of Leo Melamed
on the Stock Market Crash of 1987
Nicholas Brady and Gerald Corrigan
Papers on Financial Services
you very much, Tony. I am delighted to be part of this important
conference and to be included in this prestigious panel.
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.
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.
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.
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.
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.
is the next shoe going to fall?” He asked.
had thought about that question often and had come to a conclusion. “I
think both shoes are off!” I replied.
was surprised at the certainty of my answer. “How can
you tell?” He asked.
do not know.” I said, “It’s my trader’s
instinct. I think all the air is out of the system.”
in the days and weeks that followed, that turned out to be
right. I was lucky, but I think it impressed Mr. Brady.
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.
Nick Brady’s surprise when in response to his question,
our president, Bill Brodsky, who winked at me with a smile,
“How about before you leave?”
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.
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.
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
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
there was one big lesson of the 1987 crash. As the Brady
“We are one market.” Yes we are, totally connected, not just New
York and Chicago, but worldwide.
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.
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
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.
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.
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.
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
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.
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.
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
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.
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.
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.
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.
was the scariest moment because the truthful answer I gave
do not know.”
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.
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.
the middle of the night, we had to call the chairman of that
financial giant and alert him to the problem.
are you?” he asked being awakened in the middle of
are the Chicago Mercantile Exchange,” we said, “and
you owe us a billion dollars.”
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
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.
asked, “Wilma, how are we doing?”
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.”
shouted, “You mean you are going to let a stinking
100 million stand in the way? Just advance the money!”
she said, “I cannot do that.”
said, “Wilma, we know the customer. They are good for
the 100 million.”
said, “I know that too, Leo, but I do not have that
kind of authority.”
fate intervened. Tom Theobold, chairman of the Continental,
arrived at that very moment.
it, Leo, there is Theo. I’ll ask him.”
moment later, Wilma said, “Leo, Tom said it was okay
to advance the money.”
opened at 7:20 a.m. The money actually did come in 30 minutes
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.
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
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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