How Regulation Killed Liquidity in this Market

Jared Dillian |

Pretend you are a corn trader. As such, you have two choices: have a position in corn futures or own physical corn.

It may seem silly to even consider owning physical corn, because corn futures are easy to trade—just click a button on your screen. But assume you have a grain elevator, and whether you own futures or physical corn is all the same to you. How do you decide which you prefer?

If one is mispriced relative to the other.

If you consider owning physical corn, you have to take into account the cost of storage and any transportation costs you may incur getting the corn to the delivery point. You also have to think of the cost of carrying that physical corn position, or the opportunity loss you incur by not investing the money in the risk-free alternative.

The thing is, there’s nothing keeping the spot and futures markets on parallel tracks, aside from the basis traders who spend their time watching when the futures get out of whack from the physical.

That basis exists in just about every futures market, even in financial futures that are cash-settled. In fact, that was pretty much my life when I was doing index arbitrage—trading S&P 500 futures against the underlying stocks. I was basically a fancy version of the basis trader in corn.

With stock index futures (like the S&P 500, or the NDX, or the Dow), the basis is slightly more complicated. Not only do you have to calculate the cost of carry—which is usually determined by risk-free interest rates and the stock loan market for the underlying securities—but you also have to take into account the dividends that the underlying stocks pay out. Remember, futures don’t pay dividends, but stocks do. At Lehman Brothers, we had a guy whose sole job was to construct and maintain a dividend prediction model for the S&P 500.

So far, so good. However, one of the first things I learned about on the index arbitrage desk was EFP, which stands for Exchange for Physical—a corner of the market almost nobody knows about.

Basically, we could take a futures position and exchange it for a stock position at an agreed-upon basis with another bank or broker. Interdealer brokers helped arrange these EFP trades. The reason so few people know about them is probably because, historically, the EFP market has been very sleepy. The most it would usually move in a day was 15 or 20 cents in the index, or in interest rate terms, a few basis points.

Now it is moving several dollars at a time.

A Basis Gone Berserk

Back when I was doing this about ten-plus years ago, we had a balance sheet of about $8 billion, which is to say that we carried a hedged position of stocks versus S&P 500 futures (also Russell 2000 futures, NASDAQ futures, etc.).

We did this for a few reasons. One, it was profitable to do so—the basis often traded rich so that by selling futures and buying stock and holding the position until expiration, we would make money. Also, by carrying this long stock inventory, we were able to offset short positions elsewhere in the firm and reduce the firm’s cost of funds. At Lehman and most other Wall Street firms, index arbitrage was a joint venture with equity finance.

During the tech bubble in 1999, the basis got very, very rich because money was plowing into mutual funds and managers were being forced to hold futures for a period of time until they were able to pick individual stocks.

During the bear market in 2008, the basis traded very cheap, up until very recently, because inflows into equity mutual funds were weak, and index arbitrage desks were willing to accept less profit on their balance sheet positions.

But now, the basis has gone nuts.

It always goes a little nuts toward year-end because banks try to take down positions to improve the optics of their accounting ratios. If you have fewer assets, your return on assets looks better. So when banks try to get rid of stock inventory into year-end, they buy futures and sell stock, pushing up the basis.

But now it has skyrocketed, and the cause seems to be the effects of regulation.

We’ve talked about this before, in reference to corporate bonds. Banks aren’t keeping a lot of inventory anymore, because there’s no money in it. The culprits here are a combination of Dodd-Frank and Basel III. There are all kinds of unintended consequences, and the EFP market going nuts is probably the least of it.

But even that is a big one. Basically, it has introduced significant costs (about 1.5% annually) to the holder of a long futures position, which includes everyone from indexers all the way down to retail investors. These are the sorts of things that don’t get talked about in congressional hearings. Did XYZ law work? Sure it worked. But now it costs you 1.5% a year to hold S&P 500 futures and roll them, and you can’t get a bid for more than $2 million in a liquid corporate bond issue.

It’s All About Liquidity

The liquidity issue is the biggest one, and the one I harp on all the time. Pre-Dodd-Frank, the major investment banks were giant pools of liquidity. You wanted to do a block trade of 20 million shares? No problem. You wanted to trade $250 million of double-old tens? It could be done.

Not anymore. Liquidity has diminished in just about every asset class, from FX to equities to rates to corporates, because compliance costs have gone up and it’s expensive to hold more capital against these positions. Someday, someone might take up the slack, like second-tier brokers or even hedge funds.

But here’s the biggest consequence of the equity finance market blowing up: High-frequency trading (HFT) firms that aren’t self-clearing now find it difficult to trade profitably and stay in business. With fewer of them around, we will finally get an answer to the question whether they add to liquidity or not.

So if you talk to an index arbitrage trader about what is going on with the EFP market, he can tell you precisely why it is screwed up. It’s an open secret on Wall Street. Introduce a regulation over here, an unintended consequence pops up over there. Then there are more regulations to deal with the unintended consequences. Regulations have added 100 times the volatility to one of the most liquid and ordinary derivatives in the world—the plain-vanilla EFP.

Less liquidity, more volatility—welcome to 2015.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:


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