It was the most forceful conclusion in the Brady Commission's hard-hitting report on last October's stock market crash: While the nation's stock, options and futures markets have become increasingly unified, the regulatory structure designed to oversee them remains fragmented and ineffectual.
But a week after the report's release, Congress shows no sign of following the commission's advice and consolidating regulation under a single "overarching authority," perhaps, but not necessarily, the Federal Reserve Board.
In fact, Senate Banking Committee Chairman William Proxmire (D-Wis.) said in an interview that Congress is likely to "leave as much as possible to the status quo."
In October, according to the Brady Commission, the status quo meant that links between the stock markets in New York and financial futures markets elsewhere contributed to massive selling pressure in both. And regulatory structures designed for separate marketplaces, it held, proved incapable of responding effectively.
The commission, whose chairman was former Sen. Nicholas Brady (R-N.J.), now chairman of the Wall Street firm Dillon, Read & Co., kindled a debate that is certain to continue when congressional committees hold public hearings about the stock market crash beginning later this month.
Prominent on those committees' agendas will be their own turf. Rearranging regulatory authority inevitably means reassigning congressional committees' jurisdiction over the regulatory agencies, and no committee is likely to give up any authority without a fight.
'Flex More Muscle'
"If the world was pure and it wasn't political," said a staff member of the Senate Banking Committee who asked not to be named, "you'd probably want all stock and stock-related instruments under one jurisdiction. But I can't see that happening."
The Securities and Exchange Commission, which regulates the New York Stock Exchange, is in the jurisdiction of the Senate Banking Committee and the House Energy and Commerce Committee. But the Commodity Futures Trading Commission, which is responsible for the futures markets in Chicago, reports to the Senate and House agriculture committees.
Even if Congress declines the Brady Commission's invitation to reshuffle financial regulatory authority, however, it is likely to try to force the regulators to flex more muscle.
"It's clear that there is a regulatory black hole that has been opened and has to be closed," said Rep. Edward Markey (D-Mass.), chairman of the House Energy and Commerce subcommittee on telecommunications and finance. "We can be a little flexible as to what we do to solve the problem as long as we are inflexible in recognizing that the problem must be solved."
At the least, Congress is expected to take action to strengthen regulation of the controversial stock index futures, whose introduction on futures markets in 1982 made possible the computer-driven program trading strategies blamed by the Brady Commission and others for accelerating October's market plunge.
The most likely step is an increase in margin requirements--or down payments--for stock futures, which the Brady Commission said should be consistent with margins for stocks. Commodities exchanges have raised stock futures margins since the market crash, but those margins remain at 10% to 12%, considerably lower than the 50% margin for investments in the stock market.
Critics say the low margin requirement makes speculation in stock futures too easy.
"The difficulty under present circumstances is the fact that you can play the futures market with such a very small commitment," Proxmire said. "We need to provide some uniformity so that you don't have this terrific mishmash, particularly on margin requirements."
Michael Brennan, a professor of banking and finance at UCLA, added: "I don't see why one would want to distinguish between margin levels in futures and margin levels in stock transactions. They are essentially the same thing."
Long before stock index futures were invented, a stew of federal agencies and a hodgepodge of rules governed behavior in different marketplaces, leaving the markets with no conscious coordination.
The SEC was established under a reform after the market crash of 1929 to regulate securities markets.
But, at the same time, the Federal Reserve was empowered to set margins for stock purchases, which had been as low as 10% before the market collapse, a factor blamed for encouraging speculation. Under Fed governance, stock margins were first set in 1934 to range between 25% and 45% and, often for reasons of monetary policy, have been raised as high as 100% before dropping to 50% in 1974.
Other aspects of regulation were left to the stock exchanges themselves, and for 40 years futures exchanges remained wholly self-regulatory despite two attempts in Congress in the 1940s to set margin requirements for futures as well.
Not until 1975 did Congress create the CFTC to oversee the futures exchanges. But the CFTC's powers were limited; except in emergencies, the power to set margins was left to the exchanges themselves.
The lack of coordination among the various agencies did not worry most observers, but hindsight suggests that it became of crucial importance after 1982, when the CFTC voted to allow stock index futures to be traded on commodities exchanges.
Suddenly the agency created to oversee the tradings of contracts to purchase wheat, pork bellies and other commodities was responsible for monitoring trading of stock index futures, whose prices were closely linked to those of the underlying stocks traded on stock exchanges.
More important, the creation of stock index futures made it possible for sophisticated investors to invest in the same stocks in both markets, taking advantage of tiny price discrepancies in the two markets or to make investments in one market designed to protect against losses in the other. High-speed computers were essential to the strategies, known collectively as program trading.
