Future liquidity
10 December 2013
Short-sellers could arguably increase their profits by shorting single-stock futures rather than engaging in securities lending. So why aren’t they doing so? SLT takes a look
Image: Shutterstock
A single-stock future (SSF) is a contract to facilitate the exchange of shares for a price agreed in advance for a delivery on a specified future date. The contracts are traded on an exchange. The buyer hedges on a price rise and the seller on a fall. Unless the share price remains as it was when the contract is signed, one or the other of the two parties will benefit from the deal, while the other makes a loss.
The prudence of a single-stock future investment is determined in accordance with the standard theoretical pricing model for futures. The only underlying factor in its success is the position of the stock on the date agreed between the two parties.
The value of the SSF contract is nil upon establishment. This value changes to reflect the increase or decrease in the price of the stock, minus the originally established cost of the futures contract.
By convention, SSFs are traded in batches of 100. They come without voting rights or dividend expectations—because they are futures contracts they are traded on margin—but crucially they are not subject to the same short selling limitations as shares.
They are predominately traded in the South Africa, the US and the UK. The largest SSF market in the world is in South Africa, where more than 700,000 contracts are traded daily.
Out of favour
In the 1980s in the US, SSFs were disallowed from all exchange listings. The Commodity Futures Trading Commission and the Securities and Exchange Commission could not agree which body was responsible for the regulation of the instruments.
Following the Commodity Futures Modernization Act in 2000, a joint jurisdiction plan was shaped, and the first SSFs were traded in the US in late 2002.
Initially, two exchanges offered the product, although one has since closed. OneChicago, the remaining market, enjoyed record growth in November, surpassing the 8.3 million mark in year-to-date volumes.
The volume increase, 31 percent over November 2012, was largely driven by participants diversifying their holdings using SSFs. “The record year-to-date volume underscores that the combination of a complex regulatory environment and a market with tighter capital has an increasing number of discerning investors turning to these products as vital components of their overall portfolios,” said David Downey, CEO of OneChicago, in a statement.
Supporters of SSFs believe that the instruments have advantages over securities lending transactions. Thomas Halikias of Light Horse Market Solutions says: “Since the SSF market matches both the lender and borrower directly, funds often get improved pricing over what their prime brokers may offer. Additionally, there are select opportunities to be paid to replace a short equity position with the corresponding short equity futures position.”
In the futures market, there are no lending fees. Because traders in SSFs know in advance the date by which the stock must be returned, the nature of the market eliminates the risk that a securities loan will be called in a higher value than when it was borrowed.
To trade in an SSF does not specifically require registration with the Commodity Future Trading Commission. Exemptions are available from the commission for most equity-based strategies.
Short sellers could arguably increase their profits by shorting single-stock futures rather than engaging in securities lending. Why aren’t more of them doing it? Halikias believes that this is due, in part, to ignorance of the opportunity that SSFs can offer, as well as a conflict of interest for prime brokers.
“Unfortunately, most prime brokers or custodians don’t promote the market, they’re worried about losing stock lending and financing revenues. The product’s fixed term can be an issue for some strategies, but it’s mostly because managers don’t know about the opportunities.”
Another bonus in single-stock futures for US equity holders internationally is that the use of SSFs can significantly reduce US dividend withholding tax exposure. Fund managers can finance US equities and improve net equity and portfolio retentions considerably. The US Treasury’s 4 December 2013 proposed legislation regarding “equity linked investments” implies that the simplicity of the SSF 1C contract, solely requiring future delivery of the underlying equity, provides no payment or dividend adjustment to be withheld.
Halikias says: “The futures economics don’t warrant withholding; they are completely indifferent to the dividend process. We’ve discussed this with the US Treasury and believe the recently released 2013 proposed regulations support this view.”
SSFs may benefit organisations in ways that are not immediately obvious to portfolio and asset managers. As opposed to counterparts and public exchange transactions, with the enhanced credit rating of the Options Clearing Corporation structure, Basel capital reporting can be improved.
Implementing a trading platform for SSFs can take time, but for firms with options or futures activity, the trading and risk mechanisms are similar.
