As always, I want to begin by thanking our Staff for the hard work reflected in today's release. In particular, Tom McGowan and Sheila Swartz provided helpful briefings to my Office, addressing a wide range of questions in connection with this proposal.
Today's proposal addresses margin requirements for security futures. We haven't revisited those rules in almost two decades, so updating them makes sense.[1] But the majority simply proposes to lower the required margin without seriously analyzing the consequences of doing so or assessing alternatives.[2] The proposal favors deregulatory intuition over market-driven analysis, so I respectfully dissent.
* * * *
Security futures are contracts to buy or sell shares of a stock at a specified price on a future date.[3] They're often used by sophisticated market participants to sell stock short.[4] So they can provide a valuable price-discovery function in stock markets and give investors an important way to diversify.[5] But they're also highly leveraged products, so they can expose retail investors to significant risk.[6]
Today, the majority proposes to lower the margin for these products from 20% to 15%.[7] The reason, the majority explains, is to reduce "customers' costs of engaging in security futures transactions," which the release guesses will "increase their liquidity, and provide an opportunity for greater leverage."[8] For three reasons, it's far from clear that that prediction is correct. And the proposal's failure to engage with that possibility—and alternative approaches we might have taken had we more carefully studied this unique market—leaves me unable to support it.
First, the proposal assumes that law is more important than market dynamics in driving demand for investment products. The logic goes like this: options and futures are economically similar products, but the law sets margin at 15% for options and 20% for futures, so we're favoring options over futures.[9] But that's not right: assembling an option portfolio replicating a single-stock future is extremely expensive, and after taking account of those costs, it's not clear that futures are really disfavored.[10] So different margin rules probably don't fully explain why futures are relatively unpopular, and the differing treatment offers no real basis for today's proposal.[11]
Second, the proposal's consideration of the consequences of lowering the margin requirement amounts to vague claims about improved market efficiency and liquidity.[12] A serious economic analysis would consider whether reducing margin will actually improve price discovery or simply make it easier for uninformed investors to migrate into the futures markets in search of leverage. If that happens, we may get less liquidity in related markets without improvements in price efficiency.[13] That's a question that can be studied, of course—all that's necessary is collecting the relevant data across stock, options, and security futures markets. Instead the proposal simply speculates, offering no basis for its claims about improved market conditions other hand-waving towards efficiency.[14]
But third, the most striking sentence in the proposal is this one: the Commission "does not believe that there are reasonable alternatives to the proposal to reduce the . . . margin levels for unhedged security futures to 15%."[15] There are, of course, many alternatives we could and should have considered. Here's one:[16] rather than asking us to lower margin requirements, an exchange could simply reduce the contract size for single-stock futures.[17] Like a stock split for a high-priced stock, reducing contract size could also increase access to single-stock futures for the most popular securities and improve efficiency.[18] Indeed, one of the most liquid contracts in the world, the S&P E-mini Futures contract, is the product of cutting the classic S&P Futures contract in half.[19]
That's just one alternative to this proposal. In a study published fifteen years ago, two former SEC economists analyzed these exact questions and came up with a clever alternative: rules-based margin with flexible settlement intervals.[20] Rather than rush to reduce margin requirements, we should have considered those alternatives carefully. Because we didn't, I cannot support this proposal.
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Policy choices like these deserve careful study of the markets we mean to regulate, not reflexive reference to our beliefs. I urge investors and market participants who know these markets well to come forward to help us do better. I very much appreciate the Staff's work on this proposal. And I look forward to hearing from the marketplace about the wide range of real alternatives we can and should consider before finalizing any rules in this area.
[1] See, e.g., Securities & Exchange Commission and Commodity Futures Trading Commission, Customer Margin Rules Relating to Security Futures, 67 Fed. Reg. 53146 (Aug. 14, 2002).
