JAWS OF VICTORY
at the Fifth Annual CME London Finance Symposium,
Le Meridien Piccadilly Hotel,
November 13, 1989.
fallout from the 1987 stock market crash lasted nearly two
years. The debate became ugly before it got better. Index arbitrage—and
consequently futures—were blamed for nearly all the ills of
the stock market and beyond. Futures markets were innocent
of blame. The underlying problem was not with index arbitrage
or program trading, but with modern equity investment techniques
and their impact on traditional investment strategies.
latest trend in portfolio management utilized index enhancement
strategies, techniques that required constant adjustments
to portfolios and utilized stock index futures markets. Unfortunately,
these portfolio adjustments caused price movements (volatility)
in individual stocks that had no relationship to fundamental
values. As a result, futures were perceived to be the cause
of volatility in the market. The issue became quite serious
and threatened the life of the stock index futures contract.
I plan to address the subject of program trading, particularly
the aspect of it known as index arbitrage. It is a subject that
unfortunately has become a somewhat heated topic in U.S. financial
circles. While this American debate may sound peculiar and insignificant
to the outside world of finance, it is even more profound than
a surface examination will divulge. The issues unfortunately
include some serious anti-free market implications. One cannot
therefore help but muse that we Americans have chosen a rather
strange moment in history to question our successful market philosophies.
For we stand at the historical juncture when the triumph of capitalism
and free market economics is undeniable and nearly worldwide.
Perhaps the debate is only indicative of a U.S. penchant to snatch
defeat from the jaws of victory.
are four kinds of program trades. The first three types do not
require stock index futures and use futures only when they meet
the objectives in a cost-effective way.
first and most general form of program trading is defined by
the New York Stock Exchange (NYSE) as "the simultaneous placement
of buy or sell orders for a portfolio of at least fifteen different
stocks valued at more than $1 million." A broker executes these
transactions using DOT, the NYSE automated stock order-routing
system. DOT, which requires computer utilization, has greatly
increased the efficiency of stock executions.
insurance, the second type of program trading, is also known
as dynamic hedging. This technique sometimes utilizes the futures
market and is effectuated whenever the cash market index falls
to a predetermined level. Though this strategy was found somewhat
inadequate during the 1987 stock market crash, it is beginning
to make a comeback. Its alleged inadequacy during the crash was
likened to an attempt to buy fire insurance after one's
house is on fire—it can become rather expensive.
asset allocation, the third program trading strategy, examines
the relative value of stocks, bonds and cash equivalents. A pre-determined
formula makes trading decisions in an attempt to achieve the
highest yield for an investment portfolio by exchanging one asset
for another. This strategy has been gaining popularity steadily
with many money managers worldwide. Programmed computers—including
the NYSE's DOT system—as well as futures and options markets
can be and often are utilized to effectuate this strategy.
arbitrage, the last category of program trading, is the strategy
that is usually called into question and is the topic of the
current debate. Traditional arbitrage activity—not to be confused
with that of risk arbitrage—is as old as markets themselves.
Not only is there nothing sinister about the activity, but it
greatly benefits the markets with which it interacts by adding
liquidity and equalizing price differentials. Simply explained,
arbitrage works this way: if the widget market in New York is
higher priced than the widget market in Chicago, an arbitrageur
will—after accounting for transportation costs—sell New York
widgets and buy Chicago widgets, and vice versa.
index arbitrage, an arbitrageur monitors both the equity cash
market at the NYSE and a stock index futures such as the S&P
500 contract at the Chicago Mercantile Exchange. On the date
the futures contract expires, its price will converge with the
underlying stock cash price. However, during the life of the
futures contract its price will often differ from the cash market.
Whenever the futures and cash index price differ by any appreciable
amount, an arbitrageur can lock in a profit by buying the lower-priced
market and selling the higher-priced market. It is an age-old
and totally legitimate practice which offers an arbitrage profit
from price differences that develop between two or more markets.
In the case of equities and futures, the price differential results
because futures markets react quicker to market information.
The reason is that futures markets are more cost-efficient than
their counterparts in the cash market.
often, when money managers want to quickly adjust their portfolio,
they will choose to initiate the indicated transaction in futures.
