Futures shock

On March 1, 2001, William Brodsky, chairman and CEO of the Chicago Board Options Exchange, addressed a meeting of the Investment Analysts Society of Chicago at the Metropolitan Club, which overlooks the Loop business district from the 66th floor of the Sears Tower. More than 80 people had assembled to hear Brodsky speak about one of the most eagerly anticipated innovations in recent financial market history: the imminent U.S. launch of trading in single-stock futures.

For nearly two decades federal regulators had banned contracts to buy or sell individual stocks at a set price in the future, in part because they couldn't agree on which agency should oversee them. Besides, there had been a general lack of interest in trading the instruments. But after several exchanges expressed a desire to list single-stock futures, regulators relented.

The new instruments had the potential to be revolutionary. Investors would be able to make more highly leveraged bets than they could by using equity options, which had existed for nearly three decades, and they could hedge positions more cheaply and efficiently than through stock index futures. Short-sellers would find it easier and cheaper to sell a stock future than to borrow shares from a broker to sell short. What's more, they could sell the stock future without waiting for an uptick, as was required for shorting an actual stock.

"This is as great a development as we've had in a long time," Brodsky told his enthusiastic audience. But he also issued a warning to firm officials who were in the lucrative stock loan business: "Your ability to get a nice return on that stock may be limited if people who normally borrow your stocks can sell a stock future instead."

Brodsky's optimism turned out to be premature. Handicapped by that long-running dispute over which agency should regulate them -- the Securities and Exchange Commission, which supervises securities, or the Commodity Futures Trading Commission, which oversees futures -- single-stock futures wound up becoming the first financial product deemed part security, part future, and overseen jointly. The SEC and CFTC took almost two years to work out how to apply tax and margin rules, delaying the launch of trading until November 2002.

Then, in a compromise that weakened the appeal of the new instruments, the agencies decided that their margin requirements should be comparable to those on options so that the two types of derivatives would compete on a level playing field. To top it all, single-stock futures made their debut in the teeth of the brutal bear market that followed the collapse of Internet and telecommunications shares.

For a while, things looked grim indeed. One of the two electronic exchanges created expressly for stock futures, NQLX, folded in September 2004. The other, OneChicago, formed in May 2001 by the CBOE, the Chicago Board of Trade and the Chicago Mercantile Exchange, started out with far more fanfare than activity. For the entire month of November 2003, fully one year after it kicked off trading, volume was 73,827 contracts. (Each contract represents an obligation to buy or sell 100 shares.)

That pales in comparison to the CME's popular e-mini Standard & Poor's 500 stock-index futures, which were trading 580,000 contracts per day at the time. And almost one third of OneChicago's volume that month came from contracts on five stocks: Applied Materials, Best Buy, Coca-Cola Co., Microsoft Corp. and Pfizer. Things didn't improve much in 2004 -- average daily volume for the year stood at just 7,630 contracts. (By comparison, the nation's big stock options exchanges routinely handle more than 1 million contracts daily.)

But this year OneChicago has begun to rebound. Through the end of November, volume for 2005 was up 181 percent compared with the same period in 2004. In November, average daily volume hit 33,480 contracts, up a whopping 271percent year-over-year. The CME says that it broke even on its investment in the third quarter. One reason for the turnaround: Hedge funds and investment banks have begun to develop trading and investment ideas for single-stock futures.

Hedge funds account for a high proportion of recent trades, because they see futures as a cheaper way to finance stock bets than turning to prime brokers. Institutions are also coming to appreciate how stock futures can help them cope with volatility.

"Any time you launch a new product, it takes a while to catch on and for people to understand what it is that you are offering," says OneChicago president Martin Doyle, a 20-year veteran of the futures industry.

The exchange has another reason to feel encouraged. As Congress prepares to reauthorize the CFTC (as it must do every five years), OneChicago and its allies are lobbying hard for regulators to drop the stiff margin rules and treat single-stock futures the same as stock-index futures.

