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EXCERPTS
FROM TESTIMONY RELATING TO
THE 1987 STOCK MARKET CRASH
Oral
Statement
U.S. Senate Committee on Banking, Housing and Urban Affairs February
4, 1988.
Congressional
testimony is one of the most serious burdens of exchange leadership.
It demands a carefully worded and meticulously balanced statement,
one that embodies the exchange's fears, hopes, and strategies
concerning a particular issue that is presented before Congress
at a particular juncture in history. It is usually prepared
in consultation with exchange officers, executive staff and
legal counsel.
The
full written testimony is seldom read at the hearing before
the Congressional Committee; rather an oral opening statement
is made before questioning ensues. However, the written testimony—which
is always made part of the official record—is often read and
scrutinized by Committee members and staff, the media, and
opponents of the views represented. Thus, Congressional testimony
is a highly important element in the life of an institution
and can be pivotal to its continued credibility and viability.
The
1987 stock market crash was as momentous an event in U.S. financial
history as memory allows. For futures markets—which many immediately
blamed as the cause of the crash—it could have spelled the
end to their potential and growth. As expected, there was a
rash of Congressional investigatory proceedings and an interminable
number of Congressional hearings. These became the focal points
of media attention and the cause of follow-up debates and countless
news reports. The official testimony we offered in these proceedings
was a crucial component in our strategy to repulse the false
accusations and reverse the negative image occasioned by our
markets as a consequence of the crash. It was as critical an
endeavor as anything we have undertaken in the history of financial
futures. The following are excerpts of two examples of oral
statements.

Mr.
Chairman, this is the second time we have appeared before this
Committee with respect to the events of October 19. When we appeared
before you the first time, just ten days after the crash, we
testified that our preliminary findings demonstrated that the
CME had carried out its responsibilities in a flawless fashion.
Nothing that has happened since that testimony, no evidence nor
report has contradicted this fact. Indeed, our finding that the
CME provided a pressure valve for a large number of investors
to hedge their stock risks has been borne out by all the evidence.
We have now seen many reports, each from a different viewpoint
and motivation. It seems to us that of these reports, only three
can be viewed as truly independent—the one authorized by the
President (the so-called Brady Report), the one by the G.A.O,
and the report from the Federal Reserve Board. All of these reports
have many common points, and none of them lay any blame on the
futures market.
In
our opinion, the report most likely to gain your attention is
the one from the Brady Commission. The Chicago Mercantile Exchange
is pleased to embrace its central theme, namely, that the stock
market, the stock options market and the stock index futures
market are, in fact, components of "one market." We also emphatically
agree that there needs to be better coordination among all these
markets.
As
our written testimony explains, there is more than one way to
achieve that result. It is our opinion that the expertise to
achieve better coordination among the markets lies within the
markets themselves. Thus, our suggested approach is through the
private sector rather than requiring additional regulatory authority.
The CME stands ready to work with every exchange toward this
goal.
The
Brady Report recommended that the Federal Reserve act as the
super coordinator for the principal inter-market areas of concern.
In this respect, the Chicago Mercantile Exchange is in accord
with the testimony of the Federal Reserve as well as the CFTC.
Our recommendation is for the creation of an Inter-Market Coordination
Committee (IMCC) comprised of all the securities and futures
exchanges as well as representatives from the CFTC, SEC and Federal
Reserve Board. This can be achieved by expansion of the existing
Inter-Market Surveillance Group (ISG), an entity created and
operated under the auspices of the SEC.
The
proposed IMCC could then act as the coordinating forum for the
sharing of cash flow and trading data among the commodities and
securities exchanges. This will include the ability to provide
lenders comprehensive information on a clearing firm's position,
thereby facilitating bank financing and reducing liquidity pressures
of the type that were experienced by some firms during the crash.
This centralized information sharing will greatly enhance the
financial integrity of all the exchanges and will facilitate
detection of inter-market violations such as front-running.
