Market makers and special ists may soon have a new crystal ball to catch the market's direction in the wee hours.
Once single stock futures (SSFs) start trading in the U.S., say Wall Street pros, traders may look at their performance in the early morning, pre-opening for the kind of market indicators now found in stock index futures.
Trading in U.S. single stock futures is set to begin soon, following enactment by Congress last year of the Commodity Futures Modernization Act. Facing industry complaints, Congress ended an 18-year ban on single stock futures trading.
"There's a possibility that single stock futures will wind up being a proxy for pre-open trading in the primary market," said Michael LaBranche, who heads an NYSE specialist, LaBranche & Co., a firm that expressed interest in trading SSFs. "These can be a way to absorb a lot of volume for event news, such as a merger."
A futures contract is an obligation to make or take delivery of an underlying asset at a time and in a manner specified in the contract by the exchange. Whether or not the SSF business lives up to the hype generated by some industry officials, single stock futures have spawned the birth of new exchanges. They have also raised the hopes of dealers who expect a potentially lucrative franchise.
The American Stock Exchange, Nasdaq/LIFFE Markets and OneChicago (a joint venture of the Chicago Board of Trade, the Chicago Mercantile Exchange and the Chicago Board of Options Exchange) are pumped up for the new instruments.
The brokerage industry was "screaming for single stock futures," said former SEC attorney Mark Borelli, now in private practice in Chicago.
Single stock futures, popular on some overseas exchanges, are expected to find a following among broker dealers, proprietary traders, market makers, banks, hedge funds and other investors.
Pros say they have many attractions: no uptick rule for short sellers, which means an ability to short the futures contract of the underlying stock without having to borrow the stock. (Short squeezes are not an issue.)
Single stock futures are said to cost less than trades in the underlying market. Experts say they will reduce net volatility in these underlying markets.
"Look at the early second quarter, say April, for the launch of trading," said Howard Simons, senior vice president of product research at Nasdaq/LIFFE, a joint venture between Nasdaq and the London International Futures and Options Exchange. "The uncertainty is due to operational and regulatory uncertainties, particularly in regard to margin issues," Simons added.
Launch Details
At first, the Nasdaq/LIFFE launch is expected to consist of 10 Nasdaq, 20 listed and other contracts. There are also plans to offer Nasdaq/LIFFE indices. Nasdaq/LIFFE will tap the customers of LIFFE futures and options traders. It will use the electronic LIFFE Connect system and clear through the Options Clearing Corporation (OCC).
Like the Nasdaq/LIFFE, OneChicago will capitalize on its large customer base. Orders will be handled electronically and entered into the CBOEdirect and GLOBGEX2 electronic trading systems. As Traders Magazine went to press, OCC was negotiating to clear all CBOE transactions.
All told, 50 SSFs will participate at the launch, according to Peter Borish, senior managing director of business development at OneChicago.
"There are a lot of moving parts to set up this exchange," he said. "But we will be focusing on lead market makers as our base of distribution."
The Amex intends to route its orders to its open outcry trading floor. Officials see the exchange's options pros providing liquidity.
Meanwhile, LaBranche is working on the logistics of trading single stock futures, Michael LaBranche told Traders Magazine. "We certainly have an interest in trading this new product," he added. "I think all the major specialist firms will trade single stock futures."
Right now, specialists are not allowed to be market makers in both the stock and options markets. The same division is likely to apply to single stock futures.
Some controversies, affecting tax rates, margins and other areas, do remain. "The big challenge is deciding whether [a single stock future] is an equity or futures contract or something in between," said securities industry attorney Borelli.
The new law leaves it up to the SEC and the CFTC to figure out how to implement SSFs. But that could spell trouble.
"There is the possibility of turf wars," Borelli said. "Another problem is that some things might fall through the cracks. One agency thinks the other agency is responsible for something and nothing happens."
The SEC and CFTC have been putting the finishing touches on the margin rules. Some pros expected margins of 20 to 25 percent (compared with 50 percent on stock trades). "Regulators are leaning toward permitting a portfolio, or risk-based margin system akin to SPAN [standard portfolio analysis of risk]," Simons said, "but this won't apply for the initial launch."
Another issue is settlement. Futures settle everyday, but stocks settle three days after trade execution, or on T+3. Regulators have leaned towards T+3 for SSFs.
Then there's so-called fungibility. Can a contract bought on Nasdaq/LIFFE be sold on OneChicago, for instance? The SSF exchanges need to coordinate how the SSF contracts will be standardized.
It is expected that SSFs will be taxed as short-term capital gains except for market makers, which will instead get the 60/40 long-term/short-term blend.
Open-trade equity at the end of the year will be taxed, just like ordinary futures. Moreover, it looks like a sale of a future against a long stock position will not be considered a constructive sale unless the stock is delivered. But it appears that the wash sale rule will apply. (Under the wash rule, if you sell a stock at a loss and purchase a substantially identical stock within 30 days, you cannot claim the loss for tax purposes.)
Futures for Traders
What does all this mean for market makers and specialists? Too early to tell, but it will be significant, industry officials predict.
"Specialists might turn out to be one of the major users of SSFs to offset their own position risk," said Simons at Nasdaq/ LIFFE. "The same goes for option market makers."
"OneChicago obviously has support on the CBOE among market makers while the Amex can count on its own specialists," he added. "Competitive interests elsewhere should boost [Nasdaq/LIFFE]."
Simons believes that having competing market makers will be critical for supplying liquidity to institutions, hedge funds and commodity trading advisors.
"For that reason," he added, "we intend to allow crossing inside of the book and to allow our market makers a limited percentage of block orders once these orders are shown to the book."
Borish at OneChicago contends that SSFs will be as revolutionary as debt futures. "This new product allows for equities, options and futures markets to be linked," Borish said. "This is good for the consumer because of lower costs. There will also be less risk since positions can be hedged."
"With the linking of the markets, we will see many new trading strategies," he added. "It will only be a matter of the creativity and imagination as to how these new products will be used."
