Can you outline what OneChicago’s derivative contract is and how it is used within the OneChicago marketplace?
At OneChicago, our product, known as a security future, is an exchange-traded derivative contract. They are often lumped in with other forms of futures contracts, which isn’t incorrect but means some of the subtlety becomes lost, particularly in terms of what they are and what they are not.
If a participant wants synthetic exposure they have a couple of options, but none of them will bring the pure delta one exposure that a security future contract will. For example, a long call, short put position brings certain risk characteristics such as pin risk and exercise and assignment risks, along with dividend exposure. Whereas OneChicago’s security future contracts provide pure delta one exposure, meaning there is no optionality in the derivative. It offers very specific replication of the underlying stock exposure.
How does OneChicago’s derivative product differ from other synthetics options?
There are none of these additional risks attached with our exact duplication of owning stock. There is no other derivative out there like it.
That sounds a lot like a total return swap. Are they the same?
A security future is a total return swap, but one trades over-the-counter (OTC), while ours trades via an exchange in a heavily regulated environment where all of the transactions are centrally cleared through a AA+ counterparty, which makes it US Dodd-Frank Act-compliant.
The other thing to remember about OTC total return swaps is that for buyers, such as hedge funds, if they want to exit the position they have to return to the same broker and pay to do so. The customer is captive and that makes it enormously profitable for brokers’ delta one desks that service these trades.
In most futures markets, participants look for daily, weekly and monthly trends on market participation, whether for price discovery or liquidity. This is different in our marketplace because participants do not trade in and out. There are no high frequency traders at OneChicago.
OneChicago has seen some very volatile month-to-month trading figures this year. Does that concern you?
Our participants enter into these contracts for terms and so we see a lot of monthly contract rolls where those participants often choose to extend their long-term positions. Sometimes they may wish to add or trim their position, but overall they are simply holding them. There are some days where we see as little as 6,000 contracts and others where we trade 165,000 contracts. However, the nature of having a marketplace of low-frequency traders means that if a participant does choose to close out their exposure, then that creates a much larger impact on our volume data than it might otherwise.
At OneChicago, we have very few quarterly contracts because it’s an interest rate trade. The only variable that must be negotiated is how many basis points (bps) will be charged to finance the next term. Our low fees allow people to keep their terms down to a month to allow participants to remain nimble.
At the same time, in today’s world, with so much uncertainty around interest rate levels, it pays to keep terms short. For example, we saw a significant fluctuation in our American depository receipt (ADR) volumes recently because we had huge positions open with two Brazilian oil companies with low stock rates. The customer in question held these large positions for a long period of time, but when the trend was over, it exited the position.
As a result, we had a negative spike in our ADR volumes for that month. It only takes one or two of our biggest customers to close out their positions to have a massive impact on monthly volume, which can be misleading.
What would be a more appropriate way of gauging OneChicago’s progress?
I don’t look at monthly volumes at all. We have to publish those but it’s value for us is often misunderstood. I focus on notional value, which is based on the fact that our basis point charge is a flat transaction fee. Everyone in our OCX.NoDivRisk products pay the same—$5 per million dollars per notional value.
Can you expand on your fee structure and how it compares to other similar marketplaces?
Other marketplaces will charge a per-contract fee, which ranges depending on your status in the market, such as a member or a customer. We changed our fee structure because it’s a financing trade. Therefore, I have the notional value fee and a daily carry fee of $1.6 per million dollars for each day the contract is open. The key point to remember is that for the participant, the fees are transparent and easily calculable.
Are you seeing the number of participants in your marketplace growing?
We are growing, the prime brokers would begrudgingly admit, because they do not want to see the total return swap turn into a single-stock future (SSF). Calling them SSFs makes them subject to regulation and therefore more transparent. It also means that because they are centrally cleared, their customer is no longer captive.
In terms of new customers, we have introduced commodity trading advisors to the market and taught them to speak to each other. We also now have pure financing players coming to market. Participants that send their stock to prime brokers via securities lending and repo and get maybe 12 to 15 bps are now looking at our roll market and seeing others looking to pay 80 bps for a 30-day term. When someone is asking you to buy one future and sell another in the same stock, there is no risk there because they are both delta one.
Nothing is risk free, is it?
It is risk free, that’s what a delta one trade is. If I buy 100 shares of IBM and then sell 100 shares of IBM in the same account, where is the risk? For every penny IBM goes up, my long will benefit and my short will suffer, or visa versa. As a prime broker, this allows you to engage in risk-free financing trades and bank the interest rate difference that’s built into the contract.
What are the barriers to entry for other market participants looking to leverage this product?
In order to get access to the OneChicago marketplace you have to go through the Options Clearing Corporation and the only people that can do that are brokers, meaning a lot of people do not have direct access to this type of trade. Very few prime brokers have ever brought customers in to deal directly with OneChicago, the vast majority don’t allow it. They don’t just resist it, they refuse it.
OneChicago is in direct competition with prime brokers and we challenge their business model. We are trying to get into that game because I think mutual funds are taking unnecessary risks by working with lower-rated brokers, particularly when there’s a new way to do the business.
With OneChicago, they can upgrade their counterparty exposure while enhancing their yields by offering directly to the consumer. By removing the spread, both parties will do better with less risk.