Regulators, according to the Brady Commission, did not keep up. Indeed, the regulatory agencies seemed consumed by a deregulatory spirit through most of the Reagan Administration, inclined to trust in self-regulation of the markets and to play down the consequences of the new financial instruments.
The CFTC was widely viewed as a kindly but ineffective regulator, too friendly to the futures industry to regulate it effectively and too short of staff and budget to keep pace with rapidly increasing trading in financial futures.
Until just before the October crash, margins on stock index futures, set by the exchanges with oversight but little input by the CFTC, remained as low as 7% of a contract's value, permitting investors to speculate huge sums of money with little cash outlay.
The SEC earned a reputation as a tougher regulator, but as trading in stock markets grew rapidly, it was viewed as progressively understaffed.
Congress' General Accounting Office argued that the agency had been outstripped by the market. Critics still contend that, while the agency was active in prosecuting insider trading cases, it did "essentially nothing" to monitor market developments. In testimony to Congress earlier this year, veteran securities lawyer Milton Cohen said the SEC should examine program trading and other new developments more closely.
As for the Fed, it exhibited a determination only to relinquish its only stock market-related responsibility--setting margin requirements for stocks. It sought unsuccessfully in 1984 to convince Congress that margin-setting authority should be transferred to the exchanges and securities dealers. Later it suggested that the SEC should be given that authority, but the SEC expressed little interest.
As the volume of program trading increased, making the links between the stock and futures markets more apparent, some in Congress and on Wall Street noted that the financial markets had in effect become merged and expressed concern about the possible consequences.
But it was not until October that Congress and the regulatory agencies began giving careful consideration to the unified nature of the financial markets. Within weeks of the crash, committees called closed-door hearings with officials of the regulatory agencies and the exchanges to consider what could be done to regain control over the markets.
And though the precise causes of the market crash are still under debate, the central lesson that members of Congress and others appear to have drawn from early analyses is the argument--emphasized by the Brady Commission--that stock and futures markets can no longer be seen as distinct.
"The most important intellectual statement (in the commission report) is the statement that primary and derivative stock products together constitute a single market," said James Stone, chairman of the CFTC under President Jimmy Carter. "To look at them separately always leads to confused conclusions."
"The analysis is fundamentally accurate and as a result is very, very helpful," Rep. Markey said. "It will help build the consensus we need."
While some have focused their criticism on stock index futures and program trading, suggesting that either the instruments or the strategies that take advantage of them be banned, many of the proposals advanced in the wake of the market crash have focused on structural reform.
"There's a whale of a difference between wiping out an established industry and heading off a new product before it gets going," said Stone, who opposed the creation of stock index futures. "There's a big industry out there, and it's probably better to regulate it than to wipe it out."
Less than two weeks after the crash, SEC Chairman David S. Ruder told a congressional committee in a private hearing that the government should be directly responsible for setting margins for trading on stock index futures.
More recently, in its own report on the market crash, the New York Stock Exchange proposed that the trading of stock index futures be moved to the stock exchanges, where they would be under SEC oversight and governed by the Fed's margin-setting rules.
An alternative measure that would shift regulation of stock index futures from the CFTC to the SEC but allow trading of the instruments to remain in commodities exchanges is likely to be introduced in Congress early this year, according to congressional sources.
Futures traders and the commodities exchanges would strongly resist such a proposal and have sought to emphasize the self-regulatory steps that they took to increase margins and impose price limits on trading in the wake of the market crash.
"The Brady Commission wants a system that is rational and efficient," said Merton Miller, a professor of finance at the University of Chicago and chairman of a panel appointed by the Chicago Mercantile Exchange to consider the causes of the market crash.
"I would argue that the way the exchanges set the margins on futures is rational and efficient," he said. "When volatility picks up, then margin requirements go up. The exchanges have the right combination to balance the costs against the incentives."
Miller called the stock and futures markets "fundamentally different. . . . I can see no reason why you would want one agency, certainly not the Federal Reserve, to be jointly regulating those."
Such opposition is sure to be reflected in Congress, where the agriculture committees that regulate the trading of stock index futures tend to be sensitive to the concerns of the futures industry and, like any committee, to be protective of their jurisdictional turf.
"A future is different from a stock, so I have not yet jumped into the league of those who say we ought to transfer authority," said Rep. Dan Glickman (D-Kan.), a member of the House Agriculture Committee.
"If the first legislative idea out of the box is to merge the SEC and the CFTC . . . we'd have everyone with their backs against the wall on which agency regulates which instrument," Glickman said. "That's really an unfortunate bureaucratic way of looking at it."