In
addition, the CME has submitted a comprehensive package of internal
trading, procedural and financial rules to the CFTC. These proposals
are in accord with Brady recommendations:
Brady
recommended circuit breakers. The CME has proposed
a set of permanent "daily" price limits as well as a
new concept of "opening" price limits. It should be noted
that the CME was the first exchange to voluntarily impose
such emergency circuit breakers, long before the Brady Report
concluded such a procedure was central to ensuring that October
19 does not recur.
Brady
recommended that futures margins and securities margins be
rationalized in line with professional margin on securities. While
we strongly disagree with this proposal, since the function
of futures margin is substantially different than that in
securities, we nonetheless have proposed the following improvements:
The
CME proposes to adopt a new and highly accurate system for measuring
option risk.
The
CME has petitioned the CFTC to add a risk-based capital requirement
that will impose higher charges on firms that represent above
average risk;
The
CME proposes to substantially increase the level of liquid assets
guaranteeing performance by its clearing house; and
The
CME will maintain its initial speculative stock index margin
at a level of approximately 15% of the value of the contract.
This percentage will bring our futures margin into substantial
alignment with professionals' margin on securities.
Brady
recommended enhancement of the clearing system and settlement
process. The CME will act promptly to resolve
the specific problems that interfered with prompt fund transfers
during the crash. In particular, we will modify our intra-day
pay/collect procedures and coordinate with the other futures
exchanges and the Options Clearing Corporation (OCC).
Mr.
Chairman, allow me now to turn to another aspect of this discussion,
the underlying nature of our financial markets, their differences
from traditional markets, and their global significance. The
Chicago Mercantile Exchange, the Chicago Board of Trade and the
other futures markets in our country understood that the world
had entered an era of great financial uncertainty—that uncertainty
breeds risk—that risk seeks insurance. Thus we created markets
and procedures that responded to the needs of sophisticated users.
Were this not the case, we could not have possibly grown or succeeded
in the phenomenal fashion we have.
Unfortunately,
because these markets represent sophisticated applications to
instruments of finance, because they cater better to present
technology, because they function differently from older traditional
markets, the nature and importance of futures markets is sometimes
misunderstood.
It
is perhaps important to note one of the unique differences of
futures which has a profound impact on their regulation and use:
All futures market positions are marked-to-market on a daily
basis, i.e., any price changes in futures positions representing
losses must be paid for in cash at least before the next market
day. This financial system is thus substantially safer than traditional
systems that are credit-based and allow losses to accumulate
for many days.
Nevertheless,
futures often become easy targets in our uncertain and complex
world. Some have derided them, calling them dens of speculation,
casinos and worse. While this is not funny, there is an amusing
irony about such beliefs. Most non-capitalistic societies have
held similar views about all our financial institutions—the NYSE
in particular.
Mr.
Chairman, in truth, the U.S. futures markets are the envy of
every financial center in the free world. There is not a capital
market in existence, be it London or Tokyo, Paris or Singapore,
Sidney or Zurich, that does not seek to copy the formula of our
American success, or wrest from us the business we have garnered.
In the telecommunications era of this day and age, that is no
idle threat. Futures markets can be re-created in any financial
center. Even as we debate the cause of the recent stock market
crash and the right of futures to exist as efficient markets,
the Japanese government proudly announced its decision to proceed
with the formation of a Tokyo Futures Exchange.
Indeed,
our markets have been hailed by the academics as the most important
financial innovation of the last twenty years. They provide a
most efficient risk transfer mechanism, an effective price discovery
system, offer large transaction cost savings, and are an integral
component in capital formation.
Our
markets are utilized by investment bankers and broker-dealers,
by primary security dealers and block traders, by banks and savings
and loan institutions, by corporations and financial institutions
of every sort and by pension funds, insurance funds and mutual
funds. Over one-third of our business flows are from foreign
shores, providing a meaningful and positive factor to our balance
of payments.
Mr.
