THE GOOD OLD DAYS

The October 1987 Stock Market Crash: A Futures Market Perspective
Essay presented to the Securities Regulation Institute,
San Diego, California,
January 26, 1989.

The annual conference of the Securities Regulations Institute represented the inner sanctum of the securities world. Everyone of consequence with respect to the American securities markets was in attendance. Among those presenting their point of view with respect to the 1987 stock market crash were David Ruder, chairman of the Securities and Exchange Commission, John Phelan, chairman of the New York Stock Exchange, and Joseph Hardiman, president of the National Association of Securities Dealers.

It was imperative that futures markets be represented and provided an opportunity to address this forum. It was my goal to fully present our case, lay to rest any remaining doubts about the role of futures in the 1987 stock crash, respond to some of the remaining issues still in controversy, and to underscore the value of futures markets as a risk management tool in a world substantially changed by technology and globalization.

Upon presenting our point of view, it seemed that the two years that had elapsed since the crash had substantially reversed the conventional opinion about the role of futures markets. It was clear to me from the other papers presented, as well as from the questions we received from the audience, that the vast majority of those present recognized that futures markets had not been at fault in the crash—as they were originally portrayed—and that our markets made and continue to make a valuable contribution to the overall structure of the equity market.

It is inescapable: the older we get, the more we long for the good old days. Like my contemporaries, I too have many fond memories of days past and cannot suppress occasional daydreams reliving those moments. Clearly, life was much more simple, music was softer, and dancing was slower and closer. Alas, those days are gone forever. If only one could reverse the flow of time!

The October 1987 stock market crash occasioned a far less personal longing for the good old days. In newspapers, in magazines, on television, and in hearing rooms on Capitol Hill, there were calls for a return to those halcyon days before there were stock index futures, before program trading, before index arbitrage. Those uncomplicated days when the average daily volume on the New York Stock Exchange was 11.5 million shares and a good day boasted 20 million shares; when large block transactions accounted for 15% of reported volume as opposed to the current 50%; when stocks were bought on the basis of your broker's assessment of inherent individual stock values; before mutual and pension funds complicated the financial landscape and competed for the investment dollar with performances based on collective results or comparisons with indexes; before such concepts as asset allocation reared their complex heads; when fixed commissions were legal; when globalization of markets was but a futuristic notion; before we were so dependent upon and competed for foreign cash; before we cared what foreign stock markets were doing and foreigners had little impact on ours; long before LBOs, zeros, or junk bonds, and eons before unbundled stocks.

At the moment the crash officially ended—the moment that probers and pundits began poking at the corpse—a belief arose that the October 1987 stock market crash must have been caused by a specific villain. It was, after all, unthinkable that so many successful financial advisers who had been telling their clients to hold on to their investment or even to buy more could possibly have been so wrong.

Never mind that in the words of Fed Chairman Alan Greenspan "Stock prices finally reached levels which stretched to incredulity expectations of rising real earnings and falling discount factors...[that] something had to snap ... [that] if it didn't happen in October, it would have happened soon thereafter ... [that] the market plunge was an accident waiting to happen."(1) 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 trigger the collapse. Never mind all that and let us instead search for some specific causation, some special factor that intervened, some villainous sabotage that stopped the six-year long bull market dead in its tracks.

And so the search began. A bevy of studies, official and ad hoc—a total of 77 according to SEC Commissioner Joseph Grundfest—were launched to seek the answer to who or what did the bull market in.

When a demon is 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 were on automatic pilot. Technology had 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 in the direction of futures.

Throughout the process, the media—whose ability to create a public impression has no equal—proved to be the critical medium. Because the October crash was extraordinary and frightening, because the issues were 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. That was most unfortunate, because when the media knows little about the subject, or when it is misdirected and there is no villain except in the minds of those who desperately desire that there be one, it can become a monstrous bully from which it is nearly impossible to escape. Thus, it allowed itself to be used as the conduit of accusation and misinformation, and sometimes even became the inquisitor itself.

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 scapegoat. With volume and commissions down, someone or something must be blamed for the loss of investor confidence. Volatility became the watch word of the day. Volatility caused 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 volume might suffer, that jobs might be in jeopardy. Of course, volatility was just a code word for futures-related program trading.

