Electronic Bulls and Bears: U.S. Securities

Markets and Information Technology

September 1990

OTA-CIT-469

NTIS order #PB91-106153
Recommended Citation:

U.S. Congress, Office of Technology Assessment, Electronic Bulls & Bears: U.S. Securities

Markets & Information Technology, OTA-CIT-469 (Washington, DC: U.S. Government

Printing Office, September 1990).

For sale by the Superintendent of Documents

U.S. Government Printing Office, Washington, DC 20402-9325

(order form can be found in the back of this report)
Foreword

Communication and information technologies—the telegraph, then ticker tape, telephones, and now computers—have historically played important roles in structuring and

improving the operation and performance of securities markets. In 1975, Congress-realizing

the potential of computer and telecommunications systems for improving competitiveness

among U.S. securities markets and dealers-enacted the Securities Exchange Act Amendments. This Act sets forth goals for an electronically integrated ‘national market system’ that

would lead to improved liquidity, higher efficiency, fairness to all domestic investors, and

greater attractiveness of U.S. markets to international investors.

This report, Electronic Bulls and Bears: U.S. Securities Markets and Information

Technology, responds to requests by the House Committee on Energy and Commerce and the

House Committee on Government Operations to assess the role that communication and

information technologies play in the securities markets. The Committee desired a benchmark

for gauging progress made toward the national market system envisioned by the 1975 Act.

This report assesses the current use of information technology by U.S. securities exchanges

and over-the-counter dealers, by related futures and options markets, and by associated

industries and regulatory agencies.

OTA characterizes the present U.S. securities markets as the most liquid, efficient, and

fairest in the world, but still there are serious problems besetting or threatening the U.S.

markets. Some of these problems result from the reluctance to accept and adapt technologies

that may threaten traditional roles and long-standing business relationships. Others are caused

by the forces of information technology that now link securities, futures, and options markets

into a seamless web of transactions. There is also a mismatch between the capabilities of

technology to link these markets and the fragmented jurisdictions of the agencies that are

charged with regulating them.

Technology is a double-edged sword that must be used with care and skill. Information

technologies will never supplant human function and reason, but when properly and

judiciously used they can help achieve the objectives of the 1975 Act.

OTA thanks the Advisory Panel and the many workshop participants, contractors,

contributors, and reviewers who contributed to the report. All were unfailingly generous with

their knowledge, judgment, and time in helping OTA in this assessment. OTA, of course, bears

sole responsibility for the contents of this report.

 Directo r
John Bachman

Managing Partner

Edward D. Jones &

John C. Baldwin

Director

Securities Markets and Information Technologies

Advisory Panel

Paul l?. Glaser, Chairman

President, Quotron Systems, Inc.

co.

James Martin

Executive Vice President

Teachers Insurance Annuity Association

College Retirement Equities Fund

Martin Mayer

Utah Department of Business Regulation Journalist

Allan Bretzer

Vice President

Midwest Stock Exchange

William Brodsky

President and Chief Executive Officer

Chicago Mercantile Exchange

Eric Clemens

Professor

Wharton School

University of Pennsylvania

James B. Cloonan

President

American Association of Individual Investors

Jack A. Conlon, Jr.

Executive Vice President

NIKKO Securities Co., Inc.

Janine Craane

Financial Consultant

Merrill Lynch, Pierce, Fenner & Smith, Inc.

Gene L. Finn

Chief Economist and Vice President

National Association of Securities Dealers

Richard GraSSO

President and Chief, Operating Officer

New York Stock Exchange

William Haraf

Vice President

Citicorp

Robert E. Litan

Senior Fellow and Director of Center for Economic

Progress and Employment

Brookings Institution

NOTE: OTA appreciates and is grateful for the valuable assistance and thoughtful critiques provided by the advisory panel members.

The panel does not, however, necessarily approve, disapprove, or endorse this report. OTA assumes full responsibility for the

report and the accuracy of its contents.

iv

Robert McEwen

President

Conference of Consumer Organizations

Charles McQuade

President

Securities Industry Automation Corp.

Susan Phillips

Vice President

University of Iowa

Peter Schwartz

President

Global Business Network

Howard Sherman

Department of Economics

University of California, Riverside

Robert Shiner

Yale University

Cowles Foundation

Hans R. Stoll

Director

Financial Markets Research Center

Owen Graduate School of Management

Vanderbilt University

Alan Strudler

Research Scholar

Institute for Philosophy and Public Policy

University of Maryland, College Park
Electronic Bulls and Bears: U.S. Securities

Markets and Information Technology

OTA Project Staff

John Andelin, Assistant Director, OTA

Science, Information, and Natural Resources Division

James W. Curlin, Program Manager

Communication and Information Technologies Program

Vary T. Coates, Project Director

Charles K. Wi1k, Senior Analyst

Danamichele Brennen, Inhouse Contractor

Steven Spear, Research Analyst

Mark Anstine, Research Assistant

Administrative Staff

Liz Emanuel, Office Administrator

Karolyn St. Clair, Secretary

JoAnne Price, Secretary

Contractors

James Butkiewicz

University of Delaware

Eric Clemens

University of Pennsylvania

Robert DeContreras

IBM Corp.

Dennis Earle

Bankers Trust Co.

Michael Hoffman

Bentley College

Don McNees

Peat Marwick & Co.

Junius Peake

The Peake/Ryerson Consulting

Group, Inc.

David Ratner

University of San Francisco

Law School

Monica Roman

Trading Technology, Inc.

Anthony Saunders

New York University

Peter Schwartz

Global Business Network

Charles Seeger

Chicago Mercantile Exchange

Joel Seligman

University of Michigan Law School

Manning Warren III

University of Alabama School of Law
Workshop Participants

Morris Mendelson

University of Pennsylvania

Clearing & Settlement Donald Solodar

New York Stock Exchange Andrea Corcoran

Commodity Futures Trading Commission Junius Peake

The Peak/Ryerson Consulting Group, Inc.

Shyam Sunder

Carnegie-Mellon University

Dennis Dutterer

Chicago Board of Trade Clearing Corp.

Dennis Earle

Bankers Trust Co.

Donald W. Phillips

Ameritech

Richard Van Slyke

Polytechnic University, New York

Robert Schwartz

Stem School of Business

R.T. Williams

R. Shriver Associates, Inc. Roberta Green

Federal Reserve Bank of New York

John Hiatt

Options Clearing Corp.

Joel Seligman

Michigan State University

Scenarios on International

Securities Trading

Bruce Simpson

Chicago Board Options Exchange

Peter Bennett

International Stock Exchange Jonathon Kalman

Securities and Exchange Commission

Gerard P. Lynch

Morgan Stanley Co., Inc.

John W. McPartland

Chicago Mercantile Exchange

Donald J. Solodar

New York Stock Exchange

Michael Wailer-Bridge

International Stock Exchange

Lewis Solomon

George Washington University Law

School

Eric Clemens

University of Pennsylvania

James Cochrane

New York Stock Exchange Hans R. Stoll

Vanderbilt University Junius Peake

The Peake/Ryerson Consulting Group,

Inc.

Michael Reddy

Merrill Lynch World

Roberta Green

Federal Reserve Bank of New York Paula Tosini

Futures Industry Association David Hale

Kemper Financial Services The Role of Securities Markets in the

U.S. Economy Martin Mayer

Journalist

Robert Woldow

National Securities Clearing Corp. James Butkiewicz

University of Delaware Todd Petzel

Chicago Mercantile Exchange

Technology in Securities Markets

Gerald Cavanaugh

University of Detroit Richard Breunich

Merrill Lynch & Co., Inc. Peter Schwartz

Global Business Network Jim Cochran

New York Stock Exchange Ron Dale

Midwest Stock Exchange Marming Warren

University of Alabama School of Law Richard Florida

Carnegie Mellon University Patricia Hillman

Bank of Boston Links Between Equities and

Derivative Products Markets Ronald Gallatin

Shearson, Lehman, Hutton, Inc. George Kenney

American Stock Exchange

Robert M. Mark

Manufacturers Hanover Trust Co.

Harold McIntyre

Citibank Financial Institutions Group

John Parady

Pacific Stock Exchange

Brandon Becker

Securities and Exchange Commission David Hale

Kemper Financial Services William Brodsky

Chicago Mercantile Exchange Douglas Henwood

Left Business Observer Richard Chase

Philadelphia Stock Exchange Robert Makay

Commodities Futures Trading

Commission Andrea Corcoran

Commodities Futures Trading

Commission Junius Peake

The Peake/Ryerson Consulting Group,

Inc.

Richard Sylla

North Carolina State University Gene Finn

National Association of Securities Eugene White Joe Rhyne

Quotron Systems, Inc. Dealers Rutgers University

Banks and Securities Markets

.

Lawrence Larkin Donald D. Serpico

Chicago Mercantile Exchange First Boston Corp. Mike Becker

Citizens for a Sound Economy Casimir Skrzypczak David Lipton

NYNEX Corp. Catholic University

vi
Gunter Duffey

University of Michigan

Catherine England

CATO Institute

Gerald Hanweck

George Mason University

Myron Kwast

Federal Reserve Board

Irving Leveson

Hudson Strategy Group, Inc.

Robert Litan

Brookings Institution

Anthony Saunders

New York University

The Small Investor

Lewis W. Brothers

Virginia State Corporation Commission

Janine Craane

Merrill Lynch, Pierce, Fenner & Smith,

Inc.

Greg Dorsey

Investor Research Center, KCI

Gene Finn

National Association of Securities

Dealers

Robert E. Frederick

Bentley College

Michael Hoffman

Bentley College

Marcia Kramer Mayer

American Stock Exchange

David Lipton

Catholic University

Jennifer Mills Moore

University of Delaware

Thomas Murray

TJM Securities Inc.

Lisa Newton

Fairfield University

Lynn Sharp Paine

Georgetown University

Lee Poison

North American Securities Administrators

Association

Diana Robertson

University of Pennsylvania

Alan Strudler

University of Maryland

Tom Wilkinson

Associate Attorney

Office of John Caldwell

Systems Discussion Workshop

Robert Anthony

Institute for Defense Analyses

Robert Crosby

FAA Automation Service

Robert Knisely

Systems Research and Applications

David McCaffrey

State University of New York, Albany

George Richardson

State University of New York, Albany

Elin Smith

Old Dominion University

Stuart Umpleby

The George Washington University
Other Reviewers and Contributors

Alden Adkin

Securities and Exchange Commission

Anthony Ain

Securities and Exchange Commission

Julius Allen

Congressional Research Service

David Alywood

National Strategies, Inc (for Reuters,

International)

George Ball

Prudential-Bache Securities

Richard Barry

New Jersey Bureau of Securities

Brandon Becker

Securities and Exchange Commission

John Behof

Federal Reserve Bank of Chicago

Gerald Beier

Chicago Mercantile Exchange

Peter Bennett

International Stock Exchange

Alan Biller

Alan Biller & Associates

Marshall Blume

University of Pennsylvania

Dan Brooks

Cadwalader, Wickersham, & Taft

Isolde Burik

Chicago Mercantile Exchange

Mary Ann Callahan

International Securities Clearing Corp.

Dale A. Carlson

Pacific Stock Exchange

James Cochrane

New York Stock Exchange

Andrea Corcoran

Commodity Futures Trading Commission

Richard J. Cowles

Consultant

Jim Croftwell

Boston Stock Exchange

Ron Dale

Midwest Stock Exchange

John P. Davidson, III

Chicago Mercantile Exchange

Harry Day

New York Stock Exchange

Dennis A. Dutterer

Chicago Board of Trade Clearing Corp.

Dennis Earle

Bankers Trust Co.

Frank Edwards

Center for the Study of Futures Markets

Columbia University

Susan Ervin

Commodity Futures Trading Commission

Mark Fitterman

Securities and Exchange Commission

Giulia Fitzpatrick

Bankers Trust Co.

Jane Fried

Bankers Trust Co.

Daniel Gillogli

Assistant U.S. Attorney

Gary Ginter

Chicago Research & Trading Group, Ltd.

David Gitlitz

United Shareholders Association

Frances Grace

Editor

Andrew N. Grass, Jr.

Security Traders Association

Roberta Green

Federal Reserve Bank of New York

David D. Hale

Kemper Financial Services, Inc.

Kenneth Hall

Securities and Exchange Commission

John Hiatt

Options Clearing Corp.

Dan Hochvert

NYNEX Corp.

Gary Hughes

American Council of Life Insurance

Kruno Huitzingh

The Chicago Board Options Exchange

Brian Hunter

American Bankers Association

Jonathan Kallman

Securities and Exchange Commission

Peter Karpen

First Boston Corp.

Rick Ketchum

Securities and Exchange Commission

Edward Knight

Congressional Research Service

Olaf E. Kraulis

The Toronto Stock Exchange

Raleigh Kraft

Prudential Bache, Inc.

David Liebschutz

Public Securities Association

Alan Loss

Asset Management Technology Corp.

Louis Lowenstein

Columbia University

Wayne Lutheringshausen

Options Clearing Corp.

Gerard P. Lynch

Morgan Stanley & Co. Inc.

Robert M. Mark

Manufacturers Hanover Trust Co.

Robert S. McConnaughey

American Council of Life Insurance

Harold McIntyre

Citibank Financial Institutions Group

Jim McLaughlin

American Bankers Association

John W. McPartland

Chicago Mercantile Exchange

Morris Mendelson

University of Pennsylvania

Merton H. Miller

University of Chicago

Richard Minck

American Council of Life Insurance

Kurt Mueche

Union Bank of Switzerland

Thierry Noyelle

Columbia University

Peg O’Hara

Investor Responsibility Research Center,

Inc.

G.W. Palmer

AT&T Bell Laboratories

Todd E. Petzel

Chicago Mercantile Exchange

Richard Pogue

Investment Company Institute

Irving Pollack

Merrill Lynch

WI
Lee Poison

North American Securities Administrators

Association

Paul Quirk

Pension Reserves Investment Management

Board

Ira Rafaelson

U.S. Attorney

Paul Reardon

American Council of Life Insurance

Michael J. Reilly

Reuters America, Inc.

Ivers Riley

American Stock Exchange

Joseph Rosen

Rosen, Kupperman Associates

Steven N. Roth

Technical Analysis Group

Thomas Russo

Cadwalader, Taft& Wickersham

Roger P. Rutz

Board of Trade Clearing Corp.

Mark Rzepczynski

Chicago Mercantile Exchange

Pavan Sahgal

Wall Street Computer Review

Martha Scanlon

Federal Reserve Board of Governors

Jeffrey M. Schaefer

Securities Industry Association

Robert Schwartz

New York University

Charles M. Seeger

Chicago Mercantile Exchange

Joel Seligman

University of Michigan

School of Law

Donald D. Serpico

Chicago Mercantile Exchange

Yuji Shibuya

Nomura Research Institute

Steve Shoepke

Investment Company Institute

Bruce Smith

Philadelphia Stock Exchange

James Smith

New Jersey Bureau of Securities

Scott Stapf

North American Securities Administrators

Association

Roxanne Taylor

Quotron Systems, Inc.

Paula Tosini

Futures Industry Institute

John Turner

Pension & Welfare Benefits

Administration

U.S. Department of Labor

Christine Trudeau

Montreal Exchange

Richard Van Slyke

New York Polytechnic University

Marming Warren, III

University of Alabama School of Law

Kevin Winch

Congressional Research Service

Dwayne Witt

North American Securities Administrators

Association

Robert Woldow

National Securities Clearing Corp.

Eric S. Wolff

Chicago Mercantile Exchange

Robert Wood

Pennsylvania State University

Stephen Wunsch

Kidder Peabody & Co.

Karen Saperstein

National Securities Clearing Corp.
Contents

Page

Chapter l. Summary: Publicand Securities Markets ........ ”” ”” ”” ”” ”” ”” ”” ””s. ””””””.””””” 3

Chapter 2. What Securities Markets Do-And For Whom . .......””.”-”””-”””””””””” ““”””””””””. 25

Chapter 3. The Operation of Stock Markets .. .. ”” ”” ”” ”” ”” ””””””.”” ““” ”” ”” ” ” ”” ”” ”” ”” 41

Chapter 4. The Operation of Futures Markets....”.-... . . . . . . . . . . . . . . . . . . . . . . . . . . . .....”...... 69

Chapter 5. The Operation of Options Markets . . . . . . . . . . . . . . . . . . . . . . . .. .. .. .. .. .. .” ..o. . . . . . . . . . 93

Chapter 6. Domestic Clearing and Settlement: What Happens After Trade . . . . . . . . . . . . . . . . . . . . . 107

Chapter 7. How Technology Is Transforming Securities Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

Chapter 8. Market Fraud and Its Victims.. . . . . . . . . . . . . . . . . ................ . . . . . . . . . . . . . . . . . 149

Chapter 9. The Bifurcated Regulatory Structure . . . . . . . . . . . . . . . . . ................. ............. 167

Appendix. Clearing and Settlement in the United States.......... . . . . . . . . . . . . . . . . . .......... 181

Acronyms and Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .“...”.....”..... 194

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ........ ,....., . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
Chapter 1

Summary: Public Policy and

Securities Markets
CONTENTS

Page

THE PUBLIC INTEREST IN SECURITIES MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The Investors . . . . . . . . . . . . . . . . . . . . . . . . . ... ........+.. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Brokers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ● .........................

SECURITIES MARKETS UNDER PRESSURE.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The Specialist System ................ ......................................

The Crash of 1987 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. .. .. .. .. .. .........

Securities Markets and Competition .. .. ... .. . . . . . . . .. .. .. .. ... ... .........*.+.’

Technological Directions for the Future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE OPERATION OF FUTURES MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Issues Related to Futures Market Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Issues Related to Stock-Index Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ISSUES RELATED TO OPTIONS TRADING .. .. .. .. .. .. .. .. .. ... +.. . . . . . . . . . . . . .

CLEARING AND SETTLEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . .

TECHNOLOGY AND SECURITIES TRADING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE REGULATORY STRUCTURE FOR MARKETS .. .. .. .. .. .. .. .. ... ..+. . . . . . . .

Redefinition of Jurisdictions . . . . . . . . . . . . . . . ........ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

An Inter-Market Coordination Panel ... .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5

6

7

7

8

9

10

12

13

14

15

16

17

18

20

20

21

22

22 “ .
Chapter 1

Summary: Public Policy and Securities Marketsl

U.S. securities markets have been changed by

strong social, technological, economic, and political

trends over the past two decades. During the 1970s

automated systems were put in place, institutions

emerged as dominant investors, new kinds of

financial instruments began to trade, and Congress

passed landmark legislation encouraging greater

competition among markets. In the 1980s securities

and futures markets became linked through new

financial products and computer-assisted trading

strategies. The decade of the 1990s will bring still

greater challenges for the markets, their regulators,

and congressional oversight committees, as foreign

competition becomes intense and electronic trading

systems mature.

The world is moving toward electronic around-theclock and around-the-globe securities trading.2 These

challenges will require strong efforts to maintain

efficiency and fairness and to meet the needs of

domestic and foreign investors. The ability of U.S.

markets to compete with foreign counterparts is

becoming critical. The U.S. regulatory structure will

have to maintain and protect essential domestic

policy objectives in an environment buffeted by

change. The regulatory structure, designed for yesterday’s markets and assets, may not be up to

tomorrow’s tasks. New or revised legislation may

become necessary. The private sector cannot achieve,

without government assistance, some of the necessary adjustments to keep American markets strongly

competitive and to protect American investors and

financial systems.

Securities markets are created by the exchange of

information-bids, offers, orders, and prices. The

efficiency of the technology used to send and receive

information shapes the markets’ structure and operation.3 From the first telegraph in 1846 to electronic

order routing systems in 1990, information technology has greatly increased the speed with which

orders move from customer to broker to dealer.

Increases in speed or in control over the direction of

information flow can mean large profits or losses in

securities markets. The obvious advantages of better

technology have always in the past eventually

overcome inertia, tradition, and cost to bring information technology into markets. Eager traders

sooner or later seek the benefits of advanced

technology for themselves and for their customers,

either on established markets or by trading outside

of those markets.

Now information technology is moving beyond

merely routing and transmitting market data and

orders, to acting on that information. It can automatically queue and match bids and orders, execute

trades, move them through final settlement, and

create an audit trail. The security itself can exist only

in electronic form, with no printed certificate.

Although some foreign exchanges are putting in

place early versions of completely electronic marketplaces, no one is sure of what the costs, benefits,

and risks of such systems would be. There is

insufficient experience as yet to provide a basis for

policymakers to mandate specific technological

changes.

Fifteen years ago, Congress instructed the Securities and Exchange Commission (SEC) to guide and

assist U.S. securities markets in using technology to

create an efficient and fair national market system.4

The SEC was to promote vigorous, open competition among exchange markets and over-the-counter

(OTC) markets, among brokers and dealers, and

among customer orders. The intent of Congress has

Ims chapter is a summary of the report as a whole. For citations and for extended explanation or development of points, readers must go to the other

chapters.

2see OTA Ba&ground p~m, l“r@~g Arou~ the Clock: Global Secun”ties Markets andlnfo~fi”on Technology, OTA-BP-W-66, (_waSh@tOq

DC: U.S. Government Printing Offke, July 1990).

36’S=~ties’ 9 WMIIy refers to stocks, bonds, options, and closely related instruments that are either means of mpiti formation or contrac~ rights

to buy and sell such assets (i.e., options). Equity securities are stocks-shares in the ownership of corporations. Debt securities include corporate,

municipal, and U.S. Treasury notes and bonds. Debt securities are sometimes called “fixed-income securities,” because in the.past most debt has carried

a fixed rate of interest; now debt securities includes both fixed- and variable-rate instruments. Options are contracts conferring the right to buy or sell

assets (e.g., stocks) at specifkd prices for a speciiled length of time. Futures are contracts creating an obligation to deliver or receive assets at a specii%xl

price at a future time. They are traded not on securities markets but on commodity markets. This assessment discusses futures contracts trading, primarily

stock-index futures, but does not otherwise cover commodity markets.

‘t~e Se.cfities Act Amendments Of 1975.

–3–
4 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

been reaffirmed through legislation, authorizations,

hearings, and recent legislative proposals.

Congress wisely did not specify how markets

should design technology to meet these goals,

leaving that up to market institutions. Decisions

about the use of new information technology, by the

markets, have however often favored preservation of

traditional market structures, trading techniques,

and professional skills-at times probably at the

expense of the best interests of the U.S. market

system as a whole. Insistence on maintaining

personal intermediary roles and traditional face-toface bargaining techniques may have led to inflexibility in dealing with economic and institutional

forces for change.

At the same time, advanced information technology has encouraged market professionals and large

investors to use computer-assisted trading strategies

that can cause short-term price volatility, or spread

selling or buying pressure from one market to others.

Some people insist that financial markets have

become “excessively volatile”; others insist that

they are only more efficient (i.e., reflect investors’

changing judgments more swiftly). From 1955 to

1982, there were only two occasions when stock

market prices fell more than 4 percent in 1 day; from

1982 to mid-1990, there have been 10 such episodes.

Many investors conclude that this indicates increased short-term volatility since 1982, when

stock-index futures were introduced and computerassisted intermarket program trading became common.

The changes buffeting U.S. securities markets and

derivative products markets5 do not come solely

from technology. There are two other related factors:

1) the evolution of a global economy with multinational corporations seeking capital markets worldwide, and 2) the development of giant institutional

investors, with increasing opportunities to satisfy

their investment objectives in world markets. These

are institutions with large investment portfolios,

some worth billions of dollars. They include public

and private sector pension funds, insurance companies, mutual funds, labor unions, and banks. Institutional investors differ from individual investors in

many ways besides size. For example, they are

managed by full-time professionals, they have

fiduciary responsibilities (legal obligations to invest

prudently to the advantage of their beneficiaries);

they usually trade more often and are probably more

likely to hedge, and to hedge in more complex ways,

than individual investors. Many of them-such as

pension funds-are largely tax exempt.

Securities, futures, and options markets are increasingly interdependent because of the opportunities technology provides for interactions between

markets, for the purposes of portfolio hedging or

short-term profits. Dual regulatory agencies may no

longer be appropriate, for what is now one marketplace. The SEC and the Commodity Futures Trading

Commission (CFTC) often take radically different

positions on issues-e.g., on the tolerable level of

price volatility, the causes of market breaks, and the

efficacy of measures designed to calm markets under

stress. These differences raise doubt about the

reliability of their coordination and cooperation

during market emergencies. Other problems, especially recurring dispute over authority for new

products, also point to the need for improving the

regulatory structure.

Reassessment of the regulatory structure is timely

because U.S. markets currently have problems that

will be even more serious in the future. Exchangelisted securities trading may be moving away from

the primary exchanges to regional exchanges, OTC

markets, off-board trading, and foreign markets.

This is less a sign of healthy competition (since

institutional barriers and regulations still limit competition) than it is evidence of growing dissatisfaction with the quality and cost of exchange trading.6

There are problems in handling large block trades

and basket trades for institutional investors. (A block

trade is a transaction involving at least 10,000 shares

of one stock; a basket trade is the synchronized sale

or purchase of a large group or portfolio of many

different stocks.) Small investors are worried about

excessive price volatility and unacceptable levels of

market fraud or manipulation in both securities and

sD~vative products are those like Stock-inclex futures, stock options, and stock-index options, for which prices are depend~t on the Prices of *

market items (stocks).

6~ 1989 o~y 69 percent of ~ad~g iD stocks listed on the New York Stock Exchange (NYSE) was clone on tit exc~ni?e, the lowest ~~~e

ever reached. Some of the trading is done on regional exchanges, some on proprietary electronic exchanges, and in some weeks, as much as 17 pexcent

may be done in foreign markets. Usually price is not the detemining factor. See ch. 3.
derivative product markets. Futures and options

markets are criticized for developing products that

are suspected of increasing the likelihood of a

market crash. These problems call for a reexamination of public policies including changes in the

regulatory structure.

Stock exchanges have sophisticated trading support systems on their trading floors, but they have

resisted the use of electronic systems for after-hours

and remote-site trading. Just-announced plans for

after-hours electronic trading are belated, cautious,

and tightly limited. The OTC dealers represented by

the National Association of Securities Dealers

(NASD) are putting some international systems in

place now. Futures markets are moving to seize the

opportunity for around-the-clock and around-theglobe trading, but have resisted bringing technology

into their domestic trading pits. There are signs that

these conditions may be ready to change, but further

congressional and regulatory encouragement is needed.

THE PUBLIC INTEREST IN

SECURITIES MARKETS

[See ch. 2]

Should governments “interfere” with securities

markets? Some people believe that securities markets should be regulated only by the forces of the

marketplace. Others believe that government regulation is needed because there is a strong public

interest in the markets’ efficiency, fairness, and

competitiveness, and in their role in encouraging

investment in economic growth. To understand the

public policy issues related to securities markets,

one must understand what the role of securities

markets is in our economy, and how it is changing

in response to technology and to economic and

social forces.

The securities markets discussed in this assessment do not directly raise capital They are secon-
6 ● Electronic Bu1ls & Bears: U.S. Securities Markets & Information Technology

dary markets, for the public resale of securities after

their issue and first placement. Secondary markets

encourage people to invest their savings in securities

by making it possible to resell their investments for

cash when necessary, and by establishing the going

price for stocks and bonds. Futures and options

markets provide ways for people to hedge, or protect

the value of their investments by related market

transactions.

Securities markets have several vital functions in

a democratic-capitalist society:

Together with primary markets, they enable

corporations to raise capital for growth and

expansion, and make it possible for localj State,

and Federal governments to borrow money.

They help to direct capital toward its most

promising use.

They provide opportunities for people to increase their savings by investing them in

profit-producing enterprises.

They provide feedback and guidance to corporate management, by revealing the collective

judgment of investors about a corporation’s

potential.

They generate jobs and contribute to gross

national product.

Securities markets have other political or social

values as well. By giving citizens a tangible stake in

wealth-producing industry, they may encourage

citizens to pay attention to a broader range of

economic decisions and policies. Because securities

markets are sometimes considered barometers of

economic health, they may bean important factor in

maintaining confidence in our economic system.

But the importance of securities markets in the

economy is, nevertheless, often overstated. These

secondary markets do not directly generate capital,

and most corporate capital is not, in fact, raised by

issuing equity securities. Moreover, secondary markets may now be doing a poor job of resource

allocation. The economic welfare of most American

families is only indirectly affected, if at all, by stock

market performance. The vexing problem of low

national savings and investment probably cannot be

solved by making securities markets either more

efficient or less volatile. Finally, these markets

directly generate less than 1 percent of national GNP

and employment.7 The many proposals discussed in

this assessment for strengthening market structures

are aimed at improving the operating efficiency and

competitive position of U.S. securities markets, but

it should be recognized that they may have little

positive effect on American business or on the

business cycle. By the same token, efforts to

improve some aspects of market performance should

not necessarily be ruled out on the grounds of any

supposed negative effects on capital formation or

GNP.

In spite of these caveats, sound securities markets

and their smooth functioning are important. Public

officials are rightfully concerned with their performance and their fairness, especially as mutual funds

and pension funds investment increase the number

of Americans affected by market behavior. Happily,

improving the performance and fairness of securities

markets is in the interests of both honest market

participants and the general public. Most actions

toward that end can be taken by market participants

and private-sector institutions. The government role

may, for the most part, be to remove unnecessary

barriers to private-sector action. In some cases,

however, the self-interests of market participants

create resistance to desirable market improvements

or modernization, or otherwise do not match the

public interest. In these cases, more direct government actions may be necessary.

The Investors

Institutional investors increasingly dominate U.S.

securities markets in terms of total assets and

volume of trading (doing about 55 percent of all New

York Stock Exchange trades).8 The largest and most

numerous of institutional investors are corporate and

government pension funds (with about $2.2 trillion

in securities investments), insurance companies

(another $1.2 trillion in securities investments) and

mutual funds (assets of over $800 billion). The giant

institutions trade large blocks of securities and

allocate or hedge their portfolios in ways that can

move markets, especially when they act in unison.

7Approximately 1 million jobs nationwide are related to securities exchanges, OTC dealers, and brokerage firms. Employment in the futures industry

is estimated at approXimately 100,OOO.

s~ey d. not yet OW most of the st~ks, but their propofion of the ownership of WSBlisted Stocks ~timw~ over tie ~t 4Y-‘iom 13

pereent to nearly 50 pereent, Institutions own about 39 percent of OTC stocks. They also do&inate trading in privately phwed corporate securities, and

hold 87 percent of all privately placed aeeurities.
Chapter 1-Summary: Public Policy and Securities Markets ● 7

Their needs strongly influence the types of products

offered by exchanges.

Fewer than one in five trades are done for

individual investors, but individuals or households

still directly own about 50 percent of American

equity securities. There is a tiering of equity

ownership, with about 45 percent of all individual

portfolios holding less than $5,000, another 35

percent of individual investors with between $5,000

and $25,000 invested, and about 10 million individual investors (20 percent) with over $25,000 invested, probably averaging about $90,000.9

The United States has the highest level of

individual participation in securities markets of any

country. The long-term trend, however, is that small

investors are leaving the market as direct investors,

and are increasingly found under the umbrella of

institutional funds. This has broadened the base of

participation and given more Americans a stake in

the liquidity, efficiency, and fairness of securities

markets. But traditional public policies or regulatory

procedures, framed around the objective of protecting “the small investor,” may not recognize the

implications of these changing patterns of market

participation. It remains important to ensure investment opportunities and fair treatment for small

investors, but even more Americans may be adversely affected if the needs of institutional investors

are not also met.

Brokers

The brokerage industry has seen major changes in

its operations and structure during the past few

decades, driven by the paper-work crisis of the late

1960s, the unfixing of commission rates in the early

1970s, the departure of many retail investors from

direct investments in stock, and the increase of

institutional investors. Some effects have been

increased industry concentration,10 a decline in

brokerage fins’ profits from commission revenues,

and cyclical swings in the industry’s employment

and profit levels.

There have been other long-term effects, not all

beneficial for small investors. During the 1980s,

many firms broadened the scope of their brokerage

business to add personalized financial consulting

and other services and products, some of which are

particularly profitable because they generate underwriting fees and commissions in addition to annual

management fees. Brokers have a conflict of interest

in selling those products that generate the highest

commissions versus helping clients target on those

investments best suited to their needs. Institutional

investors that generate greater revenues may be

treated more favorably by brokerage firms than other

investors, paying lower commissions and having

better access to research and analysis. This may soon

create a three-tiered brokerage system with large

institutional investors, medium-size institutional

and large retail customers, and small retail customers treated differently.

SECURITIES MARKETS

UNDER PRESSURE

[See ch. 3]

U.S. securities markets are the largest and probably the world’s most liquid, efficient, and fair

securities markets. The New York Stock Exchange

(NYSE) lists 1,740 securities and does almost 95

percent of trading in exchange-listed stocks. The

smaller American Stock Exchange (AMEX) lists

860 stocks. There are also five regional exchanges.

About 4,300 securities are traded by OTC dealers.

Trading volume in the OTC market, largely because

of technology,ll has grown to almost 80 percent that

of the NYSE (in number of shares traded) .12 The

problems of U.S. markets today are, in many cases,

those of successful, growing markets that are slow to

recognize the implications of growth.

%ese estimates were based in part on survey data collected in 1985, and will have changed some. After the 1987 market crask small investors

decreased their direct investments and decreased their participation in mutual funds; more recently, they may have resumed their net purchases.

%1973 tie top 10 industry f~ac~unted for 33 pement of the industry’s share of capitalj but by September 1989, the~ she ~d in~- to

61 percent.

llun~ 1971, OTC quotations were published only on dtily ‘‘Pink Shmts.’ Since the introduction of an electronic system to display their quotations

(NASDAQ), OTC volume has grown rapidly. The automated quotation system (National Association of Securities Dealers Automated Quotation

System, or NASDAQ) displays timely dealer quotes on over 4,000 stocks (fm only for 100 share lots, or for those eligible for automated executio~

for up to 1,000 share lots); transactions are negotiated by telephone. (Small orders can be ffled electronically through the computerized Small Order

Execution System SOES.)

lzIt is, however, about 27 percent by dollar volume, because of the lower average pfice of OTC stocks.
8 ● Electronic Bulls& Bears: U.S. Securities Markets& Information Technology

Securities markets, in the United States, have

market-makers-dealers who stand ready, whenever

the market is open, to buy or sell securities at firm,

publicly displayed prices, or “quotations.” Stock

exchanges have one designated market-maker,

called a specialist, for each stock. The specialists are

exchange members, who in return for having the

unique and profitable role as dealer for several

assigned stocks, have an ‘affirmative obligation’ to

provide liquidity and to moderate and smooth out

price changes by buying for and selling from their

own inventory if there are no bids (or offers) near the

market price. They also have a “negative obligation’ not to buy or sell for themselves when there are

customer orders that can be matched (a buyer with

a seller) at a price acceptable to both. The OTC stock

market, in contrast, is made up of many marketmakers-an average of 10 dealers for an actively

traded stock—who do not match customer orders

directly, but make markets by buying and selling

stocks for and from their inventory. They compete

for customers’ orders by trying to make the most

attractive bid (to buy) or offer (to sell).

The Specialist System

Both exchange floor trading and the specialist

system (as well as procedures for OTC dealing)

evolved to serve markets that have now radically

changed. There are at least four serious strains on the

specialist system, which was developed to handle

moderate-sized orders, in ‘‘round lots” of 100

shares: 1) the greatly increased volume of trading, 2)

capital inadequacy, 3) large block trades, and 4)

basket trades.

Trading volume has increased in parallel with the

growth of large institutional investment funds, from

16 million shares daily in 1973 to 162 million daily

in 1989 (and 600 million daily in the midst of a

crash). There are sharp peaks in volume associated

with factors such as computer-assisted large transactions (“program trading”) and the expiration of

related futures and options contracts. The limitations

on specialists’ capital become apparent when many

institutional investors begin to sell large blocks and

baskets of stock at once. The ability of the specialist

to balance these sell orders by buying for his own

inventory may be rapidly exceeded.

The average size of a transaction on the NYSE is

now over 2,300 shares. In 1961, there were about 9

“large block” trades (10,000 shares bought or sold

in one transaction) per day, and they accounted for

only 3 percent of share volume. Now there are more

than 3,100 large block trades per day, accounting for

more than 45 percent of the shares traded. Many of

these blocks are of 250,000 shares.

Basket trades-the purchase or sale of many

different stocks (a portfolio) simultaneously or as

part of a single strategy-are usually the result of

inter-market hedging strategies, that is, balancing

stock investments with stock-index futures transactions. When many institutional investors are using

similar inter-market hedging strategies, the stock

exchange may be hit with a tidal wave of basket sales

(or purchases), so that the entire market seems

suddenly volatile.

These changes placed a heavy burden on the

specialist system, and exchanges made efforts to

relieve it. For example, the NYSE responded to the

challenge of large block trades13 by allowing large

securities firms to act as block positioners. They

effectively make markets ‘‘upstairs, ” soliciting and

putting together enough buyers (or sellers) to move

a block of stocks at a negotiated price. They must

still bring the block transactions to a specialist for

execution. This “fro” alleviated the problem, but it

is not a perfect solution. Liquidity for large blocks is

probably decreasing because big firms are less

willing to risk their capital as block positioners.

Block trades seem to be moving from the NYSE to

regional exchanges and the ‘‘fourth market’ in

search of better service.14

At the other end of the scale, small-order transactions were also a problem, becoming relatively more

expensive and less attractive to execute compared to

large blocks, after deregulation of commissions in

ls~e~exmtionw oneblockc~s~ly change thepriceeven ifonebuyer (or seller) can be found to take (or sell) the entire bloek order. Wwould

disadvantage other investors whose orders arrive or are on the limit order book while the block is being executed. Alternatively, the block has to be broken

up and worked off, which takes time.

ld~e ‘ffo~-et’is tie ~org-market of large institutions trading directly with one another, often through proprietary ~dw SYsterns,

without going through an organized market.
Chapter 1-Summary: Public Policy and Securities Markets ● 9

the early 1970s.15 Exchanges have installed automated order routing and execution systems for 1,000

shares or under.16

When the NYSE developed a new “basket

product,” the exchange elected not to use the

specialist system but to use competitive basket

market-makers, operating upstairs with computer

terminals. Like upstairs block positioning, the increased capitalization requirements, and the encouragement for large member firms to take over

specialist fins, these actions seem to be tacit

recognition of the limitations of the specialist

system.

Strains on the specialist system are likely to

increase. Barring another crash, the upward trend in

trading volume will resume as institutional investors

continue to grow both in numbers and in size.17

Program trading and large block trading are also

likely to increase. With growing cross-national

investment and international securities trading, foreign money can flush in and out of markets. The risk

that a market break will exceed specialists’ capitalization has not been removed.

Meanwhile, exchanges struggle to cope with the

awkward interface between electronic systems on

the one hand, and person-to-person bargaining on

the other hand. The threat to the NYSE is that its

customers will decide that its services are inadequate

or too expensive. But regional exchanges and OTC

dealers, unless more fully integrated by an effective

electronic order-routing system, may not offer the

depth and efficiency that a concentrated market

offers.

The Crash of 1987

In spite of the vigor of U.S. markets, the stock

market crash in October 1987 revealed three serious

problems yet to be fully solved:

●

●

●

the limits of technological systems when trading volume spikes,

limits on the ability of market-makers to

function when markets are under stress.

recurring excessive short-term volatility that

may promise further crashes.

Technological systems for quote dissemination,

order routing, and small order execution, in both

exchange and OTC markets, were overwhelmed by

the unprecedented volume of orders on October 19

and 20, 1987. Some failures of design had not been

apparent until the systems were stressed.18 Steps

have been taken in all of the markets to correct such

problems and increase the capacity of electronic

systems. But these systems for the most part only

deliver orders to a market-maker or otherwise

depend on personal intermediation at the transaction

stage. During the crash, not just the systems but the

market-makers also were overloaded and overwhelmed. The problems that occurred at the human/

machine interface are probably the most difficult to

correct, because human capacities are less expandable than machine capacity.

There were four major government studies of the

1987 crash, several exchange studies, and innumerable academic studies. No clear consensus emerged

about the cause of the crash, nor is there agreement

as to the cause of the near crash of October 1989.

Frequent sharp short-term price volatility has been

evident for about 4 years. Academic researchers

disagree about the definition of “volatility,” about

whether it has increased, and about the break point

between how much volatility is desirable and how

much is excessive. The traditional objective of fair

and orderly markets implies, nevertheless, that at

some level volatility is excessive.

lsBroker4~er ~~~~i~nswere re~t~~~1975; ~ter ~$ ~m@tionin offe~services for me investors drove their mks down while

rates charged to small investors remained higher. But the larger volume handled for institutional investors still makes these services more attractive for

brokerdeakrs.

16~sE~s S~pe..Dot ties orders up to 2,099 ~Ma The (_)Tc met, NASDAQ, dso h.s a small order execution SySteIn.

17Pemion fids ~d ~mmce ~ds sho~d continue to grow M the U.S. pop~ation grows. MuM tids may continue tO grOW zs .Wlld iIIVeStOrS

seek an institutional umbrella.

18For e=ple, tie NASDAQ auto~t~ Smd ~der fi~tionSyst- (SOES) WM designed to stop trading any stock hl which lockd Or CrOSS@d

orders occurred-i. e., the lowest priced offer to sell was equat to or lower than the highest priced bid to buy—and wait for the dealer to intervene. This

occurred during the crash because the dissemina tion of quotes fell behind rapid price changes.
10 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Certain kinds of computer-assisted trading, called

portfolio insurance, were implicated in the 1987

crash. 19 They had two disastrous characteristics: 1)

identical or similar computer programs were used by

many institutional investors, so that many large sell

orders were triggered almost simultaneously; and 2)

portfolio insurance called for selling stock when

prices were already dropping, which reinforced the

trend.

Portfolio insurance is implemented through program trading, the simultaneous sale (or purchase) of

large, diversfied “baskets” of stock, often but not

necessarily in conjunction with a balancing purchase

(or sale) in futures markets. Program trading (now

accounting for about 13 percent of shares traded on

the NYSE) is almost prohibitively cumbersome and

expensive without computer support.20 It could

involve hundreds of different stocks. When many

program traders attempt to buy, or to sell, huge

baskets of stock at the same time, the ability of the

market to provide liquidity-i. e., to execute these

transactions without the price moving sharply in

response-may be strained or exceeded. Proposals

have been made to curb program trading,21 but this

would not address the needs of institutional investors to trade and hedge large portfolios with the

lowest possible transaction costs.22

The most serious problem highlighted by the 1987

market crash is the limited capacity of marketmakers to respond to extreme price movement and

unprecedented high volume. Neither specialists nor

OTC dealers can assure liquidity in a period of

intense selling pressure caused by aggressive trading

by large institutions. Exchange specialists for the

most part tried hard to carry out their affirmative

obligation to buy when prices are falling, in order to

restore balance (to “lean against the market”).

Many specialist firms quickly exhausted their buying power, however, and others gave up in the face

of overwhelming selling pressure. At the most

critical point in the 1987 crash, it was necessary for

the Chairman of the Federal Reserve Board of

Governors to make a public announcement encouraging banks to extend credit to market participants

by promising that the Federal Reserve would back

them up.23

CapitaI requirements for specialist firms have

been increased since the crash, but the aggregate

capitalization of specialists will still probably be

inadequate on days when volume peaks and huge

order imbalances appear. Even before the crash, the

NYSE and AMEX had recognized this problem.

They changed their rules to encourage large brokerdealer firms to buy or affiliate with specialist firms.

However, there have been only four such acquisitions, and one of those firms has since gone

bankrupt.

The performance of OTC market-makers in the

NASDAQ system also faltered in October 1987.

Some withdrew from the small order execution

system, some probably abandoned the market altogether, and some ignored phone calls. Steps have

been taken to strengthen discipline and performance

in such situations% and telephone and computer

capacity have been enhanced.

Securities Markets and Competition

The Securities Act Amendments of 1975 directed

the SEC to facilitate the establishment of ‘a national

19A ~dely ac~pted scefio (but one disputed by the futures industry and the CFI’C) goes like this. When stock priCeS began to f~for w~tever

reasons, portfolio insuran ce programs were triggered. Widely used algorithms called for selling stock-index futures. As many institutions began to sell

these futures contracts at the same time, their price fell, which in turn led index arbitragers to sell stock in order to buy index futures, causing stock prices

to fall further. Many investors had limit orders to sell outstanding on the specialists’ books. Falling prices jumped over these stop prices and their sell

orders were not implemented (theproblem of the ‘gapping market’ ‘). The portfolio insurance strategies were discredited by the crash and have not been

used as much since. To compensate, some large brokerage fms reportedly began writing put options to provide a portfolio hedge for their large

institutional customers, and on Oct. 13, 1989, when stock market prices began to slide sharply aga@ these securities fms rushed to A@st their own

hedges by selling futures and stocks, again reinforcing the downward price movement,

mFor a &scussion of how this percentage is calculated, see chapter 3, op. cit., footnote 52.

Zlsome brokerage fm stopped doing program trading after the 1987 crash or after the 1989 near crash either dtOgdhCT Or O@ for tie~ own

accounts, and usually for only a few months. A New York Stock Exchange “blue ribbon panel, ”established to study program trading after the 1989

br~ reported in June 1990. It did not recommend restrictions on program trading but did recommend additional circuit breakers.

22R~o@~g tie problm of tie market’s fibflity t. absorb insti~tio~ pofiolio ~~g,tie SEC! and tie NYSE IEpOrtS on the 1987 crash c.d.kd

for a “basket trading product” that could provide a more eftlcient mechanism than program trading for trading baskets of stocks. Exchange Stock

Portfolios (ESPS) were introduced in late 1989. But ESPS cost about $5 million and there has been little trading in them.

23~s, ~ a seine, ~~e~ risk t. taxpayers. However, the consequences of a complete market collapse for tie mnomy (and ~PaYers) ~ve never

been calculated.

~For ex~ple, p~clpation b Som is now mandatory; before the crash it was voluntaIY.
Chapter 1-Summary: Public Policy and Securities Markets ● 11

market system” with fair competition among brokers, dealers, exchanges, and markets. The SEC was

instructed to encourage use of modern information

technology and to move toward eliminating rules

that limit competition.

The automated systems that have been put in use

by the Self-Regulatory Organizations (SROS)

25 were

designed to facilitate and support, but not replace

traditional trading practices. They have probably

increased the efficiency, fairness, and liquidity of

markets, but they have not fully achieved the policy

objectives of full and vigorous competition. An

Intermarket Trading System, linking the NYSE and

regional exchanges, has improved customer services

and helped regional exchanges to maintain or

increase volume, but it does not encourage the

exchanges to compete with NYSE specialists in

making markets by bettering the NYSE prices.

Market participants on any exchange floor (but not

brokers or public customers) can either route an

order to a market with a better price, or execute the

order themselves at that price. An alternative could

be a direct link between brokers and markets that

would automatically switch orders to the market

with the best price (’‘a universal message switch’ ‘).

It is possible, however, that a universal message

switch might not strengthen regional exchanges as

market competitors, but might create an integrated

electronic market in which all orders flow to the

most liquid market. In that case, regional exchanges

could become only service centers.

The SEC has not, since 1975, pushed the exchanges to eliminate some of the rules that limit

competition. The NYSE’S Rule 390 prohibits exchange members from competing with exchange

specialists by making markets off-exchange for

listed stocks-crossing customer orders in-house

(internalizing order flow) or acting as dealers.26

Investors who wish to engage in after-hours trading

of listed stock do so through the third market

(non-member OTC dealers), the fourth market

(direct investor-to-investor trades, often through

proprietary’ electronic systems), or in foreign markets. Many of these trades are now done in London

markets .27

The risks in eliminating Rule 390, as cited by

defenders of the rule, are: 1) with several securities

fins, as well as the exchange, acting as dealers,

fragmented markets would offer less liquidity; and

2) securities firms could internalize orders, not

exposing customers’ bids and offers to all market

participants. It is possible, however, that competing

market-makers might increase rather than decrease

liquidity.

The costs of not eliminating Rule 390, as cited by

critics of the rule, are: 1) spreads (the difference

between bid and quote) may be wider than they

would be with competing market-makers, and 2)

investors will trade many of the NYSE-listed stocks

of 1,740 major corporations on foreign exchanges.

As for the first point, most NYSE spreads do not

exceed the one-eighth point (12.5 cents) minimum

now, and eliminating the restriction on dealing in

19c-3 stocks did not lead to narrower spreads on

those stocks. However, with exchange rules that

permitted less than one-eighth increments (not now

permitted), spreads might be one-tenth or even

one-sixteenth point.

The end of Rule 390 would probably encourage

the development of proprietary electronic trading

systems, by large securities firms or by information

services vendors to serve those firms. This would

encourage competition for NYSE and its specialists,

but individual investors-particularly small investors-might not share the benefits of this competition.

The second rule that restrains competition between markets prevents exchange specialists from

competing with OTC dealers by making markets in

unlisted stocks. After a 15-year delay the SEC has

just approved a pilot program allowing the AMEX

~’rhe seven Swurities excbg~ and the National Association of Securities Dealens (OTC dealers) are Self-Re@atory ~m=tions. Undm tie

Securities and Exchange Act of 1934 and subsequent legislatio~ they have the authority to censur e, free, suspend, or expel members and are responsible

for drawing up their own rules, which must however be approv~ by the SEC. ‘r’he futures exchanges and industxy association are SROS with shnihw

authority under the CITC.

~There is exception for stocks fmt listed on the exchange after Apr. 26, 1979 (Rule 19c-3). Rule 390 does not forbid me* f-ac-~

market-maker for other NYSE listed-stocks in foreign OTC markets ay%NYsE exchunge kwr.s, or on domestic exchanges or foreign exchanges at any

time. But market-maker participation on foreign exchanges or in foreign OTC markets would in fact be determined by the rules of those markets @

their regulatory authorities; and on U.S. exchanges there is only one market-maker, the designated specialist.

msome say ~~q me often done by U.S. ~s hem ~repofl~ M being done by the ~ndon mtes or tiches of tiOSe fklIIS.
12 ● Electronic Bu1ls & Bears: U.S. Securities Markets & Information Technology

and regional exchanges to trade 100 unlisted stocks

(the NYSE has chosen not to participate).28

Technological Directions for the Future

The 1975 Securities Act Amendments anticipated

that telecommunications and computers would ensure investors of the best execution of their transactions through vigorous competition among markets

and among dealers. Although securities markets

have installed powerful information dissemination

and trading support systems, the dominant criteria in

design of those systems (in both exchange and OTC

markets) have been to maintain or enhance the

competitive position of the particular market; to

maintain the intermediary role of existing marketmakers; and to preserve the traditional modes of

trading of that market. These goals may have been

consistent with the public interest in the past; they

may not be so in the future.

Looking ahead, there are several approaches that

American securities markets might take to cope with

the challenge of information technology in domestic

trading. The long-range goal may be to move

carefully toward a fully electronic market, in which

a national market system could automatically match

customers’ bids and offers, execute and record

transactions, carry them through clearing and settlement, and provide an audit trail, with dealers making

markets only when buyers and sellers are not in

dynamic balance. But the most responsible approach

to modernizing securities markets is a flexible

approach, or several parallel avenues, because it is

uncertain what the indirect costs and risks of

completely electronic markets may be, and therefore

how to avoid or control them. There are examples of

securities markets with competing market-makers:

the U.S. OTC market and the United Kingdom’s

International Stock Exchange. There are markets

with no market-makers (e.g., Japan). There are

markets with automated trading systems (e.g., Instinet, Toronto’s Computer Assisted Trading System

(CATS), U.S. exchanges’ small order execution

systems). There is one example of a fully automated

market (the Cincinnati Stock Exchange). But there

are as yet no adequate models of fully electronic

trading in a major national securities market.

Parallel operation of automated and negotiated

(dealer) markets would be a wise intermediate step.

Securities firms might be allowed to compete in

making markets through proprietary trading systems. Or the exchanges could have a “single price

auction” daily or several times a day,29 interspersed

with traditional continuous auction trading. Proprietary trading systems might develop rapidly if remaining rules that restrict or discourage competition

between exchange specialists, exchange members,

and OTC dealers are eliminated.

> If exchanges are too slow to move in this direction

they may be preempted by information services

vendors. In one way or another aggressively trading

investors will seek to take full advantage of modern

information technology and its ability to overcome

limitations of time, distance, and human skills. The

result may be a larger and more liquid fourth

market-i. e., many large financial institutions and

institutional investors trading with each other over

electronic proprietary trading systems, which are not

now regulated as exchanges. In the best case, if done

with regard for the public interest and guided by

balanced public policies, such a highly competitive

and efficient electronic market could attract investors from around the world. But if this development

were driven entirely by self-interests, the public’s

interest in fair and open markets could be ignored or

given low priority. This could result in fragmented

markets, or markets used by institutions but inaccessible to individual investors, and less fair, efficient,

and visible than today’s markets. Such a two-tier

market should be avoided.

U.S. stock exchanges will eventually be pushed

by competition from abroad and by the demands of

institutional investors to develop electronic systems

for trading outside of exchange hours. In late June

1990, as this assessment is being completed, the

NYSE announced plans for a five-step process “to

prepare for continuous 24-hour trading by the year

2000. ” The frost three phases of this plan merely

extend trading, at the closing price, for a brief period

after the NYSE business day. This is designed to

recapture domestic trades now lost to London or

Tokyo (estimated by NYSE officials at between 6

~~e ~SE gets a si~~t portion of its revenue from the fees fOr ~dllg CO~m@ stocks.

% a single price auctio~ all bids and offers could be collected and arranged by computer in order of price (and then by size and the order in which

they were received). The computer would thenfmd the single price that would clear, or most nearly clear, the market and execute the trades automatically.
Chapter l-Summary: Public Policy and Securities Markets ● 13

Photo credit: National Association of Securities Dealers

Over-the-counter markets reach over the ocean.

and 20 million trades per day), rather than to

facilitate or encourage international trading. The

fourth phase envisions several single-price auction

sessions during the night. Only the fifth phase, to be

implemented about the year 2000, would be designed for around-the-clock, around-the-globe trading.

After the NYSE announcement, three exchanges

(the AMEX, the Chicago Board Options Exchange,

and the Cincinnati Stock Exchange) announced that

they are working with Reuters to develop plans for

an electronic after-hours trading system. It is possible that at some later time these exchanges could

find their business hostage to one vendor. The

NASD, already having links with overseas markets,

expects to begin dawn trading hours on September

1, 1990; the OTC dealers will begin to trade

electronically at 3:30 a.m. e.s.t. (corresponding to

the opening of the London market).

THE OPERATION OF

FUTURES MARKETS

[See ch. 4]

Futures contracts are standardized, contractual

agreements to buy and sell commodities at a

specified price for future delivery, regardless of the

cash market price at that time. They developed

because of the needs of farmers and commodity

merchants to manage the price fluctuations caused

by weather and other crop cycle uncertainties.

Because of the agricultural origins of futures contracts, they are traded on commodity exchanges.

They are regulated by the Commodity Futures

Trading Commission.

Futures contracts on financial instruments (e.g.,

currencies, bonds, interest rates) did not develop

until the early 1970s. Financial futures now account

for over 60 percent of all futures trading volume.

Stock-index futures were not introduced until 1982,
14 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

and account for only 5 percent of all futures trading.

They are enormously important, because they are

used for inter-market trading strategies that link

securities markets with futures markets.30 Stockindex futures are used by institutional investors for

hedging a diversified portfolio of stocks. This allows

those who have fiduciary responsibilities to avoid

unnecessary risk, to transfer some risk to professionals (speculators) who assume it in the hope of

profiting by price movement. Speculators buy and.

sell stock-index futures as a way of betting on the

market as a whole-taking on the risks that institutional investors seek to avoid. Arbitrageurs buy

stock-index futures and sell the underlying basket of

stock, or vice-versa, to profit by temporary disparities in their prices. This has the effect of bringing

their prices back together by the simple operation of

supply and demand, and in ordinary circumstances

tends to stabilize prices.

It is these trading strategies that link securities and

futures markets. Pressure in one market tends to

increase pressure in another. Because it is easier,

cheaper, and faster to buy a stock-index future

contract than to buy the hundreds of shares represented by the stock index, changes in stock-index

futures prices tend to lead, or forecast, prices in stock

markets. In economists’ terms, this is “price discovery.” (But it is the average price of the basket that is

“discovered.’ To the extent that index arbitrage

then affects its price and hence the price of individual stocks, the stocks will change price for extraneous reasons.)

All U.S. futures contracts are traded in auction

markets, on futures exchanges. There is no OTC

market and no electronic trading systems for futures

contracts in the United States. Trading is done by

‘‘open outcry,‘‘ i.e., shouted bids and offers. It takes

place on tiered exchange floors or “pits.” Futures

markets are now the focus of two kinds of policy

issues: those related to the operations of the markets

themselves, and those that focus specifically on

stock-index futures.

Issues Related to Futures Market Operations

Open outcry trading, cherished by market participants, has three characteristics that can cause probPhoto credit: Chicago Mercantile Exchange

Chicago Mercantile Exchange trading floor.

lems: the limitations on volume inherent in face-toface auctions, the lack of automatic time records or

audit trails, and dual trading.

The frantic action of several hundred shouting and

gesticulating traders and brokers in financial futures

pits makes it difficult to be sure that a customer gets

the best price available at any one moment. It is

doubtful that such a system can accommodate

further growth. The Chicago Mercantile Exchange

and the Chicago Board of Trade, in conjunction with

Reuters, the British information services firm, are

poised to introduce GLOBEX, an electronic trading

system that will operate outside of exchange hours.

GLOBEX is designed to meet the challenge of

international trading. If it is successful, however—

i.e., if market professionals make the transition to a

different mode of trading and find it advantageous to

use-GLOBEX could demonstrate one way to

relieve the strain on open outcry trading threatened

~st~k-index fi~es cover the st~ks represented in an inde~ such as the Standard & POOH 500 St~k ~dex (SW 500). ~fidex is a s~tistic~

indicator of market performance. It is the average price (usually a weighted average) of a diversified basket or portfolio of stocks. Stock-index futures

must be settled in cash (the difference between the current index value and that speci.fkd in the contract) rather than by delivery of shares. There are

no futures contracts on single stocks; this is now prohibited by legislation.
Chapter 1-Summary: Public Policy and Securities Markets ● 15

by further volume growth. GLOBEX could operate

24 hours a day, and become a real competitor for

existing futures exchanges.

The lack of an automatically generated, firm audit

trail for transactions in futures pits further limits

surveillance and monitoring, and makes it difficult

to detect and prove fraud and manipulation. This

serious problem may be overcome by the introduction of hand-held computers, now being developed,

to be used by traders on the floor to record

transaction data and transmit it immediately to the

central exchange computer.

In futures pits floor brokers may trade both for

customers and for themselves, although not in the

same transaction. This involves potential conflicts

of interest. Dual trading has always been strongly

defended by futures markets and their regulatory

agency, the CFTC, as necessary for liquidity and

beneficial for customers. After a recent study cast

doubt on those assumptions, and after revelations

and allegations of market fraud coming from FBI

investigations in the futures markets pits, the CFTC

has proposed a limited prohibition of dual trading of

some futures contracts.

Issues Related to Stock-Index Futures

After the 1987 market crash several task force or

government agency reports identified the use of

inter-market hedging techniques using stock-index

futures as a major contributor to the break. A normal

dip in stock prices may have set off and then been fed

by complex shifting of resources between stock and

stock-index futures, on behalf of institutional investors, as already noted. The effects were amplified by

the widespread use of computer-assisted trading

strategies. Some of the reports said that the effects

were further amplified by the greater leverage in

futures markets.31 There were not enough active

individual investors, making their own judgments of

values, to offset this imbalance. Index arbitrageurs

were unable to keep prices linked across the markets.

The sudden violent surges of sell orders in stock

markets overwhelmed the ability or the willingness

of stock exchange specialists to counter and control

them.

This is the most credible scenario of the market

crash, but it is not universally accepted. It is, for

example, vigorously denied by both futures markets

and the futures regulatory agency, the CFTC.

Statistical analyses of 1987 trading data by academic, industry, and government regulators are, in

the aggregate, inconclusive. Their conclusions differ

because researchers define volatility differently, use

differing time periods, or use different statistical

measures. Those on both sides of the debate pick and

choose among the empirical studies to bolster their

claims, and sometimes overstate the strength of the

scholars’ conclusions.

Recent studies of the market break of October

1989 by the SEC and the CFTC again offered

differing interpretations of the extent to which

trading in futures markets contributed to a price

decline in stock markets, or merely foreshadowed

it.32 The SEC said:

When concentrated selling (or buying) strains the

liquidity of the futures market, program trading

strategies such as index arbitrage, executed by large,

well capitalized broker-dealers and institutional

money managers, quickly transfer this activity to the

stock market.

The CFTC said:

Neither program trading nor futures sales by those

with large positions, explain the observed price

movements on these dates.

This again suggests that statistical analysis is

inconclusive and cannot resolve the highly charged

issue.

31~verage fi fi~e~ -k~ts is hi@ bec~u~~ of lower ~W ~@, lower tramaction costs, and spdier execution for stock-index fUtWtX

transactions, compared to the buying or selling of a portfolio of 500 stocks.

qzon Oct. 13, 1989 (a Fn&y) the Dow Jones rndmh-ia.l Average fell 191 points (6.9 percent); this was the tidex’s second ~gest single-day @fit

decline and the 12th largest percentage decline. On October 16 (Monday), the Dow fell an additional 60 points before rallying. Both the CFTC and the

SEC studies noted that there was concentrated selling of stock by brokers who were hedging their risks from put options that they had written for

institutional clients as a substitute for the portfolio insurance strategies that did not protect them in October 1987. CITC, Division of Economic Analysis,

“Report on Stock Index Futures and Cash Market Activity During October 1989,’ May 1990; SEC, Division of Market Regulation “Trading Analysis

of Oct. 13 and 16, 1989,” my 1990.
16 ● Electronic Bulls & Bears: U.S. Securities Markets& Information Technology

A second closely related policy debate focuses on

the system of margining33 used in futures markets

and the question of whether the initial margin

requirement should be raised. Futures exchanges,

futures market participants, and the CFTC hold that

the function of margins is to bolster the financial

integrity of market participants, and that present

levels are-and have proven to be throughout recent

market breaks-fully adequate to fulfill that function. Higher margins are unnecessary, they say,

because margin accounts are adjusted twice daily or

more often to reflect market conditions and changing

risks ( "marked-to-rnaxket"). Higher margins are

undesirable, they also say, because they would

reduce liquidity (i.e., tend to depress the volume of

trading).

Some critics of futures markets or of stock-index

futures call for higher margins to depress the volume

of trading in stock-index futures, in the hope of

reducing the likelihood of short-term volatility in

stock markets. Other critics of futures margins say

that higher margins would reduce the leverage that

index futures trading exerts on stock prices. These

critics, including the SEC and the Secretary of the

Treasury, say that futures margin requirements

should not be set solely with a view to protecting

futures market clearing organizations, but should be

set in the broader context of the effect on all financial

markets.

This issue too cannot be resolved on the basis of

empirical or statistical evidence. Adjustment of

margin requirements as a tool of public policy would

likely change the way stock-index futures are used

for hedging, arbitraging, and speculation. This

intervention, if undertaken could be justfied because of the public interest in the efficiency and

fairness of securities markets. Whether such intervention would accomplish the desired end-control

of stock market volatility-is uncertain. There are,

as yet, few relevant studies of the effect of futures

market margins on stock market behavior, since the

direct linkage began with stock-index futures in

1982. Such studies as have been done (and more

general studies of the relationship between stock

market margins and price volatility) are again

inconclusive and subject to differing interpretations.

Proposals to create Federal authority to intervene in

determining margin levels are discussed below.

ISSUES RELATED TO

OPTIONS TRADING

[See ch. 5]

An option contract confers the right to buy or sell

an asset or financial instrument at a specified price,

during the lifetime of the contract.34 Options on

individual securities and indexes of securities are

traded on five stock exchanges or special options

exchanges, and are regulated by the SEC. Options on

commodities, on futures, and on stock-index futures

are traded on commodity exchanges and are regulated by the CFTC. Options on foreign currency are

regulated by the CFTC, except those on currencies

traded on securities exchanges, which are regulated

by the SEC. Methods of trading options vary

accordingly; some are traded through open outcry,

others through a modified version of the specialist

system. A few are written and traded over the

counter.

Since 1980, the right to trade a new option on a

specific stock or index of stocks has been awarded

to only one exchange, chosen by lottery. Anew SEC

rule (Rule 19c-5) will allow all listed equity options

to be traded on all stock options exchanges (“multiple trading”) after January 1991. This rule is aimed

at the increased competitiveness goal of the 1975

Securities Act Amendments, but the change was

long delayed while the SEC urged the exchanges to

develop a market integration system.

The options exchanges resisted market integration systems in the form of order routing or

execution systems, both to avoid increased competition and because of the difficulties of keeping their

quotations current.35 The size of the crowd on an

WUtUI-M mkets def~ margin as a performance bond put up by futures buyers and sellers to protect futures clearing orgatitions a-tdef~t

on the obligations embodied in the contract. Typically, it is 3 to 5 percent margin accounts are adjusted twice daily or more oftmL and account holders

may be called to put up additional margin if prices have moved against them. See ch. 4 (Futures Markets) and ch. 6 (Clearing and Settlement) for a full

explanation. In stock markets, “margin” is a downpayment made by a purchaser of stock. It has been set at 50 percent for the past 15 years.

MA sell option is a “put.’ A buy option is a “call.’ Option ‘writers” write (i.e., sell) botb puts and calls. The options clearinghouse, however, takes

the other side of the transaction for both option writers and option purchasers, and settIes accounts with both of them.

35fich_ket.~~ co~d be__kets in500 options ~ries ~d cl~ses, ~eir pric~ derivative of the frqendy cbW@g priCOS Of Up to 30

stocks. Market-makers said they could not keep up with these changes well enough to guarantee that their quotes were current and firm.
Chapter1-Summary: Public Policy and Securities Markets ● 17

options trading floor (sometimes several hundred)

also made it difficult to develop a quotations system

that could identify the market-maker with the best

quote. Technology can solve both of these problems.

An “auto-quote” device is available that automatically adjusts options quotes to stock price changes,

and hand-held computers are being tested for use by

market-makers on the floor.

This could make an electronic market integration

system feasible. It could be: 1) an inter-market

system to route orders between exchanges, 2) a

“neutral switch” to route brokers’ orders to the

market with the best quote, or 3) a central limit order

file to expose all limit orders to all exchanges. The

argument about technology continues, even as

multiple-trading is about to begin. The SEC has

mandated multiple-trading without insisting on a

market integration system being in place. However,

unless there is a system to force competition from

the beginning of multiple-trading, past experience

indicates that trading in each option may soon

concentrate in one exchange where the most liquidity appears. Should this happen, the benefits sought

from competitive market-making-i.e., narrower

spreads-will not be achieved. There may still be

some benefits from competition in terms of improved services.

The options margin system involves two issues:

1) proposals for cross-margining (under review by

both the SEC and CFTC), and 2) proposals for

futures-style margining (under review by the CFTC).

Cross-margining would adjust margin requirements

to reflect the amount of hedging that options buyers

enjoy by trading in several markets (e.g., stock,

futures, and options). The Options Clearing Corporation (OCC)-the only clearing organization for

securities options markets-would be allowed to

recognize positions in one market as hedging

positions in another market (the options market) that

reduce the position holder’s total risk. This would

reduce the demands for collateral from firms that are

trading in more than one market (and therefore

presumably increase the amount of money available

for market transactions). Cross-margining requires

cooperation between two or more clearing organizations serving different markets. There are reservations about the adequacy of cross-margining under

all market conditions. There are, nevertheless, two

pilot programs underway.

Futures-style margining for options is proposed

by advocates of unified clearing systems, in order to

reduce the obstacles resulting from having different

margin systems for different markets. However, it is

currently being considered only by the CFTC for

options traded on futures exchanges. It is opposed by

the OCC (which clears and settles all securities

options), the securities industry, and the SEC

because marking-to-market, daily margin calls, and

the requirement of margins from options writers

would alter the nature of equity-related options and

the way they are used for hedging.

Debates about options margining involve intermarket issues and should be examined within the

context of linked markets. As with many issues

involving equity, options, and futures trading, the

issues are complicated by the existence of a bifurcated regulatory structure in which the CFTC and

the SEC make conflicting assessments of the effects

of margining arrangements and neither position may

reflect overall national interests.

CLEARING AND SETTLEMENT

[See ch. 6]

Clearing and settlement is what happens after the

trade: matching the records of buyers and sellers and

delivery of the asset and payment, or (in the case of

derivative products) satisfaction of the terms of the

contract. Clearing and settlement is important because the failure of one or more major clearing

members could have far-reaching effects on the U.S.

financial system, and even on those of other nations.

The 1987 stock market crash put a public spotlight

on clearing and settlement and raised questions as to

whether the process had broken down under the

strain. Several U.S. studies were made that resulted

in recommendations designed to strengthen these

critical systems. A later study by the Group of

Thirty, an international forum of business leaders

and financial experts, also developed recommendaions, and improvements are underway. Some clearing and settlement problems are domestic in scope

and others are international.

Better protections are needed for investors against

the risk of default by clearing members. Protections

now in place are piecemeal, non-uniform, and
18 ● Electronic Bu1ls & Bears: U.S. Securities Markets & Information Technology

complicated by differing Federal and State statutes.

36 A second concern involves risks in the

payment process, including delayed or inadequate

bank credit, uncoordinated timetables for finality of

settlement, and disparate netting procedures. Problems may arise with 24-hour trading, if margin calls

are made when banks are closed.

