QUINTESSENTIAL LESSONS

Presented before the National Association of Futures Trading Advisors,
Chicago, Illinois,
July 22, 1988.

One of the most amazing results of the 1987 stock market crash was its boomerang effect on the stature of futures markets.

The initial perception of many in the financial world was that futures markets were the culprit responsible for the crash. But the facts and the ensuing process did not bear out this mistaken belief. Of the 77 studies undertaken in the aftermath of the crash, virtually none found blame with futures markets.

On the contrary, despite the clamor to ban computers and index arbitrage, futures were not only vindicated in virtually every academic study, they received the highest of praise from the most knowledgeable of experts. Indeed, most highly qualified experts characterized futures as a critical mechanism for risk management in today's modern global markets.

The 1987 stock market crash was an awesome event. It provided many lessons and proved many things. Allow me to name at least five.

First, of course, it was brutal market punishment for the sin of a global mania that had swept good sense to the side and taken world stock prices to levels far beyond rational levels. Alan Greenspan, Chairman of the U.S. Federal Reserve Board, summed it up best in his report to the U.S. Senate Banking Committee on February 2, 1988:

Stock prices finally reached levels which stretched to incredulity expectations of rising real earnings and falling discount factors. Something had to snap. If it didn't happen in October, it would have happened soon thereafter. The immediate cause of the break was incidental. The market plunge was an accident waiting to happen.

Second, it was an expensive lesson, proving to what extent our technological competence had out-distanced our market mechanics. To put it bluntly, most of our traditional markets were operating on a technological standard equivalent to the steamboat, while those who make market decisions were using the jet plane.

In other words, the disparity between markets and their participants is growing. It is primarily the result of the changed nature of the decision-making power in matters of finance. Scientific and technological advancement have forced the world to become highly specialized and professional, a trend that will not abate and is nowhere more obvious than in finance.

In the United States, investment managers now represent over 33 million mutual fund shareholders and over 60 million pension plan participants and their beneficiaries. These funds equal nearly $2 trillion in assets compared with only $400 billion a mere decade ago. The reason is obvious. Large pools of capital offer access to professional management, enabling even small investors to equal the profit capabilities of institutional participants. As a result, a myriad of specialists, techniques and strategies have evolved. Moreover, technological sophistication has enabled these professionals to apply their strategies with lightening speed. Unfortunately, traditional market mechanisms, particularly in stocks, are simply not structured to accommodate the massive and sudden money flows these managers command. On October 19, 1987, we learned the foregoing truth in a very real and painful fashion. Financial managers with colossal market positions under their control attempted to institute similar market decisions at the same moment. The stock markets could not possibly handle the sudden surge of money flows these orders represented when combined with the extraordinary flood of general selling which was at hand.

Third, the 1987 stock market crash provided clear and convincing evidence that market globalization was upon us. The marriage between the computer chip, the communications satellite and the telephone changed the world from a confederation of autonomous financial markets into one continuous marketplace. No longer is there a distinct division of the three major time zones—Europe, North America and the Far East. No longer are there three separate markets operating independently of external pressures by maintaining their own unique market centers, product lines, trading hours and clientele.

Early on the morning of October 19, hours before the sun began its ascent over the East River and even longer before the New York Stock Exchange opening bell rang, grim news from Tokyo, London and elsewhere was flickering on computer screens throughout the United States. Some portfolio managers, anticipating the worst, were moving to beat a selling avalanche in New York by unloading shares in London. Rarely was the impact of globalization on the markets more amply demonstrated.

Fourth, to our chagrin, we learned how shallow is the understanding by a large segment of the financial universe about markets in general and about futures markets in particular. From the outset, a belief arose that the October 1987 stock market crash must have been the fault of a specific cause. After all, financial advisers who had been telling their clients to hold on to their investment or buy more could not possibly be so wrong. There had to be an explanation: some special factor must have intervened; some villainous sabotage that stopped the bull market in its tracks. Never mind that the October collapse was a global event. Never mind that all speculative bubbles must finally burst. Never mind the plethora of accumulating fundamental economic and psychological factors that could cause the collapse. Never mind all of that and let us instead search for a specific culprit. And search we did. A large number of studies, official and ad hoc, were launched to seek the answer to the question: Who or what caused the crash? When a demon in hunted, a demon will be found.

