The Brady Report; C. L. Culp

The Brady report maintained that the be havior of the futures market was one cause of the "market break" on October 19, 1987. The report explains that almost one hour into the trading day, portfolio insurers attempting to cover their losses with gains from sales of fu tures contracts were driving prices down. This, in tum, increased selling pressure on the fu tures markets. Index arbitrage-a financial strategy whereby an investor can gain profits Christopher L. Culp is an Associate Policy Analyst at the Competitive Enterprise Institute in Washington. from price disparities between index futures and their underlying stocks-was one factor in transmitting the selling pressure to the NYSE. The Commission fell into the camp of those who feel that because the market adjusted ac cordingly to the S & P 500 index of the futures market-almost a self-fulfilling prophecy the "tail was wagging the dog. ' , That analysis is not altogether inaccurate.

However, the conclusions that the Commission dr~w from that premise are not ones that would decrease market volatility. Because the Brady Commission saw these markets as fundamen tally linked and felt that the downfall of one led, in part, to the downfall of another, it rec ommended several courses of action to prevent another market dysfunction from causing yet another market break. Perhaps its greatest error is recommending that margin requirements should be consistent between stock and futures markets. The Com mission study implies that futures margins should be changed to decrease speculation in the futures market and to limit the amount of leverage that individual investors have in the futures market. Some critics feel that the over leveraging of the futures market was partially if not totally responsible for the bullish climb of the market from August 1982 to Black Monday. The Commission is quick to bring up the possibility of cross-margining to illustrate that they are not simply trying to raise futures margins. Cross-margining implies that while some margins may increase, others will de170 THE FREEMAN. MAY 1988 crease, having little net effect on the margins paid by the investor. Even though the Commis sion may not be trying to raise margins, their conclusions are rooted in a general misunder standing of the function of futures margins. Al though few would argue with the Commis sion's assertion that the futures and stock markets are one market, it is a different issue altogether to say that futures margins and stock margins can be examined and regulated as one.

Futures margins serve an entirely different purpose than stock margins. While stock margins represent a percentage of actual owner ship in an investment, futures margins are simply price insurance mechanisms contained in stock-derivative futures contracts-"perfor mance bonds," if you will. It would be a se rious mistake to allow the government the re sponsibility of making margins consistent be tween these two markets. The alternative to government intervention already exists in Chi cago, where margins are determined largely by market movements. Some people argue that CME margins are too low, but they are in many ways much stricter than their NYSE counterparts. If the S & P 500 fluctuates, the investors are respon sible for paying the per cent of that fluctuation, often making their margins near NYSE levels. The maintenance margins at CME ensure that investors have adequate capital backing at all times. In contrast to a popular view that stock margins are always higher than futures margins, the NYSE allows a number of exemp tions in margin requirements for such things as block trading and arbitrage, often bringing their margins below CME margins.

Furthermore, while the NYSE has a five-day settlement period, the CME has a twenty-four hour settlement period. The CME does not ex tend credit. On Black Monday, the CME col lected $2.6 billion (against an average $100 million) and established its liquidity for the Tuesday open. The CME's Committee of In quiry explains, "All margin calls were met, no clearing member defaulted, and thus no cus tomer funds were lost due to insufficient finan cial integrity." 1 Furthermore, the CME had two intra-day margin calls that were met by in vestors within one hour of their issue.2 The real doubt came from the uncertainty of whether New York investors would still have liquidity five days after the crash. That time lag created doubts that caused a number of problems at the open on Tuesday, October 20. The Commission did not demonstrate that it understood the necessity of the futures market as a mechanism of risk management. Its recom mendation for consistent margins is clearly in dicative of this. The Commission apparently failed to understand the significance of "specu lation." Often thought of as random gambling, speculation on the futures exchange is actually short-term investment. Speculators provide the market with buyers when prices are low and sellers when prices are high. Without specu lators, long-term investment would be next to impossible. Furthermore, by buyi~g or selling against market pressure, they allow long-term investors to "hedge" their risks, thereby strengthening the entire market and preventing order imbalances (cited by the Commission as one of the main reasons that many NYSE stocks could not open on Black Monday).

