Understanding Implied Liquidity in Select Sector Futures

Liquidity for equity index futures is often measured by what investors can see quoted or traded on-screen. If the central limit order book (CLOB) displays a wide bid-ask spread or shows small size, you may incorrectly conclude that the contract is illiquid. However, with the multitude of ways to trade futures, such as through the CLOB, Basis Trade at Index Close, Block Trades or Exchange for Physicals, you can tap into additional sources of liquidity.

Finding Additional Sources of Liquidity

Consider, a fund manager that needs to trade $25 million in the Financial Select Sector Index intraday, and prefers to trade capital efficient futures. The manager calculates a need to buy 425 XAF contracts to achieve the desired exposure. The manager sees a three-tick wide market on 15 contracts and notices that XAF trades ~300 contracts per day on average. While realizing that working the order may take too long and may result in price slippage, the manager contacts his/her broker or a futures’ block liquidity provider, and indicates interest in a block trade.

Block Trade

A futures block trade allows participants the flexibility to privately negotiate larger transactions at fair and reasonable prices. The dealer will most likely provide a market based on the liquidity of the underlying single-stock index constituents or the corresponding ETF. By taking advantage of the activity in adjacent markets, the block provider may quote prices on quantities, more than what could be seen on the futures CLOB. In this case, for a $25 million Financial Select Sector futures block trade, the dealer could easily combine its hedge from the nearly $30 billion that trades daily in the underlying stocks and the corresponding ETF market.

Basis Trade at Index Close (BTIC)

When participants seek intraday liquidity via blocks, the tightness and size of markets can be affected by the dealer’s ability to hedge the associated risk in the continuous cash market. One way to access additional liquidity for size is to align the futures block execution against the close, to leverage the volume transacted in the index component market-on-close (MOC) auctions. The best way to achieve this alignment is to utilize BTIC block trades. A BTIC block trade enables investors to trade futures at a negotiated spread to the underlying cash index official close and thus provides participants price and size certainty.

To execute a BTIC block, a fund manager needs to reach out to a liquidity provider and negotiate the fair value spread, or basis, of the futures to the Index, say -1.50 index points. The dealer may hedge the BTIC futures trade by buying the required number of shares per component in each stock’s respective MOC auction and perfectly replicating the cash index closing value. If the official index close was 241.5, the 425 futures contracts would be executed at 240.00 via the BTIC block. This enables a fund manager to execute a full order in one trade with price certainty, and encourages a dealer to trade more size via BTIC as a result of the hedge certainty provided by transacting stock in the MOC auction.

Exchange for Physical (EFP)

A third way to access futures exposure is by tapping into the liquidity of the ETF market and then converting the ETF position into futures via an Exchange For Physical (EFP) transaction. EFP transactions are also privately negotiated.

For example, a fund manager purchased ~1 million shares of the Financial Select Sector ETF at a price of $25 to use liquidity in the ETF market, the fund manager could then negotiate an EFP with a dealer to exchange the ETFs for an equivalent futures position using E-mini Financial Select Sector Futures contracts.

Summary

The complete liquidity profile for a futures contract is dependent on the availability of equivalent and substitute products that market makers can use to price and hedge the futures, as well as the availability of exchange mechanisms such as blocks, BTIC and EFPs that can be used to access the contracts. CME Group offers exposure to benchmark equity indices where both on- and off-screen liquidity can be accessed to best meet your risk management needs.