Cheaper global trading

USFs make buying and selling across borders that much simpler – and hefty settlement costs are lower too.

The latest single-stock futures products, Universal Stock Futures (USFs), aim to simplify cross-border investment strategies such as pairs trading. They do this through exposure to a range of equities from different countries, as well as to a range of currencies. For example, if BP’s prospects look better in the short term than Total Fina Elf’s, USFs make it simple to buy the BP USF and sell the Total Fina Elf contract. Unlike shares, there is no UK stamp duty to pay, and the products can be cross-margined. It is also possible to use USFs to take advantage of different tax regimes around the world through dividend arbitrage. Trades that account for up to 90 per cent of the volume of the underlying shares are now commonplace. These aspects are particularly relevant for global investors looking to trade across borders efficiently. Simply put, they no longer have to worry about varying rules and regulations in different markets. This in turn dramatically lowers cross-border settlement costs that – according to a Bank of International Settlements study last year – amount to 60 per cent of transaction costs. Selling point But USFs, which have been launched by the London International Financial Futures and Options Exchange (LIFFE), have not arrived unopposed. Their cheapness, compared with counter products, may be a powerful selling point as the product develops, with institutional users finding that, as there are discounts for bulk transactions, they will pay the same or lower fees for USF business that they pay for their index futures business. Around 2.3m USF contracts, with a notional value of Ł5.4bn, changed hands in 2001. Average daily turnover was just under 10,000 contracts. Trading volumes in 2002 are growing, with average daily volume up to the 17,000 mark, and on 11 May 2002, open interest reached a record level or 462,126 lots. With a total of 122 contracts available to trade, the range of stocks covered means that individual components of tradable indices like the DJ STOXX 50 Europe can be traded through USFs. Most of the main industry sectors can also be replicated through USF trading, enabling strategies that give exposure to certain sectors at the expense of others – pharmaceuticals versus telecoms, for example. Comparing the volumes of individual USFs with trade in the underlying stock in the cash markets provides another sign that investors are coming to see single-stock futures as an alternative to trading the underlying stock. Volume in the Nokia USF one day recently equalled 7.8 per cent of the volumes in the technology giant’s stock. Other USFs have seen even higher percentages – up to 20 per cent and 15 per cent in the volumes of BASF and ENI respectively. Challenges The challenge ahead lies in persuading investors to use single-stock futures instead of the cash products or over-the-counter derivative products they have traditionally used in the past. Their design will help, as they offer investors far more flexibility than trading the underlying share. Single-stock futures facilitate the initiation of short positions, without having to worry about stock borrowing. They can be used as a proxy for investment in a particular sector and as a cash-flow tool by minimising balance sheet usage when initiating exposure to a new sector. Moreover, as USFs are cleared through one centralised clearing house, the London Clearing House (LCH), the security of the product is strong. Single-stock futures users are not dependent on a single counterparty, as there are several market makers quoting a particular contract. And because they are exchange-traded products, other participants may well have entered orders, resulting in a tightening of the bid/offer spread. The circumstances favour equity-based derivatives. In 1990, the US equity market was approximately one and a half times the size of the government bond market. By the turn of the millennium, it was more than four times bigger. Pointing to the growth of equity markets in comparison to debt markets, Dr Richard Sandor, regarded by many as one of the founding fathers of financial futures, believes that equity products will be to the 21st century what debt instruments were to the 20th, as the equity markets become an increasingly important source of finance. Appeal A major barrier to the growth of equity derivatives, the Shad-Johnson Accord – which effectively focused the derivatives explosion of the 1990s on the debt markets by banning single-stock futures trading – has now been removed. So US investors, both wholesale and retail, will shortly be able to start trading. What is clear is that there has been a huge surge of interest in the whole concept of stock futures as instruments to seize opportunities in the market and for risk management. Stock futures are now listed by around 15 different exchanges. In the UK, LIFFE has forged a partnership with Nasdaq, called NQLX, to take single-stock futures to the US investor. But much as the ease with which sophisticated trades can be structured through single stock futures matters, their real appeal is likely to stem from the fact they allow easy, leveraged access to equities. They can be used both to initiate positions, or to hedge existing portfolios, and this can be done quickly, efficiently and cheaply. The Centre for the Study of Financial Innovation, a think-tank based in London, recently turned its attention to the single-stock futures phenomenon. USFs, they concluded, “could radically alter the dynamics of equity investing”.