The Cato Review of Business & Government

After The Crash:
Linkages Between Stocks and Futures

The following panel discussion is drawn from "After the Crash: The Financial Market Studies and Policy Proposals," a policy forum held by the American Enterprise Institute in Washington, DC, on February 24,1988. The forum brought together a distinguished group of scholars, market participants, and regulators, among whom were William J. Brodsky, president and chief executive officer, Chicago Mercantile Exchange; Professor John C.Coffee, Jr., Columbia University Law School; Joel J. Cohen, former general counsel for the Presidential Task Force on Market Mechanisms; Thomas Coleman, vice president and director of economic analysis and planning, Chicago Board of Trade; Commissioner Robert R. Davis, Commodity Futures Trading Commission; Professor Franklin R. Edwards, director, Center for Study of Futures Markets, Columbia University; Commissioner Joseph A. Grundfest, Securities and Exchange Commission; Philip McBride Johnson, partner, Skadden, Arps, Slate, Meagher & Flom; Thomas Eric Kilcollin, executive vice president and chief economist, Chicago Mercantile Exchange; Roger M. Kubarych, associate, Henry Kaufman & Company; Professor Merton H. Miller, Graduate School of Business, University of Chicago; Professor Hans R. Stroll, Owen Graduate School of Management, Vanderbilt University; Paula Ann Tosini, chief economist and director of the Division of Economic Analysis, the Commodity Futures Trading Commission; and Richard Zecher, president, Chase Investor Management Corporation. The complete proceedings of the forum have been published by the American Enterprise Institute in a new book, After the Crash: Linkages between stocks and Furtures, edited by Robert J. Mackay, 1988.

---

What Happened Last October?

MR.COHEN: In the four trading days between October 13 and October19,1987, the value of all outstanding stocks in the United States dropped by about a trillion dollars. What quickly became apparent to the Brady commission was that, notwithstanding the enormous volumes of shares and futures contracts traded, only 3 percent of the total shares of publicly held stock changed hands during those four trading days. Yet this 3 percent resulted in the loss of one trillion dollars in value. To us this revealed an unusual frailty in the market.

In the stock market, the top fifteen sellers on October 19 accounted for 20 percent of the total sales, or $25 billion. Index arbitrage involved about $1.7 billion worth of stock. In the futures market, the concentration of trading among big players was even more significant. Portfolio insurers sold $4 billion worth of stock index futures contracts, which was about 40 percent of the public volume. The top ten sellers accounted for 50 percent of the volume.

The result was that all the markets were virtually overwhelmed with massive, one-sided volume. Specialists could not cope. The New York Stock Exchange automated systems could not cope. The over-the-counter markets did not cope well; their communication lines were jammed, and their automated execution systems did not work. The futures market plummeted as well. There was just not enough capital or enough buy-side interest. The Dow Jones Industrial Index (Dow) closed down a record 508 points.

The problems on Monday and Tuesday seemed to have been exacerbated by unprecedented discounts between the futures market and the stock market, which ordinarily would prompt index arbitrage. That did not happen for two reasons. Arbitrageurs rely on the New York Stock Exchange's designated-order turnaround (DOT) system, the quickest and cheapest way to execute large orders involving the sale or purchase of baskets of stocks. The DOT system broke down on Monday afternoon because the massive volume overwhelmed the system.

On Tuesday arbitrage was further limited because the New York Stock Exchange announced that member firms could not use the DOT system for index arbitrage. This made a lot of sense from the point of view of the exchange but probably not from the point of view of the overall financial system and the linking of the two markets. There were enormous discounts in the futures market, which persisted because of the absence of arbitrage. These discounts discouraged people from buying stocks. As a result, both the stock market and the futures market went into a virtual free fall.

MR. ZECHER: Whatever caused the market drop on October 19-and I do not have the answer to that question-it is certainly true that the drop was much more likely to happen in 1987 than in 1967. Most of our markets, including the stock market, the bond market, foreign exchange markets, and commodity markets, are far more volatile than they were 20 years ago. The frequency and the amplitude of movement in prices in these markets are vastly different from what they were 20 years ago. Most of the blame for the increase in volatility lies with the breakdown of the discipline on monetary and fiscal policies. In thinking about the events of October and trying to understand where we are today, we ought to keep in mind that this increased volatility in prices is what has driven the development of the new products and markets.