It did not take long. Quite soon the fingers were pointing to technology. The words were catchy. Mindless computers on automatic pilot were the culprits. Technology has out-distanced its effectiveness. Efficiency needs a brake pedal! Then the search got specific: program trading. Then even more specific: index arbitrage. All the while, the fingers were pointing westward in the direction of futures and options.

Throughout the witch hunt, the media was the medium, used and abused. Because the October crash was extraordinary and frightening, because the issues were deeply complex, because so many within the financial world seemed to agree that there was a specific villain to be found, the media generally accepted the premise at face value. And Congress played its part: Was there really a problem to be fixed? Or simply an issue to be had. Either way, an investigation was in order, an opportunity for a public forum.

And there were those who had a special motivation to find a culprit. With volume and brokers' commissions down, someone or something had to get the blame for loss of investor confidence. Volatility became the watch word of the day. Volatility caused the lack of investor confidence. Volatility, rather than the simple logic that after a major market decline, only the imprudent would blindly rush back to the market. Volatility, rather than have someone conclude that there was a bear market about, that business and volume might suffer, that jobs might be in jeopardy.

Indeed, the movement gained momentum and an impressive following. Demagoguery and misinformation are powerful combinations. On May 10, 1988, the most prestigious U.S. investment banking firms bowed to this nonsensical pressure and announced their withdrawal from proprietary index arbitrage. It was a particularly sad day in American financial history. The movement might have grown further except that it reached a level of near-hysteria with a call for a ban on index futures. For most of the financial community, this went too far. For most, it served as a sudden, chilling tonic bringing them back to reality. A call to ban was indeed too much.

When I was but a child on the floor of the old Chicago Mercantile Exchange, long before financial futures, long before futures became a respected and even indispensable risk management tool, Elmer Falkner, an old line CME member who had made and lost many a fortune, took me by the hand. "Don't let our futures markets get too successful," he ominously warned, waving his big cigar in the air (Elmer was a little guy, something under 5 feet tall and his cigar almost as big as he was).

"Why not?" I innocently inquired.

"Because," he replied, "futures markets tell the truth and nobody wants to know the truth. If the truth is too bad and too loud, they'll close us down."

I learned all too clearly how sage Elmer's advice was on October 19, 1987, when the futures index markets were the first to tell the truth. The truth was indeed too bad and too loud.

Who was Elmer Falkner? Why is he important? Allow me to digress a bit and tell you something about the little guy. I have often been asked who invented index futures. I don't know the answer. Clearly it wasn't I. The idea had been around long before I showed up on the scene as a runner for Merrill Lynch. But it was Elmer Falkner who first told me about it.

"The ultimate futures contract," he confided to me, "is stock market futures."

When I didn't immediately understand his meaning, he whispered, "you know, like Dow Jones futures. But," he quickly added waving his cigar again, "it will never happen. You can't make delivery."

I never forgot Elmer or the things he taught this young and innocent disciple. Three decades or so later, cash settlement made Elmer's ultimate contract a reality.

Today, as before the crash, the CME's Standard & Poor's 500 futures contract is the most successful stock index futures contract in the world. Its success stems primarily from the fact that it represents an equity risk management tool for the present day and offers the most liquid and cost-efficient environment yet devised.

Finally, the fifth lesson of the 1987 October crash proved that it was no exception to the rule that every cloud has its silver lining. For in the final analysis the truth will out. After all the studies were in, after all the evidence was presented, after all the analysis was made, after all the misinformation was laid to rest, futures markets were not only exonerated from blame, they were vindicated by receiving the highest of praise from most knowledgeable experts. Indeed, these experts could not be deemed fellow travelers of the Chicago exchanges. Rather they were classic products of the Wall Street community.

Allow me to quote some pertinent testimony of the Chairman of the Federal Reserve Board:

There is no avoiding the fact that, as our economy and financial system change, our financial markets are going to behave differently than they have in the past. We cannot realistically hope to turn back the clock and replicate behavior of the past. Rather, we need to understand better how the system is evolving and the consequences of such change. Our efforts need to focus on making sure that the financial system is more resilient to shocks rather than embarking on futile endeavors to artificially curb volatility.

