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.

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     (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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