MR. JOHNSON: My opinion, held with the conviction that only a person without economic or finance training could have, is that an elephant was present last October and remains in our midst today. More important, it is likely to hang around even if the markets are purged of program trading, portfolio insurance, specialists, stock indexes, unreliable computers, or any of the other targets of criticism.

So allow me to introduce you to the elephant. The Brady commission report states that 60 percent of publicly outstanding common shares are owned by householders. But roughly 80 percent of daily big-board volume is accounted for by institutions such as mutual funds, insurance companies, pension plans, and broker-dealer proprietary accounts. On average, about half of the daily volume on the New York Stock Exchange consists of block trades, that is, transactions of at least 10,000 shares each. The retail investor, in other words, may own the train, but its operation is firmly in other people's hands. That message was underscored during the October unpleasantness.

What all this means is that the securities markets have become highly institutionalized and control of financial assets has become concentrated in a very few hands. A small group of money managers is capable of dictating both the direction and the velocity of equity prices. An important brake on market volatility in past decades, namely, the need for a broad public consensus to develop before a significant change in market trend could occur, has disappeared.

MR. GRUNDFEST: Two categories of events contributed to the decline on October 19. The first category encompasses events beyond the government's control. The government cannot effectively write or enforce rules that control investor psychology or dictate the way investors react to fundamental changes in the economic environment. Any such efforts are bound to be self-defeating and expensive.

Efforts to control trading strategies such as portfolio insurance fall into this category. Portfolio insurance is, in essence, little more than an elegant set of rules for stop-loss selling in a declining market. Stop-loss selling has been with us for decades.

The second category encompasses events within the government's control and about which the government can do something. This category can be further subdivided into measures that can expand the market's capacity by increasing liquidity and improving information flows, and measures that slow the market down by throwing sand in the gears in any one of a number of ways. A great deal of effort has already been invested in devising more clever ways to shut the markets down when, for whatever reason, policy makers don't like the prices the markets are generating. Personally, I am more interested in focusing energy on efforts to improve market capacity, enhance liquidity, and generate better information because, in the long run, the effective survival of our domestic financial services industry depends on these measures much more than on any circuit breaker mechanism, no matter how well designed.

PROF. STOLL: The Brady report commented on the low volume that produced a 500-point drop in the Dow. In fact, the best way to accomplish a 500-point drop in the Dow is with nearly zero volume. We want the price change without all the accompanying scurrying around and pressure on the market mechanism. If everybody thinks the price ought to change, we should figure out what the new price ought to be and then let it change.

The Role of Financial Futures

PROF. MILLER: After looking at all the data complied by the staff of the Chicago Mercantile Exchange, three colleagues and I came to four main conclusions about the role of futures on October 19.

First, the presence of an index futures market in the United States-at that time virtually only in the United States-cannot credibly be charged with the substantial worldwide rise in equity values between January and September 1987. Was it part of the picture? Clearly it was. But let us be sensible about this. At no time was the total open interest in futures much over 1 percent of the total value of equities outstanding.

Second, the crash did not originate in Chicago and flow from there to an otherwise cal and unsuspecting New York market. The tidal wave of selling hit both markets simultaneously. The evidence is crystal clear on this point.

It only seemed to hit Chicago first, because so many stocks did not open on time in New York on Monday. As a result, the published index of stock prices was still reflecting the hopelessly out-of-date prices at the Friday close. This reporting lag explains a large part of the apparent discount between the futures market and the cash market. I think the record will show that no one made any money on arbitrage on that opening gape.

Third, the futures market, rather than transmitting selling pressure to New York by program trading-as has been charged-on balance absorbed net selling pressure by a substantial amount. We estimate the absorption at the equivalent of about 85 million shares that might otherwise have been sold on the New York Stock Exchange.
Finally, the futures markets were no more the source of the dramatic turnaround on Tuesday than they had been the source of the dive on Monday morning. The fresh infusions of buying power on October 20 from both corporate buy-backs and Federal-Reserve-sustained dealer positioning turned the tide.

Certainly substantial portfolio insurance selling did occur on October 19. Nobody denies that. But the fall in stock prices on that day was more than a matter of the actions of a few big price-insensitive sellers, as the Brady report often seems to suggest. There was also substantial selling by others. In fact, the value of selling by others on the New York Stock Exchange was three to five times as large as the selling by portfolio insurers.

