Remarks of Leo Melamed

Panel on the Stock Market Crash of 1987
With Nicholas Brady and Gerald Corrigan

Brookings-Wharton Papers on Financial Services
First Annual Conference
Washington, DC
October 29, 1997

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Thank you very much, Tony. I am delighted to be part of this important conference and to be included in this prestigious panel.

I do not have any prepared remarks. Instead, I am going to go back and forth between my memories of the past, thoughts about the present, and hopefully provide a bit of a peek into the future as it relates to financial markets.

I can embrace most of what Nick Brady and Jerry Corrigan said this morning. The three of us have had numerous occasions over these years since 1987 to reflect on those times. During that period, we saw each other often, sometimes more than we wished, but often enough to recognize the similarity of the lessons we learned, and to respect each other’s opinion on most of the matters involved.

Let me also state that as a representative of futures markets, I probably saw Bob Glauber more than anybody during those times. On more than one occasion, during the time Nick Brady was leading the so-called “Brady Task Force,” I was thankful that Bob Glauber was there because often he was one of the very few who understood that “futures” represented a market, and not simply something about “tomorrow.” In fact, I’m not at all certain how many futures exchanges Nick Brady had visited previous to his visit to the Merc directly after the crash. That visit stands out in my memory.

It was about a week after the crash and we who were about to receive Nick Brady were very concerned. To put it mildly, often members of the New York market community came with a built-in negative bias about futures. So we were apprehensive and wanted to make a good impression. We were lucky in that visit. Not only did it go very well, Mr. Brady unexpectedly gave us an opportunity to shine.

As the Merc officials and the Brady Task Force officials sat around the Merc’s boardroom table, it became obvious that Nick Brady was very concerned that the market may have more to fall and that things could get worse.

When is the next shoe going to fall?” He asked.

I had thought about that question often and had come to a conclusion. “I think both shoes are off!” I replied.

He was surprised at the certainty of my answer. “How can you tell?” He asked.

I do not know.” I said, “It’s my trader’s instinct. I think all the air is out of the system.”

Fortunately, in the days and weeks that followed, that turned out to be right. I was lucky, but I think it impressed Mr. Brady.

The second thing that must have impressed the head of the Brady Task Force during that visit was when he asked how long it would take us at the Merc to give him a complete transcript of all the transactions of October 19 and 20. Nick had been a professional in the securities markets and was used to the fact that a complete transaction record of the trades on any given day at the New York Stock Exchange would take a very, very long time to produce. Indeed, it actually took years before the NYSE produced the full record. Still, Brady knew that in order to complete the Brady Report, he would need to know all of the facts, the figures, and the statistics of what happened during those critical days—not just in New York, but in our markets in Chicago as well.

Imagine Nick Brady’s surprise when in response to his question, our president, Bill Brodsky, who winked at me with a smile, responded, “How about before you leave?”

Actually, that answer epitomized one of the main differences between futures markets and securities markets. While that difference has been significantly corrected since then, at that time futures markets, in contrast to their New York counterparts, represented a market that was almost always current—not only in flashing the immediate S&P futures price, but in its ability to instantly provide the facts, figures, and statistics about the transactions. We knew almost everything the following morning. Not only the exact prices and times of the transactions, but who did what to whom, and how. And, as a result, we knew with certainty the following morning that futures were not the culprit as the media portrayed us and as much of the world believed in the aftermath.

That is what the world thought. So much so that Congressman Ed Markey, of Massachusetts, I believe, made a public statement to the effect that: “We have found the culprit and it is index arbitrage.” He could not have been more incorrect. We could confirm with exactitude the next morning what some of us knew intuitively even on October 19, 1987—that there was very little index arbitrage going on. How could there be? The New York Stock Exchange had never really opened. Oh, the lights were on and the air conditioning was working, but there was hardly any trading. You cannot have index arbitrage unless you have a cash market. And there was none. For hours, many of the NYSE specialists did not or could not open a multitude of major stocks. And index arbitrage cannot be done without two markets: One must buy in one market and sell in the other. By definition, you cannot arbitrage against only one market.

Thus, I and many of our officials knew that in reality there was hardly any index arbitrage going on. I was watching the index arbitragers. They were holding their hands in their pockets. What could they do? As the statistics later confirmed, there was no more than 10 percent index arbitrage on October 19. Ninety percent of the sales that occurred were direct sales by investors.

Our market opened on time and there was a price. Problem was, no one liked what the price was saying. But there was a price, and the price correctly reflected what the buyers and sellers were willing to do. It was horrible. It was the most frightening moment in my life, but at least there was a price. We answered the telephone. Our traders were in the pit. Hardly anyone left.