More information-sharing between clearing organizations is needed. Better decisions on extending

credit can be made by creditors if they have more

information about participants’ positions and risk

exposure. Inter-market trading patterns make information-sharing increasingly critical, as does the

trend toward global investing. Some important

improvements have recently been put in place but

there are still shortcomings in the informationsharing process. A common format for reporting and

distributing exposure information would be a major

improvement, as would uniform approaches to

evaluating risks.

Most of the U.S. clearing and settlement system is

technologically advanced, but some areas need

improvement. While clearinghouses have done significant upgrading of systems, the benefits of these

upgrades can be diluted if all clearing members are

not sufficiently advanced technologically to respond

to new requirements.

Lack of standardization is another problem. The

operating hours for banks and financial markets are

not uniform; banks, including the Federal Reserve

Bank, may be closed even if financial markets are

open.

37 Cross-border trading makes this problem

worse, since national holidays are not the same. The

settlement period for equities must be shortened to

reduce risk of default. This will require immobilizaion of securities in a depository and a change to

same-day funds.38 The elimination of physical

delivery of certificates (which some investors insist

on holding) and prompt payment by buyers are

critical to further shortening the clearing and settlement process.

Resolving these issues will require continued

efforts by the private sector. Some will also require

efforts by government regulators, or legislative

change. A number of clearing and settlement issues

will require international consensus and coordinated

efforts as well.

TECHNOLOGY AND

SECURITIES TRADING

[See ch. 7]

One hundred and fifty years ago, it took about 1

week for a market quote to travel from New Orleans

to New York, and about 3 weeks for market news to

reach Europe by clipper ships. Information technology—from the telegraph, stock ticker, and telephone

in the 1800s, to the first computers in the 1960s, to

today’s automated order routing systems—has

brought great changes in market operations. The

overwhelming advantages of speed and accuracy

have ultimately overcome the reluctance to change

and the resistance of those who prefer traditional

methods of trading based on personal, highly

specialized skills.

Computers and telecommunications are now used

by securities markets for trading support systems,

including quotations display and dissemination,

order routing, and transaction execution (for small

orders). They are also used for market surveillance

and monitoring, and for ‘back office’ data processing and clearing and settlement of trades. These

functions are automated, in both exchanges and the

OTC market, in such a way as to preserve the role of

market-makers. This can enable investors to get a

price ‘between the quotes’’—i.e., better than displayed bids and offers or dealers’ quotations. It may

increase liquidity, by attracting skilled professionals

whose experience and understanding of floor behavior can make trading highly profitable to them and to

their customers. However, the mixing of manual and

automated steps in information processing seldom

allows the optimum use of either manual skills or

sG~e Satities tivmtorfiot=tion Corporation for example, provides a uniform Ievcl of protection to market users in @ties, bonds, and

equity-related options markets. The protections afforded to market users by exchanges and clearinghouses in futures markets, however, vary and are

extended mainly to clearing members of the exchange’s clearinghouse. Further, some failures in securities markets are resolved though bankruptcy

proceedings under the Federal Bankruptcy Code, which relies largely on State laws to determine rights to property. These may include State commercial

law that often relies on the Uniform Commercial Code (UCC), and since the UCC is accepted on a State-by-State basis and may be amended, investors

may be treated non-uniformly. Laws dealing with bank liquidation also need to be updated :, nd made more consistent with other bankruptcy laws. In

nonregulated markets, such as foreign exchange, there is little investor protection.

37~~ i5me, for the Utited Stites, was rals~ at the Feb. 8, 1~ m=ting of tie Ban~g ~[~d {J]e@@ouse Ro~dtable, where members agreed tO

hold further discussions. The problem is more complicated intermtionally and far fron, being resolved.

38sme-~y ~ds mems tit Pawent is f~ or, the by paid, ~ It wo~d be ~~ ~~e(~,~l[ f~~ transfer rather ttin Mm payment by check.
Chapter 1-Summary: Public Policy and Securities Markets ● 19

system capabilities, and may create backlogs and

opportunities for error, diversion of information

flow, or fraud.

The markets have not moved the country much

closer to the integrated, highly competitive national

market system envisioned in 1975. Instead, the ad

hoc integration brought about by inter-market program trading imposes stress on all markets and on

the fragmented market regulatory structure.

The technological link between the markets and

their ultimate user, the investor, is the system that

disseminates bids, quotes, last-sale prices, etc.

Market data flows from organized markets through

systems provided by information services vendors

and common carriers to brokers and customers

located in nearly every U.S. city, town, and hamlet.

Advances in information technology have thrown

the information services industry into a state of flux.

Driven by competition, vendors are developing

value-added products and moving into transaction

services, creating proprietary trading systems that

could become the markets of the future.

International trading has induced foreign vendors

such as Reuters to enter the competitive arena for

distribution of U.S. stock quotations, and American

companies such as Quotron to expand their overseas

operations. The financial information business is

still growing and continues to attract new competitors. The growing interactions between equities,

futures, fixed-income and foreign exchange markets

have led vendors, who until recently specialized in

one market, to diversify into other markets.

Because vendors can readily obtain data from

most stock markets, the market for quotation, price,

and volume data has itself become a ‘‘commodities

market, ‘‘ in the sense of highly standardized products competing on the basis of price or on value-

-added features such as software for portfolio analysis. To satisfy the demand for analytical tools,

vendors began to offer data in digital form, allowing

users to reformat and manipulate data. This raises

troublesome questions, e.g., copyright and pricing

issues.

Information services providers are also moving to

offer transaction services, via automated trading and

execution systems. The largest of these, Instinct,

now has about 13 percent of the daily volume of the

NYSE (but this includes both exchange-listed and

OTC stock). If institutional investors become dissatisfied with exchange services and their costs, or with

the liquidity available for large block transactions,

they may move to proprietary trading systems,

perhaps offered by Reuters, Quotron, Telerate, or

other vendors. Familiarity with trading private

placement issues among themselves on NASD’S

new Portal system may also encourage institutions

to use other electronic systems.

U.S. exchanges are clearly wary of these developments but are adopting different strategies for

dealing with it. The futures exchanges and, more

recently, some stock exchanges are working with a

dominant vendor (Reuters) to develop their own

electronic transaction systems; the NYSE is developing a strategy that would ‘‘encourage many

vendors to provide access to NYSE after-hours

trading. ’

The SEC has jurisdiction over companies that

collect, process, and deliver market data. So far

information vendors have not been subject to much

regulation. The SEC has in the past exempted

proprietary trading systems from registering and

being regulated as exchanges. It may now be

appropriate to reconsider both of these exemptions.

It is not clear whether information technology has

been a net benefit to small investors or has put them

at a disadvantage relative to large investors and

institutional investors. Sophisticated portfolio management software is available for home computers,

but is used by relatively few individual investors,

and even fewer have access to “at-home trading

systems” (which send orders to brokers, but do not

provide automated execution). Many small investors

feel that they are put at risk by volatility that they

suspect results from program trading techniques

encouraged by information technology. Computerized surveillance techniques have been relatively

ineffective against types of market fraud that prey on

small investors, such as penny stock scams and

collusion in futures trading pits.

Advances in technology to support exchange

trading, OTC dealing, proprietary trading systems,

brokerage order routing, and customer end use may

require accelerated development of standards to

ensure interoperability. Improvement is needed in

three categories of standards: data, technology, and

operational standards. Standards are, however, especially important in developing 24-hour systems for

transnational trading.
20 ● Electronic Bulls & Bears: U.S. securities Markets & Information Technology

MARKET FRAUD

[See ch. 8]

Both institutional and individual investors, but

especially the latter, are deeply concerned about

market fraud and manipulation. Fraud affects both

the securities and futures markets, as recent disclosures show. In both, greed and dishonesty on the part

of some participants are compounded by difficulties

in surveillance and enforcement. Regulatory agents

in both the SROs and in government are often

thwarted by shortcomings in existing laws, regulatory measures, and surveillance technology. The

costs of self-regulation are high-about 23 percent

of total costs for the NYSE, for example.

Inter-market trading, and, increasingly, global

trading, challenge continuing efforts to protect the

public against undisclosed risks and assure all

investors of fair practices. Enforcement efforts may

be hampered by the divided regulatory structure that

looks separately at each side of inter-market transactions, and by the limits of national sovereignty.

Some market abusers profit by increased ability to

operate from off-shore, often from locations where

privacy laws block attempts at international cooperation in enforcement. Inter-market and international

abuses are growing while more traditional forms of

fraud continue.

Recent congressional hearings, FBI investigations, prosecutions, and news media revelations of

abuse have stimulated both securities and futures

regulators to look for improved methods of detecting

and proving fraud. These measures include increased enforcement, expanded legislative authorities, and greater use of technology. Major foreign

trading partners are strengthening mechanisms to

control abuses in their markets; this shows promise

for improved international cooperation in controlling fraud. These domestic and international efforts

are likely to help curtail traditional forms of abuse.

But new forms of fraud may occur as after-hours

trading systems emerge, and many abuses are

beyond the jurisdictictional reach of regulators to

detect. The key issue will continue to be: how to

balance public policy goals of fairness with other

objectives, such as efficiency; the competitiveness

of our marketplaces; and cost-effectiveness in enforcement?

THE REGULATORY STRUCTURE

FOR MARKETS

[See ch. 9]

Securities and equity options are regulated by the

Securities and Exchange Commission, established

in 1934. Futures contracts, including stock-index

futures and options on stock-index futures, are

regulated by the Commodity Futures Trading Commission, created in 1974. The organic acts creating

the two regulatory agencies were written 40 years

apart. Both were written when some of today’s most

heavily traded derivative products did not exist.

Securities markets and futures markets were

originally unrelated, and the regulatory structure

reflects this. The markets are now linked. The prices

of some products traded in the futures markets are

derived from those of products in stock markets.

Supply and demand in one market influence supply

and demand in the other market. Problems and

pressures are transferred from one market to the

other. Yet the regulatory structures remain separate.

Since 1982, when stock-index futures contracts

were introduced, three problems have become apparent: 1) confusion over jurisdictional responsibility for new trading instruments, sometimes carried to

the courts for resolution; 2) differences in leverage

caused by different margining systems; and 3) the

effects of inter-market trading strategies on market

volatility. The CFTC, as well as the futures industry

and some academic experts, does not agree that these

are problems. (See chs. 4 and 9.) Balanced against

these drawbacks to the use of stock-index futures are

the great advantages to institutional investors, who

manage assets belonging to increasing numbers of

Americans, of being able to hedge their portfolios.

As a general rule, the SEC regulates the trading of

securities, or assets, which are instruments of capital

formation, and the CFTC regulates instruments that

are used for hedging and speculation (they are

contracts, not assets) .39 Futures exchanges have

been highly innovative in developing new products

and the CFTC has been flexible and responsive in

approving them. The SEC has been more cautious in

approving new products for exchange trading. Innovation in securities exchanges maybe more difficult
Chapter 1-Summary: Public Policy and Securities Markets ● 21

than innovation in futures markets.40 Most innovative financial products are derivative of traditional

assets (equity securities, debt securities, currencies)

and are successful because they are useful for

hedging or risk transfer. They almost always, for that

reason, have some element of future delivery or

settlement. Because of the way that the CFTC

legislation is written (“the exclusivity clause”),

such products fall under the jurisdiction of CFTC

even if they are designed by securities exchanges to

meet perceived needs of securities traders.

Stock exchanges have recently attempted to

become more innovative. The result has sometimes

been dispute over whether the SEC can approve and

regulate the trading of such products. Exchanges try

to shape new products to fit the authority of their

preferred regulatory agency. Exchanges also are

likely to challenge (in regulatory agency hearings)

approval of innovations by other exchanges that are

potential competitors for their own products. Futures

exchanges have in a number of cases used litigation

or the threat of litigation to discourage competition

from securities exchanges.

The two regulatory agencies have strongly different perspectives on inter-market factors in shortterm volatility, and on the relationship between

futures margin levels and stock market volatility.

These different perspectives make it hard to develop

an objective and pragmatic approach to identifying

and solving problems in either market. Their disagreement over the inter-market effects of futures

margin levels results in turning that question into the

issue of who should set margins on financial futures

and particularly on stock-index futures.

The possible loci of responsibility for futures

margin requirements are: the futures exchanges

(who now set them), the CFTC (which maintains

that margins should be set by the exchanges, and

which has consistently defended current margin

levels), the SEC (which does not have the authority

to set margin levels for stocks), or the Federal

Reserve Board (which sets stock market margin

requirements but would like to rid itself of this

responsibility and does not want responsibility for

futures margins). The issue of whether this responsibility should be shifted turns on the question of the

purpose of margins: should they be designed only to

protect the futures exchanges’ clearing organizations (and through them, the other major participants

in futures markets) or should they also be designed

to achieve desired effects in national markets as a

whole? If the former, the current locus is probably

appropriate. If the latter, the responsibility should

probably not reside in private-sector organizations

whose members have a strong self-interest in the

determination of margin levels.

The most important question raised by a bifurcated regulatory structure is the reliability of smooth

coordination of responses by two agencies in the

event of an emergency—a threatened market crash.

In the market breaks of 1987 and 1989, the two

agencies stayed in constant communication and

apparently worked well together. But continuing

evidence of strong disagreement on the causes of

such market breaks, and the efficacy of existing

means of controlling them, raises the question of

how much reliance can be placed on effective

coordination in all such situations that may arise.

There are now several proposals, some developed

in Congress and one presented by the Administration, to shift jurisdiction over stock-index futures

from the CFTC to the SEC. There are also proposals

before Congress to integrate the two regulatory

structures. The several alternative approaches to be

considered are outlined below.

Redefinition of Jurisdictions

Another attempt might be made through legislation to define the respective agency jurisdictions so

as to minimize confusion over innovative products.

This could reduce the need for prolonged negotiation and the opportunity for resorting to litigation.

However, it would do nothing to resolve other

outstanding or potential problems, such as coordination in stressed market conditions. Shifting authority

over stock-index futures trading to the SEC would

be a step in the right direction for addressing some

of the margin and emergency response issues.

However, how that step will affect the willingness of

exchanges to offer these instruments, the liquidity

that will be available, and the ability of institutional

investors to hedge large portfolios are all uncertain.

~Some of tie most ~ovative securit.ie~.g., mortgage-backed securities and other ‘asset-backed securities” = managed by banks and are not

traded on exchanges.
22 ● Electronic nulls & Bears: U.S. Securities Markets & Information Technology

An Inter-Market Coordination Panel

The addition of another layer of responsibility

over both agencies, to assure broader consideration

of inter-market relationships and issues, is another

possibility. Such a mechanism already exists, in the

form of the President’s Working Group on Markets.

If the inter-market agency consists, as does the

Working Group, of representatives of several government agencies, there is likely to be little gain over

the present situation. A panel at the supra-agency

level is not an operational working group, and

usually is not prepared to intercede immediately, in

the midst of an emergency. Inclusion of nongovernmental experts may seem to promise a

broader perspective, but in practice it would be

difficult to find people knowledgeable about problems of markets that do not bring with them a history

of affiliation with either futures markets or securities

markets or their respective regulatory agencies.41

With a panel representing the viewpoints of the two

industries or the two regulatory agencies, jurisdictional disputes would have to be settled elsewhere.

Integration of the Regulatory Structure

A third approach meriting strong consideration is

the creation of one regulatory agency, to replace the

SEC and the CFTC, with responsibility over the

trading of securities and derivative products, including financial futures and options. Physical commodities and commodities futures trading could be left to

another regulatory entity. Critics of this approach

argue that the benefit of competition between

regulators would be lost. The benefits of regulatory

competition, however, carry with them the costs of

regulatory arbitrage-i.e., it tempts the regulated

industries to play off one agency against the other.

It also tempts the regulators to identify closely with

the regulated industry. A single agency would

facilitate coordination, allow better consideration of

inter-market relationships and interdependencies,

and encourage a unified approach to ongoing

cross-national efforts to strengthen clearing and

settlement problems and harmonize regulations and

enforcement related to international securities trading.

dlone reviewerof~s assessment commented about other reviewers, “Ifthey are experts they are not neutral; if they are neutral, they aren’t experts.”
Chapter 2

What Securities Markets Do—

And For Whom
CONTENTS

Page

DO SECURITIES MARKETS DO A GOOD JOB OF RAISING CAPITAL? .........25

DO STOCK MARKETS DO A GOOD JOB OF RESOURCE ALLOCATION? .......26

Do SECURITIES MARKETS BENEFIT ORDINARY AMERICANS? ..............28

DOES PUBLIC OWNERSHIP IMPROVE CORPORATE MANAGEMENT? .........29

DOES STOCK MARKET IMPROVEMENT ENCOURAGE SAVINGS AND

INVESTMENT? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

HOW MUCH EMPLOYMENT IS GENERATED BY SECURITIES MARKETS? . . . . 31

THE INVESTORS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Institutional Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Individual Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33

BROKERS ● . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

The Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . 34

A Tiered Client Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Figures

Figure Page

2-1. Mutual Funds Net Capital F1OWS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33

2-2. Share of Domestic Broker-Dealer Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

2-3. Securities Industry Main Revenue Sources ● ...............,**.**......*.....*,. , 36

Tables

Table Page

2-1. Institutional Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

2-2. Volume of Stock Trading on the NYSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

2-3. Size of Individual Portfolios, 1985 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34

2-4. Individual Equity Investment . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . 35
Chapter 2

What Securities Markets Do—And For Whom

Securities markets have five basic functions in

a capitalistic economy:

1.

2.

3.

4.

5.

How

they make it possible for corporations and

governmental units to raise capital;

they help to allocate capital toward productive

uses;

they provide an opportunity for people to

increase their savings by investing in them;

they reveal investors’ judgments about the

potential earning capacity of corporations,

thus giving guidance to corporate managers;

and

they generate employment and income.

important are these functions, and how well do

securities markets, in 1990, perform them? Who

benefits?

DO SECURITIES MARKETS DO A

GOOD JOB OF RAISING

CAPITAL?l

Corporations raise new capital by issuing stock

(i.e., selling ownership shares) or by borrowing

through bonds, notes, and related debt instruments.2

State and local governments and the U.S. Government also issue debt securities.

Both stocks and bonds can be sold to investors

directly or through underwriters. This is the primary

market. It converts household and business savings

into investments, to the benefit of both the savers

and the corporation.3 The secondary securities

markets, the subject of this report, are for the

reselling of stocks and bonds. People would be less

likely to invest in securities, even with high dividends or interest, without assurance that they can sell

their investments for cash when they wish to.

A decision about which stocks or bonds to buy is

supposedly based on information that an investor

has about the issuing fro’s assets, markets and

customer base, future earnings and growth potential,

and management skills. Past performance is therefore important in evaluating established firms.

Evaluation of new firms is, by comparison, difficult.

For startup firms, public stock and bond offerings

are often not an effective mechanism for raising

capital, and venture capital specialists are more

likely to provide it.4 At some later point, successful

growing firms often move to public sale of equities

or bonds.

A market, whether physical or electronic, is a

meeting place for potential buyers and sellers. A

market that attracts many buyers and sellers is said

to be “liquid” or to have liquidity. In a liquid

market, selling or buying can be done with minimal

effect on the prevailing competitively established

price. The advantage of a liquid market for customers is ‘‘immediacy, ’ the ability to sell quickly when

the customer needs his assets, or buy quickly when

there is a chance for profit, and to clear and settle the

trade quickly. Some markets attempt to assure

immediacy by designating certain traders as marketmakers, with an affimative obligation to buy shares

at a price close to the last sale price, or to sell from

inventory when there is an eager buyer. Other

markets depend on the interaction of bids and offers

from customers and market professionals to provide

liquidity and immediacy.

Another desirable characteristic of securities markets is “efficiency.” This means that changes in

investors’ collective judgment about the fundamental value of corporations are accurately and swiftly

reflected in the prices at which stocks and bonds are

bought and sold, with minimum distortion from

transaction costs, regulations, or other external

factors. Information technology should speed up the

process of registering changes in investors’ judgment, and both information technology and dereguIParts of ~ctipter draw on an OTA contractor report: James I.,. Butkiewicz (university of Delaware), The Role of the ~toc~ Market ~~ the ~-s.

.Economy, May 3, 1989; and on a workshop by the same name held at OTA on Apr. 5, 1989.

%e bond is a contract obligating tie borrower to repay the debt principal at a specifkd time and also to make interest payments to the bondholder

at a specifkd rate and time.

sAltemtively, ~v~s ~ygofit. o~er ~ds of ~ves~ent (e.g., ~ estate), or into various kinds of bank a~ounts wtichbti then use tO make

loans to individuals, corporations, or governments. Corporations also use retained earnings and depreciation as sources of capital for growth.

4~e U+se s- Business A_@ation is s~d~g he feasibilig of spec~ regio~ stock ~c~es to ~dle issues of dC,OmpaI1.ieS.The

International Stock Exchange in London set Up such a market for small or startup f-in 1987; it trades stocks of about 50 f-.

–25–
26 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

lation should tend to lower transaction costs. Some

people believe, however, that as a result of technology and deregulation market prices have recently

become too volatile, and that transaction costs

should be deliberately raised by taxing, to discourage “in and out” trading.

New equity issues in public markets are not the

major source of finding for corporate investments

From 1952 through 1981, the proportion of funds

raised by American non-financial corporations

through stock issues ranged from an occasional high

of 7 percent to a low of 0.2 percent in 1980-81. From

1982 through 1988, new stock issues made no net

contribution to capital formation. As corporations

bought back and withdrew stock, there was in fact a

net loss of 14.7 percent. The percent of corporate

funds exclusive of bank loans supplied by bonds and

notes grew from 10.5 percent in 1980-81 to 19.6

percent during the rest of the 1980s. The proportion

of all corporate funds supplied by both equity and

debt securities averaged about 16 percent from 1952

to 1982, and has been much less since then.6

This has led some people to believe that financial

markets “may have deteriorated over time in performing their social functions of spreading risk and

efficiently guiding the allocation of capital.”7 John

Maynard Keynes said, over 50 years ago, “As the

organization of investment markets improves, the

risk of the predominance of speculation does increase . Today, some critics perceive that more

efficient markets (in part a result of information

technology) have encouraged a kind of speculation

that drives stock prices away from fundamental

values and leads to misallocation of financial

resources. Other people argue, however, that securities markets work far better than they have in the

past, and without them the growth of today’s

multinational enterprise would not be possible.

DO STOCK MARKETS DO A GOOD

JOB OF RESOURCE

ALLOCATION?

In addition to facilitating capital formation, securities markets are assumed to allocate capital to its

most productive uses, by allowing stocks (and other

securities) to compete for the investor’s money.

Stock market prices theoretically reveal the relative

values placed on ownership in a corporation (’ ‘price

discovery”). Market efficiency in performing this

function is essential, according to many main-stream

economists. They say that a stock price is the

collective best estimate by investors of the present

value of future earnings, reflected in prices that are

set by people bidding against each other, each using

incomplete but overlapping information. The interaction of supply, demand, and price is assumed to be

the best signal for allocation of resources.

Taxes and regulations affect market pricing by

altering the rewards for risk taking. When that effect

is deliberate and desired, tax and regulatory policies

are working as intended. When the outcomes are

unintentional and undesirable, taxes and regulations

may cause capital to be misallocated. Efficientmarket theorists tend to see most market regulations

and taxes as harmful.

Changes in stock prices are also affected dramatically by mergers, acquisitions, takeovers, and leveraged buyouts that may have unpredictable affects on

corporate values and corporate performance for

reasons not related to market valuation.

Efficient-market theory emphasizes the importance of information in market behavior. It is

therefore not considered possible to "outperform the

market” over time, even by studying all available

information, because, in an efficient market, all

information about stock value is presumably already

reflected in market prices. The only “special”

5b the fist 6 mon~s of 1989, 1,955 new securities issues were offered on American domestic markets, valued at $142 billiov but o~y 4 P~nt

were initial public offerings of new stock. Junk bonds accounted for 11 pemen~ other bonds for 44) percen~ convertible debt and preferred stock for 5

perceng and mortgage- and asset-backed securities (which are pools of loans packaged and resold by banks) accounted for the other 40 percent. Kevin

Wincl+ “Orowing Risk in Corporate Finance,” CRS Review, October 1989, pp. 20-21. Data from Investment Dealers’ Digest. This does not count the

implicit cbange in net equity from earnings retentioq used as a method of shielding dividends from higher income tax rates.

GBoardof Governors of the Federal Reserve System,l%w ofFundsAccounrs. During this period the percent of corpo~tetiti suppli~byre~~

earnings and depreciation ranged from a low of 62 percent (1970-73) to a high of 81.3 percent (1982-88), with the rest accounted for by loans.

~awrence H. Summers (Harvard University) and Victoria P. Summers (Hale Dorr), ‘‘When Financial Markets Work Tm Well: A Cautions Case

fora Securities Transactions Tax,” presentational the Annenberg Conference on Technology and Financial Markets, WaShingtOrL DC, Feb. 28, 1989,

p. 2.

8Jo~ ~Wd Kepes, The General TheoV of E@q~~r, zn:~~~st, and~oney @ew Yorb ~: mcourt B~~, 1936).
Chapter 2—What Securities Markets Do-And For Whom ● 27

information is knowledge that is available only to

“insiders’ (i.e., corporate officials, regulators, etc.),

in which case its use is illegal. Many large investors,

because they believe that one cannot outperform the

market except in very brief instances, hold “indexed” portfolios that contain all of the stocks used

in computing the Standard and Poor 500 index or

another standard market index. (The index is the

weighted average price of a basket of selected stocks

that are assumed to represent the market as a whole.)

The indexed portfolio, by definition, should appreciate or depreciate just as the overall market does.

These investors may also use “passive” trading

techniques aimed only at reflecting general market

trends.

Some people dispute the claims that markets are

efficient, that investor behavior is rational, and that

the price investors are willing to pay represents any

judgment about fundamental values.9 Economist

Joseph Stiglitz said the market is “a gambling

casino for the rich,”10 and John Maynard Keynes

likened it to a beauty contest in which:

. . . it is not a case of choosing which [faces] are

redly the prettiest, nor even those which average

opinion genuinely thinks the prettiest [but] . . . we

devote our intelligences to anticipating what average

opinion expects average opinion to be.ll

Many empirical studies, especially since the

market crash of 1987, have cast doubt on efficient

market theory.12 They ask whether corporate assets

really declined in value by one-third between

October 13-19, or what new information caused

investors to collectively revise their previous judgment so quickly. Alternative explanations of “excessively volatile” stock prices vary from large

swings in the discount rate that people use in valuing

future earnings streams, to the blind following of

perceived trends in general investor behavior, to

mass hysteria, or the actions of those who seek to

profit by anticipating changes in “market psychology. ‘ ’13

Many people have concluded that price jumps

caused by large block trades, by new computerized

trading strategies, and by professional “speculators” make stock prices excessively volatile. This,

they say, endangers financial systems, causes instability in the economy, and imposes unnecessary

risks on small investors. Others blame excessive

volatility on arbitraging, hedging, and manipulation

(although critics sometimes confuse these behaviors

in discussing volatility). These arguments are considered in chapters 3,4, and 5, which describe stock,

futures, and options markets.

There is, in short, little consensus about whether

investor behavior, even in the extreme circumstances that result in a market crash, is rational or

irrational. If investors do behave irrationally a

significant portion of the time, then prices may not

reflect fundamental values, and investment decisions may be based on inappropriate prices. But even

if stock markets are efficient and investors behave

rationally, the allocation of investment capital is

affected by more than securities prices. It is also

affected by banking decisions, interest rates, the

mortgage market, and the domestic money markets;

gsee Michael C. Jensen et ~., “Some Anomalous Evidence Regarding Market Efficiency,” Journal of Financial Econornz”cs 6, 1978; Robert J.

Shiner, “Do Stock Prices Move Too Much ‘Ib Be Justifkd by Subsequent Changes in Dividends?” American Econom”c Review 71, June 1981, pp.

421-436; Lawrence Summers, “Does the Stock Market Rationally Reflect Fundamental Values,” Journal ofFinance 41, July 1986, pp. 591-601. There

are many articles byeconomichistorians on ‘bubbles,’ panics, and crashes in the past, but no consensus is apparent on the extent of investor i.rrationality.

A number of recent papers along this line were presented at a Salomon Brothers Center Conference on Crashes and Panic.r in Historical Perspective,

New York University, Oct. 19, 1988.

IOJoseph Stiglitz, “Comment on Robert Schilier, ’ Keynes’ Economic Legacy: Contemporary Economic Theories, James L. Butkiewica et al. (eds.)

(New York NY: Praeger, 1986).

llJo~ w~d Keynes, op. cit., footnote 8.

lz~e most vocal proPnents of the irratio@~ of markets at present are Prof. Robert Schiller of Princeton ~d Prof. J-Awwmm s~~ of ~.

See op. cit., footnote 9. David M. Cutler, James M. Poterba, and Lawrence H. Summers examined news events on the 20 days over the last 50 years

when the largest market moves occurred and concluded that it was not possible to relate the events convincingly to price movement. (“What Moves

Stock Prices, ’’Journal of Por@oZio Management, 1989.) Richard Roll examin ed the futures market in frozen orange@ice in the context of predictions

about the weather in Florida and reached similar conclusions. (“Orange Juice and Weather,’ American Economi”cReview, 1984, pp. 861-880.) Kenneth

French and Richard Roll compared price movements during and between trading sessions and found no evidence that they reflected information bearing

on fundamental values. (“Stock Return Variances: The Arrival of Information and the Reaction of Traders, ” Journal of Financial Econow”cs, 1987,

pp. 5-26.)

13Apsycholo@t ~ww tit p~cs become almost inevi@le when bull markets continue for a long time. Pticipation in~kets bmomesv~high

and “there are no new believers to be recruited”; “slight tilts in trends will destroy faith that a trend will continue, ” causing investors to flee from the

market. Donald C. Hood, “Toward Understanding Stock -et Movements: A Mm-iage of Psychology and Economics, ” presented in a Science and

Public POliCy Seminar held by the Federation of Behavioral, Psychology@ and Cognitive Sciences, Washingto~ DC, July 1, 1988.
28 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

and increasingly, it is affected by markets, currencies, economic conditions and policies in other

countries. At best, increased efficiency of the stock

market may not improve, or may only slightly

improve, the allocation of corporate capital.

DO SECURITIES MARKETS

BENEFIT ORDINARY

AMERICANS?

A third function of securities markets is to provide

opportunities for people to invest and increase their

savings, and thus to encourage overall savings and

investment. Public policy has traditionally focused

on encouraging small investors by protecting them

against market fraud and manipulation. But trading

on stock exchanges is increasingly dominated by

large investment funds. Only about 18 percent of

trades in 1988 were made on behalf of individual

investors. 14

Most stock—about 59 percent—is still owned

directly by individuals and households.15 Even more

people own stock indirectly through pension funds

and mutual funds. The rest is owned by banks,

insurance companies, foreign owners, and brokerdealers.

It may be misleading to think of individual

investors as ‘‘small investors. While about 19

percent of American households own some stock,16

43 percent of stock shares and31 percent of mutual

fund shares is owned by wealthy families-those

with incomes higher than that of 99.5 percent of

American households.17

The largest group of individual investors-which

is, however, shrinking in numbers-are those who

have a few thousand dollars invested in securities;

this generally does not represent a large proportion

of their household assets. Most of these investors

probably seldom trade their stocks; some trade them

almost as a “dabble”, not as a livelihood. A much

smaller class of individual investors have securities

that average $75,000 to $100,000; these wealthier

Americans are probably much more frequent and

sophisticated traders.

Small investors have been leaving the stock

market for about 20 years, a trend that accelerated in

1987. In early 1989, individual investors were net

sellers of stock at the rate of an average 3.5 million

shares per day, according to the Securities Industry

Association. In the last 5 years, individual investors

decreased their direct holdings by more than a

third. 18 The “small investor” will increasingly be

found mostly under the umbrella of large investment

funds with professional investment managers, and

individual investors still directly in the market are

increasingly less likely to be the traditional small

investors.

Pension funds now give more Americans, and less

wealthy Americans, a stake in the markets.19 Pension plans cover more than 57 million people. Before

the late 1940s, pension plans were rare, and pension

reserves did not show up in accounting for household assets. Even in 1950, pension reserves constituted only 2.6 percent of household assets. By 1987

this had risen to 15.1 percent of household net

worth. 20 In 1955, pension plans owned only 2

percent of corporate securities, in 1988 they owned

~dse~ties Industry Association, Trends, Mar. 16, 1989. This is an estimate; other estimates vary according to how shareholder ~categofizd.

ls~~rding to the Sectities Industry Association in its publication Trends (Mar. 16, 1989), direct individual owllerShip of txltities fell tim 82.2

percent in 1968 to 58.5 percent in 1988. Ownership of securities, both direct and through mutual funds, makes up a decreasing share of household assets;

it was 10.6 percent in 1988, compared to over 18 percent in 1958 and 1969. Bonds constituted 6 percent of household assets in 1988, compared to 6.7

percent in 1958 and 6.8 percent in 1969. Edward N. Wolff, “Trends in Aggregate Household Wealth in the United States, 1900- 1983,” The Review of

Zncmne and Wealth 35(l), March 1989:1-29.

IGRobert B. Avery (Cornell University) and Arthur B. Kennickell @xkml Reserve BoMd), ‘‘Rich Rewards,’ American Demographics, June 1989,

pp. 19-22. Based on 1983 and 1986 Surveys of Consumer Finance conducted by the University of Michigan, Survey Research Center, for the Federal

Reserve Board. The median value of stock owned by households was reported as $6,000, and the average value as $81,300. Stocks, on average, constitute

about 9 percent of household assets, according to this report.

17For compfiso~ the top ~of 1 ~rwnt of f~ies by income distribution own 3 percent of MWingS accomts, 5 percent of owner-occupied ho~~,

14percent of IRA and Keoghs, 28 percent of corporate and Treasury bonds, and 69percent of tmst accounts. Robert B. Avery and Gregory E. Elliehaus~

“Financial Characteristics of High-Income Families,” Federal Reserve Bulletin 72, March 1986, pp. 164-175. This data is probably from 1985; since

small investors have been leaving the markets at a high rate since theu the concentration of ownership in the top 0.5 percent of households is probably

understated.

18~c&el c. Jemem “E&pse of the ~blic Cowratiou HaWard Busine$$ Review, September-October 1989, p. 61.

1!)As f~st pointed out by Peter Dm~ker, The Unseen Rev~l~tion: How Pension Fund So<.ia[ism Came to A~n”ca (New York NY:-r&ROW,

1976).

m~k J. WaSSIMwS@, “pension Plans: Funding, Assets, and Regulatory Envhoment, ” Federal Reserve Bulletin 74, November 1988, p. 725.
Chapter 2-What Securities Markets Do-And For Whom ● 29

25 percent. Pension plan investments have become

a major force in the securities markets.21

Two-thirds of these pension plan investments,

however, are held by defined-benefit plans.= When

the market value rises, this reduces the contribution

the corporation has to make to the plan, but does not

increase the wealth of the workers, whose retirement

benefits are already specified. Such plans cover 72

percent of all covered workers. Only one-third of the

securities owned by pension plans (approximately 9

percent of all securities) are owned by definedcontribution pension plans, in which workers directly own the assets and thus benefit directly by

market gains. Defined-contribution plans also make

those people directly vulnerable to market declines.

The proportion of people covered by definedcontribution plans is growing rapidly and thus the

number of people potentially directly affected by

market losses will grow.

Policymakers and regulators must take these

complexities into account. The traditional public

policy focus on “the small investor’ may not in the

future be as realistic or useful as in the past. The

interests of securities owners and of securities

traders are not always the same. The interests of

wealthy speculators and small investors are not

always the same. The needs of individual investors

and investment fund money managers may be

different. Technology for trade support may not

meet the needs of these groups equally. Exchange

rules and government regulations may not affect

them the same way. Understanding the benefits and

costs to all parties is important in framing public

policy.

DOES PUBLIC OWNERSHIP

IMPROVE CORPORATE

MANAGEMENT?

A fourth function of securities markets is to

control corporate management, or provide it with

guidance. First, the prices at which shares trade in

the market should indicate to managers the public’s

judgment about the earnings prospects of the corporation and thus about the quality of their management. Second, shareholders have the rights of

owners to exercise control through voting in shareholder meetings and elections. The question is, how

effective are these controls now?

Monitoring management performance is difficult

and time-consuming. Since each shareholder has

one voice among many thousands, there is a

vanishingly small amount of leverage, and little

incentive for most shareholders to vote. One school

of thought says that the separation of ownership and

control in publicly held corporations may result in a

misallocation of resources and is a serious problem.23 Among these critics, some see a basic conflict

of interest between shareholders and corporate

managers. It is assumed to be in the shareowners’

interest to maximize company profits and pay them

out as dividends; and in the interests of corporate

management to enlarge the corporation through

developing new products, entering new markets,

spawning new divisions, acquiring other companies,

investing in research and development, etc. This

may defer the paying out of profits to shareholders.

Some argue that managers will seek to further the

long-term growth of the corporation from a spirit of

healthy entrepreneurship, or from a feeling of

responsibility to the workforce and the surrounding

community; others say that managers will be motivated chiefly by the need to justify large salaries or

bonuses for themselves. In either case, shareholders

are (according to this school of thought) deprived of

immediate possession of their profits.

Takeovers are seen as the way to enforce these

alleged rights to immediate profits. In a takeover, an

individual or group acquires enough shares to exert

control, install new management, and change corporate policy. After a takeover, ‘‘excess” corporate

resources-labor, facilities, products, divisions, or

subsidiaries-can be sold and the proceeds paid out

to shareholders for re-investment.

Critics of takeovers say that the fear of takeovers

discourages managers from investing in long-range

productivity improvements such as research, development of new products, and ventures into new

markets. The threat of a takeover encourages strategies aimed at short-term profits rather than longzl~<~e pOwti of tie Pemion F~@” Business Week, NOV. 6, 1989, P. 154.

~~k J. w~shws@, op. cit., footnote 20, pp. 717.’7

?3AdolfA. Bale ~d G~din~ C. M~~ ~~~~ ~r~ps me f~st to iden@ ~s prob~~, in The &f~&?r~ co~oration U?ld~rh@t? ~rO@?~ (~GigO,

IL: Commerce Clearing House, 1932). See alSO Hal R. Varian et al., “Symposium on ‘l%keovers,” Journal of Economic Perspectives 2, Winter 1988,

pp. 3-82.
30 ● Electronic Bu1ls & Bears: U.S. Securities Markets & Information Technology

term growth that would strengthen American industry’s competitive position in world markets. At their

worst, takeovers may destroy jobs, hurt local communities, and often weaken or destroy the corporation. At least 39 States have passed laws to

discourage hostile takeovers.24

There is disagreement about whether takeovers

result in more efficient and profitable firms. There is

also little agreement as to whether or when a

corporate emphasis on short-term profits, if it exists,

is attributable to fear of takeovers.25 A short-term

focus can also result from high real interest rates.26

Advocates and critics of takeovers often agree,

however, that securities markets may not exert

strong discipline over very large corporations. This

may be due to the proportionate decrease in the

influence that can be exerted by even the larger

shareholders, as corporations and corporate assets

have increased in scale. Another reason maybe that

the indexed portfolios and program trading strategies of large investment funds have blurred the

relationship between stock prices and public judgments about the fundamental value of corporations.

Some people advocate public policy incentives to

encourage the long-term holding of large blocks of

stock and the active exercise of shareownership

rights in corporate governance by large institutions

(e.g., pension finds’ corporate sponsors), or other

mechanisms for stronger shareholder control.

An internal defense against acquisition or takeover is the ‘‘buyout,‘‘ in which a corporation buys

back much of its own stock, removing it from the

public market. Most buyouts are highly leveraged,

that is, they are accomplished by borrowing heavily

and committing the corporation to very high interest

payments. The acquired corporation will often sell

assets, pare down staff and workforce, cut other

costs, and pay out the proceeds as interest and as

dividends to the remaining (internal) shareholders.

Leveraged buyouts are usually funded by issuing

“junk bonds’’—i.e., debt that is not given an

investment-grade rating, but carries a high interest

rate. ’27

Michael Jensen claims that “privatization of

equity’ is becoming the central characteristic of

corporate activity today, signaling the “eclipse of

the public corporation.”28 This privatization is

being carried out by the switch to public and private

debt instead of equity, by the concentration of

shareownership in large institutional investors, and

even more strikingly by the wave of hostile takeovers and leveraged buyouts. If Jensen is right that

“privatization of equity” is the wave of the future,

then the role of securities markets in the American

economy could decline in importance even more.

This is a minority viewpoint, but it is likely to be

widely debated in the future.

DOES STOCK MARKET

IMPROVEMENT ENCOURAGE

SAVINGS AND INVESTMENT?

The behavior of the stock market is assumed to

influence the level of investment and possibly the

~~vestor RNpomibility Research Center, Washington, DC.

~David J. RWCI-SCbra,ft and F.M. Scherer studied 95 firms before and after takeovers, and found that their profitability did not Significmfl

(“Life After Takeover,” Journal of Zndusrrial Econom”cs 36, December 1987, pp. 147-156.) See also, F.M. Scherer, “Corporate Takeovers: The

Efficiency Arguments,’Journal of Economic Perspectives 2, Winter 1988, pp. 69-82. Frank R. Lictenberg and Donald Siegel studied manufacturi

establishments taken over from 1972 through 1981 and found that their productivity did increase significantly. (“Productivity and Changes in 

of Manufacturing Plants, ”BrookingsPapers on Econom”cActivity 3,1987, pp. 643-673.) In subsequent studies they found that managerial employment

growtb in these acquired fms was less than industry averages, resulting in cost savings; that there was no si~lcant difference in R&D em

betsveen acquired fm and industry averages; and that growth in wages and benefits was 12 percent lower in acquired than non-acquired firm

Effect of Takeovers on the Employment and Wages of Central-Office and Other Persomel,’ 1988, National Bureau of Economic Research Working

Paper No. 2895).

~RA ~terest rates tie Uketrates less the expected rate of inflation. If one assumes that ‘expected” hI.fkitiOnrateS approfite red ~ation

then real interest rates in the 1980s have still been higher than in recent decades. At a 5 percent rate of interest, the present value of a dollar of 

to be realized 10 years in the future is 61.4 cents. At a 10 percent rate of interes4 it is only 38.5 percent. Thus long-term investments that seem rea

at periods with relatively low interest rates, may not appear justified at periods such as the present with higher interest rates.

zTJ~ bonds me sometimes considered “quasi-equity” because unlike conventional bonds “less a bet on interest rates than on a given they ue

company’s earningpowerand . ..on its ability to meet interest payments out of cash flow. “ “JunkBonds: Last Resorts,” The Economist, Sept. 2,1989,

p. 75. Companies with large debt and interest burdens are vulnerable to small setbacks as well as to general economic recessions, and m

competitive disadvantage relative to other companies. The junk bond market grew very rapidly in the 1980s, to about $200 billiom but began

rapidly in 1988 and 1989. Some companies that used junk bonds for leveraged buyouts were unable to either meet interest payments or refina

debt.

~Mic~el c. Jeme% ~~~hpse of the ~blic copratio~” Harvard Business Review, September-October 19*9, PP. 61-99.
Chapter 2—What Securities Markets Do-And For Whom ● 31

savings rate.

29 The availability of capital for industry

(and thus the cost of capital) is the product of the

multiple decisions of individuals to save or to

spend. 30 The American rate of saving is considered

low compared to that in other developed nations, and

personal saving has declined in recent years. 31 Many

explanations have been offered for this: people may

feel less need to save for retirement because of

insurance coverage and pension plans; large purchases can be financed by borrowing rather than

saving; the baby boom generation until recently was

in the youthful low-savings phase of their lifecycle;

and two-income households engenders confidence

that reduces the need to save.

It maybe that saving in the United States is neither

low or declining.32 Economists count only private

savings, not the purchase of a home, pension

contributions, and insurance policies that many

Americans think of as their life savings. Pension

plans, insurance, and homeownership represent

long-term, predictable investment, and public policies that encourage their growth might yield more

capital for investment, in the long run, than a cut in

the capital gains tax. Some people assume that

increasing the income of upper-income households

will tend to increase savings more than would

income redistribution downward, which would tend

to increase consumption. Others argue that the

wealthy need not invest most of what they have in

order to generate more income than they can

consume, and therefore have relatively little incentive to seek productive investments.

The relationship between income, return on investment, and savings is not empirically wellestablished. The extent to which the saving rate is

responsive to rates of return is still doubtful.33

Continuing debate about the taxation of securities

markets transactions or of income derived from

securities markets cannot be resolved on these

grounds. Nearly all of the possible public policy

approaches to encourage saving and investment in

productive capital are highly controversial from a

social or political standpoint.

HOW MUCH EMPLOYMENT IS

GENERATED BY SECURITIES

MARKETS?

Gross revenues for the securities industry tripled

between 1980 and 1986, reaching a high of $50

billion. Revenue was flat in 1987 and 1988, and

probably declined in 1989. Employment for New

York securities firms reached a high of 262,000 just

before the 1987 crash, and declined to 227,000 by

September 1989, a drop of 13 percent. There have

been further cuts since then, accelerating with the

bankruptcy of the large firm of Drexel Burnham

Lambert in early 1990.34 Total employment nationwide is estimated, on the basis of Labor Department

and Census figures, at 641,000.

The National Association of Securities Dealers

has 6,148 member firms, with 29,235 branch offices.

These firms have altogether 438,701 registered

representatives. The number of support staff is

unknown, but total employment can be estimated at

approximately 530,000. However, there is some

double-counting between this and the earlier figure

of 641,000. A loose estimate of 1 million jobs related

to securities markets sounds realistic.

z~e~ ~e VariOUS economic modeh of invmtment behavior, including the neoclassical model, James Tobin’s ‘q theoI’Y of tivt%tm=4° the ~te@

cash flow mode~ etc. The role of securities markets is explained somewhat differently in each model. For an econometric evaluation of these models,

see Richard W. Kopcke, ‘‘The Determinantts of Investment Spending,” New England Economic Review, Federal Reserve Bank of Boston..July/August

1985, pp. 19-35.

%ereareseveraltheoretical explanations ofhow individuals decide when to consume andwhento save. The “permanat income” model developed

by Milton Friedman says that consumption decisions depend on the level of income expected over long periods of time, so that temporary fluctuations

in incom~,g,, loss of employmen~ or the fear of it—have only marginal effects on decisions to save or not save. The lifecycle model developed by

Modigliani, Brumberg, and Ando says that people attempt to stabilize consumption over their lifetime, including retirement, so that they tend to be net

borrowers in early adulthoc@ net savers during the later working years, and “dissavers’ or net consumers during retirement. Other theories emphasize

the effects of inflation-adjusted rates of return on savings and changes in government or business-sector savings rates.

slAIInual average personal savings dd.ned by IME from 1981 to 1989. This is about one-third the avemge for other industrialized mtio~.

32Robert Ku~er, The Econo~”c Illusion: False Choices Between Prosperity and Social Justice (BostOrlj M.& Houghton= 19M).

33 See for example, Martin Felste@ “Social Security, Induced Retirement and Aggregate Capital Accumulation,” Journal of PoZiticalEconomy 82,

September/October 1974, pp. 905-926; Lawrence Summers and Chris Cmrol~ “Why Is U.S. National Saving SO I.Dw,” Brookz”ngs Papers on Economz”c

Activity, 1987: pp. 607-635; Gregory V. Jump,“Interest Rates, Inflation Expectations, and Spurious Elements in Measured Real Income and Saving, ”

American Econom”c Review 70, December 1980, pp. 990-1004.

~Da@ from the Sectities Jlldusties Association, by telephone and published iII Trends, D=emb= 1989.
32 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

There are 362 firms of futures commission

merchants. They include (as of Jan. 31, 1990) 37,240

“Associated Persons”; 13,638 principals (who are

not themselves registered to sell); and 24,184

“introducing brokers,” commodity trading advisers, and commodity pool operators. There are also

7,470 futures floor brokers. This is 82,532 jobs—

with support staff, total employment might be

estimated as 100,000.

These estimates indicate that employment in

securities and futures markets accounts for, at most,

one-tenth of one percent of U.S. employment. The

majority of these jobs are probably concentrated in

New York and Chicago; only in those cities would

they have a perceptible effect on the local economy.

THE INVESTORS

Institutional Investors

Institutional investors now are the dominant users

of U.S. financial markets in terms of trading on

exchanges, ownership of equity ownership, and total

assets invested in equities. Their assets grew from

$2.1 trillion in 1981 to $5.2 trillion in 1988.35 (See

table 2-l.) This amounts to a 14 percent compound

annual growth rate for the period. The New York

Stock Exchange (NYSE) says that about 10,000

institutions, representing 150 million Americans,

use its services.36

Corporate pension funds managed more than $1

trillion in 1988; public (governmental) pension

funds held more than $600 billion and were growing

faster than corporate plans. The 500 largest corporate pension plans together had over $640.2 billion

invested in securities in 1988. The four largest—

General Motors, AT&T, General Electric, and IBM—

each have assets of more than $26 billion. There are

also very large public pension funds, e.g., New York

City Employees Retirement Fund has over $30

billion and California’s employee fired had over $50

billion invested in 1988.37

Table 2-1—institutional Investors

0

/0 average

annual

Total assets Percent of growth

Category ($, end 1988) assetsa

(1981-88)

Pension funds . . . . . . . . . . 2,240 43.0 14.3

Insurance companies . . . 1,259 24.0 12.3

Investment companies . . 816 15.5 18.5

Bank trusts . . . . . . . . . . . . 775 15.0 12.7

Foundations & other . . . . 133 2.5 13.2

Total . . . . . . . . . . . . . . . . 5,223 100.0

apercentage of all institutional investment holdings.

SOURCE: Columbia Institutional Investment Project, Columbia University,

Center for Law and Economic Studies.

U.S. insurance companies also manage over $1

trillion in securities investments.38 Historically,

stocks were only a small part of insurance company

assets, for reasons rooted both in the industry’s

investment philosophy and in laws regulating the

 State laws now Commonly allow some industry .-

investment in stocks, often requiring them to be

maintained in a separate account.

In the last few decades, mutual funds became

popular. A mutual fund, often setup by a financial

management services company to invest in securities, might have growth, income, or other objectives.

It might focus on securities that are either all or

mostly domestic, foreign, or international. Customers, including many small investors, buy shares of

the funds, and share in the funds’ profits or losses.

Mutual funds’ assets grew at a rate of nearly 27

percent per year from 1975 to 1987, when for a time

after the market crash of 1987 the industry had net

redemptions. Historical ownership patterns suggest

that institutional investing has broadened the base of

participation in markets. (See table 2-2.) By 1989,

the total number of mutual fired accounts, including

money market funds, was 36 million. Their total

value by April 1990 had grown to $1 trillion ($554

billion of which was in stock, bond, and income

mutual funds).40

ssCaro@~yBr~cato and Patricia. Gaugha.n, The Growth ofZnstitutionalZnvesrors in U.S. CapitalMarbts: 1981-1987, The IUStitUtiOMl ~vest

Project, Columbia University School of Law, New York City, Novanlxz 1988, and The Growth of Znstitutional}nvestors, Updated Data: 1981-1988,

Jan. 12, 1990.

%TYSE AnnWl Report, 1989, p. 16. These dam however, appear to come from a 1985 NYSE survey of investors.

ST” 1989 Pemiom Directory, ” Institutional Investor Magazine, January 1989, p. 131.

3smomtiou from tie American Council of Life Insurance, courtesy of Paul R_do~

WIII tie 19th ~n~, common stock was regarded as a speculative investment and avoided by insurance funds. Often this avoidance was written into

law. For example, until 1951 life insurance companies opemting in New York State were prohibited from investing in common stock.

%ata from the Investment Company Institute, June 1990.
Chapter 2-What Securities MarketsDo-And For Whom ● 33

Table 2-2—Volume of Stock Trading on the NYSEa Figure 2-l—Mutual Funds Net Capital Flows

Member

Year Institute Retail firms

1969 . . . . . . . . . . . . . . . . . . . . . . . . . . 42.4% 33.4% 24.2%

1980 . . . . . . . . . . . . . . . . . . . . . . . . . . 47.4 25.7 26.9

1988 . . . . . . . . . . . . . . . . . . . . . . . . . . 54.6 18.2 26.2

aThese SIA estimates were revised in 1990 to adjust for NYSE-provided

data on the contribution of program trading to the volume of trading by

institutions.

SOURCE: Securities Industry Association, Trends, Mar. 16, 1989.

Institutional ownership of NYSE-listed stocks has

increased from 13 percent in 1949 to nearly 50

percent. Institutional funds do about 55 percent of all

NYSE trades; another 26 percent are done by

exchange member firms for their own accounts; and

only 18 percent are done for individuals.41 (See table

2-2.) According to the Securities Industry Association, less than 50 percent of institutional trades are

in blocks smaller than 900 shares. Institutions own

about 39 percent of the stocks listed on NASDAQ.42

They also dominate the market for privately placed

corporate securities.

Individual Investors

Individual investors now own just over 50 percent

of American equity and account for less than

one-fifth of all trading. Over half the population

owns some type of equity investment, although for

most it is through participation in institutional

investments, such as mutual, pension, and insurance

funds. Direct ownership is concentrated among a

relatively small proportion of investors. The United

States, nevertheless, has the highest level of individual participation in the securities markets of any

country in the world. Less than 25 percent of British

citizens hold stock investments.43

In 1985, the NYSE conducted its llth survey of

Americans who own stock in public corporations.44

(The NYSE has not published more recent data and

uses this data in its annual reports and Fact Books

through 1989.) The number of respondents who only

owned mutual funds increased from 4.5 million

(10.8 percent) in 1983 to 8.0 million (17.1 percent)

in 1985.

$6-— –— .

I ! 1 1 I 1 , 1 1 , 1 I 1 I , i , 1 1 I

1987 1988 1989 1990

It is commonly said that individual investors are

“leaving the market” because they have been net

sellers for 5 years and their holdings are decreasing.

The number of Americans owning stock actually

increased at least until 1985, growing from 42

million to 47 million in the preceding 5 years.45

However, nearly all of the increase was in ownership

of shares of mutual finds. (See figure 2-l.) The

number of Americans directly owning stock has

almost certainly decreased since 1985, although the

numbers are hard to pin down. In 1969, shares of

common stock represented 36 percent of personal

financial assets, but by 1979, that figure dropped to

25 percent, and to about 20 percent by 1989.

Individual shareholders’ median income was $36,800

in 1985, a 5.3 percent annual increase over 1983.46

The median size of their stock portfolios increased

from $5,000 to $6,200 in that same period.

Income and investment patterns suggest that

individual investors can be grouped into three sets.

The frost includes people who have less than $5,100

directly invested in the stock market. This is about

45 percent of all individual investors. Approximately 35 percent of individual investors had

portfolios of between $5,000 to $25,000. These are

the traditional small investors. Approximately 20

dlh con-t, about 55 to (jo Pement of the volume of trading of NASDAQ stock is attributed to individuals, according to NASD ofilc~s.

dz~omation provid~ by tie National Association of Securities D~tis.

43Nofi American Smurities Administrators Associatiorh hc.

44New YOrk Stock Exchange, Shareownership, 1985.

d%id,

46~e U.S. ~~n~come, ~ comp~om ~crem~ from $20,2(X) to $22,400 during tie -etime, a 5.5 percent ~llid hl~~.
34 ● Electronic Bulls& Bears: U.S. Securities Markets& Information Technology

percent of individual investors had portfolios in

excess of $25,000. (See table 2-3.)

The 37 million small investors, although probably

better off than the “average American,” clearly do

not depend on securities markets profits for a major

part of household income, and probably do little

trading. The other 20 percent of individual investors9 million people whose average portfolio is estimated at $78,000 to $94,000-are wealthier Americans who may trade more frequently .47

Table 2-4 shows the historical pattern of ownership of equity in the population.

BROKERS

The Industry

Major changes have occurred in the operations

and structure of the brokerage industry during the

past few decades; contributing factors were the

paper-work crisis of the late 1960s, the unfixing of

commission rates in 1975, the departure of many

retail investors from direct investments in common

stock, the increasing dominance of institutional

investors, and more attractive returns for brokerage

firms from “risk-based” businesses. This has resulted in floundering and uncertainty for many

brokerage firms. Other changes include cyclical

impacts on the industry’s employment and profit

levels and increased concentration in the industry.

The long-term effects on small investors have not all

been beneficial.

The “back office” overload of the late 1960s

accelerated the introduction of computers into brokerage fins. Since then, computers have increasingly permeated most of their operations, from

Table 2-3-Size of Individual Portfolios, 1985

Number of

investors Portfolio

Percent of individual portfolios (millions) ($ value)

45 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.1 less than 5,000

35 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.5 5,000 to 25,000

20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.4 over 25,000

SOURCE: Data from New York Stock Exchange, Share Ownership, 1985.

recordkeeping to order entry, transaction confirmation, client report preparation, client account analysis, and clearing and settlement.

Competition for commission rates led to substantial rate reductions for institutional customers and

kept rates on small orders from rising. Between 1970

and 1989, for example, commissions on institutional

investors’ transactions dropped from 26 cents to

between 4 and 7 cents per share.48 Pension funds,

which in mid-1985 paid little attention to transaction

costs, now look hard at ways to reduce them.49 Based

on a survey conducted by the Institutional Investor

in 1989, 99 percent of responding pension plan

sponsors monitored their commission costs, 50

percent monitored soft-dollar50 usage, 45 percent

monitored market price impact, and almost half

reported that they have cost-cutting programs or are

planning to start them.51

In spite of the growth of stock trading volume,

commission revenues in the brokerage industry have

declined as a proportion of total revenue.52 Institutional and retail trading volume both have fallen

below record peaks in 1987.53 The combined effect

of this trend (and the rapid growth of other businesses), is that commissions from equities transactions have declined from over 60 percent of all

revenues in 1965 to under 17 percent in the first half

AT~e U.S. public equity tiets Mve a capitalization of about $2.5 trillion. Consematively estimating that one-ha.lfof this is OWnti by 47 *on

individuals ($1.25 trillion), then the uverage stock portfolio is $27,000. Yet, 45 percent of stock portfolios me $5,000 or less. Assume that these $5,000

accounts collectively amount to between $59 billion and $106 billion of stock owned by individuals. Stock owners with portfolios of $5,000 to $25,000

account for an additional $247 to $411 billion of individual stock ownership. Therefore, the remaining 10 million (one-ftith of 47 million) investors has

between $733 billion and $944 billion of the $1,250 billion of equity owned by individuals, or an average portfolio of $78,000 to $94,000.

~About 70pmcent of pension plan sponsors responding to a survey reported that their commission costs were MtW@n 4 ~d 7 rents Pshe. “me

Drive To Cut Transaction Costs,” Znstitutiond lnvestm, May 1989, pp. 125-126.

Amid. Tr~saction costs consist of commissions, market impac~ portfolio turnover, futures trading COStS, md soft-do~ u~ge.

50Soft do~s is ameas of pa~g brokerage fms for ~efi servims ~ou@ commission revenue, ratier ti~ tiu@dhed payments, or htird dolh

fees. For example, amutualfundmayofferto pay for the research of abrokeragef~ by executing trades generated by that research through the brokerage

firm. The brokerage fm may agree to this arrangement if the fund manager promises to spend at least $100,000 in commissions with the broker that

year.

s~Imti~tio~l Investor, op. cit., footnote 48.

s~rokers~ lmge @asactiom+ore ~n50 percent were from using risk ~d index arbitrag~receive few COInIniS sions per share relative to smaller

transactions.

fis’1’’rading avaaged 189 ~lion s~es ~r day ~ 1987, a re~rd yew for tie New York Stock Excknge, md 165 million skes in 1989. NYSE ~990

Fact Book, p. 80. Trading averaged 156 million shares per day by mid-June 1990, according to the NYSE.
Chapter 2-What Securities Markets Do-And For Whom ● 35

Table 2-4-individual Equity Investment

Percentage

Number of Percentage of Owned mutual of equity

Year equity owners population funds only owners

1956 . . . . . . . . . . . . . . . . . . . . . . . . . . 8,630,000 5.20 935,000 10.83

1962 . . . . . . . . . . . . . . . . . . . . . . . . . . 17,010,000 9.20 2,165,000 12.73

1970 . . . . . . . . . . . . . . . . . . . . . . . . . . 30,850,000 15.10 3,977,000 12.89

1980 . . . . . . . . . . . . . . . . . . . . . . . . . . 30,200,000 13.50 2,231,000 7.39

1985 . . . . . . . . . . . . . . . . . . . . . . . . . . 47,040,000 20.10 6,219,000 13.22

SOURCE: New York Stock Exchange Shareholder Surveys.

of 1989.54(See figure 2-2.) The trend also has

affected large, full, service brokers. At Merrill

Lynch, for example, commissions were about 53

percent of total revenues in 1972, while by 1988 they

had fallen to 15 percent.15 The securities industry

also has undergone considerable concentration. In

1973 the top 10 industry firms accounted for 33

percent of the industry’s share of capital. By

September 1989 their share had increased to 61

percent.

Even though cyclical trends, e.g., large-scale

swings of employment and profits, are not uncommon in the industry,56 capital increased fivefold

from 1980 to midyear 1989 from $7 billion to $39

billion.57 Another key long-term trend is diversification through financing principal transactions, many

of which have become large revenue earners. (See

figure 2-3.) These include proprietary trading, merchant banking, bridge loans, sole-managed underwriting, and participation in ownership of commercial enterprises. These are areas in which the

industry is risking its own capital, in contrast with its

historical tendency to provide services for clients’

fees. Risk-based revenues in the securities industry

accounted for 64 percent of all revenue in 1989 v. 42

percent in 1980.58

A Tiered Client Structure

Some brokerage firms have begun to treat all but

their largest institutional clients like “retail” cusFigure 2-2-Share of Domestic Broker-Dealer

Percent

40

70

Revenues

*Principal transactions are revenues from trading and investments.

SOURCE: Securities Industry Association, Trends, An Analysis of Emerging Trends in the Securities Industry, vol. XV, No. 4, May 30,

1989, p. 9, updated by SIA, July 1990.

tomers. One firm found that 150 of its clients were

contributing 90 percent of its revenue, while the

remaining approximately 700 institutions contributed about 10 percent. Only the 150 largest institutional clients now get lower commissions, access to

the firm’s research, and direct access to its analysts.

Another firm has similar plans; these disadvantage

clients whose accounts generate less than $60,000 in

commissions per year.59 Medium-sized institutions

and large retail clients, however, still receive better

service than do small retail clients. If this trend

~Se~ties bd~q Assoeiatiou Trends, Dec. 29, 1989, VO1. XV, No. 7, pp. 7-8.

ssData from IWefl Lynch’s 1972 and 1988 annual reports.

56For ~=ple, at lat 35,~ jobs fi the ~dusq ~ve ken ~t in the 2 yens fo~owing the octo~r 1987 st~lc market Cmh, although total

employment grew by 62 pereent from the end of 1980 to the thirdquarter of 1989. Securities Industry AssociatiorL Trenalr, vol. XV, No. 7, Dee. 29,

1989, p. 3. At least another 10,000 jobs maybe cut in New York during 1990 alone. “Wall Street’s Mediocre Managers Again Lurch From Binge to

Bus~” Wall Street Journal, Feb. 1, 1990, p. Cl.

STSee Sm, Tre~, op. cit., footnote 56, p. 3.

58sw, Tr,gds, Oct. 20, 1989, p. 1.

59~~p~eWebber WtS s~ee~ on Clients That Don’t Trade, ’ Wall Street Journal, Jan. 11, 1990, p. C 1. Shearsom LehnmrL Hutton, for example,

offers “preferred client” status to customers based on assets in theti accounts of at least $200,000 and account activity which generates $1,000 in annual

eoromissions. Shearsoq LehmML HuttorL The FM4 Journal, Apr. 2, 1990.
36 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Figure 2-3-Securities industry Main Revenue Sources

45 $ billions

40- Commissions have not doubled in a

decade and are less than 17% of all

revenue. Principal transactions have

35- increased four-fold while “securities

related” revenue has grown 12•fold and

30- account for one-third of today’s revenue. “Securities related”

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

SOURCE: Securities Industry Association, Trends, Oct. 20, 1989, p. 3.

becomes industry-wide, it will create a three-tiered

brokerage system, with institutional investors, medium institutional and large retail customers, and

small retail customers each paying different rates

and receiving different services by full-service

brokers. The emergence of the discount brokerage

industry represents still another level of treatment.

This could mean higher costs and fewer services for

small investors from major brokerage firms.

Stockbrokers in the past were generally paid

commissions based on sales volume. They were

motivated to encourage clients to buy and sell

securities and, later, an expanding array of other

products. Coremissions are higher for sales of a

fro’s proprietary products. Stockbrokers typically

had some measure of independence. For example,

they might or might not recommend to clients the

same stocks or other products that their employers

recommended. The key factor that distinguished

stockbrokers from most other sales workers was

their personal relationship to clients. If a stockbroker

became a trusted adviser to clients, those clients

often could be lured away when the stockbroker

changed employers. These relationships made possible frequent job changes to other brokerage firms.

One of the effects of the introduction of brokerage

fins’ proprietary products-mutual funds, real

estate limited partnerships, and cash management

accounts-was to strengthen the relationship between the client and firm, while weakening the

stockbroker-client relationship.60

By the mid- 1980s, computer terminals and workstations had become commonplace for most brokers.

They are valuable for keeping track of customer

accounts and providing rapid access to securities

prices and other market news. Computerization also

made it easier for employers to audit stockbrokers’

performance and productivity.61 New software made

it possible for brokerage firms to standardize certain

customer services. Many firms broadened the scope

of their brokerage business to add personalized

financial consulting, relating their clients’ broader

financial interests to financial securities, real estate,

annuities, college and retirement planning, mutual

funds, and life insurance investments, some of which

were proprietary. Some of these products are particularly profitable for the firm, because they generate

underwriting fees and commissions in addition to

‘Garso~ Barbara,“TheElectronic Sweatshop” (New York NY: Simon& Schuster, 1988), Ch. 5, The Wall Street Broker: Decline ofa Salesman,

p. 128.

611bid.
Chapter 2—What Securities Markets Do-And For Whom ● 37

annual management fees.62 There is a conflict of

interest between selling those products that generate

the highest commissions and helping clients find the

investments best suited to their needs.

The terms ‘registered representative’ and ‘stockbroker” were replaced by “Account Executive,”

which, in turn, was largely replaced with ‘Financial

Consultant” (FC). FCs increasingly are being encouraged to use their employer’s specialized software packages to enter data on clients and to analyze

clients’ needs for products offered by the brokerage

firm. This leads to standardized recommendations to

clients and a closer relationship between the firm

and the client; proprietary products may be difficult

to transfer to another brokerage firm. There is also a

trend toward replacing FCs with lower paid employees, sometimes salaried, who are less well-trained

and even less independent than brokers.63

Many midsize investors who need professional

help in managing their assets are unwilling to be

dependent solely on FCs. They may manage substantial amounts of funds (typically between $100,000

and $10 million, representing perhaps a family’s

assets or a small business’ pension fund)-yet the

amount may not be sufficiently large to qualify for

the management services of a large investment

house that manages only bigger portfolios. Brokerage firms began to bring these clients together with

outside portfolio managers, who make investment

decisions for the client for a fee.64 The brokerage

firm executes transactions, arranges depository services and keeps records of transactions, and provides

independent reports on the performance of the

manager. For this the brokerage firm receives a

separate fee. This has become one of the fastest

growing parts of the investment business. Competitive commission rates have facilitated the unbundling of investment advice and brokerage.

For large investors, the long-term collective

effects of these changes in the brokerage industry are

probably positive. They may be less so for midsized

investors. The small investor benefits from the larger

range of products available, the greater competitiveness of the industry, and the availability of discount

brokers.65 In other ways, however, the small investor

may become worse off because some brokerage

houses may not give their interests high priority due

to the difficulty of profiting from small transactions.

Moreover, the competitive economic forces unleashed by the unfixing of commission rates and the

unbundling of services mean that services for small

investors may be becoming less subsidized by large

investors.

Some FCs say66 that their office managers no

longer inquire about how well they are serving the

fro’s clients, but instead use computer printouts to

monitor the commission revenues each FC has

generated on a daily basis.

These trends indicate an ongoing restructuring in

the brokerage industry with greater concentration,

realignment of business focus away from retail sales,

continued pressure on floor brokers for lower

commissions, and different treatment of investors

according to the commissions generated. For small

investors the question arises: where may they get

good advice and how much will it cost?

62Someproducts, such as some closed-end funds of stocks or bonds, are sometimes offered to clients at “no commission%” which is mis

the brokerage firm is one of the lead underwriters, the broker may receive between 4 and 5 percent of the amount of these sales.

63GW50Q op. cit., footnote 60, pp. 145-154.

~The a,nnual fee either is a freed (“wrap’ fee) or variable percentage of the total value of the client’s portfolio, e.g., * Ptm3ent of the frost $3

1.8 percent of the next $20,000, and 1.5 percent of the amount exceeding $50,000. Fees vary among portfolio managers.

GsThe dis~~tbrokmage industry alSO has been undergoing concentration. Some estimates are that the number of independent discount~

by as much as 25 percent since 1983 to about 100 by early 1990, and is still shrink@ as the industry remain s competitive. One comparison of

commissions notes that full-service brokers’ commissions may be about two to three times or more as much as those of the big three disco

even greater tban deep-discount brokerages. One discount broker recently announced a three-tier commission structure for traders ranging fro

per share to 5 cents per share, depending on their trading volume. “Now Fewer Firms Are Chasing Small Investors,” The New York Times, June 17,

1990, sec. 3, p. 10.