When the framework has been laid, trading in SSFs is as simple as any other institutional futures transaction. Existing risk accountancy capabilities can be easily applied to SSFs, and so implementation costs can be kept to a minimum.
Single-stock futures are a valuable commodity in a market struggling for alternative sources of capital and could prove to be the next big success story in the years ahead.
The prudence of a single-stock future investment is determined in accordance with the standard theoretical pricing model for futures. The only underlying factor in its success is the position of the stock on the date agreed between the two parties.
The value of the SSF contract is nil upon establishment. This value changes to reflect the increase or decrease in the price of the stock, minus the originally established cost of the futures contract.
By convention, SSFs are traded in batches of 100. They come without voting rights or dividend expectations—because they are futures contracts they are traded on margin—but crucially they are not subject to the same short selling limitations as shares.
They are predominately traded in the South Africa, the US and the UK. The largest SSF market in the world is in South Africa, where more than 700,000 contracts are traded daily.
Out of favour
In the 1980s in the US, SSFs were disallowed from all exchange listings. The Commodity Futures Trading Commission and the Securities and Exchange Commission could not agree which body was responsible for the regulation of the instruments.
Following the Commodity Futures Modernization Act in 2000, a joint jurisdiction plan was shaped, and the first SSFs were traded in the US in late 2002.
Initially, two exchanges offered the product, although one has since closed. OneChicago, the remaining market, enjoyed record growth in November, surpassing the 8.3 million mark in year-to-date volumes.
The volume increase, 31 percent over November 2012, was largely driven by participants diversifying their holdings using SSFs. “The record year-to-date volume underscores that the combination of a complex regulatory environment and a market with tighter capital has an increasing number of discerning investors turning to these products as vital components of their overall portfolios,” said David Downey, CEO of OneChicago, in a statement.
Supporters of SSFs believe that the instruments have advantages over securities lending transactions. Thomas Halikias of Light Horse Market Solutions says: “Since the SSF market matches both the lender and borrower directly, funds often get improved pricing over what their prime brokers may offer. Additionally, there are select opportunities to be paid to replace a short equity position with the corresponding short equity futures position.”
In the futures market, there are no lending fees. Because traders in SSFs know in advance the date by which the stock must be returned, the nature of the market eliminates the risk that a securities loan will be called in a higher value than when it was borrowed.
To trade in an SSF does not specifically require registration with the Commodity Future Trading Commission. Exemptions are available from the commission for most equity-based strategies.
Short sellers could arguably increase their profits by shorting single-stock futures rather than engaging in securities lending. Why aren’t more of them doing it? Halikias believes that this is due, in part, to ignorance of the opportunity that SSFs can offer, as well as a conflict of interest for prime brokers.
“Unfortunately, most prime brokers or custodians don’t promote the market, they’re worried about losing stock lending and financing revenues. The product’s fixed term can be an issue for some strategies, but it’s mostly because managers don’t know about the opportunities.”
Another bonus in single-stock futures for US equity holders internationally is that the use of SSFs can significantly reduce US dividend withholding tax exposure. Fund managers can finance US equities and improve net equity and portfolio retentions considerably. The US Treasury’s 4 December 2013 proposed legislation regarding “equity linked investments” implies that the simplicity of the SSF 1C contract, solely requiring future delivery of the underlying equity, provides no payment or dividend adjustment to be withheld.
Halikias says: “The futures economics don’t warrant withholding; they are completely indifferent to the dividend process. We’ve discussed this with the US Treasury and believe the recently released 2013 proposed regulations support this view.”
SSFs may benefit organisations in ways that are not immediately obvious to portfolio and asset managers. As opposed to counterparts and public exchange transactions, with the enhanced credit rating of the Options Clearing Corporation structure, Basel capital reporting can be improved.
Implementing a trading platform for SSFs can take time, but for firms with options or futures activity, the trading and risk mechanisms are similar.
When the framework has been laid, trading in SSFs is as simple as any other institutional futures transaction. Existing risk accountancy capabilities can be easily applied to SSFs, and so implementation costs can be kept to a minimum.
Single-stock futures are a valuable commodity in a market struggling for alternative sources of capital and could prove to be the next big success story in the years ahead.
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