On September 8, CME chairman Terrence Duffy complained to the U.S. Senate Committee on Banking, Housing and Urban Affairs that "interexchange competitive concerns combined with regulatory and legislative turf contests largely mitigated the hope for this product even before it was launched in this country." Predictably, OneChicago's request has ignited a storm of protest from options exchanges, which fear that futures would gain too much of an advantage over options.

Last month brought what may be an acceptable compromise. The President's Working Group on Financial Markets -- comprising SEC chief Christopher Cox, CFTC head Reuben Jeffery III, Federal Reserve Board chairman Alan Greenspan and Treasury Secretary John Snow -- reported to Congress that the SEC plans to approve rules that would allow more-liberal margin requirements on both stock futures and options. This could revolutionize the way all stocks and equity derivatives are traded.

"For those wanting to trade on credit, particularly the more sophisticated investors that engage in derivatives trading, it will clearly reduce the amount of capital required and increase the amount of leverage available," says Anthony Leitner, a consultant on securities and futures regulation and former general counsel for Goldman, Sachs & Co.'s equities division.

THE CONTENTIOUS MARGIN ISSUE FIGURES prominently in the convoluted history of derivatives regulation. In 1982 the Shad-Johnson Accord decreed that securities would be overseen by the SEC and futures by the CFTC. This was necessitated by the launch of options and financial futures in the early 1970s. The CBOT and the CME, which had until then traded agricultural commodities like soybeans and pork bellies, began dealing in derivatives based on financial instruments, notably futures on Treasury bills and interest rates. So successful were these ventures that in 1973 the CBOT spun off the CBOE as a separate exchange to trade equity-related options.

Toward the end of the decade, with trading in government bond futures well established, the CBOT, the CME and other markets approached the CFTC for permission to list futures contracts on major stock indexes, such as the Standard & Poor's 500. The SEC hadn't objected to futures on government debt, but this was something else entirely. The agency challenged the CFTC's authority to approve stock-based futures, viewing that as an encroachment on its regulatory domain, and warned that it would fight the CFTC in Congress.

To avoid a debilitating turf war, Philip McBride Johnson, then chairman of the CFTC, hammered out a historic pact with then-SEC chairman John Shad: The CFTC would regulate futures on large stock indexes, while options on stocks and stock indexes would continue to be considered securities and fall to the SEC. Shad also asked for Johnson's assurance that the CFTC would not approve single-stock futures. Johnson complied.

"No exchange had expressed any interest in listing those products, so I agreed that we would ban their listing by either agency until someone wanted to list them," recalls Johnson, who now heads the exchange-traded derivatives practice of law firm Skadden, Arps, Slate, Meagher & Flom in Washington.

All seemed settled until the late-1990s bull market, when interest in stock futures took off like a dot-com IPO. The Chicago exchanges lobbied Congress for the right to list them. Though both the SEC and the CFTC staked a claim to supervision, the two agencies agreed to share oversight. Congress repealed the ban on single-stock futures by passing the Commodity Futures Modernization Act, which became law in December 2000.

To boosters of single-stock futures, however, the regulatory compromise ensured that the product had too many strings attached. Options exchanges had maintained that stock futures weren't futures in the usual sense, but rather, were economically equivalent to stock options and thus should be treated equally by regulators -- that is, saddled with identical margin requirements. In other words, stock futures couldn't take advantage of the portfolio-based margining system that governs other futures trading. This method considers the breadth of an investor's holdings when determining how much collateral he or she must maintain to support a given position. In practice, this often means that futures traders are required to tie up far less capital to support their positions than is required in the stock and options markets, where margin levels are decided on a security-by-security basis, often without regard for the effect of offsetting positions.

Many market participants -- including some regulators -- say that the risk-based approach is superior. The CBOE and other options exchanges have, in fact, long wanted to adopt such a system, but the SEC has balked, for fear of encouraging the overuse of leverage in the financial system.

Still, single-stock futures offered a good deal more leverage than stocks themselves. (Traders can margin 80 percent of their stock futures positions, compared with only 50 percent for stocks.) That made them appealing to hedge funds and other aggressive traders. Using single-stock futures, an investor could put on a short position without having to borrow a stock and pay interest on it or be at the mercy of a prime broker. Moreover, the investor wouldn't have to scramble for shares to borrow and sell short; futures on those stocks would, in theory, be ready at hand. OneChicago offers contracts in 200 stocks and expects to offer 500 by the end of 2006, according to president Doyle.

