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An Open Letter to the Incoming CEO of IBM, Sam Palmisano,
Dear Sir:
I would like to tell you about a new exchange traded regulated derivatives
product that could offer substantial benefits to your company. As the CEO of
one the worlds’ most well known corporations, I think you will find this
product interesting for the market information, capital efficiency, and
corporate strategy opportunities it offers to IBM.
I am talking about Single Stock Futures (‘SSF”). SSF are a new product to
be launched this year that was legalized back in the closing days of 2000.
SSF should have already launched by now, but were delayed by the events of
9-11-01 and after, and a certain understandable slowness on the part of the
regulators to offer final rules for this new product.
SSF are to be regulated by both the Commodity Futures Trading Commission and
the Securities Exchange Commission, though they are supposed to work jointly
and not double regulate. We are awaiting final rules on margins, taxes and a
few other issues.
IBM’s stock will be listed by at least two exchanges, in addition to already
being listed on LIFFE as a Universal Stock Futures in London. The main
difference between the LIFFE’s USF and the U.S. brand of SSF is that the
contracts in the U.S. will be physical delivery. That means that if I am
long a contract of IBM and do not exit the position before the end of trading
for that month’s contract, I will be delivered 100 shares of IBM stock.
Should IBM have need to buy back some stock they could use IBM SSF to do so.
That would be one use for IBM.
Because IBM stock will be listed by various U.S. exchanges, including One
Chicago (a joint venture of the Chicago Board Options Exchange, Chicago
Mercantile Exchange and the Chicago Board of Trade), Nasdaq-LIFFE (a
partnership by the London International Financial Futures Exchange and
Nasdaq), and possibly on the American Stock Exchange and on the ECN Island,
there will be plenty of opportunities for IBM in the SSF markets.
One benefit to SSF is the ability of holders of a stock to hedge their
positions. IBM is one of the most widely held stocks in the world. I am
sure you yourself have substantial holdings. I would bet there are times
that you yourself would like to hedge your IBM holdings, or reallocate your
portfolio to balance it better. With SSF you have that opportunity. Selling
IBM SSF against your IBM stock holdings would be a perfect hedge. And, there
would be no premium cost or double transactions you could incur if you were
to use exchange traded equity options for the same task.
You may choose to rebalance your portfolio. You can do that by selling SSF
and buying the SSF contracts of the company you wish to add to your
portfolio. This position is called a spread or a matched pair. You are only
responsible to put up a small margin (final rules are pending) and keep
enough money to absorb the movement between the prices of the stocks. If you
are right about the market and the SSF you bought goes up more than the IBM
SSF you sold, then you will have open trade profits. This open trade equity
could even be removed from your account as cash, assuming the final rules
from the CFTC/SEC treat Open Trade Equity like a traditional futures
contract. Of course there are insider trading rules to consider as well.
One big advantage of SSF is that SSF are simply a more efficient instrument
to trade than the underlying shares are. SSF can be shorted without having
to have an up-tick in price. They can be shorted without having to borrow
the stock from someone and pay the party lending the stock for that right.
SSF will be processed and cleared the same day. In fact, you may find that
SSF trades are already in the back office record keeping software of your
brokerage firm in the next few minutes after a trade was executed. By
comparison, trading individual shares of stock can take up to the trade date
plus 3 days to settle.
If the exchanges are able to offer SSF with traditional futures contract
functionality, including Exchange For Physical trading, IBM may have an open
and transparent market mechanism to gauge the potential costs of a secondary
share offering or selling of treasury stock.
An Exchange For Physical, or what is called a Versus Cash by some exchanges,
is a trade where the underlying physical commodity is exchanged with an
opposite party for the opposite side futures position. For example, if ADM
is long corn futures at the CBOT and wants that corn now, they can execute an
EFP with another firm that has the physical corn. The other party gives ADM
the cash corn and gets a long position in the futures market. Their long
cash corn position was replaced by a long futures position. ADM, which was
long corn futures, will receive the cash corn and a short futures position.
This will offset versus their long corn futures, leaving them just long the
cash corn.
How could IBM use EFPs? Well, if IBM had need to raise some cash they could
look at a centralized EFP market (assuming one was developed and offered by
the SSF exchanges) and then offer to do an EFP on IBM stock for how many ever
shares of treasury stock IBM wished to offer. IBM would deliver the stock to
the opposing side and would receive an equivalent amount of long SSF
contracts. IBM would also receive the full cash value of the stock it sold
in the EFP. IBM would still have to have some capital up to margin the SSF
position, but that capital could be interest earning debt instruments or more
IBM stock.
