ForRelease: February i, 1988 (202)

, NEWS RELEASE

Release: 2864-88

ForRelease: F e b r u a r y i, 1988

|

Contact: Kate Hathaway (202) 254-8630

W a s h i n g t o m - - T h e C o m m o d i t y Futures T r a d i n g C o m m i s s i o n

r e l e a s e d t o d a y t h e final staff report on s t o c k index f u t u r e s a n d r e l a t e d stock m a r k e t a c t i v i t y d u r i n g O c t o b e r 1987. The r e p o r t a n a l y z e s the d e t a i l e d data c o n c e r n i n g the futures t r a d i n g

a c t i v i t i e s of m a j o r b r o k e r / d e a l e r s and i n s t i t u t i o n a l investors, a l o n g w i t h c e r t a i n p e r t i n e n t aspects of t h e i r t r a d i n g in the s t o c k market. A d e t a i l e d s t a t i s t i c a l a n a l y s i s of f u t u r e s and s t o c k m a r k e t p r i c e r e l a t i o n s h i p s was also conducted. In

addition, this final r e p o r t e x a m i n e s the p e r f o r m a n c e and f l o o r a c t i v i t i e s of f u t u r e s e x c h a n g e m e m b e r s in h a n d l i n g and e x e c u t i n g c u s t o m e r orders, m a r k e t m a k i n g and t r a d i n g p r a c t i c e s in g e n e r a l . Finally, the r e p o r t i n c l u d e s staff r e c o m m e n d a t i o n s to a u g m e n t or improve several a s p e c t s of futures m a r k e t regulation.

In c o m p l e t i n g the e c o n o m i c a n a l y s i s c o n c e r n i n g O c t o b e r m a r k e t events, t h e C F T C staff i) a n a l y s e d special s u r v e y d a t a w h i c h d e s c r i b e d the a c u t a l t r a d i n g a c t i v i t i e s of m a j o r

p a r t i c i p a n t s in t h e f u t u r e s and t h e i r r e l a t e d s t o c k m a r k e t

activities, and 2) a n a l y s e d p r i c e r e l a t i o n s h i p s b e t w e e n the S & P 500 futures c o n t r a c t and s t o c k p r i c e s from O c t o b e r 14 - 26. C F T C staff found no e v i d e n c e to s u p p o r t the f r e q u e n t l y c i t e d a r g u m e n t that the c o m b i n e d t r a d i n g s t r a t e g i e s of index a r b i t r a g e and

p o r t f o l i o i n s u r a n c e s e l l i n g c a u s e d the m a r k e t b r e a k on O c t o b e r 19 or t h a t these s t a t e g i e s c o m b i n e d to cause a d o w n w a r d spiral or c a s c a d e in s t o c k prices.

The bull m a r k e t i n s t o c k s that s t a r t e d several y e a r s ago b e g a n to t r e n d d o w n in late A u g u s t a n d t h e d o w n w a r d t r e n d w a s a c c e n t u a t e d in e a r l y October. Recently, the Dow J o n e s A v e r a g e and the S&P 500 v a l u e s h a v e h o v e r e d a r o u n d levels e s t a b l i s e d in late O c t o b e r or e a r l y November. T h e s e facts c o m b i n e d w i t h t h e r e v i e w of t r a d i n g a c t i v i t i e s s u p p o r t the b e l i e f t h a t the m a s s i v e w a v e of s e l l i n g t h a t e n g u l f e d b o t h the s t o c k and f u t u r e s m a r k e t s o n O C t o b e r 19 w a s p r e c i p i t a t e d b y an u n p r e c e d e n t e d c h a n g e d in investors' p e r c e p t i o n s and was not i n i t i a t e d by t e c h n i c a l t r a d i n g s t r a t e g i e s w h i c h i n t e r a c t e d w i t h each o t h e r and the s t o c k market.

A m o r e d e t a i l e d s u m m a r y of the e n t i r e final r e p o r t follows.

