When program trading came into vogue in the mid-1980s, it was at the forefront of Wall Street's computer revolution--and its practitioners included the Street's largest and most luminous brokerages. Merrill Lynch, Morgan Stanley, Dean Witter, Bear Stearns, and Salomon Brothers all profited mightily from the most controversial form of program trading, index arbitrage. By exploiting momentary price differences between index futures and underlying stocks, these firms designed a nearly riskless money machine. The only drawback, it seemed, was persistent criticism that such rapid-fire trading made the market too volatile.
Today, index arbitrage has all the awe-inspiring technological finesse of a four-slice toaster--and is about as profitable. As spreads between stocks and futures prices have turned razor-thin, most of the giant program traders have retreated, with Merrill, Dean Witter, and Salomon having pulled out entirely. But index arbitrage has managed to survive--and even thrive--in its new incarnation. Today, index arbitrage has come into its own not as a stand-alone money-maker but rather as a hedging technique for sophisticated options and swap contracts. And that's good news for the stock market, because the new index arbitrage is far less likely to be blamed for market turmoil.
COMMON THEME. Statistics released each week by the New York Stock Exchange show how the new program traders stack up (table). At the top of the heap in volume in recent months has been the U.S. arm of the Japanese brokerage giant Nomura Securities International Inc. High in the rankings is another foreign-owned brokerage, UBS Securities Inc., the ambitious, rapidly expanding New York-based trading operation of Union Bank of Switzerland. Meanwhile, white-shoe investment banker J. P. Morgan Securities Inc., while not engaged in program trading as of yet, has hired an ace trader from Merrill Lynch & Co. to get started in index arbitrage. These three firms have one thing in common: Each is establishing a presence in the lucrative, high-tech world of custom-designed equity options--"derivatives" in Street lingo--and swap contracts.
The continued resilience of index arbitrage reflects the vast growth of custom-designed options and swaps. These new financial instruments are light-years ahead of the options and futures contracts that are traded on the exchanges. The exchange-traded options and futures contracts that are widely available to ordinary investors do little more than give people the ability to bet on market indexes or stocks over a short period of time--weeks or months at the most. The new kinds of options are custom-tailored deals more than they are financial products. For pension funds, insurance companies, and other institutional investors, these custom options and swaps are an easy, low-cost way to reduce the risk of their portfolios or to quietly shift from one form of investment to another.
This largely unregulated, multibillion-dollar business is dominated by a handful of companies, notably Bankers Trust and Salomon in the U.S. and Credit Suisse and Societe Generale in Europe. Their ranks are being swelled by a number of upstarts attempting to enter the business, including Nomura and UBS. For them, program trading is a crucial hedging mechanism.
COLD FEET. Here is how a typical equity swap would work--and how, traders say, program trading comes into play:
An investor with a portfolio mirroring the Standard & Poor's 500-stock index gets cold feet and wants to withdraw from the market without actually selling his stocks. So the investor agrees with a "counterparty"--a bank or brokerage--to engage in a swap. The investor agrees to pay to the brokerage the total return (dividends plus price change) on the index for a period of time, receiving from the brokerage, in return, the London interbank offered rate minus a commission (perhaps 15 basis points or so). LIBOR is the rate international banks charge each other for large loans.
But this transaction gives the brokerage a stake in the market--just what it doesn't want. Brokerages set up options and swaps to make a low-risk buck, not to bet on the vagaries of the market. If stocks decline during the term of the swap contract, the brokerage loses money. To hedge against that risk, the brokerage will nullify its exposure to the S&P 500 index by either selling index futures or options--or stocks in the index--depending upon which is priced higher at the time.
That's where program trading comes in. The hedge must be continually adjusted during the life of the swap contract, sometimes for years, and that means that baskets of stocks or futures contracts must be bought and sold. While engaging in those trades, the brokerage may simultaneously buy or sell related futures or stocks and make money via index arbitrage. Even though the profits from index arbitrage are small, they are enough to make adjusting the hedge a more pleasant pastime.
Officials at UBS, which has ambitious plans to enter the global derivatives business, say the firm's ranking in the Big Board's weekly program-trading statistics is pretty much a result of that kind of hedging. Such trades, they say, are but the "tip of the iceberg" of the firm's custom swap and options business. At Nomura, likewise, index arbitrage is used to hedge derivatives, while also giving the firm a presence in futures and stock-basket trading as its equity options business is built up. It's a process one Nomura executive likens to an athlete keeping in shape. "You have to train every day," he says. "In trading you have to trade every day, so that when a client comes in you can trade effectively. We want our traders to trade as much as they can."
Such giants in the swaps and options business as Bankers Trust and Salomon don't have to engage in program trading to hedge their deals and contracts. The reason is simple: Their volume of business in swaps and options is so large that such hedge-related program trading is unnecessary. Bankers Trust Co., for example, immunizes itself from market risk by finding other counterparties to take the opposite side of transactions. In a swap where the bank assumes the responsibility to pay the LIBOR in return for accepting the S&P, for example, it would try to find another institution that was willing to accept the S&P and pay the LIBOR. "The amount of activity directly traceable to our hedging activities is kept to a minimum because the bank wants to do as many offsetting trades as possible," observes Dean D'Onofrio, who heads Bankers Trust's U.S. equity derivatives operations.
CALMER WATERS? To the extent that program trading is motivated by a need to hedge derivatives, the market will probably benefit. For one thing, traders who are engaged in hedge-related index arbitrage are unlikely to engage in a practice known as "legging," in which a stock basket is bought or sold some time prior to the transaction in the futures or options market. Legging transactions have come under criticism for moving the stock indexes, contributing to volatility. But moving the markets runs counter to the market-neutral motivation of swap and options hedging. "People do it," concedes one Nomura exec. "We don't."
The need for index arbitrage as a hedging device will probably decline as customized swaps and options proliferate and even small players find counterparties on both sides of each transaction. If so, spreads will widen--and profits will increase for the diehard index arbs from the 1980s who stuck with that business through thick and thin. And none has shown more loyalty to index arbitrage than Philadelphia's Susquehanna Investment Group, one of the most innovative and active members of the tribe. Susquehanna is the only firm that loomed large in the NYSE program trading rankings in 1988 and still remains a major player to this day. But even though Susquehanna is committed to index arbitrage as a stand-alone technique, it is not turning up its nose at the world of custom derivatives. In recent weeks, it has entered into an alliance with Chase Manhattan Bank to develop sophisticated currency options. The traders at Susquehanna know better than to put all their eggs into one basket. After all, that's what hedging is all about.