But not everybody was fooled. Here is George D. Gould, former U.S. Treasury Undersecretary for Finance:

Some observers believe the individual investor has left the market because of a perception of increased volatility. It is equally possible that much of the retreat is in fact investors' collective views that the bull market has paused or that more attractive alternative investments are available.(2)

Nor was SEC Commissioner Joseph Grundfest fooled when he bluntly questioned the motives of some of those who were so anxious to return to the good old days:

... some participants in the policy debate have a perfectly rational incentive to continue to confuse the message with the messenger in order to forestall technological progress that threatens traditional trading mechanisms that generate substantial rents for certain market participants. Put more bluntly, some people are making money off the system as it operates today, and measures designed to make our markets more efficient by improving information, expanding capacity and enhancing liquidity are not necessarily in everyone's financial interests.(3)

Still, witch hunting can be seductive. Indeed, the movement gained momentum and an impressive following. It reached its zenith on May 10, 1988 when several of the most prestigious U.S. investment banking firms bowed to nonsensical pressure and announced their withdrawal from proprietary index arbitrage. This was to be a singularly sad day in the annals of American finance. The movement might have grown further except that it reached a level of near-hysteria with a call by some 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. Wiser voices began to drown out the prattle. Reason stepped forward.

When I was but a young man 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 Faulkner, 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, "because futures markets tell the truth and nobody wants to know the truth. And 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.

Today, as before the crash, the CME's Standard & Poor's 500 futures contract is the most successful stock index futures contract in the United States. 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. Success is a clear measure of merit. 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. Nor could the experts be blithely dismissed as fellow travelers of the Chicago exchanges. Rather they were classic products of the Wall Street community.

"What many critics of equity derivatives fail to recognize," said Chairman Greenspan, "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."(4)

The Chairman also knew why, as Elmer Faulkner said, "futures tell the truth."

It is also worth noting that we routinely see the futures markets reacting to new information more rapidly than the cash markets. Some have concluded...that movements in futures prices thus must be causing movements in cash prices. However, the costs of adjusting portfolio positions are appreciably lower in the futures market and new positions can be taken more quickly. Hence, portfolio managers may be inclined naturally to transact in the futures market when new information is received, causing price movements to occur there first. Arbitrage activity acts to ensure that values in the cash market do not lag behind.(5)

Similarly, the former U.S. Treasury Undersecretary, a man who spent better than thirty years as a Wall Street investment banker, also knew the truth: "Much public criticism of index arbitrage," he succinctly stated, "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..."(6)

Why have stock index futures become so successful? Why did Merton H. Miller, PhD., Professor of Banking and Finance, University of Chicago, name financial futures as "the most significant financial innovation of the last twenty years?"(7) The answer is clear. Our success is primarily the result of two interrelated factors: The changed nature of the decision-making power in matters of finance; and scientific and technological advancement. Both factors represent trends that will not abate and which have forced the financial world to become highly specialized and professional.

Nor have futures markets aided and abetted institutional traders in forcing the little guy out of the stock markets. The direct participation of small investors as a percentage of total volume has shrunk as the size of institutions such as pension and mutual funds has grown. These institutions now represent the little guy. The trend has been evident for decades and is unrelated to program trading. It began long before the advent of futures trading of stock indices. One set of statistics will suffice. 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. As a result, a myriad of specialists, techniques and strategies have evolved. Technological sophistication has enabled these professionals to apply their strategies with lightning speed.

SEC Chairman David S. Ruder, explains it well:

To understand what happened in the U.S. securities markets in October 1987, it is necessary to understand changes in institutional trading strategies that took place during the last decade. During this period, the increasing size of many institutional portfolios made it difficult for portfolio managers to trade in the stock of a single company without unduly affecting the price of that stock. In addition, modern portfolio theory gained increasing acceptance. As a result, many portfolio managers began to shift emphasis from individual stock selection toward trading the market as a whole.(8)

Consequently, says Mr. Gould, "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."(9)

Unfortunately, traditional market mechanisms were not structured to accommodate the massive and sudden money flows these managers now command. Until recently, the technological disparity between markets and their participants was growing. On October 19, 1987, we learned the extent of the foregoing truth in a very real and painful fashion.

Again the Fed Chairman summed it up well when he recently asserted that "the severity of the crash of October 19, 1987 was in a sense the outcome of a confrontation between dramatically advancing computer and telecommunications technology on the one hand and ingrained human speculative psychology on the other."(10)

Of all the undeserved missiles directed at futures during the witch hunt, the two I found particularly unfair were the call for a single regulator and for higher futures margin—as if these issues were factors in the crash or could prevent the next one. Proponents of such views were wrong. As far as the crash is concerned, such issues were classic red herrings. At best they were a knee-jerk reaction based on misunderstanding and misconceptions about futures; at worst they were much more disconcerting.