Commodity Futures Trading Commission 2033 K Street, N.W., Washington, D.C. 20581 Regulatory Agency for Futures Tradin 9

--2--

. S u m m a r y o f F I N A L R E P O R T O N S T O C K I N D E X F U T U R E S A N D C A S H M A R K E T A C T I V I T Y D U R I N G O C T O B E R 1 9 8 7

C A S C A D E T H E O R Y

The final r e p o r t a d d r e s s e s the a s s e r t i o n that s t o c k i n d e x futures trading, s p e c i f i c a l l y p o r t f o l i o i n s u r a n c e c o m b i n e d w i t h s t o c k m a r k e t / f u t u r e s m a r k e t a r b i t r a g e activities, c a u s e d a

d o w n w a r d spiral in s t o c k prices. This s p i r a l is c o m m o n l y

r e f e r r e d to as the "cascade" effect. T h i s "cascade" s c e n a r i o is m o s t f r e q u e n t l y r e c o u n t e d as follows: s t o c k p r i c e s b e g i n to d e c l i n e as a result of f u n d a m e n t a l l y n e g a t i v e e c o n o m i c news;

p o r t f o l i o h e d g e r s then put p r e s s u r e on f u t u r e s p r i c e s as t h e y use the r e l a t i v e l y liquid, low t r a n s a c t i o n - c o s t futures m a r k e t s t o i n c r e a s e t h e i r short futures h e d g e s in light of d e c l i n i n g s t o c k prices; s t o c k index futures b e g i n t r a d i n g at a s i g n i f i c a n t

d i s c o u n t to the stocks in the u n d e r l y i n g index; a r b i t r a g e u r s e n t e r the markets, b u y i n g the (relatively) u n d e r p r i c e d f u t u r e s and s e l l i n g the (relatively) o v e r p r i c e d r e p l i c a t i n g b a s k e t of stocks; s t o c k p r i c e s then d e c l i n e further; m o r e short h e d g i n g t a k e s p l a c e in the futures market; and that b e g e t s more a r b i t r a g e s e l l i n g in the s t o c k market, etc.

Careful a n a l y s i s of s p e c i a l s u r v e y data c o l l e c t e d j o i n t l y by the CFTC and the SEC for the p e r i o d O c t o b e r 14 t h r o u g h 23

i n d i c a t e s t h a t the actual t r a d i n g p a t t e r n s w h i c h o c c u r r e d in m i d - O c t o b e r do not c o r r e s p o n d with the t r a d i n g a s s u m p t i o n s w h i c h w o u l d have to o c c u r to s u p p o r t the c a s c a d e theory.

The CFTC a n a l y s i s a l s o e x a m i n e d i n t r a - d a y t r a d i n g a c t i v i t y , s p e c i f i c a l l y a r b i t r a g e and p o r t f o l i o i n s u r a n c e strategies, on O c t o b e r 16, 19, 20 and 22 and found no s u p p o r t for the a s s e r t i o n that futures p r i c e s led s t o c k m a r k e t p r i c e s in a d o w n w a r d spiral.

The i n t r a - d a y a n a l y s i s i n d i c a t e s that, d u r i n g the p e r i o d s w h e n the r e p o r t e d futures p r i c e s were at an e x t r e m e d i s c o u n t to s t o c k p r i c e s (e.g., the m o r n i n g s of O c t o b e r 19 and 22), a s i g n i f i c a n t p o r t i o n of t h o s e d i s c o u n t s o c c u r r e d w h e n a s u b s t a n t i a l n u m b e r of the s t o c k s i n c l u d e d in the S&P 500 index w e r e not a c t i v e l y

t r a d i n g . Thus, the index was d i s t o r t e d by i n c l u d i n g the l a s t - r e p o r t e d "stale" p r i c e s of t h e s e stocks.

L E V E L S O F A R B I T R A G E A N D P O R T F O L I O H E D G I N G A C T I V I T Y

On O c t o b e r 16 and 19 the largest a r b i t r a g e trades a c c o u n t e d for a b o u t ii and 6 p e r c e n t (nearly 38 m i l l i o n shares) of N Y S E v o l u m e for t h o s e days, respectively. T h e s e levels w e r e l o w e r than index a r b i t r a g e sell p r o g r a m s on O c t o b e r 14, w h e n a r b i t r a g e a c c o u n t e d for more than 13 p e r c e n t of total NYSE s t o c k sales.

P o r t f o l i o hedge sales in the C h i c a g o M e r c a n t i l e E x c h a n g e ' s

(CME) S&P 500 futures m a r k e t were at t h e i r h i g h e s t levels on

O c t o b e r 16, 19 and 20. D a i l y g r o s s s a l e s r a n g e d from n e a r l y

" - 3 -

1 5 , 0 0 0 to n e a r l y 3 4 , 0 0 0 S & P 500 f u t u r e s c o n t r a c t s , a m o u n t i n g t o b e t w e e n i0 to 30 p e r c e n t of t o t a l d a i l y v o l u m e in t h e S & P 500 f u t u r e s m a r k e t .

S i n c e i n d e x a r b i t r a g e w a s o n l y s i g n i f i c a n t f r o m O c t o b e r 14 t h r o u g h 19, a n d p o r t f o l i o h e d g e s e l l i n g w a s s u b s t a n t i a l o n l y o n O c t o b e r 16 t h r o u g h 20, a s i g n i f i c a n t d o w n w a r d p r i c e p r e s s u r e c a u s e d b y t h e t w o t r a d i n g s t r a t e g i e s m o s t l i k e l y w o u l d h a v e o c c u r r e d on O c t o b e r 16 a n d 19. T h e a n a l y s i s o f t h e s u r v e y d a t a o n an i n t r a d a y basis, h o w e v e r , d o e s n o t s u p p o r t t h e c o n t e n t i o n t h a t t h e t w o t r a d i n g s t r a t e g i e s c o m b i n e d t o c a u s e t h e l a r g e f a l l in s t o c k p r i c e s e x p e r i e n c e d on t h o s e days.

F u r t h e r m o r e , on O c t o b e r 19, for e a c h h a l f - h o u r i n t e r v a l a f t e r i 0 : 0 0 a.m., s t o c k s a l e s a s s o c i a t e d w i t h o t h e r p r o g r a m

s e l l i n g n o t i n v o l v i n g f u t u r e s m a r k e t s w a s of a g r e a t e r m a g n i t u d e t h a n s t o c k s a l e s r e l a t e d t o i n d e x a r b i t r a g e .

P o r t f o l i o h e d g i n g s a l e s of f u t u r e s c o n t r a c t s c o n t i n u e d

t h r o u g h t h e d a y on the 19th. H o w e v e r , p o r t f o l i o s e l l i n g w a s n o t p a r t i c u l a r l y h e a v y d u r i n g p e r i o d s w h e n s t o c k m a r k e t p r i c e s f e l l t h e most, n o r p a r t i c u l a r l y l i g h t d u r i n g t h e s e p e r i o d s w h e n s t o c k p r i c e s w e r e r e c o v e r i n g . T h i s c o m p a r a t i v e s t a t i s t i c a l a n a l y s i s d o e s n o t s u p p o r t the c o n t e n t i o n t h a t p o r t f o l i o h e d g e s e l l i n g a n d a r b i t r a g e t r a d i n g c o m b i n e d t o c a u s e a d o w n w a r d s p i r a l in s t o c k p r i c e s .

S I G N I F I C A N C E OF T R A D I N G A C T I V I T Y A F T E R OCTOBER 2 0

A f t e r O c t o b e r 20, s t o c k p r i c e s c o n t i n u e d to be v o l a t i l e a l t h o u g h t h e r e w a s no s i g n i f i c a n t i n d e x a r b i t r a g e or s i g n i f i c a n t h e d g e s e l l i n g of futures. F o r e x a m p l e , o n O c t o b e r 22, w h e n t h e D o w fell 78 p o i n t s on v o l u m e of n e a r l y 400 m i l l i o n shares,

r e p o r t e d i n d e x a r b i t r a g e s t o c k s a l e s w e r e l e s s t h a n 3 m i l l i o n shares. S i m i l a r l y , on O c t o b e r 26, w h e n t h e D o w fell 157 p o i n t s on v o l u m e of o v e r 200 m i l l i o n shares, no i n d e x a r b i t r a g e t r a d e s w e r e r e p o r t e d .

