Manager Spotlight: John Dolan, independent market maker in CME Case-Shiller Index futures and options

OnlyVIX: Thank you very much for agreeing to this interview. Let’s start at the beginning - how did you come to become a market-maker in such an exotic product? Your background is in bond/bond derivatives trading, and you worked at some big funds. Did you see a big opportunity for Shiller Index futures in general, or a niche for yourself?

John Dolan: I actually backed into this role as it fit a number of my interests.  During 2006, in my capacity of Chief Investment Officer of a $20 billion asset management company that focused on deep RMBS credit (Hyperion-Brookfield Asset Management) I certainly had paid attention to the roll-out of housing futures.  At the time, I thought this was a useful tool, as while MBS analysts had models that predicted prepayment projections with incredible precision most of what you heard about home prices was that there had never been a national decline in home prices, and much of "analysis" ended at that.  There had been good (appropriate) awareness that increases in home price drove mortgage refinancing - which was generally good for RMBS credit, but most of what you read at the time was that home prices might rise between 5 and 10%.  In theory, the Case Shiller futures would become a market for public expectations.

Unfortunately (for the CME contracts), portfolio managers’ attention and trading shifted to the OTC ABX credit-default swaps (a more lucrative business for Wall Street, that better hedged their positions) and interest in the Case Shiller futures became incredibly one-sided (i.e. mostly sellers).
I left the asset management business in 2007 and found my way to litigation consulting, and eventually expert witness work (which I continue to do today, along with teaching).  Many of the questions in 2007-2009 were of a Watergate-like mindset, "what did they know and when did they know it?"  I became interested in addressing that question as it related to the decline in home prices, and thought that the futures (which were forward looking) might have given an earlier signal than the commonly referenced housing indices (as most were moving averages issued with a lag).
So as a former trader, and huge fan of futures as a hedge (I've traded gas, FX, S&P, T-bonds, coffee and cattle in my PA)  I looked into the contracts and noticed that they were quoted with very large bid/ask spreads – almost 20 points in some cases, and in other there were no quotes at all. Also forward curves had no consistent message - closes indicated that forward prices would be higher or lower, or in some cases both, with different slopes for different regions.  Having seen just what had happened in the 2006-07 housing collapse I thought that the market (and distressed RMBS and Whole Loan buyers) might be well served by a more robust market for housing futures, so I started bidding and offering.

After a while I grew frustrated that there were so few responses (counters) so I called the CME to inquire.  They told me that all of the market makers had either re-prioritized their efforts, or had left their firms, and that in fact there was no real market maker.  I don't recall who asked first, but I figured that if I was taking the risk of making markets, that I might as well have the upside of being known for that.  That role continues to open doors to meetings that might otherwise be a challenge to arrange.

And that's how I came to be the market maker in 2010.

OV: So now you have been doing it for five years; how is it working out?

JD: At one point I became quite obsessed with making sure that there were prices on all 121 contracts (11 regions* 11 expirations).   I think that may have diffused some potential trading interest, so later (and through today) I decided to just be more responsive to, and offer better quotes on, inquiries, offer a tighter set of bids and offers for the first 5 expirations (while continuing to maintain a full set on the 10-city index).  Bid/ask spreads are at historical narrow levels.  I try to keep at least one CUS contract (10-city index) under one point (bid/ask).

In the last five years I encouraged the CME to switch from having the contracts open 21 hours/day to today's ~8 hours, and also worked with the CME to reintroduce electronic options (but only on 4 regions to focus interest.).  However, that effort only resulted in one sizeable trade (35 lots) in 2014.  (BTW- I am taking another run at that with focus on the LAX Nov' 17 contract.)

OV: I can imagine that risk management can be quite difficult - there is no forward arbitrage (like VIX index, and other non-store-able commodities). Also, for you as a market maker there are additional issues (correct me if I'm wrong) – trading is sparse, and city-indexes are not correlated with anything?

JD: Yes, I have often been > 50% of quotes and open interest for last few years, there is no cash (OTC) market, and as such, there is no one to hedge with.   Beyond that, I've analyzed that home price futures are not highly correlated with anything.  So, maybe a good portfolio tool, but a lousy product to hedge.

For now, I just try not to get offside by more than 30 contracts ($1.5mm position) and try to bias the markets I quote to be more likely to get back to even.

Net, I use the market making role to be the sounding board for parties looking for other sides to trade with, and, in the past, have come close to brokering 50+ lots.   Keeping quotes posted keeps me current on issues related to home prices, which helps in other parts of my consulting business.
Success to me would be having some Wall Street firm realize the potential, make very tight 10x10 markets, and find a use for the futures in other products (e.g. an ETF, capital relief, etc.)

OV: So if this is such a big market AND if people have very recent memories of taking big losses, why is there not more trading in these futures?

JB: While there is some element of chicken-and-egg (i.e. limited trading because people don't see others trading) I sense that there may be a few other good reasons:

In my experience in talking to potential traders, while hedgers are happy to hedge using an index, most longs seem to be less enthusiastic about buying an index.  Real estate longs feel that it’s all about “location, location, location” and as such, active management (e.g. asset picking) prevails.  While there have been periods where asset selection provided great opportunities (e.g. S&L crises, post the 2007 crash), I tend to think that the equivalent of passive management, i.e. buying the performance of an index via a futures contract should appeal to some potential longs at some points in time.

Case Shiller futures represent the price of the index at a point in time.  Unfortunately, some longs would like to buy the spot index, and carry it (to ride the price rise), but can’t replicate that via futures.  Unlike forward S&P500 contracts, which trade versus spot based on carry (and anticipated dividends) Case Shiller futures are not spot levels carried forward.   One-year forward futures prices were ~8% higher than spot in 2012 reflecting a belief that the turn had come and that the percent of assets sold at distressed levels would decline.

Home price futures have exhibited almost no correlation to the stock market over the last two years. For example, the S&P is up ~300 points and the CUSX16 (10-city contract for Nov ’16) is flat. Traders express frustration that the futures can’t be hedged.  Great, I say, because as a portfolio manager I want assets that have low R^2 to the stock market.

A final angle is that there’s an element that the futures are “too good” a hedging asset.  Someone looking to hedge against a price decline could sell Nov ’17 contracts and never have to roll the position.  While that might work well for a hedger, the futures broker won’t see much trading. Brokers seem to prefer day traders and tight, deep markets.

Finally, I think that options, rather than futures might be a better retail product.  I’m working on that.

OV: Thank you very much, John!

John Dolan's website is where he writes about home price derivatives.

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