MR. DAVIS: Let me quickly summarize two observations that come directly from the analysis in the Commodity Futures Trading Commission's (CFTC's) report. First, there was no cascade on October 19. As it has been described in the press, the cascade theory implies an interaction between the stock market and the futures market so that both markets decline to some artificially low price. The price level that results is an aberration rather than a reflection of fundamental values. Our evidence suggests that there was not a cascade. Had there been, the market would have returned to something close to its previous value, and it obviously has not.

Also after one adjusts the stock price data for the problem of nonsynchronous trading there were no huge discounts in the futures market on the morning of October 19 that would have led to significant arbitrage selling on the stock market, selling that would have driven the stock market down and repeated the process over and over in a mechanical way. Instead, the futures market reflected about where the stock market was during that period, at least until index arbitrage broke down because of system failures and other types of institutional restraints.

PROF. EDWARDS: Did futures cause the crash? All the studies basically agree that the answer is no. The possible exception is the Securities and Exchange Commission (SEC) staff study, which says that although futures did not cause the crash, it may have been sharper and gone further than it would have without futures markets. No evidence is presented on this point, but the suggestion is there that the futures markets played a role.
Are futures markets valuable? All the studies say yes. These markets provide valuable financial services-hedging and price discovery.

Given those conclusions, how do we make any sense of the fact that the studies go on for pages and pages and make recommendation after recommendation to change things? The explanation might be that it takes a brave commission to study a subject for two or three months and say, we do not have any recommendations.

"One Market" and a Super-Regulator

MR. COHEN: The delinking of the stock and futures markets appeared to us to be a major problem. It may explain why all the markets declined so rapidly during those two days. This led the task force to what we considered a fairly obvious conclusion: the futures market, the options market, and the stock market are really a single market. The instruments are fundamentally driven by the same economic forces; the same financial institutions are the major players in all these markets; trading strategies such as portfolio insurance and index arbitrage link these markets, as do clearing and settlement procedures.

In recognition of these important links, we concluded that the regulation of the stock, futures, and options markets should be better organized. A single agency should be charged with the responsibility for regulating certain important intermarket issues. At present, no one agency looks across all these markets and makes sure that they work in harmony.

The task force did not envision adding a whole new layer of regulation. Adequate regulation already exists. We simply suggested that the regulation be organized and coordinated in a more rational manner. From our analysis, we selected four issues that raised significant inter-market concerns.

First, and probably the most important, is the unification of the credit and clearing mechanisms. The second issue is the margin issue. The task force believed that margin requirements ought to be harmonized between the stock and the futures markets. The third issue is information. Simply put, there is a tremendous amount of information about who is buying and selling in the futures market. The same type of information, large-trader data, is not available for the stock market. That information should be available. The final issue is circuit breakers. Ad hoc circuit breakers now exist but they were not organized rationally.

Who should be responsible for these inter-market issues? We considered a variety of committees and agencies, but it seemed logical to us that it should be the Federal Reserve. We leave that to other people to judge, however.

MR. ZECHER: Ten years ago the regulators at the SEC and at the CFTC gave a tip of the hat to what economists were saying about derivative markets-that they were part of the same market as the underlying security; that they were, in an economic sense, priced from the same information; and that we therefore had to think of the underlying market and the derivative market as a single unified market. Although a tip of the hat went to that concept, the rules and regulatory structure that were set up were quite separate for the different derivative instruments.

The concept of physically separating the markets and making different rules and regulations for key matters such as clearing, margins, and the rules that govern the exchanges led to the problems that we remember from the late 1970s. Remember the problems with front running (trading options in front of block trades) and tape racing (trading options before they were printed on the tape). The physical separation of these markets does not have much economic relevance. But the different treatment-the rules they function under, their clearing systems, and their margin systems-has caused many of the problems that we have seen over the years and are talking about today.

PROF. STOLL: Arbitrage is critical to maintaining effective links among those physically dispersed markets. It is the mechanism that connects index futures to the cash market, currency futures to currency, and wheat futures to the spot markets for wheat. It is an integral element of the marketplace. And the arbitrage that connects index futures to cash is no different from the other kinds of arbitrage that we see in every kind of market. I am continually amazed by the criticisms of program trading and especially by the restrictions on program trading that have been imposed by the New York Stock Exchange.

We need to facilitate and improve program trading and index arbitrage and to find new methods of handling basket trading. We need more computer trading, not less. It would be unfortunate if we introduced regulatory changes that weakened the link between markets.