Not long after the instruments were approved in 2000, each Chicago exchange mulled setting up its own trading platform. CBOE's Brodsky, however, urged that they team up to create OneChicago. The CME and the CBOE each took 40 percent shares, the CBOT bought a 10 percent stake, and private investors the remaining 10 percent. The joint venture allowed the exchanges to save on costs and bring together their diverse customer bases. "There is a lot more power together than trying to market the product individually for each exchange," says Richard Redding, head of product development at the CME.

At the outset, that advantage appeared to be critical. Early on there was buzz that others -- including the American Stock Exchange and electronic trading network Island ECN -- wanted to enter the business. But only one serious competitor emerged: a joint venture between the Nasdaq Stock Market and the London International Financial Futures and Options Exchange, known as NQLX. (Euronext acquired LIFFE at the beginning of 2002.)

In November 2002 both OneChicago and NQLX began listing small groups of single-stock futures contracts. Most of the early trading focused on a handful of names, such as Bank of America Corp., Citigroup and Microsoft. The rival exchanges also offered narrow-based indexes and futures on exchange-traded funds, such as the popular QQQ, based on the Nasdaq 100.

Volume grew slowly, in part because of poor timing. "The product was launched into really terrible conditions as far as the state of the economy and the health of the brokerage community," notes OneChicago's Doyle. The S&P lost almost one quarter of its value and Nasdaq nearly one third in 2002. OneChicago and NQLX also confronted the catch-22 of any new market: You can't build liquidity without first having liquidity.

Listing requirements, dictated by regulators, also dampened the market's appeal. To be listed, a future's corresponding stock had to have average daily trading volume of 109,000 shares. That disqualified the penny stocks and bankrupt companies beloved by short-sellers. "The stocks that the short-sellers were looking to pounce on you really couldn't get, because they didn't meet the requirements -- you were only listing stocks nobody cared to short," notes Howard Simons, the former head of product development at NQLX and now a strategist for Chicago-based research and brokerage firm Bianco Research.

Even if an investor had sought to short one of the more reputable corporate names available on the exchanges, he might not have been able to trade enough contracts at once to fully hedge the stock position, because volume was so thin. Some brokerages, meanwhile, were reluctant to market stock futures lest they undercut their highly profitable stock-loan businesses. "The securities side did not necessarily embrace this product, because they make more money trading stocks, making markets and loaning stocks to people," says John Lothian, president of John J. Lothian & Co., a Chicago-based futures advisory firm.

NQLX became a casualty of these multiple injuries in September 2004. Its volume had dipped to fewer than 400 contracts a day. "We did not see a viable market for single-stock futures in the U.S.," says George Anagnos, executive vice president of business development at NQLX's parent, Euronext.Liffe. NQLX's loss was literally OneChicago's gain. Last December, 27,000 unexercised NQLX contracts went to OneChicago, giving it 90 percent of the market.

OneChicago's success was relative, however. The exchange last year traded 1.9 million contracts; by contrast, London-based Euronext.Liffe, which in 2000 started trading a product akin to single-stock futures called universal stock futures, traded 13.5 million contracts in 2004.

"Universal stock futures are significantly ahead of the U.S. in terms of consistency," notes Anagnos. More-liberal margining requirements, he concedes, would start to even the score.

Still, since NQLX shut down, OneChicago has been making significant, and surprising, progress. In September, 538,267 contracts were traded; a month later the number of unexercised contracts at the exchange reached a record 1.46 million.

Potential investors in stock futures are becoming more comfortable with their peculiarities. But OneChicago has also been marketing innovative uses for the instruments. For example, suppose an investor wants to borrow money from a broker to purchase 100 IBM shares at $84 to hold for six months. He must pay not only for the shares, but also for the loan, while he holds the stock. Instead, the investor could buy an IBM futures contract expiring in six months for $84.75. The 75 cents take into account the future's expiration and might be cheaper than buying the stock on margin. If a broker offered even cheaper financing, the investor could sell the stock future and borrow money from that broker to buy IBM shares. One professional investor compares it to shopping around for the cheapest mortgage: wielding the futures card to obtain the best financing.

