gorodenkoff
Introduction
This article catalogs the relative strengths of futures trading compared to securities trading. Briefly, futures markets have a safer, more efficient margining system and clearing mechanism. Moreover, futures exchanges have a more innovation-friendly regulator.
Both the futures market and the securities market have deserted investors in favor of other customers. With securities markets, this is probably permanent, since they have always been focused on the needs of securities issuers with their lucrative IPOs. The securities exchanges cannot serve two masters. This leaves the listing of investor-friendly securities to the futures exchanges.
To successfully build investor-friendly markets, the futures exchanges might provide new long-term liabilities to institutional investors. These exchanges could also attract HFTs through the advantages of futures clearinghouse technology – lower, risk-sensitive margins and T+0 clearing.
Futures markets’ strengths
Futures markets have been quite successful since the advent of electronic trading circa 2000. Especially in comparison to securities exchanges. Some reasons why: futures’ risk-sensitive, retail-friendly margining, retail-friendly clearing, and innovation-friendly regulation on one hand, and securities exchange loyalty to customers whose interests are counter to investor interests on the other.
Effect of futures margining
Futures owe their better performance in part to futures exchange clearing’s positive impact on arbitrage. There are two kinds of arbitrage in a financial market environment – unproductive and productive. An unproductive arbitrage transaction becomes a closed position on a single exchange – for example, the purchase and sale of the same security. A productive arbitrage leaves a combined position on the same exchange — for example, the simultaneous purchase and sale of two different closely correlated securities, a basis trade.
Why is futures market arbitrage more efficient?
First, by including the exchange clearinghouse as a counterparty to every transaction, the exchange closes the door on offsetting a transaction on another exchange. No HFT unproductive arbitrage is possible.
Second, the futures clearinghouse system also reduces the cost of trading and offset compared to trading on two separate exchanges because two-exchange offset trading creates margins for both the purchase and sale. Trading the same offset on a single exchange drops margins and eliminates the two positions altogether.
Third, a futures exchange can adjust margins on paired transactions downward if their combined risk is less than the risks of the two transactions separately. Two futures exchanges cannot make this margin adjustment, nor can any securities exchange.
This encourages traders to find related transactions at the exchange of their existing transactions. This capability is a powerful reason to trade every related instrument on the same exchange. The resulting economies of scale allow one exchange to dominate the rest.
Effect of all-to-all clearing
Because futures run an all-to-all book — read here for an explanation – there is no market separation into insiders and outsiders. Both the securities exchanges and the futures exchanges set out to prevent outsider markets, but high-frequency trading (HFT) denied outsiders access to securities exchanges – read here.
Futures’ all-to-all clearing assures that markets provide an equal playing field for both retail and wholesale traders.
Effect of futures’ exchange-friendly regulation
SEC (Securities and Exchange Commission) inflexibility. The SEC’s original NMS rules – find them here — were intended to inspire inter-exchange competition, a competition that would assure the best fill for all traders equally. But when it failed, SEC inflexibility would not allow the agency to make simple adjustments such as exchange matching engine colocation (read here) that would reduce trading costs generally and eliminate HFT specifically.
A second HFT fix, branding, (read here and here) would inform investors whether their trade has been executed OTC or through an exchange, and if through an exchange, which one. This would enable investors to reward quality execution through repeat business.
The SEC, due to its inflexibility, is not open to this kind of simple rule change. Thus, the agency has not opened its regulated exchanges to investors again.
CFTC (Commodity Futures Trading Commission) laissez faire attitude. The CFTC, on the other hand, is open to change. In the early 1980s, the CFTC required exchanges to provide an extensive justification for any futures trading change — consistent with the then-in-vogue theory that for a futures exchange to do anything new was a bad thing, requiring the exchange to demonstrate that there would be an offsetting benefit.
Since then, financial regulation has evolved to a more reasonable theory – if the market finds a change useful, let it be. This CFTC laissez faire approach makes the futures markets the place to introduce innovation in market structure.
How securities and futures exchanges’ constituencies affect exchange attitudes toward investors
Securities exchanges. Securities exchanges make most of their profits from two kinds of securities market participants – corporate listers and HFTs. Corporate listers are a long-term source of profits for two of the 15+ exchanges – the New York Stock Exchange (NYSE) and NASDAQ.
The other 13+ exchanges exist solely to create unproductive arbitrage for HFTs. This is not a long-term source of profit but instead, a market-wide cost that could be eliminated with a wave of the SEC wand. (See “SEC (Securities and Exchange Commission) inflexibility.” above.)
In short, an efficient outcome that the SEC could easily achieve is the old two-exchange system, but now focused on listings, not matching. The rise of electronic trading has made matching a trivial activity that over thirty Alternative Trading Systems (ATS) perform. The big two securities exchanges are now shills for corporate issuers and HFTs, leaving futures exchanges with the opportunity to serve both investors and day traders and perhaps to attract HFI-arbitrageurs as well.
Futures exchanges. Futures exchanges to date have been lazy in seeking to attract trader business other than day traders. The opportunity, with a more aggressive attitude, is substantial. Most importantly, a financial futures exchange decision to manage the securities delivered in the settlement of futures contracts would place an exchange at the center of capital formation through investment in exchange-originated and -listed securities.
Futures exchange opportunities.
The exchanges can introduce these three improvements in customer service.
- Market expansion. Exchange listing and management of deliverable securities is a desirable measure, enabling an exchange first to list new securities that have greater appeal to investors; second, to modify existing deliverable securities to meet the changing needs of both investors and regulators.
