Futures
& Derivatives Law Reports Vol. 17, No. 7, Oct 1997
LOOKING
BACKWARD – LOOKING FORWARD
by Brandon Becker and Sandeep Parekh
---
Mr. Becker
is a partner, and Mr. Parekh an associate at the Washington D.C. firm of
Wilmer, Cutler & Pickering. Mr. Becker formerly served as Director of the
Division of Market Regulation, Securities and Exchange Commission. In 1987, Mr.
Becker was an Associate Director in the Division and participated in writing
the SEC report detailed in the article. This article is for general
informational purposes only and does not represent legal advice regarding any
particular set of facts.
---
A decade after the stock market Crash of 1987, the causes and consequences of
the Crash continue to be a source of debate. Although the Crash gave birth to a
cottage industry in various studies, reports and recommendations for reform,
this article will review the report by the Division of Market Regulation
("Division") of the Securities and Exchange Commission
("SEC"), The October 1987
Market Break issued in February of 1988 ("Report"). The
Report set the framework for much of the SEC's subsequent efforts to reform the
securities markets in light of new trading developments. This article focuses
on the various recommendations made in the Division's Report. Although
identifying "the" cause(s) of the Crash is still controversial, its
immediate effect is reasonably clear. Several significant price declines
in mid-October 1987, ignited mechanical, price insensitive selling by a number
of institutions following portfolio insurance strategies and a small number of
mutual fund groups. The selling by these investors, and the prospect of
further selling by them encouraged a number of aggressive trading oriented
institutions to sell in anticipation of further declines. These
aggressive trading oriented institutions, included, among others, hedge funds,
a small number of pension and endowment funds, money management firms and
investment banking houses. This selling in turn stimulated further
reactive selling by portfolio insurers and mutual funds. Selling pressure
in the futures market was transmitted to the stock market through index
arbitrage. Throughout the period, trading volume and price volatility
increased dramatically. Even though such a broad scale decline might
suggest investors all decided to reduce their positions in equities, in fact, a
limited number of investors played the dominant role during this tumultuous
period.1
Following the Crash, the Division undertook an analysis of the operation of the
trading markets during the Crash with a view toward identifying "how the
trading systems for stock and its derivatives (i.e., options and futures) may
have contributed to the rapidity and depth of the market decline."2 The Division specifically stated that it did "not
answer the question of why, in October of 1987, the value of common stocks was
reduced by approximately 30%."3 Indeed, the
division concluded that "[w]e may never know what precise combination of
investor psychology, economic developments and trading technologies caused the
events of October."4 Rather, the focus of the
Division's inquiry was whether the trading process itself contributed to the
severity of the decline and whether any steps could be taken to ameliorate such
declines in the future.
The scope of the Report is important to emphasize. The Report did not
argue, as some of its critics implicitly seemed to assume, that its
recommendations would prevent a market decline. Rather, the Report
assumed that, in the long run, market forces would determine the valuation of
equities. Accordingly the Report focused on the narrower question of
whether trading mechanisms might be modulated to better handle dramatic
revaluations such as October 1987. To strain the metaphor, the Report
recognized that automobile accidents are "caused" by a variety of
factors, e.g., driver error, alcohol, highway design and mechanical
failure. The Report did not try to untangle all of the possible causes5 of accidents or preclude the possibility of future
accidents, but rather sought to identify whether different highway design
features, speed limits or automobile manufacture requirements might reduce the
likelihood of future accidents or reduce the number of fatalities from such
accidents.
In looking backward, the Report's primary recommendations had varying degrees
of effects.6
A.
Limited Effect
1. Market Basket Trading
Due to its concern "over the impact of market basket activity on the
liquidity of the stock market"7 the Division
recommended "the creation . . . of one or more posts where the actual
market baskets could be traded" as an alternative that "might alter
the dynamics of program trading."8 The New
York Stock Exchange ("NYSE") developed such a trading mechanism.9 Nevertheless, for a variety of reasons, this
approach to trading stock baskets never took hold. Rather, investors
continue to rely on program trades, the futures markets and increasingly, the
upstairs swaps market as a method to trade large portfolios of equities.
2.
Large Trader Reporting
Due to the difficulties in reconstructing market activity during the Crash, the
Division recommended "creating more specific recordkeeping rules at the
broker-dealer level and developing a system . . . for rapidly identifying large
traders in the stock market."10 Ultimately, such
an approach was adopted by Congress in the Market Reform Act of 199011 when the Congress authorized creation of a large
trader reporting system. Nevertheless, the Commission is yet to act on
its proposed rules to implement such a system. It appears that the
Commission, when finally confronted with the full implications of developing
such a routine large trader reporting system determined that it was simply too
expensive to implement.
