After several years of sluggish growth in the US and modest growth outside the US, equity index futures celebrated its 20th anniversary of trading in 2002. This historical event comes at a time when prospects for new product introduction and growth are the best in over a decade. Several factors have converged to bring us to these crossroads in the equity index futures business. In the short-term, some investors believe that these factors will result in product overload leading to a high cost structure, while others view them as a new platform for business growth.

The factors driving index futures products include:

• A less bullish market backdrop that has increased the focus on risk management, hedging, market-neutral investing, and absolute return strategies
• The increasing acceptance of electronic trading of index futures products
• The growth of exchange-traded funds (ETFs) volume and assets. ETF growth has had a positive follow-through effect on futures volume, increased investor interest in more creative index trading, and provided a competitive stimulus to pricing and product introduction.

With a 20-year history of floor trading for index futures, a significant shift to electronic trading is occurring in the US. Futures volume in the US grew 73% in contract terms in 2001, and was up another 37% in the first quarter of last year. Much of this growth has been in the electronically traded e-mini con-tracts.  Even if the contract size difference is adjusted by dividing e-mini reported volume by five, it shows a 29% growth in US futures in 2001 and 16% growth in the first quarter of 2002.

Figure 1 shows the growth in overall trading and the proportion of electronic trading for S&P 500 and Nasdaq 100 futures. Even after adjustment for contract size, the charts confirm that the availability of electronic trading has helped spur more overall trading activity. Volume in the S&P 500 e-mini grew to represent 38% of the total S&P 500 futures volume during the first quarter of 2002. Even more striking, the Nasdaq 100 e-mini contract has overtaken the trading volume in the standard futures contract and captured 66% of the overall Nasdaq 100 futures volume. The removal of order size limits and expansion of Chicago Mercantile Exchange (CME)'s Globex access has helped spur this growth.

Looking back in time, the US was the early leader in equity futures products, building on its long tradition of floor trading for commodity and financial futures in Chicago. S&P 500 futures started trading at CME in April 1982. At the time, open outcry pit trading was as linked to futures in the US as was the city of Chicago. It wasn't until the launch of the Nikkei 225 contract in Osaka, Japan, where there was a history of electronic trading in equities, that electronic trading was even considered to be viable for futures products. US index futures have been a resounding success, benefiting from demands for liquidity for shifting broad equity exposure as US equities experienced an extended period of strong performance from 1982 to 1999, interrupted by the October 1987 stock market crash. Until 2001, when macroeconomic issues were in the forefront, stock volume grew at a faster rate than futures volume from the late 1990s, as individual equities and active management captured the primary attention of equity investors.

Resurgence

Taking a look back at trading activity data for stocks, futures and options in 2001, we can see how the most important investment themes for the year were reflected in volume patterns. With 2001 being one of the worst performance years in a decade in North America and Europe, it is not surprising that index derivative volume grew relative to stock volume after several years of decline. Figures 2A and 2B show the significant increase in futures and index options trading activity relative to stock volume in North America and Europe. However, in the Pacific region, the drop in derivatives activity relative to stock market volume continued.

Figure 3, on the other hand, shows the growth in futures trading in 2001 versus a three-year growth rate. The S&P 500, Dax and Topix grew at a faster rate than the previous three years, with the most notable gains in S&P 500 in S&P 500 futures. These were used more aggressively in 2001 for hedging, asset allocation and market timing. The slower growth of the Cac-40 and more modest gains in Dax activity came in part because of the increasing dominance of the EuroStoxx future as the trading vehicle of choice for large-cap continental Europe. Futures gained appeal as vehicles to take short positions and institute hedges in declining markets. These activity patterns were certainly being replicated in  2002.

Volume

However, e-mini volume has grown, despite the higher fees. One of the impediments to the further growth of electronic futures trading today is the fee structure for clearing e-mini contracts relative to standard contracts. These fees were set with the idea that the e-mini contract would be used for smaller orders. Clearing fees essentially are one-half of those of the large contract while the notional size is one-fifth. The consequence is that currently the component of trading costs represented by commissions is significantly higher for electronic trading compared to floor trading in CME index futures products. Commissions for most e-mini customers are approximately three times those of the larger contract for the same notional amount. The higher commission costs may be offset by the advantages of savings in other components of trading cost, such as market impact or opportunity costs, because of faster order execution.

The growth in electronically traded volume has occurred, despite higher customer commissions per notional value. Users of e-mini contracts typically point out the following advantages of electronic trading over floor trading:

• Anonymous execution - some traders attach very high importance to anonymous execution in the futures markets
• More rapid execution, with potentially lower execution costs - users of futures typically claim that their executions are completed more rapidly in the e-mini contract
• Access to liquidity - investors who ignore e-mini futures are ultimately excluding themselves from a significant liquidity pool
• Price discovery - there is an impression among active traders at broker dealers that price discovery occurs first in the e-mini contracts at this time
• A lower error rate and easy integration in the reports and risk analysis generated from the trader's electronic system.

New product offerings by CME are being designed to function on an electronic trading platform and it is likely only a matter of when, not if, floor trading in the US becomes a minor component of global index futures trading. This is also being driven by futures dealers, who have almost universally embraced the operational efficiency and lower cost of the electronic trading platform. In conclusion, the shift is on; revisions in exchange policy may accelerate the trend and encourage more electronic trading by customers. Futures brokers and investors are encouraging the exchange to facilitate broader electronic access by pursuing one or both of the following alternatives:

• Modify the exchange fee structure for e-mini contracts to a level closer to that of the standard contract, perhaps by introducing a tiered clearing fee structure with discounts for trading a larger volume of e-mini contracts, eg, 200 contracts per day
• Offer Globex access side-by-side to floor trading of the standard contract during the trading day. (Alternatively, create a mid-size multiplier contract, eg, $125, to trade alongside the standard contract.)

It is unlikely that exchanges and brokers will be enthusiastic about supporting both electronic and floor trading of equity index futures indefinitely. Maintaining both trading platforms is clearly the highest cost solution for both exchanges and brokers. Institutions, and other users, would probably also prefer a futures mechanism that operates with minimum costs, since some of the cost savings would be passed on to them and they would benefit from the growth in liquidity.

Mutual appeal

ETFs and futures appeal to investors for many of the same reasons. Like futures, investors can sell ETFs short without a plus tick. Also for institutional investors, ETFs offer strategy applications similar to those possible with futures, such as investing idle cash targeted for equity investment or funds for transition to another manager, asset class or style.

With a broader-range of index offerings in both ETFs and futures, a large group of institutional investors are making direct and indirect use of the index futures market. Pricing has become more competitive benefiting the end-user, and risk control has been enhanced in investor strategies. With the new regulatory environment, and more sector and industry trading interest spurred by ETFs, there is potential for greater activity growth in futures as well for existing contracts and new product offerings.

The combination of lower equity return expectations and heightened risk sensitivity has brought index futures and risk management into focus again, after a period where most of these products were used primarily to buy equity exposure. In addition, electronic trading, the growth of hedge funds and ETFs has given a lift to prospects for business growth in the equity derivatives arena. In order to provide comprehensive services in the continually diversifying futures markets, equity futures brokers must incur a substantial cost to attain the needed technology and infrastructure. This investment is likely justified, however, since the prospects for revenue growth are probably the best in the last ten years.