Market Reform Ends Up as Only a Minor Tuneup : Old-Line Firms Lose Out to Those Using New Strategies
As a mass of investors fled the markets after the crash, a mass of experts rushed in to find out what went wrong.
Market specialists from Wall Street, government and academia evaluated and calculated, grinding out 12 reports that filled more than 3,000 pages and 3 linear feet of shelf space. It was by far the most searching analysis of the financial markets in 50 years, and many predicted that it would catalyze sweeping change and end a decade of market deregulation.
That didn’t happen.
As the months have passed, the most dramatic prescriptions for market reform have been discarded in favor of modest refinements that most observers applaud but many consider only a partial cure. Proposals for a regulatory restructuring and for curbs on the new high-tech trading strategies have languished as public alarm over the crash faded and as industry interests and key regulators mobilized to block change.
The debate over reform thus closed in a stunning victory for the ascendant interests of the investment world: the Chicago futures markets and the Wall Street firms that have uncorked cash gushers in the past decade with the new short-term trading strategies popularly known as program trading. On the defensive in the panicked aftermath of the crash, the industry’s vibrant new wing has now established itself more firmly than ever and cleared the way for the similar trading innovations that are no doubt to come.
“No matter what we might hope for, the genie is now out of the bottle,” says A. A. Sommer, a former member of the Securities and Exchange Commission who advocated tighter regulation of the trading practices that have been accused of destabilizing the markets.
The losers in the reform battle are the old-line Wall Street firms that make much of their money the old-fashioned way, by selling stock to individual clients. These so-called retail brokerages have long been unsettled by the new trading techniques, which they believe create volatility that frightens their clients and interfere with the market’s primary function of enabling corporations to raise money by selling stock.
Had Many Problems
Executives of these firms today speak bitterly of the reform debate and warn that investors’ painful absence from the market will continue unless more dramatic action is taken. “The changes we’ve seen are largely of a cosmetic and PR nature,” says George Ball, chairman of Prudential-Bache Securities. “Greed has been the industry’s primary motivator.”
But if the general clamor for reform has subsided, it was strong indeed last October. Investors couldn’t get through on the telephone to their brokers, traders couldn’t get their orders executed, computers jammed, the exchanges sometimes didn’t seem to be working together.
At the New York Stock Exchange and in the over-the-counter market, the functionaries charged with keeping trading going were accused of pulling back to avoid having to buy more and more stock. As a half-trillion dollars in paper losses piled up, the flow of information on the debts and assets of investors bogged down, and some lenders hesitated to extend further credit.
To address those problems, the exchanges and over-the-counter market began improvements immediately after the crash. They have increased the capacity of their computers to process trades, taken steps to see that there are enough buyers and sellers during a crash, and increased automation of the trading systems that became gummed up in October.
The New York Stock Exchange has sharply increased the amount of money and stock that must be held in reserve by specialists, the traders designated to supervise and participate in buying and selling of individual stocks. It has expanded its computer capacity and says it can now handle daily volume of 600 million shares almost as easily as it used to handle 200 million shares.
The difficulties faced by small investors in the over-the-counter markets during the crash will live long in Wall Street legend. Central among them was the withdrawal from trading of many OTC market makers, the dealers who are supposed to keep the market alive by buying and selling when others won’t.
Threat of Suspension
In the crash, some market makers disconnected their phones to avoid having to buy the public’s stock, while others disabled their links to the automatic trading system by entering incorrect price quotes.
The largest over-the-counter trading organization, the National Assn. of Securities Dealers, has taken several steps to keep market makers trading during a crisis. Market makers who withdraw from trading will now be suspended from the market for 20 days, compared to a former two-day suspension. And market makers who want to handle some of the most popular OTC stocks--those in the 2,500-stock National Market System--must agree to be hooked up to the NASD system that automatically carries out trades. The rule is intended to prevent them from ducking small orders for such stocks called in by telephone.
Trading in about 2,200 other OTC stocks are not affected by these rules, however.
The nation’s markets also seem to be headed toward adopting a scheme proposed by the Big Board and the Chicago Mercantile Exchange that would temporarily close all markets in hopes of ending a slide if one began.
Several of the crash studies concluded that the nation’s exchanges have come to function as one intertwined market as big institutional investors have simultaneously traded huge blocks of stocks in one exchange and the related investments called stock index futures and options in other exchanges.
Stock index futures contracts are a means of speculating on the direction of the market as a whole; they are, essentially, bets on the price of a basket of stocks at a certain date in the future. Options contracts give an investor the right to buy a stock or a stock index at a certain price up to a certain date.
Would Close Markets
Analysts of the crash at two White House-sponsored study panels--the so-called Brady Commission and the successor White House Working Group--concluded that the markets would benefit from “circuit breakers” that would interrupt trading during sharp declines. They theorized that an orderly interruption of trading would give investors time to learn key information and brake the momentum of a fall.
The proposal, which the SEC is expected to approve soon for a one-year test, would temporarily close all markets for one hour if the Dow Jones industrial average fell 250 points in a single day, and for a second hour if the decline reached 400 points.