MR. BRODSKY: Instead of a super regulator, we prefer an intermarket coordination committee, which would be involved in clearing and settlement and financial integrity issues, as well as other aspects of market coordination.

On the clearing side, for example, the group could coordinate the pay and collect data used in daily settlements. We do that now on the futures side but not on the securities side. In regard to clearing, firms often have positions in the securities markets, say in stock options, and in the futures market with offsetting valuations, but have no place to look at all their positions. We would use a concept that already exists, the Designated Self-Regulatory Organization.

In short, a lot can be done in market coordination beyond ideas like circuit breakers. If this committee is properly composed, it could be a vehicle for working out issues on a regular basis as well as in emergencies.

MR. KUEARYCH: There are fundamental differences in regulatory philosophy between the securities and futures markets; concepts such as fair and orderly markets, on the one hand, and efficient but volatile markets, on the other. Part of the struggle over regulatory harmonization has to do with this fundamental distinction.

I do not believe that these philosophical differences can be resolved easily, if at all. If they cannot be, we face two questions: How much volatility arc we willing to tolerate to get the benefits of efficiency? How orderly do markets have to be to be considered orderly? These are essentially empirical questions that cannot be easily resolved by appeal to some general principle.

MR. GRIJNDFEST: Although some have suggested that the Federal Reserve be established as a super-regulator over the securities and commodities markets, the Fed apparently does not want the high honor, privilege, and responsibility of overseeing every financial market in America. As for the suggestion that the SEC take over responsibility for stock index futures from the CFTC, I think it important to recognize that any such shift would also entail a substantial reallocation of authority among powerful congressional committees. Since we are constrained as policy makers to deal only with realities, the proposal to reallocate jurisdiction strikes me as a nonstarter. Thus, rather than spend a lot of energy on a fruitless exercise, it makes far more sense to devote energy to good-faith attempts at interagency cooperation within existing jurisdictional constraints.

"Harmonizing" Margins

MR. KUBARYCH: Concern about margin requirements goes to the question of how to secure a level playing field in the stock and futures markets. Lower margins in futures created the misapprehension that there was more liquidity than there turned out to be in a time of stress. People selling futures thought that the futures market was much deeper than it turned out to be. One of the reasons they thought so was that most of the time the futures market depth had been quite strong. One of the main reasons for that was the lower transactions costs, due to the absence of the short-sale rule and the lower effective margin requirements for futures.

With a level playing field the relative ratios of cash, stock, bonds, and other financial assets in portfolios would not have become so skewed. Without this illusion of liquidity there would have been less need for a major adjustment in prices. Portfolio managers thought stocks were less risky than they really were, because the convenient and cheap futures market allowed them to build up exposures that after the fact were riskier than they had appreciated.

MR. BRODSKY: On October 19, we had three intraday margin calls requiring funds within one hour, which we do when markets make big moves. These calls and mark-to-market at day's end brought the amount of money we had on account to upwards of 40 percent of the value of the S&P contract. We learned, however, that we were asking for money from people who owed us money, but we were not giving any money until the next day to those we owed. We were therefore getting in more money than we needed. We now recognize that we can create a liquidity crunch in our zeal to do a good job for our financial integrity and have changed our procedures.

We have increased our speculative margins to 15 percent, as an indication of the benefit of the concept of harmonization in the Brady report. But we are vehemently against the idea that the margins should be the same just for the sake of being the same. Different margins reflect different concepts that work differently. The amount of risk in the system on a five-day settlement cycle on securities is far greater than any in the futures market. It involves an enormous liability, with no money coming in for five days.

We recognize that margin is an important issue, but we also believe that our track record has been superb.

MR. ZECHER: White we use the word 'margin" in the cash market and in the futures and options markets, margins perform different functions in those markets. I view margins in the futures and options markets as a substitute for credit judgment. That is to say, there are two basic ways in our economy to guarantee the performance of a counter party in a financial contract. One is to devote a lot of resources to studying the creditworthiness of the individual.

The alternative way is to demand cash on the barrel head That is essentially what margins do in the futures markets and, to a lesser extent, in the options market.

The nature of margins in the cash market is very different. Margins were never conceived as primarily or even substantively designed to guarantee counter party performance. In the l930s the argument for margins was developed in terms of macro-credit allocation and as a way of slowing speculation.

Some modifications in margins would be desirable, however. If I create an overall position involving positions in futures, options, and cash on a variety of different exchanges, my positions should be offset against one another. That is, what I actually have to put up as margins should reflect my true exposure. There should be cross-margining. There should be consistent treatment of margins for a given economic position, regardless of how it is created.