Chairman, we urge that Congress avoid policies that impose unnecessary
restrictions on these markets and drive this industry to a foreign
competitor as has been our unfortunate experience with so many
other American industries.
We
urge that simply because our markets are different, we not be
forced to become the same. That because we have advanced into
the technological present, we not be forced to retreat to a less
technological past. That because we are efficient, we not be
forced to become mediocre. That because we have succeeded in
an arena that some mistakenly view as the exclusive domain of
New York, we not be forced to relinquish our market share.
Oral
Statement
U.S.
Senate Committee on Banking, Housing and Urban Affairs Subcommittee
on Securities
May
18, 1989.
Mr.
Chairman and Members, good morning. We welcome this opportunity
to appear before this Committee to address the October 19, 1987
world stock market collapse and the after-effects of that phenomenon.
At the outset, allow me to compliment this Committee for the
foresight and prudence it exhibited in the weeks following the
frightening events of that October. It should serve as a model
lesson to all Congressional committees and members of the Congress.
Amid the near-panic conditions that then pervaded the media,
amid the calls for market reforms by many, amid outlandish statements
and irresponsible accusations by some who pointed in one or another
direction for the perceived cause or culprit of the crash, this
Committee retained its composure, refrained from any emotionally
dictated reaction, and was not panicked into any unwarranted
legislative action. Today, historical hindsight allows us now
to assess the wisdom of this Committee's deliberate inaction.
Any legislative response would have been misplaced, counter-productive,
and would have interfered with the marketplace to its ultimate
detriment.
Nearly
one year ago, this Committee heard testimony from the White House
Working Group(1) which
analyzed the events of the October 1987 Crash and clarified the
Brady Report recommendations on clearing and settlement procedures,
information flows, margin requirements, financial safeguards
and cross-market circuit breakers. These intricate and complicated
areas prompted Chairman Greenspan to advise this Committee that "The
most important result of the crash is that market participants
learn and act. They have done so and are doing so."
Indeed,
all actions taken to date have indicated that the present regulatory
environment is capable of addressing issues raised by the Crash
and of instituting changes that can address dampened market volatility
in the future. We see no signs of any "gaps" in regulatory oversight,
no unnecessary duplication of oversight, nor any need to consider
a consolidation of government regulation of the futures and securities
industries.
The
most important trend affecting securities markets and capital
formation is the acceleration toward international markets. Capital
moves across national boundaries with increasing ease, reflecting
both enhanced opportunities and sophistication on the part of
investors to exploit the opportunities. The Chicago Mercantile
Exchange early on recognized the importance of this phenomenon
with the development of foreign currency and Eurodollar futures
and options. Most recently, the development of our global electronic
transaction system, GLOBEX, is a demonstration that not only
do the trading instruments need to reflect an international orientation,
but that the mechanism of trading must fit in the international
community as well.
Steps
to keep our economy in a position to benefit from this trend
must be made today, or the United States may lose its place of
preeminence in the world capital markets. Private U.S. firms
have demonstrated an ability to move quickly and effectively
in this environment, but regulatory burdens and institutional
inertia on the part of some major institutions should be addressed
promptly.
Regulation
of securities and futures markets internationally has shown little
consistency across national boundaries. While regulation should
be adequate, great care must be taken that our regulations do
not place unnecessary constraints on the U.S. securities and
futures industries. Many instruments are traded at several different
locations around the world, and regulatory inequities could chase
U.S. business to foreign markets.
Institutional
change is also needed to keep up with these rapid developments.
Traditionally our banking system has been oriented to domestic
business, but to remain competitive it is necessary to change.
Allowing U.S. banks to hold foreign currency deposits beginning
in 1990 is a major positive step, but many more will be necessary.
Our central bank now operates during our business day, leaving
the important tasks of clearing, settlement and oversight of
international monetary flows to other national banks. It is likely
that some national bank will expand its activities to cover more
of the twenty-four hour span. If the U.S. Federal Reserve moves
in that direction first, it would insure that our facilities
and policies, which are currently the focus of the entire world,
would maintain their dominant role. If another central bank seeks
this role, our influence internationally could be diminished.