‘OTA interviews,
Chapter 3

The Operation of

Stock Markets
CONTENTS

Page

OPERATION OF THE EXCHANGE MARKETS . . . . . . . . . . . .... +...... .. ....” 42

THE OTC MARKET AND NASDAQ . . . . . . . . . . . . . .., .., .. .. .. ”” ”” ”” 45

THE NATIONAL MARKET SYSTEM. . . . . . . . . . . . . . .. .-....-........”.’””’.””.” 47

CHALLENGES TO THE SPECIALIST SYSTEM . . . ................’”~o”~o..o 49

Changes in Trading patterns . . . . . . . . . . . . . . . . . . . . . .....O~.......C...O... 49

Small Orders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. ................ . 49

Block Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .,. .........-.w.....0.00.... s.* 50

COMPETITION IN STOCK MARKETS . . . . . . . . . . . . .. .. .. .. .. .. .. ... ... .*. 51

Competition Among Market-Makers . . . . . . . . . . . . . . . . . . . . . . ’ . ”. . . +. . . . . . . . . . . . 51

Competition Among Market Facilities . . . . . . . . . . . . . ............”....”.’..”“. 52

Competition Among Customers’ Orders . . . . . . . . . . . . . . . .......+..””..””.!. .... 53

THE 1987 MARKET BREAK AND THE PROBLEM OF VOLATILITY . . . . . . . . . . . . 54

The Debate About Volatity . . . . . . . . . . . . . . . . . ................. . 54

The Debate Over Program Trading . . . . . . . . . . . . . . . . .. .. .. .. .. .” .+ ... .”. .”.”.”” 55

The Debate About Circuit Breakers . . . . . . . . . . . . . .................+.~.””.. ● “?”’.” 57

THE 1987 MARKET BREAK AND THE PERFORMANCE OF

MARKET-MAKERS . . . . . . . . . . . . . . . . . . . . . . . . . ........~.....”..”.”.... 58

NYSE Specialists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... . . . . . . 59

OTC Market-Makers . . . . . . . . . . . . . . . . . . . . . . . . . . . .....,..... . 60

THE 1987 MARKET BREAK AND THE LIMITATIONS OF TECHNOLOGY ... ....61

AUTOMATION AND STOCK MARKETS: THE FUTURE................ . . . . . . . . . 61

Domestic Exchanges of Tomorrow . . . . . . . . . . . . . . . . .. .. .. .. .. .. .. .”. ... 62

Around-the-Clock, Around-the-Globe Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

Box

Box Page

3-A. The Mechanics of a Stock Transaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Figure

Figure Page

3-1. Saga of a Stock Transaction . . . . . . . . . . . . . . . . . .. .. .. .. .. ... ... ~.. ... ..... 43
Chapter 3

The Operation of Stock Markets

A securities market is at core a communication

system and a trading mechanism. Its functions are:

1) to communicate orders for securities and the

prices bid or offered for them (“quotes”), and 2) to

match those orders and transform them into trades.

Because of this, communication and computer

technology (“information technology”) not only

can, but inevitably will, change the nature and

operations of securities markets. Their performance

and efficiency must be evaluated in the light of what

could be achieved with advanced information technology. 1

The stock market crash in 1987 highlighted three

problems that could cause future disasters—

excessive short-term volatility, technological risk,

and strains on the abilities of market-makers to

perform their functions under stress. Neither the

markets nor their regulators have completely solved

those problems in the intervening 3 years.

Stocks are traded in two different kinds of

markets-exchanges and over-the-counter (OTC)

markets. These markets differ in several important

respects. In exchange markets, member firms act for

themselves and as agents (brokers) for customers,

bringing their orders to a central facility-a “floor”-

to be executed. These member firms are large

securities companies such as Merrill Lynch or

Goldman Sachs. Orders can be executed in two

ways: against other orders—i.e., a bid to buy

matching an offer to sell; or if there is no such order

at an acceptable price, by a sale to or purchase from

the “specialist”—a member designated by the

exchange to be the sole market-maker for that stock.2

The largest U.S. exchange, by far, is the New

York Stock Exchange (NYSE). Approximately 1,740

companies’ stocks are listed on the NYSE. The

smaller American Stock Exchange (AMEX) lists

approximately 860 stocks. In general, the stocks of

the larger and better-known corporations are traded

on the NYSE, which has more stringent listing

requirements. The NYSE-listed stocks account for

almost 95 percent of the trading volume in all

exchange-listed stocks.

There are also five regional exchanges-the

Midwest, Pacific, Philadelphia, Boston, and Cincinnati Stock Exchanges-that serve as alternative

markets for stocks listed on the NYSE and the

AMEX (and a few stocks listed solely on the

regional exchanges).

3 Exchange-listed stocks are

also traded over the counter. This is the so-called

“third market,” which accounts for about 3.2

percent of the volume in NYSE-listed stock.

Many stocks do not trade on stock exchanges.

They are traded only in the OTC market, operated by

the National Association of Securities Dealers

(NASD) as a self-regulatory organization. In this

market securities firms can act as brokers (agents) or

dealers (principals) with respect to any stock.4 A

firm receiving a customer’s order to buy stock can

either sell the stock to the customer from the firm’s

own inventory (if it is a dealer in that stock) or act as

broker in purchasing the stock from another dealer.

In this market, nearly every transaction involves a

dealer as one party, whereas in exchanges, customer

buy and sell orders can be matched. OTC orders are

not routed to a central physical facility but handled

by dealers working over the telephone or through a

computerized small order execution system. About

4,900 actively traded OTC stocks are listed, and bids

and offers for them are displayed, on NASD’s

~Some of tie material in this Chapter draws on an OTA contractor report, Joel Seli_ ‘‘Stock Options, and Stock-Index Futurm Tmding,”

University of Michgan Law Schoo~ August 1989. For further background on the issues discussed in this chapter, see Joel Seli- “The Future of

the National Market Systen” 10 JOZWUZZ of Corporate Law 79, 1984; Macy and Haddoclq “Shirking at the SEC: The Failure of the National Market

System,” 1985 University of Illinois Law Review 315; and Normon Poser, “Restructuring the Stock Markets: A Critical Look at the SEC’s National

Market Systa” 56 New York University Luw Review 883 (1981). See also U.S. Congress, Progress Toward Developing a National Ma

Report of the Subcommittees on Oversight and Investigations and Consum er Protectioxu Committee on Interstate and Foreign Commerce, U.S. House

of Representatives, No. 96-89, Sept. 24, 1979. Contributions to this chapter were also made by contractors Professor David Ramer, Georgetown

University School of Law, and Junius Peake, Peake/Ryerson Consulting Group, Inc.

%l_YSE rules technically allow for competing specialists, but there bave becm none since 1%7, and exchange procedures (including those procedures

for disciplining specialists by reallocating stock assignments) are framed around the assumption tbat there will be only one specialist per stock.

3S~e volUe ~ NyS&list~ stW~ ~ 1989 Wm: ~dwes~ 5.6 percen~ Pacfilc, 3,1 percent p~~elp~ 1,8 pemen~ BostoU 1.6 perCen4

Cincinnati, 0.5 percent.

dNew York Stwk fic~We member f- are, however, forbidden by NYSE rules tO do 50 @de 390, discussed latm).

4 1 –
42 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Automated Quotation system, NASDAQ. Corporate

bonds, municipal bonds, American Depository Receipts, and U.S. Treasury bonds and notes are also

traded in the OTC market. Figure 3-1 and box 3-A

illustrate the mechanics of a stock trade.

OPERATION OF THE EXCHANGE

MARKETS

A key function of securities markets is to facilitate

capital formation by providing liquidity, i.e., to

enable investors to buy and sell securities when they

wish to do so. Many (not all) securities markets use

intermediaries or professional market-makers to

increase liquidity by helping would-be traders find

each other or by themselves trading. Stock exchanges in the United States have a specialist, or

designated market-maker, for each listed stock.5

U.S. stock exchanges are continuous auction

markets. Members of the exchange bring their own

or customers’ orders to the exchange floor and, in

face-to-face negotiations, offer to sell a specified

number of shares at a specific price (“an offer”) or

to buy a specified number of shares at a designated

price (“a bid”).

The customers served by exchange members are

increasingly institutional investors (e.g., pension

funds, mutual funds, insurance finds). Over 55

percent of NYSE trading is for these institutions;

another 26 percent is for securities firms’ proprietary

accounts, including those of specialists. Only 18

percent of trades are for individual investors.6

Stock exchange specialists act as both brokers and

dealers. As brokers, specialists buy and sell for the

public, by executing limit orders that are brought to

them on behalf of customers by floor brokers; they

also execute market orders that reach them through

the automated order routing system, SuperDOT.7 (A

limit order specifies the price at which an investor is

willing to buy or sell. Limit orders are put in the

specialist’s ‘book’ until they can be executed at the

designated price or a better price.8 A market order is

an order to buy or sell immediately, at the prevailing

price.) Specialists are prohibited by law from

handling customer orders other than limit orders.9

The specialist’s book was once a looseleaf notebook

but now it is, for most NYSE stocks, a computer

screen. The specialist is not, with some exceptions,

required to show this screen to other traders,

exchange members, or the public, although he must

disclose aggregate price information.10

As dealers, specialists buy and sell for their own

account. They have an “affirmative obligation” to

do so when it is necessary to provide liquidity.

Specialists provide liquidity by buying or selling

when there are no other bidders or offerers at or near

the market price. The specialist tries to keep prices

from making big jumps, by making a bid or offer that

acts as a bridge when there is a wide gap between

bids and offers. The specialist also has a‘ ‘negative

obligation,’ not to trade for his own account when

there are already customers wanting to trade at or

near the market price.11

Specialists participate in a substantial proportion

of NYSE trades. NYSE figures in 1990 show that

specialists’ purchases and sales as dealers account

for 19 percent of all sales and 9 percent of all

transactions (purchases and sales) on the exchange.

One study in 1985 concluded that specialists might

me exception is the Cincinnati Stock Exchange, which is completely computerized and uses “designated dealers.” In other U.S. exchanges, the

specialist is part of a specialist fm, or unit, that is a member of the exchange. Historically, specialist fms tended to be small, well-capitalized firms,

distinct from the Iargebroker-dealer firms that are better lmown to the general public; more recently, a few of the specialist firms am owned by brokerage

houses such as Merrill Lynch. At the end of 1989, the NYSE had 52 specialist fms with 434 individual specialists making markets in 1,712 common

stocks. [Source: NYSE, February 1990]

GSecfitim I.ndWtry Associatio~ Trends, W. 16, 1989.

7A~o ~ bmkem, ~~s~~~stop~~ ~~et orders when hey s= tittie order my & executed at a better price later (e.g., when a block trade iS

being negotiated). The specialist guarantees that the order will receive at least the price available at the time the order was stopped.

8A ~=~~dof tit Order is a stop order, ~~ which a Customm s~fies titthe order sho~d be executed wh~ the stock price drOpS tO a CRlbbl

price level, or rises to a certain price level.

9SWtiti= Exchange AC6 SeC. 11 (b), 1934.

l~e NYSE is fi~g ~~the SEC a propo~ for ‘CA ~k at tie Book” mot ~o~,wh~eby limit orders for 50 st~ will be -e available

to the public through vendors. Information provided by the NYSE, July 16, 1990.

llB=ides acfig ~ b~kers ad de=.ers, s~i~sts ~ve a ~dfiction, which ~ to begin ~ch trading s@sion by overseeing or orchm-the

determination of the opining price.
Chapter 3-The Operation of Stock Markets ● 43

1

-1

-1
44 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Box 3-A—The Mechanics of a Stock Transaction

What happens when you visit or call a stock broker to buy or sell stock? The following description traces the

chain of events that results in a transaction by a small investor.

A. When you decide to buy or sell stock an Account Executive writes an order ticket, filling in the

details-whether to buy or sell, the name of the security, how many shares, whether the order is to be executed at

the market price or is a limit order (an order to buy or sell when the price reaches a specified level). The market order

is passed to a teletype operator who keyboards the information and sends it immediately to an electronic system

linking the broker to the various exchanges and over-the-counter dealers.

B. If the order involves an exchange-listed stock and there are no special instructions routing it to another

market center, the order will enter the Common Message Switch, an electronic pathway linking brokerage firms and

trading floors. This is the beginning of a journey that could carry the order to several alternative destinations.

C. Most orders in NYSE-listed stocks are routed to the NYSE’s SuperDOT 250 system, where orders of fewer

than 2,000 shares are executed. These orders can go either to the specialist’s post on the floor of the exchange, or

to the brokerage firm’s floor booth (although with a small order, that is unlikely).

What happens next depends on the timing. On a typical day, between 15 and 20 percent of all orders are

executed at the market opening. Through SuperDOT, market orders to buy or sell, routed to the specialist post prior

to the market opening, are automatically paired with opposing orders. The specialist, after matching buy and sell

market orders and checking outstanding limit orders and larger opening orders, sets an opening price for the stock.

The specialist then executes all paired orders at one price and sends confirmation notices to originating brokers

within seconds of the market opening, through the Opening Automated Reporting System (OARS).

Orders that arrive at the specialist’s post through SuperDOT after the opening can be filled in several ways.

Orders of up to 2,099 shares are usually filled at the best quoted price or better in the Intermarket Trading System

(ITS). This system connects NYSE, AMEX, five regional exchanges, and NASD’S Computer Assisted Execution

System (CAES). ITS quotes are displayed at the NYSE specialist’s post for all floor traders to see. An order sent

to ITS will be filled within 1 or 2 minutes at the best price among any of these markets.

For larger orders, or when a wide spread exists between bid and asked prices, the specialist will execute a

SuperDOT order in the traditional way (see D). He can also execute the trades from limit orders in his “book.” The

specialist is obligated to get the best price available at that moment for the client.

D. Some orders are not handled electronically but rather by the broker firm’s floor broker. Wire orders reach

floor brokers when they are too large for SuperDOT (see C above) or are larger than the broker’s chosen parameters

for direct routing through SuperDOT

At the broker’s floor booth, these orders are translated into floor tickets containing the essential buy/sell

information necessary to make the trade. Floor clerks pass the details to floor brokers by hard copy (or through hand

signals at the AMEX). The floor broker then presents the order at the specialist’s post. There the stock is traded with

another brokerage firm, or with the specialist, who may be acting as agent for a client on his books, or who may

be acting for his own account. Or the floor broker may execute the trade on another exchange, if there is a better

price posted on the ITS screen over the specialist’s post. The above applies to exchange-traded stock.

E. If the stock is traded over the counter, and the quantity is more than 1,000 shares, the wire order goes to one

of the broker’s OTC traders at its main office. There, a computer on the OTC trader’s desk displays the identities

of all market-makers for that stock and their current bids and asked prices. The trader telephones the market-maker

with the best price, and executes the trade.

If the brokerage firm itself makes a market in that stock and the broker’s OTC trader is willing to match the

best price shown on NASDAQ, the trader can buy or sell it as principal. In either case, at the press of a button on

the trader’s keyboard, the trade is executed and a confirmation notice is sent to the originating office.

If the OTC order is for 1,000 shares or less, and the stock is listed on NASD’S “National Market System,”

it will be automatically routed via NASDAQ’S Small Order Executive System (SOES) to the market-maker with

the best price at the time of order. (If the stock is not on the National Market System, it must be for 500 shares

1A&pt~ fiorn “me Saga of a Stock Transaction,” The Zndividua2 Investor vol. 3, No. 3, June-July 1988 (American Association of

Individual Investors).
Chapter 3-The Operation of Stock Markets Ž45

maximum to go through this system.) Trades executed through SOES take less than 90 seconds from order wire

to confirmation.

F. What happens next is “after the trade” activities, and the process depends on whether the trade was executed

manually or electronically. Generally, the trade confirmation is sent back to the broker through the same pathway

by which the order arrived, and the broker calls the customer to confirm the transaction.

Executed trades are also reported immediately to the brokerage firm’s purchase and sales department and to

the exchange, so that the transaction will go on the Consolidated Ticker Tape. Once on the tape it is visible to the

investor community, and to the exchange’s and regulatory agency’s surveillance analysts.

G. On or before the day following a trade, the brokerage firm sends its customer a written confirmation showing

the details of the transaction. The customer has five business days from the trade date to pay for purchases delivery

(i.e., to settle). About 95 percent of trades are settled through the National Securities Clearing Corp.

The Depository Trust Company (DTC) stores stock and other certificates and maintains records of ownership

for brokerage firms and banks. Under normal circumstances, your stock certificate will be registered in DTC’S

nominee name-’ ‘held in street name’—for you as the beneficial” or real owner. Or you may choose to request

physical delivery of the stock to you.

For customers who want physical possession of their stock certificates, these shares are registered in the

customer’s name by the transfer agent of the issuer. Errors and delays can occur in the paperwork trail from

brokerage firm to NSCC, NSCC to DTC, DTC to transfer agent, transfer agent back toDTC, DTC to brokerage firm,

brokerage firm to customer. For this reason (and other good reasons) there is considerable interest in eliminating

paper certificates (“dematerialization’ and replacing these with electronic records, as some countries have already

done.

be involved, either as dealers or brokers, in more

than 70 percent of all NYSE trades at that time.12

THE OTC MARKET AND

NASDAQ13

Until 1939, the OTC market was largely unorganized and unregulated. In that year the Maloney Act

Amendments to the Securities Exchange Act allowed the creation of the National Association of

Securities Dealers as a self-regulating organization

with responsibilities in the OTC market like those of

securities exchanges.

Stocks traded in the OTC market are divided into

two tiers—the 4,900 NASDAQ stocks, and 40,000

others. NASDAQ includes the more active stocks;

for these, the bids and offers of all registered

market-makers (dealers) are shown and continuously updated on the automated quotation system, so

that the broker or customer can identify the dealer

offering the best quote. A NASDAQ market dealer

can become a market-maker in a security merely by

notifying NASDAQ operations of intent. There were

an average of 10.6 market-makers per security in the

NASDAQ market at the end of 1989.14

For 40,000 less active stocks, until mid-1990

dealers could advertise their prices only by printed

quotations (the “Pink Sheets”). On June 1, NASD

opened an electronic “Bulletin Board,” on which

dealers may post and update quotes for these stocks.

lz~ns R. StoIl, The Stock Exchange Specialist System: An Economic Analysis. New York University, Salomon Brothers cater for the Stidy of

Financial Institutions: Monograph Series in Finance and Economics, Monograph 1985-2, p. 15. This was based on analysis of SEC data indicating that

limit orders left with the specialist are involved in approximately 24 percent of all purchases and sales. Since the specialist would not be on both sides

of a single Wmsactiou this would mean that limit orders were behind 48 percent of total trades (24 percent of purchases added to 24 percent of sales).

These figures will be somewhat different from year to year.

13~ket data in this section supplied by NASD.

ldNatio~Ass~iation of Securities Dealers, Inc., 1989 Annual Report.
46 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

The Bulletin Board can be accessed by 2,700

terminals in the trading rooms of member firms.15

Until 1971, all OTC stock quotations were

reported only in daily Pink Sheets, which listed bid

and ask prices of each dealer for each stock for the

previous trading day. To getup-to-the-minute quotations and meet commonly accepted “best execution” standards, a stockbroker had to telephone at

least three dealers and compare their quotes. The

time and effort involved in contending with busy

signals and wrong numbers made this an ideal

situation for using computer and telecommunicaions technology.16 Since the introduction of the

NASDAQ system in 1971, the volume of trading in

NASDAQ securities has grown rapidly. In 1976

NASDAQ share volume was 31 percent of NYSE

share volume. In 1989 it was 76 percent of NYSE

share volume.17 Now the NASDAQ market is the

second largest stock market in the country. In the

frost half of 1989 daily volume was more than 134

million shares, up from 123 million at the end of

1988.18 Increasingly the NASDAQ market is used

by institutional investors as well as small investors,

and block trades now account for 43 percent of total

volume. This growth is largely due to technology; as

computer systems supplement telephones, dealers

can handle larger volumes and provide immediate

automated execution for many trades, and customers

can receive more competitive prices.

The NASDAQ-listed stocks are further divided.

National Market System or “NMS” stocks are the

most widely held and actively traded stocks, for

which transactions are reported as they occur. Of the

4,500 stocks in the NASDAQ system, approximately 2,800 are NMS securities.

NASD is basically a telephone market supported

by a computer screen quotation-display system (and

the automatic execution system for small orders).

Quotations are collected and disseminated by leased

telephone lines from the NASDAQ Central Processing Complex to dealers’ desktop terminals. For

NMS securities, OTC dealers must provide last sale

data within 90 seconds of a trade. For the second-tier

stocks dealers need report only the aggregate trading

volume at the end of the day.

NASDAQ quotations are indicative rather than

firm for lots over 100 shares, except for orders

eligible for small order automated execution, for

which prices must be firm up to 1,000 shares.19 In

other words, NASDAQ market-makers do not disclose how many shares of stock (over 100 shares)

that they are willing to buy or sell at their quotation

prices. 20 The OTC dealers continue to display the

minimum size (100 shares) required by NASDAQ

rules. The price for transactions over that size must

be negotiated.

Market-makers are required by now-mandatory

SOES participation in the Small Order Execution

System (SOES) to execute public small orders up to

1,000 shares in NMS stocks (the number varies by

stocks) at market prices, and to maintain minimum

SOES exposure limits up to five times that amount.

However, SOES trades are less than 2 percent of

NASDAQ volume.21 The Securities Exchange Commission (SEC) has repeatedly encouraged NASD to

change its NASDAQ requirements. An NASD

proposal, submitted to the SEC on March 20, 1989

and not yet acted on at mid-1990, would require a

NASDAQ market-maker’s size display to be at least

151JI tie f~st w~k of opmatio~ over 100 OTC dealers advertised prices for about 3,000 domestic and foreign securities. NASD says tit 7,235

market-making positions were displayed. The Bulletin Board differs from the NASDAQ quotation system in several ways: 1) there are no listing

standards; 2) dealer quotations need not be fm quotations, and can even be unpriced indications of interest; 3) the Bulletin Board does not transmit

data to press wire services or to information services vendors, as does NASDAQ; 4) it has no equivalent of the NASDAQ’S Small Order Execution

System.

lsForhisto~ of OTC trading, see Joel Selig-rnq 1982, op. cit., footnote 1; and Simon and Colby, “TheNational Market System for Over-t.he-Counter

Stocks,” 55 George Washingtontiw Review 17, 19-34, 1986.

IvAbout 27 percent by dollar volume, because the average price of OTC stock is much lower than the average pfice of NYSE stock.

lgSource: NASD, February 1990.

lgfiofessio~-proprie~ (dealer) orders, and customer orders over 1,000 shares, are not eligible for SoES.

~ASD points out that in NASDAQ stocks, where dealers are exposed on an identified basis to both automated execution and othrx real-time

quotation-executionprocesses, the display of size has impacts on dealers that do not exist in othermarkets. In NASDAQ eachdealerquotationis displayed

and the identity of each market-maker fm is disclosed. Actual execution size is as large, above the displayed minimunL as the quantity all competing

dealers are willing to take into inventory at a particular time and price. Size in individual dealer quotations contains inventory-related information and

it requires additional resources to update on a continuous basis. In simpler terms, if a dealer is offering the lowest offer, a competing dealer could “pick

him off,” i.e., buy all of his stock and then resell it at the second dealer’s own (higher) price.

21A number of propfie~ automted systems at dealer firms’ also execute such smd order m~es.
Chapter 3-The Operation of Stock Markets ● 47

the SOES required order size in the stock (i.e., up to

1,000 shares).

THE NATIONAL MARKET

SYSTEM

In the early 1970s and again in the late 1980s, the

operation of American stock markets aroused congressional and regulatory concern. In 1969 to 1970,

a series of operational and financial crises caused the

collapse of a number of securities fins, and thereby

provoked studies of the securities industry and

markets by both Houses of Congress and by the

SEC. These studies ultimately led to the passage of

the Securities Acts Amendments of 1975, which

included the most far-reaching revisions of the

Securities Exchange Act of 1934 in more than 40

years.

A more recent wave of congressional and regulatory concern followed the October 1987 market

crash. A number of reform proposals were made by

special commissions, regulatory agencies, and Senators and Representatives. More were proposed after

disclosure in 1988 and 1989 of a string of stock

market abuses and frauds, and a near crash in

October 1989. A few of these reform proposals were

implemented by self-regulatory organizations, some

are still before Congress or regulatory agencies, and

some have been dropped for the time being.

The 1975 Amendments directed the SEC to

“facilitate the establishment of a national market

system for securities” and to order the elimination

of “any . . . rule imposing a burden on competition

which does not appear to the Commission to be

necessary or appropriate in furtherance of the

purposes” of the Act.22 The basic objective of the

1975 Amendments was the development of a more

efficient, fair, and competitive national market

system that could provide:

●

●

●

●

economically efficient execution of transactions;

fair competition among brokers, dealers, exchange markets, and other markets;

availability to brokers, dealers, and investors of

information about quotations and sales;

practicability of brokers executing customers’

orders in ‘‘the best market, ’ and -

● “an opportunity, consistent with [other] provisions. . . for investors’ orders to be executed

without the participation of a dealer. ”

Congress said that these objectives were to be

achieved through “the linking of all markets for

qualified securities through communication and data

processing facilities. . ..,” but it did not specify the

exact nature of these systems and facilities.

There is disagreement over whether the objectives

of the Amendments, as subsumed in the phrase ‘‘a

national market system,’ have been fully achieved.

The nature of the basic objective seemed to call for

some necessary steps:

●

●

●

●

a consolidated quotation and price dissemination system, so that market-makers could compete with each other to make better bids and

offers;

electronic order routing and execution systems,

to speed up transactions, reduce transaction

costs, and assure customers that their bids and

offers are taken in order by price and time of

arrival;

a way of efficiently directing orders to the

market or market-maker with the best quotation

at that moment; and

a national clearing and settlement system,

making effective use of information technology.

The SEC’s efforts to develop a markets-wide

communication system predated the 1975 Amendents. Until 1972, NYSE and AMEX ticker tapes

and electronic displays gave a continuous report of

transactions on those two exchanges. They did not

report transactions in the same securities on regional

exchanges or in the OTC market. Under SEC

prodding, a consolidated last-sale reporting system

was established in 1972 by the Securities Industry

Automation Corp. (SIAC). SIAC is the central trade

price processor and reporter for exchange-listed

securities for the NYSE, AMEX, the five regional

exchanges, and the NASD.

But a consolidated quotation system that would

allow brokers to check all markets for the best price

to execute a customer order was still not available

for exchange-listed stocks at the time of the 1975

Amendments. In 1978, the SEC proposed requiring

~S~ties Exc~ge Act, see. 1 IA(a)(l). me ~mtients also extended the Act to cover clearing agencies and tiOMMiOn p=eSSOrS, ~d

increased the SEC’s oversight powers over the Self-Regulato~ Organizations (SROS) in the securities industry.
48 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

a universal message switch, a broker-to-market link

through which a customer’s order would automatically be routed by a broker to the market or dealer

showing the best quote. The exchanges objected,

and the next year the SEC shelved its proposal.23 It

approved, instead, the development of a market-tomarket link-the Intermarket Trading System or

ITS-as proposed by the exchanges. The ITS

enables specialists and floor brokers on one exchangenot customers or non-member retail brokers—to

transmit orders to market-makers on another exchange floor or operating over-the-counter, who

have posted a better price on the consolidated

quotation system. The market-maker receiving the

order must respond within 1 or 2 minutes or the order

expires.

The ITS does not require that an order be routed

to the market with the best quote. The order can be

executed in the market in which it is received,

provided the specialist or a floor broker matches the

best quote available elsewhere. The regional markets, most of the time, match NYSE quotes; i.e., their

prices are derivative of those on the NYSE.

The Securities Acts Amendments of 1975 sought

to increase competition by having the SEC review

exchange rules “which limit or condition the ability

of members to effect transactions in securities

otherwise than on such exchanges. The SEC was to

report its findings within 90 days and begin a

proceeding “to amend any such rule imposing a

burden on competition which does not appear to the

Commission to be necessary or appropriate in

furtherance of the purpose of this title.”24 A

“fail-safe” provision authorized the SEC to limit

trading in listed securities to exchanges, but only if

it were necessary to protect investors and maintain

an orderly market, and after public hearings.

The most significant restraint on market-making

in exchange-listed securities is NYSE Rule 390

(originally Rule 394), which prohibits members

from making markets off-exchange in listed stocks

(i.e., they can act as dealer only as a specialist on an

exchange). In a proceeding to determine whether it

should eliminate Rule 390, the Commission found

that the “off-board trading rules of exchanges

impose burdens on competition” and that the SEC

was “not now prepared to conclude that these

burdens are necessary or appropriate for the protection of investors. ” It proposed repeal of the rule.

However, after 4 years of deliberation and hearings,

the Commission announced in 1979 that it was

withdrawing its proposal. It instead adopted an

experimental rule, 19c-3, that allows NYSE members to make OTC markets in stocks first listed on an

exchange after April 26, 1979.

A number of major stock exchange members then

started making markets in newly listed exchange

stocks, about 10 percent of the 100 most actively

traded NYSE stocks, including the “Baby Bell”

companies spun off in the split-up of AT&T. This

market-making proved unattractive or unprofitable,

either because of the small number of stocks or

because of the competition, or for other unrevealed

reasons. By 1983 member firms had largely withdrawn from that activity, although a few have since

resumed marking markets.25

There are several arguments against abolishing

Rule 390. Large member firms might internalize

their trading by executing orders upstairs. This

would, critics say, fragment the market for those

securities, with none of the upstairs or off-exchange

markets being liquid or deep enough to keep the

spread narrow. However, it could also cause a

screen-based market for those securities to develop,

with competing market-makers providing good liquidity.

Critics also argue that abolishing Rule 390 could

lead firms to execute customer transactions at less

favorable prices than could be found on the exchange floor.26 This is, however, also true for orders

~SeC. Ex. Act Rels. 14,416, 14 SEC Dock. 31, 1978; 14,805, 14 SEC Dock. 1228, 1978; 14,885, 15 SEC DOCk. 1391978. S* ~SO: Norman Poser,

“Restructuring the Stock Markets: A Critical Look at the SEC’s National Market System,” 56 N.l! University Luw Review 883, 923, (1981); Joel

Selix “The Future of the National Market System,” 10 Journal of Corporate LawJ 79, 136-137, 1984.

ms~tiesfic~%e AC$ SeC. 11A(c)(4). lheseprovisions were deleted from the Act in 1987, as “obsolete,” on the ground that “theserequirements

were met several years ago. ’ Senate Rep. No. 100-105 at pp. 20-21, 1987. The 90-day provision was obsolete but there is not complete afpement that

the substantive intent of the requirement had been met.

~Mfi Lynch dropped out h April 1983, followed by Paine Webber and bkiman Sachs.

~“TradcMhrough” rules could forbid brokers from executing orders at a price less favorable t.tum that offered on any exchange or NASDAQ; but

when trades are made on the floor the price is sometimes better than the published quotatio~i.e., the trade is -de “between the quotes” as a result

of floor negotiation. There have been several proposals of various kinds of order-exposure rules, which would require orders to be exposed for a length

of time before transactions; this could add to transaction costs or to dealers’ risks.
Chapter 3-The Operation of Stock Markets ● 49

sent automatically by many brokers to one exchange

(usually the NYSE); they may miss better prices off

the exchange. The SEC has been reluctant to force

the NYSE to change the rule on the basis that market

participants—the members of the exchange-are

best able to determine the effects of this NYSE rule.

Competition from overseas markets makes it

important that Rule 390 be reexamined. With global

securities trading,

27 Rule 390 is becoming increasingly burdensome. Many trades by large investors in

89 of the 100 most actively traded exchange-listed

stocks are done after NYSE closing in the London

market. (As discussed later, the NYSE is planning

limited actions to try to recapture these trades with

electronic trading mechanisms. These are likely to

be ineffective if large investors want to trade these

stocks ‘‘around the clock. ’ The SEC has been

criticized for this hands-off attitude toward Rule

390. Congress may soon find it necessary to direct

SEC to reconsider.

Another major barrier to competitive trading

among markets has been the rule preventing exchange specialists from competing with OTC marketmakers in trading unlisted stocks. The 1975 Amendments directed the SEC to grant unlisted trading

privileges where ‘‘consistent with the maintenance

of fair and orderly markets and the protection of

investors.

For 10 years the SEC made only tentative moves

to meet the intent of the 1975 amendments. In 1987,

the SEC allowed exchanges, as a trial, to trade up to

25 NASDAQ securities. Only the Midwest Stock

Exchange took advantage of this, and it captured

only about 1 percent of the volume in those shares.

On June 1, 1990, the SEC expanded this trial into a

pilot program that will (in 9 months) allow up to 100

selected OTC stocks to be traded by the Midwest,

Philadelphia, Boston, and American exchanges.

Because it relies heavily on listing fees for revenue,

the NYSE refused to participate. Companies might

be reluctant to list with the NYSE if their stocks

could be traded on the exchange without listing.

Some large corporations now traded only over the

counter (e.g., Apple and Nike) may benefit by the

added exposure, and investors may get better prices

because of increased competition. However, these

stocks already have competing market-makers on

NASDAQ, and it is uncertain how much additional

exposure the smaller exchanges will provide.

CHALLENGES TO THE

SPECIALIST SYSTEM

Changes in Trading Patterns

The stock exchanges and the NASDAQ system

were organized to deal with moderate-sized orders

based on a “round lot” of 100 shares. With the

growing importance of institutional investors, this

system became strained.28 Institutional trading grew

rapidly in the 1960s and thereafter. Institutions

increasingly traded in large blocks (10,000 shares or

more), that require special techniques because large

volumes are difficult to handle in the usual reamer.

Between 1975 and 1988, the average size of an

NYSE transaction increased from 495 shares to

2,303 shares. Comparable increases occurred in

other markets. Brokers’ commissions were deregulated in 1975. Small individual orders (less than

1,000 shares) became too expensive to handle in the

traditional manner. Techniques had to be developed

to funnel these orders to the market-maker in a more

efficient reamer. Traditional techniques based on

specialists became increasingly unsatisfactory for

both small and large orders.

Small Orders

Faced with either losing money on small-order

transactions, or charging high commissions and

driving away the small investor, the exchanges and

NASDAQ developed automated order routing and

execution systems for orders over a specified size.

The NYSE’S Designated Order Turnabout System

(DOT later called SuperDOT), began in 1976. In

1988 the order routing system handled 128,000

orders a day. Orders are sent to the specialist post,

where they are announced to the floor brokers,

executed, and reported back. SuperDOT reduces the

costs and eliminates most of the errors in executing,

transferring, or reporting trades.

The AMEX Post Execution Reporting is much

like DOT, allowing members to electronically route

27s~~oTAB~&gm~d paper, Tr~i~gArou& the clock: secun”tie~~~~k~t~ a~lnfo~tion Technology, CjTA-BPa-66 (Wd3.hl@O~ ~: U.S.

Government Printing Office, July 1990).

2S~emly 1990, fiti~tio~~ve~tor~ ~Womt~ for45e3 ~e~entofNYSE~@. The ann~av~age, howev~,bsbenss percentby share vohune.
50 ● Electronic Bu1ls & Bears: U.S. Securities Markets & Information Technology

orders up to 2,000 shares directly to the specialist.

Routing may be done from the member’s trading

room or from the broker’s desk on the floor, with an

execution report generated automatically.

Four regional exchanges have developed smallcustomer-order-execution systems that operate as

derivative pricing mechanisms, basing prices on

NYSE quotes. (The fifth, The Cincinnati Exchange,

is completely automated.) Brokers or trading rooms

can electronically route an order to a specialist at a

regional exchange. The specialist must accept the

order at the best price available in the Consolidated

Quotation System, or at abetter price. (The Philadelphia system does not allow the specialist to better the

price.) If the specialist does nothing, at the end of 15

seconds these systems execute the order automatically on behalf of the specialist and report it back.

These systems have helped the regional exchanges

to increase their share of NYSE-listed volume.29

On NASDAQ’S small order execution system,

SOES, orders of up to 1,000 shares are automatically

30 No telephone executed at the best market price.

contact with a dealer is needed. At the end of 1988

only about 9.4 percent of NASDAQ transactions by

value (1.4 percent by volume) were being handled

through SOES. However, SOES is the standard for

a number of proprietary automated execution systems in NASDAQ stocks. About 70 percent of

NASDAQ trades are “SOES eligible” (i.e., within

SOES size limits), so this allows the automatic

execution of a large proportion of NASDAQ trades.

Block Trading

The big problem with trading large blocks is not

cost, but liquidity. Big blocks usually have to be

broken up, and their execution often sharply changes

the prevailing market price. Neither the specialist

system on the exchanges nor the NASDAQ system

in the OTC market were designed to provide instant

liquidity for very large transactions near current

market price.

Block trades involve 10,000 or more shares, or

have a market value of $200,000 or more.31 Transactions of this size were rare 25 years ago. They

increased rapidly because of the growth of large

investment funds with large assets for investment

and trading. Block trades made up only 3.1 percent

of reported NYSE share volume in 1965, with an

average of 9 block trades a day. In 1988, more than

54 percent of reported share volume on the NYSE

involve block trades, with an average of 3,141 block

trades per day. About 20 percent of these block

trades involve over 250,000 shares. Block trades

accounted for 43 percent of share volume on

NASDAQ in NMS stocks in 1988, and on the

AMEX they accounted for 42 percent.

Specialists were increasingly strained to fulfill

their affirmative obligations to provide liquidity and

smooth out price jumps when these large blocks

came to the floor. The NYSE responded by developing procedures for ‘‘upstairs’ trading of blocks.

Under these procedures, an institutional investor

goes to an exchange member (a large securities firm

such as Goldman Sachs or Merrill Lynch) that has

registered as a “block positioner.”32 The block

positioner usually commits itself to execute the

entire block at a specific price, itself taking all of the

shares that it cannot sell to others. The positioners

primarily work “upstairs” in their trading rooms

rather than on the exchange floor. They are, in effect,

making markets, although they have no affirmative

obligation to do so as does the specialist.

A positioner who receives an order for the

purchase or sale of a block is required by NYSE Rule

127 to “explore in depth the market on the floor,”

and must “unless professional judgment dictates

otherwise, ask the specialist whether he is interested in participating in the transaction. Rule 127

also requires the specialist to “maintain the same

depth and normal variations between sales as he

would had he not learned of the block, ” in other

words, to act as though he has not been warned.

In advertising the block, the positioner may find

additional interest on the same side as well as on the

other side—i.e., in the case of a block to be sold,

additional sellers as well as potential buyers—and

may agree to handle these shares also. Once the

positioner has put together as many buyers and

29CTS ~tivity Report, December 1989. NYSE Strategic PI*g and Marketing Research.

~These titsvwaccorfig to the security-they may be 200 shares, 500 shares, or 1,000 skes.

JINew York stock Exchange Guide (CCH) Rule 127.10, SeC. 2127.10.

32~ OCtober 1989 three were 57 f~s re@ster~ ~~ NYSE as block positione~ (source: NYSE) w comp~ed to G15 in 1986, according to the Brady

Report, VI-9.
Chapter 3-The Operation of Stock Markets . 51

sellers as it can find, the positioner may buy for its

own inventory any shares left over, or the specialist

may do so when the block is taken to the floor.

When the order is carried to the floor, the

negotiated price may be above the current offer or

below the current bid. There are elaborate rules to

make sure that customers with limit orders on the

book at or near the current price will not be

disadvantaged, as they could be if their orders were

executed just before the price moved as a result of

the block trade. Instead, their orders are supposed to

be executed at the ‘cross’ price (i.e., the block trade

price).

Because of strong competition among the block

positioners, institutional customers pay very low

broker commissions. Possibly for this reason, securities firms now appear increasingly unwilling to risk

their capital in block positioning. The block positioners have no affirmative obligation to make

markets. SEC officials assert that while these block

procedures worked well in addressing the volatility

encountered with block trading in the late 1960s,

they do not handle progam trading well, and there is

evidence that liquidity for the large blocks may now

be decreasing.33

There is currently a tendency for large institutional trades to be executed on regional exchanges

rather than the NYSE. According to the Midwest

Stock Exchange, the reasons are to suppress advance

information about the impending trade, and to make

it less likely that ‘‘others will intervene before the

institutional trader can play out a particular (positioning) strategy. "

34Brokers like to put together

‘‘crosses” (i.e., to match buyers and sellers) without

going through the specialist or the floor crowd so

that they can collect commissions on both sides.

They may go to a regional exchange to avoid the

NYSE limit order book, because in New York ‘the

block probably would have gotten broken up,” or a

specialist may “try to come in late on a deal that’s

already established.’ ’35

COMPETITION IN STOCK

MARKETS

Assessing competition in the stock markets is

difficult because of several structural features. First,

stock markets involve many services, including

execution of transactions, market-making, and information processing and dissemination. Competitors

may provide one or more of these services, and a

firm that provides one service may either provide or

be a customer for another service. Second, the nature

of trading requires that competing firms cooperate

with one another by adopting standardized procedures that enable the market to function. Finally, the

exchanges and the NASD are membership organizations whose goals and practices reflect the interests

of their members. The membership of these organizations overlaps. A firm that is a member of all or

most of these organizations may oppose practices in

one organization that adversely affect the fro’s

operations in another.

The three areas of competition which have been

most controversial since the 1975 amendments are:

1) competition among market-makers, 2) competition among market facilities, and 3) competition

among customer orders.

Competition Among Market-Makers

The SEC has been strongly criticized for not

moving toward a national market system by forcing

the repeal of NYSE Rule 390. That would permit

NYSE member firms to compete in OTC markets in

listed stocks. This would in turn encourage the

development of proprietary electronic trading systems that could become, in a sense, competing

exchanges.

There are reasons to approach such radical change

cautiously. There is experience with exchange

(specialist) markets and with competing dealer

(OTC) markets. There is no real experience with a

market where traditional floor-based specialists

33~~Ketchu Says Stwk F-Ae Balking at Putting Capitid ~ BIWk positiom, “ 21 Sec. Reg.&L. Rep. (BNA) 547, 1989.

~~dwest Stock ExC~ge br~h~e: I~titUtiO~l Tr~erS und Regional Exchanges.

35~id0
52 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

compete with multiple dealers or automated execution systems.36

The closest approach to competition of this kind

is the “third market” (non-members of exchanges

dealing in listed stocks over-the-counter) and the

“fourth market” (trading between investors on

proprietary electronic trading systems). But these do

not show how such a market might develop if the

dominant large brokers of listed stocks become

market-makers. Experience with Rule 19c-3 indicates that most firms will not make markets in a

small number of stocks. If they were able to route

orders in all stocks to themselves as market-makers

(or even to a neutral electronic facility), marketmaking might be more attractive.

Some people predict that if Rule 390 were

rescinded it would have a negligible impact on the

market. Others argue that exchanges would be

abandoned and all trading shifted to an OTC market

modeled on NASDAQ or on the International Stock

Exchange in London. There is disagreement about

whether investors are best served by an exchange or

an OTC market.

While NYSE members cannot compete on the

exchange in market-making for NYSE-listed stocks,

there is competition between the NYSE and other

markets. Trading of NYSE-listed stocks on regional

exchanges, NASDAQ, proprietary trading systems

such as Instinct, and overseas markets now accounts

for 30 percent of all trades in those stocks and more

than 15 percent of the share volume. The third

market alone-OTC dealers-accounts for 3.2 percent of volume in NYSE-listed stock. Some dealers

now pay brokers for directing order flow to them

rather than to exchanges (where the broker would

pay a transaction cost).

The NYSE also must compete with the NASD for

listings. It has successfully retained almost all of its

listed companies (it is nearly impossible for a

corporation to “delist” from the NYSE),37 and has

even lured some large companies from NASDAQ.

NASD, on the other hand, has been successful in

holding many large companies that qualify for

NYSE listing. One measure of NASDAQ’s success

is that on many days there are almost as many stocks

that trade more than 1 million shares on NASDAQ

as on the NYSE.38

There were once competing specialists within the

NYSE, but the last disappeared in 1967.39 Now

NYSE procedures, customs, and technology are

geared to a single market-maker. Another way to get

internal competition would be for member firms to

compete for the privilege of being the specialist in a

particular stock, but the turnover in specialist

assignments is very low.

Competition Among Market Facilities

The SEC has also been criticized for not insisting

on more competition among market facilities. It

approved the ITS instead of pressing for a universal

message switch (UMS) that would automatically

route brokers’ orders to the market where the best

price was being displayed. The critics’ assumption

is that a UMS would encourage the regional

exchange specialists to more effectively compete by

offering better prices than offered by the NYSE or

AMEX specialist. The regional systems compete

with the NYSE and AMEX through speed and

transaction costs under the ITS, but there is no

inducement to compete by bettering NYSE prices.

They need only match the NYSE price.

The regional exchanges warmly defend ITS.40 In

1989 the Midwest received more than 10 percent of

its trades (15 percent of its share volume) from ITS.

The number of stocks listed on ITS has grown from

300 in 1978 to 2,082 (of which all but 300 are

NYSE-listed). The number of shares traded on ITS

sG~e ~eric~ Stock Exchange and the Philadelphia Stock Exchange have a specialist and competing dealers (On the floor) in cea of tie options

which it trades. However, because of the complexity of options (puts and calls, different prices, and different expimtion dates), this may be more an

example of sub-markets than a model which would work in the single market for the single class of stock.

3’7T~ dehst its stock volm~ly, a co~ration must ~ve two.~ds of fie s~es voted to dehst and no more ~~ 10 percent of the shareholders

opposed to delisting.

38~SE and NASDAQ ~ol~e fiWes ~e not completely comp~able, sinm ~ NASDAQ ~des involve a purc~e or Ae by a d~er while sOme

NYSE trades involve a direct transaction between two investors. Customer to dealer to customer is two sales; customer to customer is one sale.

s% 1933, mere were 466 NYSE stocks with competing specialists, in 1963 there were 37.

~or example, a vice president of the Midwest Stock Exchange says that ITS “is vital to the continued competitive viability of all market centers

that compete with NYSE. . . . Without H’S there would be insufficient liquidity on markets other than on NYSE to adequately service most investor

needs.’ Allan Bretzer, Oral Statement before the OTA Advisory Panel on Securities Markets and Information Technology, Jan. 22, 1990. Text provided

by IW. Bretzer.
Chapter 3-The Operation of Stock Markets ● 53

annually has grown from 42,000 in 1978, its first

year, to 2.3 billion in 1989.

ITS is not sophisticated; it is simply a communication system. After the 1987 market crash, the SEC

concluded that “the present configuration of ITS is

not designed to perform efficiently in high volume

periods.”41 ITS has been modernized and expanded

since the crash; some of its critics have moderated

their criticism. Other critics say that one of the

objectives of a national market system is not being

fully met—that of inter-market competition.42 It is

still much simpler for brokers to route orders

routinely to the NYSE than to spread them among

exchanges, especially if the price differences are

small or nonexistent. Only with automatic routing of

customers’ orders to the market with the best price

will regional and OTC market-makers have a full

incentive to provide competing quotations. This is a

chicken-or-the-egg situation.

Is real market-making competition among exchanges (as they are currently organized) either a

realistic or desirable expectation? The benefits of a

central market, with a physical floor and specialists

to whom all orders are routed, are touted by those

who think an electronic market would be fragmented

and less liquid. There is some inconsistency in

extending this defense to five or six competing

floors with specialists, each receiving a portion of

the order flow. The regional exchanges have chosen

to compete: 1) by offering less expensive service to

brokers for the automatic execution of small trades,

and 2) enabling block positioners to complete

crossed transactions without exposing orders to the

NYSE specialist or customer orders on the NYSE

floor. Less expensive services may pressure the

major exchanges to reduce the costs of executing

small transactions,43 but their services to block

positioners may result in denying to customers

whose orders have been routed to the NYSE floor an

opportunity to participate in the crossed transaction.

The advantages of the regional exchanges for

small orders or for block trades might or might not

ensure their competitive survival if a UMS routed

orders to the market with the best price. A UMS

might not strengthen the regional exchanges as

competitors with the NYSE but might instead create

an integrated electronic market in which all of the

exchanges would become only service centers for

brokers and issuing companies, and perhaps regional

regulatory organs.44

Competition Among Customers’ Orders

The most far-reaching criticism of the failure of

the SEC to ‘facilitate the establishment of a national

market system” is that it has not pushed for the

establishment of a single system in which:

1.

2.

3.

all customer orders would have an opportunity

to meet,

customers’ orders could be executed against

one another without the participation of a

dealer, and

any dealer would be permitted to make markets.

Such a system would differ from today’s stock

exchange system (which does not meet the frost and

third criteria), and from today’s OTC market (which

does not meet the first or second). Some experts

argue that this would require the SEC to replace the

exchanges and NASDAQ with a computerized

system in which all orders and quotes would be

inserted and all transactions would be executed.

Such a system is technically feasible and it would

hold the promise of cost reductions in trading

securities. The basic questions are: Would it work?

Would it be an improvement over the current

system? What are the risks? Other possibilities are

discussed later in this chapter.

41 SEC Division of Market Re@atio~ The october 1987 Market Break, 1988; Report of the Presidential Task Force on Market Mechanisms, 1988

[the Brady Commission Report]. The NYSE acknowledged that extremely high trading volumes generated backlogs of orders. According to the Brady

Report, SEC suggested that ITS might adopt default procedures ensuring tbat if a commitment to trade was not accepted or rejected during the specifkd

time period, execution would automatically occur.

dzseli~an, contractor report to OTA, op. cit., footnote 1.

43~e success of there@o~exc~nges ~ this competition c~be gaug~ by the fact that they curren~y account for more than sOperWnt Of the tiUdeS

(not volume) in NYSE-listed stocks, most of their activity being in small trades.

44France p~m t. ~tegate iw regio~ bo~es With ~elw~ofic ne~or~ and offlci~ anticipate an outcome such as sketched here. See OTA

background paper, op. cit. footnote 27.
54 ● Electronic Bulls& Bears: U.S. Securities Markets & Information Technology

THE 1987 MARKET BREAK AND

THE PROBLEM OF VOLATILITY

The stock market crash in 1987 focused attention

on three important problems—volatility, technological risk, and market-maker performance. Several

times in 1986 and 1987 there was extraordinary

short-term volatility in the stock market.45 The break

came in October 1987. From the close of trading on

October 13, to close of trading on October 19, the

Dow fell 769 points, or 31 percent. In the frost hour

of trading on October 19, the Dow fell 220 points, or

over 11 percent. In all, the drop on that day was 508

points, nearly 23 percent, with a record volume of

604 million shares. On the next day, October 20,

there was great volatility, with the market rising

nearly 200 points in the frost hour, declining more

than 200 points in the next 2 hours, and rising again

by 170 points just before closing, with a new volume

record of 608 million shares. On the third day the

market rose 10.1 percent, the largest one-day rise in

history; but there was another one-day fall of 8

percent the following week. These losses were

paralleled by similar declines in the U.S. regional

exchanges and OTC markets, and in stock exchanges around the world.

Several special studies by task forces, regulatory

agencies, and exchanges reached different conclusions about the cause of the 1987 crash.% In the

following 2 years no general consensus has emerged.

Blame has been placed on rising interest rates, trade

and budget deficits, decline in value of the dollar,

new financial instruments such as stock-index futures, program trading for portfolio insurance, too

much and too little inter-market linkage, discussions

in Congress about changing tax laws, investor

irrationality, over-reliance on computer systems, and

under-use of computer systems.

It is also possible that increasing volatility is

nearly inevitable given the increased volume of

trading, coupled with computerized trading. The

average daily volume has increased from about 30

million shares in the mid-1970s to 165 million in

1990. Peaks in volume can go much higher; on

October 19, 1987, 604 million shares were traded.

The NYSE said at that time that it was preparing—

technologically-for a billion share day. The rate of

turnover (number of shares traded as a percentage of

total number of shares listed) has also been increasing. Between 1951 and 1966, the turnover rate never

exceeded 20 percent. Between 1967 and 1979,

turnover ranged between 20 and 30 percent; it then

began to increase rapidly. Since 1983, turnover has

exceeded 50 percent every year, reaching a peak of

73 percent in 1987. This is one of the forces that

raises doubts about the continued capability of

traditional trading mechanisms to cope with increased pressure.

The Debate About Volatility

Whatever the cause of the 1987 market break, a

more persistent concern is the appearance of excessive short-term volatility in the stock market before

and since the crash. By some estimates the 1987

volatility was roughly twice the level of volatility

over the preceding 4 years.47 On at 1east four

occasions in April, 1988, there were abrupt rises and

falls; for example, on April 21,1988, the Dow fell 36

points in 30 minutes. On October 13, 1989, the

market dropped about 190 points, or 7 percent, most

of it in the last hour of trading.

Many experts nevertheless deny that there is

excess volatility. There is disagreement over how

much is ‘‘excessive’ or how volatility should be

measured (e.g., changes in price from day to day,

4f@n Sept. II ad IZ, 1986, the DOW declined 6.5 percent with daily volume of 238 and 240 million shares. On Jan. 23, 1987, it fe~ 5.4 Pement in

1 hour.

46Brady Repo~ ~A7; SEC ~ket Bre& Rqo~ 7-48; T-J. S. Congress, &nerd kCOUntiUg Office, Pre~i?nI”fIaQ @.SematiOns on the October 19=

Crash, 1988; N. Katzenback An Overview of Program Trading and Its Impact on Current Market Practices, Dec. 21, 1987 [the Katzenbach Report];

Commodity Futures Trading Commissio~ Divisions of Economic Analysis and Trading and Markets, Final Report on Stock Index Futures and Cash

MarketActivity During October 1987, 1988.

47Rqofi of the ~~identi~ ~k Form on ~ket Mech~sms, 1988, pp. 2-4. This did no~ however, approach the volatility of 19331 when on 10

percent of all trading days there were moves of over 5 percent.
Chapter 3-The Operation of Stock Markets ● 55

during the day, during half-hour periods, etc.) fig If

stock prices actually reflect “fundamental values,”

how much up-and-down movement is inevitable as

the market homes in on a consensus about value?

Professor G. William Schwert of the University of

Rochester concludes that the volatility of rates of

return to broad market portfolios of NYSE-listed

common stocks has not been unusually high in the

1980s, except for brief periods such as October

1987.49 Volatility has seemed high to the public,

Schwert says, because the level of stock prices has

risen over the last 20 years, and a drop of many

points is actually a relatively small percentage drop.

Some theorists contend that any attempt to curb

volatility makes markets less efficient and is undesirable. But the historical objective of “fair and

orderly markets “ implies that at some level volatility becomes excessive. Fast rising markets raise

fears of “bubbles,” and sudden unexplained drops

cause many investors to withdraw from the market.

The Debate Over Program Trading

Many people who are concerned about excessive

short-term volatility place the blame on portfolio

trading, program trading, portfolio insurance, or

index arbitrage. These terms are often loosely used

by the media, with considerable overlap. This gives

rise to much public confusion. Generally, portfolio

trading means the buying or selling in a single order

or transaction of a large mixed group (portfolio) of

stocks. Some trades involve hundreds of different

stocks. “Program trading” means the same thing. It

is defined by the NYSE, Rule 80A, as either: a) the

buying or selling of 15 or more stocks at one time or

as part of a single maneuver, when such trades

involve at least $1 million; orb) index arbitrage. The

term usually also means that a computer program is

used to guide trading decisions and to route the

orders.

Portfolio insurance is a kind of program trading

designed for hedging (protecting one’s investment

by an offsetting investment or transaction). Portfolio

insurance calls for balancing transactions in several

markets (e.g., the stock and futures markets) in order

to reduce risk. (When the average price of a basket

of stock changes adversely, an investor holding a

stock-index futures contract covering that basket has

locked in the more advantageous price. See ch. 4.)

With “passive hedging,” there is relatively little

turnover of stock. “Dynamic hedging” portfolio

insurance can lead to many large institutional

investors deciding to sell baskets of stock (and large

blocks of each stock) at the same time, when the

stock prices are already declining. This can make the

decline even more precipitous.

Several forces caused program trading and associated trading strategies to increase in the mid- 1980s:

1) the growth of investment funds with very large

portfolios and a legal obligation to make prudent

profitable investments; 2) computers and telecommunications for making complex, multi-asset transactions simultaneously; 3) the development of

computer algorithms for managing dynamic trading

strategies; and 4) the invention of stock-index

futures.

Institutional investors often hold an “index” of

stocks, i.e., a portfolio matched to the stocks used in

an indicator index such as the Standard and Poors

500 (S&P 500). In this way, fund managers can be

sure that their investment fund does at least as well

as the market average (and usually no better). About

20 percent of all stock owned by pension funds, for

example, is in indexed funds.50 These institutional

investors often use hedging techniques involving

stock-index futures (as described in ch. 4) to protect

the value of their portfolios. Some of these strategies

require rapid switching of assets among stocks,

stock-index futures or options, cash, or other markets. They may turn over every share in the portfolio

4$See, for example: M@onH. Miller, FinancialZnnovations andMarket Volatility, Mid America Institute for public POfiCY Research 1988; Theodore

Day and Craig M. Uwis, “The Behavior of the Volatility Implicit in the Prices of Stock Index Options,” Owen Graduate School of Management

Vanderbilt University, June 1988; Steven P. Feinste@ “Stock Market Volatility,’ Federal Reserve Bank of Atlan@ Economic Review, December 1987;

James F. Gammdl “ , Jr., and Terry Marsh, “TradingActivityand Price Behavior in the Stock and Stock Index Futures Markets in October 1987, ’’Journal

ofEconomic Perspectives, vol. 2, No. 3, Summer 1988, pp. 25-44; G. William Schwe~ ‘Why Does Stock Market Volatility Change Over Time,’ 1989,

and other papers on volatility, University of Rochester Bradley Policy Research Center; Robert J. Shiner, “Causes of Changing Financial Market

Volatility,” presentation at Federal Reserve Bank of Kansas City Symposium on Financial Market Volatility, Aug. 17-19, 1988; Adrian R. Pagan and

G. William Schwert, “Alternative Models for Conditional Stock Volatility,” University of Rochester Bradley Policy Research Center, BC-89-02.

‘lgSchwert, “stock Market Volatility,” New York Stock Exchange Working Paper No. 89-02, December 1989.

SO~e ]mge~tpemion ~d indexed ~vestors we now ~.C~F ($26 b~ion), New York State and LOC~ ($15.9 billion), New York State Teachers

Fund ($13.7 billion), California I%blic Employees ($13 billion), and California State Teachers F~d ($12.7 b~ion). One h~dr~ Percent of the=

portfolios are indexed (1989). Pensions & /nvestmentAge Magazine, Jan. 22, 1990, p. 38.
56 ● Electronic Bu1ls & nears: U.S. Securities Markets & Information Technology

several times in a year. The effect of program trading

on stock price volatility is related to the strategy used

to direct the switching of assets. If the strategy calls

for selling stock when the price is declining and

buying when the price is rising, this “positive

feedback” will accelerate price movements and

increase volatility. This is particularly so if very

large blocks of shares are traded and if many

investment funds are using similar trading strategies.

Program trading of all kinds accounts for about 21

million shares a day on the NYSE,51 about 13 or 14

percent of NYSE trading.52 About half of the

program trading on the exchange is in the form of

index arbitrage (trading in order to profit by temporary discrepancies or misprizing between stock and

stock-index futures prices). Much of the rest is

various hedging behaviors for the purpose of risk

management rather than profit on trading volume,

but they sometimes lead to behavior similar to profit

strategies-rapid shifting of assets.

Just before the 1987 market break, the use of

portfolio insurance was increasing rapidly. It is

likely that when stock prices fell rapidly on October

19, this triggered selling of stock-index futures,

causing their price to fall. This in turn led arbitragers

to sell stock in order to buy futures, causing stock

prices to fall more rapidly. (As discussed in ch. 4,

this thesis is still a subject of controversy, and is

challenged by the futures industry and its regulators.) The SEC reported that at least 39 million

shares were sold by institutions on that day because

of portfolio insurance strategies that called for stock

sales either in lieu of futures transactions or as a

supplement to them.53

On October 19, 1987, portfolio insurance sales

accounted for only 15 percent of total sales. The

effect may have been magnified for two reasons.54

First, about half of reported sales are accounted for

by direct and indirect market-making (specialist

activities, block positioners, arbitrageurs, etc.), so

that the portfolio insurer sales were about 30 percent

of ‘true sales. The volume of such attempted sales

was perhaps twice the volume that insurers were able

to complete, again doubling the perceived demand

for liquidity. Secondly, market participants could

not know how persistent these sales would be, or

how far they might go. Specialists saw that their

fins’ capital could quickly be exhausted.

Many market participants say that “portfolio

insurance” of the kind that provides strong positive

feedback loops has been largely abandoned and is

unlikely to become popular again, since it failed to

protect portfolios. Other observers are skeptical of

this conclusion. The more one believes that others

have given up portfolio insurance, the more strongly

one may be tempted to try to beat the market by

using it.55 Many firms said they were giving up

program trading, or some forms of program trading,

after the 1987 break, but gradually resumed it. After

sharp declines on the afternoon of Friday, October

13,1989, there were renewed demands for ‘abolishing” or “controlling’ program trading, with little

attempt to distinguish among the kinds of program

51see mon~y NYSE program Trading Releases. In September 1989 program trading amounted to 13.8 percent of NYSE Wtq; this is about the

level of early October 1987, prior to the crash. In 1988, program trading was down somewha~ to about 8 to 13 percent depending on the month. There

is large variation from week to week however.

sz~ere is much ar~ent over how program trading volume should be calculated. The NYSE calculates it as the sum of stis bough~ sold, and

sold short in program trading, divided by total reported volume. Some experts think this is double-counting (the same shines are bought and sold), and

would prefer to calculate program purchases as percentage of total purchases, or program sales as percentage of total sales, or program purchases and

sales as percentage of twice total volume. However, many transactions do not involve program trading on both sides of the trade; and program trading

may have one leg in stock markets and one in futures markets; therefore the NYSE believes that its method is a more reliable indicator of the contribution

of program trading to volume.

sxse~ties Exchange CO~“ xiom The October 1987 Market Break, p. 1.

~According t. R. Stmen WWXSC~ then Vice President of Kidder Peabody, in discussions with OTA project staff and in ‘‘Phoenix Rising From the

Gas@’ ’Znstitutiom2Znvestor, December 1988, p. 25. Wunschalsonotes that most specialists stayed at their post”. . .andmanypmbably des=emedals

for doing so, particularly stock specialists who in many cases suffered severe financial and personal stmin living up to their affkrnative obligations to

make markets. . ..”

55A substitute forpo~olio insuran~ developed in the form of brokers writing put options for iIIStitUtiOIMd inveStOrS tO “insme” the~ stock po~olios.

When stock prices declined onOct. 13, 1989, these brokers attempted to hedge, or adjust their hedges, by selling stock. This was identitledas a contributor

to the rapid price decline. CFTC, Division of Economic Analysis, Report on Stock Index Futures and Cash MarketActivity During October 1989, May

1990, p. 3; SEC, Division of Market Regulation Trading Analysis of Oct. 13 and 16,1989, May 1990, p. 5.
Chapter 3--The Operation of Stock Markets ● 57

trading or determine exactly how it could be

controlled. 56

To the extent that “program trading” means the

trading of diversified portfolios or “baskets” of

stock simultaneously (with or without the assistance

of computers), it is probably an essential procedure

for institutional investors trying to manage very

large portfolios. A “blue ribbon panel,’ established

by the NYSE to consider the problem after the 1989

market break, did not recommend restraints on

program trading.

57 Significant restraints on the

practice would certainly run the risk of driving

institutional funds into off-exchange or foreign

markets where much program trading is already

done. According to the NYSE, in a recent week, 78

percent of program trading (in equities) took place

on that exchange, 5.2 percent in other domestic

markets, and 16.8 percent in foreign markets.58

Some of this program trading was done in the

‘‘fourth market’ ’59 on two electronic, off-exchange,

trading systems: Instinct’s “Crossing Network”

(owned by the British company, Reuters), and

“Posit,” a system operated by a Los Angeles

brokerage firm.60 Currently only about 400 institutions trade over these systems. Many of the large

program trades cannot be executed on these systems

because of limited liquidity. However, if program

trading were to be forbidden on the exchange, these

systems could become a preferred alternative.

Whether it is possible or wise to reduce program

trading by abolishing stock-index futures, by adjusting their margin requirements, or by changing the

way in which they are regulated, is another question,

which is considered further in chapter 4. The

question here is whether or how markets can be

helped to cope with the problems that arise when

many large investors make instantaneous sales (or

purchases) of large baskets of stock. One approach

is the increased use of ‘‘circuit breakers”—

techniques for halting trading when prices move

rapidly.

The Debate About Circuit Breakers

The perception of excessive short-term volatility

raises the issue of circuit breakers, which were first

widely advocated after the 1987 crash, especially by

the Brady Report. Circuit breakers are procedural or

operational ways of halting trading when there is an

abrupt or sustained decline in market prices and a

volume of trading that threatens to overload the

markets’ capacity. Circuit breakers may be designed

to be triggered by price limits, volume limits, order

imbalances, or trading halts in a related market.

Critics, including free-market advocates, claim

that circuit breakers unfairly prevent some investors

from leaving the market when they are frightened.

This, they say, makes panic worse, and sell orders

pile up until the dam breaks. Circuit breakers also

inhibit use of some hedging and arbitrage strategies.

Proponents say that circuit breakers allow time for

people to consider fundamental values, for traders to

determine who is solvent, for credit to be arranged,

and for imbalances to be advertised so that bargain

hunters can be located and get into the market.

Circuit breakers could counter the “illusion of

endless liquidity’ that tempts institutional investors

to try to sell huge amounts of stock quickly.

Market breaks produce ad hoc circuit breakers, in

any case. Technological systems overload and break

down; some market-makers abandon their posts;

communications become chaotic. But to be effective, circuit breakers must be mandatory, be in place

56Shemon _nHutton-~wced~ o~t~ber 1987 tit it ~~~d not do progr~ &ad@ for itse~, and anno~ced in October 1989 that it wotid

do no program trading for customers. Many other securities firms took similar actions. Several stock-issuing companies were reported to be putting

pressure on securities fiis to end program trading; the chairman of Contel Co. said program trading was turning the NYSE into ‘ ‘a gambling casino.”

William Power, “Big Board Faces Fight on Trading,” Wa12Srreet JournuZ, Nov. 30, 1989. See also, Sarah Bartless, “Wall St.’s 2 Camps,” New York

Ti%ws, Oct. 23, 1989, Dl; Alan C. Greenberg, Chahman of Bear, Stearns, & Co., “How To Reduce Stock Market Injury Potential,” letter to the editor,

New York Times, NOV. 14, 1989. In May 1990 Kidder Peabody resumed program trading.

sTThe panel was made Up of 19 corporate executives and business leaders chaired by Roger B. SmitlL chairman of General Motors COrP. It reported

to the exchange on Jme 12, 1990.

sS~ tie pr=e~g W=ks, the comparable perentage figures were 78, 8.7, and 13.3. NYSE Weekly pro~~Tra~g Da@ Mar. 201 199~ ‘b‘X

for the week of Feb. 20-23.

s9ttFo~ market” refers t. off-exchange (i e direcfly between institutions) trading of stock that k hkd On an ~Cha~f% Exchanges are ‘e ‘~t

. -!

market and OTC dealers make up the second market OTC trading of listed stock is the third market.

6f)About 13 ~ions~esae sold WYon~~et, a~cord@to Reute~; the number sold on posit is not known. Most of the “fourthmarket” pm~Slll

trading does not involve stock-index futures, but is for t,hepurpose of liquidating orbaktncing a portfolio after exchange closing. All of I.nstinet’s Crossing

Network trades and 10 Wrcmt of Posit trades are execut~ after NYSE’S close-of-business, at closing prices.
58 ● Electronic Bu1ls & Bears: U.S. Securities Markets & Information Technology

ahead of time and hence predictable, and be coordinated across stock, futures, and options markets.

Some circuit breakers were put into effect by

exchanges following the crash, and others have been

proposed. Under specified conditions, the stock

exchanges and futures exchanges execute coordinated halts for 1 or 2 hours. This formalizes ad hoc

procedures used during the crash (when, for example, the Chicago Mercantile Exchange (CME) suspended trading of stock-index futures in reaction to

halts of trading of individual stocks on the NYSE).

Some circuit breakers are designed to interrupt

program trading rather than halting all trading. The

NYSE has adopted a circuit breaker that is activated

if the Dow declines or advances 50 points or more in

1 day. It prohibits members from entering program

trading orders into the, SuperDOT system. When it

was frost applied on a voluntary basis, 13 of 14

exchange members then engaged in index arbitrage

continued program trading manually instead of by

computer. More arbitrage selling was done for

customer accounts during this voluntary restraint

than before it was imposed.61 Under an NYSE rule

that replaced the voluntary collar, when the stockindex future traded on CME (S&P 500) falls a

certain amount, program trading orders will be

automatically routed by SuperDOT into a separate

file (a “sidecar”) for delayed matching and execution.

An NYSE panel, created after the October 1989

market break to consider the problems of program

trading and excessive volatility, has recommended

new and stronger circuit breakers to halt equity

trading in all domestic markets when the market is

under pressure.62 A movement in the Dow Industrial

Average of 100 points (up or down) from the

previous day’s close would call for a l-hour halt; 200

points would call for 90 minutes, and a 300 point

movement would call for a 2-hour pause.

The proposed Stock Market Reform Act (H.R.

3657) would give the SEC authority to suspend

trading in stocks and options for up to 24 hours

during a‘ ‘major market disturbance. ’ ’63 With Presidential approval, the SEC could extend this for two

additional days. (Congress is considering whether

the SEC should be given regulatory authority over

stock-index futures. Such authority would enable the

SEC to coordinate trading halts across markets.) The

Market Reform Act would also give the SEC

authority to require large-trader reporting, that

would improve the Commission’s ability to monitor

inter-market trading and effectively analyze the

results of program trading.

