Tucked deep inside a 250-page packet of legislation that would revamp much of the nation's futures industry is a provision that would for the first time open the door for U.S. exchanges to begin trading a new kind of derivative: the single stock future.
But even if the Commodity Futures Modernization Act of 2000, the legislation's proper title, can be finalized before legislators go home for the year, not everyone agrees institutional investors will want a piece of the new action. Both the Senate and the House adjourned Nov. 3, but they will return for a lame-duck, post-election session when there is a chance, albeit a slim one some say, that the Senate will reconcile its version with the House version and send the legislation on to the president. Some say single stock futures are of little use to large investors, who prefer trading in stock index or commodities derivatives rather than getting down and dirty with individual stocks. Single stock futures also might have other cost-benefit drawbacks that could suppress demand. Others disagree, however, and say the new futures products will prove to be valuable tools for managing risk, diversifying and rebalancing portfolios, cutting costs and increasing liquidity.
"It provides everyone, including the institutional investor, another option," said Rick Redding, director of index products for the Chicago Mercantile Exchange. "It would make the markets more efficient, and that's really what a lot of investors are looking for: efficiency in the market, different ways to trade portfolios and using them to manage risk."
The CME, through Chairman Emeritus Leo Melamed, has been pushing hard along with the Chicago Board of Trade for single stock futures trading. Not surprisingly, the CME and CBOT stand to gain new business once those futures begin trading on their boards.
As things stand now, options exchanges have the corner on the single stock derivatives market because of their ability to trade a variety of single stock options. Unlike a futures contract, which binds the buyer and seller to exchange a security at a set price by a certain date, an option allows the buyer or seller to choose whether to exchange the security by the set date at the set price.
Both futures and options have a big advantage over equities: Investors don't have to pay the full value up front. For options, investors pay a premium, usually a percentage of the stock's value, for the right to trade. For futures, investors also can make a smaller payment, known as a margin, that is also a percentage of the full purchase price.
Exchanges like the Chicago Board Options Exchange already trade a number of options contracts on single stocks. Perhaps not surprisingly, options exchanges worry the pending futures legislation could soften the demand for products traded on their floors.
The CBOE had opposed passage of any legislation opening the door to single stock futures trading unless those contracts were subject to the same transaction fees, taxes and margins as options.
But as hard as options exchanges have been pushing to hold up passage of single stock futures deregulation until their concerns are addressed, the CME and CBOT have been pushing equally as hard to pass it. That's because they see competition coming soon. In September the London International Financial Futures and Options Exchange announced it would begin trading single stock futures on its exchange by the end of January.
Days after LIFFE made its announcement, the CME and CBOT issued a joint statement calling for an end to "delays" in lifting the ban on single stock futures trading. Once business is lost to foreign exchanges, they argued, it will be difficult to win it back.
Already institutional investors can hedge their investment portfolios by buying futures and options based on stock indexes like the Standard & Poor's 500 and Nasdaq. But trading in futures contracts for single stocks like AT&T Corp. or General Electric Corp. has been forbidden since 1982 when congress passed the Shad-Johnson Accord.
Accord says no
Among other things, Shad-Johnson made trading in single stock futures verboten, primarily because at the time the Securities and Exchange Commission and the Commodities Futures Trading Commission could not agree on who would regulate the trading of such futures and how, said Philip McBride Johnson, former SEC chairman and now head of the exchange-traded derivatives group at the New York-based law firm Skadden Arps Slate Meagher & Flom. It is Mr. Johnson's name that appears on the Shad-Johnson Accord.
Mr. Johnson is among those who believe that single stock futures will appeal to institutional, not retail, investors.
"They could be very popular at the institutional level," Mr. Johnson said. A pension fund or money manager that wants to capture some expected movement on a particular stock, but doesn't have enough cash on hand yet to make a play in the equities market, could buy a futures contract on that stock because the cost of the futures contract is much less than buying the stock, Mr. Johnson explained.
This isn't to say companies or money managers have not been able to capture those movements before. Mr. Redding pointed out that single stock futures have been available for trading for years, in a synthetic form using options.
But synthetic futures are more expensive because they involve two transactions and often two transaction fees. In theory, then, single stock futures should reduce costs.
Vikram Kuriyan, director of portfolio management at Banc of America Capital Management Inc., San Francisco, said the lower cost of buying single stock futures makes them an attractive instrument that he plans to offer to clients.
Less expensive, more liquid
In addition to being less expensive than other hedging methods, single stock futures also enhance transparency and provide more liquidity, he said.
"Our general thought process is we will use any instrument that will improve performance for our clients," Mr. Kuriyan said. "There are a number of advantages for futures and I think institutions could find them quite attractive."
At Environmental Financial Products LLC, Chicago, Chairman and CEO Richard L. Sandor said he thinks single stock futures are an idea whose time has come. He pointed to the popularity of stock index futures, and said he expects single stock futures will prove just as popular for institutional investors.
Not everyone agrees, however. Donald M. Chance, professor of finance and associate director for the Financial Risk Management Center at Virginia Tech University, Blacksburg, said he doesn't think institutional investors will be interested in single stock futures.
"I have some doubts about whether it's going to work," he said. "When they (institutional investors) use derivatives, they use index funds and options, because they're thinking more along the lines of trading at the portfolio level. They don't generally pick individual stock options."
Likewise, Robert Arnott, managing partner at First Quadrant LP, Pasadena, Calif., doesn't think there will be enough demand for single stock futures contracts, nor enough liquidity for arbitrage.
"Frankly I'm a skeptic," Mr. Arnott said. "As for institutional need or interest in the product . . . I don't see a huge amount of institutional demand for the instruments. There's a risk that the instrument fails on two counts: lack of institutional interest and lack of an easy low trading cost arbitrage for the floor traders to lay off their risk in the physicals market."
Jack Gaine, president of the Managed Futures Association in Washington, said a number of the association's 700 members have been clamoring for single stock futures. Whether the futures succeed or fail should be left up to the market, he suggested.
"I don't know for sure if they're going to be successful," Mr. Gaine said. "But let's at least get it legal to trade them. It's the view that it's another product to trade. Let the market form a judgment."