Another use for SSF for IBM would hopefully come less often. But this
situation has arisen from time to time. During times of extreme market
turbulence corporations like IBM have come into the market and bought back
shares of their corporations in order to stabilize the markets. Utilizing
the leverage of SSF during such times will give companies like IBM extra
balance sheet firing power to help stabilize the prices of their stock.
This may be a much better way to accomplish the same goal during highly
uncertain times and leave IBM with more cash on their balance sheet. During
the stock market crash of 1987 many people credited the turn around in stock
prices to buying in a stock index contract at the CBOT. So futures contracts
can help stabilize markets and have a record of doing so.
Some people will question the value of SSF. They will point to the lack of
an up-tick rule say that short sellers will overwhelm the SSF market and send
the stock spiraling down in price. Certainly in some thinly traded stocks
the up-tick rule has some value in this regard. But a widely held and highly
traded stock like IBM is hardly in need of such protections. And it is
highly likely that the up-tick rule at securities exchanges will be modified
to exclude those widely held and actively traded markets.
In fact, the ease of selling to speculate on a declining stock price or to
hedge against such a possibility makes SSF a very efficient and useful risk
management tool. As different regulated futures contracts have been launched
to meet specific risk management needs, volatility in those commodities or
financial instruments has decreased. Decreased volatility is a positive
factor that will broaden the population of investors who will want to own IBM
stock. That could have a very positive result on the price of IBM stock and
IBM’s ability to raise new capital in the equity markets.
One veteran industry professional, who now is a major player at one of the
SSF exchanges, noted at last November's Futures Industry Association Expo
seminar on SSF that the introduction of stock index futures in 1982 coincided
with the low being set in the S&P 500 index the next month. With the
introduction of an efficient risk management tool that allowed investment
managers to quickly invest large sums of cash by buying stock index futures,
risk went down and the market went up. With the introduction of stock index
futures the risks of a falling market were also decreased because investors
and investment managers could quickly neutralize their market risk by selling
stock index futures against their holdings.
Stock index futures introduced new efficiencies (and trading opportunities)
to the marketplace while giving traders a tremendous risk management tool.
SSF offer that same efficiency in many ways, but even more importantly for
firms like IBM, SSF offers a directly correlated risk management tool.
Exchange traded equity options are also a very directly correlated risk
management tool, but SSF are more correlated. Many of the factors that can
trip up an investor/trader/hedger who is using exchange traded equity options
to hedge a position in the underlying security are not present in SSF. SSF
are a plain vanilla hedge compared the complexity of an equivalent position
in exchange traded equity options.
The capital efficiency of SSF, with the lower margins, Open Trade Equity
flexibility, ability to earn interest on margin deposits and decreased short
selling related costs makes SSF an attractive risk management tool as well.
All of these factors lead me to believe that it would be in the best
interests of IBM, and firms like it, to support the introduction and growth
of the SSF market. Even though SSF are being offered by both futures and
securities exchanges and related entities, many in the securities industry
are not in favor of SSF. They see it as a threat to some of their businesses
and revenue sources. And it would seem they will do everything they can to
make SSF fail.
I don’t believe that result would be the best result for IBM and other firms
with SSF contracts listed on their shares. I encourage IBM to consider the
value that SSF would bring and to take a stand supporting them. Let your
securities industry investment banks and brokerage firms know that you want
and need SSF. Let them know that IBM supports SSF and needs their help in
realizing the benefits that SSF offers.
SSF may be a small thing to a giant firm like IBM, or even to the overall
equities market, but IBM could play a huge role in defining and shaping this
market and the utility it offers. And making such a large impact on
something that could help IBM stock go up in price would be a terrific way to
start your tenure as CEO.
Something to consider.
Regards,
John J. Lothian
The Price Futures Group, Inc.
Electronic Trading Division
Disclaimer: This letter is strictly the opinion of its writer, and not
necessarily those of The Price Group and its management, and is intended
solely for informative purposes and is not to be construed, under any
circumstances, by implication or otherwise, as an offer to sell or a
solicitation to buy or trade in any commodities or securities herein named.
Information is obtained from sources believed to be reliable, but is in no
way guaranteed. No guarantee of any kind is implied or possible where
projections of future conditions are attempted.
Futures and options trading involves risk. Past results are no indication of
future performance.
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