In the meantime, the SEC is being urged to

reconsider the oldest form of circuit breaker, the

“short sale” rule. Rule 10a-1, adopted in 1938,

prohibits traders from selling stocks short@ when the

price is falling. If prices fall and traders believe that

the price will continue to fall, they can profit by

selling short. This would accelerate a price decline.

Efficient-market theorists and many practitioners

argue that Rule 10a-1 keeps market professionals

from immediately expressing new information, thereby

distorting the market function of price discovery.

They say, moreover, that the rule is ineffective

against panic selling and can be circumvented by

trading stock in London. Defenders of the rule point

out that negative expectations are not ‘new information,’ and that selling short on down-tick merely

manipulates the price to the practitioner’s advantage. The SEC last reviewed the rule in 1976 but

declined to abolish it, and is not expected to do so in

the immediate future.

THE 1987 MARKET BREAK AND

THE PERFORMANCE OF

MARKET-MAKERS

The 1987 market break also exposed problems

with the ability of market-makers to respond to the

challenges of rapid downward price movement and

unprecedented high volume. The performance of

exchange specialists and OTC market-makers was

criticized. One lesson that may be drawn from the

market break, however, is that neither the specialist

system nor a system of competing market-makers

61Mmor~d~to SEC C~RuderfromRichard G. Ketch- Director of SEC Division of Market Regulation July 6,1988. The event described

was on Apr. 14, 1988.

@SW footnote 57 for the makeup of the panel.

63~e como~~Fu~mTr~gco~s~iomwhich ~wlates fi~~ ~kets, ~~dy~MS power. The SEC can now ~~d tding fOr 24

hours but only with prior Presidential approval.

~Se~g shofi is tie practim of sefling borrowed stock, or stock tit one does not yet own. It is done in the belief that One CUl, befOre Sellkmell$

buy the stock to be delivered at a lower price than one has sold it for, thus making an instant profit.
Chapter 3-The Operation of Stock Markets ● 5 9

can assure liquidity in a period of intense selling

pressure caused by aggressive trading institutions.

NYSE Specialists

NYSE specialists were net buyers of 9.7 million

shares between October 14 and 16, 1987, and made

net purchases of 21.2 million shares on October 19,

in a futile effort to stem the tide. They were ‘‘often

the primary, and sometimes the only, buyers”

during the crash.65 By the end of trading on October

19, however, 13 of the 55 specialist units had no

buying power left. On the next day, October 20,

specialists were net sellers of 9.1 million shares.66

By contrast, “upstairs firms’ (non-specialist members) sold a net 7.6 million shares from their own

inventory from October 14-16, and were net sellers

of 4.5 million shares on October 19 and 9.6 million

shares on October 20.

The President’s Task Force on Market Mechanisms (the Brady Task Force) evaluated the NYSE

specialists’ performance during the crash. It reported

that as the market collapsed, most specialists “were

willing to lean against the downward trend in the

market at a significant cost to themselves. ’’67 But

there were exceptions. Of 50 specialists, 30 percent

were net sellers on October 19. Of 31 stocks on

October 20, specialists contributed to, rather than

countered, the market’s fall in 39 percent. The Brady

Report acknowledged that some of the poor performance by specialists may have been caused by

“exhaustion of their purchasing power following

attempts to stabilize markets. ” For others, however,

it seemed hopeless to attempt ‘ ‘to stem overwhelming waves of selling pressure. ’

Studies after the 1987 market break confined

that the performance of specialists is highly variable.

Some specialists fulfill their obligations to “lean

against the market’ more aggressively than others.

The SEC criticized the NYSE for not using its power

to punish specialists for poor performance during the

preceding 10 years by reallocating their stock to

other specialists.68 After the crash, however, the

NYSE reallocated 11 stocks from 7 specialist units,

and in 1989 reallocated stock from another specialist

unit.@ The SEC, in its report on the market break,

suggested that the NYSE develop regular comparative evaluations with a view to reassigning stocks

from less effective to more effective specialists. The

NYSE rejected this suggestion at the time. However,

in 1990, the exchange began an experiment with a

specialist performance questionnaire system, scored

entirely on the basis of relative ranking of specialist

units’ performance. After further experience, the

exchange intends to develop formal performance

standards .70

In June 1988 capital requirements for specialist

firms were substantially increased over those that

prevailed during the 1987 crash. Each specialist unit

or firm must be able to buy or sell 15,000 shares of

each common stock in which it is the registered

specialist. Each must have additional net liquid

assets equal to 25 percent of those position requirements or $1 million.71 Some market professionals

conclude that the capitalization of specialist firms—

in the context of growth in market volume and

market capitalization-is inadequate and will become more inadequate. Stanley Shopkorn, Vice

Chairman of Salomon Brothers, Inc., says:

New York Stock Exchange specialists in the

aggregate have slightly over a billion dollars of

capital. . . . [T]his capital cannot make a meaningful

contribution to stability on days when $15-25 billion

in stock changes hands on the exchange.72

65SEC Division of Market Regulation The October 1987 Market Break, February 1988, Pp. 4-24 to 4-26.

66Data in this paragraph on specialists’ and upstairs f~S’ perfOlllEltlce was supplied to OTA by the NYSE, Apr. 17, 1990.

157Report of tie ~esidentia.1 Task Fome on Market Mechanisms, Op. Cit., fOOt.UOte 41, PP. 49-50.

@SEC, The 0ctober1987MarketBreak, op. cit., footnote 41, p. 4-29. When in 1972 the SEC assembled evidence of poor Perfo rmanceby 14 spedic

specialists, the Exchange committee on Floor Affairs (of whose 11 members T were specialist) refused to take disciplinary actio~ citing as extenuating

circumstances ‘‘unusual market conditions” or ‘‘thinness of the book. ” This is summarized in U.S. Congress, Semte Committee on Banking,

Subcommittee on Securities, 4 Securities Industry Study Hearings, 92d Cong. 2d sess., 1972, pp. 34-46.

@Between 1984 and 1989, the NYSE censured, susWnded, and/or freed 28 specialists, and barred 4 specialists either pe rmanently or conditionally

from membership, employmen~ or association with any member firm. Source: New York Stock Exchange.

mCorresPndence from the NYSE,JulY 1990.

TINote titups~s fires on OCt. 19, 1987, were net sellem of 4.6 ~lions~es; if me average price at de wme $30, it would require $138 XIIilliOII

to offset these one-day sales, averaging $3 million per specialist firm. On Oct. 20, upstairs fms sold yet another 9.6 million shares.

72From a letter siw~ by ~+shopkom ~dSent t. clients of Salomon Bro~ers, ~c,, and ~printed wi~ permission k Commoiiiti”es kW @t(?r,

November-December 1989.
60 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

In 1986, before the crash, the NYSE and AMEX

had implicitly acknowledged strains on the specialist system by requesting and getting SEC approval

for rule changes to encourage large broker-dealer

members to become (buy or affiliate with) specialist

firms. 73 The Commission hoped that:

The financial backing of well-capitalized upstairs

firms would serve . . . to strengthen the financial

resources available to specialists to withstand periods of market volatility.

However, no broker-dealer acquired a specialist

firm until the crash, when Merrill Lynch acquired

the financially troubled A.B. Tompane, Inc. Acquisitions were later approved for Bear Stearns & Co.

(already a specialist fro), for Drexel Burnham

Lambert, Inc. (now bankrupt), and for Smith New

Court, Carl Marks, Inc., only four approvals since

the rule change.

Both SEC and NYSE reports on the 1987 crash

noted the problem of the market’s ability to absorb

institutional portfolio trading. The reports recommended developing a ‘‘basket-trading product’ that

could restore program trades to more traditional

trading techniques. Such a product could provide

better information “by identifying program trade

executions and overhanging program orders in

individual stocks, and provide an efficient mechanism for trading, clearing, and settling baskets [of

stock] in a cost-efficient way. ’ ’74

A basket product was approved for trading in late

1989. “Exchange Stock Portfolios” or ESPs are

standardized baskets of stocks traded at an aggregate

price in a single execution on the exchange’s stock

trading floor. The initial contract contains the 500

stocks represented in the Standard and Poor 500

Index, and is designed to sell for about $5 million.

It is subject to normal margin requirements.75

The NYSE elected not to use the traditional

specialist system to trade ESPs. Instead, it developed

a special adaptation that makes use of advanced

information technology. The ESPs, or basket contracts, are assigned to “competitive basket marketmakers’ (CBMMs) who are not required to be on

the floor, as are specialists. They operate upstairs,

using special terminals. They do have affirmative

obligations as do specialists.76 However, there has

been almost no trading in ESPs since their introduction.

Block trading procedures, the 1986 rule change

and the increased specialist capitalization requirements, and the competitive market-maker arrangements for ESPs, are all intended to reduce the strains

on the specialist system, as markets try to adapt to

increasing pressures.

OTC Market-Makers

The competitive OTC market-makers also performed poorly during the market break. Volume on

NASDAQ jumped to 223 million shares on October

19, and reached record levels of 284 million and 288

million on October 20 and 21. (However, NASDAQ

share volume on October 19 increased only 49

percent over its average daily volume of the preceding 9 months. )77 This points to differences in the

functioning of the exchange and OTC markets. The

NYSE had to halt trading in many stocks for long

periods on October 19 and 20. On the other hand, the

Brady Task Force found that there were trades

reported in 36 of the 50 leading NASDAQ stocks

during each quarter-hour on those 2 days and for the

remainder of those 50 stocks, trades were not

reported in only one or two 15-minute periods.

However, the volume of trading that customers were

able to do in the OTC market was far less than the

volume on the exchanges, as many market-makers

either withdrew, ignored telephone calls, or only

traded the 100-share minimum they are required to

accept.

Prior to the break, 46 of the 50 top NASDAQ

market-makers participated in the Small Order

Execution System (SOES), in which they are obliT3This Md not been pro~bited before, but was discouraged by prohibitions or restrictions on member fihmS trading securities tit were Xsigned to

specialist fms affiliated with them. See SEC Release No. 34-23765, Nov. 3, 1986.

TASEC Rel. 34-27382, Proposed Rule Changes Related to Basket Trading, approved Oct. 26, 1989-

TS~t is, users must put up 50 percent fiti~ margin ~d maintain 25 percent maintenance mZ@IM, as with other stock trmsactiom.

76cB-~y~e ~roprietwbids ~d offers o~y ~ am~er comistent wi~ m~~~g a fair ~d orderly market, must help alleviate temporary

disparities between supply and demand, and must maintain a continuous two-sided quotation in the basket product subject to a specfled bid-ask

parameter. CBMMS must meet a $10 million capital requirement over and above other capital requirements. They are treated as specialists for margin

purposes.

77NASDAQ Shine Volue, which was ~~ to more ~80 percent of ~SEvolume in tie weeks prior to the market bre~ W= *tO OIdy 37

percent of NYSE trading on Oct. 19,47 percent on Oct. 20, and 64 percent on Oct. 21. Brady Report at VI-50.
Chapter 3-The Operation of Stock Markets ● 61

gated to buy or sell up to 1,000 shares. (Participation

in SOES was then voluntary.) At times during the

break, up to one-third of these firms completely

withdrew from SOES (thus reducing their exposure

to the 100 shares mandated by NASDAQ for

non-SOES transactions) and others reduced the

number of securities in which they were SOES

participants. 78

Non-SOES trading also became difficult, because

market-makers’ telephone lines were overloaded

and some market-makers simply stopped trading.

Market-makers withdrew from 5,257 marketmaking positions (over 11 percent), according to the

SEC.79 NASD maintains that these may have been

inactive positions that were abandoned to allow

market-makers to concentrate on more important

active positions. The average spread of NASDAQ

quotations expanded by over 36 percent.

THE 1987 MARKET BREAK AND

THE LIMITATIONS OF

TECHNOLOGY

Experience during the market break indicates that

information technology, if not developed and utilized wisely, can worsen imbalance and volatility

instead of correcting them. All markets had pile-ups

of sell orders that could not immediately be executed

and therefore overhung the markets for long periods.

The NYSE’S SuperDOT system, designed to make

trading by small investors more economical, was

overwhelmed by institutions executing their program trades. However, the order pile-ups could have

been worse without the technology. Almost certainly clearing and settlement mechanisms would

have failed.

The NASDAQ Small Order Executive System

(SOES) was disabled by “locked” or “crossed”

quotations (i.e., bid quotes equal to or higher than

asked quotes). SOES was programmed to require

human intervention when that occurred.

The consolidated tape system became overloaded

and there were several computer breakdowns at

SIAC. These were mostly isolated incidents that

were quickly remedied.80 But prices of derivative

products such as stock-index futures depend on last

transaction prices for stocks. Even short delays in

reporting those prices can lead to spurious discounts

of index futures prices to stock prices. This could

cause volume surges on one or the other markets,

generated by computer-trading strategies.

After October 1987, the exchanges and the NASD

increased the capacity of their systems and took

steps to prevent repetition of the practices which

made it impossible for public customers to get their

orders executed. The NYSE increased the capacity

of its SuperDOT system and the number of electronic display books, increased the capacity of the

Intermarket Trading System, and constructed a

second SIAC data processing facility. The NYSE

says it could now handle 800 million trades in 1 day.

It now gives small orders of individual investors

priority in routing to the specialist when markets are

stressed. The NASD made SOES participation

mandatory for all market-makers in National Market

System securities. The system was modified so that

it will continue to execute orders even when

quotations are locked or crossed. An order confirmation and transaction service (OTC) was put in place

so that dealers can negotiate trades and confirm

executions through NASDAQ when they cannot do

so by telephone. Other forms of automation have

also been put in place, including an Automated

Conflation Transaction service that allows telephone-negotiated trades to be “locked in” through

automatic reporting, comparison, and routing to

clearing organizations.

AUTOMATION AND STOCK

MARKETS: THE FUTURE

The fundamental problems with technology during the crash may have resulted from the fact that the

automated systems currently in use in the securities

markets were designed for the purpose of facilitating, not replacing, preexisting trading practices. The

Brady Report stated in assessing the performance of

the NASD’S automated system, but in language that

is equally applicable to the automated systems on the

exchanges:

Many of the problems emanated from weaknesses

in the trading procedures and rules which were

programmed into the automated execution sys78Br~y Repofi, op. Cit., fOO&lOte 41, ~-s3.

79SEC, ~to~r 1987 Report, op. cit., footnote 41, pp. 9-19.

80The October 19g7 Market Break, op. Cit., fOOmOte 41, pp. 7-3 t“ 7-7.
62 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

terns. . . From the beginning . . . each advance in

automating the market was greeted with apprehension by many if not most of the market makers . . .

To ease that apprehension and, more importantly, to

sell the systems to its membership, the NASD found

it necessary to build in trading procedures and rules

which were not necessarily aimed at achieving the

most efficient trading system but were believed

necessary by the membership to protect their economic interests. . . Unfortunately many of these

compromises came back to haunt the over-thecounter market during the October market break.81

This judgment applies to exchanges as well as

OTC dealers. The American stock markets have by

and large used technology to facilitate and support,

rather than replace, traditional trading methods and

practices. The exchanges and OTC markets have

each automated some of their functions (order

routing, data display and communication, monitoring and analysis, and small order execution), but

they have preserved the central role of the marketmaker.

Domestic Exchanges of Tomorrow

The capabilities of information technology in data

collection, matching, aggregation, manipulation,

storage, and dissemination have enormously increased over the last four decades and can reasonably be expected to make comparable advances over

the next four decades. The limitations and vulnerabilities of information technology are also becoming

better known. Information technology could be used

more extensively for automatically routing orders

among market-makers, matching like-priced bids

and offers, automatically executing and recording

the transaction, carrying it through the clearing and

settlement process, and providing an audit trail for

regulatory purposes.

Alternatively, technological and personal-intermediation trading systems might be operated in

parallel, with the customer and/or broker given a

choice. Technology might be used to change the

nature of exchanges from continuous auctions to

periodic single-price auctions, or to offer other

alternative trading mechanisms—some of which are

growing up around and outside of traditional securities markets, as proprietary trading systems. The

fundamental policy question is whether it is desirable to encourage and facilitate the replacement of the

current exchange and OTC market structures with

fully automated trading systems, or to allow this to

happen incrementally, slowly, or not at all. There are

assuredly risks in either course.

Proponents of computerized trading systems say

that they provide more information more equally to

all participants, reducing the advantage that market

professionals have over public investors, and that

they would provide better liquidity by encouraging

bids and offers anonymously from all geographical

locations and aggregating them for all to see-thus

encouraging new buyers (or new sellers) to enter the

market when an imbalance exists and bargains are to

be found.

Opponents of computerized trading systems extol

the advantages of personal presence on the floor for

both stimulating and gathering or perceiving information (i.e., better price discovery), and providing

the incentives for vigorous trading. They stress the

advantage to investors of the obligation of the

specialist to assure liquidity and immediacy, and the

specialist’s ability to negotiate prices. Opponents of

electronic markets also insist that specialists (or

other intermediaries and market-makers) are uniquely

able to position and manage large block trades.

The SEC has approved Rule 144a, to allow

institutional investors to trade unregistered securities (usually corporate bonds) without the financial

disclosure otherwise required. In the past, investors

who bought private placement securities often had to

hold them. Now the market should be more liquid,

and many foreign corporations may participate. But

there is a real risk that such developments may

accustom institutional investors to using electronic

trading systems off-exchange, and in so doing create

a two-tiered market where the best prices and deals

occur in an electronic market for institutions only,

while individuals are left in outmoded physical

markets.

The only example of a fully automated trading

system in the United States is the Cincinnati Stock

Exchange. Its National Securities Trading System is

a “black box” that lets brokers instantly execute

orders up to 2,099 shares through the computer. Bids

or offers are entered automatically, the highest bid or

lowest offer is filled first, and identical bids/offers

are taken in the order in which they arrived, except

that public orders take precedence over specialist or

81 Brady Repofi, op. Cit., fOO~Ote ’41, ‘-s2-53.
Chapter 3-The Operation of Stock Markets . 63

dealer orders. However, the Cincinnati Stock Exchange failed to attract customers and does little

business (0.46 percent of trades in NYSE-listed

securities in 1989). The Exchange is now only a

computer at the Chicago Board Options Exchange,

of which it has become an affiliate.

A number of securities markets in other countries

have recently installed computerized trading systems. The Toronto Stock Exchange has a Computer

Assisted Trading System, or CATS. This is an

order-driven system. Those wishing to trade put

their orders (with price and size of the order) into a

computer that establishes a queue of bidders and

offerers arranged first by price, and then by the time

of arrival of each order at that price. The computer

also displays the number of shares offered or bid for.

When the order at the top of the queue is filled (that

is, when the offer is taken or the bid accepted) it is

replaced by the next order at the same (or the next

best) price. A complete record of all trades is

automatically generated. In this system, there is still

a “registered trader’ who is committed to buy or

sell for his own account when the size of orders does

not match—i.e., when the number of shares offered

at the best price is not sufficient or is in excess of the

number of shares bid at the matching price. Equity,

futures, and options “floor traders” use CATS to

maintain their responsibilities for designated stocks

and to trade on their firm’s or their own behalf. Other

users are upstairs traders, with CATS terminals on

their desks.82

CATS now handles about half of Toronto-listed

stocks and 22 percent of the total trading volume on

the exchange. Toronto also has an electronic execution system for small-sized floor transactions. As a

result, automated assistance applies to at least 75

percent of Toronto trading. The volume of trading in

Toronto is, however, extremely small compared to

that at the NYSE. Only about 50,000 trades a day, on

average, are done on CATS, with a projected

maximum trading capability of 250,000 trades.

Interviews at the Toronto Exchange indicate a

high degree of support and enthusiasm for the

automated systems, as allowing the exchange ‘to be

more competitive in the cost and level of service. . .’ ’83 Some skeptics feel that the CATS will not

be able to handle the needs of traders for the kind of

information that they think comes only from perceptive observation on the trading floor. Others are

concerned that an attempt to improve market quality

and service might have an opposite effect. It could

give people with sophisticated computer support an

unfair advantage over others, and encourage institutional dominance of the market. Some are concerned

that computer techniques could encourage market

manipulation (in Canada, surveillance has historically not had adequate computer support) .84 Finally,

there is a concern that a failure in computer systems

could cause catastrophic losses.

Other foreign exchanges are also automating. The

Paris Bourse, the Belgian Bourse, the Spanish

exchanges, and the Sao Paolo exchange in Brazil

have all adopted CATS. The Copenhagen stock

exchange is being restructured and will eventually

include three automated trading systems, one based

on CATS.

As another possible alternative to the current

systems in the United States, several experts argue

that a computerized single-price auction should

either supplement or replace the continuous auction

market and the specialist function .85 In a single-price

auction, trading takes place at specific times, as

contrasted with a continuous auction market. All

outstanding bids and offers are collected, compared

by computer, and executed at the price that will

come closest to clearing the market. Bids above or

offers below the clearing price are held for the next

round. A single-price auction might be held once or

twice during a trading day, with a continuous auction

on the side for those who want to trade immediately.

It would provide an automated and open display of

the specialist book. It might replace the specialist

system, because “a continuous market requires the

participation of a dealer who is willing to trade

s~on~ctor Report on Canadian Market Systems, prepared for OTA by Digital Equipment of Canada, Limited (Rob@ G. Angel, Hketing manager,

Capital Markets), July 241989. Hereafter cited as “Digital Report to OTA.”

83rbid. me reP~ ~~o d~~ri~~ extensive ~pga~gand e~ncaentin the Mon@e~ Exc~nge, with introduction of a FAST automated ~ding

system which includes a screen based knit order book with executable orders.

wDi@~ Report t. Om, op. cit., footnote 82, P. 4.

Sssteven Wunsch, in written communication to OTA, February 1990; see Steven WunSCh “SPAworks-The Single Price Auction Network:

Question-and-Answer Series,” manuscript provided by author; and Joel Chernoff, “Trading Plan Stirs Debate, ” 1nvewnentAge, July 25, 19**.
64 ● Electronic Bulls & Bears: U.S. Securities Markets& Information Technology

immediately, while a call market can operate without dealers. ’ ’86

It may also be necessary to consider whether the

national market system that might evolve because of

current economic pressures should be a unitary

system, or should include “subsystems for particular types of securities with unique trading characteristics, “ as contemplated by the 1975 amendments.87

The NYSE and the AMEX use the same trading

system for all listed stocks, regardless of the level of

trading activity, even though this varies from fewer

than five trades per day for some stocks to several

hundred, or more than a thousand, trades in a day for

others. On the Tokyo Stock Exchange, by contrast,

the trading of the 150 most active stocks is done

though a continuous auction process (without the

intervention of dealers), while 2,000 less active

stocks are traded by matching orders through

computer terminals. The early development of

proprietary trading systems operated by market data

service vendors (and soon by U.S. futures exchanges) is discussed in chapter 7.

Around-the-Clock, Around-the-Globe

Trading

U.S. OTC dealers, through the National Association of Securities Dealers, have begun several

initiatives aimed at competing in international

markets. NASD is installing computer facilities in

London to extend the NASDAQ network to the

United Kingdom. In September 1990 NASDAQ will

begin “dawn trading sessions,” beginning at 3:30

a.m. e.s.t., to coincide with the London opening and

continuing until just before the regular NASDAQ

trading day begins at 9:30. In addition, NASD has

opened the “PORTAL” system for electronic trading by institutional investors of private placement

stock issues around the globe.

Until mid-1990, there was no discernible movement by security exchanges to recognize the growing international securities markets, or to prepare for

24-hour trading.88 In June 1990 the NYSE announced that it was planning a five-step process “to

prepare for continuous 24-hour trading by the year

2000. ’ The NYSE’S plan is conservative, cautious,

and limited in scope.

The first step consists of proposed rule changes

filed with the SEC a year ago. It would extend

pricing procedures now used on “expiration Fridays,’ ’89 which guarantee that already-paired orders

received at “close-of-market” will be executed at

the market’s closing price. These trade executions

can be done within a few minutes after the exchange

closes. This change, to be implemented as soon as

approved by the SEC, merely seeks to recapture

some of the trades now done in Tokyo or London

after the NYSE closes.

The second step would involve a 45-minute

“crossing session “ immediately after the end of the

trading session, using SuperDOT Members could,

as the market closes, submit either matched or

unmatched orders, to be executed on a first-in,

f~st-fried basis at the closing price. This step too is

intended to recapture trades now lost to London, by

letting index arbitragers rebalance or close-out their

positions. A third step would add to this a second

‘‘crossing session” of about 15 minutes, in which

paired orders that are part of inter-market trading

strategies (i.e., related stock/stock-index futures or

options transactions) could be completed rather than

being done on the domestic fourth market (i.e.,

Instinct or Posit).

The fourth, and comparatively more daring, step

could involve several single-price auctions—as

described above-in which all 1,700 listed stocks

might trade. These computer-assisted auctions might

occur, for example, at 8 p.m., midnight, and 5 a.m.

e.s.t. The NYSE says that these ‘‘pricing sessions”

would be essentially the same procedures now used

by the specialists to open each day’s trading system;

but it is not yet clear whether they would involve a

dealer or even the daytime specialist firm.

Only the fifth step, which the NYSE does not

envision occurring for another decade, would allow

continuous 24-hour trading, possibly but not surely

from remote locations. NYSE officials are not

convinced that there is or will be any real demand for

such trading until 2000.

86stoll, op. cit., footnote 12, P. 3.

BvSecurities Exchange Act 1 lA(a)(2).

88 See OTA back~ound paper, op. cit., footnote 27.

8~e Imt Fn@ ~ each ~u~ qu~m, on which stock-index fu~es ~d stock-~dex OptiOQS expir~the “tiple Wifih@ hem.”
Immediately after the NYSE announcement of its

plans, which would not have been made so soon

except that they were prematurely disclosed by the

press, three other stock exchanges (the AMEX, the

Cincinnati, and the Chicago Board Options Exchange) announced that they were working with

Reuters to develop plans for systems for eventual

24-hour trading. U.S. futures exchanges and Reuters

have already developed a system (GLOBEX, described in ch. 4) for global trading of futures

contracts. The NYSE strategy emphasizes the need

to encourage many brokers and vendors to plan ways

Chapter 3- The Operation of Stock Markets ● 65

to supply the services NYSE would need for

providing global access to investors, to avoid

‘‘becoming the captive of one vendor. The suggestion here is that when the original contract between

exchange or exchanges and a vendor expires,

exchanges could be left without a viable mechanism

for serving (and monitoring) remote members. With

the NYSE strategy, however, vendors may decide

independently to offer transaction services before

the NYSE target year of 2000. These risks have to be

compared in planning strategy for the future.
o
CONTENTS

FUTURES MARKETS TODAY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

REGULATION OF FUTURES MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE OPERATION OF FUTURES MARKETS . . . . . . . . . . . . . . . . . . * . . . * * * . + * ....

ISSUES RELATED TO PIT TRADING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Audit Trails . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. .. .. .. .. .. ... .”+ ...................

Dual Trading ● . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .*.+**.* .+.

INNOVATIONS IN FUTURES CONTRACT’S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

STOCK-INDEX FUTURES . . . ● . . . . . . . . . . ● ● ● . . . . ~ . ● . . “ . . ● . ● . . . ● ● ● . + . ● Q ● . ● 

9 

● ● 

9 

● . ● ● ● ●

THE USES OF STOCK-INDEX FUTURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + . . . . . . . .

THE DEBATE ABOUT STOCK-INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

MARGINS . . . . . . . . . . . .

PREPARING FOR THE

Figure

. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

FUTURE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4-1. Futures Contracts Traded

Table

69

71

72

73

73

74

75

76

78

80

84

88

Page

by Commodity Group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

4-1. Incentives for Using Stock-Index

Table

Page

Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
Chapter 4

The Operation of Futures Markets

A futures contract is a standardized agreement to

buy or sell a specific amount of a commodity (now

including financial instruments) at a specified price

on delivery at a future date. The contract creates an

obligation of the buyer to purchase, and the seller to

sell, the underlying commodity. This report focuses

particularly on one kind of futures contract-stockindex futuresl

-because of its importance to securities markets and to current public policy issues.

The origins of futures contracts go back to

“forward sales” in the grain markets of the Middle

Ages, but futures contracts in the United States

began in the 19th century.2 The grain trade, essential

to an agrarian economy, suffered from cycles of

shortages and surpluses because of weather or other

variable conditions. These caused sharp price fluctuations at harvest time. Both farmers and grain

merchants wanted to reduce the uncertainty about

the prices they might receive or pay when crops were

brought to the market. Merchants therefore began to

use ‘forward contracts,’ pledges to buy or sell grain

to be delivered in the future.

Forward contracts were unreliable in that they

were not standardized as to the quality of the

commodity or as to delivery terms. Commitments by

contracting merchants were sometimes abandoned.

To remedy this, 82 businessmen formed the first

organized futures exchange in the United States in

1848, the Chicago Board of Trade (CBOT).3 Chicago rapidly developed into a center of the grain

market.

Beginnin g in 1865, futures contracts were standardized and cash bonds, or initial margin payments,

were required to ensure that contractual commitments would be met. Clearinghouses were created to

match and verify trades and guarantee the fulfillment

of each contract. The basic structure of today’s

futures markets had come into being.

FUTURES MARKETS TODAY

Sixteen exchanges in the United States are authorized to trade futures contracts.4 Futures markets and

futures exchanges are synonymous in the United

States. There is no competition from an over-thecounter market, or from proprietary trading systems,

as there is for securities exchanges.

Futures contracts need not, and now usually do

not, involve any intention to make or take physical

delivery of the underlying commodity, whether it be

grain, foodstuffs, metals, corporate stocks, or foreign currencies. Less than 1 percent of futures

contracts of any kind are now settled by delivery of

the underlying commodity. 5 When one buys a

December futures contract in September, (e.g., in

wheat, metal, or some other commodity), one agrees

to pay a specified price in December. The buyer can

satisfy this obligation either by receiving and paying

for the commodity or by ‘offsetting’ the obligation,

that is, by selling a December futures contract.

Each futures contract is now standardized with

respect to quantity, quality, and month of expiration.

The trading is conducted by intermediaries (floor

brokers) for customers and by “locals” or floor

traders, trading for themselves, on the floor of a

1~s fi~es con~act coven the basket of stock counted in a market index such as the Standard & Poors 500 (the index is tie weight~ avemge Pfice

of 500 heavily traded stocks, and is used as an indicator of price trends). The stock-index future is settled in cask not by delivery of the stocks.

~utures Industry Association, Futures Trading Course, Washingto~ DC, 1988, p. 1. Historical material in this section was also adapted, in part,

from Futures: The Realistic Hedge for the Reality of Risk, Chicago Board of Trade, 1988. ‘‘To arrive” contracts were used in Liverpool, England, as

early as 1780.

sFu~es exctiges are authorized to trade futures contracts, options on futures, and options on physical goods.

d~e 16 exc~g~ me: tie Chicago Board of Trade (CBOT); Chicago Mercantile Exchange (CME); New Yofi Merc~Me ExchaWe -X);

Commodity Exchange, Inc. (COMEX); Coffee, Sugar& Cocoa Exchange (CSCE); New York Cotton Exchange (NYCE); New York Futures Exchange

-);MidA.mefica COmmOditY Exchange (M.idA@; Kamas City Bored of Trade (KCBOT); Minneapolis Grain Exchange (MGE); Chicago Rice

& Cotton Exchange (CRCE); AMEX Commodities Exchange (AMEXCC); Philadelphia Board of Trade (PHBOT); Pacilic Futures Exchange (PFE);

PacKlc Commodities Exchange; and American Commodities Exchange.

Seomodiq Fumes Tradfig Co~5Sioq A Follow.llp Report on Financial Oversight of Stock-Indtzc Futures Markets During October 19873 Jan.

6, 1988, p. 15.

-69 –
70 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

futures exchange.6 For every buyer, there is a seller.7

But after the buyer’s and seller’s understanding of

the terms of the trade have been matched, a clearing

organization places itself between the buyer and

seller; i.e., the clearing organization becomes the

seller for every buyer, and the buyer for every seller.

It thereby guarantees each transaction. In the example above, if the futures price rises from the

September purchase price level, the buyer collects

from a futures commission merchant, which collects

from the clearinghouse, or pays the futures commission merchant, who pays the clearinghouse, if the

price declines.

In 1989, 267.4 million futures contracts were

traded, compared to 18.3 million in 1972, when

financial futures were introduced.8 About 75 percent

of this trading occurs on the CBOT and the Chicago

Mercantile Exchange (CME), the two largest futures

exchanges in the world. Financial futures began in

the early 1970s, with contracts on currencies and

debt instruments, but as late as 1978 they constituted

less than 7 percent of the futures market. This had

increased to about 38 percent by 1982, when

stock-index futures were introduced; and by 1990,

61 percent of futures contracts traded were financial

futures. 9 Financial futures now account for over

three-quarters of the business of the CBOT and the

CME.

The CBOT began trading grain contracts in 1848,

and now trades futures on metals, oil seed products,

and financial instruments. The CME specialized in

foodstuffs until 1947; then added livestock and

frozen meat futures, which by 1969 accounted for 86

percent of its trading volume; and now mostly trades

financial futures. Currently, about 80 futures contracts are traded on commodities ranging from wheat

and oil to Treasury bonds.

Almost any commodity might be considered

suitable for developing a futures market, if there is

considerable variation and hence uncertainty in

price.10 At one time or another, at least 79 produc

have been covered by futures contracts,ll but by

1967, grains and foodstuffs accounted for more than

half of all futures trading. Today, however, futures

contracts on agricultural commodities account for

only 20 percent of total contract volume. Interest

rates accounted for 46 percent in 1989; energy

products, 12 percent; foreign currencies and currency indexes, 10 percent; precious metals, 6 percent; stock-price indexes, 5 percent; and nonprecious metals, 0.8 percent.12 (See figure 4-l.)

U.S. Treasury bond futures are the most heavily

traded U.S. futures contract, with a volume of 70.3

million contracts, valued at $6.3 trillion, each

contract based on $100,000 face value. Eurodollar13

futures are even more heavily traded in terms of

dollar volume (each contract is for $1 million), but

are second highest in volume of trades.

The main function of futures contracts is still to

shift risks from those less willing to bear them to

those willing to assume them for a price, or in hope

of profit. With the appropriate futures position one

can hedge or offset price risk that arises in the ‘cash

market. ” If the price of grain falls, the value of a

short futures contract will rise. (It should be noted

that hedging is not cost free; if the market price

moves up, having hedged will cut into one’s profits.)

Futures markets also allow one to speculate on one’s

expectations about price trends with the possibility

of profiting by a successful forecast.

6Atpresen~ futures contracts are traded ordyface-to-face on future,s exchanges. The CME and the CBOTwill soon begin trading futures on GLOBJW

an electronic after-hours trading system (see OTA Background Paper, Trading Around the Clock: Global Secun’ties Markets and Information

Technology, OTA-BP-CIT-66 (Washington, DC: U.S. Government Printing Office, July 1990). Trades executed on GLOBEX will still be cleared,

margined, and guaranteed by futures clearing organizations.

T~ica~y tie ~u~tomer de~s with a fi~es commission merchant (FCM) firm, which in turn deak witi a cl-g member of the exchange! or> if

the FCM is itself a clearing member, then directly with the clearing organization. Details of clearing and settlement are described in the appendix.

8~Mon~yVolmeRe~~D~ember1989. #Jso, 55.4 million optiom con~acts were traded on futures exchanges in 1989, when U.S. fUtUreS

exchanges traded 322.8 million futures and options contracts.

~ Summary by Year, December 1989.

l~e~s w< Cmltom “Futures Markets: ~eir Pqose, Their History, Their Grow@ ~eir Successes and Failmes, ‘‘ The Journal ofFutures Markets

4, No. 3, 1984, pp. 237-271. Carlton+ pp. 242-244, also discusses other factors: correlations in price with related ptoducts such as would allow hedging,

many different producers and distributors, industry structure, large value transactions, government regulation influencing price.

lllbid., p. 242.

IZFu~S kdus~ Associatio~ FIA Monthly Volume Report, December 1989.

lqEmodo~ms we U.S. c~ncy held in banks outside the United States, and COmmOdy used in setthlg klterMtiOWd &a.llSaCtiOIIS.
Chapter 4-The Operation of Futures Markets . 71

Interest rate

Equity indices

Energy products

Foreign currency/

index

Metals and other

Commodity Group

124 I

54

I

27

0 20 40 60 80 100 120

SOURCE: Futures Industry Association, 1990.

From the standpoint of the economy, futures

contracts on physical commodities tend to lower

prices to the consumer by allowing producers and

merchants to plan more effectively, to carry smaller

amounts of inventory, and to price their goods more

competitively. But financial futures are not wellunderstood by the general public. Because they are

divorced from the underlying commodity or stock,14

many people view them as only instruments for

gambling and as a diversion of resources from more

productive uses.This lack of understanding, which

the industry has done little to correct, creates

problems for the industry. Futures markets, by

providing ways to hedge stock investments, may

increase the willingness of investors to put their

savings into securities rather than other kinds of

investments, and most economists say that they do

not divert money from capital formation.16

Another benefit of futures markets is ‘‘price

discovery. ’ Prices in futures markets, based on

different information and insights acted on by

experienced traders risking their own capital, forecast prices in cash markets. This ‘‘price discovery”

function is valuable in a market-based economy .17

One expert on futures markets says that in the late

1970s the pivotal development in securities law was

the recognition of futures trading as an economic

function involving risk transfer and price discovery,

and divorced from any specific commodities.18

REGULATION OF FUTURES

MARKETS

Futures trading was regulated for decades by the

Department of Agriculture,19 but as the futures

market expanded beyond agricultural commodities

into financial instruments, the Department’s role

became less appropriate. Recognizing this, Congress in 1974 created the Commodity Futures

Trading Commission (CFTC)20 to oversee all trading in futures contracts under the 1936 Commodity

Exchange Act. The responsibilities of the CFTC

include:

1.

2.

3.

4.

direct surveillance of futures markets and

market participants,

oversight of futures trading Self-Regulatory

Organizations (SROS),21

approval of all new futures contracts and

changes in the terms of existing ones, and

dealing with investigations and disciplinary

and enforcement actions.

14Accord~g to the Interti Revenue Service, futures contracts are nOt aSSetS, but Contractual agreements.

‘‘The millions of futures contract trades executed each year, representing trillions

of dollars, are in reality engagements for mutual speculation conducted in an environment of institutionalized chicanery, which except for the employment

of several thousand floor brokers in Chicago and New Yorlq serve no useful economic purpose. ’ (signed A. George Gianis), Dec. 6, 1989, p. A30.

IGAFeder~Reserve Bored paper, FinancialFutures adoptions in the U.S. Economy, December 1986, stid: “The conclusion that futures and options

markets will not diminish the total supply of funds available for investment seems quite strong and widely accepted. ”

designation of anew futures contract would be in the public interest. UnderCITC practices this means that it would have to be shown that it had a hedging

or price discovery function.

18C~les M. Seeger, The DeveZopme~t of congressional concerns About Financial Futures Mar~e~$, The Americm Enterprise hlstih,lte fOr Public

Policy Research, Project on the Economics and Regulation of Futures Markets, p. 3.

the Department of Agriculture. In 1936, the Commodity Exchange Act extended this regulation to other agricultural commodities, and this Act was

administered by the Commodity Exchange Authority, also in the Department of Agriculture.

~’rhe Commodity Fumes Trading Commission Act of 1974.

QISelf.Re@ato~ Orgatiations me the exc~nges and the Natio~ Futures Associatio~ an industry ass~iation to which the CITC delegates the

responsibility for registering and overseeing floor brokers and futures commission merchants. The Commodity Futures Improvements AcZ now before

Congress, would authorize the CF’rC to register floor traders.
72 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Oversight of the CFTC remains with the House

and Senate agriculture committees, although agricultural commodities now underlie only a quarter of

futures contracts at most.

As the growth of financial futures trading continues, the appropriate locus of regulatory responsibility is again becoming an issue. The “commodities”

that underlie the financial futures contracts fall

under the regulatory jurisdiction of the Department

of Treasury, the Board of Governors of the Federal

Reserve System, and the Securities and Exchange

Commission (SEC). The invention of stock-index

futures has linked futures markets to stock markets

in new ways, and raised questions about the effects

of those linkages.

THE OPERATION OF FUTURES

MARKETS

Futures contracts are traded in auction markets,

where prices are determined by “open outcry. ” In

this colorful and noisy form of trading (which has

often been described as archaic or anachronistic22),

bidding is conducted in a crowded, tiered floor or

‘‘pit.’ Floor brokers and traders, each wearing

identifying badges, trade by shouting their orders

and using hand signals. The pit crowd may have

more than 400 participants. There are currently no

alternative methods of trading futures in the United

States; upstairs block trading and over-the-counter

trading of futures is forbidden by statute.

Floor traders-also called “locals’ ’-trade exclusively for their own accounts; floor brokers are

allowed to do “dual trading,” that is, to both

transact customers’ orders and trade for themselves. 23 When an order to buy or sell financial

futures contracts arrives by telephone at the floor

booth of an exchange member, the order taker either

walks the order to the floor or (for large orders)

“flashes” the order by hand signals to a floor trader

in the pit, who makes the trade and flashes back to

the booth the price at which it was filled. This

information is then repeated to the customer, usually

still on the telephone. The entire transaction takes

about 3 seconds. Futures brokers insist that this is the

speediest way to carry out a transaction, and that

nothing slower would be satisfactory to the majority

of their customers who are simultaneously trading in

cash markets in some form

arbitrage maneuver. It is not

computerized trading support

slower.

of speculative or

clear however that

systems would be

Unlike stock exchange specialists, floor traders

have no obligation to stabilize prices. There are other

stabilizing mechanisms in futures markets; CFTC

analysts stress the importance of price limits and

speculative position limits in providing “a similar

stabilizing influence. ”24

In futures markets, each broker and trader can buy

at the lowest offered price and sell at the highest bid

price25; liquidity is achieved through the participation of many buyers and sellers. Some of these

buyers and sellers are hedgers, seeking to protect

their investments in securities markets. Some of the

buyers and sellers are speculators. Speculators-a

term neutral and without opprobrium in futures

markets-are professional risk-takers, individuals

or firms trading for themselves (or sometimes for

institutional funds), who through their willingness to

trade in pursuit of profit incidentally keep bid and

ask prices close together and facilitate rapid and

efficient trade executions by hedgers. 26 Ordinarily,

hedgers hold about 71 percent of long and 66 percent

of short open positions. Speculators are listed as

holding about 4 percent of open long positions and

10 percent of open short positions in S&P 500

stock-index futures. The remainder of open positions (about one-quarter) are held by people not

~AS a r=ent ex~plq wchard A Miller, editor-in-chief of the Commodities ~w Utter, wrote: “Dual trading, imprecise audit trails, and clublike

self-governance are anachronisms more appropriate to the 19th century than to the 21st. ” Commodities Luw Utter ix, No. 9-10, November-December

1989.

~*CD~ ~a~~’~cms when ~in~vid~ (or repr=entative of a f~) sometimes trades on be~ of c~tomers (i.e., as a broker) and SOmetimeS

trades for his own or the firm’s proprietary account (i.e., as a dealer).

?@TA correspondent ~m s~of the ~C Division of Trading and ~kets, Apr, 6, 1990. The Cmc ~ystsfi~also @iit the Case fOr

the specialist system as a maintainer of stabilized prices in securities markets is not strong.

25’rhe exception is a si~tion when daily price tits are in effect or when the trade would exce~ a spectiator’s position liInitS.

26~OT, Futures, The Realistic Hedge for the Realify of Risk, 1988, p+ 12. The Dicfio~~ of Fi~nce and Investment Te~ (2nd cd.) SayS that the

term “speculation” implies that a business or investment risk carI be analyzed and measured, and it differs from “gambling’ which is based on random

outcomes.
Chapter 4- The Operation of Futures Markets ● 73

covered by large-trader reporting requirements.

Most of these are also speculators.27

Futures contracts are designed so that their prices

should always reflect underlying cash market prices.28

The activities of “spreaders’ and arbitragers alSO

bring price alignment. In “calendar spreading”

traders sell the current delivery-month contract and

buy a later delivery-month contract, or vice-versa.

This reduces price variance between the contracts.

Arbitrage also helps keep the cash and futures prices

aligned. If, for example, futures contracts seem

overpriced in relation to the underlying commodity,

arbitrageurs will sell the futures contract and simultaneously buy the commodity, making a profit on the

difference.

ISSUES RELATED TO PIT

TRADING

At least three characteristics of open outcry

trading may cause problems: crowding in the pits,

the lack of an automatically generated audit trail, and

dual trading. The presence of as many as several

hundred participants, without a central checkpoint

(whether computer or designated market-maker),

makes it uncertain that a customer will get the best

price, or the market price. His floor broker may have

a less penetrating voice than others, or be shorter in

statue, or unlucky, or unpopular. Pit-based trading is

deeply embedded in the history of futures trading,

but it has become a problem as the number of

participants and the volume of trading greatly

increased, and as the speed with which orders can be

transmitted also greatly increased (the last being an

effect of information technology). It is possible that

the pits cannot accommodate additional pressure, as

may result from the growth of translational trading.

It is also difficult to spot and control collusive and

fraudulent trading given the difficulties of visually

monitoring the hectic trading.

Audit Trails

The inadequacy of audit trails in futures exchanges is currently a lively issue. Rules require that

the exchange assign a time of execution, within 1

minute, to each trade. The CME reports that it uses

the following information to assign times to transactions:

●

●

●

●

●

●

●

●

the time that an order reaches the floor,

the Time and Sales Report, a record of reported

sales prices timed to the nearest 10 seconds,

a 15-minute bracket character recorded by the

trader,

‘‘other trade information,”

the timing information with respect to the

opposite side of the trade,

the length of time it takes an order to reach the

trading pits,

“unique price information, ” and

‘‘in limited cases, reported execution times. ”

Each transaction is run through approximately

nine computer processes before a time is assigned at

the end.

Using such procedures (which differ somewhat

from exchange to exchange), an exchange’s computer is said to be able to “reconstruct” an audit

record of the trade that establishes its timing within

1 minute. But at best, these systems still have serious

shortcomings that are known both to the CFTC and

the exchanges.29 For example, a single minute

during active trading may include hundreds of

trades, several of which could be made by a single

floor participant at different prices.

Moreover, the CFTC says that in some instances,

members are not “providing accurate data which

will permit an exchange to meet the performance

standard, ’ and that exchanges have ‘‘failed to

implement adequate measures to address this situation. ’ The CFTC has just changed the rules to

require that trading cards contain preprinted sequencing information; that they identify the user,

that they be used in exact numerical and chronological sequence, and that they be promptly time stamped

and submitted to a clearing member or to the

27~eSe fiwmwe b=~on the ~vaage of m~n~.end open ~sitiom for 23 consecutive months ending November, 1989, zs reported in ~C’S

Co-”tments of Traders. (Reported positions are those of the owners of the account, not their brokers or clearing members.)

~C~CRe@ations, Sec. 22247, Appendix A-Guideline No. 1, B(3). CFTC contract approval guidelties ~uire “evidence that the cash settlement

of the contract is at a price reflecting the underlying cash market [and] will not be subject to manipulation. . ..”

29~ner~~co~~gOfflce, Chi~ago F~t~resMar~t:InitiaJ Ob$ervationson Tr~ing Practice Abuses, GAO/mD-89-58, N&ch 1989. ThiS GAO

report studied the “level, or intensity, of CFTC [and the CME and CBOT] exchange efforts to detect and penalize trading abuses” between 19*4 ~d

early 1989, and made “no recommendations. ” Ibid, pp. 13-17.
74 ● Electronic Bulls & Bears: U.S. securities Markets & Information Technology

exchange within 30 minutes of the trade (to be

shortened later to within 15 minutes of the trade) .30

Even highly automated trading and surveillance

systems may not be able to deter certain types of

abusive trading practices, especially given the opportunities for collusion among floor brokers and

traders in the pits, which are difficult to detect except

through undercover investigations.31 It may nevertheless be necessary to replace “trade reconstruction” techniques with devices that can establish

more precise and verifiable audit trails from the

beginning-i.e., at the time of the transaction.

Technology is being developed to meet the complex

needs and difficult environment of the pits. The

CME and CBOT have each appropriated $2.5

million for design of a hand-held computer for

recording trades, and are reviewing vendors proposals. NYNEX has developed a wrist-strap or handheld computer for floor traders, capable of storing

trade data and transferring it to a main computer.

These will be tested in 1990 by traders at the

Commodity Exchange (COMEX) in New York.32

There is likely to be resistance from some floor

professionals who may resent the intrusion on the

floor of technology that will erode

unique skills and experience.

Dual Trading

Dual trading, fully legitimate,

the value of their

has become increasingly controversial in the last 2 years. As

already noted, floor traders are allowed to trade both

for themselves (proprietary trading) and for customers. They charge a fee for executing customer orders

brought to them by futures commission merchants

(FCMs), who are analogous to retail stock broker/

dealers. From 12 to 25 percent of floor traders’

profits come from proprietary trading.33

Dual trading has been strongly defended as

necessary and desirable by the industry, by the

CFTC,34 and by academic experts.35 It has, nevertheless, often been criticized because of two potential

conflicts of interest. First, dual traders can, when

trading for their own accounts, use information

communicated by their customers, putting other

traders at an information disadvantage. Second, a

broker may be tempted to trade on his own behalf

before he trades for a customer, if the customer order

is likely to move the price. That would constitute

‘‘frontrunning, ’ and regulations prohibit brokers

from trading for their own accounts before filling

customers’ orders and from filling customers’ orders

from the broker’s own account, whether or not there

is any effect on price.

Futures industry representatives point out that

dual trading also occurs in securities markets; for

example, 1) an upstairs firm acting as a ‘‘block

positioner’ for a customer (see ch. 3) may buy or sell

some of the stock for (from) its own inventory; and

2) specialists trade both for themselves and for other

brokers. Securities market practitioners say in rebuttal that this form of dual trading is different in kind

from dual trading in the pit; for example, specialists

have a‘ ‘negative obligation’ to trade for themselves

only when no other customer is willing to trade at or

near the last-sale price).

~The cBOT has, since Sept. 1, 1989, “made members accountable” for keeping trading cards in numerical order and timeStiimped by the cltig

member when they are collected for clearing and settlement.

slAccordingto U.S. attomeyhtonValukaS, who headed the Justice Department probe into trading abuses in the chiCagO exCkngeS,. . ..’’exptienm

suggests that some of the things we found could only have been discover~ by having people actually in the pits. . . . The whole aspect of how audits

are conducted and what type of audit trails are kept is something tbat should be reviewtxi, “As quoted in “Paladin in the Pits,” Barren’s, Aug. 21, 1989,

p. 6.

szDemom~tiom and conversations witb NYNEX scientists in White Plains, New York see also ‘Will Paperless Trading Clean Up the Pits,” news

item in Business Week, Oct. 16, 1989, p. 90A.

33The ~Cest~ates 12 percent (fi ~tten ~oments t. OTA); sever~ knowledg~ble fi~es ~kets p~cipan~ told OTA it was probably 20

to 25 percent in financial futures pits, and the Chicago Memantile Exchange declined to provide information on the grounds that it is cordident.ial. The

CFTC estimate does not distinguish between commodity futures pits and fwncird futures pits. They mayor may not be different in this regard, but durd

trading is more common in highly active markets, according to CFTC studies.

34~ backwowd discussion Pubfished ~ tie Federal Register, volt 55, No. 8, J~. 11, 1990, p. 1048, in conn~tion Mm a proposed Ilde tO reS&iCt

dud trading in some circumstances, the commission statti titiw traditioti position had been that notwithstanding concern over possible abuses, ‘ ‘(1)

dual trading was necessary to achieve adequate mwket liquidity and accompanying market efficiencies, and (2) the potential for abuse could be addressed

adequately. . . . WC Division of Trading and Markets analysts in discussions with OTA also emphasized that dual trading increases liquidity and that

abuses can be adequately controlled by regulation and surveillance.

s5For ex~ple, Professor Sanford Grossman says: “Dual trading increases the supply of both brokers and floor traders because a dual trader canemn

income from two activities to cover the costs of tm.ining, an exchange sea~ and time spent on the floor. . . .The direct effect is an increase in tie quality

and quantity of brokers. . . . The indirect effect derives from an increase in the liquidity of the market caused by an increase in the numbers of market

makers.” Prof. &m.ford Grossrna~ Econo~”c A~lysis of Dwl Trtiing, ReseNch Paper, Rodney L. White Center for Financial Research 4 1989.
Chapter 4-The Operation of Futures Markets . 75

Both critics and defenders of dual trading may

have exaggerated its frequency. A recent study by

the CFTC found that most floor traders do in fact

usually limit themselves to one kind of activity.

About 90 percent of them either do at least 90

percent of their trades for themselves or else do 90

percent of their trades for customers. The other 10

percent—frequent dual traders-account for only

7.4 percent of total market volume. The incidence of

dual trading may however be higher in financial

futures pits.36 The issue is important because dual

traders were heavily implicated in recent FBI

charges of abuses in futures trading.

Section 4 of the Commodity Exchange Act

required the CFTC to reassess the effects of dual

trading and its continued permissibility from time to

time. In 1976, an extensive study by a CFTC

Advisory Committee found that the record systems

then used by exchanges were inadequate to permit

verification that dual trading was important in

maintaining liquidity, yet recommended that the

Commission continue to permit it, which it did. In

1984 another CFTC report37 said that if dual trading

were to continue an improved audit trail was needed

for more effective surveillance.

The CME, in May 1987, began experimentally to

disallow dual trading on the top step of the stockindex futures trading pit. The exchange says that this

was done because the top step, where most of those

trading for customers stand, had become overcrowded. Also, locals (trading for themselves)

complained that those on the top step (some of

whom were dual trading) had an advantage over

them in visibility. The CME concluded after the first

2 years that there was little effect on liquidity; but

decided that this might not be the case with less

actively traded contracts, and that for them “dual

trading is a necessary practice to maintain adequate

liquidity. . ..”38

In 1989 the CFTC Economic Analysis Division

conducted yet another study on the effects of dual

trading. 39 It concluded that dual traders generally

specialize in one or the other form of trading, as

noted above; that the incidence of dual trading tends

to be higher in high-volume markets than in

low-volume markets (which challenges the assumption that it is useful because it assures liquidity); and

that dual traders do not, as often asserted, secure

better trades for their customers than do non-dual

traders. The agency therefore issued a proposed rule

in January, 1990, concerning Restrictions on Dual

Trading by Floor Brokers. Regulation 155.5 would

prohibit a floor broker from trading for himself and

for customers during the same trading session,

“except to the extent permitted by contract market

rules. ” The notice of proposed rulemaking cited the

economic analyses in its November report, and also

emphasized that the enforcement actions, indictments, and plea agreements from the Chicago

undercover investigation of floor trading practices

“indicate that some brokers have used their dual

status to facilitate abuses of customer orders. ’

This rule change will not end all dual trading. It is

intended ‘‘to curb dual trading-related abuses,”

while permitting the practical results to be tested

‘‘on a limited basis before the restriction is extended

to all markets. ’ It would apply at first to only one or

two commodities futures contracts and one financial

futures contract at each exchange, and would allow

exceptions, for example, a ‘‘customer opt-out. ’

INNOVATIONS IN FUTURES

CONTRACTS

The CFTC must approve a new futures contract

before it is traded. It must be satisfied that the

contract has an economic purpose and is not contrary

to the public interest.

41 Innovations in futures

instruments have been frequent during the past 15

S6CFI’C Division of fionomic Analysis, Dud Trading Study, Nov. 17, 1989. Neither this repofi or the CIWC 5W mspomible for the s~dy,

distinguished between commodity futures trading and fiincial futures trading; these statistics were broken down only by exchanges. The study

concluded, however, that dual trading tended to be higher in the most active markets. This would include financial futures markets, although CFTC does

not draw this conclusion.

3i’u.s. Co-oditiFumes Tra&g co~ssio% A Stiyof the Na~re, Exfent, ad Effects of Fu~res Trading by persons possessing Material

NonpubZic Information, WashingtorL DC., September 1984.

38Reportof the Chicago &fercantileExchange: special committee to Review Trading Practices, to the Board of Governors, Apr. ~9~ ~989* PP. 7-8.

BgEcono~”c Analysis of Dual Trading in Commodity Exchanges, NOV. ~T, ~gsg.

4clFedera/Register, vol. 55, No. s, Jan. 11, 1990, p. 1050, The propos~ of the new tie s~ess~ tit “tie cwent systelI1.S are not capable of detecting

all abuses related to dual trading,”

41 Untfl 1974, fi~es con~acts co~d be issued ~d ~~~ Unze$s disapprov~ by the Dep~ment of A@c~~e. The SEC is not required to assess

the economic value of new securities, but bas evaluated the economic purpose of proposed options, such as those on stock indexes and Treasury securities.
76 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

years, and are likely to continue.42 For example, two

exchanges announced plans last year to introduce

trading in futures contracts on computer memory

chips-commodities whose prices tend to be volatile. 43

Exchanges introduce new products if they may

make money. But it is really the profit or cost-saving

for a particular group of market participants (e.g.,

floor traders, or speculators, or hedgers) rather than

profit for the exchange that drives the process,

because U.S. exchanges are not-for-profit organizations. According to the CFTC, exchanges sometimes

may introduce anew product if there is demand for

it by one of these member groups even if it is

marginally nonviable, because there can be crosssubsidization from more viable contracts.

Not all new products are approved by the regulators, and those that are approved are not always

successful. Success depends in large part on the

needs of investors. For example, the rapid success of

interest rate futures reflected a widespread investor

demand to reduce risk from adverse movements in

this market.44

Futures contracts tend to be traded on only one

exchange; that is, even if the product was introduced

almost simultaneously on several exchanges, the

trading quickly concentrates. There is intense competition among exchanges to be the frost to introduce

new products, and they sometimes submit copy-cat

products for regulatory approval. Significant costs

are associated with developing and introducing new

products, and they have a high risk of failure—

according to the CFTC, from 20 to 30 percent of new

contracts fail within 2 years, and 50 to 55 percent

endure less than 9 years. This has led some exchange

officials to suggest an exclusive right to a new

product for a specified length of time, similar to a

patent.

45 However, this right would have to be

recognized by all of the world’s major exchanges in

order to protect fully the original innovating exchange. This is unlikely, given the present state of

international law on protection of intellectual property.

Some innovations do not fall neatly within the

jurisdictional boundaries assumed when the Securities Exchange Act and the Commodity Futures

Exchange Act were written. This has been the cause

of heated disputes between the two regulators, as

discussed later in chapter 6.

STOCK-INDEX FUTURES

The most important innovative product in this

decade is stock-index futures, introduced in 1982.

This product and the various trading strategies that

rely on it are the critical link between stock and

futures markets. Since they were first introduced in

1982, stock-index futures trade volume has grown

faster than volume of stock transactions, exceeding

the daily volume of New York Stock Exchange

(NYSE) trades in the first 2 years. However stockindex futures still constitute only about 5 percent of

all futures trades.

The volume of stock-index futures trading has

increased primarily because the number and size of

institutional investors have grown. Futures markets

have always been used heavily by institutions.46

Some individual traders participate, both as speculators and as hedgers, but many retail clients cannot

meet brokerage house annual income and net worth

requirements for margin accounts.

Institutional investors are hedgers, using futures

contracts as a means of reducing market risks and

lowering transaction costs. To hedge investments in

any cash market they may take an equal but opposite

42dzFor a discussion of competition betwmn futures exchanges as a source of innovative products, see William L. Silber, “hOvatiOr4 Comwtitiom

and New Contract Design in Futures Markets, ” The Journal of Futures Markqs, vol. 1, No. 2, 1981, pp. 123-156.

ds~ese me dynamic random access memo~ chips or DRAMs. The Paciiic Stock Exchange and the Twin Cities Board of Trade (Minneapolis) hop

to start trading a futures contract on computer memory chips in 1990 or early 1991. Approval of applications to trade new contracts generally take 3

to 6 months; innovations that present complex issues or require new exchanges may take much longer.

~Foradiscussion of v~ous @es of fisks, p~ic~=lyfiom foreign currency mov~ents, and a process toward mana@g such exposures, S=: JdfRy

Barr, “Coping With Financial Risk,” Institutional Investor, vol. 3, April 1989, pp. 112-113.

45~s was advocated, for e=ple, by Wchard Cke, fi~utive Vice president of the philadelpb.ia Stock Exchange, at an 0’E4 workshop, June 30,

1989.

46CmltoQ op. cit., foo~ote 1(’). Before the development of fin~cial fitures, many of those using the commodities futures marketwere “COIIIIIlerCialS,”

such as large cereal companies or meat packing companies.
Chapter &The Operation of Futures Markets ● 77

position in the futures market.47 They can switch

back and forth rapidly and cheaply, since transaction

costs are low, and small or medium-sized futures

trades tend not to move market prices because of the

liquidity in these markets.

Institutional investors often choose to allocate the

assets they manage in specific ways, e.g., by keeping

60 percent in bonds, 25 percent in equities, and 15

percent in cash, depending on factors such as the

outlook for interest rates or equities prices. Asset

allocation strategies are not new, but until recently,

allocation readjustments could not be made rapidly

or efficiently because transaction costs were high.

Today’s futures contracts let asset managers reallocate assets rapidly because of their low costs and

narrow bid-ask spreads. This links the equity,

options, futures, and government/corporate bonds

markets in the United States and, increasingly, the

major world markets.

Stock-index futures are used for speculation,

hedging stock market investments, and index arbitrage. The most popular stock-index futures contract

is the CME S&P 500 Stock Price Index Future (it

accounts for 79 percent of total volume). There are

also options on stock indexes, traded on securities

exchanges, and options on stock-index futures

traded on futures exchanges.

Parties to a stock-index futures contract agree to

settle by receiving or delivering a cash sum equal to

the difference between an amount stipulated in the

contract and the weighted prices of the stocks in a

stock index (usually the S&P 500)48 at a stipulated

later time. The contract obligations can only be

settled by cash payment, not by actual delivery of

stocks. One trading in stock-index futures is, in

effect betting on the movement of the stock market

as a whole-whether the average stock price will

move up or down. A more academic way of saying

this is that the trading is based on an analysis of the

return to be derived from a projected movement of

the stock market as a whole.

Both stock-index futures and stock-index options

are based on (or derivative of) the stock market.

Their nominal value is derived from the weighted

average of values of the stocks represented in one

index.49 But stock-index futures (and options on

stock-index futures) are traded on futures exchanges

and regulated by the CFTC, while the SEC regulates

stock-index options as well as stock.

While stock-index futures and stock-index options serve some of the same purposes, they are

different in effect and in risk-return characteristics.

Stock-index futures create the obligation to deliver

or receive the cash equivalent of a portfolio of

stocks. Stock-index options gives the holder the

right but not the obligation to receive or deliver the

cash equivalent. For the holder of either a long or

short stock-index futures position, the risk is limited

only by how much stock prices can move in a given

time-it can be a ruinous amount. With the option

contract, the purchaser can lose only what he paid for

it (the premium), since the option need not be

exercised; and he has unlimited potential for gain if

stocks appreciate so as to increase the value of the

options contract. The writer (seller) of an uncovered

or “naked” option contract (as opposed to the

holder of the contract) unless he is fully hedged, has

unlimited risk like that of the unhedged futures

contract holder, cushioned only by the premium the

writer received for writing the option.

dTF~r ~xmple, ~ f~ncial fiti~tion may be concerned tit interest rates wfi rise, causing a drop in the v~ue of the firm’s long-term U.S. Treasury

bonds. The firm may hedge that risk by selling interest rate futures contracts. If interest rates rise, the futures contracts can be closed out for a profit,

which would compensate for the loss of value in the bonds. An investor having non-U.S. funds invested in a foreign country may wish to reduce the

risk of a fall in the value of that country’s currency against the U.S. dollar or other countries’ currencies. The investor might sell the appropriate foreign

currency futures contracts to hedge the risk of the currency’s fall relative to the U.S. dollar, or, as do many U.S.-based international mutual funds, might

shift to futures contracts based on the currency of another country whose currency movements are highly correlated with that of the United States

(cross-hedging).

4S~e ~on~ct is budon the v~ue of the S&p 500 ~dex multiplied by $500.” E the weight~ average of the v~ue of the 5M StOCkS represented in

the index is 245, one futures contract would be worth 245X $500 or $122,500. The contract would call for the buyer to buy or “go long in” the S&P

500 at 245 on the expiration date. If on some earlier date the S&P 500 stood at 247 the holder might choose to sell or offset the fimres contract. He or

she would make a profit equal to the current market price minus 245 multiplied by $500, or a profit of $1,000. If instead, he or she holds the contract

until the expiration date and the S&P 500 has risen to 248, the buyer’s profit would be $1,500. If at expiration the index stood at 242, the buyer would

have lost $1,500.

.wmere men. fi~es ~on~cts on a Spwific stock. The SEC IMS opposed such contracts on the grounds that the futures contract codd be used to

manipulate the price of the stock to the detriment of the corporation and its shareholders. At the insistence of the Cl_TC, the Shad-Johnson Accord, an

agreement between the CITC and the SEC (discussed in ch. 6), left open the door by saying that there should be further study of the practicality and

safety of allowing futures on individual stocks. Subsequent legislation prohibited such contracts. IInformation based on oral and written discussion with

staff of the CFTC and SEC.]
78 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

From 1982 through September 30, 1989, the

CFTC approved and exchanges began trading 33

index futures contracts, of which 6 are now trading.

The others are dormant or have been withdrawn. In

1989, the CME’S S&P 500 Stock Price Index

Futures Contract accounted for over 79 percent. The

New York Futures Exchange Composite Index

accounts for 12 percent, and the Chicago Board of

Trade’s Major Market Index (MMI), 8 percent.50

THE USES OF STOCK-INDEX

FUTURES

The trading of stock and stock-index futures is

dominated by institutions and brokerage proprietary

accounts, while that of stock-index options has until

recently been dominated by individual investors and

retail brokers. (Stock-index options are now being

increasingly used by institutional investors in hedging.) The reason they were preferred by individuals

is in part the size of the contracts. The S&P 500

futures might, for example, have a nominal value of

$142,500 (the value of the index times the multiplier

of $500); and at the same time the S&P 100 options

contract might have a nominal value of $28,000. For

institutions, the futures contract is more attractive

because there is greater liquidity in its trading, and

there are also cost incentives (see table 4-l).

In the S&P 500 futures trading pit at the CME

there are usually several hundred brokers and floor

traders or locals. With so much competition, spreads

under normal circumstances are much tighter than

price spreads in the underlying stock.51 On a typical

day, floor traders may be responsible for over 50

percent of the trades, and customers (both institutional and individual) for less than 30 percent.52

Floor traders may buy and then sell the same

contracts in as little as 1 or 2 minutes, perhaps

buying or selling 100 or more contracts at a time,

Table 4-1-incentives for Using Stock-Index Futures

S&P 500 Portfolio

of Stock S&P 500 Futures

Cost Incentives:

Volume ...........2.3 million shares 800 contracts

Transaction cost

per unit . . . . . . ...$0.07 cents per share $12.50 per contract

Total transaction

costs . . . . . . . . . . .$318,000 $20,000

Market Impact Incentives:

Market . . . . . . . . . . . .Bid: 292.35 Bid: 294.85

Ask: 293.65 Ask: 294.90

Bid/ask spread ....1 .30 index points 0.05 index points

Dollar value . . . . . . . $520,000 $20,000

SOURCE: R. Sheldon Johnson, Morgan Stanley

hoping to make a profit of $2,000 to $5,000.53

Because of the great liquidity of the stock-index

futures market, large incoming orders can usually be

executed rapidly, often with two or more locals

(floor traders) sharing the other side of an order.

Changes in stock-index futures prices usually

precede changes in stock prices. An investor can buy

or sell the S&P 500 Futures Index with one trade,

while to assemble a comparable portfolio of stocks

might take 500 separate transactions. Thus investor

opinions about the stock market are registered more

quickly in the futures market than in the stock

market. 54

Stock-index futures are used in inter-market

arbitrage and in inter-market hedging. These maneuvers are implemented, on the stock market side,

through program trading-i. e., the use of computers

to send sell (or buy) orders simultaneously for a large

basket of stock.55 About half of program trading is

in the form of index arbitrage.56

Index arbitrage exploits the fleeting price differences that occur between a stock-index future and

50 Monthly Volume Report December 1989.

In AuWst 1988 one study found the S&P 500 average spread to be 0.0185 in contrast to 0.55 in the underlying stock. %domon Brotiers. S@c~

Versus Futures for the International Investor: Trading Costs and Withholding Taxes, Aug. 31, 1988, p. 3.

szFor example, onFeb. 8, 1989, CBOT data showed that 52.9 percent of that day’s trades were floor traders trading for their own account; 20.9 Permnt

were trades for a clearing member’s house accounq and 26,2 percent were trades for another exchange member or for any other type customer.

ssBrady commission Repo% W-20.

~Ham Stoll and Robert Whaley, ‘‘Futures and Options On Stock Indexes: Economic Purposes, Arbitrage, and Market Structure,” Review ofFutures

Markets, vol. 7, No. 2, 1980.

SSNYSE defines ‘progr~ trading” as tie pmchase or sale of 15 or more stocks with a value of over $1 million. The Vohune of program tr~es Per

month varies typically between 7 and 14 percent of total trades. Not all program trading, however, involves both stock and futures markets.

fiNYsE monthly program trading press relaes.
Chapter 4-The Operation of Futures Markets . 79

the underlying basket of stock.57 For example, on

January 27, 1989 (to take a day chosen at random),

the S&P 500 closed at 293.82 and the S&P 500

March futures closed at 296.30. In index arbitrage

one might sell the futures contract at 296.30 and buy

the underlying stocks at 293.82.58 If the final index

average were at 300 on March 17 (the third Friday of

the quarter, when contracts expire) the institutional

investor could let the futures contract expire with a

loss of 3.70 (300-296.30) and sell the underlying

stocks for a gain of 6.18 (or 300-293.82), preserving the spread that existed on the day of the original

transactions. The actual profit on this transaction

would be the price difference of 2.48 minus the cost

of the transactions (and the foregone interest not

recouped as dividends).