[2] For a thoughtful treatment of some of those questions in a working paper released nearly two decades ago that this proposal fails even to cite, see Frank Partnoy, Some Policy Implications of Single-Stock Futures, at 10 (working paper Feb. 2001) (pointing out, among other issues, that "high transaction costs preclude the use of options to replicate long stock or futures positions, especially in small trading lots, and therefore single-stock futures will be an attractive alternative to options even at higher margin requirements").
[3] Security futures can also reflect narrow-based indices. See Securities & Exchange Commission, Customer Margin Rules Relating to Security Futures, [July 1], 2019, Release No. 34-86304, at 7 [Proposing Release].
[4]See, e.g., Louis Gagnon, Short Sale Constraints and Single Stock Futures Introductions, 53 Fin. Rev. 5 (2018) (providing evidence from the introduction of single-stock futures on OneChicago that "derivatives represent a viable alternate synthetic short selling venue, relaxing" the well-known constraints on short sales of underlying assets). This study, which addresses this exact category of products, is also nowhere to be found in today's release.
[5] Facilitating price discovery is among the most important social functions securities law serves. For the canonical explanation why, see Zohar Goshen & Gideon Parchomovsky, The Essential Role of Securities Regulation, 55 Duke L.J. 711 (2006) (noting, among other things, that "a competitive market for information [and thus for the accurate value of a particular stock] reduces management agency costs"); see also Kevin Haeberle, Stock-Market Law and the Accuracy of Public Companies' Stock Prices, 2015 Colum. Bus. L. Rev. 121 (applying that insight to the law of market structure).
[6]See, e.g., Financial Industry Regulatory Authority, Security Futures—Know Your Risks, or Risk Your Future ("Security futures are among the riskiest financial products available in the United States.").
[7]See Proposing Release, supra note 3, at 62 ("The SEC is proposing to amend SEC Rule 403(b)(1) to reduce the minimum initial and maintenance margin levels for unhedged security futures to 15% from the current requirement of 20%."); see also id. at 15 (noting that "SRO risk-based portfolio margin rules established a margin requirement for unhedged exchange-traded options and security futures of 15%").
[8] See id. at 64.
[9] See id. at 28 (stating, as a "belie[f]" held by both Commissions, that "certain types of exchange-traded options . . . are comparable to security futures," and that "the margin requirements for [those products] must be consistent."). I appreciate the release's precision in describing this as something that the Commissions believe rather than know, although why we're making securities law on the basis of belief rather than knowledge is beyond my ken. Commissioner Robert J. Jackson, Jr., Statement on Proposed Amendments to Sarbanes-Oxley 404(b) Accelerated Filer Definition (May 9, 2019) (arguing that, when we do our job well, "hard evidence from the market, not ideological intuition," is the basis of the Commission's decisions).
[10]
To see why, note that to replicate a single-stock future one needs to be long a
call and short a put. Partnoy, supra note 2, at 2. A futures contract is
priced at the expected value of the stock price
at some future time
, or
. A call option with strike
, is priced at
, where the superscript
indicates the region where
. A put option is priced at
. A portfolio of options with the same strike and expiration replicates a
synthetic long futures position. Executing this trade typically requires the
payment of a net option premium, which may be particularly large for
out-of-the-money options. So it is not at all clear that the option position is
less costly than the single-stock future position, even given the higher margin
requirements that apply to futures under current law.
[11] A more likely explanation is that, as the Release notes, futures are used in a fashion "more similar to total return swaps," which makes sense in light of the difficulty of assembling an option position that's economically identical to a single-stock future, see Proposing Release, supra note 3, at 10. But if that's the product futures are competing with, we should be comparing futures margin requirements to those of swaps, not just those of options.
As it happens, my colleagues recently finalized those rules, Securities & Exchange Commission, Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants, and Capital Requirements for Broker Dealers, Release No. 34-86175 (June 21, 2019), which may give swaps much more favorable treatment than my colleagues propose for futures today. Given those changes and that swaps, rather than options, are the more economically comparable products to futures, lowering the margin requirement from 20% to 15% on the thesis that futures should be treated the same as options makes little sense.