MR. DAVIS: During a crisis, when people are scrambling for the exits, it does not make much difference whether margins happen to be 15 percent or 20 percent or 50 percent. Investors are heading out the door. Those constraints do not have much impact during periods of crisis. But during normal times-99.9 percent of the time- excessive margins impose a dead-weight loss on the market. There is a loss in terms of trading activity and a loss in liquidity to the market. It is a loss to every institutional investor, every participant in a mutual fund, and every person vested in a pension Dlan in the United States.

MR. COLEMAN: In the most extreme exam-pies of negative market moves, the futures margin system collects money quickly; it gets it in cash, and it pays that money back out on the other side. That kind of system meets the needs of the marketplace in managing risk.

The press has commented frequently about a 50 percent stock margin versus a 10 percent or smaller futures margin. Clearly this amounts to comparing apples and oranges. There are many different margin levels on the securities side, depending on capital considerations and positions in the marketplace. This is also true on the futures side.

MS. TOSINI: The futures market is a professional market. With a professional market, what would consistent margins be? First, they would not be the 50 percent public margins. A better comparison would be the exemptions from the Federal Reserve Board's margins for specialists and professional broker-dealers. As the Brady commission correctly recognized, these professionals pay margins in the range of 20 to 25 percent, although sometimes margins can be as low as 5 or 10 percent. Basically, they pay a good faith deposit to ensure that there will be money available to pay the claims if there are any losses. In fact, then, for many important market participants, there is not significantly different leverage between the futures markets and the stock market.

PROF. MILLER: The issue of futures margins and the question of who sets them are more than just organizational details. There are delicate business trade-offs involved. In my view, taking these business decisions away from the private sector, where the incentives are right, and transferring them to the public sector, where the incentives are wrong, will ultimately kill the futures industry. Regulators never lose by setting margins high. In fact, some people who are recommending the transfer of the margin responsibility have precisely that in mind. They make no bones about it.

The Brady commission itself certainly makes no such arguments. In fact, it makes no attempt to relate its recommendations about margins in any way to the detailed analysis in its study. The Brady report simply refers, both directly and implicitly, to the famous Federal Reserve staff study of 1984 and calls for making margins consistent between markets. We agree, but only to a point. Why not make margins consistent the easy way by taking the Federal Reserve out of the picture altogether? The New York Stock Exchange already controls everything about the margin process except the initial margins. Certainly the Federal Reserve does not believe that its control over the initial margins is a major weapon in the arsenal of monetary control. It set the initial margins on stock at 50 percent in 1974 and has kept them there for the past fifteen years.

Breaking Circuits

MR. DAVIS: Price change and, hence, volatility are obviously necessary to market processes. You cannot have market adjustment and you cannot have fundamental values reflected unless there is an ability to trade-unless prices change and there is some volatility.

It is also true that it is difficult to distinguish between volatility that is good and volatility that is excessive. For that reason, I have to come to the conclusion that if we cannot readily distinguish good from bad volatility, then it may be appropriate to establish some type of predictable mechanism that might come into play when the market moves to extremes. That is one thing price limits do. When you run up against that constraint, you have essentially said that you do not know whether this is an equilibrium price movement or not, but the system cannot cope with any larger movement in this period. Economists have a hard time with that proposition. But we have seen that the people who run futures exchanges have relied on certain types of price limits for virtually the entire history of futures markets. I cannot dismiss out of hand what the Brady commission referred to as circuit breakers. I can only say that as a regulator in Washington, I do not have a clue what the appropriate market level is. When is a market move so extreme that it is disruptive to market behavior? When is a market move just something that worries everyone but ought to be allowed to continue? These questions are not ones that regulators in Washington really have very much insight into.

PROF. STOLL: In situations where markets are overwhelmed, trading halts are appropriate when the order imbalances are large. When markets are simultaneous and many orders are coming in, the market price may be uncertain because of the great volume of activity. In those situations we cannot expect market makers to handle the volume of orders in the usual sequential manner. Even if they could, we cannot expect them to provide the necessary liquidity to bring the markets down slowly.

The essence of a trading halt is that the market remains open in the sense that the price discovery process continues. Indications of possible prices should go out while imbalances are "publicly reported." That way market participants can see what is going on and make informed decisions about what to do.