So how much safer are the markets because of these reforms?
There is broad agreement that the technical refinements would ease the pressures on vulnerable points in the system in another crash. “Nobody’s going to ring a bell and say, ‘The market’s now perfectly safe,’ ” says Evers Riley, senior executive vice president at the American Stock Exchange. “But probably we’re a lot better off today.”
Some of the most ardent reform advocates now seem to concur with that view, including members of the Brady Commission, which took its name from that of its chairman, Treasury Secretary Nicholas F. Brady. Members of the Brady Commission reported their findings last January, then in early May issued a statement decrying the lack of action to implement them.
Brady, who was head of the investment banking firm Dillon, Read & Co. when he chaired the panel, has noted that several of the key proposals have been put into place. But perhaps the most outspoken of the panel members about the dangers of the new high-tech trading strategies was Robert Kirby, the chairman of Capital Guardian Trust Co., a Los Angeles money-management firm.
‘Worthwhile Experiment’
Today, Kirby says he is “encouraged” by the changes that have been made, pointing in particular to the New York Stock Exchange’s new practice of disclosing monthly the names of firms that have engaged in heavy program trading. While the big program traders don’t seem to mind that they are identified at the current modest level of program trading activity, fear of negative publicity would make them think twice about pounding a falling market by selling huge blocks of stock during another crash, Kirby says.
Big Board Chairman John J. Phelan, at first an opponent of the circuit breaker proposal, now asserts that it is a “worthwhile experiment.” He suggests that the plan will reassure the public that some stabilizing action will be taken to curb volatility that is “politically and socially” unacceptable.
Others remain to be persuaded that all’s well. After the crash, Garry Glennon, head of over-the-counter trading for the money-management firm First Manhattan, wrote in a memo that the OTC market during the crash had shown itself an “abysmal failure.” Today he observes that the market’s refinements “haven’t had much of a test yet, have they?”
Progress has been slow toward a key recommendation of several study groups, better integration of the so-called clearing and settlement systems. This system functions behind the scene to arrange credit for investors and trading firms, to sort out and complete the millions of transactions as they are made in the stock and commodities markets.
During the crash, the information flow bogged down, making some lenders hesitant to extend further credit to their customers and threatening to force key investors out of the market at a time when they were badly needed to keep trading going, regulators and crash analysts have pointed out.
Many analysts have urged a more closely knit system that would give investors, lenders and the clearing agencies quicker access to information on investors’ financial positions in all the different markets.
But these efforts have been slow to get off the ground, partly because the patchwork of firms that handle the task, like duchies and principalities in medieval Europe, resist changes that might diminish their autonomy or threaten their prosperity, industry officials say. The Big Board’s Phelan says he considers the lack of an integrated clearing system to be the markets’ principal weakness.
SEC Chairman David S. Ruder praises the improvements that the markets have made since October. But he warns big institutional investors that the market--and their interests--may someday again be badly damaged if they all try to bail out of a collapsing market with the kind of high-volume trading techniques that worsened the October, 1987, crash.
The proposal to close the markets temporarily remains a subject of angry debate. Critics contend that a trading halt, even for a short period, will panic investors and build up additional pressure to sell when the markets reopen.
The extent of the industry’s opposition was evident several weeks ago, when SEC Chairman Ruder made an unusual appearance before the board of directors of the National Assn. of Securities Dealers to argue for the measure. While Ruder’s appearance was a means of placing pressure on the group, the board nonetheless again voted against the idea, so profound was its displeasure with it. (The group has recently grudgingly agreed to the circuit breaker experiment.)
The circuit breaker proposal has also come under fire from the retail brokerage flank as too little, too late. Jeffrey B. Lane, president of the Shearson Lehman Hutton brokerage firm, says that after a 250-point slide of the Dow “the cows are out of the barn.”
The giant brokerages such as Shearson, Prudential-Bache and Dean Witter Reynolds have backed reform proposals such as the market reform bill of Rep. Edward J. Markey (D-Mass.), chairman of the House subcommittee on telecommunications and finance. Markey’s bill would have extended the SEC’s authority to include regulation of stock index futures and index options and would have authorized the Federal Reserve to set margins on stock index futures.
Program Trading Rapped
But the Markey bill went nowhere in the congressional session that is now winding down, and most observers are skeptical that, barring another calamity, any major regulatory reform will make it through Congress in the years ahead, either.
The defeat of the old-line brokerages is all the more stunning considering the strength of the momentum for reform immediately after the crash. Program trading came in for heavy public criticism.
The Brady Commission blamed a handful of big investors for worsening the collapse with heavy program trading. It called for a single regulator, such as the Federal Reserve, to oversee issues that concerned several markets and to consider raising margins, or down payments, on stock-index futures.
In April, responding in part to pressure from the brokerages, the Big Board put into effect a “collar” that made program trading more difficult on volatile days by forbidding use of the technique through its computer system that routes buy and sell orders for execution. As late as mid-May, the big program traders of Salomon Bros., Goldman, Sachs & Co. and Bear, Stearns & Co. said they would no longer conduct the kind of program trading called index arbitrage for their own accounts.
