Industry Pro Thomas Halikias contributed the following “Single Stock Futures…A New Dawn?” to Tabb Forum. Excerpted version is below, full article available by clicking on Tabb’s logo..
In nearly every conversation about single stock futures – and they’re happening more frequently than ever these days – several typical misconceptions emerge:
- “Futures? We don’t trade futures.”
- “Single stock futures? They don’t seem very liquid.”
- “How do single stock futures minimize our U.S withholding tax?”
The product’s unfortunate association with speculative trading strategies often found in illiquid commodities has been a significant barrier in extolling the many virtues of this sophisticated financing and stock lending instrument. While customers can and do trade single stock futures in a speculative manner, the more subtle uses of them can be easily overlooked. Additionally, trading single stock futures does not specifically require Commodity Future Trading Commission (CFTC) registration – exemptions are available for most equity-based strategies.
Single stock futures can be packaged against the underlying equity to either finance a long equity position or to “lend” the underlying equity to parties interested in obtaining the long shares for an extended period of time.
For example, if an institution wishes to finance a specific equity position, it would sell the underlying equity simultaneously with the purchase of the equity’s single stock future. This simultaneous transaction is called an exchange for physical (EFP) and bears absolutely no directional market risk. The pricing differential is based solely on market financing rates.
For a “lending” transaction, the institution would perform a similar simultaneous equity for future EFP but in this case the pricing differential would be based on the market rate for borrowing the stock. In both transactions, the institution would select the appropriate future expiration cycle to match their desired time frame for financing or “lending” the security.
While transactional volume on OneChicago continues to grow – the exchange experienced record volume this March – the “shadow liquidity” in the financing or lending market is extraordinary.
The two major attributes of single stock futures are the listed nature of the product, fortified by the AAA-rated Option Clearing Corp.’s (OCC) explicit delivery guarantee, and the wide diversity of market participants able to transact via the OneChicago exchange.
The diversity of participants and their accompanying institutional strengths creates an extremely efficient market framework. The OCC guarantee enables large institutional cash managers to seamlessly fund small or poor credit quality entities or for large position holders to monetize equity holdings for an extended period of time without concern for counterparty credit lines or documentation requirements.
Additionally, the opportunity to pair up “naturals” – two counterparties with offsetting exposures – further improves market pricing. An example of a “natural” transaction would be the financing of an equity that is involved in the purchase of another listed company. Under such a scenario, a merger arbitrageur would actually receive payment for borrowing the security he needs to short for the arbitrage. The joining of the financing and lending function in one market improves the pricing for all participants.
Another significant virtue for international holders of U.S. equities is that the use of single stock futures can dramatically reduce a firm’s U.S. dividend withholding tax exposure. Portfolio managers can finance high yielding U.S. equities and improve net equity and portfolio “retentions” considerably. The U.S. Treasury’s Jan. 19, 2012, proposed legislation regarding “dividend equivalents” implies that single stock futures 1C contracts, priced with an implied estimated dividend, will not be withheld as “dividend equivalents.”
We believe this ruling leaves single stock futures as the most efficient tool for optimizing off-shore U.S. equity portfolios. In our conversations with clients, we tend to focus on the quantifiable attributes of single stock futures for front line traders or position managers. These individuals tend to focus on pricing, counter-party risk and group or desk profits.
But single stock futures offer an array of organizational benefits that might not be a priority to desk heads or portfolio managers. These benefits include improved Basel capital reporting due to the superior credit rating of the OCC compared with traditional over-the-counter counterparts and exchange-listed price transparency that is easily incorporated into standard risk metrics and allows organizational risk managers to properly identify and calibrate the exposures inherent in their equity finance and stock loan activities. Utilizing single stock futures also conforms to the intent of Dodd-Frank.
Once clients understand the many virtues of single stock futures, they almost universally want to learn more. Like most new products, implementing a single stock futures trading platform takes some time and internal organizational approval and support. However, once all in-house requirements have been satisfied, the actual trading and clearing of single stock futures is relatively simple.
From our vantage point, we see the dawn of new opportunities afforded in the single stock futures market.