Clearly, there was one big lesson of the 1987 crash. As the Brady Report said, “We are one market.” Yes we are, totally connected, not just New York and Chicago, but worldwide.

Witness what happened this very week during the minor Asian contagion which spread across the world from the East to the West, from Hong Kong to New York, to Chicago. The world again reacted to it just as we expect all humans to do —just as happens when someone shouts “Fire!” in a crowded theater.

In recent months and weeks, while prominent stock market analysts at Goldman Sachs and other places kept saying that it cannot happen, I was conscious of something wrong with that statement. Because emotion takes over whenever greed and fear are in contention. Emotion has not been outlawed, nor has panic or greed or fear. As long as there are human beings, there will be expected reactions based on greed and fear and market crashes.

I do not know one specific cause of the crash of 1987. As Mr. Corrigan indicated, there was no specific cause. There were a combination of causes. But the cause certainly was not the futures market.

The one major difference between 1987 and 1997 is that today we immediately knew that no one would be blaming futures. And no one did. One marked difference between then and now is that the exchanges and market participants are much, much more technologically advanced. We can all better handle the influx of large volumes. The NYSE, in particular, has greatly advanced since 1987. But perhaps the greatest difference between then and now is that today the world has a much better understanding of OTC derivatives and futures markets, their differences, their importance, and their interaction with each other and the cash market. The knowledge that has permeated the financial communities about futures, options, OTC derivatives, and the cash markets is light-years different than what anyone knew ten years ago. Credit academia, credit the information revolution, and credit the media.

Mr. Brady still has his fear of derivatives and leverage. I do not blame him. I do too. In fact, we both agree on that more than he probably realizes. I too recognize that there is a certain unknown degree about leverage that is out there, what it can do and how it will react and impact the markets during an emergency. But, as he correctly stated, “The genie is out of the bottle.” There is nothing any of us—including Jerry Corrigan—can do about that, even if we wanted to. Financial OTC derivatives and exchange-traded futures are with us for the foreseeable future, and we must learn what we can about them and to live with them.

This has been an extraordinary century—and here we are at its end. It was a century during which mankind traveled from the big to the little. For instance, in physics, in 1905, Albert Einstein taught us about relativity, the universe—the very big. And from there we went to discover the atoms, electrons, and protons. Enter quantum mechanics. Later we dug deeper and unearthed quarks and leptons—the very, very little. In biology, the same happened. We began the century learning about the human body. We learned about cells and thought they were the ultimate element within the human body. Then we discovered genes. Enter gene engineering. We learned to look inside the genes and discovered we could break them open. We learned how to manipulate genes and create living things—even sheep.

So you see, it was a century in which we went from the big to the little. The central reason, of course, was the advancement in technology and the invention of the computer. And what happened in physics and biology also happened in markets. In 1972, when we launched a market in currency futures, we launched a big financial instrument. Currency markets, Eurodollars, stock index instruments—the big financial tickets. Today’s quants use their computers to create 14 separate little derivatives which are the equivalent to the Deutsche mark. Forget the currency market, forget the Deutsche mark, forget the Eurodollar; these guys can create what ever you want through the computer. The derivatives they create in markets are the financial equivalent to the creation of sheep in biology. Yes, again from the big to the little. So, the genie is out of the bottle. You are not going to change that.

Right now, as we sit in this room, there are thousands of financial engineers creating new financial derivatives, products we never heard of with names we cannot even pronounce. And yes, a lot of that creates leverage. And I too worry about that. Indeed, if Jerry Corrigan tells you that we should be vigilant, he knows what he is saying. And I agree. But we are not going to stop it. The computer gets better and faster with every passing day. The financial engineers get better and faster with every passing day. The process is unending. Our only hope is that the information age we live in will keep us informed and that we can keep pace with it.

I do not pretend to know what the future will bring. I do know that the world now understands that the futures markets are an integral part of finance. That was a clear result of the 1987 crash. Risk management is today a prerequisite to survival, and instruments such as futures and options are the mechanisms of choice. And will be in the world of tomorrow. That will not change.

Alan Greenspan will tell you that this ought not change. In the years following the crash, the Fed chairman testified that futures markets were the messengers that in 1987 were first to advise the world that suddenly prices were a lot lower and values had changed dramatically. The messengers, he said, did not cause the change in price value. Nobody on our futures floor caused the change in price value. We rapidly reported the change and reacted to it. In similar fashion, during the recent correction—which should not be labeled “crash”—futures markets were again the messenger. They quickly reported the truth of what occurred. Of course it is incorrect to compare the recent upheavals with the 1987 crash. Mr. Brady is correct when he states that while the absolute numbers may sound the same, a 7.2 percent drop in one day, as we just had, is a far cry from the 1987 drop of 22.6 percent.