Locking in the spread between stocks and stockindex futures is not automatic; an apparent opportunity to do profitable index arbitrage may be lost in

the time it takes to execute the orders in the two

markets. This risk from the time gap is especially

signficant when the arbitrageurs buy the futures and

sell index stocks short (i.e., sell stocks they do not

yet own, expecting to buy them subsequently at a

lower price), because under SEC Rule 10a-1, short

sales of stock must be executed at a price the same

as, or higher than, the last price (the uptick rule). If

the market is declining, arbitrageurs may not be able

to sell stocks when they need to.59

If the arbitrageur already owns the underlying

stocks, he or she could buy the futures, sell the stock,

and invest the proceeds in a risk-free debt instrument, such as a Treasury bill. At expiration, when

the differential between stock and future disappears,

the stocks could be repurchased with the proceeds of

the Treasury bill, and the futures contract be allowed

to expire.

Opportunities for index arbitrage should disappear rapidly as arbitrage brings the stock and futures

prices into convergence. In fact, the opportunities

sometimes persist, both because of the difficulties

posed by the uptick rule and because there are not

many firms with the capital necessary to do index

arbitrage.60

Index arbitrage should also act to stabilize the

markets by continually bringing stock prices and

futures prices closer together. But four times a year,

the expiration of stock-index futures and options

contracts places a great strain on equity markets. As

futures and options traders ‘unwind their positions’

by selling the stock that has been hedged by index

options or futures, specialists on stock exchanges are

called on to match those orders by finding buyers or

buying for their own account. (Alternately, “unwinding” could involve arbitrageurs buying stock

and specialists or customers selling them stock.) At

the last trading hour of the quarter, called the “triple

witching hour, ”61 large imbalances of orders can

develop and price volatility increase accordingly.

This problem was helped some by moving the

expiration of the S&P 500 futures and options to the

opening, rather than the closing, of the third Friday

of the quarter. In this way, orders can be matched and

executed on that day’s opening price, and other

efforts can be made to restore balance before the

market opens. The CBOE’S S&P 100 option and

AMEX’s Major Market Index option still expire at

the close, with resulting stress. The SEC is encouraging them to change also.

Hedgers use stock-index futures in reducing the

risk associated with a broad portfolio of stocks.

Institutional fund money managers often develop

and hold an ‘‘index” of stocks (i.e., a portfolio that

sTsUChpfiCc differences reflect several factors: 1) transaction costs for stocks and for stock-index futures; 2) the tie rernainin g to expiration of the

index and the volatility of the index; 3) the institution’s cost-of-carry, and 4) the dividends to be paid on the stocks in the index, through expiration of

the futures’ contract.

ssk theo~, one would se~ the fiwe and buy the stock if the differential in their price exceeded the (risk-free) interest rate to expiration Of the fi~s

plus the transaction costs in the futures and stock markets, minus the dividend yield on the index, to expiration. When the index futures contract expires,

its terms require that its value will be deterrnined by the underlying stocks; that is, the differential or spread disappears.

5~e SEC ww~on Apr. 25, 1990, that it wo~d act to disco~age brokers from “mis~te~reting” a 1986 ex~ption to the de that applies tO

transitional index arbitrage [e.g., buying a basket of stock in London, selling the S&P 500 in Chicago, and then selling the stock portfolio in New York

if the prices are falling]. Firms unwinding a stock position acquired overseas, according to SEC, will be more strictly monitored in the future to prevent

them from using translational trading to avoid the uptick rule that would apply to trading in New York.

@Estimated in 1987 to be at last $25 rnillio~ see N. Katz.enbac~ An Overview of Program Trading and Its Impact on Current Market pracfi”ces,

1987, p. 13.

‘lOptions and fitures on stock-indexes expire concurrently, causing large-scale trading of the options, futures, and stocks.
80 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

mimics the basket of stocks represented in a standard

index such as the S&P 500). They do this to be sure

that their investment does at least as well as the

market (even though this also means they will

usually do no better). Replicating an index has other

advantages over assembling a portfolio from

scratch: it is less expensive to manage, since it does

not require comparable investment advisory fees,

and transaction costs are less. About 20 percent of all

stock owned by pension funds is estimated to be

indexed.62

Most institutional funds also hedge their indexed

funds to further reduce their market risk. This could

be done with index options, or with stocks and

riskless assets such as Treasury bills, but typically it

is done with stock-index futures. Some institutional

investors do “dynamic” hedging, a continuous

effort to lock in gains or minimize losses by buying

and selling baskets of stocks and/or the stock-index

future, depending on which is momentarily most

attractive. Some index funds may turn over every

share in the portfolio a half-dozen or more times a

year.

One means of hedging that became popular during

the 1980s was portfolio insurance, a mechanical

hedging strategy that involves ‘the sale of securities

into a declining market in order to protect a portfolio

against large losses. “63 The concept may predate

stock-index futures and options but now regularly

uses them, and is also now generally exercised

through a series of computer algorithms or models.

When some marker such as the S&P 500 declines to

a trigger level, the investor’s computer might

generate an order to sell S&P 500 stock-index

futures or alternatively to sell the stock portfolio, to

ensure against further declines. A typical goal in

portfolio insurance is to make sure that at least 95

percent of the value of a current portfolio is safe from

loss.

THE DEBATE ABOUT STOCKINDEX FUTURES

After the 1987 crash, there was widespread

concern that program trading-especially portfolio

insurance and index arbitrage-may have contributed strongly to the debacle. Immediately after the

crash, several reports said that inter-market programs (using stock-index futures) were a major

factor. The Brady Report said that “By reasonable

estimates, the formulas used by portfolio insurers

dictated the sale of $20 billion to $30 billion of

equities over this short time span [Oct. 19-23 ],’ and

thus “played a dominant role” in the crash.64 The

SEC reported that at least 39 million shares were

sold by institutions on October 19 alone because of

portfolio insurance strategies that called for stock

sales either in lieu of futures transactions or as a

supplement to them.65 That report said that “the

various strategies involving program trading were a

significant factor in accelerating and exacerbating

the declines.’

This was not universally accepted, and especially

not within the futures industry and the CFTC. The

Chicago Mercantile Exchange concluded that “index

arbitrage does not appear to have played a major role

in the crash,” and program trading “does not by

itself explain the magnitude of the crash. ’ The

CFTC report said that the trading data “does not

provide empirical support for the theory that hedging in the futures market and index arbitrage

activities interacted to cause a technical downward

price spiral of stock prices.”66 Both have continued

to maintain that position.

The suspicion voiced by critics of futures markets

was that when stock prices began to decline,

program trading using stock-index futures accelerated and magnified price movements. The problem,

according to these critics, is twofold: 1) the program

trading may cause traders to dump stock in a

declining market, and more importantly, 2) many

62~e @eSt~dex ~veStorS ~e New y~~k s~te co-onFund, ~dthe pension ~ds of New York Stite Teachers, the l?xxon COW., CdifOti

State Teachers, and Central State Teamsters. From 74 to 100 percent of each of their portfolios is indexed. In 1988, this was a total of about $38 billion

for these five investors. (Reported by Wall Street Journal, Oct. 20, 1989, using figures provided by Pensions & ZnvestmentAge Magazine.)

63wil~ s. H~@ c ~~.som of tie stock ~ket cram: ~tWe ~ve ~n~ About Securities Mkets and Their Regulation,” The AEf

Economist, May 1988.

@RePOrt of the presidential Task Force on Market Mechanisms, Washington DC. 1988, P. 41.

65~e Setities and Exc~ge Cotissioq Division of ~ket Re@atio~ The October 1987 Mar~t Break, 1985, pp. Xiii and 1-5.

66CommodiQ Fumes Tra@ Co~ssio& Final Report on Stock Ind~Fu~res and Cash MarketActi~@During October 1987, Wmh@tO~ DC,

1988, p. 137.
Chapter 4-The Operation of Futures Markets ● 81

institutional investors, with very large portfolios,

may act in concert, using the same or very similar

formulae and the same market signals, rather than

disparate bits of information that might add up to a

balanced assessment.

The Brady Commission said, however, that the

real problem was the failure of index arbitrageurs to

hold the stock and futures markets’ prices together

once prices began to slide: “. . . the problems of

mid-October can be traced to the failure of [stock

markets, options markets, and futures markets] to act

as one. A third view was that, at worst, stock-index

arbitrage had increased volatility slightly by increasing the speed with which new information is

reflected in market prices.67

The particular form of inter-market program

trading described above as portfolio insurance was

most vulnerable to criticism because in 1987, many

large institutional investors were using the same or

very similar formulae. A sudden sharp fall in stock

prices would call for an increase in the portfolio

share allocated to lower risk debt securities and

hence a corresponding decrease in the equity proportion; stocks sales would surge. Portfolio insurance

programs would trigger buying and selling that

reinforced the direction of the initiating stock market

move.

Some defenders of portfolio insurance and stockindex futures point out that ‘‘traders have always

dumped stock in a declining market and bought in a

rising market. ’ But the classical theory of market

equilibrium holds that a declining market will attract

buyers who follow the rule of ‘buy low, sell high.’

In portfolio insurance, situations occur where either

all participants are using similar algorithms to make

decisions, or so many sellers attempt to sell so many

shares so quickly, there is no time for buyers to be

recruited.

One problem with this kind of portfolio insurance

became clear to users after the 1987 crash. The

typical formula directed that stocks be sold when

their price dropped to a certain level or “stop-loss

price,” but prices were falling so rapidly that they

often skipped over the trigger price, with n o

transaction occurring close to that price on the slide

downward. ‘Stop loss’ orders did not get fried and

it may have been some time before the would-be

seller could establish that fact. This is the problem of

the “gapping market.” It clearly contributed to the

panic that set in on October 19.

Until the 1987 crash, the use of portfolio insurance was growing rapidly, increasing fourfold in the

frost 9 months of that year, and covering an estimated

$60 billion to $90 billion of equity assets.68 Some

large securities firms publicly renounced both index

arbitrage and portfolio insurance strategies after the

market crash in 1987. Program trading fell to about

6 percent of NYSE average daily volume. Most of

those firms subsequently resumed their use at least

for customers.69 But after a severe one-day market

decline on October 13, 1989, there was renewed

agitation against “program trading. ” Several firms

again publicly renounced the practice. The NYSE

called for voluntary restraints and announced that it

was initiating controls and establishing a blue ribbon

panel to study the whole question of volatility.70 The

CME announced that it would “tighten its rules on

trading halts in falling markets. ” These measures

were to some extent attempts to disarm public

hostility and head off more drastic congressional

actions. They were criticized both by those who saw

the limits as too weak, and by many institutional

investors who saw any limits on computer-based

inter-market trading strategies as harmful to risk

management. Some institutional investors threat67WiIIim S. HMK, then of the American Enterprise Institute, pointed Out: *“Because trading index futures is the best way to quickly adjust the

proportions of debt and equity in a portfolio, trades based on news about the near-term macroeconomics outlook . . . are often directed fiist toward the

index futures markets. . . . Arbitrage ensures that stock prices adjust quickly to the new information initially transmitted to the index futures markets.

To those on the floor of the stock exchanges, it may look as though futures trading caused the market to move, but that is only because it is the preferred

market for trading on macroeconomic information, op. cit., footnote 63, p. 3.

6sBrady ‘Ihsk Force Repom 1988, P. 29.

G~or exwple, De~ Witter says tit it cew~ using program trading for its own account in 1987 but continued to do it for customers ~til J~y 18,

1989. Merrill LynclL Salomon Brothers, Paine Webber, and Shearson also program-traded for customers but not for their proprietary accounts for some

period after October 1987.

me panel, chaired by Roger B. Smit@ chairma n of General Motors COW., reported in June 1990. It did not recommend restrictions on program

trading, but did recommend stronger circuit breakers to control volatility.
82 ● Electronic Bu1ls & Bears: U.S. Securities Markets & Information Technology

ened to continue program trading manually or move

their equities transactions to off-exchange markets.71

The debate continues as to whether the use of

stock-index futures in some or all kinds of intermarket trading strategies: 1) caused or contributed to

the crash of 1987, or 2) in general, leads to or

contributes to excess volatility in securities markets.

The empirical studies that deal directly with this

issue do not, in the aggregate, provide conclusive,

answers:

●

●

●

●

G.J. Santoni (whose research was concluded

and reported prior to the 1987 crash) concluded

that daily cash market volatility was slightly

lower after 1982 (when stock-index futures

were introduced) and weekly volatility was

slightly higher, but neither difference was

statistically significant.72

Professors Stoll and Whaley, a year before the

1987 crash, found that stock price volatility

increased around the triple-witching hours, but

this volatility did not last long.73

Professor Frank Edwards found, in June 1987

that stock return volatility was not higher on

average since the beginning of trading o f

futures and options, but was higher on futures

expiration days, especially in the last hour.74

Lawrence Harris, using data covering 1982-86,

reported that before 1985, the volatility of

stocks represented in the S&P 500 index was

not significantly greater than the volatility of

non-index stocks when allowance was made for

relative risk, price, firm size, and trading

frequency. He concluded that the stock-index

futures did not affect stock volatility in the first

3 years. In 1985 and 1986 index stock did show

more volatility .75 Harris nevertheless said that

rather than destabilizing the cash markets, trade

in futures and options may serve to make the

cash markets more efficient, causing them to

adjust more quickly to new information.

. In another study of the week of the crash, Harris

concluded that “the crash might not have been

as large’ had it not been that exchange

regulation, congestion in the order and confirmation systems, and other difficulties in executing sale orders in the stock market “removed a significant flow of buy orders in the

futures market” and increased the number of

sell orders coming into the futures market.76

This, Harris says, accelerated drops in futures

prices, and they were transmitted to the stock

markets since ‘‘the evidence strongly suggests

that the cash follows the futures market.”

. Professor G. William Schwert concluded that

over the long run, stock market volatility of

rates of return “have not been unusually high

in the 1980s, except for very brief periods such

as October 1987. ” Therefore “there is little

evidence that the level . . . has increased since

the beginning of trading [of stock-index futures] . . . in the early 1980s.’ Schwert also

says that there is evidence that large levels of

trading occur when volatility is high, but he

cannot tell ‘‘whether the large volume causes

high volatility, or whether large volatility and

trading volume are caused by the arrival of

important information. ’ ’77

71Ab~ut 6 ~~on ~~e~ ~ day ~~ ~x~~~ed by sev~al h~dr~l~ge fiti~tio~ in tie third m~ke~ throu@ two off-exchange electronic SyStemS:

Crossing Network (Reuters/Instinct) and Posi4 a system run by a Los Angeles securities company. Most of these program trades do not involve

stock-index futures (for which there is no legal off-exchange trading), and are done to liquidate or rebrdance portfolios built during the trading day. But

it is possible that if program trading is forbidden on the exchanges, much of it could move to these off-exchange systems.

7ZG.J. Santoni, “Has Programmed Trading Made Stock Prices More Volatile,’ Economic Review, Federal Reserve Bank of St. Imuis, May 1987, pp.

18-29.

TsHam Stou and R. wey, “ExpirationDay Effects of Index Options md Futures, ” Monograph Series in Finance and Economics, No. 1, Salomon

Brothers Center for the Study of Financial Institutions, New York University, 1986.

7dFr~ Edw~ds, ‘CF~ci~ Fu~s and Cash ~ket vo~tility,” CSFM Work@ Paper 159, Colllmbia Universi@, June 1987. hl subsequent

papem, Edwards concluded on the basis of review of major agency and’ academic studies of the crash that higher margins and price limits cause price

inefficiency. “Does Futures Trading Increase Stock Volatility, “ Financial Analysis Journal, January-February 1988, pp. 63-69.

T%awrenceHarris, “S&P 500 Futures and Cash Stock Price Volatility,’ Working Paper, University of Southern California, IAs Mgeles, CA, May

1988.

76~Wence H~s, ‘‘T’he Octobm 1987 S&p 500 Stock-fitures Bmis, ’ Jour~Zof Finance, vol. 44, No. 1, ~ch 1989, pp. 77-79. Nonsynchronous

trading refers to the fact that the S&P 500 index lags behind the real value of the underlying basket of stock when some of the constituent stocks have

not recently traded (since the “true’ value of the stock may change between trades). If the price of the futures contract is efficiently mirroring the ‘true”

value, Harris says, spurious conclusions about volatility, market efficiency, and the relation between the futures and cash markets can be obtained.

77G. William Schwert, “Stock Market Volatility,” NYSE working paper No. 89-02, December 1989.
Chapter 4-The Operation of Futures Markets ● 83

●

●

●

Al McGartland and George Wang, in a study

for the CFTC,78 developed a model that compared exchange-traded stock volatility with

volatility in the over-the-counter (OTC) market

(which has no derivative futures contracts).

They concluded that in 1984 and 1985 stockindex futures decreased cash market volatility

somewhat and in 1986 and 1987 [data after Oct.

1, 1987 were not included] “cash market

volatility increased somewhat as a result of

stock-index futures. ’ McGartland and Wang

said: “However, even if daily volatility is

increased slightly by stock index futures, like

Harris (1988) we do not know if this is good or

bad. It maybe that stock index futures allow the

S&P 500 cash market to reflect market fundamentals more rapidly than the cash OTC

market. In this case, the increased volatility is

beneficial since prices more accurately reflect

market fundamentals. The increase in volatility

may be due to temporary shortages of liquidity .

Dean Furbush, in a study for the SEC, analyzed

data over 5-minute intervals for October 14 to

20, 1987, and concluded that: 1) index arbitrage

was insufficient to keep futures prices from

falling to unprecedented discounts relative to

their fair value; 2) the size and persistence of

the futures price discount induced much of the

heavy portfolio insurance selling to spill from

the futures market into the stock market; 3)

despite the increased volume of program trading on October 19, “this study does not find

that greater price declines systematically occurred at times of more intensive selling by

portfolio insurance or any other program trading strategies. ’ ’79

Lawrence Harris, George Sofianos, and James

E. Shapiro, in a 1990 paper for the New York

Stock Exchange, examined data on the relation-

●

ship of volatility to program trading and

concluded that futures price changes instigated

program trading which led to stock price

movement. 80

Chen-Chin Chu and Edward L. Bubnys found

that volatility in S&P 500 futures is higher than

volatility in the cash market.81

There is no clear consensus on the effects of

stock-index futures on stock market volatility. The

researchers have used differing definitions and

criteria for volatility, different time periods and data

sets, and different research hypotheses.

The policy debate . has been shaped by a bitter

battle for market share between the futures and stock

exchanges and by rivalries between their respective

federal regulators. . ..”82 The SEC has generally

maintained that the presently inadequately regulated

use of stock-index futures threatens stock market

stability, and wants these products under its own

jurisdiction (see ch. 9).83 The CFTC, nearly always

defensive of the industry it regulates, denies that

there is any causal relationship between stock-index

futures and stock price volatility. Alan Greenspan,

Chairman of the Federal Reserve Board (FRB), said

that the FRB was concerned “about what seems to

be a higher frequency of large price movements in

the equity markets, but he was ‘‘not convinced that

such movements can be attributed to the introduction of stock-index futures and the opportunities

they offer for greater leverage.”84

As already noted, this debate is made more heated

because many people in the general public, and

many small investors, view the use of derivative

products in general and stock-index futures in

particular as merely gambling. They argue that this

gambling increases the velocity of trading in the

underlying stocks and increases the risks borne by

other market participants.

78AI McGartland and George Wang, “The Effects of Stock Index Futures on Cash Market Volatility: An Empirical Study,” Staff Working Paper

#89-3, Commodity Futures Trading Commission April 1989.

T~ew Furbush “~=m Trading and price Movements Around the October 1987 Market Break” OffIce of Economic Analysis, U.S. Securities

and Exchange Commissio~ May 9, 1989, p. 35.

%Wrence Harris, George Sofianos, and James E. Shapiro, “Program Trading and Intraday Volatility,” New York Stock Exchange Working Paper

9003, March 1990.

slchen.~ Chu and Edward L. Bubnys, “A Likelihood Ratio Test of Price Volatilities: Comparing Stock Index Spot and Futures,” The Financial

Review 25, No. 1, February 1990, pp. 81-94.

8’2fi~, op. cit., footnote 63.

83Former SEC C ‘ hamnan Ruder told Sen. Proxmire that the existence of these products, “. . . may encourage additional trading in the equity markets,

witha resultant increase in intra-day volatility. ” Letter to Sen. William Proxmire from SEC Chairma nDavid S. Ruder, Mar. 30, 1988, reprinted inl?lack

Monday, the Stock Market Crash of October 19, 1987, Heat-ings before Senate Coremittee on Banking, Housing, and Urban Affairs, IOOth Cong., 2d

sess., 1988, pp. 515, 516.

&tTe~~ony before tie su~o~ttee on s=fitie~ of the Semte Committee on Banking, Housing, and Urban Affairs, Mar. 29, 1990.
84 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Whether there is or is not a fundamental difference between buying stock and buying stock-index

futures, this difference in perception has direct

political/economic implications. It has led to demands that stock-index futures and options should

be abolished by regulation, or that at a minimum

their trading should be discouraged (perhaps by

higher margins or by a substantial tax on short-term

investments, or by requiring transfer of stock rather

than the much less expensive current method of cash

settlement) .85 The debate over stock-index futures

has recently shifted grounds, to the issue of which

regulatory agency (the CFTC or the SEC) should

regulate stock-index futures. This issue is explored

in chapter 9.

MARGINS

In futures markets, financial integrity is bolstered

by a system of margins, defined by the industry as a

security deposit, or performance bond,86 the purpose

of which is to make sure that the futures market

participant will be able to meet the obligations

embodied in the futures contract. Futures margins

have two elements, initial margin and variation

margin. Initial margin is paid in advance, by anyone

entering either a buy order or a sell order. It remains

on deposit at a clearing firm (or is passed through to

a clearinghouse) while the contract is open. It might

be, for example, 5 percent of the face value of the

contract, but this requirement changes from time to

time. A futures customer must deposit additional

funds if the equity in his account falls below a

maintenance margin level, to bring it backup to the

initial margin level.

Variation margin must be paid to cover losses on

a daily, pay-as-you go basis. This is called "markingto-market,’ and it is done twice daily and more often

during periods of significant market swings. Thus to

maintain a futures position, a customer must have on

deposit an amount equal to at least maintenance

margin, and must be able to pay out in cash 100

percent of all losses daily. (They may also withdraw

their gains.)

The level or amount of the initial margin is set by

the futures exchange, and is intended to be high

enough to protect against contract nonperformance,

but low enough to make futures contracts very

economical for the user. It has typically been 5

percent or less of the face value of the contract,87 and

for the market professionals it is typically much

lower, about 3 percent, especially at the CME and

CBOT

The subject of futures margins has sporadically

been controversial, and since the 1987 market crash

it has again been hotly debated. This issue, like that

of dual trading, is not directly related to information

technology. Yet information technology, by facilitating the linking of futures markets and stock

markets and by encouraging portfolio trading, has

given new life and new urgency to the issue.

The issue involves the level at which futures

margin requirements are set. This controversy follows much the same industry and jurisdictional lines

as that about the use of stock-index futures. Some

policymakers and financial experts believe that low

margins allow speculators to hold large open positions with relatively small amounts of money (i.e.,

high leverage). This, they reason, may cause excessive volatility in futures markets, and that through

inter-market arbitrage and other less direct effects

this volatility is extended to stock markets. This

concern is most acute in the case of margins on

stock-index futures. These critics usually argue that

futures market margins should be raised, to a level

that is more consistent with margins in stock

markets. 88 They often argue also that the locus of

responsibility for setting margin requirements

85Allen B. Paul, “The Role of Cash Settlement in Futures Contract Specification, ” Futures Markets: Regulatory Issues, Anne E. Peck (cd.)

(Washington, DC: American Enterprise Lnstitute, 1985).

M~~Open ~~itiom ~ ~Wes represent leg~ obligation either to make or take delivery, ad magh Me s~~ty de~sits-a p~o~~ce

bond—intended to ensure performance on the contract. . . . Since most initial positions in futures are canceled by taking opposite positions rather than

by delivery and since both short (a sale) and long (apurchase)positions are margined,it should be clear that the margins are not downpayments.’ William

G. Tome~ “Margins on Futures Contracts: Their Economic Roles and Regulation,” Futures Markets: Regulatory Issues, Anne E. Peck (cd.)

(Washington, DC: American Enterprise Institute, 1985), p. 144.

87~May 1990, fiec~ was ~w~g spfllators to post $9,~ fiti~ ~p@~d hedgers $4,000. ~ J~y, as ~S rcpofi went to press, fitid Mgin

for speculators was $22,000 and for hedgers $8,000. (Margin requirements change frequency.) When the index is at 350, a stock-index finure contract

is worth $175,000 (350 x 500, the S&P multiplier), and the initial margins are set at $9,000 and $4,0C0, the margins would be 5.1 and 2.2 percen~

respectively.

88~ stock -kets,mm~we defied ~ doWa~ents on stock pmc~ses (tie se~er pays no mmg@ fi con~mt to fUhUeS markets); the rt?@d

level is set by the Federal Reserve Board, and has been50percent since 1974, but much less for specialists. Options margin requirements for broad-based

stock-index options were raised after the 1987 crash to premium plus 10 percent (from 5 percent) and raised again to 15 percent in May 1988.
Chapter 4-The Operation of Futures Markets ● 85

should be changed, the assumption being that so

long as requirements are set by the exchanges (or

their clearing organizations) they will remain too

low.

The futures industry (and the CFTC, which

oversees but does not directly determine margin

levels except in emergency situations) counters that

futures margins are fundamentally different in purpose and function from margins in securities markets; that they are and have been consistently proven

to be adequate to protect the financial integrity of the

markets and their participants; that they have no

demonstrated adverse effects on levels of volatility;

and that low margins are desirable to increase market

liquidity. Futures margins levels are supposed to be

determined by the level of volatility (indicating risk)

in the market. Both buyer and seller deposit margin

to guarantee performance of the contract.89

The longer time to settlement in stock markets,

and the fact that stock margins are not “marked-tomarket’ justify some difference in absolute levels of

funds required. The industry’s premise that stock

and futures margins are “fundamentally different”

is questionable.90 More pragmatically, the concept

that futures margins need only protect futures

clearing organizations and do not effect other

markets, is questionable. After the 1987 crash, then

SEC Chairman Ruder, among others, suggested

changing margin requirements in order to “limit

leverage in the futures markets’ and control market

velocity. He cited SEC staff findings that the

‘‘illusion of liquidity’ in futures markets and the use

of stock-index futures as surrogates for stock basket

positions pushed up stock prices and thus led to their

drastic readjustment.91 The Brady Report also recommended that margin requirements be ‘ ‘harmonized between the equity and derivative markets. ’ ’92

The Katzenback report (for the NYSE) made a

similar recommendation.93

Among those who have called for harmonized (or

for higher) margins on stock-index futures since the

1987 market break are Congressmen, securities

exchange officials, other representatives of the

securities industry, and securities law practitioners.

94 These recommendations were based On the

reasoning that when futures prices begin to fall and

there are margin calls during the day, investors may

sell stock to meet those calls, thus transferring stress

to the stock market. There are strong differences of

opinion about this. The futures industry and CFTC

point out that during the crash the largest sellers of

futures were pension finds which held large inventories of stocks and could have sold them to meet

s%at~~~ of the fumes con~c~ the buyer wishes to take possession of the underlying asset the total cost of the asset must be supplied. However,

stock-index futures cannot be settled by taking possession of the stocks in the index. For more informatio~ see Hans R. Sto~ “Margins on Stock Index

Futures Contracts,” Chicago Mercantile Exchange Working Paper No. 89-21, Oct. 2, 1989, p. 1.

WFor example, Professor James Gammill of the Harvard Business School has reproved the futures industry for its insistence that “’Stock margins

me down payments but futures margins are not. ’ I believe that nothing beats this slogan for creating confusion about margins on the part of policy-makers

and analysts who are not familiar with financial markets. The main source of the communication problem is the fact that the term ‘margin’ is sometimes

used as shorthand for ‘margin account equity,’ while other times it is used as shorthand for ‘margin requirement.’ (And neither use of the term ‘margin’

is directly analogous to a down payment.)’ James F. Gammill, Jr., “The Case for Federal Regulatory Oversight of Futures Margins,” in Proceedings

of the Fall Research Conference on Regulatory Issues in Financial Markets, The Review of Futures Markets, vol. 7, No. 3. Washington DC, November

1988. The fti sentence in the quotation is, in the original, a footnote to the preceding sentence.

glSEC Recommen~tiomRegmtig the October 1987 Market Break: Testimony of David S. Ruder Before the U.S. Semte COmmittee on Banking,

Housing and Urban Affairs (Feb. 3, 1988), pp. 7-8 and 14-15. Commissioner Edward H. Fleischman reaffirmed in 1988 the SEC’s position that margins

on futures and options should be increased to increase investor confidence, to decrease speculation in futures and options, and to reduce the illusion that

the futures and options markets provide suftlcient liquidity to allow quick portfolio liquidations in large amounts. See Panel Discussion on Regulatory

Issues Facing the Futures Industry, Chicago Board of Trade, The Review ofFutures Markets, vol. 7, No. 1, May 1988, p. 202.

~Report of the Task Force on Market Mechanisms, my 5, 1988, PP. W66.

gsNichoh Katzenbac& An Overview of Program Trading and Its Impact on Current Market Practices, December 1987, P. 31.

WA swpl~ ~cludes: Rep. Edwad ~key, Subcommittee on Telecommunications and Fhince, House Ener8Y and CO mmerce Committee, in

hearings July 14, 1988, and press release, May 4, 1989; Arthur Levit4 Chahman of the American Stock Exchange, writing in The Washington Post, July

12, 1988, A23; John L. Watso~ President of the National Security Traders ASSOCiatiOn in a letter to the SEC Division of Market Regulation, Mar. 10,

1988; George L. Ball, “ Chamnan of Prudential-Bache Securities, in testimony before the Senate Finance Committee, May 11, 1988; Peter Buchanom

President of The First Boston Corp., in a letter to the Chairm an of the NYSE, Jan. 29, 1988; Jeffrey B. Lane, President of Shearson Lehman Huttom

in testimony before the Subcommittee on Telecommunications and Finance, House Energy and Commerce Committee, July 14, 1988; Philip Purcem

Chmrman of Dean Witter Financial Services Group, Inc. letter to the Chairma n of the SEC, Feb. 24, 1988; Felix RohatyrL Partner, Lazard Freres, in

testirnonybefore the Subcommittee on Telecommunications and Finance, House Energy and Commerce Committee, July 14, 1988; StardeyB. Shopkow

Vice Chairman and Mamging Director, Salomon Bros., at a Center for National Policy Symposium on Mar. 8, 1988; Thomas A. RUSSO, P@ner,

Cadwrdader, WickerSham & Taft in testimony before the Subcommittee on Telecommunications and Finance, House Energy and Commerce Committee,

May 3, 1990.
86 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

even higher margin calls;95 CFTC analysts say that

some pension funds use as margin their significant

cash or cash-equivalent holdings and would have no

need to sell stock, which in any case would take 5

days for clearing and settlement. By contrast, many

individual speculators were net buyers of futures

during the crash, but might have been forced to

liquidate by higher margin requirements. The CFTC

chairman claims that ‘margin call sell-off” was not

a factor in the crash.96

A Federal Reserve analysis, however, notes that

"

. . .speculators will shift to markets where initial

margin requirements are effectively lower,’ and

thus “excessive volatility, as well as nonfundamental pricing, may be transmitted from one market to

another. ’97

Again, empirical studies of the relationship between futures margin levels and stock market

volatility reach conflicting findings and are in the

aggregate inconclusive. Both sides of the debate can

marshal some statistical evidence, depending on the

times studied, the definition of volatility that is used,

and the way the question is framed. Only a few

empirical studies directly relate to this point; many

of those sometimes cited deal with stock margin

levels, but not futures market margin levels. G.A.

Hardouvelis, who found a negative relationship

between margin levels and volatility, and Hsieh and

Miller, who claimed to have refuted this finding,

both analyzed stock market margin levels.98 G.

William Schwert (University of Rochester) analyzed

many factors thought to affect stock volatility and

concluded that leverage has a relatively small effect

on stock volatility, and there is no evidence from the

stock market that increasing margin levels would

change volatility.90 A CFTC study of events during

the crash concluded that low futures margins “could

not be shown to have contributed to excessive

volatility." 100 

The debate on this issue, like that on stock-index

futures and volatility, often reflects long-standing

industry/agency positions. The CFTC holds that the

margin on stock-index futures should be 28 to 29

percent as high as the margin on the underlying

stocks (but also maintains that futures exchanges

should set margin requirements without government

interference). 10l The President’s Working Group on

Financial Markets reported in May 1988 that it ‘was

not able to agree on whether or not it is appropriate

or effective to raise margins above prudential levels

in an attempt to reduce leverage or dampen velocity. ” Their report was specific about the disagreement; the SEC chairman wanted higher futures

margins, while the CFTC chairman, the Department

of Treasury representative, and the FRB chairman

“do not believe that the evidence supports the

conclusion that higher margins will reduce volatility, ’ and were reluctant to raise them because this

would increase transaction costs and ‘‘could have a

negative effect on market liquidity and efficiency,

possibly increasing volatility and risking the movement of futures trading into off-shore markets. ’

After the Working Group’s report the futures markets subsequently reduced their margin requirements, to levels below those at the time of the crash.

By 1990, this line-up was changing. Secretary of

the Treasury Nicholas Brady had chaired the President’s Working Group and had acquiesced in its

gSMany pemion funds (and otier institutional investors), however, had short futures positions and had no mmgin cdk w tie mmket fe~.

‘“. . .Anexaminationof the magnitude of open interest in the S&P500stock-index futures contract onhighvolatility days contradicts the supposition

that margin call sell-off exacerbated the market decline. On both Oct. 19, 1987, and Oct. 13, 1989, open interest at day’s end was higher than on the

previous day-more positions were opened than were closed. ”Wendy L. Gramm, Ph.D., statement before the Securities Subcommittee of the Senate

Committee on Banking, Housing, and Urban Affairs, Mar. 19, 1990.

97Artur0 Es~eli~ “consistent IV@@ Requirements: Are T’hey Feasible,” Quarterly Review, Federal Reserve Bank of New York VO1. 13, No. 2,

summer 1988, pp. 69.

98G.A. Hardouvelis, “Margin Requirements and Stock Market Volatility,” Federal Reserve Bank ofNew York Quarrerly Review, 1988, pp. 80-89.

David A. Hsieh and Merton H. Miller, “Margin Regulation and Stock Market Volatility,” Graduate School of Business, University of Chicago, April

1989. Hardouvelis tested the historical effect of stock market margins on volatility, and concluded that margins are related inversely to volatility and

low margins are associated with speculative bubbles. Kusarkand Salinger, in two separate working papers for the ClWC, reexamin ed Hardouvelis’ study.

Kusark said that its regressions were unstable and biased both by the pre-1945 time period that was included and by the method of calculating volatility.

He concluded that margins had no effect on volatility. Srdinger concluded that HardouveLis’ thesis did not hold up regarding the bull market of the

1920s-Iow margins did not cause it.

wG. William Schwem “why Does Stock Market Volatility Change Over Time’?’ GPB 87-11, May 1988, and “Stock Volatility and the Crash of

‘87,” BC 89-01, Januay 1989, General Working Papers: Bradley Policy Research Center, University of Rochester.

IOOMcG~and and Wang, op. Cit., foomote 78.

1°IWendyL. GramnL CFI’C ChairmarL in a statement to the Subcommittee on Telecommunications and Finance of the House Energy and Commerce

Committee, May 19, 1988. Chairman Gramm said that margin on stocks should be roughly 3.5 times higher than the margin on stock-index futures.
Chapter 4- The Operation of Futures Markets . 87

findings, although the 1987 President’s Task Force

which he had also chaired, had called for harmonization of margins across the markets. However, Brady

later announced that he intended to ask the Working

Group to reconsider the issue, because “there is a

public interest involved beyond the private interest

of the exchanges. "102

Debate about the appropriate level of futures

margin usually becomes debate about where the

ultimate responsibility for these decisions should

lie: in the private sector, as it does now or in a

regulatory agency? If the latter, should it be the SEC

(which does not set stock margin requirements, but

wants higher futures margins), the FRB (which does

set stock margin requirements, but does not currently want the responsibility for futures margins),

or the CFTC (which has generally favored leaving

this responsibility with the futures exchanges, and

has generally defended low margins)?

On the issue of futures margins, and who should

determine their levels, the two U.S. regulatory

agencies disagree. The CFTC has consistently affmed the futures industry’s position that futures

margins are fundamentally different from securities

margins, that they should be kept low and flexible,

and that as a policy tool, margin regulation is

“poorly adapted to controlling or even limiting

volatility. "

103 Higher margins might reduce the

activity of speculators, leaving the markets without

liquidity. The agency position has been that there is

no need for regulatory control of futures margin

levels, either by CFTC or other Federal authorities. 104

When stock-index futures were first proposed in

1979, the FRB asserted that it had the authority to

impose margin requirements, and would do so, on

the grounds that the proposed contract would be a

functional equivalent of stock-index options and

therefore should be subject to equivalent regulation

and margin requirements. The FRB’s responsibilities are broader that those of the SEC and the CFTC;

its mandate includes caring for the stability of U.S.

financial markets generally. In this context, the FRB

may have considered assuming responsibility for

stock-index futures margin requirements as another

kind of credit control. After the futures exchanges

set higher margins for the index futures contracts

than those for other kinds of futures, the FRB did not

insist on setting margin levels, and it has not

renewed its claim to responsibility.

Congress has several times considered the possibility of futures margin regulation as a potential

policy instrument to restrain market behavior and to

protect naive investors. For example, in 1974 when

the CFTC was created, in 1980 after a silver market

scandal, and after the 1987 market crash there were

proposals to authorize either the CFTC or the

Federal Reserve Board to set futures margins. With

the development of financial futures, and especially

stock-index futures, this interest in margin requirements focused especially on the issue of parity of

regulation of margins among futures, options, and

stocks. 105

Margin requirements may have different functions in futures markets and in securities markets,

but they have two common purposes in both markets

when viewed from a public policy perspective:

protection of the integrity of the markets, and control

106 Margins limit of excessively speculative activity.

the credit risks of individual participants, primarily

not to protect those participants but to insure that in

times of stressed markets, cascading failures could

not in the aggregate cause the breakdown of the

market as a whole. The question is whether harmonization of margin levels-or “consistency in margin

requirements across equity-related markets”—

would achieve those two objectives. In this case,

‘‘consistency’ could mean allowing the various

parameters of margin requirements (i.e., initial,

maintenance, and variation margins, posting periods, exemptions) to be set at different levels, but in

such a way that the probability of default are about

the same in each market.

IOzTestimony before the Senate Committee on Banking, Housing, and Urban Affairs, Oct. 26, 1989, p. 12.

IOsAndreaM. CoICoran(Dir~torof me @TC’S Division of Trading and Markets), ‘ ‘Aftermath of the Crash: policy Assessments, Public PerC@OIIS,

and prospective Reforms, ” a speeeh for the Japan Center for Intermtional Finance, 1988.

l~~amrn, op. cit., footnote 101; Corcora~ op. cit., footnote 103.

105will~ G. Tomek, “Margins on Futures Contracts: Their Economic Roles and Regulations, ” Anne E. Peck (cd.), Futures Markets: Regulato~

Issues (WashingtorL DC, American Enterprise Institute, 1985), p. 195.

106~s fomulation &aws on tit ofh.Es@ll~ Fede~ Reserve Board a~ys~ in ‘ ‘consistent ?vf@n Requirements: Are They Feasible?”

Quarterly Review, Federal Reserve Bank of New York vol. 13, No. 2, Summer 1988, pp. 61-79. Estrella concludes that if speculation is a real issue,

the consistency of at least initial margins should be seriously considered.
88 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

The Bush Administration has asked that authority

to regulate stock-index futures be transferred, which

presumably would transfer responsibility for their

margin requirements either to the SEC or to the FRB,

which is responsible for stock margin requirements.

This issue is discussed in chapter 6.

PREPARING FOR THE FUTURE

Two Chicago futures exchanges have recognized

the challenge posed by the strong movement toward

international trading.107 The CME and the CBOT are

developing an electronic system for “24-hour trading,” or the execution of transactions at a geographical distance or outside of trading hours of local

markets. CME and CBOT are taking the calculated

risk that their own automated systems for off-site

trading, if successful, may eventually put out of

business their traditional form of market, the ‘‘open

outcry” or pit auction system. They may recognize

the likelihood that if they do not take the lead, others

outside the industry will do so.

Foreign futures exchanges have began to compete

directly with U.S. futures exchanges. There are

futures exchanges in Aukland, London, Paris, Frankfurt, Zurich, Hong Kong, Tokyo, Singapore, and

Sydney. When they began to offer their own local

versions of U.S. contracts, investment firms were

able to offer these products to customers without

regard to trading hours in the United States, the

threatened U.S. exchanges took action. 108 They first

attempted to meet this competition through mutual

offset agreements,109 e.g., one between The Chicago

Mercantile Exchange (CME) and the Singapore

International Monetary Exchange (SIMEX) for Eurodollar and foreign currency contracts. CME/

SIMEX was successful, although only marginally

so. Another response was to lengthen trading hours;

for example, CBOT began both an earlier opening

(7:20 a.m.) and an evening session.

In September of 1987, the CME announced that it

would develop-together with Reuters—an electronic futures and futures-options trading network,

the Post (Pre) Market Trade System, later renamed

GLOBEX for “global exchange.” CME members

accepted the idea, with the assurance that GLOBEX

was strictly an off-hours system, and in return for

receiving a portion of the revenues generated by

GLOBEX. 110

In early 1989 the CBOT unveiled plans for

another off-hours global system, ‘‘AURORA. ’

While the GLOBEX system is an automatic order

matching system, AURORA attempted to emulate

the traders in the pit with icons (symbols) that allow

traders to select the counterparts to their trade. The

CBOT claimed that AURORA would capture “all of

the economic advantages of the auction market

combined with the advantage of the ability to

conduct trading from any location in the world. ’’ill

There were complaints from the financial futures

community about the need to install two terminals,

and CME and CBOT announced they would consider merging the GLOBEX and AURORA development efforts. While sporadic negotiations continued, development proceeded independently on each

system for over a year. In May 1990, the two

exchanges announced that they had agreed to merge

GLOBEX and AURORA. The details of this plan

are not yet worked out. It is possible that AURORA

will become an optional user interface with the

GLOBEX system.

The network will bean interactive data communications network linking individual user terminals

with a central computer at Reuters. It will operate

only after normal U.S. hours of trading and will link

investors in North America, Asia, and Europe.

GLOBEX adjusts the timing of all bids and offers to

equalize for distance; i.e., the speed with which they

are posted depends on the transmission time for the

most distant trader active at that time. For entry of

orders, trader terminals consisting of keyboard,

monitor, and printer will be located in the offices of

CME clearing members and individual members

(including overseas members) who are qualified and

backed by a clearing member. (See ch. 6 for an

loTSee OTA’S background paper, op. cit., footnote 6.

108Karen Pierog, “How Technology Is lhckling 24-Hour Global Markets,” Fuzures, June 1989, p. 68.

l~~~~set~~ (~ ~s context) mamtit one mn own a ~sition in one country and close it in another, ~d pay O~Y One brokewe fee.

ll~e rights COnfCITEXI by membership in CME, or “a -t,” are to be divided into access to pit trading and access to trading through GLOBEX.

Members will have the right to “lease” one of these rights; e.g., a pit trader can lease to someone else, presumably overseas, his access to GLOBE~

thus generating additional income. If GLOBEX (or other electronic trading systems) comes to dominate Mums trading, the increase in value of their

access to it will presumably compensate the pit members for this competition.

11 l’ IAURORA_EOS, S’ promotio~ literature distributed by CBOT.
Chapter 4-The Operation of Futures Markets . 89

explanation of the responsibility of clearing members.) Administrative terminals, in the offices of

clearing members only, would also receive confirmations of all trades resulting from orders entered

into associated trader terminals. The terminals will

display the 10 best bid and 10 best offer prices, along

with the quantity bid or offered; the last sale price,

and other data.

Reuters will provide the computer hardware and

software and also make available other Reuters’

services (e.g., news and cash market quotations)

through GLOBEX terminals. CME will determine

the instruments, and the rules and procedures for

trading, and will provide clearing facilities, auditing,

compliance, and market surveillance. Despite Reuters being a British company, the joint effort is

largely seen as a globally strategic move for the

preservation and enlargement of the U.S. position in

commodities and financial futures trading. It may

also be a harbinger of global ‘‘floor-less’ trading in

the future. It is significant, however, that Reuters has

recognized the value of partnership with an organized and regulated marketplace, the exchanges.
Chapter 5

The Operation of

Options Markets
CONTENTS

Page

THE OPTIONS MARKETS ................................................~... 9 3

OPTIONS EXCHANGES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ● . 95

TRADE SUPPORT SYSTEMS IN OPTIONS MARKETS . . . . . . . . . . . . . . . ● . . . . . . . . . . 96

OPTIONS MARKETS IN THE 1987 CRASH. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

SIDE-BY-SIDE TRADING . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

MULTOPLE-TRADING OF OPTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

OPTIONS MARGINS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Cross-Margining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

Futures-Style Margining . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
Chapter 5

The Operation of Options Markets

THE OPTIONS MARKETS

Options are financial contracts that confer the

right to buy or sell a specific asset or financial

instrument at a given price-the “strike price. ”1

Thus they differ from Futures contracts, which create

an obligation to buy or sell. There are listed options

on individual securities, on securities indexes, on

foreign currency, foreign currency indexes, and

Treasury instruments, on “physicals other than

securities’ (e.g., metals), and on futures contracts.

Options on individual securities and indexes of

securities are traded on securities exchanges, and are

regulated by the Securities and Exchange Commission (SEC). Options on commodities (nonsecurities, e.g., farm products and oil), and on futures

and stock-index futures are traded on commodity

exchanges and are regulated by the Commodity

Futures Trading Commission (CFTC). Most options

on foreign currency are regulated by the CFTC,

except those that are traded on a securities exchange

(the Philadelphia Stock Exchange, which trades

options on seven foreign currencies and is regulated

by the SEC).

Call options give the holder the right to buy; put

options give the holder the right to sell. For example,

the holder of a call option on a stock might find that

the market price of the stock has risen above the

option contract’s strike price. The holder can exercise the option, buying the stock at the lower strike

price and selling it immediately at the higher market

price. Or the holder can sell the option itself at a

higher price than was paid for it. (Most options

contracts are closed out in this way rather than

exercised.) The holder of a put option, on the other

hand, watches for the market price of the security to

fall below the strike price. The holder can buy stock

at the lower market price and then exercise the put

option to sell the stock at the higher strike price. An

option contract on stock is normally for 100 shares

of stock.

All options on a specific asset or financial

instrument, for example, Stock X, are a “class’ of

options. All options of the same class with the same

strike price and expiration date are a “series” of

options.

Both call and put options are sold by an option

writer, the person who in theory must deliver stock

when the call option is exercised, or buy it when the

put option is exercised. (In fact, transactions are

handled through the options clearinghouse.) The

option writer is paid a premium when the option is

purchased, and keeps the premium whether or not

the option is exercised.

The premium earned by an options writer is

determined in the market place and has several

elements. An option may have an intrinsic value

when it is written. Thus a call option on Stock X with

a strike price of $40, at a time when Stock X opens

at $48, would have an intrinsic value of $8. An

option with intrinsic value is said to be ‘‘in the

money.’ An option also has “time value,’ the extra

amount a purchaser will pay for an increased

possibility that the price of the stock will move in the

desired direction before the option expires. The

longer the option has to run, the greater its time

value. Other factors also affect the price or premium

paid for an option, such as the volatility of the price

of the security or of the market in general, and the

effect of supply and demand.

Exchange trading of standardized options began

in 1973 with creation of the Chicago Board Options

Exchange (CBOE); this was followed quickly by

options trading on the American (AMEX), Philadelphia, and Pacific Stock Exchanges. The New York

Stock Exchange (NYSE) did not begin trading

options on stocks until 1985. Stock options trading

is still dominated by CBOE, with 60 percent of the

total volume.

Before 1973, non-standardized options had been

bought and sold for years, in an unregulated

IM~~h of ~~ ~ti~n of tie repofi draws on ~ OTA contractor report: Joel Sefi- ~fiversi(y of M.ictigan MW School), StOCk, OptiOnS, a?ld

Stock ZndexFutures Trading, 1989, pp. 100-200. See also, Joel Seligma~ “The Structure of the Options Markets,” IO Journal of Coqoorateti 141,

1984; David Lipto% “The Speeial Study of the Options Market: Its Findings and Recommendations,”7 Social Regulation andL.aw Journal 229, 1980;

Report of the SpecialStudy of the Options Markets to theSEC, House Committee on Interstate and Foreign Comrneree, 96th Cong., 1st seas. (Comrn.Print

96-1FC3 1978).

–93-
94 ● Electronic Bulls & Bears: U.S. securities Markets & Information Technology

over-the-counter dealer market. The non-standardized options were typically written in bearer form

by professional investors or dealers, and then bought

and sold over the counter. In New York there was a

Put and Call Brokers and Dealers Association, with

20 members who did most of the Nation’s options

writing. Over-the-counter (OTC) options writing

nearly disappeared after 1973. But after computerized “portfolio insurance’ was discredited by the

1987 crash (see chs. 3 and 4), some large brokerages

began writing put options for institutional customers

to allow them to protect their portfolios.2 When

stock prices began to slide on October 13, 1989—

according to SEC and CFTC analyses—the brokers

rushed to increase their own hedges by selling

futures and stocks, thus contributing heavily to the

market break.3

Most listed options in both the United States and

Europe are ‘American-style’ options, which means

that they can be exercised at any time up to or on the

expiration date. “European-style” options can be

exercised only on the expiration date.

Total U.S. trading in options contracts increased

from 1.12 million contracts in 1973 (all at CBOE),

to 305.17 million contracts in 1987 (56 percent of it

at CBOE, 22 percent at AMEX). Options contract

volume declined more than one-third in 1988, after

the crash; and then partly rebounded to 227.02

million in 1989. Stock-option volume as a percent of

trading volume in the underlying stock peaked in

1981, at 92 percent of NYSE trading volume. The

continued decline from 1981 to 1988 may have been

related to the introduction of index options in 1983

(although there had already been some decline)

because many investors had been using options on

such highly capitalized stocks as IBM to take hedge

positions on the market as a whole.4 By 1986,

stock-index option volume was nearly equal to

volume of options on individual stocks. After the

1987 crash, index option volume dropped sharply—

down 42.5 percent in 1988 at the CBOE, 59 percent

at AMEX, and 68 percent at the NYSE. This may

have been because many individual investors who

had been using stock-index options stopped doing

so, but there was also a 40 percent drop in

stock-index futures trading volume at the Chicago

Mercantile Exchange (CME), and these contracts are

mostly used by institutional investors.5

The CBOE created modern options in 1973 by

pioneering two concepts: contract standardization

(by fixing of expiration months and strike price

intervals) so that options are fungible; and establishment of a clearinghouse to be the issuer and

guarantor of the options. This clearinghouse, the

Options Clearing Corporation (OCC), is now jointly

owned by all the equity options exchanges, and acts

as the issuer and intermediary for all listed options.

The clearing-house becomes one counterpart to

every trade; the other party being either the writer of

the option or the buyer of the option, regardless of

whether the option is a put or a call. The holder of the

option looks to OCC rather than to an individual

writer of options for performance when the option is

exercised. 6 If an options writer wants to close out a

position without waiting for an option to be exercised or to expire, the writer can buy an identical

option, balancing out the obligation to OCC. If a

purchaser does not want to exercise or hold an

option, the purchaser can sell it in the secondary

market (i.e., on the exchange).

A stock option is generally eligible for options

trading on an exchange if the stock is exchangelisted (or is a NASDAQ National Market System

security) and is widely held and actively traded. At

the end of 1989, CBOE was trading 237 classes of

options, AMEX 207, Philadelphia 148, Pacific 144,

and NYSE 33. Most stock-index options are based

on broad-based indexes such as the Standard and

% this form of hedging, if stock prices fell, the institutions would require the broker to honor the put, that is, to buy back the institution’s stock at

the higher strike price.

%EC, Division of Market Regulation, Trading Analysis of October 13 and 16, 1989, May 1990, p. 5; Commodity Futures Tratig Commissio@

Division of Economic Analysis, Report on Stock Index Futures and Cash Market Activity During October 1989, May 1990, p. 3.

dAccOrd@ t. c~les J. Heq, Resident ~d c~ef o~~~g offi~r of tie CBOE, pmsod comm~cation to OTA. hlformation On bends ill

options trading volume was provided by the CBOE, March 1990.

SAbout 11.4 Pmcent of to~ fi~es acmw~ we re~l, ~d 34 ~rcent of sec~ties options a~o~~ are re~. OCC estimates that between 25 and

40 percent of the OCC’S total open positions are part of covered call programs, usually retail. Retail investors include both small investors and wealthy

large investors, but investors in futures markets are typically wealthy. (OTA staff discussion with John Hiat~ Options Clearing Corp., Sept. 20, 1989.)

me OCC makes sure that when an option is written to a purchaser, a writer of the same series of options is contractually obligated to OCC tbrough

a clearing member of OCC. The aggregate obligations of the OCC always equal the aggregate obligations of writers to the OCC. If the writer fails to

perform, the clearing member firm is obligated to perform.
Chapter 5—The Operation of Options Markets ● 95

Poor 100 (S&P 100), although there are some on the

Oil and Gas hdex (AMEX), Gold/Silver Index

(Philadelphia), and other narrow-based indexes.

Settlement of index options is always in cash, never

in the stocks that composed the index.

OPTIONS EXCHANGES

Options are traded on U.S. exchanges in two

ways. The CBOE and Pacific exchanges use competitive market-makers who trade for their own

accounts, with an exchange employee called the

Order Book Official (OBO) handling the limit order

book. The AMEX, NYSE, and Philadelphia Stock

Exchanges adapted the specialist system to options

trading, but with additional market-making provided

by “registered options traders” (ROTS) who trade

on the floor for their own account; but have an

affirmative obligation to make markets, as a specialist does.7

In the CBOE, still the largest options market,

there are several market-makers (dealers) for every

stock option group, with dozens for the most active

classes of options, and several hundred for the S&P

100 stock-index option. Bids and offers are made by

public outcry, as in the futures market. Unlike locals

on futures exchanges, however, CBOE options

traders cannot act as both agent and principal in a

single class of options in a single trading day; i.e.,

they cannot do dual trading. Also unlike the practice

in futures exchanges, CBOE market-makers have

affirmative obligations with regard to maintaining

‘‘continuous two-sided markets with limitations on

the maximum quote spread,” and there is a public

limit order book to insure priority of customer

orders. The OBO is not like a specialist; he or she is

an exchange official, and cannot trade for his or her

own account. The OBO accepts and executes limit

orders from customers (not from market-makers or

firms trading for their own account). In general, limit

orders from the book have precedent over those on

the floor at the same price, and the OBO must

display the highest bid and lowest offer to the trading

crowd. The OBO also manages the opening of each

trading session, where bids and offers are made from

the crowd for each series of options, in rotation, to

determine opening prices.

The OBO only handles limit orders in the book.

Large market orders and more sophisticated orders

such as spreads and straddles,8 firm proprietary

orders, and market-maker orders must be handled by

floor brokers, who work only as agents and do not

trade for their own account. On the CBOE there is

also an automatic order execution system for public

customer orders up to 10 contracts, called the Retail

Automatic Execution System (RAES).

This kind of trading floor may have an advantage

over the specialist system when trading reaches a

certain volume. Limited empirical evidence suggests that the competition among market-makers on

the CBOE at high volume levels may lead to

narrower price spreads9 than the specialist system

produces. 10 It may not work as well when volume of

trading is consistently low. The CBOE currently has

a pilot program11 to use a designated primary

market-maker (DPM), much like a specialist, for

some classes of options. The Pacific Stock Exchange

(PSE) has a similar program that establishes a Lead

Market-Maker (LMM) for multiply-traded option

classes with volume in the lowest 20 percent.

Exchange members appointed as LMMs would

“assume responsibilities and acquire rights in their

appointed options classes beyond the obligations

and rights of market-makers that trade in the same

options class. ’ 12 Both the CBOE and the PSE

% the NYSE these are called competitive options traders, or COTS.

SSpread orders ~volve buying and sel~ a different series of options of the same class (i.e., on the same stock but of different expiration date);

straddle orders consist of both a put and call on the same stoclq at the same expiration date.

me price spread is the difference between the highest price that any potential buyers bid for an option, and the lowest amount that potential sellers

ofler to sell it for. When a mwket-maker is buying and selling, competition will lead him or her to keep the spread narrow; i.e., to sell for only a little

more than he can buy the option for.

loC~cagoBoard options Exchange, Exc~nge D~l Listing: A Sti Months Review, 1977, reported that for 10 dual-listed OptiOm ClaSSeS the average

bid/ask spread was 1.8 to 4.0 cents narrower on the CBOE. The CBOE volume in these stocks ranged from 19 to 86 percent of total. A second CBOE

study, “Summary of Analysis of Quality of Markets Measures in Dually Traded Option Classes, ” October 1978, had comparable findings. These studies

dealt with a small number of securities and the studies we over a decade old.

ll~e ~OEproflm~gmw a2.yem Pilot pro= in 1987 and was extended in 1989 for2 years more. SEC Release No. 27167, Aug. 22. 19*9,

54 FR 35960.

12~e L~~s additio~ Obligation for ens~g ac-te dissemination of quo~tiom, must participate fi automatic execution SyStemS, and mUSt

be present at the trading post throughout the day; in return for these and other duties the LMM would be allocated a 50 percent participation in transactions

in the issues.
96 ● Electronic Bulls& Bears: U.S. Securities Markets & Information Technology

require a “Chinese Wall,” between LMMs and any

affiliated upstairs firm to prevent any improper

behavior. 13

TRADE SUPPORT SYSTEMS IN

OPTIONS MARKETS

The CBOE began an automated order routing

system in 1978, achieving direct routing of orders to

the floor in 1979. It was the frost options exchange

to have a retail automatic execution system (RAES),

in 1985. RAES came into floorwide use in 1988 and

now handles about 25 to 30 percent of customer

orders, which is about 8 to 10 percent of contract

volume. Other options markets also have automatic

execution systems; for example, at AMEX, an

electronic system for execution of orders for stock

and stock-index options, (AUTO-EX), is responsible for handling between 1 and 2 percent of options

order flow. AMEX also has an agreement with the

European Options Exchange (EOE) by which EOE

trades options contracts fungible with the AMEX

MMI (stock-index) option contract. A trader can buy

on the AMEX and sell on the EOE, and vice-versa.

The CBOE has developed a hand-held personal

computer to capture trade data on the floor of the

exchange. This “Market-Maker Terminal” (MMT)

is scheduled to be pilot-tested during the third

quarter of 1990.14 The device will record trade data,

identify the trader, and time-stamp the transaction

record to create an audit trail. This will strengthen

the exchange’s ability to enforce tightly the opening

and closing time for trading sessions. The MMT will

also allow a trader to review his current position and

provide him with analytic and risk management

tools.

The MMT uses a touch screen to minimize

necessary keystrokes, and has a one-keystroke

“repeat” feature for speed in recording similar

trades during surging high-volume trading peaks. A

wireless communications network will provide the

interface between the MMTs, held by traders, and

the other trading support systems of the exchanges.

Photo credit: Chicago Board of Exchange

CBOE’S modern market-maker terminal.

OPTIONS MARKETS IN THE

1987 CRASH

Options trading volume on October 19-20, 1987—

although heavier than normal-declined sharply

relative to the surging volume of stock trading.15

Options exchanges have discretion to halt trading

under specified circumstances. They stopped the

trading of nearly 100 options at various times during

the crash, because of trading halts in the primary

markets and order imbalances. In addition, the

opening rotations for index options, during which

initial prices are determined, were either delayed or

long drawn out due to volume and order imbalance.

16 This delayed trading and meant that most

IsFor exwple, it would be improper for a firm to purchase an option assigned to an affiliated LMM except to redu~ or liquidate positions, when

approved by a floor official.

ld~omtion about MMTS was prepared for OTA by the CBOE, my 1990.

IsHowever, on both days, the volme of cleared contracts remained above the year-to-date average, accOrding to tie NC.

16At tiebe-gof each ha~gsessioq one options series at a time is c~~ for bids and offers &om the floor, which frees the initiid priCeS. Not

until after the opening rotation is complete does free trading begin. On the 19th and 20th some rotations in individual options were delayed in part because

trading in many of the underlying stocks on the principal stock exchange had not begun. Another factor was that CBOE had just added 112 new S&P

100 series.
Chapter 5-The Operation of Options Markets .97

orders had to wait a long time to be executed. At

some points on the rotation traders could not predict

the execution prices. When there were trading halts,

rotations had to be repeated to reopen trading.

Market-maker participation declined by 75 percent between October 19 and 23, and quoted spreads

between bids and offers drastically widened. Marketmakers’ performance was sharply criticized by the

SEC.17 Order execution through RAES and AUTOEX effectively stopped, both because they do not

function during rotation, and because the exchange

severely restricted the series eligible for these

systems due to the reluctance of market-makers to

participate.

CBOE and AMEX made some rule changes after

the crash (e.g., changing the procedure for opening

rotation and strengthening the obligation to participate in automated execution systems). As a goodwill

gesture CBOE index options market-makers made

refund payments to customers who had bought

certain options series during the period of greatest

volatility and uncertainty on October 20, 1987.18

SIDE-BY-SIDE TRADING

Options trading on stock exchanges raised the

issue of side-by-side trading of stock and options,

especially at the NYSE. NYSE competitors feared

that the exchange, the primary market for most of the

stocks on which options are traded, would have

unfair advantages in options trading. Many brokerage firms have electronic systems for automatically

routing customers’ stock orders to the NYSE, and

options orders might also be routinely routed there.

Combination orders of stocks and options would

make it more economical to hedge using options.

More importantly, the NYSE would have the possibility of trading stock and options at the same or

adjacent posts, or allowing one specialist to handle

both, which because of the specialists’ possession of

the limit order book would raise frontrunning or

manipulation concerns as well as tending to give the

NYSE strong competitive advantages.

The SEC made a special study of these issues,

which delayed the trading of options at the NYSE

until 1985. The SEC imposes special conditions on

the NYSE, such as a requirement that stocks trading

and options trading take place on separate floors.

Specialists may however use options to hedge their

risks in making markets. The NYSE has so far

remained last among the exchanges in the number of

equity option classes traded.

MULTIPLE-TRADING OF

OPTIONS

Beginning in 1980, the exclusive right to trade a

new option on exchange-listed stocks was awarded

to one or another exchange by means of a lottery .19

In May 1989 SEC promulgated Rule 19c-5, which

after January 21, 1990, allows all newly listed

options to be multiply traded, and after January 22,

1991, will allow all options to be traded on all five

options exchanges. The agency provided many

reasons for the rule change, the most important being

that competition among exchanges would lead to

improvements in the quality of exchange services. It

is expected that multiple-trading will also provide a

strong incentive to develop an integrated electronic

system that would allow brokers to route options

business to the exchange offering the best price at

that moment.

The argument about multiple-trading had been

going on for 12 years, and illustrates how, in spite of

talk about free markets and the dangers of regulation, exchanges often resist additional competition.

This resistance sometimes takes the form of opposition to technological systems.

After the introduction of options trading, there

was fierce competition between the exchanges. The

SEC said that:

. . .because many brokerage firms automatically

route their small public orders for an option to the

options exchange with the greatest volume of trading

in that option, market-makers of options exchanges

appeared to have engaged in pre-arranged trades,

wash sales, and trade reversals to give the appearance

ITSEC, The October 1987 Market Break, washingto~ DC, pp. 8-8 to 8-10.

lgc~les J. Hem-y, President and Chief operating Oftlcer of the CBOE, in correspondence to OTA, Mar. 28, 1990, said tit tiese payments were

not made by the exchange, as reported at the time in newspapers; the payments were advanced by the exchange on behalf of the market-makers and repaid

to the exchange by market-maker contributions of one cent per contract. The payments covered the part of the options premium that was determined

to be excessive. The AMEX had a similar refund program.

l%xc~nges competitively traded options on OTC stocks, a much smaller mmket.
98 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

of increased trading volume in multiply-traded

options on their options exchanges.20

There is a tendency for trading of any asset to

concentrate in one market. While at least 22 classes

of options were traded on more than one exchange

during the 1970s, by 1977 only 15 were multipletraded. The SEC was asked to rule on whether the

AMEX, Philadelphia, and New York exchanges

could engage in competitive trading. Long commited to the idea of increasing competition, SEC first

acknowledged that ‘under appropriate circumstances,

the benefits of expansion of multiple-trading appear

to outweigh any adverse consequences. ”21 Nevertheless SEC said that it would defer a decision until

the options exchanges presented a plan to develop

‘‘market integration facilities’ designed to minimize market fragmentation and maximize competitive opportunities. According to SEC staff, delay

and inaction by the exchanges discouraged the

agency from further increasing the number of

multiple-traded stock options at that time.

The argument for and against multiple-trading

turns on the effects of competitiveness on option

prices. When stocks or options are traded on only a

single exchange, the higher volume of trading that

results tends to keep bid-offer spreads narrow. When

the same volume of trading is divided among two or

more exchanges, two factors may influence whether

spreads broaden or narrow. The diminution of order

flow to each market tends to broaden price spreads,

because overhead is divided among a smaller

number of transactions and the market-making risk

increases. On the other hand, competition should

keep price spreads as narrow as possible in order to

attract orders. The little comparative data available

on options trading in 1977 indicated that with

multiple-trading, price spreads narrowed, the average variance of price from one transaction to the next

declined, and brokerage and floor broker rates also

declined.22

Some people argued against multiple-trading of

options because of their conviction that competition

is not effective in narrowing spreads. They say that

brokers, in spite of their legal obligation as agents to

execute customer orders at the best price available,

usually do not send orders to the options exchange

with a superior quotation, but route the orders

automatically to a primary options exchange. Benefits from competition, according to this argument,

are outweighed by the tendency of multiple-trading

to fragment markets and reduce order flow to any

one market.

The SEC, in urging the exchanges to develop a

market integration facility, insisted that they analyze

three approaches to market integration:

●

●

●

a market linkage system to move orders from

one option exchange to another, like the

Intermarket Trading System (ITS) operated by

stock exchanges (see ch. 3);

a neutral switch, or automatic routing of

individual orders by brokers to the market

center with the best quotation; and

a central limit order file (an order exposure

system to simultaneously display all public

limit orders to all options exchanges) .23

Several options exchanges insisted that none of

these is possible because of the difficulties that

options market-makers have in entering firm quotations. These difficulties arise because options are

‘‘derivative’ of securities. A change in the underlying stock price will require adjustments in as many

as 8 or 10 series of call options and 8 or 10 series of

put options based on that stock. The market-maker

may be following as many as 25 or 30 stocks, each

with 16 to 20 option series. It would be impossible,

some said, for market-makers to monitor and constantly update quotations on so many series.

This problem, however, has effectively been

solved by the development of “auto-quote’ devices

that automatically change several series of options

quotations when one of them is changed, or when the

underlying stock quotation changes. The CBOE

describes its Auto-Quote System as “performing

mathematical operations that use input on the

underlying stock (bid, ask, last sale or mean of the

bid/ask) and input from the market makers (industry

volatility, interest rates, supply and demand, positions, time to expiration). ” As early as May 1989,

mSEC Rel~se No. 13433, Options Floor Trading, Apr. 5, 1977. SEC Docket 2194.

21SEC. Ex. ~t. Rel. 16,701, 19 SEC D~k. 998, 19800

Z( $Rewfi of tie Specti Smdy of the OptiOnS Markets to tie ‘EC?*’ House Committee on Interstate and Foreign Commerce, %th Cong., kit sess.

1053, 1056 (corm. Print 96-1FC3 1978)

~Sec. Ex. Act Rel. 16,701, 19 SEC DOC. 998, 1008, 1980.
Chapter 5-The Operation of Options Markets ● 99

SEC reported that for this reason “the lack of firm

quotations is no longer the impediment it once was

to the development of an options intermarket linkage. ’24

Another problem has been the size of the crowd in

index options markets. It may include several

hundred floor brokers, market-makers, and ROTS. In

contrast to the stock market, where the ‘‘crowd’ by

the specialist post is usually only a few people, there

may be hundreds of traders in the S&P 100

stock-index options pit (as there are in stock-index

futures pits at the CME). Merely identifying who

entered a quotation is difficult, yet a firm quotation

system would have to include market-maker identity, quotation, and size for each series of options.

This problem, too, will soon be solved by

technology. As described earlier, the CBOE expects

to have hand-held terminals ready to be used by

market-makers in the pits before the end of 1990.

They can transmit information on quotations, time,

and quoter identity.

The SEC preferred a limit order execution system

linking the markets (the third alternative above), to

either a “firm quotation” or order exposure system.

