need - but it is a need that, in the US, is already being satisfied rather well.
What about price discovery? Well, whatever else may be wrong with the US markets, a lack of price discovery for single stocks is not one of them. On the contrary, you can't get away from the things - the TV, the internet, the newspapers, everywhere you turn in the US, you are discovering stock prices. I don't know what SSFs can contribute there.
Finally, there is circumvention of market inefficiencies. Here, maybe things are a bit more promising. You could quite reasonably say that SSFs are a different way of trading stocks. They circumvent the restrictions present in the underlying market and open up whole new fields of trading strategies. But we have already seen how this didn't work in Hong Kong (and many other places such as Denmark, Australia and South Africa). And the US has few of the restrictive practices that existed in some of these places so this competitive advantage is diluted still further.
Nevertheless, in the US there are still quite a few apparent advantages that SSFs might offer such as (regulators permitting): exemption from the up-tick rule for short sellers, lower margin requirements and T+0 settlement.
It would be nice if SSFs could get around what (in my view) are unnecessary short-selling rules - if, finally, traders were liberated from the stifling effects of the up-tick rule. So let's imagine that that really happened - no up-tick rule for SSFs and suddenly you can execute bearish strategies freely and wantonly. The first time a sharp market correction occurs, what will happen? Issuers, politicians and columnists will come down on SSFs like a ton of bricks. Same old story, the tail is wagging the dog again and suddenly SSFs would be subject to up-tick rules. The alternative scenario - where there is no such cataclysm - would see the stock exchanges and regulators wake up, realise that the up-tick rule is a pointless impediment to liquidity and abolish it in an effort to "transfer liquidity" back to the stock exchange.
Either way, the SSFs would lose their competitive advantage in regard to the up-tick rule. (I don't buy the argument that taking short positions in SSFs will be easier because of there being no need to borrow stock - as I mentioned before, somebody has to be the last-resort buyer of the SSF when the sellers start selling and that somebody, more often than not, has to be a price maker who will hedge by shorting the underlying, leading us back to the problem of whether the stock is borrowable.)
What about the margin advantage? Today there is a 50% margin rule for stocks in the US. Let's say that SSFs are launched with the 20% margin rule that is being mooted. Is that not a major advantage for leveraged traders?
Well, for one thing, day traders have not found it hard to circumvent the 50% rule and the anecdotal evidence is that plenty of stock gets traded today at margins much less than 50%. But again, let's say the 20% rule does attract oceans of liquidity to SSFs. It would be the same situation as the up-tick rule - the first little scandal (day trader holds broker hostage at gunpoint after leveraging himself into bankruptcy trading SSFs) and SSF operators will be compelled to increase margins. Or, absent a scandal, the 50% rule will be scrapped for stocks so as to "level the playing field" for stock exchanges. Again, the competitive advantage is lost.
That leaves T+0 settlement. Yes, perhaps there is some advantage to that but the industry has developed pretty impressive cash management systems - even under T+3 - that make the benefits of T+0 settlement less dramatically appealing than they might appear at first sight. The T+0 advantage is not a match winner.
The fundamental problem as I see it is that, in the US, SSFs are too similar to stocks to provide a compelling argument for their use - successful futures contracts offer something that the underlying market is simply unable to provide. For the most part, any strategy you want to execute with stocks is already available, either in the cash market or in existing equity derivatives markets. The SSFs just don't provide that great leap forward that options and index futures provided. That certainly seems to have been the case in other markets and I don't foresee things being any different in the US.
I can only see success for SSFs if they secure their own loyal brigade of traders who operate pretty well independently of the stock market. In that case, my arguments will be irrelevant because it will really be a separate market; but there is not much precedent for that kind of product anywhere.
Of course, on the day they are launched we will see quite a fanfare and I have already drafted the boss's speech for that day's press release, following the successful launch: "The strong start to SSF trading is very encouraging, a sign that the foresight and determination of the industry to work together to bring this innovative product to market was wholly justified. SSFs will rightfully take their place alongside the other great innovations of the derivatives industry to become an essential risk transfer tool for ......" You get the idea.
But the real test will be one year later and two years later. If SSFs manage even a tenth of the equivalent volume of options, I think I would consider them successful. But, in my view, even that will be hard to achieve.
I think the industry secretly knows this. Remember back in 1998 when Dow Jones finally agreed to license the rights to use their name for index futures and options? There was a heated, highly competitive bidding process between the derivatives exchanges to win the exclusive rights - a sign that they really believed this was a product worth launching. Contrast that with the response to SSFs - a collaborative, consensus-driven, passive pooling of resources between various exchanges. Somehow, I think if they believed this was really a prize worth winning, they would have gone at it in the true aggressive, competitive Chicago spirit - a winner-takes-all contest. This way, if it fails, ... well, what can they say? We tried. Wasn't our fault.
Mark Beddis is a freelance consultant, specialising in market liquidity processes and is based in Vancouver, Canada. He can be reached at mbeddis@beddis.com |