This will cause the futures market to achieve a different price
level than the cash market. The transitory price difference offers
the index arbitrageur an opportunity for profit. His resulting
arbitrage activity works to even-out the price differential between
the two markets. The practical problem occurs whenever such activities
result in a lower price for the stock market, a consequence of
an arbitrage-related sell program. To someone in the cash market
it looks as if the arbitrage activity is depressing the stock
market. Then there is then a hue and cry against program trading.
Conversely, there are few complaints when the result of such
arbitrage activities result in a higher price for the stock market.
As former Treasury Undersecretary, George D. Gould, explained, "futures
markets act as the messenger." When the message is good, everything
is lovely; but you know what happens to the messenger of bad
1987, the attack against program trading as one of the primary
causes of the crash, took on the proportions of a witch hunt
and proved without merit. Not one of the 77 post-market studies
on the crash found evidence to substantiate this belief. Today,
the attack has somewhat of a different focus: program trading
causes volatility and volatility is driving the individual investor
away from the market. Whether there is more volatility today
or not, whether volatility per se is good or bad, whether
it is driving individual investors from the market, and whether
or not it can be stopped are all important questions of yet another
dimension. Indeed, there is much evidence to suggest that, when
measured over long periods of time, there is no greater volatility
today than years ago. Nevertheless, the issue before us is whether
program trading—specifically index arbitrage—is the primary cause
of volatility in the market.
can be no dispute that volatility and liquidity are related.
The more liquid the market, the less the volatility. One could
then assume that since volume at the NYSE and other markets has
grown substantially over the years, liquidity has benefited as
well. However, in a letter to clients, Stanley B. Shopkorn, Vice
Chairman of Salomon Brothers, explained why this is not the case.
Mr. Shopkorn focused on a factor of volatility that is little
discussed and may be structural to the marketplace. Stock market
liquidity, Shopkorn states, comes from two traditional sources:
specialists and block trading firms.
a consequence of the removal of fixed commission schedules in
the mid-1970s, both specialists and block traders suffered a
dramatic decline in their commissions and floor brokerage. Transactions
that would have brought a broker $.40 a share in the 1960s might
bring less than $.04 a share today. This has had devastating
consequences to liquidity. According to Shopkorn, the higher
commissions of two decades ago provided a kind of insurance.
Block traders, for instance, "were willing to make bids and offers
that would stabilize the market because at former commission
levels they could afford to provide liquidity during periods
of stress, even if it meant losing money on a specific trade." This
is no longer true. Current commission schedules "offer insufficient
incentive to cover the risks of significant block positions.
the drop in commissions for specialists has forced them to rely
heavily on trading. In the early 1970s, Shopkorn explains, "about
two-thirds of the typical specialist's income came from floor
brokerage commissions and the balance came from trading." Today,
the relationship is reversed. Moreover, the growing reliance
by specialists on trading comes in an environment of increased
competition from other markets and has led to a narrowing of
the bid/ask spreads. A narrower spread reduces the specialist's
profit per transaction.
combined effect of these dramatic changes in business has increased
the risks and reduced the incentive to provide liquidity in the
traditional manner. Thus, Mr. Shopkorn points out, "low commission
levels for block traders and specialists do not allow them to
accumulate a cushion sufficient to provide the liquidity that
becomes so essential for smoothly functioning equity markets
during periods of stress." If this is so, Mr. Shopkorn has pointed
to a structural reason for inadequate liquidity which, in turn,
has a fundamental effect on market volatility.
this is by far not the only possible cause of modern day volatility.
Today, large institutional investors control huge sums of money.
The decision-making power by these funds are held not by vast
numbers of investors, but by a relatively small number of portfolio
managers. Their investment decisions— often instantaneous and
quite often similar—create a sudden and much greater impact on
the market than would the separate decisions of thousands of
disparate investors. And whether we like it or not, whether good
or bad, is not the issue. Scientific and technological advancement
have forced the world to become highly specialized, technologically-oriented,
and professional—a trend that will not abate and is nowhere more
obvious than in finance. 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 $2 trillion in assets compared with only $400
billion a mere decade ago.
new technologies have spawned a myriad of new techniques and
the ability to apply them instantaneously. As Mr. Shopkorn states
and most experts know, the majority of today's trading activities
are no longer conducted relative to fundamental evaluations.
