CFTC Study Fails to Link Index Arbitrage to Crash

Relatively few of the shares traded during the crash of “Black Monday” were sold by firms using computers to shift funds between stocks and stock index futures, according to federal regulators.

In a preliminary report on recent market turmoil, the Commodity Futures Trading Commission said only about 9% of the stock sold on the New York Stock Exchange on Oct. 19 was associated with index arbitrage, a form of program trading.

In fact, index arbitrage accounted for a smaller share of stock orders on Oct. 19 than usual, it said.

“These preliminary data indicate that futures-related trading did not constitute a major part of New York Stock Exchange volume Oct. 19 and the following days,” according to the report, which was obtained Tuesday.

Its conclusions buttress, but do not fully substantiate, claims by the Chicago Mercantile Exchange that program trading did not cause or aggravate the stock market’s fall on Black Monday. The CME is the home of the Standard & Poor’s 500-stock index futures, the most widely traded index futures contract.

Program trading involving stocks and stock index futures has been blamed by some for exaggerating the record Wall Street plunge. The critics of the technique include Rep. Edward Markey (D-Mass.), chairman of a House subcommittee with jurisdiction over securities regulation.

Futures are contracts to buy or sell a commodity at a set price for delivery in the future. Investors commonly use stock index futures, which are bets on the future price of a group of major stocks, to hedge against future changes in stock prices.

Index arbitragers using computers try to take advantage of unusually wide differences between stock and stock index futures prices to lock in risk-free gains by selling one of the instruments and simultaneously buying the other.

In a falling stock market like that of Oct. 19, arbitragers would have sold stocks and simultaneously bought stock index futures, theoretically narrowing the price gap separating the two.

But the CFTC report indicated that arbitragers played a smaller role in the stock and futures markets than on less hectic days, when index arbitrage generally accounts for about 20% of the volume of traded stock.

Sixteen firms using index arbitrage sold about 9% of the shares traded on the Big Board on Oct. 19. That compared with seven firms accounting for 17% of stock sales on Sept. 11 and 12, 1986, when the Dow Jones industrial average swung more than 100 points in one day.

Index arbitrage accounted for only 2% of the shares sold on the New York exchange Oct. 20, the report said.

The study also found that firms using a technique called portfolio insurance accounted for between 12% and 24% of total volume in the CME’s Standard & Poor’s 500-stock index futures on Oct. 19.

Firms using portfolio insurance would have hedged stocks by selling stock index futures contracts, braking the fall in share prices.