Convergence is a buzzword these days, except in derivatives. In the futures and options markets, convergence is more than a buzzword. Many exchanges see it as the future, although this has not always been the case. For decades, the two halves of the derivatives world all but ignored each other. After all, futures and options are two distinct product classes that require two very distinct marketplaces. These marketplaces even have different regulators, with the SEC watching over the options markets and the CFTC guiding the futures markets. In just about every respect, futures and options are different worlds. However, the fence between those worlds may not last much longer.
Symbiosis
Of course, no financial product exists in a vacuum. In the case of options and futures, there has always been some overlap between the two product classes. Many traders hedge their options positions with futures, resulting in small volume correlations between related products. On a handful of occasions, options and futures exchanges crossed over into the same territory, usually with mixed results. Perhaps the best example of options and futures exchanges treading on the same ground is the competition/cooperation between the S&P 500 options pit at the Chicago Mercantile Exchange (CME) and the SPX options pit at the Chicago Board Options Exchange (CBOE). The two products are practically identical, with activity in one pit often used as a gauge for the other. However, despite the near redundancy of these two products, both exchanges have maintained thriving S&P options volume. In many ways, the two products have become complementary, with each helping to drive business on the other exchange. So far, successful crossover products between the options and futures markets have been the exception, not the rule. But a rash of new expansions on both sides of the derivatives world may finally prove that convergence has triumphed.
Blurring the Boundaries
Driven by rising competitive pressures, steep analyst expectations and diminishing opportunities for expansion in their core product lines, options and futures exchanges have begun eyeing each other's fiefdoms. While it may sound strange, expansion into the other side of the market actually makes sense. Each side offers something that the other side does not. For the options exchanges, the futures markets hold the lure of monopoly products and the chance to deal with a regulator that actually understands their business. For the futures exchanges, the options markets offer a chance to expand beyond the limited distribution of core commodity products. They also offer a chance to capture a piece of the exploding options pie. For both marketplaces, convergence also offers the opportunity to increase the volume in their core product lines. For example, if a futures exchange lists options on an existing futures contract, the options activity will in turn generate increased demand for the futures contract.
Recent Developments
There have been a number of interesting developments on the convergence front in recent years. Two of the world's leading futures exchanges, the Chicago Board of Trade (CBOT) and the CME have both made significant inroads into the options markets. These exchanges have added significantly to their electronic options offerings, with the CBOT focusing on its DOW product line and CME focusing on its S&P product line. The result has been significant growth in its index options volume, an area that many options exchanges consider to be their bread and butter.
However, the options exchanges have not idly allowed the futures exchanges to move in on their territory. The CBOE created a subsidiary futures exchange in 2004 called the Chicago Futures Exchange (CFE). The Philadelphia Stock Exchange (PHLX) also followed suit by expanding the product lines offered on its Philadelphia Board of Trade (PBOT). Unfortunately for both parent exchanges, neither the CFE nor the PBOT made much of a splash in the futures world. The CFE launched with a product line that consisted primarily of Volatility Index (VIX) futures and S&P Variance futures. While these products were theoretically intriguing, their complexity made it difficult to find viable market makers, let alone customers. The PHLX made headlines last year when it announced plans to list event futures on the PBOT. Event futures are exciting products that allow customers to speculate on the outcome of specific events. The possibilities for these powerful products are limitless. Unfortunately, the PBOT's event futures have languished in regulatory purgatory. As of this writing, there is still no word if these products will ever see the light of day.
Strategic Alliance
In an attempt to refocus its efforts on the futures markets, the CBOE recently announced the formation of a strategic alliance with HedgeStreet, an online futures exchange that has only been in operation for a year. At the heart of this surprising alliance is the same product class that attracted so many headlines for the PBOT last year: event derivatives. Still, while the PBOT's products have yet to hit the market, HedgeStreet maintains a small but thriving market in both event futures and binary event options. The alliance between the CBOE and HedgeStreet shocked many industry analysts, but it actually makes sense for both. The upstart HedgeStreet receives the support of an established name in the derivatives world. It also receives access to its technology and experienced liquidity providers. The CBOE receives access to an established product line and the potential to develop new products for that line. While their event derivatives are currently limited to economic indicators and real estate indexes, there is potential for expansion. Unfortunately, the public relations disaster that followed the Defense Department's Terrorism Futures Exchange has made HedgeStreet and the CBOE cautious about product offerings. However, it is not difficult to foresee a time when the Super Bowl and even presidential elections are all wagered on with event futures contracts.
Technological Disparity
While convergence is definitely the wave of the future in the derivatives world, quite a few hurdles remain for any exchange looking to cross over to the dark side. Regulation continues to be the primary stumbling block. The SEC and the CFTC are notorious for not playing nice. The difficulties of dealing with both regulators have been enough to dissuade several exchanges from the process.
Technology is another significant hurdle. While both sides have made progress on the technology front, there is still a massive technological gulf between the options and futures markets. Since the options exchanges battle each other for market share every day, they have a significant incentive to offer their customers cutting-edge technology. Nevertheless, the monopolistic dominance of the futures exchanges has made them slow to update their technology platforms. An example is how both markets update their options prices. Updating options prices after every tick in the underlying is a daunting proposition. To ease this problem, the options exchanges developed the auto-quote system. Auto-quote technology updates options prices automatically after every tick, eliminating the problem of stale quotes.
While auto-quote has been standard in the options markets since the late 1990s, the futures industry relied on market makers to update their options prices manually until last year. If the futures markets want to attract technologically savvy options customers and make convergence a reality, then they are going to have to overcome their technological reticence.
The views of this column are those of its author. They do not necessarily reflect the opinions of Traders Magazine. The author can be reached at Mark.Longo@Sourcemedia.com
