Prof. Jayanth R. Varma's Financial Markets Blog

Photograph About
Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

Subscribe to a feed
RSS Feed
Atom Feed
RSS Feed (Comments)

Follow on:
twitter
Facebook
Wordpress

July
Sun Mon Tue Wed Thu Fri Sat
 
11
     
2019
Months
Jul
2018
Months

Powered by Blosxom

Thu, 11 Jul 2019

US wants to nurture single stock futures

Two decades ago, when India was trying to set up its equity derivatives market, the most contentious issue was that of single stock futures – market participants were keen on this product, while a large group of sceptics argued that the product did not exist in the US and was in fact confined to a handful of countries. It was also thought to be too similar to the indigenous system of rolling settlement known as badla which was somehow thought to be evil. The compromise was to begin with index futures and defer the launch of single stock futures. In reality, the single stock future was the first equity derivative to become successful in India, and then the earlier products picked up with a significant lag. India also became one of the largest single stock future markets in the world while also creating very liquid index futures, index options and single stock option markets. The Indian experience also demonstrated that each of these four markets catered to a different need. For example, my former doctoral student Sonali Jain in a recent paper, along with my colleagues, Sobhesh Agarwalla and Ajay Pandey and myself found that in India, single stock futures play the role that the options market plays in the US for informed trading around earnings announcements. This implies that single stock futures have some clear advantages over options in informed trading.

With this background, I found it quite amusing to read the joint proposal by the US Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) to reduce margins for retail investors in single stock futures (see press release and proposal). The US set up a single stock futures market a decade ago, but it remains tiny. The SEC is now very clear about its desire to promote the growth of this market:

The security futures market can provide a low-friction means of obtaining delta exposures, and relatively high margin requirements … may have played a role in restraining its development.

To the extent that the proposed reductions in margin requirements encourage significant growth in the security futures markets, it may, in time, improve price discovery for underlying securities. In particular, a more active security futures market can reduce the frictions associated with shorting equity exposures, making it easier for negative information about a firm’s fundamentals to be incorporated into security prices. This could promote more efficient capital allocations by facilitating the flow of financial resources to their most productive uses.

There is also a degree of anxiety about foreign markets that have stolen a march over the US in this product:

Lowering the minimum margin requirement also could enable the one U.S. security futures exchange to better compete in the global marketplace, where security futures traded on foreign exchanges are subject to risk-based margin requirements that are generally lower than those applied to security futures traded in the U.S.

To make things more interesting, there is also a public statement of dissent by one of the SEC Commissioners. I never thought that a day would come when it would be easier to obtain consensus between the SEC and the CFTC than to get consensus within the SEC. What is striking about this dissent is that it does not disagree with the goal of promoting single stock futures. Commissioner Jackson says:

So [stock futures] can provide a valuable price-discovery function in stock markets and give investors an important way to diversify.

But he is not convinced that reducing margins are the best way to accomplish this goal. He believes that there are many alternatives that could and should have been considered. As an example, he suggests that:

rather than asking us to lower margin requirements, an exchange could simply reduce the contract size for single-stock futures. … reducing contract size could also increase access to single-stock futures for the most popular securities and improve efficiency. … Indeed, one of the most liquid contracts in the world, the S&P E-mini Futures contract, is the product of cutting the classic S&P Futures contract in half.

To me, what is noteworthy is that, in two decades, the world has moved from frowning on single stock futures to trying to nurture them.

Posted at 12:23 on Thu, 11 Jul 2019     2 comments     permanent link

Comments...

David Downey wrote on Tue, 16 Jul 2019 20:50

Re: US wants to nurture single stock futures

Nurture is not the word. This request was filed with the CFTC and SEC 11 years ago after substantial pre-file discussions. It is an abomination.

If the CFTC were the regulator SSF would be using SPAN margin instead of strategy based levels. Today's 20% requirement (as much as 20 times higher than SPAN for some products) means 92% of our listings are significantly over margined vis-a-vis SPAN. The move to 15% improves that to 85% being over margined. The question is why? Futures first line of defense is the daily variation pay/collect cycle. That is the discipline which makes the futures market safe. There is no build up of liabilities requiring excessive margin. The SEC staff knows they are stifling innovation and they lean on language in the Act that erroneously equates SSF with options. This is wrong. Options do not have daily variation pay/collect. If they did they wouldn't need the hefty margin requirement. So what is really going on? Profits. Broker dealers use margin collateral to create risk free rates of return in the Repo market each night. Brokers dealers generate large profits from lending money to their customers and using the securities purchased as collateral for the loan allowing them to lend those securities out and create risk-free rates of return using client's assets. SSF is a delta one derivative, as characteristic shared by only one other derivative....Total Return Swaps. When and if these swaps move to a clearing house the SEC will allow the clearing house to decide on margin levels. They will be risk based.

It makes no sense. The SEC must know they are protecting Broker Dealer profits at the expense of the participants in the capital markets.

Securities Lending, Equity Repo and risk-less funding trades should be opened up to all users of the capital markets. It is not rocket science. While the SEC provides the needed protection of excessive margin the status quo is protected.

David Downey wrote on Wed, 17 Jul 2019 20:31

Re: US wants to nurture single stock futures

Nurture is not the word. This request was filed with the CFTC and SEC 11 years ago after substantial pre-file discussions. It is an abomination.

If the CFTC were the regulator SSF would be using SPAN margin instead of strategy based levels. Today's 20% requirement (as much as 20 times higher than SPAN for some products) means 92% of our listings are significantly over margined vis-a-vis SPAN. The move to 15% improves that to 85% being over margined. The question is why? Futures first line of defense is the daily variation pay/collect cycle. That is the discipline which makes the futures market safe. There is no build up of liabilities requiring excessive margin. The SEC staff knows they are stifling innovation and they lean on language in the Act that erroneously equates SSF with options. This is wrong. Options do not have daily variation pay/collect. If they did they wouldn't need the hefty margin requirement. So what is really going on? Profits. Broker dealers use margin collateral to create risk free rates of return in the Repo market each night. Brokers dealers generate large profits from lending money to their customers and using the securities purchased as collateral for the loan allowing them to lend those securities out and create risk-free rates of return using client's assets. SSF is a delta one derivative, as characteristic shared by only one other derivative....Total Return Swaps. When and if these swaps move to a clearing house the SEC will allow the clearing house to decide on margin levels. They will be risk based.

It makes no sense. The SEC must know they are protecting Broker Dealer profits at the expense of the participants in the capital markets.

Securities Lending, Equity Repo and risk-less funding trades should be opened up to all users of the capital markets. It is not rocket science. While the SEC provides the needed protection of excessive margin the status quo is protected.