A t t h e m a r k e t c l o s e on O c t o b e r 26, t h e D o w w a s o n l y 55 p o i n t s h i g h e r t h a n at t h e c l o s e on O c t o b e r 19. S t o c k p r i c e s a f t e r

O c t o b e r 19 d i d n o t r e c o v e r to t h e p r i c e l e v e l s of O c t o b e r 16, m u c h less to t h e l e v e l s of O c t o b e r i. T h e f a c t that s t o c k p r i c e s d i d n o t r e c o v e r e v e n w i t h o u t i n d e x a r b i t r a g e a c t i v i t y r e i n f o r c e s the c o n c l u s i o n t h a t f u t u r e s - r e l a t e d p r o g r a m t r a d i n g w a s n o t t h e p r i n c i p a l c a u s e of the c o l l a p s e of s t o c k p r i c e s . I n s t e a d , t h e w a v e of s e l l i n g t h a t e n g u l f e d b o t h the s t o c k and i n d e x f u t u r e s m a r k e t s , p a r t i c u l a r l y on O c t o b e r 19, a p p e a r s to h a v e b e e n

p r e c i p i t a t e d by a m a s s i v e c h a n g e in i n v e s t o r s ' p e r c e p t i o n s .

' -4-

T R A D I N G A N D O P E R A T I O N A L P E R F O R M A N C E O F S & P 500 I N D E X F U T U R E S C O N T R A C T

T h e o p e r a t i o n a l s y s t e m s of t h e C M E a n d its m e m b e r f i r m s

f u n c t i o n e d well, d e s p i t e h i g h v o l u m e a n d p r i c e v o l a t i l i t y in t h a t m a r k e t . W h i l e l a r g e r t h a n u s u a l n u m b e r s of o u t t r a d e s o c c u r r e d on O c t o b e r 16 a n d 19, t h e y w e r e l a r g e l y r e s o l v e d b e f o r e t r a d i n g

b e g a n t h e n e x t d a y b e c a u s e of s p e c i a l t r a d e c h e c k i n g s e s s i o n s . W h e n 23 C M E m e m b e r firms w e r e s u r v e y e d , t h e C F T C s t a f f f o u n d t h e i r o r d e r r o u t i n g and t r a d e e x e c u t i o n s y s t e m s f u n c t i o n e d w e l l a n d r e q u i r e d no s u b s t a n t i a l m o d i f i c a t i o n d u r i n g t h i s p e r i o d . T Y P E S O F P A R T I C I P A H T S I N T H E C M E S & P 500 I N D E X F U T U R E S M A R K E T

C M E a u d i t t r a i l d a t a d o c u m e n t t h a t all m a j o r t r a d i n g g r o u p s t h a t g e n e r a l l y t r a d e in t h e S & P 500 m a r k e t c o n t i n u e d t o t r a d e on O c t o b e r 19 a n d 20. CME m e m b e r s t r a d i n g for t h e i r o w n a c c o u n t s a b s o r b e d c u s t o m e r sell orders, i n c l u d i n g d u r i n g t h o s e t i m e s w h e n t h e m a r k e t fell t h e most. F u r t h e r m o r e , t h e n u m b e r of " p r i m a r y "

b r o k e r s e x e c u t i n g c u s t o m e r t r a d e s in t h e S & P 500 f u t u r e s m a r k e t i n c r e a s e d on O c t o b e r 19 and 20 f r o m t h e n u m b e r t r a d i n g on O c t o b e r 16. T h e r e f o r e , e x p e r i e n c e d b r o k e r s r e m a i n e d a v a i l a b l e to e x e c u t e c u s t o m e r orders.

R E C O M M E N D A T I O N S

B a s e d on the e v a l u a t i o n s a n d a s s e s s m e n t s in t h i s final r e p o r t a n d t h e e a r l i e r r e p o r t s i s s u e d b y t h e C o m m i s s i o n ' s s t a f f s i n c e O c t o b e r 19, the s t a f f h a s m a d e c e r t a i n r e c o m m e n d a t i o n s t o a u g m e n t or i m p r o v e s e v e r a l a s p e c t s of f u t u r e s m a r k e t r e g u l a t i o n . S o m e of t h e r e c o m m e n d a t i o n s are:

i. C u r r e n t m a r k e t s u r v e i l l a n c e s y s t e m s for s t o c k i n d e x f u t u r e s m a r k e t s t r a n s m i t to t h e C o m m i s s i o n , e a c h d a y for e a c h m a r k e t , d a t a d e t a i l i n g t o t a l m a r k e t a c t i v i t y , a g g r e g a t e p o s i t i o n s a n d t r a d i n g for e a c h c l e a r i n g m e m b e r , a n d t h e p o s i t i o n s of

i n d i v i d u a l t r a d e r s in e x c e s s of s p e c i f i e d r e p o r t i n g levels.

T h e s e d a t a a r e p r o v i d e d b y e x c h a n g e s , f u t u r e s c o m m i s s i o n m e r c h a n t s , c l e a r i n g m e m b e r s a n d f o r e i g n b r o k e r s a n d a r e

a v a i l a b l e for a n a l y s i s on t h e n e x t day. W h i l e t h e s t a f f b e l i e v e s c u r r e n t f u t u r e s m a r k e t s u r v e i l l a n c e s y s t e m s for s t o c k i n d e x

f u t u r e s a r e sound, i m p r o v e d d a t a c o l l e c t i o n c a p a b i l i t i e s in t i m e d s t o c k m a r k e t t r a n s a c t i o n s is n e c e s s a r y t o i m p l e m e n t a

c o m p r e h e n s i v e d a t a s y s t e m s p a n n i n g s t o c k a n d s t o c k i n d e x f u t u r e s t r a n s a c t i o n s a n d to e x p e d i t e s u b s e q u e n t a n a l y s i s o f t h e s e

m a r k e t s .

2. T h e s t a f f r e p o r t e d t h a t c o o r d i n a t i o n b e t w e e n r e g u l a t o r y

a g e n c i e s a n d e x c h a n g e s w a s g e n e r a l l y e x c e l l e n t d u r i n g O c t o b e r

1987. H o w e v e r , the s t a f f a l s o r e c o m m e n d e d b e t t e r s h a r i n g of

a c c u r a t e , t i m e l y i n f o r m a t i o n a n d c o o r d i n a t e d r e s p o n s e s b e t w e e n

s e c u r i t i e s and f u t u r e s e x c h a n g e s to s i t u a t i o n s , s u c h as d e l a y e d

o p e n i n g s a n d t r a d i n g h a l t s of N e w Y o r k S t o c k E x c h a n g e s t o c k s .

A d d i t i o n a l c o o r d i n a t i o n a m o n g e x c h a n g e s r e g a r d i n g e m e r g e n c y

c l o s i n g s a l s o s h o u l d be i m p r o v e d .

-= --5--

3. S e t t l e m e n t b a n k s s h o u l d h a v e a d d i t i o n a l a c c e s s to f i n a n c i a l a n d p o s i t i o n d a t a r e g a r d i n g t h e i r c u s t o m e r c l e a r i n g m e m b e r firms to f a c i l i t a t e b a n k c r e d i t d e t e r m i n a t i o n s and to v e r i f y the a v a i l a b i l i t y of funds to satisfy v a r i a t i o n m a r g i n obligations.

4. F u t u r e s e x c h a n g e s should c o n s i d e r t h e a d d i t i o n of a p e r c e n t a g e " c u s h i o n - to m a r g i n levels to e n s u r e g r e a t e r

p r o t e c t i o n a g a i n s t u n e x p e c t e d p r i c e spikes. M a r g i n systems s h o u l d b e r e v i e w e d to assure t h e y a d e q u a t e l y a d d r e s s i n c r e a s e d risks c r e a t e d by futures p o s i t i o n s c o n c e n t r a t e d in one market.

5. A g g r e g a t e d i n t e r m a r k e t m a r k e t p o s i t i o n d a t a s h o u l d b e s h a r e d a m o n g r e g u l a t o r s a n d s e l f - r e g u l a t o r s for f i n a n c i a l

s u r v e i l l a n c e of firms' p o s i t i o n s in related markets.

6. F r o n t r u n n i n g g e n e r a l l y has been d e f i n e d as t r a d i n g w h i l e in p o s s e s s i o n of n o n p u b l i c i n f o r m a t i o n c o n c e r n i n g "block"

s e c u r i t i e s or s e c u r i t i e s o p t i o n s orders that a f f e c t or c o u l d

a f f e c t t h e m a r k e t p r i c e of the i n s t r u m e n t p u r c h a s e d or sold. The q u e s t i o n of f r o n t r u n n i n g has r e c e n t l y been r a i s e d in regard t o i n t e r m a r k e t a c t i v i t y b e t w e e n s e c u r i t i e s and futures markets.

Both s e c u r i t i e s and futures e x c h a n g e s have rules that can be a p p l i e d to such activity.

The C F T C staff s u g g e s t s t h a t s t a n d a r d s b e e s t a b l i s h e d t o i d e n t i f y p o t e n t i a l i n t e r m a r k e t f r o n t r u n n i n g t r a d i n g p a t t e r n s a n d a m e c h a n i s m b e e s t a b l i s h e d to e f f e c t i v e l y c o m m u n i c a t e m a r k e t s u r v e i l l a n c e d a t a to all e x c h a n g e s r e l a t e d to p o s s i b l e front- running activities. The CFTC s t a f f has i d e n t i f i e d the

I n t e r m a r k e t S u r v e i l l a n c e Group, a g r o u p c r e a t e d in 1981 to

c o o r d i n a t e i n d u s t r y w i d e e x c h a n g e of i n f o r m a t i o n and r e s p o n s e s to r e g u l a t o r y issues w i t h i n the s e c u r i t i e s industry to a s s u r e t h e i n t e g r i t y of options and e q u i t i e s trading, as an a p p r o p r i a t e forum to f a c i l i t a t e c o m m u n i c a t i o n of i n t e r m a r k e t s u r v e i l l a n c e data n e e d e d to m o n i t o r such activities. CFTC staff also is

c o n s i d e r i n g the p o s s i b i l i t y of r e g u l a t o r y a c t i o n on f r o n t r u n n i n g . T h e a n a l y s i s in this report was b a s e d on large t r a d e r d a t a t r a n s m i t t e d each day to the C o m m i s s i o n for each futures market, on a c o o p e r a t i v e s u r v e y of m a j o r b r o k e r / d e a l e r s and sponsors of i n s t i t u t i o n a l h e d g i n g p r o g r a m s c o n d u c t e d with the S e c u r i t i e s and E x c h a n g e Commission, and on data o b t a i n e d t h r o u g h the C h i c a g o M e r c a n t i l e E x c h a n g e ' s c o m p u t e r i z e d audit trail system, w h i c h allows the i d e n t i f i c a t i o n of t r a d e s by individual c u s t o m e r s w i t h i n one m i n u t e time intervals.

C o p i e s of this final report and the other reports i s s u e d by the C o m m i s s i o n staff since O c t o b e r 19 are a v a i l a b l e from the Office of C o m m u n i c a t i o n and E d u c a t i o n Services, (202) 254-8630.

The o t h e r reports p r e v i o u s l y issued are: An X n t e r l m R e p o r t o n

Stock I n d e x F u t u r e s a n d C a s h M a r k e t A c t i v i t i e s d u r i n g O c t o b e r

1987, F o l l o w - u p R e p o r t on the F i n a n c i a l O v e r s i g h t of S t o c k I n d e x

F u t u r e s M a r k e t s d u r i n g O c t o b e r 1987, and A n a l y s i s of T r a d i n g in

the C h i c a g o B o a r d of T r a d e M a j o r M a r k e t Index on O c t o b e r 20,

1 9 8 7 .