If we compare the market structure of the two kinds of markets to the function of market instruments traded there, we can ask, “Does form follow function?” There is a missing market type. The article considers the missing function the new market would meet, how this market might be structured, and implications for existing markets.
Current market structure:
- Financial futures trade for deferred delivery of index-priced instruments (Treasury notes, foreign exchange), or deferred settlement at an index value (Eurodollars, S&P).
- Securities exchanges trade corporate claims and exchange-traded funds (ETFs).
The first diagram displays this market structure.
Now add the function of each market transaction to the diagram. There are three standard reasons for trades.
- First, to control or avoid changes in the value of an instrument.
- Second, to exercise the rights of ownership implied by a corporate obligation.
- Third, to capture the flow of non-price income from the ownership of the security.
Futures markets cater to traders who want only the most important function, to control changes in value; spot exchanges cater to traders who want all three functions. This raises a question: “Must the cost of capturing the flow of non-price income be linked to the cost of exercising the rights of ownership?” The article answers “No.”
The ETF is stuck in the middle. Arguably some actively managed ETFs seek to influence the decisions of management. Other passive index ETFs seek only to reflect a summary value of the entire market.
Certainly, though, a key competitive advantage of ETFs in their competition with futures markets for index traders is that ETFs pay the owner income other than changes in market value (dividends and interest income).
- Financial futures, ETFs, and corporate claims all perform the function of market value transfer.
- Corporate claims markets and ETFs confer on the owner the more expensive functions of ownership transfer and assignment of non-price changes in value to the buyer.
- Only corporate claims provide an implied claim on decisions of corporate management.
The diagrams raise an interesting line of questioning. Are costs of transfer appropriately aligned with the market’s function as is? Arguably not.
- Control of value is the objective of futures trading. Resource costs of futures trading are about one-third the cost of securities exchange trading because there is no transfer of ownership in futures trading. Futures traders only bear transfer of ownership cost on four days of the year, on contract delivery day. A very small percentage of futures traders hold their positions on the quarterly delivery day of futures. Thus, futures traders minimize the resource cost of receiving or paying changes in value. The cost of the most important function of trading is borne by all.
- ETF traders and traders of individual corporate claims add to resource costs of trading by requiring firms to pay owners the non-price income received by owners.
- Securities traders bear the entire burden of the cost of transfer of ownership. If there is any market where traders have an interest in bearing substantial added cost, it is the right-hand column of the diagram where traders who wish to influence the future decision-making of the management of the firm can express their value-weighted opinions through the exercise of the rights of ownership.
Is it efficient that traders of ETFs bear the cost of transfer of ownership twice – once when the ETF fund pays the cost for transfer of ownership of the security held in the ETF portfolio, then again when the ETF trader pays for transfer of ownership of the shares of the fund itself?
The argument that ETF buyers should pay for ownership transfer is stronger for active ETFs than for passive index ETFs. For active ETFs, the cost of ownership transfer is equal to its value because the manager of an active ETF does have an interest in influencing the decisions of ownership. In this respect, an actively managed ETF might be thought of as every man’s hedge fund.
This leaves us to consider the passive index ETF. The main competitive difference between passive index ETFs and stock index futures is the third function of ownership – receipt of income from ownership other than the value of the change in prices. ETFs pay this income to owners; stock index futures contracts do not.
And from that, the question arises, “Is there a missing market technology?” The diagram below adds the missing market to the previous diagram. What capabilities would this added market provide, and at what cost? The primary benefit of this new market would be the ability to uncouple the cost of receipt of non-price related income from the cost of being able to influence management decisions.
That uncoupling is a good idea only if there is a cheaper way to transfer non-price related income to holders of joint futures and spot traded instruments that is not available to owners of the high-cost existing ETFs. This is possible if the joint futures and spot indexes are managed by one exchange that transfers changes in ETF value from buyer to seller. In other words, if the manager of futures payments and receipts is one and the same as the manager of non-price related payments like dividends, there is a definite reduction in cost compared to the costs of existing ETFs.
History of market structure
Financial futures began in 1971, when the Chicago Mercantile Exchange (CME) opened its financial division, the International Monetary Market (IMM), to trade foreign exchange futures. But foreign exchange futures continued to be dwarfed by the spot foreign exchange market.
The creation that ignited futures’ afterburners was cash settlement at an index value. The 1980s saw the introduction of Eurodollar and S&P 500 futures contracts, contracts without delivery that settled in cash at a spot market-provided index value. But the absence of settlement to a spot instrument would ultimately jump up and bite the futures markets when LIBOR died.
Had no other instruments been introduced, with the wisdom of hindsight, one could imagine the markets evolving into generic markets trading gradable goods and gradable financial instruments, while the spot securities markets traded claims on corporate assets and cash flow.
But this false history does not account for the index mutual fund, the creation of Jack Bogle of Vanguard, nor for the index Exchange Traded Fund (ETF), the idea of Nathan Most of the American Stock Exchange. The index ETF rained competitive fire on the S&P 500 futures contract, replacing it in a ranking of the importance of new financial instruments.
A missing market?
There has to date been no consideration of the possibility that futures exchanges could learn something from spot markets trading ETFs and vice versa. If a market takes into account the reason why ETF index trading dominates futures index trading, a market may be added. A more sinister outcome is that one of the market types might be replaced by this new one.
An ideal step forward is for a nonaligned party to introduce a market which is not futures, not securities, and not ETFs. A new market that trades spot-like indexes in a futures-like way could apply to market regulators, asking what regulators believe is appropriate regulation. The reader can go here to find one way this market would be organized.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.