Dr. Alan H. Meltzer, the John M. Olin Professor of Political Economy and Public Policy at Carnegie Mellon University, who participated in a study of the crash by the Mid America Institute for Public Policy Research, finds no evidence to support efforts for any new futures legislation. Indeed, he suggests that a very likely reason for the hullabaloo in Washington was that the October crash created an opportunity for the SEC to gain at the expense of the CFTC. While he recognizes that this explanation may sound somewhat cynical, he finds no other rationale that is consistent with the behavior of those who sought more regulation.

"Higher margin requirements on futures," states Dr. Meltzer, "and restrictions that make options and futures more costly, if accompanied by the proposed new rules to permit portfolios to be traded in New York, would shift trading and commissions from Chicago to New York."(11)

While I personally never subscribed to so extreme a view, I do sympathize with Dr. Meltzer and others who were bewildered by demands for change in federal regulatory or margin jurisdiction without any fundamental evidence that these issues were a factor in the 1987 crash.

In his October 20th paper, after complimenting the CME for raising its initial speculative margins after the crash, Chairman Ruder questioned the fact that the CME subsequently lowered the hedge margins. First, I would ask the Chairman to examine the history of this issue. He will find that margins in securities options—competitive products to the CME index futures over which the SEC has jurisdiction—were lowered before the CME took the action of which he complains.(12)

Second, I would point out that the findings of the Presidential Working Group—of which Chairman Ruder was a member—concluded that "...the prudential maintenance margin percentages required for carrying an individual stock should be significantly higher than the percentage margin required for a futures contract on a stock index. This conclusion follows from the facts that stock indexes have a smaller percentage price variability than do individual stocks and the payment period for margins in the futures market is shorter than the period for stocks."(13)

The differences between the role, function and level of futures and stock margins exist as a natural and necessary result of the very different functions these two markets perform. They are not the result of a regulatory gap or loophole. Foreign futures markets that compete directly with our American futures markets for world business understand and apply the aforestated different standard between securities and futures margin. Allow me to call attention to this conclusion of Chairman Greenspan upon issuing the Working Group Report:

...I believe that we should not be guided in the margin area by equalization for leveraging reasons. Implementing such an approach would only tend to give rise to a false sense of security about price movements at a time when, given the underlying economic setting and fundamental change in the structure of the equity markets, price movements may well remain larger than we had come to expect in earlier years. Raising margins will add indirectly to transaction costs, which will act to reduce trading volume and market liquidity...(14)

In view of these compelling findings, the Options Clearing Corp. should be commended for leading the charge in lowering their margins. The belief that futures and options margins must somehow be "harmonious" with securities margins is not only unfounded, it runs contrary to the Working Group's enunciated conclusion that they instead need to be "prudential." This conclusion takes on even greater relevance based on the fact that today's market volatility has been reduced by a factor of four. (Volatility during the July to December time period in 1987 was measured at 59.45%, while for the same period in 1988 it was 13.58%. Even discounting the volatility of the week of the crash itself, volatility for the second half of 1988 was 49.6% less than the second half of 1987).

If our markets remain chained to the onerous margin policy demanded by some in the wake of the crash, it would do precisely as the Fed Chairman warned: "add indirectly to transaction costs and act to reduce trading volume and market liquidity." This would damage the economy as a whole and materially frustrate our ability to compete internationally. Ultimately, it would impede the favorable flow of business resulting from this American invention and, like the Eurobond market of a previous era, lose this vibrant economic activity to a foreign competitor. It is high time to slay this mythical margin monster.

Similarly, it is time to put the idea of a single regulator for all financial markets in its proper perspective. The idea is not new, and while it can be debated from various viewpoints, it has no relevance to the October 1987 crash. Its latest thrust stemmed from the Brady Report which correctly identified the "one-market" nature of the financial marketplace. However, the one-market premise incorrectly led the Report to the concept of a single regulator, albeit, in this case, that regulator—the Federal Reserve Board—would be responsible only for certain inter-market matters.

