David Downey does not suffer fools well. His statements are very direct and to the point. And he knows when he is right and is willing to point out where regulators and competitors are wrong. Downey is in the process of shutting down OneChicago, but his writings and comments about security futures products will live on much longer and may yet change the world.
A perfect example of this was his letter to the CFTC from October 1, 2018, ostensibly about security futures position limits and position accountability, but really an opportunity for him to unload about how security futures are misunderstood by the regulators. The comment was for the CFTC, but aimed at both the CFTC and the SEC.
Downey took the OneChicago job after retiring from a career with Timber Hill and Interactive Brokers. He retired suddenly, as I wrote earlier, for personal reasons that involved a tragic car accident that took the lives of two close friends. There is a great profile of Downey by Anthony Malakian in Waters Technology from 2011 I recommend.
It was Thomas Peterffy who convinced Downey to take the OneChicago job, and Malakian says it all happened because of one sentence from Peterffy, “No one thinks it can be done.”
This was a challenge for Downey that brought all his previous experience with trading, technology, clearing and financing to a new innovative product.
In his October 2018 statement to the CFTC, Downey does not pull any punches about what he knew and the CFTC did not. For example, he says in the opening paragraph, “As the only domestic exchange listing SFP OneChicago has the clearest understanding of how security futures are used by market participants and we are happy to share our perspective.”
Translation: We know the product best.
Downey goes on in paragraph two: “Before discussing the proposal, OneChicago notes that position limits are unnecessary for SSF as strategy based margin with a minimum of 20% suppresses activity far more than position limits ever would.”
Translation: Your regulation for position limits is meaningless because you have already diminished activity through your ill-conceived regulations already in place.
He tells the story of a loyal customer of several years who just left the exchange and moved his trading to Europe, where he was able to get better margin treatment and everything else OneChicago was offering. The customer even continued to trade with the same counter-parties OneChicago had introduced to him. Downey finishes with this zinger, which should make any U.S. regulator cringe, “In Europe, they enjoy the US invention of risk-based margin.”
Europe is offering a U.S. innovation that the CFTC and the SEC have not bestowed on security futures trading in the U.S.
And just to let the commission know how meaningless their meeting was, he writes: “OneChicago does not have strong feelings one way or the other about the Commission’s proposal because it will not significantly impact our market so long as margins remain at punitive levels.”
Translation: Nothing else matters if you are going to keep activity subdued with your punitive margin regulations.
Securities futures would have great potential in the U.S. if only the regulators and others understood them better and got out of the way, allowing their innovation and disruption in the markets.
Downey’s letter goes on:”OneChicago does strongly believe that the Commission should understand the unique characteristics of our marketplace and the challenges our customers face.”
Putting it bluntly, he writes: “The Commission’s proposal exposes that they do not understand these challenges. This comment letter is intended to give the Commission the understanding it needs to properly regulate our marketplace.”
Translation: You don’t understand us and until you do, you can’t do your jobs.
Downey then goes on to give a BRILLIANT explanation of the role of derivatives and specifically single stock futures and their features as a Delta One derivative.
He points out that “OneChicago lists for trading SSF contracts which have a delta of one which means that the instrument does not contain any optionality and it moves in sympathy with the underlying instrument point for point as would a perfect substitute.”
Translation: Single stock futures move point for point with the underlying stock of which they are a derivative. The optionality quote will come into play in a minute.
“Delta One derivatives are primarily used in financing transactions,” Downey says. He goes on to explain how a Delta One transaction is done at a bank, with the offering called various names, but he notes at the end, “The same transaction can be done with SSF Delta One.”
Downey then talks about equity repos and how they are structured so as to be non-taxable events. The repo must be part of an “agreement” to remain a non-taxable event.
These equity repo transactions, he explains, which are part of an agreement called a “Master Securities Repurchase Agreement,” or as he says, “just a fancy name for a Delta One derivative,” are non-taxable events.
Here is where options come into play relative to Delta One derivatives. As Downey explains, “Only a Delta One derivative can be used without triggering a tax event. This is critical to understand. No option or any combination of options can be used in these types of transactions as they are not Delta One. It is a perfect substitute. The same transaction can be done with SSF Delta One.”
No combination of options can be used to do this Delta One equity repo, master securities repurchase agreement, or whatever it is called. Options are not a substitute for single stock futures. Options have features that are not present in SSFs which give them a different risk profile, such as assignment risk, dividend risk, and pin risk.
“Whether financing a customer by placing them into a swap or by engaging in Securities Lending or Equity Repo the required derivative is a Delta One derivative,” Downey explains. “No other derivative works. No other derivative is equivalent.”