At the same time, however, it also appears that the SEC's desire to obtain
accurate, timely and complete information regarding transactions remains
unabated. The Commission's settlement with the National Association of
Securities Dealers, Inc. ("NASD") stressed the importance of timely
and accurate transaction and quotation reporting by broker-dealers.12 Moreover, as part of that settlement, the NASD,
undertook to create an Order Audit Trail System which will provide a complete
time stamped record of the handling of a customer's order from the moment a
broker-dealer receives the order.13 Thus, while
the Commission may have retreated on large trader reporting, its quest to
achieve an integrated audit trail continues full force.
B.
Uncertain Effects
1. Margin
Few topics have been as hotly debated since the Crash than the role of margins,
in particular, margins on stock index futures during the Crash. The
Division concluded "that low derivative product margins may contribute to
the increased velocity of institutional trading . . ."14 and recommended "there should be a review of the
impact on the stock market of present index futures and options margin
levels."15 In contrast, many subsequent
studies of margin levels have concluded that margin levels have little, if any,
affect on volatility. Nevertheless, after an extended debate, the Board
of Governors of the Federal Reserve System was given authority to oversee stock
index futures margin16 and that authority subsequently
was sub-delegated to the Commodity Future Trading Commission
("CFTC").
Despite the intense margin debate, the actual result – limited federal
oversight of stock index futures margin – did not dramatically change the
margin levels. Thus, while there are ample prudential reasons for some
margin oversight, the oversight which exists has not fundamentally altered
margin practices.17
2.
Circuit Breakers
Another deeply divisive development was the role of so-called "circuit
breakers." Although there are various kinds of circuit breakers, the
two most commonly discussed are the "collar"18
and the market-wide trading halt.19 The collar
is designed to require that index arbitrage and similar derivatives related
trading be executed on stabilizing ticks when the Dow Jones Industrial Average
moves up or down by 50 points. The collar was sharply criticized by program
traders and the futures industry when it was introduce as potentially leading
to a disconnect between the futures and the stock markets thereby contributing
to pricing inefficiency.20 Today, the most
forceful criticism of the collar seems to be that it does not impede program
trading and, therefore, has at most, a placebo effect. Nevertheless, the
fear that somehow the collar would impede the operation of the futures market,
in particular, or the stock market, in general, has not developed.
Market-wide trading halts are designed, among other things, to allow parties to
ensure that their counterparties are solvent and facilitate price discovery by
providing time for value traders to enter the market. At the same time,
however, concerns have been expressed that they may prove ineffective and, more
significantly, they may create greater market uncertainty, thereby contributing
to more market difficulties. The market-wide halt has not been tested yet
so it is impossible to evaluate its effect.
In one aspect, however, the critics of market-wide halts seem to have missed
the mark. When proposed, market-wide halts were criticized for the
potential "magnet effect" of increasing selling activity as the
market approached a halt. The argument was that once market participants knew a
halt would occur, there would be a race to the exit before the door
closed. Nevertheless, in those few instances where a halt has been
approached, it does not appear to have had such an effect. Even so, until
a halt actually occurs, it is too early to judge whether a halt will in fact,
contribute to orderly price discovery or create additional uncertainty.
C.
Substantial Effects
1.
Clearance and Settlement
The
most common theme among all the reports concerning the Crash, including the
Division's Report, was the need for substantial improvement in the clearance
and settlement process. In this connection, a multitude of reforms have
been undertaken which have substantially strengthened the resiliency and
effectiveness of the clearance and settlement system. While, of course,
these changes do not mean additional steps, or constant vigilance, are
unnecessary, they are one area where the sustained efforts of the regulators
and the industry have produced real changes for the better.
On the stock side, the most notable change was the shift from T+5 to T+3
settlement.21 Recognizing that "time equals
risk" the SEC required the shift to T+3 settlement in an effort to reduce
that risk, provide continued leadership in the harmonization of global
settlement time frames, and better align stock settlement practices with the
derivative markets. Indeed, there is continued discussion of further
reducing the settlement time. In addition, as important as the
Shift to T+3 settlement was the development of a same-day funds settlement
system, thereby reducing overnight exposure and also achieving greater
conformity with the payment methods used in derivatives markets, government
securities markets and other markets.