The
last few years have demonstrated the degree to which the markets
for securities and futures have become increasingly linked internationally.
This is not a trend that is likely to be reversed. Private U.S.
companies are very dynamic and capable of adjusting to these
challenges. The goal of Congress should be to provide the regulatory
and institutional framework that will allow effective competition
and to keep the U.S. economic policy role in the forefront of
the international arena.
We
agree that the regulators of financial institutions and markets,
both foreign and domestic, should coordinate regulatory activities
and exchange information with each other. However, we believe
that legislation is not necessary in this area. Both the CFTC
and the SEC have entered into or are negotiating memoranda of
understanding with their counterparts in the major financial
centers of the world.
The
CME has had extensive experience in coordinating with overseas
exchanges. In 1984, the CME and the Singapore International Monetary
Exchange (SIMEX) entered into a mutual offset arrangement in
which a trade executed on one exchange could be offset by a transaction
on the other. More recently, in connection with CME applications
to trade futures contracts based on Japanese, British and world
stock indexes, the CME entered into agreements to share surveillance
information with the Tokyo Stock Exchange and The Securities
Association in London.
In
September, 1988, the CFTC, the CME and other U.S. futures exchanges
agreed with three United Kingdom regulators to exchange financial
information respecting companies with branches in the other jurisdiction.
The
CME recognizes that the financial markets are becoming increasingly
international in scope. Trading can be done in London or Tokyo
as easily as in Chicago or New York. In the last five years,
new futures exchanges have opened or been announced in London,
Paris, Hong Kong, Sydney, Toronto, Singapore, New Zealand, Brazil,
Osaka, Zurich, Tokyo, Dublin, Frankfurt. Every financial center
knows the value of integrating actual or possible movement of
London's FTSE 100 and Tokyo's NIKKEI indices as harbingers of
the day's S&P 500 movement.
Indeed,
in response to the demands of the globalization of markets, two
years ago the CME entered into a long-range agreement with Reuters
Limited to create GLOBEX, an automated, "after-hours," transaction
system for futures and options. The GLOBEX system will provide
access to the CME's markets by overseas investors during their
regular business hours while the CME's trading floor is closed.
However,
GLOBEX is much more than an after-hours transaction system for
CME markets. The CME also is cooperating with other futures exchanges,
both domestic and foreign, in connection with the establishment
of GLOBEX as a shared international communications network and
order matching system. In that manner, GLOBEX can be used by
members of every participating exchange to trade its futures
and options contracts during the hours that the exchange's trading
floor is closed. GLOBEX will allow transactions in futures, options,
and selected foreign financial instruments to be executed from
anywhere in the world, instantly, and with financial integrity.
In
order for the GLOBEX system to work effectively, GLOBEX order
entry terminals must be placed in the major financial centers
of the world such as London, Paris, Geneva, Tokyo and Hong Kong.
The CME is examining the laws of those jurisdictions to determine
whether any legal or regulatory problems exist which might prevent
the introduction of GLOBEX terminals into their territory. One
potential concern that we have is that the government of one
or more of those countries may block the installation of GLOBEX
terminals in its territory, not for legitimate regulatory reasons,
but in order to protect the local exchanges in such country from
competition. If we determine that GLOBEX is being kept out of
a country for protectionist reasons, we will promptly notify
the U.S. Trade Representative of the situation and seek assistance
in overcoming any obstacles that may prevent us from offering
GLOBEX services internationally.
____________________
(1)
Alan Greenspan, Chairman of the Federal Reserve Board of Governors;
George D. Gould, Undersecretary of the Treasury for Finance;
David S. Ruder, Chairman of the Securities and Exchange Commission
and Wendy L. Gramm, Chairman of the Commodity Futures Trading
Commission.
Reprinted
by permission. Excerpted from Melamed on the Markets, by Leo
Melamed. John Wiley & Sons, 1993
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