Index Futures-Stock Link Spurs Volatility : Program Trading: Plunge Raises Regulatory Issue
David S. Ruder chose a controversial issue for his first public speech as Securities and Exchange Commission chairman on Oct. 6: whether computerized stock and futures trading could someday lead to a series of cascading sell orders in the stock market.
“The grand finale of this scenario,” Ruder told the Bond Club of Chicago, “would be a dramatic market collapse. Understandably, the commission is not anxious for this to occur.”
The scenario that Ruder figured the SEC could safely mull over for months struck two weeks later with a magnitude that no one expected. The severity of the market’s crash Monday and over the previous two weeks is already raising the question of whether regulators, Congress and the exchanges themselves might have better foreseen the consequences of linked trading in futures and stocks and acted to forestall the crash by restricting or even forbidding today’s elaborate and financially potent trading strategies.
Just as natural disasters like earthquakes expose weaknesses in man-made structures that few people otherwise recognize, the market crash is laying bare a complex of shortcomings in today’s financial and regulatory system that many observers have decried, often as prophets without honor.
The root causes of the Crash of 1987 are certainly numerous and complex, but one thing is clear: “The regulators are in a new era of dealing with things that aren’t very well understood,” said A. A. Sommer, a former SEC commissioner who has conducted regulatory studies for the New York Stock Exchange.
Perhaps the most important weakness in the system is the increased volatility in the stock market that results from trading, or “arbitrage,” that links stocks to futures.
In the most simplified case, a large institutional investor will shift billions of dollars between two investments: the Standard & Poor’s 500 futures contract, traded on the Chicago Mercantile Exchange, and a group of stocks selected to replicate the behavior of the underlying S&P; 500 index, on which the future is based.
The idea is to turn a profit equal to the momentary differences in price between the futures contract and the group of stocks. This is done by simultaneously selling one and buying the other. The price changes are so rapid and complex that the investor uses a computer program to tell him when to give the appropriate buy and sell orders, which typically hit the exchange floor in multibillion-dollar waves. Hence, computerized program trading.
Volatility Debated
Over the two years in which this technique has become popular, its proponents have insisted not only that it contributes virtually nothing to stock market volatility, or price swings, but that the markets are no more volatile today than in the past. Reams of academic studies have been produced to support this position.
Today, the evidence points to the opposite conclusion, for market participants say that program trades clearly had a leading hand in 50- and 100-point moves in the Dow Jones industrial average in periods of minutes over the last week.
New York Stock Exchange Chairman John J. Phelan remarked just after Monday’s 508-point collapse in the Dow: “This will put an end to those esoteric studies people have done saying the markets are not more volatile today than they used to be.”
Many of these trading techniques employ futures and stock options whose behavior in a variety of market conditions is simply unpredictable--and, more often than not, disappointing. “A lot of these new financial animals created by the rocket scientists of Wall Street have never been tested,” said Raymond DeVoe, a market analyst at the investment firm of Legg Mason Wood Walker. “Every time they have been, there’s been blood all over the floor.”
Also, the markets have become bigger than the people assigned to run them. The scale of trading this week alone has swamped the financial capability of the markets’ primary lines of defense against chaos: the “local” traders in the futures markets and the “specialist” traders in the stock markets.
These traders must use their own money to maintain stable markets. It is a task they shouldered easily when the typical investor was their own size; now that the typical investor is a major institution playing Goliath to their Davids, the system is strained.
“This is really an industry in transition from handling small and modest transactions to handling institutional markets,” said Merton Miller, a professor of finance at the University of Chicago. “A lot of people have pointed out for a long time that there is a problem of peak load capacity.”
The consequence: On Monday, the volume of futures orders was so great that local traders simply stopped trading, creating inordinately uneven prices for key futures. On Tuesday, inundated specialists on the New York Stock Exchange suspended trading in as many as 60 stocks at a time, forcing the futures exchanges to halt trading in the related futures for hours at a stretch. That meant, of course, that investors unable to buy or sell were stuck unhappily in their positions.
The SEC, the Commodity Futures Trading Commission and Congress have almost never used the authority they do have to regulate the sophisticated new trading programs implicated in the crash. The SEC, for example, has the right to veto any proposed new futures contract based on a stock index--the favored instrument of computerized traders. It has never exercised the veto.
Similarly, Ruder noted in his Chicago speech that he would consider asking for a coordinated, system-wide suspension in trading of stocks and related futures and options markets for 30 minutes to an hour during crisis times to allow exchanges to disseminate market information. He made no such recommendation Monday, although a wilder market crisis can scarcely be envisioned. (Although, under law, Ruder can only propose a voluntary suspension, the exchanges have said they would give his recommendation great weight.)
As for banning program trading, Congress theoretically can do so by banning various futures and options instruments used in the technique; but it has never considered such a step.
Of course, the trading atmosphere of today’s markets is so novel that no one knows whether any of these steps would work. “The regulators are just a fifth wheel in these markets,” Miller said.
Foe of Program Trading
Even the NYSE’s Phelan, as resolute a foe of program trading as exists in the markets, said Tuesday that “our problem was not so much a failure of regulations (as) the increased volatility that has come for a whole variety of reasons.”
Others argue that the exotic trading programs and other factors blamed for the Crash of ’87 are nothing more than messengers of more serious fundamental problems in the financial system.
“Basically, we’ve seen a complete collapse of confidence in our economic system,” said Richard L. Sandor, head of futures trading at the firm of Drexel Burnham Lambert. “I don’t think there’s any particular thing that can be done about the fact that the U.S. government has failed to address its budget and trade deficits.”
For all that, an extended market decline is likely to expose other weaknesses in the financial system. “Let’s say this is more than a one-day panic,” said James Grant, editor of Grant’s Interest Rate Observer, an iconoclastic newsletter about financial trends. “The crash will cause whole layers of onion to be peeled back, showing the system of financial guarantees that all looked good when asset values were rising but in a bear market will go wrong.”
Mushrooming Role of Credit
One latent weakness is surely the mushrooming role of credit, or “leverage,” in the corporate and financial world. Credit allows investors to buy more stocks, futures and other instruments when the markets head up, but it magnifies disaster on the way down.
One cause of the Crash of 1929 was the ability of investors to buy stocks on down payments of as little as 10%. In those days, a stock’s loss of only 10% of its value would wipe out the owner.
Today, the government requires most investors to put up at least 50% of a stock’s value. But, in the futures markets, which on an average day handle futures contracts equal to twice the value of stocks traded on the New York Stock Exchange, investors as recently as Monday were required to put up only $15,000 to own a contract worth the equivalent of more than $100,000 in stocks.