As a separate matter, while there had been calls for a unitary clearance and
settlement system,22 such a unitary system never
developed. Instead, the various clearing organizations of the different
markets have worked together on individual projects and through various
coordinating bodies to more closely connect their operations. For example,
cross-margining programs have been implemented which reduce clearing members'
combined daily margin requirements and, accordingly, reduce the potential for a
financial cul-de-sac, especially
during volatile markets when clearing organizations may demand additional
clearing margins from their members. Similarly, cross-guarantees reduce
systemic risk posed by a common member's default because that member may have
positions spread across markets such that its asset position at one clearing
agency is positive even though its asset position at another clearing agency is
negative. In addition, the various clearing organizations, responding to
regulatory as well as market pressures, have increased their capital base and
expanded their lines of credit.
The net effect of these various changes is that substantial risk has been
squeezed out of the system, funding and collateral requirements have been
better aligned across markets, and the clearing organizations have more
resources. These are all sound reasons for satisfaction that much
progress has been made in this area. Nevertheless, the demands on the
clearance and settlement system continue to grow and, therefore, it is
important to continue to examine ways to improve these systems.
2.
Automation
The common complaint that the "computers broke" during the Crash is
an overstatement at best. What did happen was that various systems were
so overwhelmed by the volume of message traffic that the timeliness of those
systems was so materially degraded that market participants could not rely on
those systems to operate in the usual and customary manner. Nevertheless, as a
result of the substantial criticisms of the various markets received due to
automation difficulties during the Crash, the markets undertook a major effort
to improve their automation capabilities.
In addition, to reduce market disruptions, the SEC issued two so-called
automation review policies ("ARP"). The first ARP (which the
second developed further) established that self-regulatory organizations
("SROs") should, on a voluntary basis, establish comprehensive
planning and assessment programs to determine their systems' capacity and
potential vulnerabilities.23 The SEC emphasized
that the SRO programs should have three objectives:
(1)
Each SRO should establish current and future capacity estimates;
(2)
Each SRO should periodically conduct capacity stress tests; and
(3)
Each SRO should obtain an annual independent assessment of whether the affected
systems can adequately perform in light of estimated capacity levels and
possible threats to the systems.
Most SROs today have excess capacity of approximately three times that needed
for an average trading session.24 Moreover, the major
broker-dealers' computerized trading systems also can now withstand volatile
trading days. The major broker-dealers also use capacity modeling and
verification models to ensure that their systems remain ahead of projected transaction
message growth rates.25 Thus, while it is impossible
to guarantee such systems, it does appear that a reasonable method is in place
to ensure continued monitoring of capacity planning efforts.
3. Capital
Once source of concern during the Crash was whether thinly capitalized entities
would be able to survive the severe market decline. Although a few firms
did fail, most firms, with varying degrees of ease, were able to weather the
storm. Nevertheless, since the Crash, the capital position of various
entities has been substantially enhanced. The SEC, NYSE and the SROs have
increased their capital requirements substantially.26
In addition, broker-dealers have increased significantly their ownership equity
and reduced their reliance on commercial banks for short-term financing,
relying instead on the commercial paper market. Moreover, the bull market
of the last several years has been an attractive opportunity for various firms
to improve their balance sheets. Thus the capital position of financial
intermediaries continues to improve.
4.
Coordination
The Crash highlighted the need for the various markets, the regulators of those
markets and participants in those markets to better coordinate their activities
to deal with inter-market and cross-market developments. Although that
concern often has become caught up in the debate about whether the SEC and CFTC
should be merged into one agency, the reality of day-to-day coordination
between and amongst the markets and regulators has improved substantially.
The President's Working Group on Financial Markets has provided a forum whereby
regulators can address issues of joint concern. In addition, as described
above, the markets have taken numerous actions to coordinate their trading
procedures (e.g., circuit breakers and cross-margining). Moreover, open
telephone lines have been created between the market and their regulators to
facilitate better coordination during emergencies. Thus, while the market
participants and regulators continue to have some deep policy differences, the
infrastructure is in place to ensure that routine coordination issues are
handled in an orderly manner and a frame work for dealing with market
exigencies exists.27
5.
Order Handling
Perhaps the single most dramatic change since the Crash has been the reform of
the over-the-counter ("OTC") market.28
After the Crash there were various complaints that OTC market makers did not
respond to telephone requests for executions. Accordingly, the Division
recommended that "the NASD and the Commission . . . review whether, if a
firm does not respond to a message in a set amount of time, an execution should
occur automatically. Such a system capability would appear to increase
substantially the incentives on market makers to update their quotes in a
timely manner."29 This recommendation, as
well as the NASD's initiatives, led to the implementation of an automated Small
Order Execution System ("SOES") in the OTC market.
