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Index Futures-Stock Link Spurs Volatility : Program Trading: Plunge Raises Regulatory Issue

October 21, 1987|MICHAEL A. HILTZIK | Times Staff Writer

NEW YORK — David S. Ruder chose a controversial issue for his first public speech as Securities and Exchange Commission chairman on Oct. 6: whether computerized stock and futures trading could someday lead to a series of cascading sell orders in the stock market.

"The grand finale of this scenario," Ruder told the Bond Club of Chicago, "would be a dramatic market collapse. Understandably, the commission is not anxious for this to occur."

The scenario that Ruder figured the SEC could safely mull over for months struck two weeks later with a magnitude that no one expected. The severity of the market's crash Monday and over the previous two weeks is already raising the question of whether regulators, Congress and the exchanges themselves might have better foreseen the consequences of linked trading in futures and stocks and acted to forestall the crash by restricting or even forbidding today's elaborate and financially potent trading strategies.

Just as natural disasters like earthquakes expose weaknesses in man-made structures that few people otherwise recognize, the market crash is laying bare a complex of shortcomings in today's financial and regulatory system that many observers have decried, often as prophets without honor.

The root causes of the Crash of 1987 are certainly numerous and complex, but one thing is clear: "The regulators are in a new era of dealing with things that aren't very well understood," said A. A. Sommer, a former SEC commissioner who has conducted regulatory studies for the New York Stock Exchange.

Perhaps the most important weakness in the system is the increased volatility in the stock market that results from trading, or "arbitrage," that links stocks to futures.

In the most simplified case, a large institutional investor will shift billions of dollars between two investments: the Standard & Poor's 500 futures contract, traded on the Chicago Mercantile Exchange, and a group of stocks selected to replicate the behavior of the underlying S&P 500 index, on which the future is based.

The idea is to turn a profit equal to the momentary differences in price between the futures contract and the group of stocks. This is done by simultaneously selling one and buying the other. The price changes are so rapid and complex that the investor uses a computer program to tell him when to give the appropriate buy and sell orders, which typically hit the exchange floor in multibillion-dollar waves. Hence, computerized program trading.

Volatility Debated

Over the two years in which this technique has become popular, its proponents have insisted not only that it contributes virtually nothing to stock market volatility, or price swings, but that the markets are no more volatile today than in the past. Reams of academic studies have been produced to support this position.

Today, the evidence points to the opposite conclusion, for market participants say that program trades clearly had a leading hand in 50- and 100-point moves in the Dow Jones industrial average in periods of minutes over the last week.

New York Stock Exchange Chairman John J. Phelan remarked just after Monday's 508-point collapse in the Dow: "This will put an end to those esoteric studies people have done saying the markets are not more volatile today than they used to be."

Many of these trading techniques employ futures and stock options whose behavior in a variety of market conditions is simply unpredictable--and, more often than not, disappointing. "A lot of these new financial animals created by the rocket scientists of Wall Street have never been tested," said Raymond DeVoe, a market analyst at the investment firm of Legg Mason Wood Walker. "Every time they have been, there's been blood all over the floor."

Also, the markets have become bigger than the people assigned to run them. The scale of trading this week alone has swamped the financial capability of the markets' primary lines of defense against chaos: the "local" traders in the futures markets and the "specialist" traders in the stock markets.

These traders must use their own money to maintain stable markets. It is a task they shouldered easily when the typical investor was their own size; now that the typical investor is a major institution playing Goliath to their Davids, the system is strained.

"This is really an industry in transition from handling small and modest transactions to handling institutional markets," said Merton Miller, a professor of finance at the University of Chicago. "A lot of people have pointed out for a long time that there is a problem of peak load capacity."

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