Should trading halts be coordinated across markets? Not necessarily. If there is a structural problem in one market that makes a trading halt appropriate, it does not necessarily follow that a trading halt should be imposed on all other markets. Certainly related markets may choose to close, but that should not be imposed on them.

If we think trading halts are a good idea, how do we do it? Trading halts are not easy to engineer. The reopening problem is difficult. Finding the new equilibrium price is difficult. It involves iteration, trial prices, and the posting of imbalances, to give the market a sense of where it is heading. It is not easy, particularly when markets are disrupted and many things are happening. But it is worth thinking about.

MR. KUBARYCH: Discretionary trading halts have some advantages, the most important of which is accountability. After the fact, one can be second-guessed. The discipline of accountability engenders a well-considered, well-reasoned decision-making process.

Other kinds of circuit breakers, like price limits, amount to automatic trading halts. Automatic trading halts have other advantages, the most obvious of which is predictability. Predictability also has considerable value.

I do not think that any of us has the wisdom to decide which is the right type of circuit breaker. I am willing to see both sides of the argument. Either way, a strong case can be made for some kind of time-out, as long as it is handled pragmatically. No one wants to go to the extreme of making it impossible for prices to move, since that defeats the whole purpose of markets.

MR. BRODSKY: We have introduced what we think is an innovative approach. We have price limits in two aspects. First, we have a price limit based on the value of the contract, which would apply at all times. That would be equivalent to approximately 120 Dow points at the current levels, which is 15 S&P points. That would be the outer range of where this circuit breaker would cut in. Second, if there is a big move in the market in the first ten minutes of trading, we wilt have a much more narrow price limit-5 S&P points, which equates to about 40 Dow points. Since this is innovative, we will have to experiment with it.

PROF. MILLER: The matter of circuit breakers is always an emotional issue, particularly with economists. By now, though, the discussion is virtually moot. Both the exchanges have implemented circuit breakers. I believe that these limits are much too narrow. But they will have performed a service if they succeed in forestalling efforts to "fill the regulatory void," as they so quaintly put it in Washington. We should proceed cautiously, since we are still paying the price of many ill-conceived regulatory void fillers devised in the 1930s and 1940s, such as the uptick rule and the insidious, though lesser-known, IRS short-short rule.

It is important to keep in mind that we are no longer King-of-the-Hill in world capital markets. The foreign share of the financial services and futures industry has already grown substantially in recent years and will continue to grow. We cannot stop that, but we can certainly accelerate it with ill-conceived regulation.

MR. ZECHER: It is critically important not to stop the price search process. This will become increasingly important as we continue trading 24 hours a day around the world. In this context I do not know what it would mean to have a price limit in a time zone. I will be trading in a few hours in Japan, Hong Kong, and Singapore. Then I will be trading in London. A price limit imposed in the United States will have little effect on what actually goes on, except to move business overseas.

"Unifying" Clearing and Settlement

MR. KILCOLLIN: Unified clearing would not have solved the problems of October 19, and it would have introduced at least two new problems. The first one relates to the management of risk. At the Chicago Mercantile Exchange we have a clearing organization, the members of which have unlimited liability for losses. If a firm should default-and one never has-all the other clearing members are immediately liable for the loss. That liability naturally makes people cognizant of what others are doing. I do not know how a large amorphous organization, where each member has a minor fractional interest, can reproduce this sort of private incentive to monitor risk. The second problem with unified clearing, perhaps more important than the first, is that it is premised on an old and flawed logic: when you perceive a problem, create a monopoly to fix it. All monopolies sound good on paper, but they seldom work well in practice. There is no reason to suppose that monopoly in clearing will work any better than it does in other enterprises.

Having said all of this, what needs to be done? Principally, we see a need for greater information sharing among the various clearinghouses. We have had very good information sharing within the futures industry, at least within a subset of the industry. The Chicago Mercantile Exchange, for example, has had an arrangement with the Chicago Board of Trade Clearing Corporation for over five years to share pay and collect information daily on all our joint member firms. We are willing, even anxious, to share that kind of information with every clearing organization.

Another option is to modify the system of intraday settlement variation calls. We believe there is also merit in looking at cross-margining proposals or at any other proposal that would facilitate financial flows between our clearing organizations.

