From the February 01, 2008 issue of Futures Magazine • Subscribe!

Will U.S. SSFs rise to the surface?

Around the world, more and more market participants are diving into single stock futures (SSFs). The asset class is booming in Europe on Euronext Liffe, Eurex and MEFF, on the South African Exchange (Safex)/JSE, on the National Stock Exchange of India, and in Asia, where the Korea Exchange plans to list individual stock futures in early 2008. In the United States, however, SSFs are merely treading water, and experts say their current convoluted regulatory structure is to blame. However, a new competitive threat from Eurex could add urgency to cleaning up the regulatory clutter in the United States and answer the question of whether SSFs in the United States will sink or swim.

Some think a general lack of liquidity is slowing down SSF growth in the United States. “With very few dependable participants, there is an overhang that may be keeping otherwise interested parties out of the market,” says Rich Seyferlich, a risk manager at Timber Hill. “That said, volumes are building – slowly.”

OneChicago reported that 369,492 security futures contracts traded at the exchange in November, while year-to-date volume stood at 7,724,891, a 13% increase from the same period in 2006. However, the stalled growth of the asset class is frustrating the U.S. SSF market’s major players.

Liffe’s offering of U.S. based equity futures in 2000 led to the Commodity Futures Modernization Act (CFMA) of 2000. The CFMA lifted the Shad-Johnson accord, which banned the offering of single stock futures and narrow based indexes. The CFMA also removed the restrictions on trading of SSFs in the United States under a joint regulatory structure of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), a structure that some say has crippled their growth. “The dual regulation has stunted growth just the same as smoking stunts growth of a fetus,” says Chris Hehmeyer, CEO of Penson GHCO.

The CFMA dictated that the treatment for SSFs should be “comparable” to the treatment for options. Accordingly a strategy-based margin methodology was imposed for U.S. SSFs and the performance bond amount was set at the higher of 20%, or the number derived from the risk-based models. Risk-based margin models are used for SSFs everywhere else in the world. SSFs can sit inside portfolio margin accounts legally but “operationally they don’t except for a couple of firms, Interactive Brokers and Fortis,” says David Downey, CEO of OneChicago. According to experts, the difference in margin (strategy-based vs. risk-based) puts the United States at a disadvantage. Downey says the strategy-based margin was set because it was argued that SSFs were a competitive product to the options market, “but the question is really whether the options market was threatened. Time has shown that the options market has exploded while the SSF market remains anemic,” he says. He adds that single stock futures compete not with options but “directly with the financing profits generated by the brokerage firms who loan monies to their customers at non-competitive interest rates when those customers trade in margin accounts. They also compete with the stock lending departments who generate profits that would be reduced if the customers were able to trade the substantially similar SSF product.” OneChicago’s Web site includes a calculator that evaluates the benefits of SSFs vs. margin trading (see “Calculate this”).

Eurex’s upcoming listing of SSFs on major U.S. equities in U.S. dollars will be a major competitive threat to OneChicago. Eurex offers SSFs on more than 570 equities from 18 countries in four currencies, and its listings use risk-based margining, which leaves the United States, with its strategy-based margin, lagging behind. “The only exchange offering SSFs that does not use this U.S. invention [risk-based margin] is the U.S. exchange. This makes no sense,” Downey says, noting that the strategy-based margin is higher than the risk-based margin used internationally. “If Eurex is successful in drawing interest from U.S. concerns, then the profits from such trading would be offshore. Why is that in the best interest of the U.S. markets?” he asks.

Hehmeyer believes the offering “adds pressure [on regulators] to do something” to make the United States more competitive. Eurex’s offering was a no-brainer on their part. A Eurex spokesperson says demand from market participants was the initial driver for the offering. “European funds with exposure to U.S. dollar equities within their funds were looking for additional ways to hedge or enhance specific parts of their portfolio,” the spokesperson says, adding that the offering also allowed Eurex to expand its product portfolio. “A vast majority of the STOXX 600 components were already covered so these were a natural extension.”

Eurex is able to stay competitive in the SSF market because “a number of our existing clients for other Eurex equity and index derivative contracts are users of these products and it is natural for them to execute this business on Eurex,” according to its spokesperson, who says some of the key drivers for the increased business in SSFs are the introduction of UCITS III, a European Union directive that allows asset managers greater flexibility in the usage of derivative instruments within their portfolios, and the different tax jurisdictions in Europe that allow market participants to use SSFs to more efficiently manage dividend payments across borders within Europe.

Eurex cites Europe’s focus on institutional trades and a more transparent regulatory structure there as reasons for the strengths of SSFs abroad compared to their relative weakness in the United States “There is a clear institutional focus with block trade fee caps in place for large size transactions, which makes the cost of execution very low for some transactions on the products in Europe, and the regulatory environment is clearer if not actively promoting the usage [of SSFs] with the introduction of UCITS III,” a Eurex spokesperson says. In a comment letter to Treasury Secretary Henry Paulson on the Department of Treasury’s review of the U.S. financial regulatory structure, Hehmeyer discussed the clarity of foreign markets’ regulatory structures. “Many foreign markets, once murky and unsound, are now highly transparent, highly organized, and highly sophisticated. Their regulators have realized that the key to attracting investment and market participation is ease of market access combined with investor confidence and trust,” he said.

So how can the United States stay competitive in SSFs? The answer seems to lie with the regulators. Downey thinks that “reasonable people should be able to look at how these products are expanding offshore and review what makes them different than the U.S. product. It will be apparent that the strategy-based 20% margin is higher then the risk-based margin used offshore. They should at least be able to ponder whether this is in fact acting as the deterrent to growth in the U.S. offering.” In his letter to Paulson, Hehmeyer disparaged the U.S. regulatory structure in general, saying it had been developed “largely as a reaction to markets and events rather than as a cohesive, planned strategy” by the government. In his letter, Hehmeyer also urged lawmakers to ask “why [foreign] markets are suddenly more attractive to investors now than they were in the past. Market participants, when given a choice between two otherwise stable markets, feel uneasy about doing business within a regulatory structure that has been known to be hard to navigate.”

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