Futures Shock

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What's the Future for Single Stock Futures?

Howard Simons

The way futures exchanges select new products calls to mind a remark attributed to 19th century German Chancellor Otto von Bismarck: Those who love sausages and laws should not watch either being made.

The exchanges' latest attempt to find a killer app, one that will spur huge new volumes of trade, centers on single-stock futures, or SSFs.

On the surface, this isn't such a bad idea. After all, the marketplace offers all kinds of investments, ranging from stocks to options on stock indices.

SSFs already trade on several overseas exchanges, including those in Sweden, Finland, Australia, Denmark, Portugal, Hungary and South Africa, with varying degrees of little success. The Swedish OM exchange has done all right with Ericsson (ERICY Quote) futures; open interest for the telecommunications manufacturer's futures now exceeds 50,000 contracts. Similarly, the Portuguese Bolsa de Derivadas contract on Electricidade de Portugal (EDP Quote) has more than 40,000 contracts open.

These successes still remain the exception; the Sydney Futures Exchange's contracts on Telstra (TLS Quote) have an open interest just over 100, and futures on Rio Tinto (RTP Quote) are struggling with open interest of less than 100.

So, why don't we just make one more combination of existing options and be done with it? As with laws and sausages, the process is a little messier than that -- not to mention that the inherent advantages to trading SSFs aren't easy to find.

Bureaucracy and Government Regulation

Federal regulatory agencies, in case you haven't noticed, aren't the most nimble of beasts. The 1982 advent of stock index futures in the U.S. created a turf war between the Securities and Exchange Commission and the Commodity Futures Trading Commission. The compromise put the SEC in charge of stocks and stock options and the CFTC in charge of stock index futures -- and it specifically forbade futures contracts on individual stocks. This became known as the Shad-Johnson Accord, named after the chairmen of these agencies.

In December, the Senate approved the Commodity Futures Modernization Act of 2000, which contains a new compromise providing for regulation of SSFs: They will be treated as a security under the 1933 Securities and Exchange Act, which will extend SEC restrictions on margin leverage and insider trading to the world of futures.

In addition, if a single-stock future reaches a trading volume equal to 10% of the volume of the corresponding shares' stock options, the single-stock future will come under SEC national market requirements. This will saddle futures markets with intermarket interchangeability requirements, consolidated quotes and best-execution responsibilities, none of which exists now in the world of futures, and all of which would be a radical departure from current futures-market operating procedures.

Interchangeability, for example, would mandate mutual offsets between identical and competing contracts listed on different exchanges. Consolidated quotes would require systems to display the best prices from these competing exchanges, and best-execution responsibilities would require brokers to seek out and execute the best available prices.

Despite the prolonged path to the National Market System mandated in 1975 by the SEC, stock traders enjoy all of these regulatory benefits as a matter of course. Commodity futures still exist in a sea of small and monopolistic fiefdoms, such as exclusive exchange listings, execution by a floor trader at a hard-to-determine, open-outcry auction, and lack of visibility of both the best prices and order sizes. All of these concerns may be unnecessary: Given the experiences with single-stock futures elsewhere, it is doubtful whether any of them will meet the 10% threshold.

The new law left issues such as contract size, expiration dates and content of quotes up to the listing exchanges. Futures exchanges don't currently require their members to disseminate bid and ask quotes or sizes -- or to provide a two-way market. And floor traders aren't likely clamoring for such duties.

Margins, Taxes and Short Sales

One major difference between stocks and futures centers on the role of margins. For stocks, margins, which are set by the Federal Reserve's Regulation T, have been at 50% for retail investors and 15% for dealers since 1974. A stock investor buying on margin borrows the difference, and can either pay the loan down, or offset it when the security is sold.

Futures margins, which are set by the exchange, don't represent a down payment on an asset -- but are rather a performance bond from the investor to the exchange clearinghouse. Margins vary quite widely as a percentage of the underlying asset, but generally are quite low. For example, the underlying value of the S&P 500 future is hovering around $335,000, but the initial margin for a speculator is only $23,438, or less than 7%.

The futures investor doesn't have to pay interest on the remaining 93%; indeed, futures investors can deposit T-bills and earn interest on 90% of the deposit with a 10% haircut in their margin accounts; 10% is held back in noninterest-bearing funds. In return for this leverage, however, the futures trader is marked-to-market daily. In other words, if account equity falls below a maintenance level, presently $18,750 for the S&P 500, a margin call is issued to bring account equity back to $23,438. A marked-to-market gain results in what are called "withdrawable funds," which can earn interest.

Futures and stocks also differ in their tax implications. A stock investor can defer the capital gains on an issue until the stock is sold. Because stocks have no maturity date other than the life of the issuing corporation, this deferral can endure for years. (Dividends, of course, are taxed as ordinary income.)

On the other hand, futures have fixed expiration cycles, which result in regular taxable events, and the short maturity of most financial contracts means most futures trades qualify as ordinary income, in the highest income-tax bracket. Over time, this constant connection to Uncle Sam will be an expensive proposition, giving cash stocks a significant competitive advantage to single-stock futures. Because most tax-advantaged accounts, such as IRAs and 401(k)s -- not to mention pension funds and other institutional investors -- are restricted in their use of futures and other derivatives, neither taxable nor tax-advantaged accounts will have any tax-linked incentives to trade SSFs.

A third difference is in the area of short sales. A stock trader needs to borrow shares, generally from a broker-dealer's stock loan department. The seller can earn interest on the proceeds and is liable for dividend payments. The total quantity of shares shorted by all sellers cannot exceed available shares outstanding. And then, of course, the uptick rule restricts short sales in falling markets.

In contrast, a short position in a futures contract is an obligation to deliver the shares or cash value equivalent to the exchange clearinghouse. The seller receives no revenue, has no dividend payment obligation and must post the same initial margin as a futures buyer. While individual traders may have position limits, there is no definite bound on total short open interest in a futures contract, so short interest can exceed the total of outstanding shares.

Where's the Advantage?

If we take away the lower regulatory burdens that the futures markets have enjoyed relative to equity markets -- and remove the advantages of lower margins, why should investors line up to trade unfamiliar instruments? Investors who wish to create their own synthetic future on a stock can do so today simply by buying a call and selling a put , same month and strike , on any options exchange. This trade has almost no comparative advantage to buying the underlying stock, and SSFs probably won't have any such advantage, either. (To understand some of the larger issues surrounding single-stock futures, see an earlier story on the subject.)

Experiences elsewhere indicate that single-stock futures are a solution in search of a problem. But let's roll out the products and let the rewards devolve to the most innovative and sophisticated users: The market, as always, will decide.

For more information about single-stock futures, please see these articles: