Recent press reports have blamed the volatility in the stock market on stock index futures and options. Traders bristle at the suggestion, arguing that the market behaves wildly because of “market fundamentals,” not because some financial tool is forcing it to. “It’s like the National Rifle Association says about guns,” explains market analyst Jeffrey Miller, referring to the lobby’s motto that guns don’t kill, people do. “Stock index futures just make it easier for the market to do what it wants to.”
Unfortunately, his analogy is perfect. Futures and options may not force the market down when it wants to go up, but they do seem to make it more likely that the trips downward will be dangerous.
The standard definition of a future is simple: a contract to purchase a commodity, such as corn or hogs, at a given price and time in the future. With stock index futures, which were first traded in 1982, the “commodity” is a bundle of stocks. The value of the Standard & Poors stock index futures contract, for example, rises and falls according to the price movement of 500 different stocks. The only difference between pork belly futures and stock index futures, then, is that in the first case if something goes very wrong, the nation could suffer a bacon shortage, in the second, a financial collapse.
Occasionally, warnings are heard in the news about stock index futures and their relationship to computerized “program trading,” usually when the stock market’s euphoria is interrupted by a brief plunge, like the 116-point dive it took in 71 minutes on January 23. But mostly the din of Wall Street’s partying has drowned out complaints that these might also lead to serious trouble.
That’s unfortunate because some of those warning of trouble are in a position to know. On December 11, as the stock market entered the final turn in its wind sprint toward 2,000, John Phelan, chairman of the New York Stock Exchange, suggested that stock index futures, in combination with certain recent trading strategies, might cause the market to experience a “meltdown.” “Two years ago, I would have said no,” Phelan told a meeting of Gannett Newspaper editors. “Now I think it could happen.” The next day he said he was thinking along the lines of a 600-point drop, adding, “A Boesky can undermine the credibility of the market. This type of trading…can destroy the market .”
Some New York Stock Exchange officials agree with futures advocates that these new instruments help the stock market in many ways and may even be partly responsible for its rapid growth. At the same time, the officials warn, the possibility that they might also contribute to a meltdown is worth taking seriously.
A 600-point drop wouldn’t necessarily lead to a great depression, but in percentage terms it would be more than twice the size of the drop on October 28, 1929. It would mean that on average the price value of stocks would decrease by close to 30 percent. The value of pension funds could drop, companies might have to lay off workers for lack of modernization capital, banks might be destabilized because their investment portfolios or too many of their customers were injured in the stock market, and, in general, pessimism would guide economic decisions.
Sleeping better
The frenzy of people screaming hysterically at each other in the futures trading pit has its origins in Renaissance Europe, at trade fairs where merchants and customers would meet and agree on purchases of products coming through town later. Despite being frequently compared to legalized gambling, futures trading does serve some important economic functions; in the U.S., it grew out of the desire of midwestern farmers to have a way of selling their produce with some certainty of the price.
Take the case of a grain elevator operator who fears that the price of his corn will drop before it can be sold, perhaps because of a larger than expected corn crop. He sells a futures contract in corn and locks in the price he will be paid, “hedging” against unpredictable market shifts. The purchaser might be a processor like General Foods, which fears that prices are going to rise and wants to preserve a low price. Or it may be a speculator whose interest is making money by betting the price of corn is going to go higher than the futures price.
In the late seventies, trade began on financial futures, including contracts for products such as deutsche marks, Treasury bills, bonds and government-backed mortgages. During the Carter administration, the Commodities Futures Trading Commission (CFTC), the agency that regulates futures, blocked approval of stock index futures for fear they would cause stock market volatility and divert capital from securities. In 1982 the Reagan administration CFTC approved the trade of these futures as well as options. (Although most of the debate has focused on futures because they are more widely used, options function much the same way, the main difference being that a futures contract confers an obligation to buy or sell, while an option merely gives the right to.)
Five years ago, five million of the contracts were traded; in 1986 26.5 million contracts were, about three-fourths of it in the pits of the Chicago Mercantile Exchange. Although this volume is a small fraction of the stock market, it is being seen increasingly as the tail capable of wagging the dog.
In the case of a stock index future, speculators bet that a group of stocks is going to go up or down in value. If, for example, it is March 5 and a speculator believes the market will rise, he might buy one Standard & Poors futures contract worth roughly $140,000 by placing a margin deposit of $10,000. If those stock values rise to $141,000 on March 6, the speculator that day could take his $1,000 profit. If, however, the market heads down sharply, the speculator would immediately feel the pinch. He would have to add money to his initial margin deposit in order to hold onto his contract. The speculator could have sold futures also. How can you sell something you don’t have? “Selling,” in this case, is the equivalent of placing a bet that the market is going to go down, the wager being in the form of a standardized contractual agreement.
The hedger in this case—the equivalent of the grain elevator operator—is the large-scale stock market investor. If money managers investing for a pension fund fear their stock portfolio might lose value, they can sell index futures, in essence betting in New York that the securities will increase in value and in Chicago that they will shrink. If the stock market declines, the investor’s losses will be partially offset by the “gains” on the futures side.
That is why leaders of the New York Stock Exchange hail the benefits of stock index futures. Futures give investors a certain security and may have helped fuel the stock market’s recent growth by making institutional investors feel more comfortable buying securities. Indeed, most of the recent growth in use of stack index futures has come from such investors. “I do work for a lot of large portfolio managers, and for the first time they don’t have to sell off stock every time they’re scared,” says Philip Johnson, formerly CFTC chairman and now a partner at the law firm Skadden Arps. “They can sleep better at night.”
But at the same time, these leaders warn of the danger of futures trading. The growth in the market has been tempered by periodic plunges, the largest being the 86-point drop on September 11 and the 45-point drop on January 23, the day that saw the Dow Jones Industrial Average plummet 116 points in just over an hour. In these and other cases, press accounts have pointed accusingly at the use of “computerized program trading,” a term reminiscent of science fiction movies about feuding computers that start nuclear wars.
Although program trading has become a catchall phrase, it usually refers to “arbitrage,” which sounds daring but is actually a strategy that institutional investors can use to lock in risk-free profits by exploiting differences that develop between the value of the actual stocks and the futures contract. Arbitrage has been blamed for market swings on “triple-witching-hour” days when the stock index futures and other equity-related options all expire. But the triple-witching-hour phenomenon may be overblown. Although arbitrage does lead to sudden bursts of trading in the closing hour of those quarterly expiration days, most of the largest swings have not taken place then.
Game of chicken
So what is the problem? The combination of stock index futures and computerized program trading has created a suped-up stock market. It allows investors to play the stock market, but by a different set of rules—the rules of futures. And futures can have the effect of throwing oil on a fire.
Futures, for one thing, require much smaller margins. While stocks require deposits of at least 50 percent, futures deposits are roughly 7 percent (recently raised from 4 percent). More important, trading on the futures side is cheaper. The brokerage fees for institutions buying one contract is about $30, compared to about $300 (or several times that amount at retail prices) for the several transactions needed to purchase an equivalent amount of stock. Buying and selling futures contracts also entails much lower “market impact costs’ L–an investor is more likely to get a better price when making one transaction than when making several. These differences add up for the large institutional investors. If the investor had bought 1,000 contracts of the Standard & Poors stock index futures, he would have had to put up a margin of $10 million and would have incurred $80,000 in direct and indirect transaction costs.
To buy the equivalent 3.2 million shares of stock, the investor would have had to post about $140 million and would bear about $720,000 in transaction costs. It’s almost as if an enterprise zone has been created within the stock market. In essence, you can play the stock market but, using futures rather than securities, can do it faster, easier, and cheaper. If you think the stock market is moving up you can react more quickly and easily on the futures side. Combine this with computerized trading strategies that enable—even encourage— investors to shift enormous amounts of money in seconds, and you have the potential for a dramatic change in the psychology of the market.
During the recent drops in the market as well as many of the surges, traders reported that stock market movement was preceded by feverish trading in the futures pits. The 116-point January 23 drop seemed to be set off in part by investors using “technical analysis,” the practice of charting broad market trends and selling off when the market seems to have reached a certain plateau, and in part by traders selling stocks and futures to exploit discrepancies between the stock and futures prices. The futures trading helped fuel the market downturn.
The scenario for a catastrophic meltdown is theoretical but commonsensical: The market starts heading down, perhaps because of some bad economic news—say, Paul Volcker oversleeps, causing worldwide financial panic. Confronted with this news, traders start selling off stock index futures, betting that the stock market will go down. As the index goes down, traders clued in to the dropping market start selling stocks. The more stocks that are sold, the more people sense a charging bear, and the lower the index goes, all of which triggers more stock sales and a rapid downward spiral. “When the stock market is suddenly hit with an avalanche of sell orders, everyone goes ‘Oh my God,’ ” says Jeffrey Miller, of the investment firm of Miller and Tabak, who helped pioneer the use of these futures but now has doubts. “It adds fuel to the fire to see those red sell tickets pouring down onto the floor.”
As the market starts to dip, computerized trading strategies kick in. Traders start selling off stocks, not because of the gloomy economic news but because the futures contracts have dropped below the value of the equivalent bundle of actual stocks and they want to lock in a quick profit. That is precisely what happened in the January 23 drop.
Robert Birnbaum, president of the New York Stock Exchange, warns that an initial slump, whether inspired by arbitrage or a case of the economic blues, may trigger another investment strategy known as computerized portfolio insurance. Under these programs, investment managers will sell fixed portions of stocks or futures when the market drops by a certain amount, often 3 percent. (The Dow Jones Industrial Average dropped 4.6 percent in September and 2 percent total on January 23.) So, one exaggerated fall could trigger another exaggerated fall, all within a matter of minutes. “The whole thing just keeps cascading down,” Birnbaum says.
Portfolio insurance programs were a major factor in the September downturn. Ironically, the strategy of hedging used to justify the stock index futures seems to help accelerate the market drops they are supposed to protect against. Portfolio insurance covers about $50 billion of roughly $1 trillion in pension fund assets, and that portion is growing steadily; the more it does, the more it will make minor downturns into major ones.
Positive karma
Futures supporters at the CFTC, the Chicago exchanges, and on Wall Street, argue that just because the futures movement preceded the stock plunge doesn’t mean it caused it but merely that the futures pit was able to react faster to the bad news. The same debate has raged over agricultural commodities for years; farmers often claim that futures speculation drives down the price of the crop, while futures traders claim crop performance drives the price of the futures. It is, to put it in terms of broiler futures, the ancient financial question: Which came first, the chicken or the chicken future?
Perhaps the market would drop just as drastically without stock index futures, but it seems that during the recent plunges trading was reacting not to economic news, but to market news, which was being shaped by the index futures and computerized trading.
Defenders of the system insist that regardless of the scenario, futures are simply a lubricant, enabling the market to get where it was going faster than in the pre-computer age, and making the market more efficient. Moreover, according to some studies, if you measure all the ups and downs of the markets in percentage terms, volatility has not increased. But Birnbaum is skeptical. “Some people say that the market would have reached that in the old days in three weeks; this time it got there in seven minutes,” he notes. “You’ve got to look at the market and say, Is everyone willing to invest in the market and accept a 300-point downturn in one day rather than over a period of months?”
The answer is that the effects on market confidence would be starkly different. After such a drop, roughly equivalent in percentage terms to Black Tuesday in 1929, large investors would be more likely to say, “Let’s take our $5 billion of fiduciary responsibility out of here,” than, “Don’t worry, we’ll just wait for the market correction.”
At any rate, given our debt-burdened economy, it is not entirely reassuring to think that the market is going to plunge uncontrollably only if there’s bad economic news. In fact, probably the scariest thing about the recent plunges is that they’ve all taken place at a time when positive economic karma pervaded. What would index futures and computerized trading do to the market if people became convinced that bad times were ahead? These market innovations have yet to be recession-tested.
Indeed, the growth of stock index futures seems even more ominous when considered in the context of other similarities between now and 1929. For example, in a January 1987 Atlantic Monthly article, John Kenneth Galbraith argued that there are several disquieting parallels between the two eras. He noted in particular a trend toward excessive speculation and fondness for that magical financial concept, “leverage,” in which small amounts of money create the potential for large profits—and large losses. He focused on junk bonds and leveraged buy-outs, and the precarious tower of debt their use has created. Such great indebtedness seems harmless enough when things are going well, but could be disastrous should a recession come and firms become less able to manage their debt.
