Change in NYSE Arbitrage Rules Urged
Four top federal officials want the New York Stock Exchange to eliminate or significantly ease a rule that limits a kind of trading known as stock index arbitrage when the Dow Jones industrial average moves more than 50 points.
The heads of the Treasury Department, the Federal Reserve Board, the Securities and Exchange Commission and the Commodity Futures Trading Commission sent a joint letter to NYSE Chairman Richard Grasso last week, saying the 50-point limitation--known as a “collar”--kicks in too frequently.
The agency chiefs questioned whether the market really needs the decade-old restriction, which was designed to guard against excessive volatility in the stock market.
An NYSE spokeswoman had no comment Monday on the regulators’ request or comments. The NYSE said it introduced the collar in response to concerns that index arbitrage aggravated large market swings.
Index arbitrage involves the trading of stocks in conjunction with the purchase or sale of futures contracts tied to the performance of market indexes. In that strategy, traders try to profit from the price difference between the futures contracts and the underlying stocks.
“Index arbitrage ensures that the securities and futures markets are aligned economically,” the four agency heads wrote. “We question the continuing need for restrictive treatment of index arbitrage trading.”
At a minimum, the government officials said, the collar should be substantially raised “to reflect increased market levels” since the limitation was adopted in 1988. Because the Dow average has quadrupled in the last decade, 50 points represents a much smaller proportional move today. As a result, the collar is triggered almost daily. In five trading days ending May 1, for example, the NYSE said the trading limitation was activated nine times.
Grasso already agreed to expand the collar to 1% of the Dow, which would be about a 90-point move. The letter--from Treasury Secretary Robert E. Rubin, Fed Chairman Alan Greenspan, SEC Chairman Arthur Levitt and CFTC Chairwoman Brooksley Born--urged Grasso to go farther and “reevaluate the usefulness of the collar rule.”
The four agencies make up the President’s Working Group on Financial Markets, which prepares the administration’s responses to financial emergencies.
Even if activated with a 1% move in the Dow average, the collar would have been triggered at least 130 times in the last year, the four regulators said. When the collar was originally set at 50 points, that represented a 2.5% move in the Dow average, the letter said. Today the restrictions kick in with a move of a little more than 0.5% of the blue-chip index.
“In extreme periods of fear and greed, these collars make sense to slow trading,” said David Baker, head of domestic program trading at Deutsche Morgan Grenfell, the investment banking arm of Deutsche Bank. “But they’re triggered way too frequently and cause a disconnect between the markets, meaning some investors are disadvantaged.”
Those disadvantaged investors include hedge funds and pension funds that conduct index arbitrage, exploiting the price differences between stock index futures and underlying stocks. For example, when the futures on the Standard & Poor’s 500 index are more expensive than the underlying shares in the S&P;, traders will sell the futures and buy the stock.