PROF. MILLER: The call for a unified clearing system is reminiscent of the grand-sounding but impractical proposals offered 15 years ago for a national market system. It strikes me as an overreaction to the rumors of clearing defaults that were floating, particularly in New York, during this chaotic period. The first we heard about them was when we read about them in the Brady report. They were not a major factor on the floor of the Chicago Mercantile Exchange.

By ordinary standards the clearing process worked remarkably smoothly in Chicago. Given the huge amounts of money involved.

The Adequacy of NYSE Specialists

MR. KUBARYCH: It is astonishing how little people know about the specialist system. The specialist has a variety of roles that differ enormously with the stock. For a large stock like IBM, which is very heavily traded, specialist participation averages about 1 percent; 99 percent of the time the trade is between two brokers, and frequently it takes place inside the quoted bid-ask spread of the specialist. For large stocks, the specialists play the role of auctioneers and agents for limit orders. For small stocks, specialist participation, of course, is much larger. This system works extremely well under most circumstances, especially for those stocks where there is a demand for a continuous market-one in which individuals can buy or sell at any moment.

It is quite clear, from all the analysis, that the specialists did an admirable job on October 19. It is also quite clear that by October 20 their buying power was significantly depleted and their ability to "support" the market had dwindled. The specialist contribution rose from roughly 12 percent to 18 or 19 percent on those days. The role of the specialist in providing this kind of buffer continued throughout this period.

But specialists are not central banks. They cannot have a responsibility to provide price support one way or another.

PROF. EDWARDS: If we are going to impose new government regulations, they should be limited to cases where the self-interests of private market participants are not correctly aligned with the social interests-in other words, where there are externalities of some kind.

Many of the problems revealed during the crash are quite clearly self-correcting. Mistakes were made. Sometimes you need a crash to illuminate weaknesses. The first ones who ought to know about the weaknesses and who have a stake in fixing them are those who have something to lose by their continued existence. Many of the problems identified will be automatically corrected.

There are also problems that may not be self-correcting, such as the market-making system. It seems to me that strong interests are involved in preserving the specialist system and resisting changes in the market-making systems in general. If there is an area of potential public policy interest, it may be in prodding exchanges to take a close look at their market-making systems to determine whether they are capable of handling the trading we have today. The time has come to say that quite possibly the specialist system is out of date and not capable of handling portfolio trades.

PROF. COFFEE: I think we should recognize that, with the emergence of portfolio insurance, the specialist is subject to far more uncertainty than in the past. Portfolio insurance is in a sense an improved substitute for the old-fashioned stop-loss order. In the past the stop-loss order was exposed to the specialist. He had the order before him, he knew the total structure of the market, and he could act in light of it. Now he does not know how much selling pressure is coming and at what points. The remedy may be to give the specialist more information. Perhaps there should be some means by which the specialist is informed about the portfolio strategies that are in place and at what point institutions will begin selling indexed futures contracts to hedge their losses.

MR. DAVIS: We need a great deal of change in terms of market-making capacity. The most important problem is related to the liquidity available for selling baskets of stock. I am not referring to futures trading here; I am referring to trading baskets of stock. On October 19, roughly 40 percent of all basket trades involved futures-related strategies, whereas the other roughly 60 percent involved other types of basket trades.

There is an asymmetry with respect to the market-making mechanism available for baskets of stock and for individual stocks. If I want to trade a big block of IBM, there are several ways I can proceed. I can send it directly to the specialist post, or I can use the upstairs trading mechanism. This amalgam of the specialist and upstairs trading brings a lot of liquidity to the market. You have the capital of the big trading houses available. Information about the block trade is disseminated and the specialist can make a market.

Basket trades, however, do not generally take place upstairs. If they go through the DOT system, as many do, they get divided into more digestible bites and loaded back-to-back so they essentially hit the specialist posts at the same time, where they hit only the liquidity available from the specialist.

The people at Salomon Brothers or Kidder or Morgan Stanley will tell you that they cannot respond fast enough to bring their liquidity to bear. We need not only to make the cash market more liquid for basket trades, but also to improve the use of the liquidity currently available.

MR. GRUNDFEST: I think it is accurate to say that many of the largest institutional users of the futures markets really do not care that they are transacting in futures. What brings them there is the fact that futures markets provide the most effective and cheapest means of reallocating equity market risk. Until the equity markets address this problem head-on by creating an effective and low-cost means of trading blocks that are composed of diversified portfolios, the equity markets will be at a distinct disadvantage in providing liquidity to the portfolio trader.

---

		Subscribe to Regulation

/div>