- Market protection. By listing deliverable instruments with safety features such as no investor redemption, an exchange could protect the market from the existing serious problem of market singularities (read here).
- Attraction of new customers.
- Investors poorly served by the securities exchanges are a constituency that could easily double the customer base of futures exchanges. Investors would be attracted by an exchange listing of investor-friendly securities, by lower transaction costs, and T + 0 clearing. The futures exchange clearing advantages would enable it to improve the existing market structure, for example.
- EFT traders. In EFT trading, futures exchanges could attract EFT arbitrage firms like Jump Trading. In EFT investing, futures markets could attract passive investors. Finally, the lower margin costs of arbitrage could attract HFTs.
What futures exchanges might change to accomplish their goals
Here are four ways the futures exchanges can proceed.
Attract users being served by the securities exchanges.
HFTs. If the SEC were to eliminate HFT trading in the securities markets (or even if the SEC fails to do so), the futures markets should seize the opportunity to provide HFT firms with another, better, venue. HFTs using futures markets are precluded from inter-exchange arbitrage but would find intra-exchange arbitrage to be less capital-expensive than inter-exchange trading.
To form a community of interest with the HFTs, futures exchanges must list multiple futures with deliverable securities whose prices are highly correlated. The joys of lower-margin basis trading are less exciting if there are no highly correlated futures prices to basis trade.
The Chicago firm, Jane Street Capital, an EFT arbitrage firm, would undoubtedly be happy to suggest highly correlated bond EFT listings that would leave Jane Street’s business model intact but improve trading costs, replace T+1 with T+0, and reduce its capital requirements.
Investors. The appeal of futures markets to investors is the elimination of insider trading, lower margins, and the ability to create investment products that meet investor needs. Several modifications to a typical futures contract would make futures contracts more investor-friendly.
Show more concern for the wishes of government regulators.
The termination of LIBOR and the end of Eurodollar futures ought to make it apparent that the Fed and Treasury can end a futures market in the blink of an eye. It is not difficult to gain regulator approval. A courtesy presentation of the terms of a proposed contract to the affected agencies, along with the implementation of regulators’ desired changes and regular contact to assure continued acceptance of the contract’s impact on market issues should be enough.
List missing securities that investors cannot otherwise issue.
Two prominent examples of major institutions with major unmet financing needs are commercial banks and pension funds.
Banks. The nation’s 4,000+ commercial banks would benefit greatly from the replacement of the complicated derivatives hedging facilities available today. Interest rate swaps have proven vulnerable to disastrous market events like the Lehman Brothers disaster. The Eurodollar futures markets were also placed under considerable stress during the Lehman collapse, although they fared better than the swaps market. If a futures market settles with a deposit-like instrument – say an asset-backed security that lists weekly three maturities (three-month, six-month, and one-year) instead of being trapped in the complicated machinations of derivatives hedging, a bank could simply sell term commercial paper that investors won’t buy during crises into the futures market settlement, providing banks with a liability maturity that more closely matches its needs.
This method would have prevented more than just the Lehman Brothers disaster. Since the bank paper delivered into the futures contracts would not be subject to withdrawal, the Silicon Valley Bank/Signature Bank electronic run would never have happened.
Following the SVB crisis, commercial paper investors dramatically reduced their willingness to accept longer-term paper. (Read here.) As markets absorbed the failures of SVB and Credit Suisse, one-to-four-day trading volume increased from 84% of total unsecured issuances at the beginning of March to 93% during the last week. Rates on the same maturities rose 15 basis points to 4.8% while 90-day rates increased 23 basis points to 4.97%.
The Fed reacted to the SVB crisis by insuring large otherwise uninsured wholesale depositors that had departed the distressed institutions. Their return to the distressed institutions gave the banks time to replace the now-plainly risky deposits with longer-term commercial paper. Futures exchange-listed longer-term paper could return the support of long-term asset, liability-sensitive banks to the private sector.
Pension funds. Defined benefit pension funds are vulnerable to changes in interest rates. Defined benefit funds insure according to the contributions of the insured, not according to the income generated by worker contributions. This means that contributions made during periods of low invested interest rates are likely to underfund future payments to insured workers when interest rates rise.
In the example of the UK Pension Fund Crisis of 2022, pension funds were liability sensitive since UK longer-term debt markets are almost non-existent. Rather than develop the missing long-term debt, insurers resorted to derivatives hedging paired with repo borrowing to disguise the underfunding problem, setting the stage for repo lenders to desert the pension funds. Ultimately, the Bank of England was forced to come to the rescue.
Rescuing is a trend, both in the US and in the UK, where central banks paper over failures of the financial system. The proposal to enhance the capital-creating capabilities of futures markets would improve the resilience of the investor-financed system and ensure the long-term funding that pension funds can’t find becomes available.
Leave behind anachronistic commodity-based practices.
First, dump the old commodities trading practice of delivering contracts infrequently. (Quarterly, for the most part.) Commodities are very expensive to deliver, so infrequent deliveries make sense. Financial futures are nearly costless to deliver. Thus, frequent delivery makes sense. Perhaps something like the Treasury’s weekly issuing cycle would be a good choice.
Conclusion
Futures markets can help themselves by helping key investor groups. By focusing on new deliverable issues, the futures exchanges can attract major new customer groups while simultaneously stabilizing the financial system.
The failure of the securities exchanges to meet the needs of investors following the introduction of electronic trading and the failure of the SEC to adjust securities regulations to return the securities markets to investor-oriented behavior has left the central-to-finance activity of building capital to the futures exchanges.