The agency wanted a system that would handle only

public limit orders and that would provide a display

summary of the orders on each options exchange,

and give floor members on each an equal opportunity to execute the orders.25 An inter-exchange task

force objected that only a small percent of trading

involved limit orders booked with a specialist or

OBO, and therefore a limit order system could not

integrate the options markets enough to let market

centers compete for order flow. It would not change

the practice of brokers always sending options

business to the exchange with the highest volume of

activity in that options class.26 The task force said

that a central limit order file “was not likely to

reduce substantially the adverse effect of multipletrading.” The CBOE also objected that the project

would cost many millions of dollars and ‘cannot be

cost-justified. ’27 The SEC decided that the industry

should make the final decisions about technological

choices. It did not compel the construction of the

limit order market integration facility, or any other

kind of market integration system immediately. But

it has since resumed its pressure on the exchanges to

develop such a system.

The SEC did permit multiple-trading of subsequent new options products, most significantly the

multiple-trading of options on over-the-counter

(OTC) stocks-not exchange-listed stocks—beginning in June 1985. Of the first 30 options on OTC

stocks, 9 were multiple-traded. But AMEX quickly

captured nearly 90 percent of that market. By June

1987 only two of the nine options were still

multiple-traded. 28 Nevertheless, subsequent experience has convinced the agency that competition in

trading these options has been beneficial. An SEC

study in late 198629 found that AMEX OTC options

which could be traded on other exchanges, had a

bid-ask spread nearly 20 percent narrower than the

spreads of AMEX options that could not be traded

on other exchanges. Moreover, in the first group 38.6

percent of trades were inside the quote (i.e., between

published best bid and best offer), a measure of

market-maker performance, compared to 21.7 percent in the second group. Another SEC study

concluded that the cost to investors of singleexchange options trading exceeds $150 million

annually. 30 SEC concluded that evidence showed

that multiple-trading may be beneficial to the

markets and at worst “has not resulted in any

deterioration of those markets.”31

In June 1987 SEC proposed Rule 19c-5 providing

for unlimited multiple-trading. For hearings in

February, 1988, the CBOE brought in evidence of

~Seco EX. Art Rel. 2(j,871, 43 SEC Dock. 1519, 1529, 1989.

HSW. EX. Act Rel. 16,701, 19 SEC Dock. 998, 10009-1010, 1980.

26SupplewntaVRepo* of the Am, pacl~c, ~ndphil~elphia Sto~kEx~hange~ and the CBOE in Re~onse to Release No. 34-26,70110, 1981.

27~tterfiomW~tmAuch “ Chaumanand Chief Executive Officer, Chicago Board Options Exchange, to George Fitzsimmons, Secretary SEC, 14-16,

Sept. 22, 1980.

28sec. Ex. ~tRel. 24,613,38 SEC Dock. 865,869-870, 1987. ~ J~~1989 -x@aded 18 m~tiply-~ded options, md held an average 88.12

pement of the market.

~Sefities Exchange Co remission, Directorate of Economics and Policy Analysis, The Effect of Multiple Trading on the A4arketfor OTC Options

2, pp. 16-17, November 1986.

~S~ties~c~geco~ssioq~lce of~echieffiono~t, potential Competition andAc~lCompetition in the Options iUarket2, November

1986. The options allocation plan distributed options among the exchanges for singl~exchange trading.

31sec. Ex. ~t Rel. 24,613, 38 SEC D~k. 865+ 871, 1987; see ~so SW. Ex. Act Rel. 26,870, 43 SEC Dock. 1498, 1501-1503, 1989.
100 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

‘‘trade-throughs” (cases in which customers did not

get the best execution) in a specific multiple-traded

stock option,32 and also argued that expansions of

multiple-trading would lead to market fragmentation and would give the NYSE unfair competitive

advantages. Other options exchanges argued that it

would be especially harmful in the absence of

effective electronic market linkages. AMEX and

NASD defended multiple-trading as providing more

liquid markets and narrower spreads, and criticized

the allocation system for leading to the proliferation

of redundant options in which investors had little

interest. The SEC says that multiple-trading should

also encourage enhancements in services, as exchanges compete with each other. Rule 19c-5 was

issued in 1989, to take full effect after a phase-in

through 1990.

This debate about technology continues, revived

by the approach of multiple-trading. A contractor for

the Philadelphia, Pacific, and New York Stock

Exchanges recommended that a market linkage

system like the ITS be adopted. Two other contractors, Professors Amihud and Mendelson, carried out

an assessment of such an Option Markets Integration

System (OMINTS), calling it a “cloned ITS. ”33

They condemned the ITS model as “likely to

produce a number of undesirable results,” because

it would violate principles that are important to the

proper functioning of the options markets. Specifically, an ITS-like link would ignore the growing

interdependencies between the options market and

cash markets, and

. . . effectively forego the opportunity to develop

alternative forms of linkage that take advantage of

the price interdependencies that are so important in

the options markets.

Amihud and Mendelson recommended two intermediate technological systems:

. an automatic routing system based on individual exchanges’ limit order books and automatic

execution systems, designed so as to preserve

important secondary priorities of time and size,

and developed by either the OCC or a commercial vendor of market information; and

. automating the opening transactions with a

kind of single price auction (see discussion in

ch. 3).

The SEC called for new systems proposals for

electronic integration of markets-linking systems—

by October 1, 1990. Two proposals are under

discussion. The Philadelphia Stock Exchange has

suggested an ‘Auction Intermarket System’ (AIMS).

Four exchanges (the CBOE, NYSE, AMEX, and

Pacific Stock Exchange) are developing ideas for a

“Public Investors Privileged Express’ (PIPE, now—

as improvements are planned-called PIPE-PIus).

The President of the Philadelphia Stock Exchange, Nicholas Giordano, told OTA:

If we are going to have a multiple trading

environment we must have electronic linkage in

order to provide the public customer the opportunity

to receive the best price available. Otherwise they

will become the victim of the arbitrageur.34

Although the SEC has approved a rule to allow

multiple-trading of securities-based options beginning in 1991, it is unlikely that competition will be

achieved easily. Trading may still tend quickly to

concentrate in one dominant market to the exclusion

of others, unless there is an intermarket order routing

system. SEC staff, however, say that the possibility—

or threat-of direct competition for the market in

options goes far toward forcing exchanges to improve the quality of their services.

OPTIONS MARGINS

Efforts are underway to strengthen and streamline

the process by which securities transactions and

related derivative product transactions are cleared

and settled (see ch. 6). (Clearing is the matching for

the buyer and seller of their records of a transaction

to be sure that they agree on terms; settlement is the

exchange of payment for ownership of the security

or derivative product.) There are differences in the

processes by which clearing and settlement is

carried out for securities, futures, and options,

especially as related to the way margins are handled

(see the discussions in chs. 4 and 9). Now that those

qzsee ‘‘Regio@ Exchanges Chsh With AMEX, NASD Over Multiple Trading of Options,” 20 Securities Regulation& Luw Report (BNA) 253,

1988. SEC objected that this option was a thinly traded option with infrequent updating of quotes, and argued that the benefits of narrower spreads in

multiple trading exceeded the cost of trade-throughs. See Securities Exchange Commissio%OffIce of Economic Analysis, Memorandum on

Trade-Throughs in Multiply-Traded Options, Sept. 23, 1988.

33YSkoV mud and Haim Mendelso~ “@tion Markets Integration: An Evaluation.L” January 1990, to be published.

34Telephone interview, April 1990.
Chapter 5-The Operation of Options Markets ● 101

markets are closely linked by hedging techniques

and arbitraging practices, differences in margining

systems between the markets are increasingly controversial.

In all markets, margin is a way of limiting the risk

that a market participant will fail to deliver what he

has sold or pay for what he has bought. When a

clearinghouse is the party to the trade, as in most

U.S. markets, margin requirements serve to reduce

clearinghouse risk.

The options buyer pays a sum which is known as

the premium; this is all the buyer owes for the life of

the option. (Of course, if he chooses to exercise the

option and buy the underlying product, he wiIl at the

time of purchase owe additional amounts.) The

settlement (payment) of premium obligations occurs

next day. The current system of options margining

requires the premium to be credited to the account of

the writer (seller) of the option, who must keep it

posted as margin and also must post additional

margin to cover the risk that the market may increase

the cost of the writer’s obligation underlying the

option. The writer also must put up more margin

collateral when the market moves against him

(beyond the maintenance margin level) during the

life of the option. However, these margin requirements may be met with assets other than cash (e.g.,

U.S. Government securities, letters of credit, stock),

because option holders pay their premiums in full

and thus do not realize gains or losses until the

position is closed out.

Some innovative margining mechanisms were

recommended by several market crash studies, and

are still under consideration. A proposal for crossmargining is being reviewed by the SEC and CFTC

(pending the results of two pilot programs), while a

proposal for futures-style margining for some options is being considered by the CFTC, but only for

use on a limited basis, because of prudential

concerns by regulators. Proposals for changing

margining methods often evoke controversy because

significant problems could result from adopting a

system that might under stressed market conditions

result in failure of market participants. However,

some of the arguments for and against crossmargining and futures-style margining are also

intended to ward off potential losses of business by

some market participants, or to gain market share at

the expense of another segment of the industry.

The potential costs and benefits of alternative

margining schemes are difficult to assess because

margin mechanisms are probably well understood

only by a relatively few experts with a stake in the

issue. The challenge to regulators is to separate

socially sound, functionally robust, innovations

from other proposed innovations that are merely

self-serving.

Cross-Margining

Four of the reports on the ’87 market break—

those of the Brady Commission, the Working Group

on Financial Markets, the SEC, and CFTC reports—

recommended some form of intermarket crossmargining. Since that time, two cross-margining

programs have been set up. The Options Clearing

Corp. (OCC) and its futures clearinghouse subsidiary, the Intermmket Clearing Corp. (ICC), began a

cross-margining program in 1988, but at the end of

1989, the program had only one participant (a firm

that is a clearing member of both the OCC and the

ICC). The OCC and the Chicago Mercantile Exchange (CME) in October 1989 began another

cross-margining program that had three participants

as of late 1989.

The basic idea in cross-margining is to reduce the

extreme demands for collateral that occur in meeting

the original margin requirements of firms which are

members of multiple clearing organizations, and are

using inter-market transactions to hedge. Crossmargining recognizes the reduced risk resulting

from hedges across markets, for example, between

an S&P 500 futures contract traded on the CME and

an S&P option traded on the CBOE. A clearinghouse

recognizes the counterbalancing or hedging effect of

positions that one market participant may have at

different exchanges, and allows such market participants to reduce their margin obligations accordingly.

It is a form of netting which reflects an overall

assessment of the net risk of default and provides an

estimate of the amount of margin required to cover

that risk.

Advocates of cross-margining argue that it reduces the gross amount of payments due, and

payments owed, by market participants and clearinghouses, and thereby both reduces the possibility

that a counterpart to the trade may default and

relieves some stress on the payment system. Crossmargining also reduces differences between pay and
102 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

collect schedules, and increases the sharing of credit

information between clearinghouses.

The CME normally pays clearing members and

collects margin at 6:40 a.m., while the OCC collects

at 9 a.m. and pays at 10 a.m. However, for

CME-OCC cross-margining accounts, there is only

one time to collect margin-6:40 a.m.—and only

one time for clearinghouses to pay clearing members10 a.m. Thus, a cross-margined member cannot use

money due from the OCC to pay the CME, but

instead must find another source of funds for the 3

hour and 20 minute interval between making and

receiving payments. Nonetheless, cross-margining

reduces the number of calls for payment flowing

through the settlement systems.

However, an SEC analysis pointed out that

cross-margining does not solve the problem of

asynchronous cash flows:

[In] essence, these commentators focus on the

need for cash to meet futures variation margin

payments when it is the futures leg of an intermarket

hedge that declines in value and the options leg

appreciates in value. In that circumstance, because

options contracts [can] appreciate in value but do not

pass through profits and losses on a daily basis, the

clearing member holding the option must finance,

from his own or borrowed funds, payment on the

futures contract.35

In the CME and OCC cross-margining program,

each participating clearing member maintains a

cross-margin account at CME and OCC, and designates which positions are to be cross-margined. Each

day, CME and OCC transmit to each other information about the positions in each cross-margin account, so that each clearinghouse knows the entire

portfolio of index option, futures, and futures option

positions. This is run through each clearinghouse’s

portfolio risk analysis margining system, and the

cross-margin account at each clearing organization

collects half of the total margin determined by that

calculation. Each clearinghouse retains the right to

make an independent assessment of the amount of

risk and of whether a greater amount of margin

should be required.

The CME and the OCC are currently working

with their settlement banks and regulators in an

effort to setup cross-margining with bank financing.

For example, participants could pledge profitable

long options positions in their cross-margining

account to a bank, in order to secure that bank’s

financing of variation margin payments for unprofitable hedged positions owed to the CME clearinghouse. 3G However, the CFTC questions the appropriateness of granting priority over the proceeds of

liquidated positions to a bank in the event of a

member’s default, because this would increase the

liquidity risk to the clearinghouse.37

OCC-cleared long securities options can currently

be pledged to banks to secure financing (separate

from any cross-margining programs), but no futures

clearinghouse has a corresponding program for its

members because banks are reluctant to accept

futures positions as collateral. Both the CME and

OCC argue that expanding the ability of market

participants to pledge cross-margined positions to

banks to obtain financing is an important step

towards reducing liquidity problems in times of

market stress.

Both the CME-OCC and the OCC-ICC programs

are currently limited to the cross-margining of

clearing member holdings which are defined as

“proprietary” (under CFTC regulations) or “noncustomer” (under SEC regulations) .38 This restriction is rooted in regulations which govern the

disposition of customer property in the event of a

bankruptcy by a Futures Commission Merchant.

Both the CME and the OCC have been discussing

ways to resolve these regulatory issues and to

expand cross-margining to include market-makers

and commodities market professionals.

Critics of cross-margining have argued that in the

event of a crisis involving defaults, cross-margining

would increase liquidation risks to the banks and the

clearinghouses. The risk would increase because of

35SEC. fi. Act. Rel. 27,296, 44 SEC Dock. 1328, Oct. 10, 1989.

36Money owed t. the market p~cipmt by each clearinghouse would be paid directly to the b~ thereby reducing the si~ of the Participants bati

loan.

q’i’~e occ po~ts out tit ~~the ~mtfig of a secm~ lien on sm~tim positions carri~ in the acco~ts of brokers/dealers is at the h- of the capital

formation process and is the longstanding practice within the securities industry.’ OCC letter to OTA, Feb. 5,1990. This issue is about different markets’

views of how safety and soundness should be achieved in different markets.

36~e c~.occpro-isopen t. ~. ~ategofies of cle~g fm: jo~t m~bers of both cm and WC, and pfis of affiiated fimxs, one of which

is a CME clearing member and the other an OCC memk.
Chapter 5-The Operation of Options Markets ● 103

the larger amounts of capital in the markets, capital

which would have been tied up in margin under

traditional margin systems. Further, they argue, risk

might be increased if offsetting positions cannot be

liquidated at the assumed values during times of

market stress. This issue highlights the need to

balance efforts to increase liquidity and concerns

about the stability of markets in times of turmoil.

Futures-Style Margining

Some of the advocates of unified or improved

clearing systems acknowledge that the different

margin systems for different markets are an obstacle.

One proposal to reduce these differences is “futuresstyle margining” of options, currently being discussed only for futures options. The current system

of margining options requires the buyer of the option

to pay a sum, the premium, which is all that the buyer

owes for the life of the option. The premium (for a

call option) is credited to the account of the writer

(seller) of the option, who must keep the premium

posted as margin and also must post additional

margin to cover the risk that the value of the option

may increase. The value of the option is marked to

market and, when the market moves unfavorably,

additional margin must be provided.

The futures-style margin proposal would change

options on futures margining so that both buyer and

seller must meet mark-to-market variation margin

requirements. The value of the option would be

marked-to-market daily, with the clearinghouse

collecting cash-only variation margin from losing

buyers and sellers and crediting the accounts of

winning buyers and sellers. This would alter the

fundamental nature of each party’s overall obligations, since both the buyer and seller would be

obligated to post margin. It would also increase

overall credit requirements in the marketplace as

both sides of the option would have to be financed.

The potential for losses on the part of the writer of

the option would remain essentially unlimited, while

the option buyer’s potential for losses would remain

limited to the value of the full premium/obligation.39

Proponents of futures-style margining (mostly

within the futures industry) say that the major

benefits would be improved information sharing on

risk positions and greater symmetry in the cash

flows on hedged options and futures contracts.40 It

could eliminate or minimize three problems of the

current margining system.

41 One perceived problem

is that the present treatment of risk is asymmetric.

The buyer of call or put options on futures has risk

limited to the value of the premiums at the time of

purchase, but are not permitted to margin and must

post the full premium (which is small compared to

the value of the underlying asset). The second

perceived problem is that the amount of funds

collected and held in the margin system exceeds that

which is necessary to guarantee performance because options profits must be kept in the account.

Holders of long or covered futures options are forced

to keep more funds in the margin system than for a

comparable position in futures. This applies to all

options and results in a significant demand on

capital. The third problem is that the options margin

system encourages the holder to exercise margins

earlier than necessary; profits from “covered”

options42 must be kept in the holder’s margin

account even though there is no risk of default, and

can be realized only by exercising the option (or by

offsetting a put option with a new call option).

The OCC, the SEC, and the securities industry,

generally, are opposed to futures-style margining

because it would create a new and potentially large

asynchronous cash flow problem for equity-related

options. Covered writers of call options pay no

margin to the OCC because the stock position

effectively serves as collateral. If futures-style

margining were extended to all options, they would

be required to pay daily margin payments whenever

their options position declined in value, without the

benefit of a positive cash flow from the securities

position. This would alter the traditional nature of

equity-related options and, with it, the types of

trading and uses of these financial products. Costs

would fall disproportionately on individual investors, who frequently do covered call option writing.

The present system of margining securities options

WHC Cement in “petition for Rukxnaking to Delete CFTC Regulation 33.4 (a) (2),” July 27, 1989.

~on~ of tie Prownents is tie CME. CME letter to the c3TC, July 27, 1989, PP. 2-3, ~ “Petition for Rulemaking to Delete CIWC Regulation

33.4(a)(2),” 54 Fed. Reg. 11233, Mar. 17, 1989.

dlIbid.

dzc’covemd~fig>! refem t. tie ~~g(sefl~g) of ~~1 ~ptiom by an investor who owns tie ins~entunderlying the option COn&aC~ m OppOSed

to one who has borrowed or must borrow it to backup the option.
104 ● Electronic Bulls & Bears: U.S. Securities Markets& Information Technology

helps to minimize margin calls by permitting various

types of collateral to be used (government securities,

pledges of approved stock, letters of credit), rather

than just cash. It is consistent with the practices of

the equities market.

This debate reflects one disadvantage of having

two separate, independent regulators. The issue of

futures-style margining for options has been centered in the CFTC, but arises from recommendations

by the President’s Working Group calling for the

investigation of futures-style margins for all options,

including those issued by the OCC and regulated by

the SEC. Discussions of futures-style margining

should be examined in parallel with current efforts

on cross-margining.

43 They involve inter-market

issues, not all of which are within either regulator’s

jurisdiction. Neither regulatory agency is likely to be

able to take into account the full effects of its

decisions on other markets.

43As r~ommend~ by representatives of the SEC and CFTC at OZ4’S meeting of experts on clearing and settlement Aug. 22, 1989.
Chapter 6

Domestic Clearing and Settlement:

What Happens After the Trade
CONTENTS

Page

HOW CLEARING AND SETTLEMENT WORKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

U.S. EFFORTS FOR IMPORTMENT . . . . . . . . . . . . . . . .. ...................... 109

PROPOSED STRATEGIES FOR CHANGE IN U.S. CLEARING AND

SETTLEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. .. .. .. .. .+ .. .+ ... +.. . . . . . . . 111

EFFORTS BY THE GROUP OF THIRTY TO REDUCE DIFFERENCES IN

CLEARING AND SETTLEMENT . . . . . . . . . . .. .. .. .. .. .. .. .. .. ~. . . . . . . . . . . . 117

POLICY ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ● * 122

Risks Associated With Default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

Risks Associated With the Payment Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

Information Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123

Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... .....123

Standardization and Harmonization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

Settlement Period Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

IS AN INTERNATIONAL REGULATORY BODY NEEDED? . . . . . . . . . . . . . . . . . . . . . 125

Box

Box Page

6-A. The Role of Fedwire . . . . . . . . . . . . . . . . . . . . .. .. ... ... . . . . . . . . . . . . . . . . . . . . 112

Figure

Figure Page

6-1. Interfaces Among Clearing Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

Tables

Table Page

6-1. U.S. Exchanges, Clearinghouses, and Depositories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

6-2. Recommendations of Major Studies for Improved Clearing and Settlement . . . . . . . 113

6-3. Group of Thirty: Current Status of International Settlement

Recommendations-Equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

6-4. Recommendations From Major International Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
Chapter 6

Domestic Clearing and Settlement:

What Happens After the Trade1

“Clearing and settlement” is the processing of

transactions on stock, futures, and options markets.2

It is what happens after the trade. “Clearing”

confirms the identity and quantity of the financial

instrument or contract being bought and sold, the

transaction price and date, and the identity of the

buyer and seller. “Settlement” is the fulfillment, by

the parties to the transaction, of the obligations of the

trade. In equities and bond trades, “settlement”

means payment to the seller and delivery of the stock

or bond certificates or transferring its ownership to

the buyer. Settlement in futures and options takes on

different meanings according to the type of contract.

Trades are processed differently depending on the

type of financial instrument being traded, the market

or exchange on which it is traded, and the institutions involved in the processing of the trade (i.e., an

exchange, a clearinghouse, a depository, or some

combination). The integrity and efficiency of the

U.S. clearing and settlement systems is important to

both its internal financial and economic stability and

its ability to compete with other nations. U.S.

markets use clearinghouses to handle the clearing

and some of the settlement processes for exchangetraded financial products, and “depositories” to

hold stocks and bonds for safekeeping on behalf of

their owners.

Major goals of clearing and settlement in the

United States are broad public access to the markets

and the reduction of risk, through the clearinghouse

as an intermediary. These policies are reflected in a

hierarchy of protections for the clearinghouse,

including minimum capital requirements for clearinghouse members.

Other aims of clearing and settlement in the

United States are efficiency and safety. The faster

and more accurately a trade can be processed, the

sooner the same capital can be re-invested, and at

less cost and risk to investors. Therefore, as markets

become global, one could expect that investment

capital will flow toward markets that are most

attractive in terms of risks and returns, and that also

have efficient and reliable clearing and settlement

systems.

The increasing trend toward global trading and

linked world markets heightens the importance of

viewing clearing and settlement systems as also

linked. The soundness of clearing and settlement

systems in one nation can impact other nations. The

failure of a major clearing member—the member

firms of an exchange or market-at a foreign

clearinghouse could affect a U.S. clearinghouse

through the impact on a common clearing member.

To reduce the risk of such an occurrence, different

countries’ clearing and settlement systems must be

coordinated, for example, by sharing risk information and harmonizing trade settlement dates. Both

the private sector and Federal regulators have begun

to take steps in this direction. It is doubtful that the

private sector can achieve the needed changes

(discussed later) without government taking a prominent and concerted role.

HOW CLEARING AND

SETTLEMENT WORKS3

Many kinds of organizations are involved in

clearing and settlement. Their functions vary from

market to market. A key role of a clearinghouse is to

assist in the comparison of trades and to remove

counterpart risk from the settlement process. Clearinghouses provide the buyer with a guarantee that he

will receive the securities-or other interest-he

purchased, and provide the seller with a guarantee

that he will receive payment.

The clearinghouse has a number of working

relationships, or interfaces, with other institutions

IFor ~ diXu~~ion ofcle~ and set~emmt ~ tie Ufitd Kingdom and Japa~ see OTA Background Report: Trading Around the Clock: secu~”fi”es

Markets and In@rmation Technology, Appendix, OTA-BP-CIT-66 (Washingto~ DC: U.S. Governm ent Printing Offlce, July 1990).

% preparing this chapter, OTA has relied heavily on a contractor report by Bankers Trust Co., Study of International Clearing and Sefflement, vols.

I-V, October 1989, to which many dozens of institutions and individuals around the world contributed expert papers and/or seined on the Bankem Trust

advisory panel. This report is hereafter referred to as “Bankers Trust report.” OTA has also used the discussions of an expert workshop held at OTA

on Aug. 22, 1989.

3A de~ed description of clearing and settlement in the United States is provided in the appendix.

–lo7–
108 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

(figure 6-l). A trade cannot settle through the central

systems until it has been matched, i.e., until buyers’

and sellers’ records of the trade are compared and

reconciled. A clearinghouse has an interface with a

market in which trades are executed and from which

the clearinghouse receives information on the

trades. 4 The clearinghouse may receive previously

“locked-in” trades (trades which have already been

matched), or it may match the trades itself.

A second interface is with its clearing members,

i.e., the member firms of an exchange or market. A

clearing member delivers trade information to the

clearinghouse and may hold positions both for itself

(proprietary positions) and on behalf of its customers. Other traders in a market, who are not clearing

members, must clear their trades through a member

of a clearinghouse for that market. The clearinghouse may also provide its clearing members with a

trade-matching service and notify members about

the way a trade is to be settled (the settlement date,

and the way payment and delivery or transfer of

ownership will be accomplished). A clearinghouse

controls the risks of the clearing and settlement

process through its relationships with its clearing

members. For example, typically it will have some

combination of minimum capital requirements for

clearing members; margins or mark-to-market procedures; and requirements that its clearing members

place collateral in a guarantee fund as protection

against default by other clearing members (one

exception is the Board of Trade Clearing Corp.). In

the event of the failure of a clearing member, the

clearinghouse may also have the ability to assess all

other clearing members.

A third interface is with clearing and credit banks.

The clearinghouse and the banks work together in

the payment and collection process, since clearinghouses do not today have direct access to the

payment system (Fedwire in the United States), as

banks do. The banks also provide credit to clearing

members.

In the securities markets-but not typically in

futures and options markets-there is often a fourth

Figure 6-1—Interfaces Among Clearing Participants

I I

SOURCE: Office of Technology Assessment, 1990.

interface, with the depository. The depository records and arranges the legal transfer of ownership of

securities, and holds securities for safekeeping. The

clearinghouse instructs the depository on how the

transaction is to be settled. The depository may act

as an agent, on behalf of the clearinghouse, to

receive funds to settle the transaction.

In addition to the relationships between clearinghouses and markets, depositories, and banks, these

organizations also have relationships among each

other. Clearing members of a designated market deal

with the banks to settle with the clearinghouse and

to obtain credit. There is an important relationship

between the banks and the depository. When a bank

acts in a custodial role, e.g., delivering securities and

receiving payments on behalf of its customers,

instructions on payment and title transfer are sent to

the bank by the customer. The depository, in turn, as

an accounting system for immobilized or dematerialized instruments, and/or as a central vault for the

physical instruments themselves, interfaces with the

banks as custodian. It may also, as custodian, have

an interface with the banks for payment.6

4The clearing entity could alternatively receive information about a trade directly from two market participants.

5This is often refm~to as “detivwverms payment’ (DVP) and ‘receive versus payment. ” These terms mean the buyer and the seller each satisfy

their settlement obligations (to pay and deliver) on the same &y. A closely related term is “true DVP,” which means that the buyer and the seller

simuhaneouslyma kegood on their settlement obligations. An example of true DVP would be a trade settled througha depository, in which the deposito~

simultaneously transferred the funds and the ownership of the traded financial instrument.

6FOW depsitofia fi the Ufited s~~s now ~ve~t. the F@er~ Reserve system. These ~ me Depsitory T~St CO., the Midwest securities

Trust Co., the Participants Trust Co., and the Philadelphia Depository Trust Co.
Chapter 6-Domestic Clearing and Settlement: What Happens After the Trade ● 109

There are two major thrusts underway for improving clearing and settlement systems, both of which

show considerable promise. The frost stems, in part,

from U.S. studies of the 1987 market crash. The

second is a result of the international efforts of the

Group of Thirty. Each is discussed below.

U.S. EFFORTS FOR

IMPROVEMENT

Legislative objectives for clearing and settlement

include: developing safe and efficient systems;

establishing uniform standards and procedures; and

establishing links between clearing and settlement

organizations. 8 The law in its current form states that

Federal policy for clearing and settlement of securities is based on:

. . . public interest, the protection of investors, the

safeguarding of securities and funds, and maintenance of fair competition among brokers and dealers,

clearing agencies and transfer agents. . . to facilitate

the establishment of a national system for the prompt

and accurate clearance and settlement of transactions.9

The Securities Act Amendments of 1975 mandated the creation of a national system for clearing

and settlement10 of securities, largely as a result of

the increased trading volume of equities that began

in the late 1960s and the associated severe problems

in back office clearing and transfer operations.

Before that legislation, clearing functions were

operated by each exchange, a practice that largely

still holds in futures markets.11 Equities clearing is

now almost entirely centralized in the National

Securities Clearing Corp. (NSCC), 12 which has

interfaces with other clearing organizations.

The Securities and Exchange Commission (SEC)

has regulatory authority over the clearing and

settlement of all equities and equity options. The

Federal Reserve has the authority to set minimum

initial margin requirements for securities trading.13

The Commodity Futures Trading Coremission (CFTC)

has authority for the clearing and settlement of all

futures contracts14 and options on futures. There is,

however, no legislation concerning clearing and

settlement in futures markets comparable to that for

securities markets. It may be needed in order to

strengthen the CFTC’s authority to force needed

improvements in the process, e.g., by standardizing

elements of the clearing and settlement process, such

as the liability of Futures Commission Merchants in

the event of a clearinghouse insolvency, and to

establish whether clearinghouses should have the

right to assess their members in the event of a

member’s default.l5

In the United States, a relatively small number of

organizations provide clearing and settlement services for nearly all domestic transactions. See table

6-1. There have been clearing and settlement organizations in the United States for almost a century.

Centralized clearing within each of the equities,

options, and futures industries developed more

recently, prompted, in part, by Federal legislation.16

?It was not until 1975 that the “clearing agency” was added to the 1934 Securities and Exchange Act and those clearing agencies registered witb

the SEC became Self Regulating Organizations. Securities Amendments Act of 1975.

sJune 6, 1934, ch. 404, Title I, sec. 17A (a)(l), as added June 4, 1975, Public Law 94-29, SeC. 15, *9 $tit. 14.

Whe June 4, 1975 amendment [Public Law 94-29, sec. 15,89 Stat. 14] of the legislation of June 6, 1934, ch. 404, Title I, sec. 17A (a) (l).

l~e sec~ties Act ~en~ents of 1975 added SeC. 17A, which among other items, required the SEC to “use its authority to facili~te tie

establishment of a national system for the prompt and accurate clearance and settlement of transactions in securities’ with “due regard for the public

interest, the protection of investors, the safe~ding of s~urities and funds, and maintenance of fair competition among brokers and dealers, clearing

agencies, and transfer agents.”

llFutures exc~ges that hve captive clearinghouses include: the Chicago Board of Trade; Chicago Mercantile Exchange; New York Merc~tile

Exchange; Commodity Exchange; Coffee, Sugar, & Cocoa Exchange; New York Cotton Exchange; Kansas City Board of Trade; and the Minneapolis

Grain Exchange. The ICC division of the Options Clearing Corp. clears for the NY Futures Exchange, the Philadelphia Board of Trade, and the AMEX

Commodities Corp.

lzAbout 95 percent of ~uities are cleared through NSCC. The rest are cleared through the Philadelphia Stock Exchange’s Stock Cle@ COIP. and

the Midwest Stock Exchange’s Midwest Clearing Corp. Securities options clearing is centralized entirely within the Options Clearing Corp. (OC~. An

interface exists between~e OCC a.ndeach of the equity ckaringcorpomtiom to effect delivery of the underlying equity securities when options contracts

are exercised.

IsFor more on magins,~d propo~ to change ~wsystems, see c~. 47 5* and 9“

IABotlI f~nc~ fi~~ and commodity futures are considered “futures” under the commodities Exchange ~t15’f’homas Russo, “The Futures Industry-Its Past and Future,’ Commodities Luw Letter, March/April 1990.

lsHowmer, a centralized C1earing and settlement system, the Regional Interface Operation (RIO), was in place in 1974, and was motivated by the

securities industry’s goal of improving operational efficiency and lowering costs.
110 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Table 6-1—U.S. Exchanges, Clearinghouses, and Depositories

Equities markets.-a Clearinghouse/depository?

New York Stock Exchange (NYSE) National Securities Clearing Corp. (NSCC)/Depository Trust Co.

(DTC)

American Stock Exchange (AMEX)

National Association of Securities Dealers (NASD)

Boston Stock Exchange (BSE)

Philadelphia Stock Exchange (PHLX)

Midwest Stock Exchange (MSE)

Cincinnati Stock Exchange (CSE)

Pacific Stock Exchange (PSE)

Total: 7 exchanges and the NASD

Futures markets:

Chicago Board of Trade (CBOT)

Chicago Mercantile Exchange (CME)

New York Mercantile Exchange (NYMEX)

Commodity Exchange Inc. (COMEX)

Coffee, Sugar & Coma Exchange (CSCE)

New York Cotton Exchange (NYCE)

New York Futures Exchange (NYFE)

MidAmerica Commodity Exchange (MidAm)

Kansas City Board of Trade (KCBOT)

Minneapolis Grain Exchange (MGE)

Chicago Rice & Cotton Exchange (CRCE)

Amex Commodities Corp. (AMEXCC)

Philadelphia Board of Trade (PHBOT)

Total: 13 exchanges

Options markets:

Chicago Board Options Exchange (CBOE)

American Stock Exchange (AMEX)

Philadelphia Stock Exchange (PHLX)

New York Stock Exchange (NYSE)

Pacific Stock Exchange (PSE)

National Association of Securities Dealers (NASD)

Total: 5 exchanges& the NASD

NSC C/D TC

NSCC/DTC, Midwest Clearing Corp./Midwest Securities Trust

Co., Stock Clearing Corp. of Philadelphia

NSCC/DTC

Stock Clearing Corp. of Philadelphia (SCCP)

Philadelphia Depository Trust (Philadep)

Midwest Clearing Corp. (MCC)/Midwest Securities Trust Co.

(MSTC)

NSCC/DTC or MCC/MSTC

NSCC/DTC

Total: 3 clearinghouses

Clearinghouse:

Board of Trade Clearing Corp. (BOTCC)

CME Clearing House Divisionc

NYMEX Clearing House Division

COMEX Clearing Association (CCA)

CSC Clearing Corp. (CSCCC)

Commodity Clearing Corp. (CCC)

Interrnarket Clearing Corp. (ICC)

BOTCC

KCBOT Clearing Corp. (KCBOTCC)

MGE Clearing House Division

BOTCC

Icc

Icc

Tota/: 9 clearinghouses

Clearinghouse:

Options Clearing Corp. (OCC)

Occ

Occ

Occ

Occ

Occ

Total: 1 clearinghouse

~here are numerous additional securities clearing agencies involved in securities markets other than the stock market.

bA ~e+ng member may designate any clearinghouse to clear and seffle stock traded on any exchange.

CA Clearinghouse is a department within the exchange, rather than Separably incorporated.

SOURCE: Roger D. Rutz, “Clearance, Payment, and Sefflement Systems in the Futures, Options, and Stock Markets,” in CBOT, The Review of Futures

Markets, vol. 7, No. 3, 1988, p. 348.

Securities clearing organizations have a statutory

obligation to provide access to the clearing and

settlement system to intermediaries that satisfy

certain nondiscriminatory standards. Minimum capital levels differ among clearing entities as a function

of the degree of exposure to default of clearing

members. Accordingly, the level of initial net capital

requirements of securities clearinghouses is lower

than that for futures clearinghouses.17 Equities

exchanges and the over-the-counter (OTC) marketplace compete based on their respective strengths in

price, speed of execution, and depth of market. The

costs of trade entry and comparison activities are

sensitive to economies of scale, which contributed to

the trend toward centralized clearinghouses, particularly for smaller exchanges.18

Many market participants now simultaneously

trade in stock, options, and futures markets (rather

than concentrating investment activity in a single

marketplace). Markets for different financial instruments, which originally developed independently

IWee Roger Rutz, “Clearance, Payments, and Settlement Systems in the Futures, Options, and Stock Markets,’ table 5, for examples of minimum

capital levels, in expert paper in Bankers Trust Co. contractor report.

18RWendy ~epac~lc Stock fichangedismntinued most of is captive cle~g~d depository operations, due to unprofitability; it nowckars thrOU@

NSCC and uses the Depository Trust Corp. for depository operations. OTA staff discussion with PSE oflicial, August 1988. Earlier, the Boston Stock

Exchange had ceased its clearing operations in favor of NSCC services.
Chapter 6-Domestic Clearing and Settlement: What Happens After the Trade . 111

and are regulated separately, are now linked. As a

result of these linkages, participants simultaneously

use the clearing and settlement processes of several

marketplaces. Many industry observers believe that

more attention needs to be given to disparities in

cross-border markets, e.g., in timetables for settlement. 19

Settlement times vary widely by type of financial

instrument. For example, forward market trades

involving mortgage-backed securities settle once a

month; ‘‘when-issued’ ’20 trades in government bonds

settle within 15 days; transactions in stock settle

within 5 business days (but if equities on certain

foreign exchanges are involved, settlement can take

up to several months); transactions on stock options

settle the next day; and futures and options on

futures settle the next morning.

These differences in timetables for settlement can

influence a market’s ability to compete with other

markets for investor capital. Many trading techniques now in use, particularly among institutional

investors, depend on the ability to trade rapidly

across instruments and across markets. Financial

instruments with longer settlement time frames may

be less useful to these investors. Also, longer

timetables for settlement carry comparatively more

risk, because they allow more time for events that

could cause one of the parties to the trade to default

on payment or delivery .21

A related issue is the amount of time required to

achieve finality of settlement, i.e., the moment when

a transfer of funds becomes irrevocable.22 The time

between the moment when the funds transfer begins

(as in writing a check, or wiring money from one

bank to another), and the time when payment is

actually received or guaranteed varies greatly from

market to market. Banks acting for U.S. market

participants can use the Federal Reserve’s Fedwire

electronic money transfer system to achieve immediate (at the time of receipt by Fedwire) finality of

settlement. (See box 6-A). Other systems may offer

end of day finality of settlement, next day finality of

settlement, or some other timetable.

PROPOSED STRATEGIES FOR

CHANGE IN U.S. CLEARING

AND SETTLEMENT

The 1987 stock market crash put a public spotlight

on clearing and settlement and raised questions

about whether the process broke down under the

strain. In the United States, the events of October

1987 stressed the clearing and settlement process,

which while it did continue to function revealed a

number of shortcomings. In exchanges, clearinghouses, and clearing member firms, trade processing

systems had back ups because of unusually high

trading volume. The Options Clearing Corp. (OCC)

had difficulty obtaining current data to value options. A number of options clearing members had

insufficient capital to meet their obligations. Some

futures clearing members’ data entry systems became overloaded and some exchange’s trade matching systems were not able to reconcile trades within

normal time schedules. There were problems with

some risk management systems and questions about

whether guarantee funds were sufficiently liquid or

adequate in size. Late payments into and out of

clearinghouses occurred for some participants in the

options and futures markets.

On October 19, 1987, the Chicago Mercantile

Exchange collected $1.6 billion in margin payments

from its clearing members, and another $2.1 billion

on October 20th, both far in excess of normal

collections. The OCC collected $2 billion in total

over those 2 days, also a much higher amount than

normal. Stock clearing corporations in the United

States processed over $100 billion in stock deliveries during the week of October 26th. A number of

market participants were unable to obtain cash from

their banks to meet obligations on time, because

some banks delayed providing credit to participants

until their creditworthiness could be established

with confidence and a few banks refused to accept

options contracts as collateral for loans. The Fedwire

operated by the Chicago Federal Reserve for a few

IgComents from p~cipants at tie OTA workshop on clearing and settlement, August 1989, among others. See also, Gmup of~,“U.S.

Working Group Report on Compressing the Settlement Period, ” Nov. 22, 1989.

~’ ‘~en.issued’ refers to a transaction made conditionally because the security, although authorized, hM not been issued.

ZIJ. p~e, A. ~~vaw and M. Mendelsoq C<Ris@ Business: me CIWmce ad Defilement of Fimci~Tramactiom, ~~ Iepfited in tie Jour~/

of International Securities Markets, ImndoL vol. 3, Spring 1989, pp. 7-13.

22Pawent wi~ ~ or~Wbank check becomes final Omy after several days, when the check is cleared by the bti; a cert.iiled check Cl~S quickly,

since it adds the backing of the issuing bank.
112 • Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Box 6-A—The Role of Fedwire

Fedwire, operated by the Federal Reserve Bank System, is an electronic wire transfer system used both for

transfer of funds and for book-entry transfer of government agency and Treasury securities between banking

institutions. Any depository institution (all domestic commercial banks, foreign banks with branches or agencies

in the United States, trust companies, savings banks, savings and loan associations, and FDIC-eligible credit unions)

may maintain both book-entry securities accounts and cash accounts with the Federal Reserve. Currently, 3,619 do so.

Financial institutions hold cash and securities both for themselves and for their customers, who could include

correspondent banks, governments, corporations, institutional investors, and individual investors. When a customer

instructs his bank to move his assets on deposit to his counterparty’s account (i.e., to “pay” someone, or to deliver

securities for settlement), this is accomplished by simultaneous book-entry (credit and debit) of the cash and

securities accounts that each bank maintains at the Federal Reserve System, and corresponding entries in the

accounting system that each bank uses to keep track of its obligations to its customers. If the two counterparties use

the same bank the transaction is effected by debiting and crediting the bank’s internal accounting system, and the

bank’s account at Federal Reserve is unaffected.

On the day after a trade (T+l), the counterparties instruct their banks to move the money and securities required

for settlement. The bank may only move securities if those securities are present in its book-entry account, however,

some funds overdrafts are allowed. The Federal Reserve System has sought to reduce the size and frequency of

“daylight” overdrafts. Some of the trades entering the Fedwire system have not yet been compared or matched.

Even so, all payment instructions which enter the Fedwire system for settlement are immediately final. As a result,

it is possible that a trade delivered against payment across the Fedwire might later turn out to have contained some

discrepancy in the terms of the trade. If this happens, the trade can be reversed, just before the Fedwire closes for

the day.

hours on October 20th, adding to delays in electronic the timetables for trading and payments going

funds transfers. in and coming out of clearinghouses, and

Studies of clearing and settlement during the 1987 coordinated attention to the credit needs of

market participants and the amount of time it crash include, among others: takes credit providers to respond to those

●

●

•

The Brady Commission (formally known as the

Presidential Task Force on Market Mechanisms), Report to the President of the United

States, January 1988;

The Commodity Futures Trading Commission,

Division of Trading and Markets, Follow-up

Report on Financial Oversight of Stock Index

Futures During October 1987, Jan. 6, 1988;

The Securities and Exchange Commission,

Division of Market Regulation, The October

Market Break, February 1988; and

The Working Group on Financial Markets,

Interim Report to the President of the United

States, May 1988.

needs; and

. the need for increased monitoring of market

participants by clearing and settlement organizations, and increased sharing of information

about the risk exposure and credit positions of

market participants.

Studies of the performance of the U.S. clearing

and settlement industry during the October 1987

crash, described below, were reasonably consistent

on the need for change in these systems. However,

some left the impression that problems in clearing

and settlement were on a par with those of the

markets themselves. They were not, although they

were extremely serious. But the crash did call

Among the main conclusions on the need for attention to needed improvements. Gerald Corrigan,

President of the Federal Reserve Bank of New York, improvement in the clearing and settlement system

were: noted that “the greatest threat to the stability of the

financial system as a whole, . . . was the danger of a

. the need to synchronize the activities of key major default in one of these clearing and settlement

institutions, with greater correlation between systems. ’23 David Ruder, former Chairman of the

23E, &~&j corn~~, ~~id~~t of tie F~m~ Rese~e B~ of NW Yo&, in a spe~h at Payment System Symposiu of the Federal Reserve B@

of Richmond, May 25, 1988, Williamsburg, VA.
Chapter 6-Domestic Clearing and Settlement: What Happens After the Trade • 113

Table 6-2—Recommendations of Major Studies for Improved Clearing and Settlement

The Interim

Report of the

President’s

Working group SEC Division

Brady on Financial of Market Greenspan Chicago Board

Commission Markets Regulation CFTC Testimony of Trade

Clarify the legal status of

the obligation Incurred by a

bank when it guarantees

payment to settle a trade or

margin call . . . . . . . . . . . . . . . . .

Create a unified regulatory

environment for all financial

instruments in a country . . . .

Create a centralized system

of market participants positions

within and across markets as

well as general market

conditions . . . . . . . . . . . . . . . . .

Yes

Yes

Yes Yes, start by

having more

exchanging of

information

Create a link between all

U.S. clearinghouses . . . . . . . .

Facilitate timely payments

to meet settlement

obligations . . . . . . . . . . . . . . . . .

Allow Brokers to cross-margin

their house accounts across

several exchanges . . . . . . . . . .

Yes Yes

Yes

Yes

Yes Yes Yes

Yes

Yes

Yes Yes Adopted trial Adopted pro- No (specific

program after gram publica- disagreement

publication of tion of the re- noted)

the report port

SOURCE: Bankers Trust, Study of Internationa/ Clearing and Settlement, OTA contractor report, October 1989, p. 250.

SEC, said: “. . . a major failure in any one of these

clearing systems, or of a major firm, has the potential

to affect all the other systems, other participants, and

even the banking system. 24

In a report on the 1987 market break, the Brady

Commission commented:

The possibility that a clearinghouse or a major

investment banking firm might default, or that the

banking system would deny credit (liquidity) to

market participants, resulted in certain marketmakers curtailing “ “ g their activities and increased

investor uncertainty.

In other words, it is not sufficient for the clearing,

settlement, and payment systems to avoid collapse.

Their strength must be such that market participants

will have enough confidence in the robustness and

integrity of the systems to avoid taking actions

which could bring them down.

Table 6-2 shows some of the major recommendations which appeared in all or several of the major

U.S. reports on the crash. The first common recommendation is that regulators should clarify the legal

status concerning finality of payment of the obligation incurred by a bank when it guarantees payment

to settle a trade or margin call. Clearinghouses are

concerned about the risk that exists between the time

a bank pledges to make a payment and the time the

payment is actually made.

Equities in the United States are paid for with

clearinghouse checks which are, in essence, nextday funds guaranteed by a money center bank. In

futures and options markets, a call for margin is a

means of ensuring the investor’s ability to meet his

obligations; the margin call is made to a bank on

behalf of its customer (a clearing member of the

exchange in the case of futures, or a member of the

clearing organization in the case of options). When

banks were queried as to whether they would

~David S. Ruder, fOILUer~an of the Securities and Exchange Commissio~ ‘October Recollections: The fiture of the U,S. Securities Markets, ”

speech at the Economic Club of Chicago, Oct. 20, 1988, p. 15.
114 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

respond to margin calls in the futures industry (prior

to October 1987), they would either actively endorse

their willingness to pay, or passively endorse it by

prior understanding that the bank would honor the

payment unless it objected by a certain time of day.

Even when a bank gives an active endorsement, the

time between that commitment and the actual

movement of funds constitutes a risk period, because

there is always the possibility that some adverse

event could prevent payment.

In several of the crash reports, it was argued that

options and futures clearinghouses should firm up

the legal agreement with their settlement banks to

lock in payment at the same time that the banks

confirm their willingness to meet the settlement

obligation of the clearing member. But even after

clearinghouses have freed up their agreements with

their banks, there remains the risk that a settlement

bank may refuse to make a margin commitment.

Another recommendation in several of the reports

on the 1987 crash was that a system should be

created to monitor market participants’ positions in

all markets, as well as general market conditions, in

order to improve the assessment of risk. Information

sharing did, in fact, occur in October 1987, despite

the fact that there were few, if any, formal arrangements in place across markets. Some arrangements

for sharing information have begun to be institutionalized. 25 Although these arrangements provide clearinghouses and banks considerably more information

with which to assess risk, liquidity, margin, and

credit, they still fall short of providing a full risk

profile. For example, participants may have undisclosed positions in unregulated markets, such as

foreign exchange, leveraged buyouts, or in foreign

markets, complicating risk assessment.

There is some resistance within the clearing and

settlement industry and from market users to sharing

certain types of information.26 As one example, the

OCC is concerned that shared information would

give an unintended competitive advantage to the

Board of Trade Clearing Corp., the “system operator, ’ or central repository .27 Also of concern are the

costs of gathering the information and its timeliness.

Another concern is that for increased information

sharing to be effective, there must be improvements

in the information gathering and utilization operations of some of the organizations involved. For

example, many clearing banks need to improve their

knowledge of cross-market and cross-product positions within their own holdings and those of their

customers. Some organizations might not be ready

to incorporate this new data into their decision making; it is not at all certain that a bank, having been

supplied risk information about its customers on

October 19th, 1987, would have been able to make

better credit decisions.

A fourth area of concern in the market crash

reports is the need for timely payments to meet

settlement obligations. Recommendations range from

sharing data on payments and credits to extending

the hours of Fedwire. These ideas had been discussed even before the 1987 market crash. Markets

have evolved faster than the banking system’s

ability to move money rapidly. But given the

underlying credit implications for the banks, having

the ability to speed up the payments still may not

ensure that the payments will be made if the banks

perceive the borrower’s position to be risky.

An earlier morning opening of the Fedwire, and

agreement by the major money center banks to

provide staff during these early hours, could help in

supporting the Chicago futures clearinghouses.

fi~mgemenKfor ~~gposition and fisk assessmentfiomtion include: the Monitoring Coordination Group, established prior to October 1987>

which includes all Securities Clearing Group (SCG) members and all securities and options exchanges and the NASD; and the newer SCG, composed

of all equity securities clearing and depository entities in the United States. Futures markets are not yet participating in these groups; however, the futures

clearinghouses have shared pay/collect information among themselves since 1986. There has also been some sharing of risk information between the

NYSEand the CME, and of pay and collect data behveenthe CME and CBOTsince 1982. The OCC recently joined the daily information-sharing system

providing futures clearinghouses for the f~st time with information on market participants in options on equities.

26~ere w= broad aWeaent ~oW re@ators, c~e~ghouses, and oth~, about tie value ofs-l-isk-expos~e information, “but no a~ment

on what inforrnatio~ when and where it should be provided, or how much is adequate, as wrnrnarized by Gerard Lynch Morgan Stanley, at OTA’s

meeting of experts on clearing and settlement, Aug. 22, 1989.

270cc letter t. OTA, Feb. 5, 1990. The OCe ~~tsout @tthe reposito~ for stied j~o~~oqif it is a ~ketp~cipant having vested hlteres~,

possesses data that might emble it to protect itself against loss earlier than others who depend on it for information dissemination. This raises the question

of whether a disinterested, independent, entity, such as a Federal regulator or a private contractor, would be preferable as the system operator. The NSCC

notes concern for BOTCC access to cotildential information and rtises the question of whether futures cltig organizations may misinterpret

pay/collect data and take inappropriate action based on it.
Chapter 6-Domestic Clearing and Settlement: What Happens After the Trade ● 115

Other measures also should be considered. For

example, the U.S. banking system is not equipped to

settle transactions in non-U.S. dollar currencies.

This is because they can only move foreign currencies with finality at times when the foreign central

bank is open.28 Another example involves the use of

letters of credit for margin. Since banks consider

some types of letters of credit to be conditional, e.g.,

“standby” letters of credit, unexpected delays in

payment can result, particularly during times of

severe market stress.

Two final items common to many of the crash

reports were the recommendations for crossmargining and futures-style margining of the accounts of clearinghouse members. These were discussed in chapter 5.

The Brady Commission Report recommended a

‘‘unified’ clearance system across all markets.29

This was later clarified to mean not necessarily a

single clearinghouse, but rather coordinated mechanisms among existing clearinghouses to facilitate

safe and efficient clearance and settlement of

equities and related options and futures that the

Brady Commission determined comprise a single

market. The SEC proposed legislation in June 1988

that would direct the SEC and CFTC “to facilitate

the establishment of linked, coordinated, or centralized facilities for clearance and settlement’ for

stocks and related futures and options.30

The key objectives that policymakers want to

achieve are to facilitate assessment of the credit or

solvency risk of participants across all markets, to

maintain liquidity, and to assure the integrity of the

settlement system and the larger national payment

system of which it is an integral part. The need for

increased attention to the clearing and settlement

process was reemphasized in testimony of Treasury

Secretary Nicholas Brady before the Senate Committee on Banking, Housing, and Urban Affairs,

October 26, 1989. The Administration called for

legislation to speed the process of refining and

coordinating inter-market clearing and settlement.

Yet, consensus on how to achieve these objectives

has been elusive, both because of genuine differences in the various financial products and procedures and because of vested interests.

Richard Breeden, Chairman of the SEC, drew a

lesson from the Drexel bankruptcy in January 1990:

“The clearance and settlement system deserves

immediate attention. "31 The events surrounding the

bankruptcy, according to Breeden, demonstrated the

necessity of provisions in the proposed Market

Reform Act (S.648) that would give the SEC the

right to information about holding companies of

which securities firms are affiliates. In the case of the

Drexel bankruptcy, Breeden said, because the SEC

did not have adequate information regarding the

Drexel holding company and its unregulated affiates, the broker-dealer’s capital ‘‘could have been

depleted in a desperate but fruitless attempt to pay

the parent firm’s unsecured creditors. ’ Breeden also

told Congress:

A sudden collapse of a major broker-dealer such

as DBL (Drexel Burnham Lambert, Inc.) could have

had extremely adverse consequences on confidence

in the marketplace, and on the smooth functioning of

our clearance and settlement system.

DBL was a major broker-dealer, a member of

most of the stock and commodity exchanges and

clearinghouses, and a member of the National

Association of Securities Dealers. DBL and a sister

2SU.S. cle~@ouses may ~ve foreiW-uency denominated derivative product contracts, although none are ~ded thy, and they my choose

to denominate margin calls in that currency. They can do this by having a U.S. bank provide payments and guarantee services, or by having a non-U.S.

bank provide these services. Ifa U.S. bank is used, the clearinghouse will require the bank to guarantee payment in the foreign currency until the foreign

central bank opens and makes the payment final. In this case, the U.S. bank incurs risk regardless of whether FedWire is open, during that time interval

behveen when its guarantee begins and when the foreign central bank’s payment is fd. Alternatively, an off-shore settlement bank could be used.

zgThe Brady Report alSO recommended that a single government agency be given the authority for coordinating ~mwirements ad monito@

activities across marketplaces. This proposal is bas~ on the view that all activities in the U.S. markets (securities, futures, options) are best coordinated

by one agency and that authority should be given to the Federal Reserve Board. The FRB appears unwilling to take on this function.

~Treasury Smre~Nicholas Brady ~terreco~ended deleting the term “centralized’ from a section of S. 648, “The mket Reform Act of 1989,’

which as revised, would direct the SEC and C~C to facilitate linked or coordinated clearance and settlement of inter-market transactions. Letter from

Secretary Brady to Sen. Donald W. Riegle, Jr., “ Chauman, Banking, Housing, and Urban Affairs, Oct. 24, 1989, p. 6. See also H.R. 3656, “Coordinated

Clearance and Settlement Act of 1989,” Nov. 14, 1989.

31This acco~t is based on testiony of Richard C. Breedeq Chainm-q U.S. Securities and Exc~nge CO remission, before the Senate Committee on

Banking, Housing, and Urban Afftis, conce~gthe batiptcy of Drexel Burham Lambert Group, Inc., Mar. 2, 1990. All quOWtiOnS are from this

testimony.
116 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

company, Drexel Burnham Lambert Government

Securities, Inc. (GSI), a bond dealer, were regulated

affiliates of a holding company, Drexel Burnham

Lambert Group, Inc. (Drexel), which also had other

unregulated affiliates. The holding company and its

subsidiaries, at the end of 1989, had approximately

$28 billion in assets and nearly $836 million in

stockholder’s equity, and had long- and short-term

borrowings of about $3.5 billion.

Many large broker-dealer holding companies do

a great deal of unsecured borrowing by issuing

commercial paper. To accomplish this conservatively, however, the holding company should hold

liquid, pledgeable, assets as a back-up. This would

permit the holding company to satisfy its liquidity

needs through secured bank loans if, for any reason,

it loses access to the commercial paper market.

Drexel (the holding company) was a highly leveraged major company that concentrated on developing and selling high-yield (junk) bonds, and financed

its operations largely with unsecured loans (commercial paper, etc.). In 1989, after 47 issuers

defaulted on $7.3 billion in bonds, the market for

junk bonds declined sharply and became less appealing to banks as collateral. As Drexel’s revenue

stream dried up, the firm became even more

dependent on outside financing. It began to have

difficulty in rolling over its short-term loans. Drexel

then began to drain off the excess capital of its

affiliates DBL and GSI.

The SEC sets net capital requirements for brokerdealers, among other things, to protect customers

(whose accounts are insured under the Securities

Investors Protection Corp. for up to $500,000 in

securities and cash, and $100,000 maximum for cash

claims). The New York Stock Exchange (NYSE)

can impose additional, even more stringent, financial responsibility standards on its members “when

a firm is faced with uncertainties in its business or

potential liquidity problems.” An objective of the

SEC’s customer protection rule is to ensure that

brokerage firms only use customers’ margin securities or free credit balances (cash payable on demand)

to finance other customer’s lending (i.e., not to

finance the brokerage fro’s own positions, investments, or operations). To the extent that customer

money is not used in this manner, it must be placed

in a special bank account for the benefit of the

customer. In 1989, the SEC and the NYSE were

monitoring DBL closely because the firm had

recently agreed to pay $650 million in penalties for

felony insider trading.

Neither the SEC or the NYSE have any oversight

or regulatory authority over the parent company,

Drexel, or its unregulated affiliates. They had no

sure source of information about Drexel. As lenders

pulled back, Drexel drew capital from both DBL and

GSI (in the form of loans) without notifying the

NYSE or the SEC. The SEC was informed by the

staff of the New York Federal Reserve Bank that

Drexel and its unregulated subsidiaries were experiencing financial difficulties.

The NYSE and the SEC then instructed DBL not

to make further loans to its holding company,

Drexel. Most of DBL’s customer accounts had

already been sold to other fins, but the brokerdealer was still holding 30,000 customer accounts

totaling $5 billion, which would be at risk if DBL’s

capital was drained off by Drexel. Drexel struggled

to come up with plans to liquidate some of its

inventory and take other steps to rebuild its capital

reserves, but these plans depended on its ability to

continue to get short term financing for its day-today trading and the renewal of its unsecured loans.

As an interim measure, the NYSE and the SEC

allowed DBL to lend Drexel $31 million to prevent

its commercial paper from being dishonored in the

clearing process, and also allowed DBL to post $7

million margin at the Chicago Mercantile Exchange

on behalf of DBL Trading (a subsidiary).

The New York Federal Reserve Bank, the U.S.

Department of the Treasury, and the Federal Reserve

Board, as well as the NYSE and the SEC, became

involved in around-the-clock discussions. These

regulators worked cooperatively to “reduce the

potential for systemic risks of a cascade of failures. ”

Working closely with the New York Federal Reserve Bank, the SEC facilitated the transfer of

DBL’s customer accounts to other financial institutions and to liquidate DBL’s proprietary positions.

These ends were accomplished successfully, without penalizing retail customers or the U.S. taxpayer.

However, if at the time of this crisis, the markets had

been under stress or other large brokerage firms had

been faltering (and thus unable to take on DBL’s

customer accounts), the U.S. Government might
Chapter Domestic Clearing and Settlement: What Happens After the Trade . 117

have had to face extensive settlement gridlock and a

potential for ‘‘a cascade of failures. ’ ’32

Among other problems hampering integrated

clearing and settlement are fundamentally different

forms of margining; unique daily (and intra-day)

mark-to-market pricing and margining of futures;

and disparate time periods for settlement-1 day for

futures and options v. 5 days for equities. Another

difference is that both futures and options contracts

are generated by the trade itself, and are guaranteed

by a clearinghouse. Unlike the fixed number of

equity shares outstanding at any time, there is no

freed limit on the number of options and futures

contracts. Finally, settlement of equity trades generally mark the end of risk to financial intermediaries

(banks, brokers, clearinghouses), whereas the settlement of the opening of an options or futures contract,

or the payment of variation margin on that contract,

reduces, but does not eliminate, financial intermediaries’ risk. The latter risk terminates when the

position is closed and settled.

Vested interests within the established clearing

and settlement systems, and possibly among their

Federal regulators, are important barriers to consolidating, or standardizing, domestic clearinghouse

operations. There are also arguments concerning the

benefits of competition among Self Regulatory

Organizations (SROS) and among regulators. 33 Rep.

resentatives from the clearing and settlement industry and others have been strong advocates for

maintaining the status quo.34

Consideration for a unified or integrated clearing

and settlement system raises a number of public

policy issues. Arguments against it range from the

inherently different character of futures, options, and

equities clearing and settlement systems to the

dangers of monopolies-including lower efficiency

(or higher prices) and the potential for stifling

innovation. 35 Perhaps the most often cited argument

is that separate systems can act as “firewalls” to

prevent a rapid breakdown of the system in the face.

of a major catastrophe. Others point out that futures

clearing organizations remain non-standard in their

rules.36

There is a question of whether the public interest

in further strengthening the clearing and settlement

system against disruption is sufficiently paramount

to foster further concentration, or standardization, of

clearing functions at the expense of competition.

There is also a question of whether clearinghouses

should be unified by products or across markets. One

alternative, which is being followed, is to retain

specialized clearing and settlement systems while

making improvements, such as information sharing

concerning participants’ risk profiles across markets.

EFFORTS BY THE GROUP

OF THIRTY TO REDUCE

DIFFERENCES IN CLEARING

AND SETTLEMENT

Improvement of clearing and settlement for global

or cross-border trading in equities is being addressed

by the Group of Thirty, an independent, non-profit

organization of business-persons, bankers, and rep32~ the ~me of the f~lme of Dmxel B~ Lambert, Inc., markets and clearinghouses were able to minimize the fmncial impact of the failure

by transferring customers’ accounts and assets to other, solvent fiis. But the experience caused the Federal Reserve Bank of New York president, in

July 1990, to encourage the private sector to establish three working groups to identify ways to avoid such problems before they arise, or to better contain

them if they arise. One group will focus primarily on improvements in the operation of clearance and settlement systems, e.g., on approaches to reducing

counterpart credit risk, including expansion of same-day delivery against payment to a broader class of funcial instmments, particularly for certain

transactions originating off-shore, and, sound netting systems. A second group will focus on contingencies, i.e., what should be done if some segments

of the clearing, settlement, and payments system appear to gridloclq including ways to establish more structured approaches for coordination during

emergencies. A third group will focus on legal and regulatory issues, including possible changes in bankruptcy laws, and regulatory issues in clearing

~d se~ement. hdtial agendas were being developed in mid-1990.

33s~ for e~ple: Marc L. Weinberg, “Uniiled Clearing Draws Henge,” Barron’s, February 1988; Roger D. Rutz, “Clearance, PaymenC and

Settlement Systems in the Futures, Options, and Stock Markets, “ in CBO~ The Review of Futures Markets, vol. 7, No. 3, 1988, pp. 367-368; John C.

Hiatt, remarks at CBOT Conference, November 1988; and Charles M. Seeger, The Development of Congressional Concerns About Financial Futures

Markets, published in conjunction with the American Enterprise Institute for Public Policy Research.

‘Roger D. Rutz, “clearance, Paymen4 and Settlement Systems in the Futures, Options, and Stock Markets,’ in CBOT, The Review of Futures

Markets, vol. 7, No. 3, 1988, pp. 346-370.

%id.

s6’’Inthe areas of clearing, for example, despite efforts to enhance cooperation and information sharing among the various clearinghouses, they remain

stand-alone entities with very different rules, in many cases, even though they perform essentially the same functions. Some of the most basic questions,

such as the liability of Futures Commis sion Merchant @cM), should a clearinghouse become insolvent, mnai.n unanswered, or at least subject to

dispute.’ Thornas Russo, “The Futures Industry-Its Past and Future,” Commodities Law Letter, March-April 1990.
118 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

resentatives of financial institutions from 30 developed nations.37 The Group of Thirty addresses

multinational financial and economic issues, including Third World debt. The Group’s recommendations for the world’s securities markets are aimed at

‘‘maximizing the efficiency and reducing the cost of

clearance and settlement,” and thereby reducing

risk. They have set target timetables of 1990 for

some objectives and 1992 for others. In a report

released in 1989,38 the Group concluded that:

While the development of a single global clearing

facility was not practical, agreement on a set of

practices and standards that could be embraced by

each of the many markets that make up the world’s

securities system was highly desirable, . . and

(reached) agreement that the present standards were

not acceptable.

Their recommendations are:

1.

2.

3.

By 1990, all comparisons of trades between

direct market participants (i.e., brokersdealers, and other exchange members) should

be compared within 1 day after a trade is

executed, or ‘‘T+l.”39

Indirect market participants-institutional investors, or any trading counterparties which

are not broker-dealers-should be members of

a trade comparison system which achieves

positive affirmation of trade details.

Each country should have an effective and

fully developed central securities depository,

4.

5.

6.

7.

8.

9.

organized and managed to encourage the

broadest possible industry participation.40

Each country should study its market volumes

and participation to determine whether a trade

netting system would be beneficial in terms of

reducing risk and promoting efficiency.

Delivery versus payment (DVP) should be the

method for settling all securities transactions.

Payments associated with the settlement of

securities transactions and the servicing of

securities portfolios should be made consistent

across all instruments and markets by adopting

the “same day” convention. 41 (No date has

been set for achieving this objective.)

A “rolling settlement” system42 should be

adopted by all markets. Final settlement

should occur on T+3 by 1992. As an interim

target, final settlement should occur on T+5 by

1990 at the latest, except where it hinders the

achievement of T+3 by 1992.

Securities lending and borrowing should be

encouraged as a method of expediting the

settlement of securities transactions.43 Existing regulatory and taxation barriers that inhibit

the practice of lending securities should be

removed in 1990.

Each country should adopt the technical standard for securities messages developed by the

International Organization for Standardization. 44

37For ~ diSmSSion of ~&er ~termtio~ org~zations’ s~dies of Clefig ~d settlement ~d related issues, see OTA’S background paper, Op. Cit.,

footnote 1, ch. 5.

38Group of~,clearance ~~settlement SyStem in the World’S Securities Markets (New York& ~ndon, Mwh 1989), p. 1.

3% tie Ufitd States, where ~e~ is ~crew~g use of automated ~ading systems in the stock exc~ges ~d OTC rnarke@ data re@red for

comparison and automatic submission to the clearing system is automatically recorded. Such systems now process two-thirds of NYSE transaction

volume; a large propotion of AMEX volume; and one-tid of OTC equity volume. These transactions are prtimatched and reported directly to the

clearing system and have been reported on T+l since the mid-1980s. Both the NYSE and AMEX have on-line trade correction facilities. The rules of

the National Securities Clearing Corp. require that all trade data not already locked in by the automated trading systems must be reported by both trading

counterparties by 2 a.m. on T+l.

@The principal function of a central securities depository is to immobilize or dematerialize securities. This function permits the processing of

transactions in ‘book entry” form, which is the basis for achieving efficient and low risk settlement of transactions by transferring ownership from one

account to another by a simple debit or credit on the books of the depository.

AISome ~kets use “same-day” funds, while others use ‘‘next-day” funds for settlement. Adoption of a single method will improve the efilciency

of the accounting and payment systems, set the stage for subsequent full automation, and facilitate other improvements such as finality of payment,

irrevocability, and bank guarantees.

42~ a roll~g settlement system, hades settle on ~ business &ys of tie week, which limits the n~er of ouwtanding (unsettled) trades and redu@S

market exposure to risk. The goal for the long term is same-day settlement.

43se~ties len~g ~d bo~~g~s &come an eff~tive tool used by m~ket p~cip~ts to satisfy their obligations to deliver Or pay a tiding

counterpart. In its absence, a failure to deliver can have the consequence of creating a series of additional failed transactions as one party’s failure to

receive becomes the cause of its failure to deliver on its obligations.

44~e 1S0 is a world~de s~d~ds-mg body. IS() stan~d 7775 applies to se~ties Message ‘rypes; swndard 6166 applieS tO hterIliltiOnd

Securities Identification Number (ISIN). Currently, no worldwide securities mitnbering system is in use. Countries each use their own unique numbering

system for identification rendering them impractical for cross-border transactions.
Chapter 6-Domestic Clearing and Settlement: What Happens After the Trade ● 119

Table 6-3--Group of Thirty: Current Status of International Settlement Recommendations-Equities

Recommendation No. 1 2 3 4 5 6 7 8 9

lnstitutional Central Rolling

Comparison Comparison Securities Securities settlement Same-Day Securities

Country on T+l System Depository Netting DVP on T+5 Funds ISO/lSIN Lending

Australia . . . . . . . . . . .

Austria . . . . . . . . . . . .

Belgium . . . . . . . . . . .

Canada . . . . . . . . . . . .

Denmark . . . . . . . . . .

Finland . . . . . . . . . . . .

France . . . . . . . . . . . .

Germany . . . . . . . . . .

Hong Kong . . . . . . . . .

Italy . . . . . . . . . . . . . .

Japan . . . . . . . . . . . . .

Korea . . . . . . . . . . . . .

Netherlands . . . . . . . .

Norway . . . . . . . . . . .

Singapore . . . . . . . . .

Spain . . . . . . . . . . . . .

Sweden . . . . . . . . . . .

Switzerland . . . . . . . .

Thailand . . . . . . . . . . .

United Kingdom . . . . .

United States . . . . . . .

