before the National Association of Futures Trading Advisors,
July 22, 1988.
of the most amazing results of the 1987 stock market crash
was its boomerang effect on the stature of futures markets.
initial perception of many in the financial world was that
futures markets were the culprit responsible for the crash.
But the facts and the ensuing process did not bear out this
mistaken belief. Of the 77 studies undertaken in the aftermath
of the crash, virtually none found blame with futures markets.
the contrary, 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. Indeed, most highly qualified
experts characterized futures as a critical mechanism for risk
management in today's modern global markets.
1987 stock market crash was an awesome event. It provided many
lessons and proved many things. Allow me to name at least five.
of course, it was brutal market punishment for the sin of a global
mania that had swept good sense to the side and taken world stock
prices to levels far beyond rational levels. Alan Greenspan,
Chairman of the U.S. Federal Reserve Board, summed it up best
in his report to the U.S. Senate Banking Committee on February
prices finally reached levels which stretched to incredulity
expectations of rising real earnings and falling discount factors.
Something had to snap. If it didn't happen in October, it would
have happened soon thereafter. The immediate cause of the break
was incidental. The market plunge was an accident waiting to
it was an expensive lesson, proving to what extent our technological
competence had out-distanced our market mechanics. To put it
bluntly, most of our traditional markets were operating on a
technological standard equivalent to the steamboat, while those
who make market decisions were using the jet plane.
other words, the disparity between markets and their participants
is growing. It is primarily the result of the changed nature
of the decision-making power in matters of finance. Scientific
and technological advancement have forced the world to become
highly specialized and professional, a trend that will not abate
and is nowhere more obvious than in finance.
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. The reason is obvious. Large pools of capital
offer access to professional management, enabling even small
investors to equal the profit capabilities of institutional participants.
As a result, a myriad of specialists, techniques and strategies
have evolved. Moreover, technological sophistication has enabled
these professionals to apply their strategies with lightening
speed. Unfortunately, traditional market mechanisms, particularly
in stocks, are simply not structured to accommodate the massive
and sudden money flows these managers command. On October 19,
1987, we learned the foregoing truth in a very real and painful
fashion. Financial managers with colossal market positions under
their control attempted to institute similar market decisions
at the same moment. The stock markets could not possibly handle
the sudden surge of money flows these orders represented when
combined with the extraordinary flood of general selling which
was at hand.
the 1987 stock market crash provided clear and convincing evidence
that market globalization was upon us. The marriage between the
computer chip, the communications satellite and the telephone
changed the world from a confederation of autonomous financial
markets into one continuous marketplace. No longer is there a
distinct division of the three major time zones—Europe, North
America and the Far East. No longer are there three separate
markets operating independently of external pressures by maintaining
their own unique market centers, product lines, trading hours
on the morning of October 19, hours before the sun began its
ascent over the East River and even longer before the New York
Stock Exchange opening bell rang, grim news from Tokyo, London
and elsewhere was flickering on computer screens throughout the
United States. Some portfolio managers, anticipating the worst,
were moving to beat a selling avalanche in New York by unloading
shares in London. Rarely was the impact of globalization on the
markets more amply demonstrated.
to our chagrin, we learned how shallow is the understanding by
a large segment of the financial universe about markets in general
and about futures markets in particular. From the outset, a belief
arose that the October 1987 stock market crash must have been
the fault of a specific cause. After all, financial advisers
who had been telling their clients to hold on to their investment
or buy more could not possibly be so wrong. There had to be an
explanation: some special factor must have intervened; some villainous
sabotage that stopped the bull market in its tracks. 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 cause the collapse. Never mind all of that and let
us instead search for a specific culprit. And search we did.
A large number of studies, official and ad hoc, were launched
to seek the answer to the question: Who or what caused the crash?
When a demon in hunted, a demon will be found.
did not take long. Quite soon the fingers were pointing to technology.
The words were catchy. Mindless computers on automatic pilot
were the culprits. Technology has 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 westward in the direction
of futures and options.
the witch hunt, the media was the medium, used and abused. Because
the October crash was extraordinary and frightening, because
the issues were deeply 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.
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.
there were those who had a special motivation to find a culprit.
With volume and brokers' commissions down, someone or something
had to get the blame for loss of investor confidence. Volatility became
the watch word of the day. Volatility caused the 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 business and
volume might suffer, that jobs might be in jeopardy.
the movement gained momentum and an impressive following. Demagoguery
and misinformation are powerful combinations. On May 10, 1988,
the most prestigious U.S. investment banking firms bowed to this
nonsensical pressure and announced their withdrawal from proprietary
index arbitrage. It was a particularly sad day in American financial
history. The movement might have grown further except that it
reached a level of near-hysteria with a call 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.
I was but a child 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 Falkner, 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 (Elmer was a little guy, something under
5 feet tall and his cigar almost as big as he was).
not?" I innocently inquired.
replied, "futures markets tell the truth and nobody wants to
know the truth. If the truth is too bad and too loud, they'll
close us down."
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.
was Elmer Falkner? Why is he important? Allow me to digress
a bit and tell you something about the little guy. I have often
been asked who invented index futures. I don't know the answer.