Current portfolio managers often apply index enhancement strategies
that require adjustments to portfolios that result in price movements
in individual stocks that bear no relationship to fundamental
values. The nation's 200 largest pension funds now have 30% of
their assets committed to some form of indexation.
critical factor in current stock market volatility is the effect
of globalization resulting from the communications revolution.
Sophisticated satellites, micro-chips, and fiber optics changed
the world from a confederation of autonomous financial markets
into one continuous global marketplace where information flows
at lightening speed as well as its resulting market applications.
to globalization as a factor of volatility is the impact of foreign
investors on our markets. Their force—both on a long-term and
intra-day basis—is an immense and relatively new influence. Japanese
investors alone represented nearly 30% of the $180 billion in
U.S. stock purchases made by foreigners in 1988. In 1983, Japanese
investors accounted for less than 3% of $70 billion in foreign
purchases. Indeed, the U.S. equity market is no longer the dominant
force it was years ago. In 1975, the U.S. accounted for 75% of
world equity markets; today it accounts for only 25%.
can we underestimate the volatility consequences of today's interest
rate and currency fluctuations or those flowing from LBOs, high
risk junk bonds, or the current massive global debt structure.
Indeed, impacts on price stability in today's global village
are quite different from several decades ago when American markets
were fully insulated from competing financial centers.
the financial landscape of the United States—as well as that
of the world—is considerably different. If one postulates that
the current U.S. stock market is more volatile, there are plenty
of substantive causes from which to choose. To conclude that
program trading is the single or even most prominent cause is
at best simplistic and at worst self-deluding. Alas, the issue
has taken on ominous proportions. Indeed, there is currently
a dangerous environment in the U.S., one that if unchecked will
blame index arbitrage—and consequently futures markets—for all
of the ills of the stock market and beyond. Witch hunts have
a certain undeniable appeal and can serve as a ready answer to
affix blame for a variety of serious problems.
there is a strong view that program trading is weakening public
confidence in the market and that it disrupts capital formation.
Already it is an accepted truth that sell programs—executed in
conjunction with futures markets—are depressing stock prices.
Already there is a view that this activity is manipulative and
that it profits a few institutional players by taking advantage
of individual investors. Already there is a movement to stop
doing business with firms and individuals that do index arbitrage.
Already there is testimony and proposed legislation in favor
of curbing or even banning this market procedure. In such a climate,
it is easy to see how index arbitrage could become the central
villain should the stock market turn bearish, an eventuality
not to be dismissed lightly. How far a step is it then to a presidential
action of the following magnitude:
has come to my attention that certain persons are selling short
in the commodity market...These transactions have been continuous
over the past months. I do not refer to the ordinary hedging
transactions, which are a sound part of our market system.
I do not refer to the legitimate...trade. I refer to a limited
number of speculators. I am not expressing my view upon the
economics of short selling in normal times, but in these times
this activity has a public interest. It has one purpose and
that is to depress prices. It tends to destroy the return of
public confidence. The intentions to take a profit from the
loss of other people. . .the effect may be directly depriving
(others) of their rightful income. If these gentlemen have
the sense of patriotism which outruns immediate profit, and
desire to see the country recover, they will close up these
transactions and desist from their manipulations.
address was delivered by President Herbert Hoover on July 10,
1931. Scary stuff, isn't it?
the United States often reaches the brink of disaster before
wiser heads prevail. Indeed, the recent editorial in the Wall
Street Journal is testimony that wiser heads are entering
the discussion. The editorial cautioned that in such complex
issues, one should not jump in favor of conclusions based on
popular misconceptions. Blaming computers will have its price.
Exchanges, the WSJ editors correctly state, have a difficult
task in these matters and have the obligation to strike a balance
between maintaining an orderly market and allowing the market
to freely perform its function. Let us hope—as does the editorial—that
if we err, it will be on the side of free markets.
by permission. Excerpted from Melamed on the Markets, by Leo
Melamed. John Wiley & Sons, 1993
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