Yes

Yes

No

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

No

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

No

No

No

Yes

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

Yes

Yes

No

Yes

Yes

Yes

No

No

Yes

Yes

No

Yes

No

Yes

Yes

No

No

No

Yes

Yes

Yes

No

Yes

No

No

No

Yes

No

No

No

No

No

No

Yes

No

Yes

No

No

No

No

No

Yes

Yes

Yes

Yes

No

Yes

Yes

Yes

Yes

No

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

No

Yes

Yes

Yes

No

Yes

Open

Weekly

Fortnightly

T+5

T+3

T+5

Monthly

T+2

T+l

Monthly

T+3

T+2

T+5

Tt6

T+5

Weekly

T+5

T+3

T+4

Fortnightly

T+5

No

Yes

Yes

Yes

Yes

No

Yes

Yes

No

Yes

No

No

No

Yes

No

No

No

Yes

Yes

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

Yes

No

Yes

Yes

Yes

No

Yes

No

Limited

Limited

Yes

No

Yes

No

Yes

Limited

Yes

Yes

No

Limited

Yes

SOURCE: Updated fromA Comparative View: The Group of Thirty’s Recommendations and the Current(U.S. National Clearance and Settlement System,

(NewYorkCity,NY:Morgan Stanley & Co.June 1989).

Table 6-3 compares nine of the Group of Thirty

recommendations with the present status of clearing

and settlement procedures in 21 countries, including ●

the United States. Major changes will be required by

many countries in order to meet these recommendaions by 1992.45 Table 6-4 shows the points of

agreement from recent studies conducted by the

International Society of Securities Administrators ●

(ISSA), the European Community (EC), the Group

of Thirty (G-30), and the Federation International

des Bourse de Valeurs (FIBC). In the United States,

which is well-positioned relative to other countries,

automated systems will facilitate trade matching on

the trade date and settlement of all trades within

three days. But, in the United States, there are

non-technological barriers to fully achieving the

accelerated trade and settlement objectives, some of

which have been acted on recently. For example:

. More stocks must be immobilized in book entry

form; this means that retail customers may have

to abandon their pattern of receiving certificates of ownership for their stock shares.

The pattern of mailing personal checks to pay

for stock purchases will have to change to a

more rapid payment method such as electronic

bank-to-bank transfer of guaranteed funds.

The Federal Reserve System’s Regulation T,

which addresses margin regulations for brokerdealers, has just been modified. Since the

maximum allowable time for clearing and

settlement of trades in the United States is

different from those of many other countries,

some flexibility is needed in tying the customer’s time period for payment to the foreign

settlement date. In March 1990, Regulation T

was modified to allow the maximum time for

payment to agree with the foreign settlement

period, provided that period does not exceed

the current U.S. 35-day maximum allowable

period for settling cash (delivery against payment) transactions.46

ds~e Group of ~ met in ~ndon in mid-March 1990, to discuss worldwide progress toward implementing its nine recommendations. s=

Clearance and Settlement Systems Status Reports: Spring 1990, Group of Thirty, New York and Imndom which covers the progress of 17 countries.

While the obstacles facing each mtion and the efforts required of each to comply with the recommendations are disparate, there was general acceptance

of the recommendations.

46See 55 Fed. Reg. 11158, ~. 27, 1~.~s 35.&y p~od is ~parate from tie s-day and s-day setd~ent priods &SCUSS~ elsewhere. It ~f~

to the maximum allowable time period for settlement in the event of unavoidable delay, e.g., a payment lost in the mail, and it does not apply to reasons

such as a customer being unable or unwilling to make payment or deliver securities.
120 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Table 6-4-Recommendations From Major

International Studies

Report

Aspect of operation ISSA

Two-sided trade matching . . . . . . . . . —

One-sided trade comparison . . . . . . . —

National central securities

depository a

. . . . . . . . . . . . . . . . . . . Yes

Evaluate securities netting . . . . . . . . . Yesb

Delivery versus payment . . . . . . . . . . Yes

Rolling settlement . . . . . . . . . . . . . . . Yes

Same-day funds . . . . . . . . . . . . . . . . . Yesd

Use of ISO standards for message

formatting . . . . . . . . . . . . . . . . . . . . Yes

binding for settlement. . . . . . . . . . . . Yesf

Cross-border Central Securities

Depositories should be linked . . . . Yes

Securities should be immobilized in

country of issuer . . . . . . . . . . . . . . . Yes

EEC G-30 FIBV

— Yes

— Yes

Yes Yes

Y e s

c Y e s

Yes Yes

Yes Yes

Y e s

e Y e s

Yes Yes

Yes Yes

Yes —

Yes —

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

aDepos~OrieS for ~~ies are already widely used in the United states.

blnd~~ as pa~ of the risk reduetion/resolution recommendation in the

report.

clnd~ed as part of the risk reduetion/resolution reeommendation in this

d[~~P~~ aS a subset of the delivery versus payment recommendation of

this report.

elnd~edaspart of thecurren~~unting recommendation of this report.

fin~uded as part of the risk reduetion/resolution recommendation in this

report.

SOURCE: Bankers Trust Co. adapted from Federation International des

●

Bourses de Valeurs (FIBV) document.

Changes also have been made in the margining

of foreign securities in U.S. accounts with

foreign currency-denominated cash and securities. 47

Implementation plans for the Group’s recommendations were initiated or considered by its members’

governments beginning in the spring of 1989. The

U.S. Working Committee of the Group of Thirty met

in May 1989 with representatives from exchanges,

the National Association of Securities Dealers

(NASD), clearing corporations, transfer and depositories firms, banks, regulators, and others, to begin

discussing the recommendations. David Ruder, then

SEC Chairman, noted at the 1989 meeting that the

Group’s recommendations are consistent with published policy objectives of the SEC.48 He listed other

areas that still require attention, such as capital

adequacy standards for market participants, information sharing among clearing entities, and the

interaction of derivative markets.49 The U.S. Advisory, Steering, and Working Committees reconvened a meeting on March 1, 1990, to discuss

progress on the recommendations related to sameday funds and shortening the time to settlement. The

Federal Reserve Board is taking some actions to

accommodate these issues and others. Officials of

U.S. regulatory agencies generally are highly supportive of the U.S. Advisory, Steering, and Working

Committee’s efforts.50

These proposals and efforts are a starting point for

improvement, but some of these will require supplementary actions by the U.S. Congress and other

governments. 51

The reforms suggested by the President’s Working Group on Financial Markets, the Group of

Thirty, and other organizations are being taken

seriously in the United States. Several recent reforms have been made in the U.S. equities markets,

many of which predate the recommendations of the

Group of Thirty. These include:52

. Trade Processing

—The NYSE in 1988, began developing an

on-linetrade reconciliation system which has

evolved into its current overnight Comparison System.

—The NSCC implemented earlier input and

output time frames to facilitate trade matching on the day after the trade (T+l).

—The NSCC is participating as part of the

Group of Thirty, U.S. Working Committee,

in the evaluation of ways to shorten the

timetable for settling equities trades to T+3

(from the current T+5).

—The NASD has implemented a Trade Acceptance Reconciliation System (TARS) for

47fii&

~pol,iw s~taat of tie U.S. SccuritiCS and Exchange Commissio~ “Regulation of the International Securities -etS,”Nov*ti 1988 and

Release No. 33-6807, Nov. 14, 1988, Fed. Reg. 46963, Nov. 21, 1988.

@Jlavid S. Ruder, “Remarks on the Group of Thirty Report on IMmnational Cl~e and Settlemen~” May 15, 1989.

50C omments by G. Corriga~ president of the Federal Reserve Bank of New York and Commis sioncr Mary Schapim, SEC, at the March 1990meMing

of the U.S. Committee.

51@up of~,op. cit., footnok 19; and Bankem Trust repo~ Op, cit., footno~ 2, P. 206.

52For ~~~ution of proge~~ on fiplmen~ tie ~-m&tiomof tie presid~t’s Work@ Group on Financial ~ks~~lst@ to Ckdlg

and settlement see General Accounting ~ce, Clearance and Settlement R~orm: The Stock, Options, and Fwes Markets Are Still at Risk,

GAO/GGD-9Ck33, April 1990.
Chapter 6-Domestic Clearing and Settlement: What Happens After the Trade . 121

same-day or next-day automated reconciliation

of unmatched trades and is currently phasing

in its Automated Confirmation Transaction

(ACT) system for same-day comparison of

all trades not already locked in through

automated execution systems.

● Risk Management

—Information sharing of the financial positions of participants who are active in

multiple markets is being worked on by the

Securities Clearing Group, which represents

U.S. clearing organizations serving equity

and equity options markets. This group is

working to develop a system for sharing

settlement, margin, and clearing fund at-risk

exposure information about joint members .53

An earlier, continuing, effort in the futures

industry (the BOTCC’S system) to share

pay-collect information is being expanded to

include OCC pay/collect data. (There is still

some concern by the OCC about the confidentiality and perishability of data, and

unintentional competitive advantage.) In the

United States, the trend is toward interfacing

existing centralized risk information systems

for derivative markets with the emerging

centralized risk information system for equities markets.

—The NSCC has proposed to the SEC changes

in its criteria for assessing risk-based contributions to guarantee funds from clearinghouse members, and to make earlier calls for

additional contributions.54 55

—The SEC proposed an increase in capital

adequacy requirements of full service brokerdealers from the present $100,000 to $250,000

to be phased in by January 1994.56

—The OCC initiated an intra-day margin call

procedure directly to the clearing member’s

clearing bank, in contrast with the earlier

procedure of contacting the member and

allowing 1 hour for payment.

—The OCC has increased the initial net capital

requirement upon application for clearing

member status from $150,000 to $1 million.

In both domestic and international futures markets there are differences in clearing and settlement.

There is, however, some commonality among U.S.

domestic futures markets for financial safeguards,

but even those common safeguards vary in form.

These safeguards include: original margins for

clearing members based on trades carried for their

customers and their proprietary accounts; daily and

intra-day marking-to-market and calling of variation

margins; initial and maintenance margins for customers; clearinghouses serving as guarantors of

trades; the posting of deposits by clearing members

which may be called by the clearinghouse; systems

for monitoring the risk positions of both clearing

members and customers; and large trader reporting.

Clearinghouses have tended to structure themselves as fortresses, able to contain significant

damage to their systems from internal causes with a

hierarchy of safeguards or “firebreaks.” Assumpions underlying the adequacy of firebreaks are

increasingly less valid because of the growing

linkages between futures, equities, and options

markets; these linkages have become international.57

Concerns about whether or not futures margins

levels in the United States are set appropriately have

been addressed by the President’s Working Group

on Financial Markets, which concluded that they are

set in a prudential manner and recommended no

SSA5 of my 1990, tie SCG w~ proceeding with its own system. OTA staff discussion with Rob@ WoIdow, NSCC,my 9, 1990.

~~e t. arment c~ge, now o~y 70 percent Of an NSCC clearing membm’s collateral may be ti the form of letters of credit. rn addition, tie NSCC

has obtained a bank line of credit of $200 million. Data from Robert Woldow, Executive Vice President and General Counsel, NSCC, March 1990.

ssThere is continuing disagr~ment~tween the SEC and CIW.C about the adequacy of guarantee funds at the Chicago Memantie Exc~r43e (cm),

which the SEC believes is inadq~te, particukly with its recent increase to ~ million and credit lines that now exceed about $250 million, and which

the CFTC defends; and with those of the OCC, which the CFTC has criticiz~ and the SEC defends. General Accounting Office, Clearance and

Settlement Reform: The Stock, Options, and Futures Markets Are Still at Risk, GAO/GGD-9@33, April 1990 (SEC Comments), app. III, pp. 64,67,68,

and (CFTC Comments), app. IV, pp. 78-80.

%ECRel~se No. 34-27249, l%oposed Rtie_g on Broker-Dealer Net Capital R~timents, Sept. 15, 1989.

sTMic~el Hewitt Setior Adviser, Finanw and Industry Dep~en~ Bank of England, “Financial htegrity of Futures ~ets,” Present~ at tie

Futures and OptionS ‘Market Re@ktors Symposium in Burgenstoc~ Switzerland, September 1989.
122 ● Electronic Bulls & Bears: U.S. Securities M arkets & Information Technology

changes in margin-setting systems58 (SEC Chairman

Ruder dissented). Nevertheless, Federal Reserve

Board Chairman Alan Greenspan, Secretary of the

Treasury Nicholas Brady, and SEC Chairman Richard Breeden have since noted their concern that

futures margins that are set too low tend to be raised

during periods of market turmoil, reducing liquidity

when it is most needed.59 (See chs. 4 and 9.)

POLICY ISSUES

Six areas of major concerns need to be addressed:

1.

2.

3.

4.

5.

6.

In

risks associated with default;

risks associated with the payment process;

information sharing;

technology;

standardization and harmonization;

shortening the time to settlement and using

same-day funds.

Risks Associated With Default

the United States, the Securities Investor

Protection Corp. (SIPC)60 provides a level of protection to market users in equities, bonds, and equityrelated options markets. The protections afforded to

market users by exchanges and clearinghouses in

futures markets vary and are extended mainly to

clearing members of the exchange clearinghouse.61

Insurance can never completely cover all losses.

Some failures in securities markets are resolved

though bankruptcy proceedings under the Federal

Bankruptcy Code. The Bankruptcy Code relies

largely on State laws to determine rights to property.

These may include State commercial law that often

relies on the Uniform Commercial Code (UCC).62

The UCC is being reexamined to reflect the realities

of today’s marketplace, especially as it applies to

third-parties holding securities. Laws dealing with

bank liquidation also need to be updated and made

more consistent with other bankruptcy laws.63 In

nonregulated markets, such as foreign exchange,

there is little investor protection. These are topics

that warrant the attention of governments and the

private sector.

Risks Associated With the Payment Process

Domestic and world markets have led to innovations in the way payments are made for transactions.

Increased volume of trading has heightened stress on

payments systems. Issues that have arisen concerning payment risk include: delayed or inadequate

bank credit, timetables for finality of settlement, and

netting procedures. Problems may arise with 24-

hour trading systems, for example, margin calls

when banks are closed.

Bank officials must become more familiar with

the processes and risks of clearing and settlement to

make better and more expedient credit decisions,

particularly in times of severe market volatility. At

such times, the lack of adequate information on

which to base credit decisions may force some banks

to restrict credit unnecessarily.@ This could exacerbate a downward market spiral. Knowledge about

sg~tefi Report of the President’s Working Group on Financial Markets, May 1988, p. 5: “. . .c-nt minimum margin requirements provide an

adequate level of protection to the fmncial system. . .“ More recently, however, the Administration appears to have taken a different view, namely,

that futures margins are set too low, and that a single Federal agency should have chy-today oversight ‘to harmonize margins between futures and stocks

to protect the public.” Testimony of Robert R. Glauber, Under Secretary of the Treasury for Finance, before the Senate Committee on Agriculture,

NutritioL and Forestry, May 8, 1990. There is also the view that higher initial margins with less frequent reviews might be safer than today’s lower

margins and more frequent reviews. Hewi% op. cit., footnote 57.

590ral testimony of Alan GreenspW ~u Federal Reserve Board, before the Senate Committee on Banking, Housing, and Urban Affairs, Mar.

29, 1990. He said: “I was shocked” about the margin setting behavior in the futures markets in October 1989. When margins are set low, they have

to be raised during market stress, reducing liquidity just when it is most needed.

@SIPC insmes an investor’s accouts up to $500,000 for securities and cash against certain types of loss, e.g., the default of a broker. This includes

a maximum of $100,000 in cash per account. Securities Investor Protection Act, 1970.

GIIt should be noted that customers’ losses stemming from Futures Coremission Merchants’ insolvencies have been rare. Insolvency losses from 1938

to 1985 amounted to less than $lOrnillion. National Futures Association study CmromrAccount Protection, Nov. 20, 1986, p. 13. The basic protection

is the statutory requirement that IOOpercent of customer funds be segregated. Commodities Exchange Act, Sec. 4d(2). Also, customers havefwst priority

in commodity brokers insolvencies under the Federal Bankruptcy Code and CFTC bankruptcy regulations.

Gz’rhe UCC is awepted on a State-by-state basis and amendments to it would still leave open the possibility Of nOn-UnifOrm treatment by the v~ous

states. The American Bar Association has a current project which is seeking improvements to this area.

63~ ~fier ties, Customem were inched t. keep possession of their s~~ties ~ficates. More recenfly, mybuyers of securities tend to hve

their certi.llcates on deposit with tid-parties, e.g., banks, brokers, depositories.

‘iThe Clearing Organimations and Banking Roundtable is addressing methods to assure that clearing members have adequate credit during times of

market turmoil. There are currently concerns for the privacy and cotildentiality of clearing members that hinder the attractiveness of the concept of a

single center for complete information on all members’ positions in all markets. This organization was started by the CME and BOTCC to begin a dialog

among futures and equity-related clearing organizations, their Federal regulators, and clearing banks.
Chapter 6-Domestic Clearing and Settlement: What Happens After the Trade ● 123

the riskiness of various financial instruments and

trading techniques are important for lenders. Educational efforts of this kind are receiving some

attention by the private sector, but more is probably

needed.

The timetable for finality of settlement is a

problem. Some payment systems, such as the FRB’s

Fedwire, offer immediate finality of settlement;

other payment systems offer “end of the day”

finality of settlement,65 and others are on later

timetables. 66 The shorter the time to finality of

payment, the less is the clearinghouse risk. Timetables for finality of payment of settlement vary within

the United States and internationally, as noted

earlier. 67 The private sector and the regulators

should harmonize disparate systems, at least to

provide same-day finality of payment.

Netting of payments reduces the stress on payment systems by requiring market participants to

pay (and receive) only the difference between the

amounts each owes and is owed by others. This

increases liquidity for market participants and reduces the risk that a market participant will default

on either payment or delivery of securities. There is

consensus among experts that legally binding netting should be expanded for payments and for

securities delivery obligations. This issue must be

addressed internationally by the private sector and

regulatory authorities.

Information Sharing

There is no central source of risk information for

financial markets participants in spite of the large

amounts of money often involved. Although some

organizations in the clearing and settlement industry

have arrangements among themselves for sharing

risk information about market participants, these

arrangements are limited in scope. Thus, creditors

are at a disadvantage because increasingly market

participants trade on more than one exchange, in

more than one market, and in the markets of more

than one country.68 69 A Bankers Trust survey of

international clearinghouses and exchanges received

18 out of 20 responses favoring the sharing of risk

position information ‘‘as useful or absolutely essential” among clearing and settlement organizations

for the purpose of reducing clearing members’

exposure risks.70

Increased automation could facilitate information

sharing. This could lead to the development of a

common format for reporting and distributing risk

information, and standards for the timely delivery of

risk information. Standards also are needed for

evaluation of different risks in different markets: for

example, a given dollar amount of financial obligations in one market may not equal the risk of a like

financial obligation in another market.

Technology 71

Technology may or may not have a significant

impact on clearing and settlement at low trading

volume; but during high volume, technology is often

a key to efficient clearing and settlement. Most of the

U.S. clearing and settlement system is technologically advanced, although there are some areas

needing improvement.

While clearinghouses have made significant

strides in upgrading technological levels, the benefits of these upgrades can be diluted if all clearing

members are not sufficiently advanced technologically to respond to new requirements of the clearinghouse for which the technology was intended. In

Gs~e&ate f~~ofsetflement is available only in the United States (through FedWire) and in Switzerland. The CHIPS system in tie United Smtes,

the CHAPS system in the United Kingdom, and the SAGITIAIRE system in France are examples of payment systems which offer end-of-day finality

of settlement.

66See B~ers Tmstrepot op. cit., footnote 2, vol. 1, P. 149.

GTRmpondents to a suey conducted by Bankers Trust Co. identifiti the use of “sameday funds’ and ‘ ‘using electronic funds @allSfer ~stead of

checks” as the major improvements that they would like to see in the way that payment systems work in clearing and settlement. In answer to anotber

question on what changes or improvements respondents would like to see in the clearing and/or settlement process, the two most fkquent responses were

“standardization of settlement times internationally’ and ‘‘centralized depositones in other countries. ”

6sAbout 39 percent of the North American respondents to the survey conducted by Bankers Trust stated that they trade in markets in mom than one

country. See Bankers Trust report, op. cit., footnote 2, vol. 1, p. 235.

6~le U.S. cle~~ouses oWrate ~ s~gle mwkets, 20 percent of ~eir member firms @ade in more than one market. General ACCOW@ OffIce,

op. cit., footuote 52, p. 4.

T@~ers Tmst report, op. cit., footnote 2, VOI. 1, p. 231.

71’’l’’his S=tion is breed on~MS~Jof Clearance a~se~lemntfor the U,S. congreS@TA, A~ga 1, 1989, which is a pall of the OTA contractor

study: Bankers Trus~ op. cit., fobtnote 2. The IBM study is based on opinions of participating experts from the world’s major exchanges and clearing

organizations.
124 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

some cases, the weakest technological link may

limit the responsiveness of the system during

operational stress, particularly under high-volume

conditions. These are areas where the private sector

will have to take the initiative to bring about needed

changes.

Standardization and Harmonization

Uniform codes of operation, or standards, for both

the process72 and the infrastructure73 of clearing and

settlement would make it easier to link the world’s

clearinghouses and depositories.

74 But progress in

this area is likely to be slow because of the

complexity of effecting change. The United States

(with respect to equities and options markets) has

standardized its domestic systems both in the

process and the infrastructure.

Operating hours and daily schedules for banks and

financial markets are not uniform, either domestically or internationally. Banks, including the Federal

Reserve Bank, may be closed even if financial

markets are open. 75 This is also true of central banks

in other countries, which can cause problems as

market participants invest in more than one country.

The FRB, SEC, CFTC, and the Treasury Department

must frost face this issue in the United States.

Settlement Period Duration

The United States must shorten the settlement

period for equities. This most likely would require

immobilization of securities in a depository and the

public would also benefit from a change to same-day

funds. 76

The elimination of physical delivery of certificates is the key to automating the clearance and

settlement systems. The U.S. Working Committee

of the Group of Thirty concluded that the greatest

deterrent to achieving shorter settlement at the retail

level, or the ‘‘customer-side, is the physical

delivery of certificates (which some retail investors

insist on) and reliance on the postal system to

accomplish this.77 The retail customer must pay his

broker on or before the settlement date. Each side

requires the delivery to the broker of either “good

funds’ or certificates in a timely fashion. There is no

easy way to accomplish these “deliveries” today,

without substantial changes for the retail investor or

added expense for investors who wish to hold a

certificate.

The Group of Thirty’s recommendation for a

change from next-day funds to same-day funds

(SDF) for the settlement of securities transactions

has no deadline for implementation, but some expect

it to be in place in the United States during the

1990s. 78 The adoption of SDF should contribute to

risk reduction and would add uniformity and simplicity across all instruments and markets.

However, the U.S. Working Committee, while

recommending the eventual adoption of same-day

funds, recognizes the need for assessing a number of

complex issues associated with its adoption. There

are substantive technical issues and the requirement

for significant behavioral changes that warrant study

before the changeover. Today’s automated payment

systems, for example, are considered to be not yet

sufficiently developed or “user-friendly” to be

viable alternatives to the postal system. Similarly,

U.S. clearing corporations that process corporate

securities transactions do not settle payment obligations in same-day funds. Further work is needed to

72~~~oceSs*~ ~efer5 t. operatio~ finction5 inclutig trade matching, the number of days to clear a trade, number of days to setfle a ~ade, the use

of a depository for holding equities and keeping records of ownership, the use of a recognized numbering system for identifying financial instruments,

formats for data transmissio~ and the method of payment.

Tq~ ~~smcme~~ refen t. w of tie ~ny nonoperatio~ features necessW to make the clearing and settlement process work fi a cons~tent and

stable reamer. These include the method of regulatio~ mechanisms to protect the clearinghouse against the financial failure of a clearing member, a

reserve of fimds to protect customers of a failing broker or futures commission merchant, bankruptcy laws to adjudicate the disposition of customer assets

if a broker fails, credit processes at banks, clearinghouse trade guarantees, capital adequacy guidelines, and bilateral tax treaties among nations.

Tdgankers Tms~ in its s~ey of clearing and settlement participants worldwide, asked the question: Which critical clearhg and settlement problems

should the U.S. Congress address, if any,. . . ? The three most frequent responses for attention by the Congress were: Support standdization efforts for

globaJ trading; Support immobilization of securities; Support increasing the standardization of the clearing and settlement process. It should be pointed

out that a significant number of U.S. respondents did not want increased congressional involvement in issues affecting the clearing and settlement

industry.

75~s issue, for the Ufited Stites, was raised at the Feb. 8, 1990, meeting of the Ba~g and Cle-house Roundtable, where members -dtO

hold further discussions. The problem is far more complicated internationally and far from being resolved.

Wi~M s~dy, op. cit., footnote 71, PP. 20>22.

77Group of~,U.S. Wortig Group Report on Compressing the Settlement petiod, Nov. 221989.

78Mmormdm from T& ~Tc to me Group of Thirty, U.S. WOrking COInfnittee, J:ln. 4, 1990.
Chapter 6-Domestic Clearing and Settlement: What Happens After the Trade ● 125

examine how these systems would have to be altered

to accommodate an SDF environment.79

A final issue concerns implementing guidelines

issued by the Federal Reserve System to mitigate

systemic risk that could be caused by a failure of a

private payment system (i.e., a clearing agency)

participant to settle its obligations.80 The guidelines

are seen as difficult to apply within NSCC and

Depository Trust Corp. (DTC) for the clearing of

corporate securities and municipal bonds, and therefore will require additional study .81

Ongoing efforts by the private sector have been

laudable. Yet, some of the issues raised by shortening the time to settlement and same-day funds,

among others, will require continued assistance

from regulatory bodies and, in some cases, the U.S

Congress, since they are not within the ability of the

private sector to resolve.

IS AN INTERNATIONAL

REGULATORY BODY NEEDED?82

Global trading has begun to raise many diverse

issues; issues that have not received much attention

until global trading began to become significant.

The list of issues is likely to grow during the decade

of the 1990s and change significantly over time. In

the past, some of the issues have been addressed, at

least in part, by different organizations, often on an

ad hoc basis and typically not for all financial

instruments or markets. A key question is whether

there is a need for a single organizational focus to

address international issues on a continuing basis.

Among the many issues currently in need of

international attention, are:

●

●

●

●

●

●

●

●

●

legal issues in cross-border trading,

information sharing across markets and across

national borders,

the minimum level of technology to be used by

various participants with regard to clearing and

settlement,

international regulation of markets,

the critical interface between international markets and banks,

means of protecting clearinghouses from externally caused major disruptions,

minimum financial standards for clearinghouses

(i.e., capital and guarantees),

standards for global custodians, and

surveillance and enforcement.

These types of issues generally are best addressed

in international fora so that the world’s markets may

evolve in a coordinated, harmonized reamer. The

International Organization of Securities Commissioners, among other organizations, has begun

examining these types of issues. Although the

private sector is already dealing with many issues,

government assistance is likely to be needed, for

example, to effect changes in laws, such as those

needed for the immobilization of securities certificates. 83 The several private sector studies do not

fully address all financial instruments, e.g., derivative products, that must also be addressed to

accommodate the linked markets of today, nor do

these studies address all of the process and infrastructure areas that must be examined. The private

sector alone cannot implement the recommended

changes fully since consensus will be required

among market participants, regulators, and national

governments.

mid.

~ederal Reserve Systeq Docket No. R-0665, Policy Statement on Private De/ivery-Aguinst-Payrnent Systems, RIN 7100AA76, June 16, 1989.

SI~oup of~,u-s. Wo~co~ttee Report on Same Day Funds Convention, Fe- 1990.

8~or a filler diwwsiow S* OTA’S background paper, Op. cit., footnote 1* ch. 5“

83s=, for e=ple, @up of~,~~u.s. Work@ @oup Report on co~ress~ tie se~~ent Period,” NOV. 22, 1989, pp. 6-10.
Chapter 7

How Technology Is Transforming

Securities Markets
CONTENTS

Page

TWENTIETH CENTURY MARKET TECHNOLOGY . . . . . . . . * . . . * . . . . ..

Trading Support Systems .. .....................”+. ..........*’”’ . “

Market Surveillance Systems . . . . . . . . . . . . . . . . . . . . ...........,.~’”.”0”0.o~s .“””

Clearing and Settlement Systems . . . . . . . . . . . . . . . . . . . .. +. .. .. .. .. .+ 000~”c~~’ooo~ ● C

INFORMATION SERVICES VENDORS ...................+.. .............~.....

Financial News . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...........”*””””” ● “00.” ”c..

Stock Quotations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Value-Added Products . . . . . . . . . . . . . . . . . . . . . . . . . . .. .............+.””.-+”””” ‘“”*”c

Foreign Exchange Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... .++.+”’

U.S. Government Bond Data . . . . . . . . . . . . . . . . . . . . .. .. .. .. .. .. ... ... ~..”..” ● ....”

Competition and Technological Change . . . . . . . . . . . . .. ..............+........+..

Digital Data Feeds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . .

Diversification into Transactional Services .. .. . . . . .......+. .., .. ... . .....+..+ . . .

REGULATIOIN OF INFORMATION SERVICES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

U.S. BROKERAGE HOUSES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Data Compilation and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...~.o.eTrading Support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Back-Office Functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Surveillance Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Customer Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

TECHNOLOGY FOR THE INDIVIDUAL INVESTOR . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE FUTURE: STRATEGIC TECHNOLOGIES AND THEMES . . . . . . . . . . . . . . . . . . .

Expert Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Hardware . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . ● . . . .

FURTHER TRENDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE MARKETS AND TECHNOLOGICAL PROGRESS . . . . . . . . . . . . . . . . . . . . . . . . . .

Standards for Automation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

24-Hour Global Trading Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

129

129

130

131

132

133

133

133

134

134

135

136

136

137

139

139

139

139

140

140

140

141

141

142

142

143

143

145
Chapter 7

How Technology Is Transforming Securities Markets

In the early 19th century, delivery of a message (or

a market quote) from New Orleans to New York

took from 4 to 7 days. The telegraph was first

demonstrated in 1844. By January 27, 1846, telegraphic communication linked New York and Philadelphia, via Newark. Until direct lines were installed

a few months later, messengers ran between the

telegraph office and Wall Street. It was 2 years more

before the New York and New Orleans foreign

exchange markets could directly communicate, but

then message time was nearly instantaneous.1 Financial markets were quick to realize the possibilities.

The New York Herald of March 3, 1846, mentioned

that “certain parties in New York and Philadelphia

were employing the telegraph for speculating in

stocks.” The use of the telegraph greatly reduced

price differences between the participating markets.

A successful trans-Atlantic cable was completed

on July 27, 1866. Four days later the New York

Evening Post published price quotations from the

London exchange. The first cable transfers occurred

about 1870 and arbitrage between the London and

New York exchanges began immediately. This led

to further reductions in price differences between

markets.

The third invention that revolutionized the exchanges was the stock ticker, introduced in 1867.

Before that, reports of transactions were recorded by

‘‘pad shovers’—boys who ran between the trading

floor and the brokers’ offices with messages. Several

ticker companies had men on the trading floor to

type results directly into the ticker machine. These

reports went to the ticker companies’ headquarters

and were retyped to activate indicator wheels at local

tickers, which then printed the results on paper tape.

In 1878, the telephone, successfully tested 2 years

earlier by inventor Alexander Graham Bell, reached

Wall Street. Until then, a messenger carrying a

customer’s order could take 15 minutes to get to the

floor; with the telephone, it took 60 seconds. By

1880, most brokers had telephones linked directly to

trading floors, and in the next few years, telephones

were installed by the thousands. Finally, in 1882, the

Edison Electric Illuminating Co. gave Wall Street

electric lights.2

By 1880 there were over a thousand tickers in the

offices of New York banks and brokers. In 1885, the

New York Stock Exchange (NYSE) began to

assemble the information for ticker company reporters to ensure consistency. The New York Quotation

Co. was created by NYSE members in 1890 to

consolidate existing ticker companies and integrate

the information distribution. This did not eliminate

“bucket shops,” where the ticker tape output was

rigged to swindle investors.

TWENTIETH CENTURY MARKET

TECHNOLOGY

Trading Support Systems

Fully electronic transmission and storage of

trading information began in the 1960s. Quotation

devices were first attached to ticker circuits to

provide bid and ask quotations and prices. An

improved stock ticker was introduced in 1964 that

could print 900 characters per minute and report

transactions without delay up to 10 million shares

per day. The pneumatic tube carried information to

the ticker and quotation system, until it was replaced

with computer-readable cards in 1966. Reporters on

the floor recorded the transaction on a card and put

it into an optical seamer. The scanner read the

information into a computer where it entered the

ticker system. At about this time the Central

Certificate Service was created as an exchange

subsidiary, to computerize the transfer of security

ownership and reduce the movement of paper. In

1973, this became the Depository Trust Company.

The computer display of dealers’ bids and offers,

described in chapter 3 and called NASDAQ (National Association of Securities Dealers Automated

Quotations), began to operate in 1971.

Despite these technologies, the securities industry

had a severe back-office paper-work crisis during

IKenne~Dc Gmbade and Wiwm L. Silber, “Technology, Communication, and the Performance of Financial Markets, ” The Journal of Finance,

vol. ~, No. 3, June 1978, pp. 819-832.

~eborahS. Gardner, ‘ ‘Marketplace: A Brief History of the New York Stock Exchange,” for The New York Stock Exchange, Office of the Secretary,

1982.

–129–
130 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

the 1960s. Brokerage houses could not keep up with

paper-work for the high transaction volume. Finally,

in April of 1968, the crisis forced trading hours to be

curtailed so that the back-offices could catch up.

This led to development of automated systems for

back-office processing. In 1972 the Securities Industry Automation Corp. (SIAC) was established by the

NYSE and the American Stock Exchange (AMEX)

to coordinate the development of their data processing.

Three systems were introduced by SIAC during

the 1970s: the Market Data System (MDS), the

Designated Order Turnaround System (DOT) and

the Common Message Switch (CMS). The MDS,

originally introduced in 1964, was improved in the

70s to process last-sale information. DOT, introduced in 1973, automated the delivery of small

orders (fewer than 199 shares) from member-firm

offices to exchange floors. The CMS let member

firms communicate with the other SIAC systems.

Since the 1970s these trading support systems

have been improved in speed, accuracy, and efficiency. Regional exchanges have developed comparable systems. In many cases the regional exchanges

led the way-e. g., in continuous net settlement (the

Pacific Stock Exchange) and bookkeeping systems

(the Midwest Stock Exchange). As early as 1969, the

Pacific Stock Exchange (PSE) automated some trade

execution. This meant that unless halted by the

specialist, a trade was completed by a computer

without human intervention. This first-of-its-kind

system was called COMEX.

In 1979 the PSE introduced an improved version

of COMEX, called the Securities Communication

Order Routing and Execution (SCOREX). When an

order reaches the SCOREX system, the current

Intermarket Trading System (ITS) price is determined, and the order and price are displayed at the

appropriate PSE specialist post. The specialist has

15 seconds to better the price for market orders,

before the order is automatically executed by the

computer, at the ITS price, for the specialist’s

account. For a limit order, the specialist also has 15

seconds to accept, reject or hold the order in his

electronic book. If the order is rejected, it is routed

back to the member-firm. Otherwise, when the

order’s designated price coincides with an ITS bid or

offer, the specialist executes the order.

Most stock exchanges now have small order

execution systems similar in function to SCOREX.

There are also systems for small orders in options

contracts, and in NASDAQ for small orders of

over-the-counter stocks. These electronic small order

execution systems were introduced with relative

ease despite the reduction in the services of the

“two-dollar broker,’ but electronic systems for

executing larger orders threaten the livelihood of

more powerful professionals on the exchange floor,

and thus are controversial.

Technology may reshape the entire exchange

structure. The Cincinnati Stock Exchange and the

London International Stock Exchange (ISE) do not

use physical trading floors but operate through

computer rooms. The ISE and NASDAQ combine

screen-based quotation systems with telephone negotiation. Exchanges in Toronto, Madrid, Brussels,

Copenhagen, Zurich, and Frankfurt are also essentially ‘‘ floorless. ” For the time being, most U.S.

exchanges have chosen to maintain their automatic

trading support systems at a level that preserves the

roles of specialists, floor brokers, and other intermediaries. Enhancements now usually mean faster

computers or new devices that work around the

traditional trading infrastructure and established

participants.

Market Surveillance Systems

Today’s financial environment has increased

securities markets’ vulnerability to illegal activity,

even as today’s technology has increased the ability

to monitor markets. The magnitude and frequency of

mergers and acquisitions and other major corporate

transactions, and the allure of staggering profits

increase the market’s susceptibility to insider trading. The addition of new derivative products and

new players around the globe further complicates

surveillance.

Manual processes for detecting illegal activity are

no longer adequate. People are not fast enough to

inspect and evaluate the enormous volumes of

information. Computers can improve detection of

some kinds of illegal activity. They are less effective

against the illegalities that occur in the least auto3’ ‘The Two-dolkw broker” or ‘ ‘Broker’s broker’ executes overflow trades for other floor brokers too busy to execute them persordly. These free

agents were once paid $2 for every round lot executed, thus the name.
Chapter 7-How Technology Is Transforming Securities Markets ● 131

mated trading arenas-the Chicago trading pitsand insider trading in securities markets. For example, to detect insider trading, exchanges must obtain

information from broker/dealers (as well as from the

Securities and Exchange Commission (SEC)).4 Some

of them are not yet able to transmit trade data

automatically, and paper-based data are difficult to

work with.5

Surveillance in Self Regulatory Organizations

(SROs) (i.e., exchanges, NASD) follows three

general steps. First, the SROs monitor market data

using computerized systems, to detect unusual price

and/or volume fluctuations. Second, when an unusual trading pattern is detected, the SRO’s staff

conducts analyses to determine the probable cause

of the fluctuation. If a satisfactory answer is not

found, the staff conducts further investigations,

using automated systems and analytical tools.6

SROs maintain large computer databases of historical information about trades, personal background

of traders, news, and past case materials, to identify,

compare, and probe suspicious trends.

Market surveillance may be further improved by

several emerging technologies, including expert

systems (computer programs that incorporate the

decision rules and judgment criteria of many human

experts). The thrust has been to build systems and

databases with great analytical power, to enable

market analysts to sift through large amounts of data.

If an expert system can give the analyst an advanced

starting point in an investigation, the rest of the job

can be done faster and more effectively.

Personal computers and “intelligent” workstations are replacing dumb terminals in market surveillance. Although interactive computing requires

greater technical expertise, such as a database query

language, it also enables analysts to retrieve information faster and integrate applications more effectively. Data feeds and programs from many sources

can be combined locally, and better analytical tools

can be applied to real-time market information. The

emerging trends in software and hardware are

entwined. The ability to manipulate data locally is

also important for the development of expert systems for recognizing trends and abnormalities in

market surveillance.7 Until recently, market surveillance systems lagged behind the technology for

trading support. Now computers offer critical tools

such as expert systems, artificial intelligence, voice

response, and complex relational databases for

further improving market surveillance.

Clearing and Settlement Systems

Clearing and settlement (ch. 6) is the process

whereby ownership of a security or options contract

is transferred from the seller to the buyer and

payment is made. The participants in this process are

the principals to the trade (investors or broker/

dealers and banks), the market places, clearing

organizations, and settlement organizations. In the

case of futures, the clearing and settlement process

also involves the posting of margin by both the buyer

(long) and the seller (short) to the accounts of the

clearinghouse.

Banks transfer funds from the buyer to the seller.

The 12 Federal Reserve Banks, their 24 branches,

the Federal Reserve Board in Washington, D. C., the

U.S. Treasury offices in Washington, D. C., and the

Chicago and Washington, D. C., offices of the

Commodity Credit Corporation are all connected by

the Fedwire, a high-speed, computerized communications network over which banks transfer reserve

balances from one to another for immediately

available credit. The depositories and registrars are

involved in the transfer of ownership. Depositories

register all securities in the name of the depository

as nominee and then transfer ownership via bookentry. Transfer agents physically transfer ownership

by creating new registered certificates.

d~e SEC IMS alSO applied automation to its task of financial ftigs and registration. The Electronic Data Gathering Analysis and Retieval system

(EDGAR) is designed to receive and display financial filings. When the project is completed it is expected that over 11,000 publicly traded companies

and 2,700 investment fms will submit their required ftigs and disclosures electronically.

SAS of August 1989, 373 broker-dealers were submitting automated data to the New York Stock Exchange, according tO exChange Offk*, Au@st

1989.

6Fore-pie, ~eymay mofitortie cov~ace between se~ties to cap~e &ekprice interrelatiom~p and hypo~esize the Correct price probability

distribution for the securities. The parameters are set by computers using a moving average algorithm or standard deviation to determine the “acceptable”

nmges of price movement and volume activity. When these limits are violated the staff is alerted by the computer to investigate unusual activity.

% general, an expert system is a computer program that attempts to replicate, to some degree, human logic and decision processes. The long range

benefits of using such systems are many, including better utilization of professional time, cost savings and improved quality and consistency of decision

rnaldng.
132 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Participants are linked by paper, tape, electronic

systems, and direct computer-to-computer links. For

example, the Options Clearing Corp. (OCC) in

Chicago receives taped data from nine exchanges,8

and has some direct computer-to-computer linkage

with them. OCC also has electronic feeds to market

data vendors. Communication with banks is via

paper and facsimile, and with regulators it is through

paper transactions. Clearing members are linked by

dial-up capabilities, leased lines, microfiche, tape,

and paper media. Clearing corporations communiate with OCC with magnetic tape transfer as well as

some direct computer-to-computer linkage. The

Depository Trust Co., the Midwest Securities Trust

Co. and the Philadelphia Depository Trust Co. are all

linked to the OCC via direct computer-to-computer

connection.

Since 1982, trade volume has surged. Critical

problems can occur in trade matching when heavy

volume, manual entry, and tight time constraints

combine to strain the system. Continuous net

settlement (CNS)9 and electronic book-entry systems have allowed the processing of these high

transaction volumes, as have faster, higher capacity

mainframe computers. The critical element in handling rising trade volume on a sustained basis,

however, is the first step in processing the trade, i.e.,

the trade entry or trade capture component. Manual

trade entry processes are prone to error and result in

a disproportionately high rate of unmatched trades

as trade volume rises.

The development, operational and maintenance

costs of automation have risen over the past two

decades. Rapid technological obsolescence in management information systems and technical infrastructures implies high reengineering costs. Regulatory rules often influence or even dictate specific

technologies that must be used. In many cases such

rules have had a positive impact. For example,

NYSE Rule 386 requires all members to use the

Depository Trust Co’s. automated Institutional Delivery system or its equivalent. The Municipal

Securities Rule-making Board’s rules G12 and G15

require municipal bond clearinghouse members to

use a municipal bond comparison system. The rules

go so far as to define the output specifications for the

system.

On the other hand, there are also regulatory,

legislative, and political factors that inhibit automation. These include domestic disputes over regulatory jurisdiction, resistance to change, tradition, and

customs; and overseas, legislation prohibiting dissemination of some data.

In hopes of achieving a competitive edge, firms

are evaluating new relational database management

systems and communication systems of copper,

fiber-optics, and microwave. Communications networks such as LANs (local area networks), hypernets, and shared terminal networks will also be

increasingly used in clearance and settlement. Higher

density storage media will be needed to accommodate anticipated increases in on-line storage requireents. As an alternative to the direct access storage

devices in use today, optical disk storage technology

may have greater use. Optical disk is also an

effective data distribution medium; for example,

Lotus sells a service providing historical price

information on securities on CD for use with the

Lotus 1-2-3 spreadsheet. Today’s systems are being

designed with several levels of backup, faulttolerant redundant hardware, and data storage

backup.

INFORMATION SERVICES

VENDORS

As early as 1850 Paul Julius Reuter first used

carrier pigeons to fly stock market quotations

between Brussels and Aachen, Germany. One year

later, an underwater telegraph cable opened between

Dover and Calais. Reuter then began delivering

news and market quotes from London to Continental

Europe. Reuters is, 150 years later, still one of the

dominant market information services vendors.

The market for financial information can be

broadly divided into three categories-news, data on

exchange-traded instruments, and data on over-thecounter instruments. The market structure is different for each of these.

8~e pm, PsE, NASD, pBoT, ACC, =,~oH,-xad ~sH. me PBoT is the Philadelphia BO~d Of T.rri&, the AcC is the AMEX

Commodities Corp. and the NYFE is the New York Futures Exchange.

!@NS ~m developed by the pacfilc Stock Exchange in the late 1960s and is much more effmtive man setig on a trade-for-trade basis, which iS

probably not viable with today’s volumes.
Chapter 7-HOW Technology Is Tranforming Securities Markets . 133

Financial News

Financial news may be gathered by information

vendors themselves, or they may carry reports from

leading news organizations. Dow Jones & Co. Inc.,

is the leading provider of financial news in the

United States. Dow Jones has tried to extend its

dominant position in equities news to the fixedincome bond market through the Dow Jones Capital

Markets Report, but in-depth news is not as essential

for the bond trader as it is for the stock trader.

Reuters has an edge over Dow Jones in news that

affects foreign exchange and fried-income prices

because of its vast international communications

network. Reuters is also a strong competitor in

delivering news about U.S. commodity markets, but

Knight-Ridder is a major presence in this market

through its Commodity News Service, and has also

made headway in supplying news concerning financial futures and underlying cash markets. Other

providers of online financial news include the

Associated Press, McGraw-Hill Inc., Financial News

Network, and Market News Service.

Stock Quotations

Five companies dominate the market for securities and futures quotations in the United States—

Reuters Holdings PLC, Quotron Systems Inc.,

Automatic Data Processing Inc. (ADP), Telerate Inc.

(now owned by Dow Jones), and Knight-Ridder Inc.

These five companies had a total of approximately

426,000 terminals worldwide as of February 1989.10

For most stocks, all commodity and financial

futures, and all options, the market data—bids,

offers, last-sale prices, and volume information—

are generated by exchanges and the over-the-counter

market and delivered to vendors. In foreign exchange and fixed-income markets, where there is no

central exchange, price information is contributed

by banks and securities firms to vendors.

Quotron Systems Inc. has long dominated the

market for U.S. stock quotations, but this market is

now in ferment.11 ADP is a strong competitor.

Outside the United States, the leading position is

held by Reuters, which recently entered the U.S.

market for stock prices. In the past, Reuters supplied

quotes and news for foreign exchange, money

market instruments, and commodities in this country, but not equities.

The internationalization of the securities markets

has prompted foreign vendors such as Reuters and

Telekurs of Switzerland to enter the U.S. market,

while American companies such as Quotron and

ADP have been expanding their operations overseas.

The growing links between the equities, futures,

freed-income and foreign exchange markets have

also led to diversification among vendors who

traditionally specialized in one market. Telerate Inc.,

which holds a near monopoly in the market for U.S.

government securities prices, has entered the equities market through acquisition of CMQ Communications Inc., the leading stock quote provider in

Canada. It remains to be seen whether Reuters and

Telerate can replace Quotron and ADP, or will

merely add equities quotes to their existing terminal

base. There are about 200,000 terminals receiving

real-time prices from U.S. stock exchanges, and

some industry observers are skeptical that the pie

will become bigger with the entrance of new players.

Nevertheless, the relative ease of acquiring and

distributing prices for exchange-traded instruments

has attracted several new competitors in recent

years, including PC Quote Inc., and ILX Systems, a

new venture backed by International Thomson

Organization. Despite the competitive conditions in

the securities quotation business, there is always

room for new ‘‘niche’ companies offering innovative products, such as proprietary analytics.

Value-Added Products

The relative ease with which any vendor can

obtain data from American stock markets and many

of their foreign counterparts has made the market for

l~nc philo ~d Ke~eth Ng, “Reuters Holdings PLC, ” Goldman, Sachs & Co., New York NY, February 1989, p. 5. There may be some

double-counting here due to screens displaying more than one vendor’s data.

llFollowing Quo@on’s acquisition by Citicorp in 1986 for $680 millio~ two major fiirms-MerriU Lynch & Co., Inc. and Shearson LehmanBrot.hem

Inc., now known as Shearson Lehman Hutton Inc.-announced they would not renew their contracts with Quotron because they consider Citicorp a

competitor. ADP has recently begun installing a personal computer-based stock quotation system for registered representatives at Shearson and Merrill.

If these installations are completed, and ADP achieves a one-for-one replacement of the terminals at both Merrill and Shearso~ Quotron’s network of

approximately 100,000 termina 1s could be reduced by up to 30 percent and ADP could surpass Quotron as the leading stock quotation provider in the

U.S. (Waters Information Systems, Transcript of Quotron-Reuters-Telerate Conference, New York NY, November 1988, p. 19.) To date, ADP’s

conversion of terminals at Merrill and Shearson is running behind schedule, and Quotron has added more terminals than it has lost. (Roxanne Taylor,

Quotmm Los Angeles, CA, personal communication August 1989).
134 • Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

exchange trade data into a‘ ‘commodities” market,

in the sense of highly standardized products competing on price or value-added features. In order to

maintain their profit margins, vendors are trying to

add value through new technology or exclusive

products, and to generate as much revenue per

terminal as possible. This has encouraged thirdparty suppliers to offer historical information, research, analytics and tailored news services through

the terminals of vendors such as Quotron, Reuters

and Bridge Brokerage Systems. Vendors that control

the distribution network typically keep 30 to 40

percent of the revenue generated by third-party

Products.12

Foreign Exchange Data

The commoditization of exchange trade data has

no parallel in markets where there are significant

barriers to entry for vendors. Reuters created the

market for real-time foreign exchange data in 1973

when it frost put computer terminals on the desks of

traders and convinced them to enter their rates into

the system. Reuters charges subscribers a flat

monthly fee but does not pay banks for contributing

their quotes to the service. Reuters also launched the

Monitor Dealing Service in 1981, allowing traders to

negotiate transactions over their terminals instead of

telephones. This system has been successful in part

because of its built-in audit trail. In 1989, between

30 and 40 percent of the $640 billion traded each day

in the interbank foreign exchange market took place

on the Monitor Dealing Service.13

While Reuters is the best established in the

foreign exchange market, Telerate is a competitive

alternate service. Traders probably like having a

backup quotation system, and also like the idea of

competition for Reuters. It was nevertheless difficult

for Telerate to gain a place in foreign exchange

(“forex”) until Reuters agreed to permit its subscribers to install ‘‘binco boxes’ ‘—bank in-house

computers—that let them simultaneously update

their rates on Reuters and Telerate. Until then,

Telerate’s forex market coverage was often slightly

behind because dealers posted their rates on Reuters

frost. Other reasons for Telerate’s success in penetrating this market are the availability of AP-Dow

Jones foreign exchange news on Telerate, and

traders’ need for U.S. interest rate data.

Telerate did not until recently offer dealers a

transactional system such as Reuters’ Monitor

Dealing Service. It has now launched a foreign

exchange conversational (on-line) dealing system

through a joint venture with AT&T. Known as The

Trading Service, this service allows dealers to talk to

several dealers at once, unlike the Monitor Dealing

Service. Now Reuters in turn is taking another step

forward with an enhanced version of the Monitor

Dealing Service and a centralized order database

facility. While the original Dealing Service facilitates one-on-one negotiation between two traders,

Dealing 2000 will emulate an auction market where

bids and offers from multiple parties are exposed.

This is designed to replace ‘blind’ brokers, who act

as middlemen in foreign exchange trading. The

system will display the aggregate size of all bids and

offers at each price, but will not disclose the

identities of the dealers participating.

U.S. Government Bond Data

Telerate is currently the only vendor broadly

distributing prices in the government securities

market. Under an exclusive agreement scheduled to

expire in 2005, Telerate disseminates bids, offers

and last-sale prices from Cantor Fitzgerald Securities Corp., the only major inter-dealer broker serving

both primary dealers and retail customers. Other

brokers provide price information only among the

primary dealers, those who are authorized to deal

directly with the Federal Reserve Bank of New

York. 14 In a 1987 study, the General Accounting

lz~ong companies successfully exploiting demand for third-party services is MMS International, which delivers analysis and commentary on

Telerate, Bridge and Reuters. MMS was recently acquired by McGraw-Hill Inc. Another third-party provider is First Call, part of International

Thomson’s InFiNet group, along withILX Systems. Jointly owned by Thomson and a group of securities firms, First Call is a leading provider of on-line

research produced by Wall Street analysts. Both Quotron and Reuters have tried to compete against First Call’s research distribution sewice, but Reuters

recently discontinued its own service and signed an agreement to offer First Call to its subscribers.

IsSpeWh by Robert E~gto~~termtio~ ~keting manager for transaction products, Reuters Holdings,PLC, New Yo*S NY* J~Y 1988”

14ficeS from one or more pmd~ers~e not ~represen~tive of ~ent ~et conditions ~ ~e ~ose from inter-dealer brokers, who receive

quotes horn all the dealers. One vender, Bloomberg (30 percent owned by Merrill Lynch), packages quotes entered by Merrill’s prirmuy dealer operation

with proprietary analytics that can help traders spot arbitrage opportunities. Bloomb~ also delivers versions of this that include inter-dealer broker

prices, but only to dealers authorized to see these quotes. If wider distribution of inter-dealer broker prices does come abouc Telerate could be hurt

financially. Under its agreement with Cantor Fitzgerald, it cannot carry quotes from any other inter-dealer broker. Telerate also distributes information

provided by Market Data Corp.. It is possible Market Data Corp. could be used as the distributor of bids, offers, and last-sale prices from other dealers.
Chapter 7-How Technology Is Transforming Securities Markets ● 135

Office encouraged brokers to distribute quotations

to non-primary dealers within 2 years. 15 In April

1989, major government bond dealers reportedly

pressured a large government bond broker into

abandoning a controversial effort to broaden access

to bond-trading information by offering its electronic trading information screens to a wider group

of customers.16

Reuters, Quotron, and Knight-Ridder have periodically held talks with individual brokers about

disseminating their quotes, and three inter-dealer

brokers have discussed distributing consolidated

last-sale prices, but none of these efforts have

reached fruition. When they do, ‘commoditization’

will probably also occur in the market for U.S.

government securities prices. Vendors would have

to compete by providing proprietary analytics or

news, or by specializing in a particular area of the

Treasury market.

Reuters and Quotron are likely to try to expand

into the fixed-income information business. Since

its acquisition by Citicorp, Quotron has been developing information and transactional services in both

foreign exchange and fixed-income markets. However, Quotron faces the same obstacles here as do

Reuters and Telerate in equities: lack of critical mass

and a shortage of space for terminals on the already

crowded desks of traders.

Competition and Technological Change

Since the financial information business is still

growing, it continues to attract aggressive competitors. This may eventually bring down prices for

information services, but some observers report that

customers who complain about the high costs of the

established vendors often ignore lower cost firms

who lack track records. Several securities brokers

have tried to use raw data directly from exchanges

and process this information in-house using customized software. They were largely unsuccessful,

having underestimated the time and expense of

becoming self-suppliers.

Technological change is creating upheaval and

uncertainty among financial information vendors.

As recently as 5 years ago, an equities trader

typically had one terminal on his desk—probably a

Quotron-which carried Dow Jones News Service

and gave the trader access to prices for U.S.

securities only. In the freed-income department of

the same firm, each trader would have a Telerate

terminal. In the foreign exchange area, each desk

would have a Reuters terminal, and perhaps one

from Telerate. Because markets did not greatly

affect one another, there was no need for most

traders in one market to be watching other markets.17

The technology used by the vendors was essentially the same, a dumb terminal connected to a host

computer by dedicated telephone circuits. But as a

number of niche services sprung up, traders ended up

with more and more dedicated terminals on their

desks. The use of single dumb terminals declined

sharply when the PC permitted local storage and

manipulation of price information. Now, because of

digital technology, the way vendors transmit the

data is becoming less important than what data they

transmit.

Several other technological advances in the early

and mid- 1980s also irrevocably changed the delivery of financial information. The video switch, long

used in the broadcast industry, reduced the clutter of

terminals on traders’ desks by allowing several

screens to be controlled by a single keyboard. They

became an important part of trading rooms, and were

also responsible for the rapid rise of two companies

that installed thousands of new trading room systems integrators worldwide. There were also rapid

changes in the reamer in which stock quotations

were transmitted from vendors to customers. In

addition to delivering prices over dedicated telephone lines, vendors began exploring other alternatives, such as broadcasting data by FM sideband and

satellite. Midwestern commodity market data vendors began in 1981 to use small, low cost, receiveonly satellite dishes which were particularly effective for one-way broadcast communications such as

financial quotations. They now distribute financial

data for vendors such as ADP, Dow Jones, KnightRidder, PC Quote, Reuters, and Telerate. Although

dedicated interactive networks remain the primary

delivery mechanism of financial information vendors, financial data accounts for 63 percent of the

15u.S, General Accoufig OffIce, U.S. Governunt Securities: Eqanding Access to htterdealer Brokers’ Services ~astigto~ ~: 1987).

IGTom He- “Big D~erS Keep Monopoly on Bond Da@” Wall Street Journal, AsJ1”. 11, 1989.

ITHoWever, fm~.&.ome &adem ~way~ n=d~ t. fo~ow tie forei~ e~c~ge~ke~sin= c~ency prices and interest rateS are CIOSely linked.
136 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

114,000 data broadcasting satellite receiving sites

currently in operation.18

Digital Data Feeds

To satisfy the demand for analytical tools, vendors have begun to offer their data in digital as well

as analog form. Digital data gives users more

flexibility in viewing and using data, such as the

ability to create customized composite pages. This

has created a dilemma for financial information

vendors and their customers because neither exchanges or vendors are sure how best to price digital

information. The fees paid by customers have in the

past been based on the number of terminals or

display devices authorized to receive information.

This created some inconsistencies; for instance, a

workstation with four separate screens will be

charged four exchange fees while a workstation with

one screen and four windows will be charged one

exchange fee. Many users will not tell vendors the

number of screens on which their data are displayed.

Several industry efforts are under way to address the

issues raised by digital data: the Financial Information Services Division of the Information Industry

Association has formed a subcommittee on digital

data feeds and workstations, and the Financial

Industry Standards Organization, a user group, is

also doing analysis.

It is now often cheaper for securities firms to buy

hardware off the shelf than it is for them to lease

equipment from vendors. In addition, the securities

firms want to be able to choose whether they get a

dumb terminal, a PC, or a UNIX-based workstation,

and they would like industry-standard hardware that

can be integrated with the firms’s other systems. In

recognition of this, Reuters recently stopped manufacturing terminals and Quotron plans to sell off-theshelf equipment. ADP is also moving to industrystandard hardware.

Diversification Into Transactional Services

With data treated as a commodity and a diminished role as systems providers, financial information vendors may move toward offering transactional services, using automated execution systems.

Citicorp and McGraw-Hill failed with the GEMCO

electronic commodity trading system a few years

ago. In the futures market, the World Energy

Exchange and the International Futures Exchange of

Bermuda (INTEX) both failed to convert open

outcry traders to screen-based trading. Security

Pacific Corp. has not had much success in automating the front office. But these failed ventures in

automated trading have not deterred Reuters, which

owns Instinct Corp., a registered broker/dealer

offering an electronic securities trading system.

Instinct began in the 1970s, but was acquired by

Reuters in 1987. The company is now executing an

average of 13 million share-trades a day (including

both over-the-counter and exchange-listed stock), a

volume still dwarfed by the 150 million or more

shares traded by NYSE on an average day, but

Reuters hopes that exchanges will begin using

Instinct during the hours when their trading floors

are closed.

It remains to be seen whether the foreign exchange market will accept the automated trading

Reuters is offering through Dealing 2000, but the

technology used in that system was adapted for

GLOBEX, an electronic 24-hour futures trading

system jointly developed by Reuters and the Chicago Mercantile Exchange and the Chicago Board of

Trade, and projected to be ready for use in 1990-91.

MATIF, the French financial futures exchange, has

already agreed to use GLOBEX for after-hours

trading and other foreign futures exchanges may also

participate.

The Chicago Board Options Exchange (CBOE)

and the Cincinnati Stock Exchange have agreed to

form a joint venture with Reuters and Instinct to

create a worldwide system for entering, routing, and

executing trades of options listed on the CBOE and

equities traded by the Cincinnati Stock Exchange,

the only fully automated securities exchange in the

Intermarket Trading System.

Quotron has not moved as rapidly as Reuters, but

reportedly has electronic execution facilities in

development for both foreign exchange and fixedincome markets. It has been aggressively marketing

Currency Trader, which allows corporate customers

of Citicorp to execute automatically foreign exchange trades of $500,000 or less.

Telerate is licensing software from INTEX and

they are working together to offer exchanges and

exchange members automated order-routing and

execution facilities. In the freed-income market,

INTEX has licensed the rights to its order-matching

lgwatem ~omtion Semices, Data Broadcasting Marketplace (New York NY: 1989)
Chapter 7-How Technology Is Transforming Securities Markets ● 137

software to Security Pacific Corp., and ADP is

collaborating with a municipal bond broker on an

automated trading system.

If this kind of competition from vendors is not

successful, Reuters may acquire a near-monopoly in

automated execution systems as it did in the foreign

exchange market. This would mean that the afterhours transactions, and possibly all transactions, of

the Nation’s futures and options (and perhaps later

stock markets) would be processed by a single

vendor, and that a foreign one. About 46 percent of

Reuters’ stock is held by Americans, and 25 percent

of its employees are American, but by Reuters’

charter it will remain a British company.

Reuters’ emergence as the leader in providing

exchanges with trading infrastructure is surprising

because other vendors have closer relationships to

exchanges. ADP and Quotron, through the latter’s

Securities Industry Software (SIS) subsidiary, have

extensive networks that route orders from brokerage

firm offices to exchanges. These networks were

installed in the stock market following the paper

crunch of 1968, but are only recently being adopted

by futures exchanges. The Chicago Board of Trade

(CBOT) has selected Bridge Brokerage Systems, a

unit of Bridge Information Systems, to build its

order processing network, while the Chicago Mercantile Exchange (CME) went to SIS for its orderrouting network. Since the futures exchanges contend that automated execution during regular trading

hours does not provide the same liquidity as pit

trading, they do not see automatic execution as

becoming integrated with order-routing.

ADP has been dominant in securities orderrouting through its Data Network Services subsidiary and the BTSI unit that it acquired from Control

Data Corp. There are also Tandem-based orderrouting systems offered by SIS and Bridge Brokerage Systems. Many operating order-routing systems

were overwhelmed during the 1987 stock market

crash, although most have since been upgraded and

enlarged. Several industry observers believe however that brokerage firms’ back-office infrastructure

is outmoded, in part because securities firms have

concentrated during the 1980s on installing video

switches and personal computers in their trading

rooms. Because of lower volumes since the crash,

those firms appear less concerned about capacity

shortages and are reluctant to make large investments in order-routing and back-office systems.

REGULATION OF INFORMATION

SERVICES

So far, the financial information vendors have not

been subject to much Federal regulation. Under

Federal law, the SEC has jurisdiction over companies that distribute and publish securities transaction

data and quotations and over companies that collect,

process or prepare this information for distribution

or publication. To date, the SEC has registered only

those organizations that process information on an

exclusive basis for a securities exchange or association

the Securities Industry Automation Corp., the National Association of Securities Dealers Automated

Quotation System, and the Options Price Reporting

Authority. But it has been keeping close watch over

vendors since the stock market crash of 1987.19

Options markets are particularly sensitive now.

Many quote vendors were overwhelmed by the

proliferation of options series and strike prices. They

were not prepared to handle the increased number of

different strike prices when volume shot up on

October 19 and 20, 1987. They could be further

overwhelmed in the future with multiple-trading of

options, introduction of automated trading systems,

and 24-hour trading.

Most options are now traded exclusively on one

exchange, but this is to change over the next 2 years

(see ch. 5). The trading of options on several

exchanges (’‘multiple-trading”) will require an

expansion of capacity by financial information

vendors. The SEC has been working closely with

options data vendors on their plans to handle this

problem. The introduction of automated trading

systems for after-hours trading by futures and

options exchanges is expected to provide quote

vendors with a glut of information to package and

sell. Smaller vendors are also concerned about the

potential for discrimination in favor of their large

competitor, Reuters, who is helping exchanges to

build the trading systems.20

194 CSEC EXpreSSeS C!oncern About Vendor CWacitY,” Trading Systems Technology, Sept. 26, 1988, p. 6.

ZOAfter Reutms b~t ~ re~.~e pricerep~~g s~ice for the ~ndon Me~ Exc~ge (L~), the exc~ngepmpsed a pricing shllc~ thiltfavored

large vendors such as Reuters. Each vendor would have had to pay a sign-up fee of 50,000 pounds sterling regardless of how many users were taking

that vendors’ quotes. After protests by vendors with small subscriber bases, the LME withdrew the plan and is formulating a new one.
138 ● Electronic Bulls & Bears: U.S. Securities Markets& Information Technology

The transactions systems of securities information processors are not now subjected to SEC

regulation as exchanges. The SEC has in the past

issued no-action letters exempting proprietary trading systems from registering as exchanges. Noaction letters have been issued for 11 proprietary

trading systems to date, with the understanding that

the operators of automated trading systems would

keep the SEC informed of their progress. The agency

is still using the no-action approach, but is working

on a new rule after several sponsors ignored

Commission requests for information; it wants to

prevent possible abuses by foreign counterparties

and ensure that access to the systems is fair and

open.

21

The agency recently proposed a rule requiring

sponsors of proprietary trading systems to file a

financial and operational plan with the Commission.22 Proposed Rule 15c2-10 also gives the SEC

authority to examine all books and records of both

the sponsor and the trading system.

In January 1990 SEC again considered the question of what constitutes an exchange.23 Delta Government Options Corp. had applied for registration

as a clearing agency, to issue, clear, and settle

options on Treasury securities, executed through an

over-the-counter options trading system operated by

RMJ Securities, Inc. This was granted temporarily in

1989, with a concurrent “no-action” letter saying

that the system need not register as an exchange.

CBOT and CME challenged in court the view that

the trading system was not an exchange. The court

returned the case to the SEC for reconsideration and

the SEC reaffirmed its decision after hearing arguments from those opposed to requiring the system to

register as an exchange, and those in favor.

Those opposed to registration argued that to

constitute an exchange, there must be members with

a proprietary interest and representation in the

administration of the exchange, a trading floor to

which orders are routed, listing of securities, an

auction process, a limit order book, and execution of

trades. They further argued that exchange registration of proprietary trading systems would serve no

regulatory purpose and would deter development of

innovative trading systems.

Those advocating a registration requirement (the

CBOT, CME, and CBOE) argued that an exchange

was any mechanism that affords to prospective

buyers and sellers advantages in ‘finding a market,

obtainin g a price, and saving time”; establishes

criteria for admission and discipline of members;

sets margin requirements and trading and position

limits; and has the discretion to terminate trading.

Characteristics such as a system of specialists with

market-maker obligations, a trading floor, and member ownership and representation, they argued, are

historical rather than fundamental attributes of an

exchange.

The SEC, in reaching its decision not to require

exchange representation, said that the fundamental

characteristic of an exchange is its centralization of

trading and the fact that it provides quotations “on

a regular or continuous basis so that those purchasers

and sellers have a reasonable expectation that they

can regularly execute their orders at those price

quotations. The means employed to do this, the

SEC acknowledged, might range from a physical

floor or trading system to other means of intermediation such as a formal market-making system or a

consolidated limit order book or single price auction.

The bulletin board established by the RMJ System,

the SEC said, does not meet this central characterization.

No clear definition of a “bulletin board” was

offered, although it was incidently described as ‘‘a

mechanism whereby indications of interest may be

displayed by participants” (a function subject to

regulation as part of the government securities

brokerage function), and again as “for the episodic

display, by broker-dealers and institutions, of buying and selling interest. ” Such bulletin boards were

not clearly distinguished from either a NASDAQlike system or a GLOBEX-like system, if such

z@n Jtiy 19, 1985, tie SEC issued a no-action letter to Security Pacitlc National Bank concerning their OptiOm on government S=urities on-tie

trading system. Concerned about competitio~ and customer protection and financial integrity in the unregulated system The Chicago Mercantile

Exchange brought their concerns to the attention of the Federal Reserve Board and Cong. John D. Dingell. Convinced that banking could be adversely

effected by such an unregulated exchange, Mr. Dingell urged further consideration by the SEC. Security Pacific sold the system to RMJ.

22ROPS4 Rtie 15c2-10 wodd apply to Reuters’ Instinct subsidiary, but would not affect GLOBEX, since the CFI’C, not the SEC, has jtisdiction

over futures trading. The C13TC has already reviewed and approved GLOBEX.

~SECRel~seNo. 34-27611. Self-Regulatory Organizations: Delta Government Options Corp.; Order Granting Temporary Regktrtion as a ~~g

Agency, Jan. 12, 1990.
Chapter 7-How Technology Is Transforming Securities Markets Ž139

distinction was intended. The SEC said that an

‘‘overinclusive’ approach to its prerogative of

determining what constitutes an exchange “would

place those evolving systems within the ‘strait

jacket’ of exchange regulation” or force it “into a

regulatory scheme for which it is ill-suited. . ..’

As financial information vendors increase their

presence in transactional services, they will have to

deal with regulation for the first time. Even if they

do not enter the transactional business, information

providers may face growing government involvement in their markets because of technological

changes occurring in the industry. If vendors,

exchanges, and customers fail to come to terms on

a pricing structure for digital data transmissions,

customer use of data received from vendors, and

proprietary rights to financial information, these

issues may ultimately be resolved by a government

agency or by the courts.24

U.S. BROKERAGE HOUSES

Brokerage houses use computers to assist in four

major functions of the firm: data compilation and

analysis, trading support, back-office functions, and

surveillance activities.