The leverage on stock index futures should be unsettling given that the infamously low 10 percent margins on stocks in 1929 were higher than the current 7 percent margins on futures. That’s not quite as threatening as it sounds. While in 1929 the other 90 percent of the stock cost was covered by debt—people getting in over their heads—the other 93 percent of the cost of futures is, or is supposed to be, covered by the actual assets of the investors. It is much harder to pile paper debts on top of each other in the futures markets since big losers must pay up at the end of each day.
Nevertheless, the low margin levels are troubling. Neither institutional investors nor speculators invest entirely on the basis of the cash they have on hand. When the Hunt brothers tried to corner the silver market in 1980, what should have been a silver crisis almost turned into a larger financial disaster. Regulatory agencies failed to intervene as the Hunts borrowed to make their payments, much as speculators had in the twenties. When they couldn’t meet their margin calls, they endangered the Bache Halsey Stuart Shields Inc. brokerage firm and a network of banks that had lent them more than $1 billion. Since the firms investing in stock market futures are also involved in the questionable debtfinancing arrangements mentioned by Galbraith, it is not unreasonable to expect that some of their stable assets are paper thin. “I have no doubt that the credit extension and internal leverage of firms are at all-time highs,” says James Stone, the chairman of the CFTC under President Carter.
Even well-heeled investors who bet the wrong way on a dramatically shifting futures market might have trouble meeting their margin calls. As noted earlier, the existence of stock index futures creates a market dynamic that increases the chances that such a scenario would develop. Should such a rapid shift happen at the same time other blocks are crumbling beneath the nation’s house of debt, the stock index futures could help transform a serious problem into a catastrophe.
A sour chorus
One way to minimize the danger of stock index futures is to make them more like securities. Stone suggests raising the margins as a way of ensuring that sharp futures market movement won’t wipe out investors. Tom Byrne, who works at the index and options desk of Shearson Lehman and is the author of The Stock Index Futures Market, thinks the main problem with futures proliferation is the creation of a “commodities mindset” in the securities industry. The regulatory goal in the stock market, he notes, has been preservation of a “fair and orderly” market, while the futures industry’s “open and competitive” standard places no premium on order. The difference is not hard to detect on the floor or in the futures prices. Futures traders thrive on volatility, big shifts, and great leverage, all values that do not lend stability to the stock market.
Byrne suggests creating a stable futures trading system. In the stock market, if an investor wants to sell 10,000 shares of General Motors, his broker doesn’t just shout it out on the floor of the stock exchange and hope for the best. He tells a stock exchange “specialist,” whose job is to find a buyer for those shares. If the specialist can’t find a buyer he is obligated to buy himself. In return, he or she gets special trading privileges. For larger quantities of stock, the major brokerage firms seek out the opposite sides of trades before they go to the floor. These guaranteed buyers keep the price of stocks from dropping like that of bald tires at a garage sale.
The CFTC and the exchanges could also be more aggressive in encouraging large investment firms to undertake a similar function in the stock index futures arena. They could agree to stand ready to take the opposite side of certain trades in exchange for special trading privileges. If such an arrangement existed, a flood of futures sell orders could be immediately counter-balanced by some large buy orders, thereby keeping the price from dropping too quickly.
Another option would be to simply impose limits on how dramatically the futures market can shift in a day, a proposal that is considered virtually un-American by the industry but which is already in effect in most other futures markets.
There may be a solution that would preserve the benefits of stock index futures while minimizing their potential dangers. But such efforts may be inherently doomed because their most economically useful function—hedging under portfolio insurance plans–also helps accelerate plunges. To give security to particular investors, the futures endanger the entire market. The only logical plan, then, may be to abolish stock index futures. Perhaps if federal regulators put their minds to it, they could devise a less draconian but equally effective solution. But so far they have refused even to acknowledge there is a problem. And why should they? The downturns in the markets have been merely a few sour notes in a chorus of hallelujahs. And anyway, stock index futures don’t cause crashes, people do.