This is not the place to review the long, tumultuous history of SOES in the OTC
market. Suffice it to say that automatic execution in the OTC market
ultimately highlighted various market practices in the OTC market which, in
turn, cause the SEC and NASD to reform substantially the order handling rules
for the OTC market, as well as other markets.30 As a
result, spreads in the OTC market have declined by 30 percent and intra-day
volatility has declined.31 It is perhaps a testament
to the law of unintended consequences that an ostensible simple recommendation
to ensure investors orders were executed in a timely manner during periods of
market stress should have sparked such fundamental change.
D.
Unfinished Business: Looking Forward
There are many reasons to be optimistic that the marketplace of ideas has
resulted in the right mix of recommendations implemented and recommendations
rejected in the give-and-take of debate. Nevertheless, the various
problems associated with the interest rate volatility during the Spring of
1994, the Barings debacle and the recent Asian currency volatility reminds us
that the only thing certain about markets is that they will fluctuate.
Thus, it is appropriate to look once again at what still might be done to
further strengthen the ability of markets and market participants to withstand
sever market declines.
1.
Rule 10b-18
Rule 10b-18 provides a safe harbor for companies who seek to repurchase their
securities from the anti-fraud prohibitions of the federal securities laws.32 During the Crash there was some confusion among
companies concerning what steps they could take to repurchase securities during
a period of market stress. Although the Division staff sought to provide
comfort to issuers, the process depended on informal telephone conversations.
Today the Division staff is considering various ways in which Rule 10b-18 could
be revised to reflect contemporary trading practices. It would be helpful
if, as part of that review, the Division also could provide greater written
comfort regarding what steps a company reasonably could take in response to a
significant market movement. Certainly a company, if it so chose, could
act, in effect, as a "buyer of last resort" for its shares.
Assuming the good faith of such company determinations, the Commission
presumably should welcome such provisions of liquidity. Accordingly the
Commission should consider how to provide greater comfort to issuers so that
they need not unduly worry about whether such purchases are
"manipulative."
2. Firm Oversight, Dynamic Hedging and Accounting/Disclosure
The continued growth of large, globally active financial intermediaries places
increasing emphasis on ensuring that those entities are well-managed,
especially concerning their risk management strategies. Moreover, the use
by such intermediaries of greater amounts of off-balance sheet derivative
instruments, especially strategies based on some form of dynamic hedging,
raises further concerns regarding the effects of such instruments on firm risk
management and the trading markets. On the 4th of September
1997, the President's Working Group on Financial Markets came out with a
report. The report supports the SEC's stand on derivatives disclosure
requirements. It also showed support to the Financial Accounting
Standards Board's (FASB) efforts at enhancing derivative accounting and
disclosure.33
In broad brush, there are two interrelated, but not identical, concerns.
The first concern is whether the individual firm effectively understands the
risks it is taking and has followed prudent procedures to mitigate those
risks. Here the questions focus on the quality of management, internal
control mechanisms, meaningful information systems and adequate liquidity
reserves. In this regard, the accounting/disclosure issues are just as important
for internal risk management procedures as they are for public disclosure
purposes.
In this area, much has been done, but much still needs to be done. The
SEC has developed its Risk Assessment Program which has materially increased is
ability to oversee broker-dealers. Similarly, the banking regulators have
worked hard to improve their oversight of off-balance sheet risks.
Nevertheless, as the financial services industry reinvents itself through ever
larger and more dramatic mergers and acquisitions, it will be even more
important for the firms themselves and their regulators to remain vigilant to
ensure effective oversight and control mechanisms are in place and followed.
A second concern is more subtle and difficult to assess. Specifically,
even though each individual firm may itself be well-managed, the various
hedging/trading activities of multiple firms in the event of a dramatic market
decline may interact to reinforce the decline or exhaust readily available
liquidity. In effect, this is what the Brady Report meant when it spoke
of an "illusion of liquidity" in the market, i.e., there was tremendous
liquidity for a variety of trading strategies on the way up, but the same
liquidity was not as readily available on the way down.34
At this point one can only hope that several developments mitigate this
concern. First, as a practical matter, despite the remarkable shake out
during the Spring of 1994, interest rate volatility adversely affected
individual firms, not the system as a whole. Second, if firms manage
their risks successfully on an individual basis, presumably, such management
efforts also should take into account the potential for liquidity gaps so that
firms will have sufficient internal liquidity reserves to deal with immediate
difficulties. Third, as more information is made available through
disclosure and otherwise concerning the scope and nature of such off-balance
sheet activity, the market itself will be able to better anticipate such
developments.35 Nevertheless, while these
developments, perhaps will mitigate, any interactive effects, they also
underscore why the various other infrastructure reforms (e.g., clearance and
settlement) are so critical.
3. Government Reform
The debate regarding how to oversee large, globally active financial services
firms as well as the markets in which they operate continues unabated.