The reason margins are 20% is that Congress and regulators said securities futures products were competitors with equity options. Downey argues that they are not.
To make this point about regulating single stock futures as if they were options, he stingingly writes: “Regulating derivatives that contain optionality similarly to those that do not is no different than imposing the same rules on chess and checkers because they are both played on a checkered board with 64 squares. It defies logic.”
He goes on about how the regulators favoring the over-the-counter market for Delta One transactions pick winners and losers and that is not the way to run efficient capital markets.
He concludes this subject with, “OneChicago disagrees with trying to level an imaginary playing field to achieve parity with a non-Delta One derivative. It does not make sense.”
Translation: The regulators are playing the wrong game.
He goes into the CFTC’s statements about securities futures and shows the commission where they are wrong, in theory and practice.
Quoting the CFTC saying, “The Commission notes that SFPs and security options may serve economically equivalent or similar functions,” Downey then goes on to write: “OneChicago fundamentally disagrees with this as no option nor any combination of options can replicate the transactions described above. Previous legislation and regulations which equated equity options and SSF were mistakes.”
Translation: You had it wrong from the start. It is time to fix this. Let me explain.
Downey walks through using options to create a Delta One equivalent, as well as other considerations for options that you don’t have to worry about with single stock futures.
He goes on to explain how security lending rates are derived in the over the counter market in secrecy. This opens up the process to abuse, as the creators of the rate have the equivalent of insider information, and those with inside information about changes in those rates can front-run other investors.
Downey and OneChicago even propose that risk disclosure statements for security futures and options be updated to include a discussion of this risk.
Downey notes, “The Commission should take the potential for this type of manipulation into account when determining its regulations for listed derivative markets such as SSF. The tail does not wag the dog.”
To make matters worse for securities futures products, it is not just the banks and the OTC market they are competing against, with the table slanted against listed securities futures products. The OCC is also clearing “securities lending agreements in the same risk pools as OneChicago’s contracts.”
These products have no position limits and they get risk-based margining, not the incongruent 20% margin required for single stock futures.
That just adds insult to injury.
Downey then moves on to talk about position limits for physically delivered and cash-settled securities futures. He writes, “OneChicago believes that if a DCM lists both cash and physically settled SSF on the same underlying that the combined positions for the same expiration date should be used in calculating position limits. Further while we agree on expanding the limits for physically settled contracts we believe that cash settled contracts pose a greater danger of potential manipulation on the closing price of the underlying security and should be constrained at the current position levels that are in force today.”
He explains how those trading physically settled securities futures still have exposure if they bid up the price of the stock the day before expiration, but the cash-settled holders do not. Their risk ends at settlement.
To further drive home the argument that single stock futures are not options, Downey mentions that the best way to extinguish a hedged position is to let it go to delivery.
He then compares numbers for options being exercised (7%) with the traditional number of futures that go to delivery (1%) and the no less than 53% of open interest at OneChicago that has gone through delivery in the last four years.
He comments, “….one of the characteristics of SSF that market participants find most useful is the ability to transfer securities through the OCC and NSCC guaranteed processes. Why does the Commission seek to treat SSF the same as options when the market clearly views them so differently?”
Downey then recommends that position limits should not be in effect the last five days, but only the last one day. He also notes that traders at FCMs roll or extinguish their positions before expiration because it is simply too costly to take delivery of securities in a futures account.
He also talks about the unnecessary regulation OneChicago faces for its STARS (Securities Transfer And Return Spread) product.
Before answering questions from the commission and concluding his remarks, he weighs in on position accountability for ETFs, reminding the commission that “OneChicago has had a petition for joint rulemaking for margin relief pending with the Commission for over 10 years. If the Commission is really concerned about its regulations stifling innovation in SSF, it should not wait a decade to respond to reasonable DCM petitions.”
He concludes with this “final thought”: “Despite being played on the same board it is impossible to play chess with checkers. Similarly, you can’t use options in financing transactions. Placing burdens such as unreasonable margins or meaningless position limits upon SSF serves only one purpose and that is to protect the OTC market from competition by innovators in the regulated exchange space. Either the Commission does not understand this reality, or they choose to ignore it. For the sake of the capital markets we pray it is the former.”
The industry lost OneChicago, but they have the passionate writing of David Downey about security futures. They have the writing of a man who understands this product best.
Single stock futures found life because of regulation, but that regulation was flawed and Downey showed us how. One can only hope after the death of OneChicago that the missteps of the past can be corrected and securities futures will be allowed to realize their potential to make our capital and derivative markets better.
Maybe we can make things right for securities futures and fulfill the incomplete mission David Downey started all at the same time.