Presented at the Fifth Annual CME London Finance Symposium,
Le Meridien Piccadilly Hotel,
London, England,
November 13, 1989.

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The 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.

The 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.

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Today, 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.

There 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.

The 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.

Portfolio 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.

Tactical 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.

Index 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.

In 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.

Quite 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 tidings.

In 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.

There 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.

As 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.

Similarly, 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.

The 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.

But 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.

Furthermore, 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.

Another 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.

Tangential 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%.

Nor 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.

Today, 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.

Already 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:

It 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 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.

That address was delivered by President Herbert Hoover on July 10, 1931. Scary stuff, isn't it?

However, 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.

Reprinted by permission. Excerpted from Melamed on the Markets, by Leo Melamed. John Wiley & Sons, 1993

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