Investors who are worried about volatility in interest rates have found another potential benefit in single-stock futures. The cost of borrowing from a broker naturally rises as rates do, whereas the implied interest rate of a single-stock future is locked in at the time one makes a trade. "Prime brokerages will see this as a competing trade, and it will force them to be more competitive," contends Mark Esposito, a 23-year veteran of the CBOE floor who joined OneChicago in 2004 as a project coordinator.

DESPITE RECENT VOLUME INCREASES, THOUGH, stock futures have a long way to go to live up to the initial hype. As OneChicago's Doyle puts it, "In relative terms it has taken off, but we see our future as much, much brighter than where we are today."

What's the hang-up, then?

Those pesky margin requirements. Testifying before a House of Representatives subcommittee in March, Doyle said that the current margin level "has proven quite simply to be unnecessarily high and has imposed an unwarranted cost that has discouraged new customers from using our products." Pointing to the more favorable margin arrangements of Europe's flourishing futures exchanges, he pleaded, "We need some help."

He just may get it. The Senate Committee on Agriculture, Nutrition and Forestry, which oversees futures, has proposed risk-based portfolio margining for single-stock futures as part of the CFTC's current reauthorization bill. Initially, the securities industry fumed at that proposal. Meyer Frucher, chairman and CEO of the Philadelphia Stock Exchange, which trades options, argued that it would destroy the balance between options and single-stock futures.

"What the futures exchanges did was try and use legislative arbitrage to achieve regulatory arbitrage on margins, and it was a mistake," Frucher tells Institutional Investor.

The reason single-stock futures have not been more successful has nothing to do with margin requirements, says Frucher, pointing to the record volumes seen of late in the options markets, which have the same requirements. Frucher adds that the success of universal stock futures in Europe can be attributed to weak equity markets in India and Spain, where it is very hard to short a stock. And in the U.K., he says, futures trading offers tax advantages over trading in stocks. But both Frucher and CBOE's Brodsky are in favor of risk-based margining for stock futures -- as long as that right is bestowed upon options as well.

"We are totally in support of portfolio margining, and we want to do everything we can to get it," says Brodsky. "We've been very frustrated that progress has been so slow on this topic."

Sources close to the SEC dismiss the suggestion that the agency fears that allowing portfolio margining could increase systemic risk. In any case, the SEC has been under concerted pressure lately to change -- and not just from disgruntled options and futures sellers. Broker-dealers have warned the agency that its rigid stance risks driving hedge fund business to Europe.

Proceeding gingerly, the SEC in July approved its own two-year pilot program to permit certain investors -- essentially, high-net-worth and institutional clients with more than $5 million in their accounts -- to use portfolio margining for a range of securities, including options. New SEC chairman Christopher Cox told the CBOE and the New York Stock Exchange at the end of September that the agency is now confident that risk-based margining can be introduced to securities without injecting systemic risk into the marketplace.

Nonetheless, it took three years for the SEC to approve even a pilot program. Understandably, the options exchanges feared it would take years more for the agency to move to the next stage. Thus during the September Senate hearings, securities market representatives, including Frucher, opposed granting portfolio margining for single-stock futures before options were accorded the same treatment.

Last month Cox and his counterparts in the President's Working Group pledged in a report to Congress that the SEC would approve rules permitting risk-based margining by September 30, 2006. A spokesman for the Senate Agriculture Committee, which must mark up the CFTC reauthorization bill for a floor vote, says such an action has yet to be scheduled, but notes that Congress already has approved the CFTC's 2006 budget.

Though it may take years for portfolio margining to filter down to ordinary retail investors, the survival of single-stock futures is no longer in doubt.

"Even without the regulatory changes, people are figuring out how to use the product and their capital more efficiently," says the CME's Redding. OneChicago's Esposito thinks bigger still. "This has the potential to be as big as the cash market, " he says.