What many critics of equity derivatives fail to recognize is that the markets for these instruments have become so large not because of slick sales campaigns but because they are providing economic value to their users. By enabling pension funds and other institutional users to hedge and adjust positions quickly and inexpensively, these instruments have come to play an important role in portfolio management.(1)

And allow me to also quote some equally strong support for futures market from the U.S. Treasury in the person of George D. Gould, the Under Secretary for Finance:

There are numerous factors that have made markets react more quickly today to changes in the fundamental determinants of stock prices. First, the nature of stock ownership has changed substantially over the past twenty years, led by private and public pension funds. There have evolved very large individual aggregations of capital of a size unknown in an earlier period...Thus, stock index futures markets have evolved as the lowest cost, most efficient response to these changed needs. "Trading the market" and hedging are not in and of themselves either good or bad — they are economic facts that are not going to go away.

Much public criticism of index arbitrage is a classic case of wanting "to shoot the messenger" that brings the bad news of selling on the CME to the floor of the NYSE. If selling is going to take place to a degree that pushes prices down sharply, then cash markets will not be made immune by eliminating index arbitrage.(2)

And to those who would criticize futures markets as dens of speculation, the Chicago Federal Reserve Bank had the following to say:

At the heart of the economic role of a futures market is risk transfer. Futures contracts provide a way of transferring risk from hedgers who seek to reduce risk to speculators who would bear risk in the hope of profiting by it. Attempts to curb speculative activity on these contracts by raising futures margins overlook the fact that such curbs would also reduce an investor's ability to sell off unwanted risk by hedging.(3)

Impressive support, powerful testimony, compelling arguments, you will agree. Thus, the silver lining. These quintessential lessons of the October crash have served to strengthen, rather than weaken, futures markets worldwide. The evidence is all about us.

Take the recent agreed to initiatives between the Chicago Mercantile Exchange and the New York Stock Exchange, the two markets where most of the equity business critical to the issues at hand, takes place: to institute a system of coordinated "circuit breakers;" to develop a system of "shock absorbers" that would be triggered by smaller pre-designated price moves; to transform the present "collar" rule (which limits use of the NYSE's DOT system after a move of 50 Dow points) into a coordinated system that temporarily diverts program trading from the DOT system at approximately 100 points on the Dow; and to create a common definition of "frontrunning."

These agreements could not have been achieved unless or until our futures markets were able to take their deserved and honored seat at the financial table. Indeed, these initiative are a direct result of the process that focused national attention on the fact that the financial markets—both stocks and futures—are strongly linked and of equal importance in today's competitive global environment.

The achievement is the direct result of the joint efforts by the Chicago Mercantile Exchange and the Chicago Board of Trade in proving that futures markets represent the avant garde of today's market demands and are indispensable as modern risk management tools. The agreements represent compelling evidence that American financial markets can work together to achieve the necessary solutions and that federal legislation is both unnecessary and would be counter-productive in the complex and sophisticated markets of today.

The evidence that the lessons of last October served to strengthen futures markets is even more evident from a global perspective. Even as the U.S. deliberated the role of futures in the October 19 market collapse, the London International Stock Exchange published its conclusion that the solution was in more—not less—index arbitrage. At the same time, the Japanese Ministry of Finance announced its decision to establish two futures markets in Japan. And, the headlines on business pages the world over confirm this judgment: "Luxembourg Ponders Futures and Options Exchange," "Japanese Markets to Cover Domestic and U.S. Interest Rates as Well as Stock Index Contracts," LIFFE Canvasses Support for German Bund Contract," "Finnish Futures Exchange to Start Soon," "ICC Sets Sights on New York," "Stockholm Foreign Exchange Market Welcomed," "China Plans Futures Markets," "French Proceed with Stock Index Plans," "German Stock Index to be Established."

Today every major center of finance must either possess or be connected to a futures and options market just as it must possess or be connected to a stock market or a major bank. As Senator Nicholas Brady concluded in his report to the President, "there is but one market." Futures are an integral and indispensable part of it.

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     (1) Alan Greenspan, Chairman, Federal Reserve Board of Governors, Testimony before the U.S. House Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, May 19, 1988.

     (2) George D. Gould, Treasury Under Secretary for Finance, Testimony before the U.S. House Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, May 19, 1988.

     (3) Herbert L. Baer, Maureen V. O'Neil, Chicago Fed Letter, The Federal Reserve Bank of Chicago, May 1988, p. 1.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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