Single-Stock Futures Markets: Where's The Fungibility?

As we draw closer to the launch of a quartet of single-stock futures (SSF) markets in the United States, questions are beginning to arise about whether NQLX, OneChicago, the American Stock Exchange and the Island Futures Exchange are fungible enough to provide investors with true best execution.

Steve Sanders, vice president of business development at Interactive Brokers -- a direct-access vendor that expects to offer its customers electronic access to three of the four SSF exchanges -- says that SSF contracts, as they are currently constructed, are not interchangeable. "What I'm really talking about is the fact that you can't hold custody with an exchange's single-stock futures contract in other markets," he says. "If I go to OneChicago and I buy a contract, and then I want to sell that contract, I can't go to Island or NQLX or some other market to sell that contract. I'd be forced to sell that contract back on OneChicago."

Noting that IB plans to build electronic interfaces to the trading engines employed by NQLX, OneChicago and Island, Sanders says the vendor will use its intelligent order-routing engine to shop for the best SSF price for its clients. That functionality, he says, should allow an IB client to swing a good deal when they enter a position. However, says Sanders, when clients want to "turn around" positions they have entered into, there is no guarantee that they will get the best price, because they have to transact with the same exchange they initially bought or sold a SSF contract from. "You would hope that because we're dealing in two-sided markets, there is going to be lots of liquidity, and that customers won't be hurt. But the best of all worlds is to have (a system) like the equity markets, where if you buy IBM on one exchange, you can sell it on any other exchange, ECN or ATS," he says.

Anthony Orantes, vice president of finance and operations at the direct-access vendor Sonic Trading, says that the Securities and Exchange Commission and the Commodity Futures Trading Commission -- the regulatory bodies that are going to share oversight of the SSF markets -- are pushing exchanges and independent software vendors operating in the SSF space to provide best execution to investors. But he also says the regulators have not pushed hard enough to force the exchanges to be fungible. "How can you provide best execution if you want to buy a contract on OneChicago and sell on NQLX, but you can't, because it's not a fungible type of security," Orantes asks rhetorically.

Without fungibility, he says, certain factors that could differentiate SSF markets -- such as speed -- are not as vital. Since the markets are not interchangeable, says Orantes, it will be harder for markets such as Island to leverage their speed. " But if you had the fungibility, I could buy on Island and sell on NQLX, and know that the speed actually made a difference," he explains.

Sources say that while Island, NQLX and Amex are willing to cooperate to make their contracts fungible, OneChicago remains on the outside looking in. "OneChicago realizes that initially it may have more of the (SSF) liquidity. So it may be against their interest at this point to focus on fungibility," one source theorizes.

Despite the fact that they lack fungibility, the SSF markets are in good position to attract liquidity from both active individual investors and hedge funds, says Sonic's Orantes. Noting that day traders are not making as much profits as they once were in the U.S.-equity markets, Orantes says that active retail investors will likely look to take advantage of the arbitrage opportunities SSF present. "I think the single-stock futures are really going to accommodate a different type of market. These contracts are going to be a real big plus for not only the active traders, but also hedge funds and institutions," he says. "I expect the hedge funds are going to be watching single-stock futures very closely. But I think they will take more of a wait-and-see approach, because they don't want to be the guinea pigs for a new product."

Trading of SSF, or futures based on individual stocks, will begin soon -- possibly as early as later this quarter. After the SEC and CFTC finalize some margin rules for SSF, trading of the contracts is expected to commence. OneChicago, NQLX and Island plan to trade SSF in all-electronic environments. The Amex, in contrast, will buy and sell the hybrid contracts on it specialist-driven trading floor.