Clearly it wasn't I. The idea had been around long before I
showed up on the scene as a runner for Merrill Lynch. But it
was Elmer Falkner who first told me about it.
ultimate futures contract," he confided to me, "is stock
I didn't immediately understand his meaning, he whispered, "you
know, like Dow Jones futures. But," he quickly added waving
his cigar again, "it will never happen. You can't make delivery."
never forgot Elmer or the things he taught this young and innocent
disciple. Three decades or so later, cash settlement made Elmer's
ultimate contract a reality.
as before the crash, the CME's Standard & Poor's 500 futures
contract is the most successful stock index futures contract
in the world. 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
the fifth lesson of the 1987 October crash proved that it was
no exception to the rule that every cloud has its silver lining.
For in the final analysis the truth will out. After all the studies
were in, after all the evidence was presented, after all the
analysis was made, after all the misinformation was laid to rest,
futures markets were not only exonerated from blame, they were
vindicated by receiving the highest of praise from most knowledgeable
experts. Indeed, these experts could not be deemed fellow travelers
of the Chicago exchanges. Rather they were classic products of
the Wall Street community.
me to quote some pertinent testimony of the Chairman of the Federal
is no avoiding the fact that, as our economy and financial
system change, our financial markets are going to behave differently
than they have in the past. We cannot realistically hope to
turn back the clock and replicate behavior of the past. Rather,
we need to understand better how the system is evolving and
the consequences of such change. Our efforts need to focus
on making sure that the financial system is more resilient
to shocks rather than embarking on futile endeavors to artificially
many critics of equity derivatives fail to recognize 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.(1)
allow me to also quote some equally strong support for futures
market from the U.S. Treasury in the person of George D. Gould,
the Under Secretary for Finance:
are numerous factors that have made markets react more quickly
today to changes in the fundamental determinants of stock prices.
First, the nature of stock ownership has changed substantially
over the past twenty years, led by private and public pension
funds. There have evolved very large individual aggregations
of capital of a size unknown in an earlier period...Thus, 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.
public criticism of index arbitrage 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. If selling is going to take
place to a degree that pushes prices down sharply, then cash
markets will not be made immune by eliminating index arbitrage.(2)
to those who would criticize futures markets as dens of speculation,
the Chicago Federal Reserve Bank had the following to say:
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.(3)
support, powerful testimony, compelling arguments, you will agree.
Thus, the silver lining. These quintessential lessons of the
October crash have served to strengthen, rather than weaken,
futures markets worldwide. The evidence is all about us.
the recent agreed to initiatives between the Chicago Mercantile
Exchange and the New York Stock Exchange, the two markets where
most of the equity business critical to the issues at hand, takes
place: to institute a system of coordinated "circuit breakers;" to
develop a system of "shock absorbers" that would be triggered
by smaller pre-designated price moves; to transform the present "collar" rule
(which limits use of the NYSE's DOT system after a move of 50
Dow points) into a coordinated system that temporarily diverts
program trading from the DOT system at approximately 100 points
on the Dow; and to create a common definition of "frontrunning."
agreements could not have been achieved unless or until our futures
markets were able to take their deserved and honored seat at
the financial table. Indeed, these initiative are a direct result
of the process that focused national attention on the fact that
the financial markets—both stocks and futures—are strongly linked
and of equal importance in today's competitive global environment.
achievement is the direct result of the joint efforts by the
Chicago Mercantile Exchange and the Chicago Board of Trade in
proving that futures markets represent the avant garde of
today's market demands and are indispensable as modern risk management
tools. The agreements represent compelling evidence that American
financial markets can work together to achieve the necessary
solutions and that federal legislation is both unnecessary and
would be counter-productive in the complex and sophisticated
markets of today.
evidence that the lessons of last October served to strengthen
futures markets is even more evident from a global perspective.
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, the Japanese Ministry of Finance announced
its decision to establish two futures markets in Japan. And,
the headlines on business pages the world over confirm this judgment: "Luxembourg
Ponders Futures and Options Exchange," "Japanese Markets to Cover
Domestic and U.S. Interest Rates as Well as Stock Index Contracts," LIFFE
Canvasses Support for German Bund Contract," "Finnish Futures
Exchange to Start Soon," "ICC Sets Sights on New York," "Stockholm
Foreign Exchange Market Welcomed," "China Plans Futures Markets," "French
Proceed with Stock Index Plans," "German Stock Index to be Established."
every major center of finance must either possess or be connected
to a futures and options market just as it must possess or be
connected to a stock market or a major bank. As Senator Nicholas
Brady concluded in his report to the President, "there is but
one market." Futures are an integral and indispensable part of
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,
D. Gould, Treasury Under Secretary for Finance, Testimony
before the U.S. House Subcommittee on Telecommunications and
Finance of the Committee on Energy and Commerce, May 19,
L. Baer, Maureen V. O'Neil, Chicago Fed Letter, The
Federal Reserve Bank of Chicago, May 1988, p. 1.
by permission. Excerpted from Melamed on the Markets, by Leo
Melamed. John Wiley & Sons, 1993
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