Critics Say NYSE ‘Medicine’ Just Made the Patient Worse
Last February, the New York Stock Exchange imposed a trading rule designed to curb the market’s volatility--its tendency toward unmanageably sharp price movements--whenever the Dow Jones industrial index moved up or down more than 50 points in a day.
Thursday’s 101.46-point drop in the Dow, reflecting the market’s most volatile day in more than three months, is likely to raise new questions over whether the rule is merely cosmetic--and whether it may even create more volatility than it cures.
In the immediate aftermath of Thursday’s trading, there remained more confusion than anything else. In a statement issued from his Washington office, Rep. Edward J. Markey (D-Mass.), a key congressional overseer of securities regulation, complained that the slump “raises questions as to the effectiveness” of the NYSE’s rule. Many traders, however, complained that the rule exacerbated the drop.
“This is a classic case showing how foolish this procedure is,” remarked Robert Gordon, head of Twenty-First Securities and a vocal opponent of the curb.
The NYSE rule is aimed at so-called index arbitragers. These are large professional investors who simultaneously trade stocks and stock index futures, which are traded on Chicago exchanges.
The futures are designed to trade at prices that theoretically track the price of their underlying stock index. But because the stock and futures markets each serve largely different communities of investors, the prices occasionally diverge, creating a discrepancy between them known as the “spread.”
At certain times this spread grows so large that an arbitrager can profit by buying the stocks and selling the corresponding future, or vice-versa, locking in a gain equivalent to the spread minus such expenses as brokerage commissions and interest on borrowed capital.
To do so, however, requires split-second trading--generally dictated by computer programs--and the placement of huge buy or sell orders nearly simultaneously on the stock and futures exchange floors. Consequently, most arbitragers transmit their stock orders through the NYSE’s automated DOT, or “direct order turnaround” system, which can transmit millions of dollars in orders to the floor in seconds.
However, because investigators have concluded that a huge logjam of such orders through DOT last Oct. 19 helped create the stock market crash, the NYSE in February imposed its rule shutting DOT to arbitragers whenever the Dow industrial index moves 50 points in a day. Under the rule, arbitragers are asked to avoid DOT for the rest of that day, even if the Dow subsequently retreats below the 50-point threshold.
The so-called collar does not restrict arbitragers from transmitting their orders manually, using the virtual army of independent brokers always available on the exchange floor. This army was widely deployed Thursday after the collar went into effect at 1:54 p.m. New York time, traders say.
“At 50 points the automated trading stopped and the (independent) brokers were all warming up in the bullpen,” said Robert Jacobson Jr., a floor specialist whose job is to supervise the trading in several stocks. “At 50.03 points they were out of the starting gate, and once it started it wasn’t going to stop for the rest of the day.”
Some arbitrage professionals argue that the collar’s impact is destined to be minimal because it chiefly affects relatively small-scale traders without access to independent brokers. “The big guys will continue to account for 80% of the trading volume anyway,” said Courtney Smith, director of futures trading in New York for Banque Paribas, the French commercial bank.
Others suggest that shutting down arbitrage trading in one market--stocks--without affecting the other--futures--is the kind of severing of trading relationships that investigators of the crash, including the Brady Commission appointed by President Reagan, specifically warned against.
Yawning Spread
By some analyses, Brady’s warning came true on Thursday: Just after imposition of the collar, the spread between the Standard & Poor’s 500 stock index future and the index itself suddenly widened to a point that attracted, rather than curbed, the arbitragers.
In truth, arbitrage is a self-limiting activity, for the spread-induced buying and selling of stocks and futures tends to bring the disparate prices back into line. When trading on one side of that equation is hampered, the disparity persists or increases, as it did Thursday.
Market charts show that for most of Thursday’s session, during which a negative U.S. trade report was sending stocks steadily lower, the S&P; 500 spread remained at a stable 50 points--too small to inspire any arbitrage trading.
Within minutes of the collar, the spread yawned open to more than 300 points, an irresistible arbitrage opportunity; stock trading volume virtually exploded. Continually hampered by the collar, the spread oscillated wildly for the rest of the day.
“From that point on, the market was entirely fueled by arbitrage,” Gordon said.
For its part the exchange management belittled the role of computerized trading in Thursday’s market. “The primary intelligence I got related to the trade picture, the dollar and the bond market” bearing the blame for the market’s drop, said Richard A. Grasso, NYSE executive vice president. In any event, he noted, the rule is designed more to protect the DOT system from overuse in extreme situations than to shut out all arbitrage trading. Moreover, the rule has yet to be sufficiently tested.
“We’ve only had two tests--one on the upside (a 64-point gain April 6) and one on the downside,” he said.