[12] See Proposing Release, supra note 3, at 50-51 (asserting, without evidence, that "[m]arket participants trading in security futures will benefit from lower margin requirements,"); id. at 66 ("The reductions to margin requirements the SEC is proposing will have the immediate effect of improving the liquidity of customers trading security futures through broker-dealer accounts.").
[13] For a canonical study showing that this is a real risk in our markets, see Stuart Mayhew, Atulya Sarin, & Kuldeep Shastri, The Allocation of Informed Trading Across Related Markets: An Analysis of the Impact of Changes in Equity-Option Margin Requirements, 50 J. Fin. 1635 (1995) (showing that margin decreases in the equity options market can lead to lower liquidity in stocks—higher spreads and less book depth—consistent with unsophisticated investors migrating to the options market). That study, too, is cited nowhere in today's release, even though one of the authors is a former Deputy Chief Economist of our Division of Economic and Risk Analysis.
[14] As commenters have noted for years, when we consider changing margin requirements the Commission should take care to understand how additional speculation from unsophisticated traders will affect the safety and soundness of markets. See Partnoy, supra note 2, at 2 ("Whether lower margin requirements make sense depends in part on how . . . . additional speculation from unsophisticated traders will affect the safety and soundness of markets. The risk is that markets will be more volatile and that volatility will increase as stock prices decline, because investor margin calls on a given day will be triggered much more quickly."). Unfortunately, today's proposal says little about these important questions.
[15] Our own guidance on economic analysis makes clear that we are obligated to "meaningfully compare the proposed action with reasonable alternatives, including the alternative of not adopting a rule." See Securities and Exchange Commission Office of General Counsel, Current Guidance on Economic Analysis in SEC Rulemakings (March 2012). I cannot see how this obligation is satisfied with a simple declaration that there are no reasonable alternatives to the idea we are currently proposing.
[16] Here's another: If we remain convinced that margin for options and single-stock futures should be the same (and again, those who understand the math behind the products shouldn't be, see supra notes 2, 10, & 11) we could—perish the thought!—raise the margin required for options to the 20% that now applies to security futures. One might think that's a bad alternative, but the proposal's claim that we see no alternatives is not credible.
[17] OneChicago, the only U.S. single-stock futures exchange, currently offers only contract sizes of 100, such that a single contract on Amazon stock has a notional value of nearly $200,000. OneChicago, Exchange Product Catalog (last accessed June 27, 2019). In contrast, Eurex offers single stock futures with standard contract sizes of 10, 100, and 1000, giving investors far more flexibility. See Eurex, Single Stock Futures Data Presentation (last accessed June 27, 2019).
[18] Roger D. Huang & Hans R. Stoll, Is It Time to Split the S&P 500 Futures Contract?, 54 Fin. Analysts J.23 (1998) (proposing splitting up the S&P 500 contract, in part because margin levels made it too expensive for small investors to enter the S&P 500 futures market after a lengthy bull run); Lars Nordén, Does an Index Futures Split Enhance Trading Activity and Hedging Effectiveness of the Futures Contract, 26 J. Futures Markets 1169 (2006) (providing evidence, in an attractive causal setting, that index splits improve hedging efficiency, increase trading volume, and do not lead to increased spreads).
[19] The S&P 500 E-mini was launched in 1997 and now trades at 10:1; CME recently added a micro E-mini, which trades at 100:1, in both cases compared to the original S&P 500 futures contract. Alexander Osipovich, Do You Want to Trade Futures? "Micro" Contracts Could Make it Easier, Wall St. J. (March 11, 2019).
[20] Hans R. Dutt & Ira L. Wein, On the Adequacy of Single-Stock Futures Margining Requirements, 10 J. Futures Markets 989 (2003). This study, too, is left out of today's release. See supra notes 2, 4, 13, 18 (same for a series of studies relevant to this area).