Daniel R. Fischel, Director, Law and Economics Program, University of Chicago, who analyzed the Brady Report with respect to this issue, forcefully dismisses the one-agency concept by concluding that the logical premise for such a proposal is erroneous. "There is not one shred of evidence in the entire Brady Report," Professor Fischel declares, to suggest that regulatory failure produced or exacerbated Black Monday. Furthermore, he argues, there is no evidence to imply that competition among regulators is harmful, nor that regulatory cooperation, when desirable, cannot occur without a single agency. Indeed, he too questions the economic theory motivating the one-agency proposal, "given the proposal's lack of rationale."(15)

Concurring with the foregoing view is SEC Commissioner Edward Fleischman who points out that the fundamental differences between securities and futures are sufficient reason not to give the SEC regulatory jurisdiction over financial derivative products. He too concludes that regulatory competition is "an extraordinary healthy development...[which is]...beneficial to both regulators."(16)

At this juncture it is perhaps important to explode one or two other false assumptions that became commonplace in the aftermath of the crash, as well as to underscore the principal differences and similarities between securities and futures.

It cannot be said better than did The Federal Reserve Bank of Chicago, in its paper published May 1988:

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.(17)

Allow me also to emphasize that many of the benefits to society resulting from futures are similar to the benefits resulting from the stock market. Both markets play an analogous role in our nation's capital formation process. By providing institutional investors with a vehicle for transferring the risk of a stock portfolio, and by providing liquidity for "baskets" of stock, the futures market increases the attractiveness of equities as an investment and thereby encourages capital formation.

Such benefits are stressed by Professors Hans R. Stoll and Robert E. Whaley in their 1988 study of stock index futures and options. Futures and options markets, they assert, "are useful portfolio management and hedging tools enabling inventories and cash flows to be hedged, enabling security analysts to concentrate on stock selection while avoiding general market risk, facilitating market timing, asset allocation and dynamic hedging, and permitting a division of responsibilities among portfolio managers."(18)

In responding to some of the more assaulting accusations levelled against futures, it is unnecessary to go much beyond the exhaustive study of the 1987 crash by Professor Richard Roll, Allstate Professor of Finance, University of California at Los Angeles. His conclusions typify those reached in virtually every other academic study.

That the crash was a global event and that the United States market was not the first to decline sharply nor did it decline the most. In a comparison of the October declines (on the basis of local currency) of 23 stock markets around the world, the U.S. had the fifth smallest decline; i.e., the fifth best performance. Since the U.S. was the only country with a highly developed index futures market, Professor Roll's conclusion goes a long way in nullifying the notion that these derivative markets were somehow a cause of the crash.

That there is virtually no evidence to support the view that the institutional structure of the U.S. market was somehow the culprit of the crash. "Automated quotations," states Professor Roll, "forward trading, transaction taxes, limits on price moves, and margin requirements all had no perceptible influence on the extent of the crash." Moreover, he argues convincingly that the global nature of the crash "debunks the notion that some basic institutional defect in the U.S. was the cause..."

That computer-directed trading such as portfolio insurance did not exacerbate the crash. Indeed, in local currency terms, the average decline of five countries in which computer directed trading is prevalent (Canada, France, Japan, the U.K. and the U.S.) was 6.6 percentage points less than the average decline of the 15 countries where it is not prevalent. Consequently, if such strategies had any impact at all, they actually helped mitigate the market decline.

That in an examination of ten characteristics empirically associated with the extent of the price decline, options and futures trading, were unrelated to the extent of the crash.(19)

As in every storm there is a silver lining. The crash became the catalyst for action long overdue. It prompted a realistic appraisal of market mechanisms that had fallen far behind current needs, it precipitated an analysis of the type of instruments necessary to serve present day transaction demands, and it resulted in a recognition that index futures are an indispensable and integral component of today's market structure. The process was difficult and exasperating, but in the end it effected perhaps one of the finer cooperative accomplishments within the private sector in recent memory.

While the measures instituted and the ones yet to come are imperfect and cannot guarantee that there will not ever be another crash, they have gone a long way to insure that the securities and futures markets do not disfunction during a panicked downswell and that critical financial safeguards have been implemented. These initiatives conform with current financial market needs as well as the recommendations of the Presidential Working Group and the Brady Commission. Briefly, they cover the following areas: the establishment of industry-wide circuit breakers (coordinated procedures and market halts for the U.S. securities and futures markets during any drastic drop in prices); coordinated shock-absorbers between the NYSE and CME; enhanced and updated CME clearing operations and risk management systems; establishment of a permanent financial surveillance group—comprised of the securities and futures exchanges and their clearing organizations—for the purpose of sharing of financial information and joint audits; enhancement of inter-exchange communications respecting market information and exchange actions that affect other markets; and the broadening of the scope of the SEC-initiated Inter-Market Surveillance Group.