The Role of Speculators Speculators are willing to take the risks that hedgers want to avoid, and the effect of this is the strengthening of the market. To establish a strong market, it is essential that buyers and sellers both exist. Unreasonable recommenda tions by the Commission regarding margins would tend to drive away much of the neces sary speculation on the futures market. On Oc tober 19, speculators in the CME served a vital function. When the pressure to sell was tre mendous, the local speculators were buying fu tures contracts. In New York, the inability of the market specialists to find buyers for stocks is cited by the task force as another major reason for the fall. Some NYSE specialists emerged as net sellers-not buyers-on Black Monday. While NYSE's risk management mechanism failed, speculation on the CME worked. It suc cessfully absorbed selling pressure and broke the fall of the NYSE. It is estimated that CME absorbed 27,000 contracts on Black Monday.

Had those contracts been transmitted back to the NYSE, they would have represented ap proximately 85 million shares of stock, or 14 per cent of the total NYSE volu~e that day.3 The task force never fully realized the signif icance of speculation. Allowing Self-Regula tory Organizations (SRO's) to set margins in stead of the government would help keep spec ulators in the market. This would put the assets of the members of the SRO at risk. The fear of market failure will lead the investors virtually to insist on adequate maintenance margins, but these margins will be flexible to change with market fluctuations. Because investors have a direct stake in the market and government does not, market-based margin requirements will support the system far better than government regulation can. A drop in the number of speculators that higher futures margins might precipitate would undermine the principal function of the stock index futures exchanges - risk management.

Markets such as the S & P 500 were created because there was a great demand for them. If the Commission's recommendations succeed in stifling the risk management process, there will still be a demand for risk management. Since a number of domestic stocks exist on foreign markets, there is nothing to stop investors from hedging their risks overseas. If the U.S. futures market is no longer available for speculation, the market demand will be exported. Needless to say, this would not have the effect of strengthening the U.S. stock market. The Brady report also mistakenly calls for ,'circuit breakers" to stop another fall, should it occur. The impracticality of this idea can be seen in the Hong Kong market. Its decision to close did not "calm" the market; it intensified the panic. Hong Kong did not find that its problems had gone away one week later. The U.S. stock markets do not need circuit breakers to shut them down. They need "surge pro tectors" so that American markets can accom modate the intense stress of a precipitous fall without shutting down completely and intensi fying the loss of investor confidence.

A Grave Error A circuit breaker that the Commission calls for is the imposition of price limits on the markets. This would be a grave error on the Chicago Mercantile Exchange. The very nature THE BRADY REPORT 171 of the CME is to allow the investor to set prices. Charles Seeger of the CME states that the futures market is ". . . a forum for price discovery. "4 Futures markets function as a pro ducer of information. Prices are the result-not the cause-of markets. Imposing price limits on the futures market would treat the symptom, not the disease. Imposing price limits on the futures markets would be much like a doctor who tells a patient that he has a temperature, and then tries to cure it by saying, "Hopefully, it will be gone tomorrow. ' , Furthermore, price limits would simply delay the movement of the market. It is naive to think that price limits would do anything more than forestall the inevitable. Without price limits, the market will proceed to its "destina tion" with as much speed as possible. Since a purpose of futures markets is to set prices, it is to the advantage of the investor to know the future price as soon as possible. Allowing the market to move with utmost speed to its desti nation will cause a "panic of the moment," as happened on Black Monday. But it will alle viate the much greater problem of prolonged panic, as happened in Hong Kong-or on a larger scale, the Great Depression. Once prices have been established, investors can deal with trades at face value, rather than trying to second guess the market's movement.

Several people have expressed the view that the October market break was nothing more than market equalization. The market was run ning above its capacity, and the break was a redefinition of capacity in the marketplace. The general attitude in London after the crash was surprise to see Americans acting as shocked as they had. They felt that markets are supposed to rise and fall-what was so different about this time? There is an unquestionable need to create a system of surge protectors, but the recommen dations of the Brady Commission do not pro vide the proper solutions. The solutions lie in the private sector-not with the government. A major problem is public confidence in the market. Fear by investors that there is no li quidIty in the market is largely due to the inade quate technology present in the existing infor mation-clearing mechanism, particularly with respect to opening prices. Modernizing the ex172 THE FREEMAN. MAY 1988 isting system would remove many of the problems associated with investor confidence.