Reflecting back again to 1987, I agree with Mr. Corrigan when he stated that the day of danger was the day following the crash. I offer the following as evidence of what I mean.

In the futures markets, as you know, all the pays and collects must be completed before the market can open. Futures are T + 1. Unlike the securities markets, we don’t have the luxury of three days to settle up; or five days like back in 1987. In futures markets, the money owed as a result of the previous day’s market movement must be paid for in cash by the following morning. It is a no-debt system. If the change in value is not paid for, we cannot open.

The value change between the longs and shorts on the day of the crash, October 19, 1987, was $2.5 billion. That was—and still is—a very large number. And when you are talking about it in cash, it is even a larger number. We had never encountered or imagined such numbers in our previous pays and collects. As I said to our clearinghouse chief, John Davidson, “That is more money than the GDP of some countries.” And the longs had to pay the shorts that amount by 7:20 a.m. on October 20. Would they do it? was the question. It was the question asked of me by Alan Greenspan when I spoke to him very late in the night of October 19. “Will you open tomorrow?” he asked.

That was the scariest moment because the truthful answer I gave was “I do not know.”

What the Fed chairman was really asking was: “Will the longs pay the shorts? Will you get the money?” Because if we did not, then we would not open the next day. And then the scare scenario Mr. Corrigan described earlier would begin to unfold. It is the fear of not being paid that throws the system into gridlock. If someone fails to pay, it sends a shiver through the financial system. Who failed? becomes the question of the moment. If anyone believed that a firm failed, it would have a domino effect. “I am not going to pay that [guy] until this [guy] does not pay me.” So the critical question was whether the Merc would open. It was the most dangerous time of the crash.

I did not sleep that night. I was in the clearinghouse of the Merc the entire night together with the other officials of the Merc. It evolved that there was one major player who had to pay $1 billion. And we were told the money was slow in coming in. No one had a doubt that this player had the money, but if he did not pay in time for our opening, we could not open. Then the rumors would start and fear would take over. It is what happened in 1932.

In the middle of the night, we had to call the chairman of that financial giant and alert him to the problem.

Who are you?” he asked being awakened in the middle of night.

We are the Chicago Mercantile Exchange,” we said, “and you owe us a billion dollars.”

Can you imagine waking up to a telephone call at 2:00 A.M. and someone telling you that you owe $1 billion and where is it?

A few hours later, at 7:00 a.m., twenty minutes before the opening, I was on the phone with the Continental Bank, which was the Merc’s settlement bank. Wilma Smeltzer was the officer of the bank charged with handling the Merc’s account. She knew that there had to be $2.5 billion paid before that account was cleared.

I asked, “Wilma, how are we doing?”

She replied, “Leo, we have $2.4 billion. There is still $100 million missing, and it does not look like it is going to make it.”

I shouted, “You mean you are going to let a stinking 100 million stand in the way? Just advance the money!”

Leo,” she said, “I cannot do that.”

I said, “Wilma, we know the customer. They are good for the 100 million.”

She said, “I know that too, Leo, but I do not have that kind of authority.”

Well, fate intervened. Tom Theobold, chairman of the Continental, arrived at that very moment.

Hold it, Leo, there is Theo. I’ll ask him.”

A moment later, Wilma said, “Leo, Tom said it was okay to advance the money.”

We opened at 7:20 a.m. The money actually did come in 30 minutes later.

And that is the fear Jerry Corrigan was talking about. The pays and collects that he was worried about and that we were worried about. It certainly represented the most dangerous moment of the crash. In the recent market movement, by comparison, it was no sweat at all. There was no doubt at the Merc that the $3.6 billion change of value at our markets was ever in jeopardy of being paid. Similarly, the coordination between us and the securities markets was now totally different. In 1987, we were in total disconnect, today we were completely in sync. We learned how to coordinate from the 1987 crash.

As a free market devotee, I do not like the idea of circuit breakers any more than any free market economists. In fact, in 1987, I had a two-hour telephone conversation with Milton Friedman trying to convince him that it was okay to try circuit breakers. Well, I never convinced him of that. Still, I did embrace the concept. The key is that everyone knows long in advance what they are and how they will work. And as far as I am concerned, they pretty much worked. I do agree that circuit breakers now require some serious adjustment to reflect current percentages and current market realities. But, all in all, I think the circuit breakers worked. This time, there was total coordination between the markets of New York and Chicago.

So, as I indicated, we learned a great deal from the 1987 crash and are much better for it. But am I not here to say that it cannot happen again—no, I am not. We had better stay vigilant because no one has outlawed the fundamental reasons that cause crashes: fear and greed. Thank you.


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