Today the debate is less about whether the SEC and FCTC should be merged, but
the nature of oversight of the OTC derivatives markets and Glass-Steagall
reform. Some believe that it is inevitable that the multitudinous regulatory
authorities will be streamlined. Others, witness to the last two decades
of hearings, are less certain.
It may be possible that the present system, especially when coupled with strong
leadership at each of the financial regulatory authorities, is adequate.
In other words, efforts to create an organizationally cleaner regulatory
structure ultimately may not be worth the candle. Indeed, if we look at
the reform efforts ongoing today both in Japan and the United Kingdom, it is
hard to see either market as providing a compelling case for fundamental
changes in the United States. Perhaps this is more a reflection of the
strong U.S. economy, but irrespective, it is difficult to view the current
structure as fundamentally impeding U.S. competitiveness. Thus, the
argument for reform would have to be predicated on improved prudential
oversight or investor protection.
E.
Conclusion
Looking back, the Division's Report seems to have addressed many of the right
questions. Nevertheless, what is notable ten years later is that the most
progress was made on concrete, infrastructure issues (e.g., clearance and
settlement) where one authority could make a decision and see it through to
implementation. The least progress was made on governance issues (e.g.,
government reform or unified clearance and settlement).
Looking forward, the oversight challenge posed by large, globally active
financial intermediaries (both internally and externally) will continue to be
important. The need to be prepared for future problems, which may not
resemble the problems of the past, invites extra caution and foresight.
1 Presidential Task Force on Market Mechanisms, Report of
the Presidential Task Force on Market Mechanisms, January 1988 (hereinafter the
"Brady Report").
5 In this regard, perhaps the greatest analytic
difficulty in discussing the Crash is the assumption that there was
"a" single cause of the Crash, rather than a confluence of various
factors at a single point in time.
6 A comprehensive summary of recent action is provided in
the President's Working Group on Financial Markets, Report of the President's Working Group on Financial Markets on Recent
Actions by Federal Agencies to Reduce Risks in Financial Markets, Sept.
1997.
9 Securities Exchange Act Release NO. 29285, June 11,
1991.
11 Public law 101-432, 104 Stat. 963.
12 1728 Fed. Sec. L. Rep. (CCH) 85824, Aug 8, 1996.
13 Release NO. 34-38126, Jan 14, 1997
16 58 Fed. Reg. 26979-03, May 6, 1993.
17 This conclusion may be an overstatement, however, if
as a practical effect, the presence of such oversight acts as a check on the
minimum level of margins that might otherwise be collected.
20 Securities Exchange Act Release No.28282, July
30, 1990.
21 Rule 15c6-1 was promulgated
in Securities Exchange Act Release No. 33023, Oct 6, 1993.
22 The Brady Report, see supra n.1.
23 Automated
Systems of Self-Regulatory Organizations, Securities Exchange Act Release
No.29185, May 9, 1991.
24 See e.g., NYSE Annual Report 1996, NYSE to
increase trading capacity from 2 billion shares to 3 billion by 1997, while
daily trading volume was only 412 million shares.
25 Dr. Richard R Lindsey
& Anthony P. Pecora, 10 Years After:
Regulatory Developments in the Securities Markets Since the 1987 Market Break
at 32, Apr. 1997 (unpublished, presented at a conference by the Vanderbilt
Business School).
26 Securities Exchange Act Release No.25677, May 6,
1988.
27 There is, however, a continuing need for increased
coordination on an international level.
28 As a separate matter, the options market also
has made significant improvements over the last decade.
30 Division of Market Regulation, the SEC Speaks
407, March 1997. See also American
Law Institute, SB 35 ALI-ABA 1, Jan 9, 1997.
31 Lindsey and Pecora, see supra note 25. But se,
"Dealers Drop Stocks As `Spreads' Narrow" WALL,ST.J., Sept. 9, 1997 at C1.
32 Rule 10b-18 under the Securities Exchange Act
1934.
33 President's Working Group on Financial Markets,
see supra n. 6.
34 The Brady Report, see
supra n.1. Similarly, this is the import of Professor Grossman's analysis
of the market's failure to price correctly the liquidity demands that might
result from various unseen OTC hedging strategies, see Grossman, An Analysis of
the Implications for Stock and Futures Price Volatility of Program Trading and
Dynamic Hedging Strategies, 61 J. Bus. 275 (1988).
35 The recent Asian
currency movements are too recent an example to evaluate whether reliance on
market self-discipline, in the face of a prolonged bull market, is a realistic
expectation. Cf. Wessel, Rubin says
Global Investors Don't suffer Enough, WALL ST.J., Sept 19, 1997, at A2.
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