But by then the tide was shifting. The White House disowned the Brady report as soon as it came out in January, prompting a commentator in the New Republic magazine to observe that the tome had “set a new record for the time it takes a blue-ribbon commission’s report to turn into a doorstop.”
High-Powered Members
A coup de grace was delivered to the sweeping reform proposals on May 16, when the White House Working Group issued a report that backed away from major major regulatory change and rejected steps to curb the computerized trading techniques.
The group warned those who would “undo the changes . . . brought about by changes in telecommunications or computer technology.” And its declarations carried significant weight, since its members include Federal Reserve Chairman Alan Greenspan, Commodity Futures Trading Commission Chairman Wendy Lee Gramm, Treasury Under Secretary George Gould, as well as SEC Chairman Ruder.
Merton Miller, a finance professor at the University of Chicago, compares Wall Street’s retail brokerage industry to a seaside hotel that long has catered to a sedate clientele but one day begins to feel its prosperity threatened by a new hotel that has set up shop next door catering to a younger, noisier group.
Like that staid hotel, “I think these firms would like somebody to come in and put their competitor out of business,” Miller says. “The fact is, they’re going to have to learn to coexist.”
THE PUSH TO REFORM
Key Studies of the Crash *BRADY COMMISSION --Concluded that a few large investors, in computer-directed selling of huge blocks of stock, were largely responsible for the crash. --Called for a single dominant regulator, such as the Federal Reserve, to decide issues that span the closely intertwined stock, stock-index futures and stock-index options markets. --Urged that margins, or down payments, for the purchase of futures and stocks be brought closer together. --Recommended improved communications between exchanges and regulators. --Called for creation of a unified system for clearing and settlement of trades. *SECURITIES AND EXCHANGE COMMISSION --Said program trading and stock-index futures trading worsened the crash. --Called for curbs on speculation in stock-index futures. --Urged that the SEC’s regulatory oversight be extended to include securities-derived investments, such as stock-index futures and stock-index options now regulated by the Commodity Futures Trading Commission. --Recommended improvements in the markets’ trade-processing capacity and improved coordination between regulators. *GENERAL ACCOUNTING OFFICE --Said repeated breakdowns in the New York Stock Exchange’s computer system aggravated selling during the crash. --Recommended increases in the trade-processing capabilities of the exchanges. --Urged that contingency plans should be established between markets in case of another precipitous drop. *WHITE HOUSE WORKING GROUP --Attached no blame to program trading or stock-index futures for the crash, and saw no need to increase margins to dampen speculation. --Urged that “circuit breakers,” or trading halts, be imposed in all U.S. markets if the Dow Jones industrial average falls 250 points in a single trading session. --Recommended that the group continue to coordinate the government’s responses to market rises. *COMMODITY FUTURES TRADING COMMISSION --Found that futures trading did not worsen the crash. --Called for better communications between exchanges. *NEW YORK STOCK EXCHANGE (Study was begun before crash) --Contended that stock-index futures trading has encouraged excessive speculation. --Called for consolidation of regulation and higher margins on stock-index futures. *CHICAGO MERCANTILE EXCHANGE --Concluded that neither futures trading nor low margins on futures were responsible for worsening the crash.
Key Reforms to Date *GOVERNMENT --The SEC is expected soon to approve a one-year pilot program of “circuit breakers” that would halt trading in all markets for one hour if the Dow Jones industrial average fell 250 points, or if the Standard & Poor’s 500-stock index futures fell 12 points. Trading would be halted for another hour if the Dow fell an additional 150 points. --The White House Working Group, including officials of the Treasury Department, CFTC, SEC and Federal Reserve, continue to work on technical improvements to the financial markets. The group has identified better integration of the markets’ clearing and settlement systems as its first goal. *NEW YORK STOCK EXCHANGE --Increased specialists’ minimum capital requirements. --Increased its computer system’s trade-processing capacity. --Established a system that will give small orders a brief time advantage over larger orders if the Dow falls 25 points in a day’s trading. --Considering selling “market baskets” of stocks on the trading floor to satisfy demand for baskets among institutional investors and to relieve pressure on specialists during periods of volatility. *NATIONAL ASSN. OF SECURITIES DEALERS --Set higher minimum capital requirements for market makers of over-the-counter stocks. --Required market makers to hook into an automated small-order system if they wish to trade National Market System stocks. Connecting to the system, which was optional before the crash, means they must accept any order under 1,000 shares. --Required market makers to accept such trades even if the price quotes they have entered into the system are not accurate. *AMERICAN STOCK EXCHANGE --Increased computer trade-processing capacity. --Raised minimum capital requirements for specialists. --Increased the system’s capacity to handle small orders automatically. *CHICAGO MERCANTILE EXCHANGE --Raised, at least temporarily, margins on its Standard & Poor’s 500-stock index futures contract. Traders must put up about 15% of the contract’s value, compared to about 7% at the time of the crash.
