A Marketplace in Transition

Fueled by the rollouts of NQLX and OneChicago, the SSF landscape will continue to take shape in 2003.

The recent launch of a pair of all-electronic single-stock-futures exchanges has ushered in a new era of hybrid financial markets. Trading of SSF - or futures based on individual stocks - had been banned in the United States for nearly two decades, prior to the simultaneous debuts of Nasdaq-Liffe Markets (NQLX) and OneChicago, on Nov. 8, 2002.

Now, however, armed with the backing of some of the world's largest stock, options and futures exchanges, NQLX and OneChicago are in hot pursuit of a broad array of potential SSF consumers - including active retail traders, hedge funds, proprietary traders and futures-commission merchants.

In truth, since these exchanges are so new, we know relatively little about them. We know that NQLX, jointly owned by the Nasdaq Stock Market and the London International Financial Futures and Options Exchange, employs a central-limit-order-book-driven business model, supplemented by multiple market makers placing bids and offers in every instrument traded at the exchange.

We know that OneChicago - owned by a Chicago exchange trio comprised of the Chicago Board Options Exchange, Chicago Mercantile Exchange and Chicago Board of Trade - uses an electronic-auction model spearheaded by so-called lead market makers that are responsible for maintaining two-side quotes for each instrument the exchange trades.

We also know that while NQLX is employing Liffe's Liffe Connect system as its matching engine, OneChicago is relying on the CBOE's CBOEdirect platform as its core trading system. What's more, we are aware that both exchanges clear their trades via the Options Clearing Corp., and that NQLX, through its first week of trading, posted a slight edge in volume (24,106 contracts traded versus 18,515, from Nov. 11 - 15) over OneChicago.

But perhaps more significant than those facts are the key questions that remain unanswered. For example, will the exchanges ever embrace fungibility? How will the competitive landscape evolve in 2003? And will potential latecomers to the SSF party - including Island and the American Stock Exchange - stand any chance to succeed?

Fungibility Fisticuffs
Over the next 12 months, answers to these queries will begin to emerge. But before the SSF landscape can truly start to take shape, the issue of fungibility must be addressed.

Today, products traded on NQLX and OneChicago are not fungible. In simple terms, that means that if you buy a contract on one exchange, you cannot sell it on the other.

Since OneChicago and NQLX plan to trade around 40 identical futures based on single stocks, this lack of fungibility is problematic to many traders - particularly to FCMs and broker/dealers that have an obligation to obtain best executions for their clients.

"Not being fungible is in the interests only of the exchanges, not the users. It's clearly counter to the interests of the trading community, and the people who are going to be using the product," says Peter Johnson, a managing director at JPMorgan Futures, a large futures brokerage firm.

Fritz McCormick, an analyst covering institutional e-brokerage at Celent Communications, says the fungibility void stems from the exchanges' competitive desires.

"Everyone says they want fungibility, but none of exchanges are moving there," he says. "I think that, right now, the fear is that (each) exchange wants to contain as much liquidity inside its walls as possible. And (they're saying), 'only when we can build enough liquidity will we provide fungibility.' But that is kind of a Catch 22, because you're not going to create that liquidity unless investors are confident that they can execute buys and sells, in the (SSF) marketplace, in any of these venues. "

However, NQLX Chief Executive Officer Tom Ascher says the blame for the fungibility void lies squarely on the shoulders of OneChicago. NQLX, he says, supports fungibility, but OneChicago is dead-set against it.

"We have not gone to a single firm, be it an FCM or a broker/dealer, that hasn't asked for fungibility, typically within the first five minutes of our visit ... . But it does not matter if I am promoted from CEO to czar of NQLX, I can't unilaterally decree fungibility," he explains.

Due to the fact that both NQLX and OneChicago clear through the OCC, the markets would not have to build any electronic interfaces between their systems to create fungibility. Rather, says Ascher, they would just have to sign a few legal documents to make their crossover products interchangeable.

"Fungibility has nothing to do with technology ... . But there is nothing to hammer out - (OneChicago) won't do it," he says.

Peter Borish, senior managing director at OneChicago, concedes that the Chicago joint venture is currently "philosophically" opposed to making its contracts fungible with duplicative contracts that trade at the NQLX. "We feel strongly at OneChicago that the best way to build liquidity in an exchange, in the early years, is not to have fungibility," he says.

Amex and Island: Party crashers
As NQLX and OneChicago work to build their liquidity, the American Stock Exchange and Island - the electronic-communications network that recently merged with its former rival, Instinet - are devising plans to break into the SSF market. Island, like its SSF predecessors, plans to launch a fully automated market - dubbed the Island Futures Exchange - within the next few months. But the Amex, in stark contrast, is scheduled to deploy single-stock-futures contracts on its trading floor.

Amex, which expects to begin its SSF rollout in the first quarter of 2003, plans to trade its individual-stock futures, side-by-side, with contracts trading in its specialist-driven equity-options pit. The Amex hopes to leverage the synergies between its options and single-stock futures in its open-outcry environment.

But JPMorgan's Johnson says that any market that attempts to list new contracts on a floor is kidding itself. "Those guys are going to get passed by, and they will never be a serious player in single-stock futures if they are going to list that stuff on the floor," he says. "The market is much, much bigger than any single local or market maker these days on the floor. You need a lot of liquidity providers and a lot of transparency, especially with new products."

The Amex, however, thinks it will be able to feed off of its large, captive audience of options-liquidity providers. Celent's McCormick says Amex's side-by-side single-stock-futures blueprint is an interesting idea, because it would enable the market to launch a new product line without having to reinvent the wheel.

However, he also wonders whether trading on the Amex's floor will eventually become too chaotic. "From a logistical perspective, it makes sense, because you're doubling up on your existing infrastructure. But will there be a problem if you get real big spikes in volatility at certain times?" he asks rhetorically. Amex officials could not be reached by the deadline for this story.

Unlike Amex, the Island Futures Exchange will be fully automated. But other than the fact that Island expects to employ a designated contract-market business model, few details about the ECN's SSF plans have emerged. An Island Futures Exchange official did not return a call seeking comment.

McCormick says that Island may try to leverage the considerable liquidity it has amassed trading stocks to boost the fortunes of its futures exchange. The trick for Island, he says, is to garner the SSF support of Instinet. But that may be easier said than done, considering that Instinet is currently busy integrating the two largest ECNs in the U.S.-equities market.

Of course, if NQLX and OneChicago prove wildly successful, both Island and Amex could be buried before they even get out of the gate. "If February comes around, and there is a whole lot of investor interest in single-stock futures, and NQLX and OneChicago have cornered the market, the other two are going to be left out in the cold," McCormick predicts.