Safeguards on the Market
Make a Crisis Less Likely

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL

To some people who experienced the 1987 stock market crash, the scariest part was not the plunge in stock prices on Monday, Oct. 19, but the near-disintegration of key elements of the financial markets themselves the following day.

In the subsequent 10 years, numerous changes have been made to prevent another crash from posing a similar threat to the financial system. People involved in those efforts believe they have minimized the risk of a repeat, but acknowledge uncharted risks could still erupt in another big drop.

"There's an important distinction between weathering a crash, which I think we can do, and preventing one, which I think is idle tilting at windmills," says Hans Stoll, director of the financial markets research center at Vanderbilt University.

"The lesson we should have learned is we should be sure our financial markets are sufficiently sound to withstand an event of that type. And we've done quite a bit along those lines."

Among the structural failures during the crash were widespread and lengthy trading halts in numerous blue-chip stocks; overloads and delays in order-execution systems at some exchanges; trading halts and pricing anomalies in many stock options; gaping disconnections between stock, futures and options prices which fed the free fall in prices; a serious depletion of New York Stock Exchange specialist capital, and a reluctance by commercial banks to extend credits to the securities industry.

Each of those issues has, in the last 10 years, been addressed, at least partly.

"One of the lessons was to always have your technology and capacity considerably in excess of your average daily demand," says Richard Grasso, chairman of the New York Stock Exchange. Big Board trading capacity, raised by investments in automation, is now 2.3 to 2.7 billion shares a day, or about 5 times average daily volume. By contrast, in 1987 theoretical capacity was 420 to 440 million shares a day. While that was more than twice average daily volume, actual volume topped 600 million both Oct. 19 and 20. In 1987, less than a quarter of Big Board stocks were traded on electronic order books. Today, all are.

The chance of another one-day 23% drop has been reduced if not eliminated by the Big Board's "circuit breakers," introduced in 1988 on the recommendation of the commission headed by Nicholas Brady, who later became Treasury Secretary. The circuit breakers halt trading for half an hour when the Dow industrials fall 350 points from the previous day's close, and for an hour when they fall 550 points, and are coordinated with other exchanges.

Such sweeping trading halts, which have never been triggered, are controversial. "Some of the scariest times during the market crash were those when trading was not occurring," Federal Reserve governor Susan Phillips told a conference on the crash at Vanderbilt last spring. "Information flows, pricing mechanisms were halted." Improved technology and regulatory changes have weakened the case for circuit breakers, she said.

But they are widely supported, even at the Securities and Exchange Commission, whose pressure last year contributed to the Big Board's decision to raise the trigger points from the original 250 and 400 points to reflect the market's higher level.

"In one way or another ... circuit breakers are inevitable in a tumultuous market," Richard Lindsey, the director of the SEC's division of market regulation, and Anthony Pecora, attorney-adviser in the division, said in a paper presented at the Vanderbilt conference. "In 1987 and 1989 they took the form of clogged order processing systems; ad hoc trading halts in individual stocks, options and stock index futures; jammed communication systems; and some less than responsive specialists and market makers." The circuit breakers create an orderly time-out for specialists to publicize order imbalances and attract buyers.

William Brodsky, chief executive of the Chicago Board Options Exchange, says stock and derivatives exchanges are better coordinated than in 1987. "One of the problems in 1987 was you couldn't reach the people at the other exchanges." Now, floor officials and top executives at stock and derivatives exchanges, the SEC and Commodity Futures Trading Commission can be brought together in instant telephone conferences via a dedicated "hoot and holler" telephone line.

The possibility that a major clearing house could fail through the default of a participant, endangering the solvency of numerous financial institutions, alarmed regulators in 1987. Since then, stock, option and futures clearing houses have raised member margin and capital requirements and adopted more sophisticated margin formulas. Jack Sandner, chief executive of the Chicago Mercantile Exchange, says cross-margining has significantly reduced the chance of a "false liquidity crisis," in which a firm, for example, has hedged a stock position with options or futures, but would risk default on a stock-only margin call.

In addition, in 1993 stock settlement lags were reduced to three days after the trade date from five, and in 1996 cash payments for securities transactions moved to same-day from next-day settlement. Both moves reduced the risk of an investor defaulting on an obligation because of a big market move, endangering an investment dealer's health.

Specialist capital has been strengthened by a tripling of minimum position requirements and industry consolidation. Still, some market officials wonder if it's enough to deal with the much larger trading volumes and capitalizations of listed companies. Mr. Grasso says specialist capital adequacy is monitored continuously, and even during the near-10% market pullback in March, it never approached the cautionary zone.

But no one can be sure any of these changes are sufficient to prevent another crisis. Mr. Brady, now chief executive of Darby Overseas Investments, a Washington-based money manager, says the causes of the 1987 crash were unknown to financial-market players beforehand. "There were practices that crept up, imperfections in the system." While those have been cured, there could easily be "other systemic problems which could cause a market break."

For example, the Brady Commission blamed portfolio insurance, a risk management technique which obligated fund managers to sell massive amounts of stock index futures into falling markets, for fueling the crash. Whether similar "dynamic hedging" strategies are currently widespread is "the great unknown," says Brandon Becker, a securities lawyer with Wilmer, Cutler and Pickering in Washington who was at the SEC in 1987.

"What's hard to measure after a period of sustained bull market activity is whether the amount of hedging has built up to a degree that it would significantly accelerate a decline in the market." He notes that various hedging techniques probably contributed to massive losses in the bond market when interest rates rose suddenly in 1994, although the financial system was not endangered.

Structural Changes to Financial Markets

New rules implemented since the 1987 market crash:

• Big Board Circuit Breakers
  Trading on the New York Stock Exchange halts for half an hour if the Dow Jones Industrial Average falls 350 points from the previous day's close, and an hour if it falls 550 points. Originally the circuit breakers were set at 250 and 400 points, and the halts were one and two hours, respectively. These circuit breakers, which are coordinated with futures exchanges, have never been triggered.

• Program Trading Collars
  When the Dow industrials rise or fall 50 points from the previous close, restrictions are imposed on trading between stocks and stock-index futures to keep such arbitrage from accelerating market moves. The "collars" are activated almost daily.

• Intermarket Coordination
  Stock, futures and options markets have dedicated phone lines to communicate data and coordinate activities during periods of extreme market stress.

• Capacity Increases
  The Big Board says it can handle 2.5 billion shares a day, five times average daily volume, up from 440 million, or more than twice average daily volume, in 1987.

• Shorter Settlement Times
  Investors must now settle three days after trade date, instead of five, reducing the risk of default between trade and settlement.

• Stronger Clearing Agencies
  Both the Options Clearing Corp. and National Securities Clearing Corp. have increased their capital and margin deposit requirements. Cross-margining among exchanges reduces the likelihood of financial gridlock.

• Better Capitalized Specialists and Broker-Dealers
  The New York Stock Exchange has raised capital requirements for specialists. Investment dealers have increased their capitalization and reduced dependence on bank financing.

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