The stock market crash of 1987 provided clear and convincing evidence that market globalization was upon us. The world is increasingly becoming smaller. What were once dozens of scattered national economies are inexorably becoming linked into one global economy. The telecommunications revolution wrought by sophisticated satellites, micro-chips and fiber optics has changed the world from a confederation of autonomous financial markets into one continuous global marketplace. In this global economy, money managers and traders no longer have the luxury of reserving investment decisions until local markets open. When a President or Prime Minister delivers a speech, holds a press conference, or in some way articulates a shift in policy, news of the pronouncement is flashed around the world. Within seconds, traders have the ability to translate this information into market action with a simple keystroke. Thus capital follows the sun, seeking out investment or risk management opportunities regardless of geographical boundaries or time zones.

Futures markets were first to respond to this reality. Two decades ago, the presence of a stock exchange and a large bank was the accepted benchmark for a city to be considered a financial center. Today, as we have seen from the investor's growing dependence on financial futures contracts, a true financial center must have a futures exchange as well.

Foreign financial centers had no problem accepting this view or understanding the value of index futures. 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, in Japan, the Ministry of Finance did not hesitate to announce its decision to establish not one, but two index futures markets—the Nikkei 225 at the Osaka Securities Exchange and the TOPIX at the Tokyo Stock Exchange.

Our community, however, as Elmer Faulkner predicted, has become afraid of the truth. Rather than face a complex and often painful reality, we would embrace a seemingly painless myth, or attempt to turn the clock back to a less complicated, less global world of two decades before. We are easily led to seek legislative solutions in an attempt to return to a less competitive past. Without question, reality is less quaint and usually less fun than nostalgia. However, what everyone invariably forgets about the good old days is that back then, if the market dropped 508 points, it was back to zero.

____________________

     (1) Alan Greenspan, Chairman, Federal Reserve Board of Governors, Testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs, February 2, 1988, p. 13.

     (2) George D. Gould, Treasury Undersecretary for Finance, Testimony before the U.S. House Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, May 19, 1988, p. 4.

     (3) Joseph A. Grundfest, Commissioner, Securities and Exchange Commission, "Would More Regulation Prevent Another Black Monday?" Cato Policy Report, September/October 1988.

     (4) 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, pp. 4-5.

     (5) Ibid., p. 8.

     (6) Gould, Testimony, May 19, 1988, p. 8.

     (7) Merton H. Miller, Financial Innovation: The Last Twenty Years and the Next, Graduate School of Business, The University of Chicago, Selected Paper Number 63, May 1986.

     (8) David S. Ruder, Chairman, Securities and Exchange Commission, "October Recollections: The Future of the U.S. Securities Markets," October 20, 1988, p. 1.

     (9) Gould, Testimony, May 19, 1988, p. 5-6.

     (10) Alan Greenspan, Chairman, Federal Reserve Board of Governors, Joint meeting of the American Economic and the American Finance Associations, New York, December 28, 1988.

     (11) Allan H. Meltzer, John M. Olin Professor of Political Economy and Public Policy, Carnegie Mellon University, "What Really Happened in the Crash," Corporate Finance, August 1988, p. 8.

     (12) The Chicago Mercantile Exchange lowered S&P 500 stock index futures hedge margins at the close of business on September 21, 1988. The Options Clearing Corporation lowered S&P 100 equity options margins on September 19, 1988.

     (13) Interim Report of The Working Group on Financial Markets, Submitted to The President of the United States, May 1988.

     (14) Greenspan, Testimony, May 19, 1988, p. 12.

     (15) Daniel R. Fischel, Director, Law and Economics Program, University of Chicago, "Should One Agency Regulate Financial Markets?" Black Monday and the Future of Financial Markets.

     (16) Edward Fleischman, Commissioner, Securities and Exchange Commission, Address before the Commodities Law Institute, Chicago, Illinois, October 21, 1988.

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

     (18) Hans R. Stoll, Owen Graduate School of Management, Vanderbilt University and Robert E. Whaley, Fuqua School of Business, Duke University, Stock Index Futures and Options: Economic Impact and Policy Issues, January 1988, p. 31.

     (19) Richard W. Roll, Allstate Professor of Finance, University of California, Los Angeles, "The International Crash of October 1987," Black Monday and the Future of Financial Markets.

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