Attempting to Tame Program Trading
The wolf that is computerized program trading is knocking on Wall Street’s door again--wearing a lamb’s outfit this time.
The arrival of an allegedly defanged form of program trading is spooking many traders and analysts, who remember very well the debacle of last Oct. 13, when the Dow Jones industrial index suddenly plunged 190 points after a red-hot rally. One of the major forces in that drop was program trading, particularly the high-speed juggling of huge blocks of stock against stock-index futures contracts.
Early this week, the brokerage Kidder, Peabody & Co. announced that it was jumping back into that juggling act, which is technically known as index arbitrage program trading. Kidder, like many brokerages, had stopped index arbitrage for its own account after last October’s disaster.
Now, Kidder says it believes that it can restart the practice without undue harm to the market. Some analysts say that’s baloney and that in any case it isn’t worth chancing it. “This is a shocking betrayal of the public,” contends Michael Metz, investment strategist for Oppenheimer & Co., a Kidder competitor.
In the wake of the market’s strong spring rally, program critics fear that some piece of bad news--perhaps a jump in interest rates or a major new corporate bankruptcy--could spark a stock selloff that would snowball quickly with the help of programs, just as last October’s collapse of the UAL Corp. buyout induced a program-amplified rout. And if the public is forced to live through yet another one-day, 200-point plunge, analysts fear a terrible backlash against Wall Street.
Kidder, however, argues that its new program strategy is designed to guard against fueling market volatility. The firm will follow a simple rule, said Thomas F. Ryan, executive managing director: It will execute a stock sale in a program trade only if the last trade of the stock was higher than the previous one.
In theory, that should protect the market from the “cascading sales” effect that can push stock prices sharply lower when wave after wave of sell programs hit the market at once.
Such programs ordinarily are executed automatically when the market gets out of sync--that is, when stock-index futures in Chicago are trading for much less than the collective price of their underlying stocks in New York. By quickly selling the stocks and buying the cheaper futures, the program trader locks in a guaranteed profit, because the futures and stocks must return to even at least once a quarter (when the futures expire).
In March, the New York Stock Exchange asked the Securities and Exchange Commission to approve a rule that would force all program traders to do what Kidder is doing voluntarily. The NYSE wants mandatory adherence to those program trading restrictions on any day when the Dow moves up or down 50 points or more.
The SEC has yet to approve the NYSE request, though the agency continues to bash program trading. On Thursday, SEC Chairman Richard C. Breeden told a House subcommittee that a new SEC study shows that index arbitrage and other program trades “significantly accelerated and exacerbated” the Oct. 13 drop. (The Commodity Futures Trading Commission, which regulates the stock-index futures traders in Chicago, disagrees with the SEC study.)
Meanwhile, some program traders say Kidder, a division of General Electric, is showing the kind of leadership that Wall Street needs on this issue--and that the firm should be commended rather than criticized. The reality, say program traders, is that index arbitrage is a profitable business, and struggling brokerages are desperate for any profit they can get these days. If program trading can be practiced within confines that guard against another Oct. 13, there’s no reason why such trading should be banned entirely, program proponents argue.
“I see it as a significant step in controlling intra-day volatility,” said Peter G. Grennan, head of stock-index futures trading at Shearson Lehman Hutton. “I think it’s a reasonable thing to do.” And if more program traders abide by such rules, “you won’t be able to blame them if the market (tanks),” he said.
But program critics worry that any rise in program activity--controlled or not--is undesirable and that Kidder’s step will encourage more brokerages to re-enter the program trading game for their own accounts. (Many of the firms, while ending the practice for their own profit last fall, have continued to do such trading for customers.)
Hugo Quackenbush, vice president of discount brokerage Charles Schwab & Co. in San Francisco, said he found the Kidder news “very depressing.” Program trading in any form can be dangerous, he said, because investors now are trained to step aside from trading when they see program activity suddenly zoom. The net effect, Quackenbush said, is that liquidity in the market dries up, and stock prices run an even greater risk of an exaggerated plunge.
Knowing all of this, one might assume that Wall Street would have learned its lesson in previous program debacles. But brokerage chieftains evidently don’t have memories as long as those of their individual investor clients. Said Metz: “The trouble with Wall Street is that it’s never concerned about something like this until after it happens.”
No Pill for Webb: Del Webb Corp., the retirement home developer that has been under siege by some big-name Los Angeles investors, has lost one weapon against an unwanted takeover bid: By a 50.4% majority, shareholders who voted at the company’s annual meeting last week rejected the company’s “poison pill” anti-takeover provision.
In announcing the vote Wednesday, Webb said it has established an independent committee of outside directors “to consider the matter and report back to the full board.”
The defeat is a blow to Phoenix-based Webb, which in recent years has seen large blocks of its stock snapped up by big investors, including James Cotter, who runs L.A.-based Craig Corp. Cotter has a 9.7% stake in Webb and led the fight against the poison pill. Cotter believes that Webb is undervalued and that the company should be receptive to takeover bids--not combative.
At the annual meeting, shareholders also approved a provision restricting Webb’s ability to pay “greenmail” to get rid of a suitor. Greenmail typically takes the form of the buyback of a suitor’s stock at a premium to the market. Webb management had sponsored the anti-greenmail provision.
Whether any suitor actually surfaces now is another matter. Wall Street bumped Webb stock up just 12.5 cents to $10 on Thursday--showing continuing disbelief that anyone wants to buy a real estate company in these depressed times, even if the company is as profitable as Webb.
Briefly: Cautious institutional investors who are keeping 20% to 30% of their portfolios in cash--despite stocks’ continuing rally--probably shouldn’t feel so cautious after all. Merrill Lynch reports that of its $335 billion of client assets under management, $125 billion now is in cash investments. That’s 37%. John L. Steffens, who heads Merrill’s consumer markets unit, admits that the numbers show that Merrill’s customers “are being very, very conservative” and that Merrill brokers probably are reluctant to suggest a more aggressive stance. “The concern on my part now is that we’re in too conservative a mode,” Steffens says. . . .
“Short” sales of stock in Calfed Inc., parent of California Federal S&L;, rocketed 732% between April 12 and May 15, to 1.4 million shares. Short sales are shares borrowed and sold, generally with the expectation on the seller’s part that the stock is headed for a fall. The seller figures to replace the borrowed shares at a lower price. But Calfed’s large short position apparently stems from benign dividend-trading strategies by a few big investors rather than a big bet on a price plunge, traders say.
WHERE PROGRAMS FLOURISH
Here are the brokerages and money managers that executed the most program trades in the week ended May 11.
Type of programs, millions of shares Firm Index arbitrage Other strategies Morgan Stanley 11.0 6.8 Susquehanna 13.3 1.5 Kidder Peabody 6.0 3.0 Bear Stearns 7.4 0.7 Merrill Lynch -- 5.9 Miller Tabak 1.5 2.9 Salomon Bros. 0.8 3.4 Smith Barney -- 3.9 First Boston 1.2 1.7 PaineWebber -- 2.9
Source: New York Stock Exchange