Data Compilation and Analysis

Brokerage houses receive and monitor market

information via electronic news wire services that

provide the broker with market price information. In

the retail branch offices of U.S. stock brokerage

fins, 90 percent of information services are provided by Quotron and ADP;25 but increasingly

emerging as strong contenders are Reuters, Telerate,

CMQ, Bridge Information Systems, Knight-Ridder

Financial Information, Beta Systems, and Standard

& Poor. Other vendors include Shark (Wang) and PC

Quote. The annual expenditure for information

services is forecast to increase to about $3 billion by

1991.26

A great deal of computing power is spent in

analyzing and formatting raw data for decision

support. Since all brokerage houses have access to

basically the same information, the analytical software and graphics packages they apply to this data

is thought to determine their competitive edge.27

Individual brokers analyze and use the information

differently, so the firm’s computer facility must

support many types of analytical software.

Trading Support

Brokerage houses were once called wire houses’

because of their use of leased wire systems and their

function as a collection point for orders to be wired

to the floor of an exchange. Individual and institutional customers still telephone their broker, but

today orders are then collected by computers and

sent via dedicated lines to trading departments and

exchange floors. Every major wire house has some

type of electronic order entry and routing system.

Program trading (buying and selling diversified

portfolios or baskets of stock) uses computers to

track market movements and enter simultaneous

buy/sell orders according to an algorithm (see chs. 3

and 4).

There are thousands of commercial software

packages available to brokers and traders that focus

on tasks such as portfolio management and risk

assessment. 28 Many of these packages are ‘ ‘projective "

29 they use statistics to predict the price of a

stock or derivative product in a certain time frame.

There are also commercially available pocketpagers, or ‘electronic watchdogs,” often offered by

information services vendors, that offer a variety of

services including alerting brokers to stock price

movements, news events, or SEC filings.

Back-Office Functions

Since the back-office crisis of the 1960s, when

brokerage houses were overwhelmed by paperwork,

the back-offices have relied on computers. To aid in

~potenti~ re~ation of f~nci~ information vendors will become a larger issue as digital data becomes the significant potion of infO_tiOn cost.

The present trend is towards unbundled costs; one price for view only, another for cut and paste capabilities and another for data manipulation rights.

~T~~ndi, IBM Securities Application Systems, New York NY, personal comumnicatiom FebW 1989.

26Hew Fmsko-Weiss, “The Battle for the Broker’s Deslq” High Technology Business, September 1988, p. 30.

27L fAs Telemte and Reut~s move tow~d element~ed digi~ feeds, fie way ~ey display the ~W will no longer be as impo~nt as what they display,”

says Robert Mark in Marine Midland Bank’s capital markets sector, “because software is able to grab specillc data elements and create customized

pages.’

~~sk ~sessment encompasses tie a~ysis of bob ~ket fisk and credit fisk. Credit ~sk is tie fisk tit a cowte~~ wifl go bankrupt whti~s

market risk is the risk that market prices wilt move adversely (away from you).

~Grant J. Renier, “me Electronic Investment System” The Fuzutist, VO1. 16, Ap~ 1982.
140 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

clearing and settlement of accounts, brokerage

houses batch-process massive amounts of data.

Trade confirmation reports from the exchange floors

and information from the clearinghouses must be

reconciled to complete the transaction. Some brokerage houses process these in-house, some use

service vendors. Much of this batch-processing goes

on in the evening hours, or all night, and this will be

a problem for 24-hour trading. In many cases, the

computers used to support trading during trading

hours are used as batch processors in the evening.

This could be remedied with the purchase of

additional machines, but most clearing programs are

designed to run in a batch mode rather than on-line.

The conversion into on-line processing will be

costly, time-consuming, and technologically difficult, considering the massive databases which will

have to be maintained and updated concurrently.

Although 24-hour/global trading may be the strong

impetus, on-line processing has other benefits. Risk

could be greatly reduced by more timely and

accurate characterization of investment positions.

Surveillance Activities

Brokerage houses monitor trading patterns and

investor positions for indications of fraud, violations

of firm policies or other improper activities by

brokers servicing customer accounts and employees

with “information sensitive” jobs (e.g., research

analysts) who may be the source of information

leaks. Compliance efforts also emphasize educating

employees as a deterrent to illegal activity,30 but

surveillance and auditing activities are now among

the more technologically advanced aspects of financial institutions’ technology. Analysts often have the

capability for on-line query or real-time market

surveillance activity. But human analysts are still the

crucial factor; computers merely indicate where

further attention should be directed.

Customer Services

Many brokerage houses lease or sell personal

computer investment systems to small investors. For

example, a personal computer dial-up service lets

people in their homes receive market information,

conduct analysis, and enter buy and sell orders. One

such service has no annual sign-up fee but can cost

the user 27.5 to 44 cents per minute. A large discount

broker serves over 26,000 customers through its

computerized trading system.31 With these systems

individual investors feel “in control” and may feel

able to compete with institutional investors. On the

other hand, many argue that when telephone lines

are jammed on a busy trading day, an investor is no

more likely to get through to a broker on his

computer than he is on his telephone.32 Most

systems are equipped with ‘fail-safe’ techniques to

protect the investor, such as requiring second

confirmations, or stopping them from selling stock

they don’t own or buying more than their margin

limit. Virtually all mechanisms a firm uses for

entering customer orders have a human review

element to protect the firm from error, liability and

loss. 33 Thus, regardless of the transmission details,

there is still a “gatekeeper” that can become a

bottleneck during heavy trading. The function of the

gatekeeper could be an application for expert

systems.

TECHNOLOGY FOR THE

INDIVIDUAL INVESTOR

Of the 40 million individual investors in the

United States, an estimated 2 million use PCs, and

the securities industry claims that perhaps 100,000

are using them to manage portfolios.34 In the near

future, individual investors should have the technology available on home workstations to incorporate

on-line trading, real-time quotes, graphics, portfolio

management, on-line news, reports on investment

activity, and historical data. Some of these services

are now available, but not readily accessible; “windowing” software to split the screen and merge

these services may be expensive and difficult to

operate.

Largely within the last 5 or 6 years, individual

investors have begun to use at-home trading systems

based on a personal computer. Many of them have

-y Vass, “Detection of Illegal Tradin& Systems and Realities in a Large Firm,” presented at the Securities Industry Association Forum on the

Prevention of Insider Trading in New York NY, June 23, 1987.

31*I Gottsc~“Compute~ed ~vestment Systems Thrive as People Seek Control Over Portfolios,” Wall Street Journal, Sept. *7, 1988.

szHoWever, ISDN and Broadband ISDN via intelligent networks could provide network services to help surmount traditional telecommunications

problems.

SST. WiII~, ~o~tion Industry AssociatioIL discussion with OTA Sti.

Wee Siegfried, “Investing in the Year 2000,” Financial World, Feb. 21, 1989, p. 56.
Chapter 7-How Technology Is Transforming Securities Markets ● 141

been quoted as saying that these systems give them

a feeling of being “in control” (although none of

the systems provides automated execution) and

better equipped to compete with the institutional

funds’ professional investment managers. This perception is encouraged by the brokers who provide

the systems, and who have been alarmed by the

perceived “flight of the small investor. ”35 The

industry estimates that 400,000 individual investors

will be using home trading systems by 1992.36 Such

estimates sometimes display more enthusiasm than

analysis, but it appears that the number of users

could have tripled in the last 3 years.

The most widely used home trading system,

provided by the largest discount broker, claims

approximately 50,000 users. Several similar systems

claim about 10,000 to 12,000 customers each.37

These trading systems offer similar services. They

allow the investor, at his computer, to:

● access research databases,

● receive real-time quotes,

. place orders and receive confirmations,

. track the progress of a portfolio, and

. set up dummy portfolios and track their progress.

Trades ordered through one of these systems go to

a broker who routes the order to an exchange.38 The

customer usually gets immediate conflation of a

trade, or if there is to be a delay of a minute or longer

a confirmation is left in a “mailbox’ in the system.

The advantages to the investor are access to information before the trade, greater ease in tracking the

portfolio after the trade, the ability to place orders 24

hours a day (but they can only be executed when the

exchange is open), and a slight reduction in transaction time, chiefly because there is no wait on the

telephone for a broker. (Trades are said to take 15 to

20 seconds, in most cases.) The feeling of “greater

control,’ although it may exist, is not highly

justified.

THE FUTURE: STRATEGIC

TECHNOLOGIES AND THEMES

Expert Systems

An expert system is a computer program that

attempts to replace a human decision process by

using several primary components.39 The first component is the experiential knowledge of an expert

expressed as a set of rules and facts (if/then

statements), more commonly referred to as the

knowledge base. Second is the inference engine, or

the computer program that sorts through the knowledge base and decides which rules apply. With the

inference engine go the user interfaces, an explanation subsystem and a knowledge acquisition subsystem. Respectively, these “front end” components

communicate with the user of the expert system,

reconstruct the reasoning of the system for inspection, and allow the expert or knowledge engineer to

add new or modified rules and facts. The potential

long-range benefits of using expert systems include

savings of professional time, cost savings, and

improved quality and consistency of decisionmaking.

There were early high hopes for applying expert

system (ES) technology to many brokerage house

activities, even possibly replacing the trader, but

users today generally have more conservative expectations.a ES applications for financial firms are

made more difficult both because it is difficult to

formulate real rules for investment decisions and

because there is little agreement on who the experts

are. Systems designed to make investment suggestions are controversial, but have sometimes been

successful. Systems designed to make investment

decisions are met with great resistance from traders,

who trust their instincts to set them apart from other

traders. Only a handful of companies are experimenting with expert systems to ‘‘replace” traders.

Two areas in which ES technology is rapidly

developing are data compilation and analysis and

35~e ~ f-fiveStorS~~ do 1*.Z ~rwnt of the ~a~g, downfiom 19.7 perc~t m 1987, amording to a s~dy by the Swtities Industrim ASSOC~tiOn.

This has been deereasing for years.

360TA discussion with various company representatives.

37’’f’he system idenfi~ by OTA me those of ~les Schwab, kc., Fide@ Investmen~, ~d @ick & Reilly. Them my bC othe~ ~ti comparable

level of use.

38’rhe Fideliy Express Semice says tit @ades ~check~ ~thin the syst~ without h-ninterme~es ~d go ~wfly to the exc~e f100r.

Wad -on and David King, Expert Systems (New York NY: John Wiley & SOm, kc., 19*5).

@JoMthon Fricdland, “The Expert Systems Revolution, ” Institutional Investor, July 1988, p. 107.
142 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

market surveillance. A common example of the first

is a ‘‘news wire sifter. ’ One security firm’s new

workstation will include an expert system that sorts

through the news wire information to determine

whether a user should be alerted to news of an event

or impending event. The New York Stock Exchange

has a similar expert system to sort and analyze news

for market surveillance purposes.

Another application of ES is risk assessment, i.e.,

a rule-based system to analyze the risk of a firms

position in rapidly changing markets. For example,

one firm has a risk management system for corporate

and municipal bond trading, running on a Compaq

386, that sorts through massive amounts of trading

data and asks for additional information when

necessary, to produce a statement of risk for

managements review.

Brokerage house surveillance is beginning to use

rule-based systems to identify trends and anomalies

in trade information. One already in use, that runs on

a PC, has a set of 25 rules; it analyzes trade data and

may suggest that a study should be made of a

particular firm, broker or customer.

Hardware

The strategic initiatives described above are

pushing firms towards faster and better hardware.

Computer industry experts expect that brokerage

houses may buy supercomputers before exchanges

do. Mini-supercomputers are popular but are already

being challenged as having insufficient power to

meet the expanding needs of brokerage houses. Until

April 1989, when Control Data’s ETA Systems

division was closed, Wall Street firms could rent

time on the ETA 10P, the first air-cooled supercomputer that was running portfolio analysis software

and complex freed-income analytics. 41 An analysis

of 150 stocks, each with 15 options, for 500 accounts

that would normally take 6 hours on a 386 (20 mhz)

computer would take only a few minutes on a

supercomputer. However, not many firms utilized

this service.

FURTHER TRENDS

Some industrywide trends are:

●

●

●

●

●

●

●

Firm-wide system integration—Firms are moving towards workstation integration with windowing, so that a user can reach many systems

and information services through distributed

processing. Relational databases are replacing

hierarchical or flat file architectures.42

More end-user computing—This will ease the

burden of the central data processing department and makes system development for user

needs more cost-efficient.

More automation of the back-office-The offfloor support functions have the greatest percentage of labor which could be made more

efficient by automation.

Flexibility to allow for multiple vendors—With

UNIX and 0S/243 becoming more nearly standard as operating systems, this task is becoming

easier.

New tools for easier, faster program writing—

One example is Computer Aided Software

Engineering, CASE. Although firms continue

to buy information services and integration

software, they are increasingly choosing to

build rather than buy their trading room systems.”

Emerging telecommunications capabilities—

ISDN and fiber optic networks are the keys in

this area.45

Cross-training of technical and “business”

side staff—-This is increasing and has been

found especially useful in systems development .46

— — .

41’’Frontline,” Wall Street Computer Review, November 1988, p. 7.

dzsa~ Hamell, “The Movitlg Target, “ Institutional Investor, January 1989, p. 79.

43A reIatio~ &@base is a dam sche~ in which t-he data is stored in tables and the associations between the tables are represented wifi tie dab

itself, as opposed to the schema defining the relationships as in hierarchical or flatfde architectures. David M. Kroenke and Kathleen A. Dol~ Database

Processing, 3d cd., (Chicago, IL: Science Research Associates, Inc., 1988).

~ne m~ket pene~ation of OS~ has been somewhat slow, and its probability for success is a contitig debate.

451vy Schmerken, ‘‘ToBuild or Buy?’ Wall Street ComputerReview, January 1989, p, 33. Peter Penczer, ‘‘Wall Street Rolls Out CASE Technology,”

Wall Street Computer Review, Febrwuy 1989, p. 55.

46Di~u~siom ~~J6W. p~m,AT&TBell Laboratories, Holmdel, NJ. New York Telephone re~ndy armouced tit it will develop itn independent

fiber optic network for securities fms in the New York City area. As of October 1989,27 f- had agreed to purchase voice and data services off of

the network. In the future this network could serve as a platform for other developments such as trading, clearing and settlement processes. New York

Telephones public network will serve as a backup to the private network.
Chapter 7-How Technology Is Transforrning Securities Markets ● 143

● Increased obstacles—Technological advances

in brokerage houses may be proceeding faster

than at exchanges, but they will increasingly be

hampered by an aging computer infrastructure

that has grown difficult to manage.47

The strategic automation initiatives of today’s

brokerage house are being driven by four major

forces: 1) customer demand for service and efficiency; 2) regulatory pressure to maintain a fair and

orderly market; 3) domestic competition and the

resurgence of program trading, which demands

faster computers with more capacity; and 4) fear of

Japanese competition.

There are two major differences in the approach to

automation of the Japanese “Big Four’ securities

firms (Nomura, Daiwa, Nikko, and Yamaichi) and

American firms.48 The Japanese appear to take a

more unified, standardized, long-term approach,

probably because of comparatively loose Japanese

antitrust laws and the influence of the Ministry of

Finance. Japanese firms also appear to plan for 5 to

10 years, unlike the shorter term but more varied

plans of American securities firms.49

For example, the Japanese have standardized

home trading system software on the Nintendo

Family Computer. The Big Four have also issued

magnetic identification cards to customers that

enable them to transfer funds from and to stock

trading accounts at automated teller machines. They

have agreed on protocol, architecture, and command

standards for lap-top computers.50

Although the Japanese seem to be making faster

technological progress with respect to customer

service and hardware, they have lagged behind in

software for analytics and investment strategies.

However, this may not be true with the next

generation of software.

THE MARKETS AND

TECHNOLOGICAL PROGRESS

Technological progress in securities related organizations is subject to two opposing factors: the

urge to use technology for competitive advantage

and resistance from established, powerful market

participants whose role is threatened. Brokerage

houses, regional exchanges, and other organizations

in which automation is a strategic necessity may be

technologically progressive, because they have the

benefit of strong trade-room and executive level

Support. 51

Research and development on leading-edge technologies in the financial industry are often behind

the technical advances and enthusiasm of universities and other industry research laboratories. In July

1988, Coopers & Lybrand estimated that only 50

percent of the major financial services firms in the

United States either used or were developing leadingedge technology, such as expert systems.52

For example, in 1988, Ford spent approximately

$200 million on expert systems research and development, while the entire financial services industry

spent only $50 million. Competitive secrecy is

perhaps part of the reason that universities and

electronics research and development facilities are

not utilized for joint financial information projects.

It may also be that the right financial incentives for,

or vehicles to establish, cooperative efforts are

lacking or not known to the financial industry. Many

States have started technology transfer centers,

which facilitate industry and university consortia.

The long-run benefits of being on the leading edge

of technology may make it worth efforts to utilizing

them.

Standards for Automation

Standards are needed for securities industry automation in three categories: data, technology, and

operational standards. Data standards apply to the

definition, form, and transmission of data. TechnolAyDiscussions with Joseph Rosen, Rosen Kupperman Associates, Riverdde, NY.

~Pavm &@@, “Automationat the ‘Big Four’ Securities Firms, ’ Wall Street Computer Review, January 1989, p. 22. These Japanese firms are much

larger than the biggest five U.S. firms combined.

49t~~e us shofi.te~ focus is hurting Our twhnologic~ Prowess)” . . according to Robert Mark Manufacturers Hanovex.

~See S~~, Op. cit., footnote 48.

51~e U.S. fi~e~ and options ~xc~ges’ ~cent t~hnologic~ progress with GLOBEX (WRC) md AURORA (C’BOT) Wm reportedly reSiStd by

floor brokers until competitive pressures forced the systems’ acceptance for off-hours trading.

szAcm~~g t. Fred clo~ey, Dre~elBu*~e~~c., New York NY, ptiSOIMI communicatio~ Nkch 1989.
144 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

ogy standards apply to the hardware, software, and

communications aspects of automation. Operational

standards apply to the way inter-professional transactions are handled. Currently the sea of “standards” includes AT&T/Sun, IEEE (Institute of Electrical and Electronic Engineers), CCITT (Comite

Consultatif Internationale de Telegraphique), POSIX

(Portable Operating System Interface Specification),

X/OPEN, and OSF.53

In general, standardization in the securitiesrelated industry is driven by two pressures: normal

attrition in the computer/electronics industry, which

leaves the survivors as market leaders the “preferable’ companies from which to buy, and the industrywide need to integrate diverse systems. Attrition is

a double-edged sword, as it intensifies competition

in the computer industry, making standards resolution even more difficult. During the 1970s and

1980s, as volume increased, Wall Street firms used

high profits to acquire systems of all makes and

models with little concern that they might be

incompatible, or would have a short economic life.

Although competition in the vendor community is

still fierce, these two pressures toward standardization are prompting vendors of software, market

information, hardware, and other systems to form

strategic alliances to solve automation needs. Tighter

Wall Street budgets are also forcing firms to look to

integration rather than replacement. Those companies specializing in systems integration platforms

are currently very important to the industry. However, this requires software vendors to expand their

hardware compatibility and the hardware vendors to

expose their proprietary architecture. Although more

established standards may begin to appear, systems

builders will still incorporate sufficient flexibility

and variation in the systems to enable organizations

to create their own competitive advantage.

It may be that market forces could produce data

standards in a reasonable length of time. However,

the road to technology standards is much longer,

and, given the competitive computer industry, is less

likely to be brought about by market forces. Proprietary (provider-controlled) technology standards setting could be bad not only for the U.S. computer/

electronics industry, but also for the securitiesrelated industry. Progress and innovation in technology are more likely to be fueled by a competitive

environment.

On the other hand, “open’ technology standards,

which allow multiple suppliers to furnish systems

elements and enhance their ability to work cooperatively, may promote this competition and improve

system efficiency and productivity. Standardization

will certainly be necessary for the United States to

move further toward an integrated national market

system. Such open standards could be developed by

broad-based industry groups, standards organizaions, and/or government.

By comparison, data standards could be established more easily and would also increase productivity and U.S. competitiveness. Beyond the issue of

U.S. data standards, is the issue of global standards.

The array of considerations necessary when attempting to set such global standards range from language

agreements to holiday s.% The development of

securities-related industry data standards could,

however, give the United States an early advantage

in non-U.S. markets, such as Japan and 1992 Europe.

As an example, the development, deployment, and

acceptance of broadband, or even narrowband,

Integrated Services Digital Network (ISDN) would

increase productivity and efficiency by integrating

voice with high-speed computer-to-computer communications and video for complex analysis graphics capabilities.

Currently, telecommunications domestically (Tl,

ANSI, and IEEE) and internationally (CCITT and

ISO) are progressing towards broadband ISDN

standards. 55 However, to achieve real standards, a

serious industry-wide effort must be made which

targets coordination of U.S. with global standards. A

standing committee with a charter and discipline

might bean effective way to approach data standardssetting.56 The committee members would have to be

influential and committed to a long-term effort.

SWictor Kulkosky, “Strategic Alliances Buoy New Technology Boom,” Wall Street Computer Review, May 1989, p. 19.

Wonsider the scenario of the Oct. 19,1987 market break occurring 1 week earlier, on Columbus Day, when the exchanges weze open but the banks

were closed.

ss~e sate Department co~~catiom and ~ormation Policy/Ikchnical Standards Development Bureau (~/’rSD) has ~nactive ~

coordinating the U.S. position on broadband ISDN and related work.

56uw~ _ofmcould include s~n~~~g order message ~d ex~ution ~port formats ~d a @ol scheme for find-income ad money

market instruments (very complex).
Chapter 7-HOW Technology Is Transforming Securities Markets . 145

Government oversight, perhaps including the State

Department and National Institute of Standards and

Technology, may be the most effective method of

ensuring implementation of such an entity and

charter. Another alternative would be an industry

driven approach such as the Securities Industry

Association (SIA) or the Futures Industry Association (FIA).

24-Hour Global Trading Systems

There are financial centers in Aukland, London,

Paris, Frankfurt, Zurich, Hong Kong, Tokyo, Singapore, and Sydney, all of which now operate futures

and options exchanges as well as stock exchanges.

Because foreign exchanges began to offer their own

versions of U.S. contracts, investment firms were

able to offer products to customers without regard to

trading hours in the United States. U.S. futures

exchanges began to suffer volume losses. This trend

originally drove the exchanges to consider accommodating 24-hour trading.

57 The first attempts to

meet this need took the form of mutual offset

agreements, such as the one between The Chicago

Mercantile Exchange (CME) and the Singapore

International Monetary Exchange (SIMEX) for Eurodollar and foreign currency contracts. Of the many

offset agreements attempted by exchanges, SIMEX

was for a time one of the most successful, although

only marginally so.

In September of 1987, CME announced that it had

developed, together with Reuters, the Post (Pre)

Market Trade System, later renamed GLOBEX for

“global exchange. ” With the assurance that

GLOBEX was strictly an off-hours system, and in

exchange for receiving a portion of the revenues

generated by GLOBEX, CME members accepted

the idea.

In 1989 The Chicago Board of Trade (CBOT)

unveiled plans for another off-hours global system,

“AURORA.” The GLOBEX system is an automatic order matching system, while AURORA

attempted to emulate the traders in the pit with icons

that offered the ability for traders to select the

counterpart to their trade. However, there were

complaints from the financial community about the

necessity of installing two terminals, and in late May

1990, the CME and the CBOT announced they

would merge GLOBEX and AURORA. In fact, the

GLOBEX system was the victor. Despite the fact

that Reuters is a British company, this is a strategic

move for the preservation of the U.S. position in

commodities and futures trading.58

There are many risks and barriers involved with

implementing 24-hour global trading systems. Some

foreign countries still restrict access to their markets.

Involving the country’s own securities exchange is

in that case often seen as a good entry strategy .59

Clearinghouses in moving into 24-hour operation

may incur large costs in changing operations and

practices. However, clearing in a shorter time frame

should reduce traders financial risk.60 ‘‘Fedwire’ ’61

does not operate 24 hours a day; other methods of

money transfer will need to be devised, some of

which may not be as secure. Communications

outages, in general, are an important factor. Line

outage contingency plans, which must coordinate

several countries, different languages, staggered

time zones and varying numbers of telephone

companies, are difficult to formulate.62 Lastly, there

is a management barrier: 24-hour operations require

competent and experienced management at all levels

around the clock.

Electronic 24-hour global trading, regardless of

product, has several barriers yet to be conquered.

The first pertains to basic global data standards, as

addressed above. There is also the issue of international regulation. In order to control market and

credit risk globally, there will have to be an

international government/industry effort.63 This is

also true of coordinating post-trade practices, which

could prove to be difficult, considering that some

foreign exchanges presently remain with a 2-week or

sTKaren Pierog, “How Technology Is Tackling 24-Hour Global Markets,” Furures, June 1989, p. 68.

s8Wil~ Cmword, Jr., “MERC, CBOT Plan After-Hours Trade System,” Washington Post, May 27, 1989, p. D1l.

59For ~=ple, the ~RC-@~ joint effofi on the Nikkei index facih~ted workings witithe Japanese MhdS@y Of Finance.

@GLOBEX has a parallel “Guard” system, which monitors positions real-time and prevents participants from entering into certain unsafe

transactions.

61 For tier information on Fedwire, see ch. 6.

62For exaple, to fi~ a dedi~ted c~c~t from New York to Tokyo can invo]ve fmm five to seven tekXomlmUIkatioIIS COmp~eS.

63~ tie case of GLOBEX, the commofi~ F-esTrading Commission (C~Q ~.sefig j~sdiction was a major enticement tO Sydney ad the

MATIF to join. However, the CWC alone may have limited jurisdiction over foreign participants in the instance of a crisis.
146 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

longer settlement cycle. It is not, in other words, which the private sector can do only so much and

technological capabilities that can hold back the government participation may increasingly be crumovement toward 24-hour global trading, but policy cial. These international issues are discussed in an

problems such as data standards, regulation, and OTA Background Paper, Trading Around the Clock:

post-trade activities. Additionally, international com- Global Securities Markets and Information Techpetition is also a major force. These are all areas in nology.
Chapter 8

Market Fraud and Its Victims
CONTENTS

Page

ABUSES IN U.S. SECURITIES MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

SEC Authorities .. .......+..........+..+.. ..........+.”””.”””0.oc”o” •“0”00”~+0

Insider Trading .. .. .. .. .. .. ... +.. . . . . . . . . .. .. .. .. .. .. .. . ””

Frontrunning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Other

Penny

Violations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......t.toeaQo~oo “~oc.””o+~+

Arbitration .

International

Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..................+~””~.o

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..~,..”. . . . . . . . . .*...””” ““””. . . . . . .

Securities Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .........+~””*.”

FRAUD IN FUTURES TRADING .. .. .. ... ... ..+..... .. .. .. .. .. .. .. .+. ..+. . . . . . . .

Approaches To Reducing Fraud in Futures Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

.49

.49

.50

.52

.52

.53

.56

.56

.59

.61

Box

Box Page

8-A. Continued Need for Coordination of Federal, SRO, and State Actions . . . . . . . . . . . 155

Table

Table Page

8-1. Foreign Activity in U.S. Corporate Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Chapter 8

Market Fraud and Its Victims

Fraud in securities markets and fraud in futures

markets stem from greed and corruption and, in

some cases, naivete' on the part of the victims. They

are similar in that detection and enforcement can be

difficult. They differ in the details of the abusive

practices. There is little consensus on whether the

losses to public customers are greater in securities or

futures markets, and there are no widely accepted

figures for the magnitude of the losses in either

market.1

Public attention has recently been drawn to a

variety of abuses in financial markets, including

insider trading, sales abuses and penny stock scams

in securities markets, and fraud in futures trading

pits. As a result, legal authorities and resources for

enforcement are being bolstered. Coordination among

regulators and law enforcement authorities is improving. International cooperation is also beginning

to broaden.

There will always be opportunities for fraudulent

or abusive behavior, but domestic actions in recent

years by Congress, the Securities and Exchange

Commission (SEC) and Commodities Futures Trading Commission (CFTC), self-regulatory organizations (SROs), and States show promise of reducing

some types of abuses and, in some cases, have raised

the penalties for convictions. Related actions concerning international fraud, including those involving foreign countries, should also narrow the scope

of familiar opportunities for low-risk fraud and

abuse. However, many of these actions are relatively

new and still evolving, so it is too early to judge their

long-term effectiveness.

Fraud and abuse are certain to continue in one

form or another and increasingly will become

international. Legislators in the world’s major trading markets will have to judge where to target their

limited resources. Recent domestic efforts to institutionalize the coordination of Federal, State, and SRO

actions to deter abuse will have to become more

coordinated internationally in order to be effective.

Undoubtedly, there will be a need for continuing

congressional attention as new opportunities emerge

for fraudulent behavior in both domestic and international trading.

The further adoption of modern electronic systems both for floor and off-exchange trading can

reduce opportunities for fraud in both securities and

futures markets. Modern systems can eliminate

many, although not all, kinds of abuses. Some types

of abusive activities, both in securities and futures

markets, will remain difficult to detect and prosecute.

ABUSES IN U.S. SECURITIES

MARKETS

SEC Authorities

The SEC, which has primary responsibility for

detection and deterrence of fraud in the securities

markets, has responded to the increases in fraud not

only with targeted enforcement initiatives (e.g.,

against penny stock fraud), but also by seeking and

applying tougher enforcement remedies (e.g., civil

penalties for insider traders). The SEC also works

closely with SROs, other Federal agencies, and State

and foreign authorities to coordinate investigations

and share information for enforcement purposes.

The SEC has broad authority to enforce the

Federal securities laws through the filing of civil

actions in the Federal courts and through administrative proceedings. These enforcement actions are

generally preceded by an investigation (or an

inspection of regulated entities). The Federal securities laws authorize the SEC to initiate formal

investigations, in order to issue subpoenas to compel

testimony and the production of books and records.

In the Federal courts, the principal remedy available to the SEC is a civil injunction, which prohibits

future violations of the securities laws. Noncompliance with an injunction is punishable as civil or

criminal contempt, and may result in fines or

imprisonment. In addition, the SEC often seeks

other equitable relief such as forfeiture of ill-gotten

gains or rescission. In SEC actions for insider

l~e NoW~eric~S-ties Administrators Assoc~tion estites that fraud in penny stock StXUIit.kS alone, diSCuSSed kter, -OUUted to *out

$2 billion in 1987 and 1988. Survey of Penny Stock Fraud and Abuse, a report by NASAA for the House of Representatives, Subcommittee on

Telecommunications and Finance, submitted September 1989.

–149-
150 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

trading violations, civil penalties can be imposed of

up to three times the profit gained or loss avoided as

a result of such violations.

The SEC may institute several types of administrative proceedings. Most such proceedings are

brought against regulated entities (e.g., brokers,

dealers, investment companies, and others).2 Sanctions that may be imposed upon regulated entities

range from censure to a revocation of registration,

while sanctions for “associated persons” range

from censure to being barred from association with

regulated entities. Administrative proceedings may

also be instituted against persons who appear or

practice before the SEC, such as attorneys and

accountants. The SEC may suspend or bar them

from appearance or practice before the agency.3

The SEC also is authorized to refer matters to the

U.S. Attorney General for possible criminal action,

and it exchanges information and assists in investigations into possible criminal violations of the

securities laws.4

Recently, several bills have been introduced to

further strengthen the SEC’s enforcement capacity.

The Securities Law Enforcement Remedies Act

(Remedies Act), introduced as H.R. 975 and S.647,

would strengthen Federal courts’ and the SEC’s

authorities to levy penalties on violators of securities

laws, require disgorgement, and issue cease-anddesist orders.5 The Remedies Act also would amend

the Federal Criminal Code to make it easier for

Federal courts to issue orders permitting disclosure

of grand jury information to the SEC for use in

matters within the agency’s jurisdiction. The International Securities Enforcement Cooperation Act,

introduced as H.R. 1396 and S.646, would, among

other things, permit the SEC and the SROs to deny

registration to persons who have been sanctioned by

foreign regulators, and would exempt confidential

documents received from foreign authorities from

disclosure under the Freedom of Information Act,

thereby removing an impediment to the development of information from, and negotiation of memoranda of understanding with, foreign authorities.6

The SROs also play an active part in the detection

and deterrence of unlawful conduct, under the

oversight of the SEC. They monitor trade and

transaction data to detect suspicious trading patterns, and may initiate their own investigations and

disciplinary actions against their member firms and

persons associated with the fins. The SROs are

authorized to apply penalties that include frees,

suspensions, and revocations of stock assignments

to specialists. The SROs may refer certain matters to

the SEC for possible enforcement action.7

The SROs formed the Intermarket Surveillance

Group (ISG) in 1981 to facilitate the sharing of

information and the coordination of inter-market

surveillance activities. The ISG provides access by

the SROs to a computerized database containing

audit trail and clearing information on all transactions in each market in which a security or derivative

contract is traded. When an SRO begins an intermarket trading investigation, the information is

readily available from the ISG database.

Insider Trading

Insider trading refers to “the purchase or sale of

securities in breach of a fiduciary duty or other

Zsee, e.g., sec. 15(b)(4) and (6) of the Sectities Exchange ~t”

317 CFR 201.2, Rde 2(e) of the SEC’S Rules of Practice. Other administrative proceedings may be instituted to suspend the effectiveness of ~

issuer’s registration statement contig false or misleading statements, or to order compliance with reporting, beneilcial ownership, proxy, and tender

offer provisions of the Exchange Act.

4Although CrhllhZd proceedings generally involve only the most egregious fraudulent conduc~ criminal penalties are available for any willful

violations of the federal securities laws. (See, e.g., sec. 32 of the Securities Exchange Act.) U.S. Attorneys may exercise prosecutorial discretion to charge

violations of various provisions of the Federal Criminal Code (typically relying upon the mail and wire fraud statutes) in cases involving conduct that

would constitute securities law violations. In addition, the Racketeer Influenced and Corrupt Organization Act (RICO) has been used, on occasio~ in

connection with indictments for securities law violations. Because RICO permits pre-trial seizure of assets as well as the imposition of treble damages

after conviction, its use in white-collar crime contexts has been the subject of criticism.

5~e Act would: 1) autho~e tie Federal courts to order the payment of civil money penalties fOr ViOktiOm Of the Securities laws; z) authorim tie

SEC to order disgorgement and impose civil penalties in certain administrative proceedings; 3) authorize the SEC to issue cease-anddesist orders; and

4) expressly affirm the authority of the Federal courts to issue orders that prohibit individuals who have committed egregious violations of the general

antifraud provisions from serving as oftlcers or directors of any reporting company.

@ther bills recently introduced include the Penny Stock Reform Act of 1990, H.R. 4497; the Corporate Integrity and Full Disclosure Act, S.1886;

and the Investor Equality Act of 1989, S.1658.

~ecause the SROS may exercise authority only over their members and persons associated with their members, cases requiring wider inquiry are

generally referred to the SEC. As a practical matter, for example, ail insider trading cases are referred to the SEC.
Chapter 8- Market Fraud and Its Victims Ž151

relationship of trust or confidence, while in possession of material nonpublic information about an

issuer or the trading market for an issuer’s securities.’ In other words, someone uses privileged

information not available to the public to make, or to

assist others to make, profitable trades. Federal

securities laws prohibit such trading not only by

corporate officers and directors and other persons

having a relationship of trust and confidence with

the issuer or its shareholders, but also by persons

who misappropriate material nonpublic information

from sources other than the issuer. “Tippees” of

such persons may also be subject to the prohibition.

Insider trading in the context of tender offers is

specifically prohibited.8

Enforcement actions against insider trading are

brought by the SEC under the general antifraud

provisions of the securities laws.9 The Insider

Trading Sanctions Act of 1984 (ITSA) authorized

the imposition of civil penalties in insider trading

cases of up to three times the profit gained or the loss

avoided by insider trading. The Insider Trading and

Securities Fraud Enforcement Act of 1988

(ITSFEA) further amended the Federal securities

laws.10 ITSA and ITSFEA also contain provisions

that increase the criminal penalties for violations of

securities laws, including insider trading violations.11

Market vulnerability to insider trading increased

in recent years because of the increased numbers of

mergers and acquisitions.12 Increases in stock prices

just before the announcement of major corporate

announcements may be an indicator of insider

trading. The General Accounting Office (GAO)

reported that for a 2-year period (1986-87), the

records of the major exchanges showed 83,000

“business events or anomalous trading that warranted analysis. ’ ’13 Of these, 468 were investigated

and referred to the SEC, which then investigated

203, or 43 percent.14

Trades by insiders must be reported to the SEC,

which publishes a record of these transactions in its

Official Summary of Security Transactions and

Holdings. A number of studies using such data have

shown that, generally, stocks in which there has been

heavy insider buying provide returns that are significantly above average, 15 thus rewarding the early

inside trader.

The detection of insider trading on the regional

exchanges is more difficult because data on transactions is collected and sorted by a manual process,

rather than by automated systems. On all exchanges,

much of the evidence on insider trading comes from

cooperative witnesses. As much as one-third of such

trading may be conducted through foreign bank

S’rhe Fede~ s~~ties laws do not con~ a deffition of tiidm trading, and the scope of the violation has therefOre been a matter Of jUdiCid

determination. Congress has on occasion considered the possibility of adopting a deftitiou most recently in connection with S.1380, the Insider Trading

Proscriptions Act of 1987, introduced on June 17, 1987.

The U.S. Court of Appeals for the Second Circuit in 1990 reversed the crimimd conviction of Robert Chestman in a case involving the liability of

a “remote tippee,” i.e., one who does not have a fiduciary or other relationship of trust or confldeme, but acts on insider information. One of the three

opinions in the case suggested that the SEC’s Rule 14e-3 is overly broad.

tiarily Section lo(b) of the Exchange Act and Rule IOb-5.

Iwt: 1) exp~ded the scope of civil penalties to “controlling perSons” who fail to take appropriate measures to prevent insider trading by their

employees; 2)gave the SEC the authority to award payments to persons who provide information regarding insider trading violations; 3) requires brokers,

dealers and investment advisers to establish maintain and enforce written policies designed to prevent misuse of material, nonpublic informatio~ 4)

increaws the maximum jail term and fme for those convicted of criminal securities law violations; 5) coditles a private right of action for persons who

trade at the same time as, and on the opposite side of the market from, insider traders; 6) enhances the SEC’s authority to assist foreign governmental

authorities in the investigation of international securities laws violations; and 7) authorized a study of the adequacy of present securities laws.

Ilwith the ITSA ~d ITSFJ3A ~end.ments, the Exchnge Act now provides that individuals convicted of securities violations may be SentenCCd to

amaximurn term of 10 years imprisonment and freed up to $1 million. Securities fns, corporate issuecs, and other defendants may be freed a maximum

of $2.5 million. These penalties in criminal actions may be obtained in addition to remedial relief obtained in actions by the SEC.

12R=ent s~dies fidicate tit insider @a&g ~s continued ~d possibly increased, despite re@atory mSpOnSCS tO such conduct, with IWge profits

to its practitioners. See Nasser Arshadi and Thomas H. Eyssell (University of Missouri, St. Louis), ‘‘The Law and Finance of Corporate Insider Trading:

The Effects of Regulation on the Volume and Incidence of Insider Trading Prior to Tender Offers,” a paper presented at the European Conference on

Financial Integration, June 28-30, 1989, University of Paris, Dauphiue, France.

13u.s. ~m~~cow~g~lce, Secun”tie~Regulation: E@o~5 to Detect,lnvestigate, andDeterInsider Tr~ing, GAO/GGD-88-l 16, Au~st 1988.

The analysis covered the NYSE, AMEX, NASD and CBOE, together having 90 percent of trade volume.

14~~ces of smpat~ insider ~~gMe us~ly referred to the SEC which my invoke is subp~m power to compel production Of do~~ts

and testimony.

15Norman G. Fosbaclq Stock h4arketLogic:A SophisticatedApproach to Profits on Wall Street, May 1987, pp. 235-239. The author is editor of ‘The

Insiders,” an investment advisory service providing coverage of insider trading activities.
152 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

accounts, and many countries have legal barriers to

providing evidence in such cases.

The investigation of insider trading cases is often

more complex than other types of investigations,

because the SEC must usually rely upon proof by

circumstantial evidence or on informers. In addition,

trading by or through foreign banks or brokers may

make it more difficult to identify the persons who

engage in insider trading.

During the 1980s, the SEC clearly seemed to

change course by bolstering its enforcement actions

against insider trading. The number of insider

trading actions brought by the SEC has increased

dramatically. From 1934 to 1979, there were only 53

such actions. From 1980 through 1983 there were 10

actions, and from 1984 through 1987, the SEC

brought 61 cases, an average of 15 per year, with 21

cases filed in 1987 alone. In 1988 there were 27

cases, and in 1989 there were 42.

In spite of these prosecutions, however, insider

trading still flourishes. A recent study indicated that,

in the year from May 1986 (when inside traders

Dennis Levine and Ivan Bees@ were arrested) to

April 1987, while “inside-insider” trading sharply

decreased, “outside-insider” trading did not.16 The

study suggested that this may be because court

decisions have narrowed the coverage of inside

trading laws to those having fiduciary duties to the

firm issuing the stock or to others having related

responsibilities (i.e., brokers) .17

Frontrunning

Frontrunnin g is the purchase or sale of securities

by a person who possesses “material nonpublic

information’ regarding an imminent block transaction. The typical case involves a broker who trades

in advance of a large order placed by one of its

customers. The broker can profit by such trades if the

block order is large enough to affect the price of the

security in which the broker is trading.18 Frontrunning can also occur in inter-market trading.19

Frontrunning is primarily regulated by the SROs.

While none of the SROs has a specific rule in this

area, their rules of just and equitable principles of

trading have been uniformly interpreted as prohibiting frontrunning and written statements to this

effect have been issued to the members of the

self-regulatory organizations.20

‘‘Self-fron trunning’ involves the purchase of

futures or options by a broker in advance of a large

trade for its own account in the equities market.

While such transactions are not prohibited by

existing rules, some critics maintain that they may

account for ‘‘extraordinary volatility ”21 that others

have more generally blamed on stock-index arbitrage, and argue that this intra- or inter-market

frontrunning is ‘‘increasingly manipulative and

detrimental.” 22 In late 1989, the New York Stock

Exchange (NYSE) and two futures exchanges began

a study of manipulative program trading that was

suspected to have caused unusual price differences

between stock-index futures and underlying stock.

Other Violations

While insider trading and penny stock fraud have

dominated the headlines in recent years, other forms

of fraud by broker-dealers also continue to cause

losses to investors.

16As~ and Eyssell, op. cit., footnote 9. “Outside+insiders” are, for example, a fro’s lawyers.

17~ my lggq a New York Ctimit Co@ of Appe~s panel tier reduced the SEC’s ability to prosecute insider -ding cmm. The COW adopt~

a narrow interpretation of the conditions under which those who receive inside informatio~ i.e., “remote tippees, ” can be held liable under the SEC’s

Rule 10135. This decisions expected to make SEC prosecutions of remote tippeesmore difficult. The same Court’s decision also narrowed the conditions

under which the SEC may prosecute insider trading cases using Rule 14+3. This rule prohibits anyone from knowingly trading on inside information

in takeover situations.

lsFrontrunnm“ g is not limited to transactions in the same security as the block order, and may involve, for example, transactions in options on those

securities.

19A reP~ of the NYSE3s blueribbon p~el ficluded among its conclusions concern about the existence of widespread inter-market trading abUSeS

involving the stock options, and futures markets, and suggested that inter-market regulation and su.meillance systems need to be improved “to prevent

undetected wrongdoing in today’s complex marketplace.’ NYSE, Market Volatility and Investor Confidence, June 7, 1990.

-e written statements regarding frontrumdng were amended in 1987 by the SROS to clarify that trading in index options by persons possessing

material, nonpublic information concerning imminent transactions in the component stocks of an index may also constitute fiontnmning in violation

of the rules of just and equitable trading.

ZIGer~d Beime, fi a le~er dat~ Da. 6, 1988, to the sEC secretary E sEC ffle SR-NYSE-88-34, which proposed a mle Change re fiOnhWlll@.

22T~timonyby John J. Morton iuHearings on tie Stock Market Reform Act of 1989, before the SUbCOrnmittee on Telecommunications and Finance,

Committee on Energy and Commerce, House of Representatives, July 27, 1989.
Chapter 8-Market Fraud and Its Victims ● 153

A survey conducted by the North American

Securities Administrators Association (NASAA)

following the 1987 crash noted that investors in

options were the most likely to complain of abusive

broker sales practices that preceded the crash.23

Many investors who suffered major losses were not

suitable candidates for placement in options markets

by stockbrokers. For example, unsuitable investment strategies executed by brokers accounted for

40 percent of all options-related complaints, though

only 9 percent of common stock-related complaints.

Investors also overwhelmingly expressed a lack of

understanding of margin agreements, mutual fund

fees and procedures, and the existence of mandatory

arbitration clauses in the written customer agreements filed with their brokers. NASAA concluded

that half of the problems complained of by investors

might have been prevented if brokers had observed

proper sales practice rules, and suggested that much

of the financial loss suffered by individual investors

was unnecessary and avoidable.

These cases often involve stockbrokers who put

their clients into unsuitable investments, such as

“naked’ call options (where the customer does not

own the underlying securities, putting him at risk of

unlimited obligations), churn customers’ accounts to

raise commissions,24 and coax customers into signing agreements which give the stockbroker discretionary authority to make investment decisions

without prior approval by the customer.

Those who were subject to abuse often were small

investors who did not understand the risks incurred,

because of relative lack of experience and training in

financial markets, as indicated by income and

education levels.

Stock market abuses tend to have colorful names.

A few other commonly recognized ones include:

●

●

Parking-One attempting a takeover gets others to buy stock with the commitment to sell it

back to him later, allowing the takeover specialist to circumvent the requirement that

anyone who owns 5 percent of a company’s

stock report this to the SEC.

Soft dollar abuses—’ Soft dollars” are rebates

on broker commissions made to large institu-

●

tional customers in the form of free research,

computer services, or other trading-related

services. Soft dollar arrangements are not per se

illegal, but are subject to abuses such as

offering investment managers research resultsor even free vacations and expensive gifts—

that do not benefit the customers who pay for

them. Such practices raise concerns about

conflicts of interest and the manager’s fulfillment of fiduciary obligations to customers.

Wash sales-securities transactions involving

no real change of ownership, for example, a

sale to one’s spouse or simultaneous sale from

one account and purchase to another account of

the same person. Such transactions have been

used as part of stock manipulations schemes, to

create the appearance of active trading in a

security.

Penny Stock Fraud

“Penny stocks” is a term used to refer to

low-priced securities traded in the over-the-counter

market. While the majority of these securities are

quoted in the “Pink Sheets” published by the

National Quotation Bureau, Inc., many are quoted

through the National Association of Securities

Dealers Automated Quotation (NASDAQ) system.

Many penny stocks represent legitimate investment

opportunities. However, many other penny stocks

are used in fraudulent schemes. They usually involve “shell” companies with no operating history,

few employees, few assets, no legitimate prospects

for business success, and markets that are manipulated to the benefit of the promoters of the companies or the market professionals involved.

Penny stock scams generally involve high-

-pressure sales operations from “boiler rooms”

where unsolicited, or cold, telephone calls are made

to prospective clients whose names are obtained

from telephone books or other readily available lists.

Prospective clients, often unsophisticated in such

investments, are promised large, rapid, and often

“guaranteed’ returns on their investments. Many of

them end up with little to show for their investments

and no way to recover their losses.

~NAS~conducteda telephone hot.l~e s~e~ for about aye~w~chre~iv~ ~ous~ds of compl~ts fmmfivestors conce~g abusive practices

by brokerage fins. About half of the complaints reflected inadequacies in investor protection measures, or poor supervision of stockbrokers, e.g.,

unsuitability of investment unauthorized trading, and false and misleading investments. The NASAA Hot Line 1988 Survey, October 1988.

~ChW~g fivolves excessive @a@ by a broker ~ a ~stomer’s acco~t over w~ch tie broker exercises discrefio~aWhOrity.
154 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

There is also a ‘‘wholesale” side in which a

network of traders in different firms might control

trading among themselves (“boxing” the stock),

perhaps including sales to the public, to manipulate

the price of a stock. This type of operation typically

involves thinly traded stock and may include buying

and holding a large block of stock off the market

(i.e., “parking” it, making manipulation easier).

Customers are sold stock from inventory after its

price rises significantly.25 Customers who decide to

sell may find that their holdings are illiquid and

therefore either worthless or can only be sold at a

significant loss.

There is no solid data on the number of investors

in the United States who are bilked of their

investments by penny stock operators, but they

probably number at least in the tens of thousands

each year. Heightened enforcement efforts by the

SEC, NASD, and State agencies manage to uncover

many such operations, but the same violators often

quickly reappear in new scam operations, or as

consultants in other operations, and can move

rapidly from one State to another, or to off-shore

locations. State regulators observe that gathering

evidence on penny stock scams often requires inside

informers or wiretaps, and that efforts to prosecute

are often frustrated. These frustrations sometimes

lead to criticisms of the SEC, whether justified or

not. (See box 8-A.)

SEC officials note that their empirical data

indicates that beginning in 1988 the increase in the

number of SEC ‘cause examinations’ ’26 was largely

attributable to penny stock fraud, but by mid-1990

there was a substantial decline in the number of

penny stock broker-dealers. Yet, some experts in

State enforcement functions are skeptical that these

scams will ever be eradicated because they are

lucrative for operators, and difficult to detect and

prosecute, and the operators often don’t get prosecuted. 27

Although penny stock fraud remains a major

problem, Federal and State enforcement agencies are

continuing their efforts to stem abuses. For example,

in October 1988, the SEC established the Penny

Stock Task Force. The Task Force has focused on:

1) increased coordination and information sharing

with other Federal, State and local regulators and

prosecutors; 2) stepped-up enforcement activities; 3)

targeted regulatory solutions to the problem of

penny stock fraud; and 4) increased investor education. The SEC brought 68 enforcement actions

during 1989, compared to 43 actions in 1988.

The SEC’s new “cold call” rule28 is designed to

address the problem of high-pressure telephone

solicitations by penny stock boiler room operators.

It requires brokers and dealers to approve new

customers’ accounts for transactions in penny stocks

by making and providing to the customer, before his

frost purchase, a written determination that penny

stocks are suitable for the customer. In addition, the

broker or dealer must obtain the customer’s written

agreement to initiate penny stock purchases.29

In the last 3 years, the NASD brought some 250

enforcement cases of its own in the penny stock area,

and now makes many surprise audits. The NASD

now operates an investor information system to

disclose brokers’ disciplinary histories and has

recently introduced an electronic bulletin board that

captures and displays on a real-time basis, during

market hours, firm and non-firm quotations, or

unpriced indications of interest in eligible over-thecounter (OTC) securities. The bulletin board provides the frost computerized listings of penny stocks.

The Justice Department has brought numerous

indictments involving activities by penny stock

fins, including Blinder, Robinson & Co., F.D.

2% a recent court cme involving a group involved with a now bankrupt fraudulent penny stock operation based in Florid% the tiP~ted Prices

of three stocks increased between 400 and 1,100 percent in a few weeks. Press release: “Two Principals of Flori&-Based Penny Stock Securities

Brokerage Plead Guilty Today in Connection With the Price Manipulation of Three Stocks,” U.S. Attorney, District of New Jersey, May 24, 1990.

‘Cause exruminations are initiated when there is an indication of wrongdoing serious enough to warrant further SEC inquiry.

~OTA interview with Richard Barry, New Jersey Bureau of securities, JtiY 11, 1990

2$R~e 15c2~, 17 C-F*R. 244).15 c2.fj.

Q~e SEC has aISO proposed amendments to Rule 15c2-11 under the Exchange Ac~ which would increase the responsibilities of broker-d~em who

make markets in penny stocks. Rule 15c2-11 governs the submission and publication of quotations by broker-dealers for certain over-the-counter

securities that are not traded on the NASDAQ system. In general, the rule requires broker-dealers to obtain specified financial and other information

about anissuerbefore initiating quotations. The proposed amendments would revise the rule bynquiring a brokerdealerto review the information about

the security .specMed in the rule and to have a reasomble basis to believe that the information is true and accurate and obtained from reliable sources.

The proposal would also require a broker-dealer to Iuwe in its records a copy of any trading suspension order, or SEC release announcing a trading

Suspension with respect to the is~er’s securities during the preceding year.
Chapter 8-Market Fraud and Its Victims •155

Box 8-A-Continued Need for Coordination of Federal, SRO, and State Actions

OTA’s exploration of penny stock fraud, including discussions with State securities regulators, revealed widely held

misconceptions. One is that the Federal budget cuts during the early 1980s led to a blossoming of penny stock fraud because

of a reduction in the SEC’s screening of initial public offerings (IPOs) and other filings. However, during the 1980s, the

SEC was not subjected to budget cuts and, in fact, continued to evaluate all securities IPOs and other sensitive applications.

It established more cost-efficient methods of operating its screening process, but there was no reduction in the level of

applications screened. Thus, the growth of penny stock seam operations probably sterns from other causes.

A second misconception concerns the basis for the criteria used by the SEC in screening IPOs, secondary public stock

offerings, and proxy statements. The SEC is required by the Securities Exchange Act of 1933 to use “full disclosure” as

its central criteria for deciding whether to register equity offerings. For decades, about 10 States relied on SEC registrations

of initial and secondary public stock offerings to automatically grant State registration. 1 The growth of penny stock scams

in Utah, Colorado, 2 and Florida, however, is evidence that SEC registration criteria alone will not protect investors against

false statements by issuers. It is not clear that any criteria can provide such protection. However, a number of these States

have now passed legislation requiring State evaluation of IPOs and secondary equity issues. The evaluation criteria in some

States is based on merit (i.e., whether the offering is fair, just, and equitable to investors). In some States, the offering price

must have some reasonable relationship to actual, or reasonable expectations of, earnings. Some States have a prohibition

against ‘cheap stock’—where shares of stock are given at no cost. Other States may disallow the sale of any issues if they

appear deceptive or especially prone to fraud.

Some State regulators argue that SEC evaluations would serve the public better if they, too, were based on merit

criteria in addition to the full disclosure criteria. Others argue that a well-informed public and State regulators are better

able to decide which entrepreneurial ventures are worthy.3 Others advocate the establishment of a national register listing

brokers and agents who have been barred from securities practice or have been convicted of securities violations.

In spite of intensified enforcement efforts, rule making, legislation, and increased coordination among the SEC, U.S.

Justice Department, the NASD, State regulators, and SROs, a goal of sharply reducing the currently significant presence

of scams may require a greater commitment of resources at the Federal and State levels for educating the public, identifying

abusers, and enforcement. The recent establishment within the SEC of a Penny Stock Task Force and an office of

International Affairs, and the annual SEC-State relators’ coordination meetings, are important steps in the right direction.

In addition, the Penny Stock Reform Act of 1990 will strengthen the SEC’s enforcement authorities.

Many State regulators are complimentary about the SEC’s and NASD’s recent efforts to fight penny stock scams. Yet

some say that the SEC could be more effective if it devoted more of its resources to protecting small investors. Perceptions

among some critics are that, compared to many States’ actions, there are relatively few SEC enforcement actions against

broker-dealers and their associated persons who directly abuse small investors. (SEC officials dispute this.) Critics argue

that the SEC’s major insider trading cases involving hundreds of millions of dollars (e.g., Michael Milken, Ivan Boesky,

and Dennis Levine), have no apparent direct impact on the abuses suffered by many thousands of ordinary citizens who

are often totally dependent on their savings, and who don’t know where to turn for assistance. 4

State regulators may never have sufficient resources to satisfactorily control the level of penny stock scam operations.

A more specific plan of attack, jointly developed by the SEC, U.S. Justice Department, the NASD, and State regulators,

may become even more important if scam operations continue to migrate to off-shore havens, and if, as some fear,5 the

current international efforts to harmonize investor protections among European countries6 results in lowering U.S.

standards of investor protection. OTA project staff, however, found little reason to expect a lowering of investor protections

in the United States.

IotheI Stites have USed their own evaluation processes, some of which are based on legislation dating born the turn of tie century.

~olorado, in the early 1980s, had no signifkant registration or enforcement authorities, which is seen as having opened the door to an

influx of penny stock scam operators.

3The debate about the appropriate Federal role dates from before the creation of the SEC. The SEC has no legislated authority to use a

merit criteria.

4These views were expressd most clearly by John Perkins, h4issouri Securities Commissioner, and Richard Bv, New Jemey Bur~u

of Securities, in telephone interviews with OTA project staff, July 1990.

5VariOUS speakers at the NASAA Conference on ‘Global Markets: A World of Risk for Small Investors, ” Washington, w,APfl lm.

6SW OmBac@omdPapr Tr~ing Arou~ the cl~~k: Securities Markets and znfo~fi~n Technology, OTA-Bp-~ (’washingto~

DC: U.S. Government Printing OffIce, July 1990).
156 Ž Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Roberts Securities, and Monarch Funding Corp. The

prosecution in the latter case is seeking $20 million

in forfeitures pursuant to the Racketeer Influenced

and Corrupt Organization Act (RICO).

State regulators believe that 70 percent of all

penny stock issues are “blank check offerings.”30

So far, some 36 States have passed or are considering regulations that ban such offerings, and Federal

legislation has been proposed that would impose

certain restrictions on registration statements filed

by any issuer in connection with blank check

offerings.

31 New Jersey, Florida, and Colorado are

among the States that have been heavily hit by such

scam operations, and each has taken law enforcement actions to reduce these abuses. New Jersey, for

example has increased its investigators from 2 in

1986 to 20 in 1989. New Jersey obtained 30 penny

stock convictions in 1989 and about 70 others during

1986-89. The Florida Penny Stock Task Force

created a law enforcement group in 1988 that

eliminated 30 scam brokers during 1988 and 1989

which collectively employed a sales force of 3,700.32

Utah prosecutors obtained 17 indictments and convictions in 1989 as a result of sting operations.

Arbitration

Many cases of clients claiming to have been

victimized are settled by arbitration. There are ten

arbitration forums. Two of them, the NYSE and the

NASD, handle 92 percent of all arbitration cases.

Three-member panels sanctioned by stock exchanges

usually conduct the arbitration. Arbitration panels

typically include a securities executive and sometimes a second panelist with ties to Wall Street. They

are therefore perceived as stacked against the small

investor, although this is denied by the securities

industry. Investors win about 60 percent of the cases

brought before the independent American Arbitration Association and about 50 percent of the cases

brought before the nine arbitration forums supported

by the securities industry. Even when the customer

wins the case, he often doesn’t recover the full

amount of the injury. Until recently, arbitrated cases

were usually decided within 2 days. Some are settled

by agreement, between the customer and broker

firm, without formal arbitration procedures.

Brokerage firms have favored the arbitration

process in the past, and many typically required all

but their larger customers to sign an agreement to

submit disputes to arbitration for settlement (i.e., to

forego seeking relief through court settlement).

However, new SEC rules allow pretrial conferences

and discovery, and hearings now take 5 days or

more. Most importantly, arbitration panels have

begun to levy large punitive damage awards (in

addition to compensatory, or actual, damage awards)

under the RICO statute or the Federal Arbitration

Act, which can be as much as triple damage.33

The caseload of arbitration has grown from under

1,000 in 1980 to over 6,000 in 1988, 65 percent of

which were filed with the NASD and 27 percent of

which were filed with the NYSE. SEC rules issued

in 1989 have opened the arbitration process to public

view, putting pressure on brokerage firms to avoid

negative publicity, in addition to their continuing

need to reduce costs. Securities firms settled 37

percent more customer disputes at the NASD since

the new SEC rule took effect.

International Securities Fraud

Increasing internationalization of the securities

markets will provide access to new sources of capital

for U.S. corporations, Table 8-1 shows the rapid

growth of foreign transactions in U.S. corporate

stock. U.S. securities regulators are not as well

equipped to tackle fraud from off-shore sources. The

%lankcheckofferings are those in which stock issuers either disclose no specific business planer purpose, or state that the business plan is to merge

with an unidenti.tied entity or to acquire unidentified assets, without iden@ing the business sought to be acquired or the managers nxsponsible for

operating the company after the merger. See Znvestor Alert! HOW to Protect Your Money From Schemes, Scams, and Frauds, The Council of Better

Business Bureaus and the North American Securities Administrators Association, February 1988. There are also “blind pool” offerings, Blind pool

offerings are those in which the business plan of the issuer is to seek mergers or acquisitions in an identifkd business line, but the specific organization

or assets sought to be acquired are not identifkd.

gl’rhe Penny Stock Reform At of 1990, H.R. 4497. For purposes of this Iegislatiou this means any developmental-stage comp~Y titis is- a

penny stock (as defined by the bill), that has no specific business plan or purpose, or has indicated that its business plan is to merge with an unidentifixi

company or companies.

sQ~e Florida penny Stock Wk Fome grew out of a meeting sponsored by the SEC’s Miami Branch OffIce, and includes tie State of ~ori~ tie

NASD, U.S. Attorneys’ OffiCXX, the FBI, tie IRS, and other Fede~ law enforc~ent authorities. The Florida Task Force serves as a model for ongoing

State and Federal cooperation.

33Bcg~g ~ 1989, da~onmbi~ation aw~s Wem ~de pm of ~epublic record. Stice ~e~ mbi~tionpanels gr~ted 21 ptitiVe -eaW~dS

totaling $4.5 million to investors. During the prior year, 9 punitive damage awards were made, totaling $1.7 million.
Chapter 8-Market Fraud and Its Victims ● 157

Table 8-l—Foreign Activity in U.S. Corporate Stocka

Purchases Sales

1977 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,154 11,479

1983 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69,770 64,360

1987 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249,122 232,849

1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 213,778 b 203,386 b

aAmountS are in millionsofu.s. dollars.

bprefimina~ctatafromthe TreasuryBulletin March 1990.

SOURCE: U.S.Treasury Department.

total amount of fraud perpetrated from off-shore is

-unknown, but is believed to be significant34and the

fastest growing form of securities fraud.

Transactions in foreign stocks by U.S. investors

grew from $15 billion to $220billion between 1982

and 1989, according to the Treasury Department.

Internationalization magnifies the need for international cooperation among securities regulators.

International pressure for increased participation in,

and easy access to, U.S. markets, will result in

increased enforcement responsibilities.

In 1988, a House Subcommittee report questioned

the ability of the SEC to police international

securities fraud. This report, based on congressional

hearings and a study of SEC records of investigations of suspicious trades originating from or

through foreign countries,35 focused on: 1) the extent

to which possible violations of U.S. securities laws,

such as insider trading and market manipulation,

involve transactions that originate from foreign

countries where SEC identification of traders can be

difficult, if not impossible; 2) the process the SEC

uses to pursue those foreign-originated trades where

violations are suspected; and 3) the problems the

SEC has encountered in investigating such suspicious trades.

One witness at the hearing noted that:

. . . the globalization of the securities markets . . .

have introduced greater rewards at. . . less risk for

those who seek to take advantage and . . . conceal

their wrongdoing behind the mantle of foreign

nondisclosure laws. I believe that. . . insider trading

has been on the rise over the last two decades, with

a significant amount of wrongful trading effected

from abroad. These foreign cases challenge the

[SEC’S] staff far more than even domestic investigations do.36

Other witnesses testified that some U.S. and

foreign investors avoid SEC scrutiny of their transactions in U.S. markets by executing their transactions through financial institutions in foreign countries that have bank secrecy and blocking statutes.37

Former SEC Chairman David Ruder testified that:

. . .[i]t is relatively easy for individuals and entities

to open accounts with foreign banks or brokerages,

which can then place trades on U.S. markets without

revealing the identities of their clients [incorporated,

for example, in Panama, Liechtenstein, Monaco, or

Costa Rica] that issue bearer shares, making it more

difficult to identify the beneficial owner. Accounts

may be opened in fictitious names, or established as

nominee accounts.

The Subcommittee also received testimony that

identifying suspicious foreign traders who use

off-shore accounts was becoming more difficult as

schemes to hide a trader’s identity increase in

sophistication. Some investors open accounts in

foreign banks and use shell corporations located in

other countries to place trades though the banks .38

Such activity may involve two or more layers

between the person who places the trade in the

United States and the actual beneficial owner

directing the trade. Detecting the identity of the

investor becomes much more complicated if layers

of nominees and agents, such as shell corporations,

~NA&&4 concludes, based on 87 major enforcement actions by 40 States during 1988 and 1989, that small investors lost an estimatti $1.1 billion

fiominternational investment fraud of various types. These include both off-shore investment scams and those that falsely claim to operatefiom overseas.

NASAA 1990 Study of International Investment Fraud and Abuse, NASM, July 1990.

35~ ~~oble~ With the SEC’s Enfor~ment of U.S. S=fities ~ws ~ Cases ~voh@ Suwicious Trades Originating From Abroa&” sllbcomnlitt~

on Commerce, Consumer, and Monetary Affairs of the House Committee on Government Operations, H.R. Rep. No. 1065, looth Cong., 2d SCSS. (1988).

~T~timony of Harvey Pitt.

37B@ s=req ~ws ~ic~y prohibit b~fi the host co~~es fim disclosing ~ch info~tion u the identiti~ of customers and records of their

transactions. These laws protect private, rather than public, interests an~ thus, generally maybe waived provided that information concerning third

parties is not disclosed. Blocking laws generally probibit the disclosure, copying, inspection or removal of financial documents located in the host

country andoftenprovide criminal penalties forviolations. Blocking laws are intended to protect the countxy’s national interest and, thus, are not waivable

by private parties.

38Defis ~v~e used tie re~tively sfiple approach of @a@ from a n~er of acco~ts in a B@~ bank. Nevertheless, he W= able to tie

illegal trades in over 50 securities from 1980 to 1985 without being identified by name. His conviction resulted from an anonymous informant.
158 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

dummy organizations, foreign banks, and multiple

accounts are used in a series of jurisdictions having

secrecy or blocking laws.

Many off-shore havens with strong secrecy or

blocking statutes means that enforcement actions

against suspicious trading from these countries may

be nonexistent, lax, or uncoordinated. In Costa Rica,

the Bahamas, Panama, parts of Europe, Liberia, and

South Africa, some violations maybe detected only

at considerable expense and with some luck, but

many will not be detected. Some of these foreign

havens have no extradition agreements with the

United States.

At a conference in April 1990, State experts in

securities predicted that a major issue for the 1990s

will be international securities fraud, much of it from

off-shore havens.39 SEC efforts to police the internationalized U.S. markets, and to overcome difficulties

of the sort identified by the Subcommittee, have

required the development of ways to obtain information from abroad.40 For example, the SEC often finds

it necessary to obtain evidence relating to foreign

trading (insider trading and market manipulation

cases) and accounting records of foreign subsidiaries

of U.S. publicly held corporations.

The SEC’s primary approach to curb foreigninitiated trading violations is via Memoranda of

Understanding (MOUs) with foreign countries for

obtaining cooperation in international enforcement

matters and for all contacts with foreign securities

agencies. In December 1989, the SEC created a new

Office of International Affairs, reporting directly to

the SEC’s Chairman, that has primary responsibility

for negotiating Memoranda of Understanding (MOU)

between the SEC and foreign securities regulators

and for coordinating related enforcement programs.

The Office will have perhaps eight professional staff

members in FY 1991, up from two in FY 1989.

As of July 1990, the SEC had MOUs with three

Canadian provinces, the United Kingdom, Brazil,

the Netherlands, and France, and treaties with

Switzerland and other countries. It has ongoing

negotiations with Mexico, Israel, W. Germany,

Australia, and certain Nordic countries. These MOU

arrangements represent a major improvement in

bilateral cooperation among nations. Nevertheless,

the development of MOUs is cumbersome, necessitated by disparate laws and regulations of different

countries. Over time, these agreements are expected

to become more uniform. Efforts by the SEC and

other countries’ regulators are needed to accelerate

the harmonization process and facilitate law enforcement worldwide. Such a goal would be a

worthy challenge for, e.g., the International Organization of Securities Commissioners (IOSCO).41

In 1989, the SEC received 150 requests for

information sharing from foreign governments, and

made 100 requests (up from about 60 in 1988) to

foreign governments.42 An increasing number of

nations are more inclined toward bilateral and

multinational cooperation as international linkages

increase and abuses in all markets become increasingly similar. The SEC and the CFTC both participate in international forums that address multilateral

issues, such as disclosure requirements for securities

offerings and multilateral recognition of brokerdealer registration.43

Some key questions are: 1) whether efforts by

U.S. and foreign regulators will adequately safeguard the public against violators, 2) what the costs

qg~k wdo~ Commissioner, Indiana Swurities Divisio~ and others at a panel on ‘International Enforcement: Con Artists C~h J-T.I on the Rush

to Global Investing,” NASAA Conference on Global Markets: A World of Risk for Small Investors, Washington DC, Apr. 26, 1990.

%e SEC, as does the CITC, requires SROS to enter into appropriate agreements regarding information sharing and surveillance before the SEC

approves a trade link with a foreign exchange. Such agreements exist, for example, between the AMEX and the European options exchanges, and the

CME and the To~o Stock Exchange.

AIIOSCC) is sch~~ed to issue a report in September 1990 on the elements of negotiating MOUS.

42Mmy of fie rWests to and ffom the SEC iIWOIVed Wnny stock ~ud.

43The SEC hU comide~ ~~Othm qproaches to inte~tio~ enformment problems. For ex~ple, the SUbCommitt~ recommended titthe

SEC adopt a regulation modeled on the ClWC’s Rule 21.03, which requires foreign brokers and traders, among others, to provide to the CIWC, upon

a‘ ‘special call, ’ certain market information. This information concerns their options and futures trading, including trader identilcation. The CFTC may

prohibit the foreign broker or trader fkom further trading on U.S. futures exchanges and with Futures Commission Merchants upon refusal to provide

such information. The SEC found, however, that this would not capture all foreign trading activity, and that both U.S. and foreign commentors believed

that the requirement would have a chilling effect on foreign investment in U.S. markets and drive legitimate business off-shore. Another concept was

published by the SEC in 1984, referred to as “waiver by conduct.” This concept would have established as a matter of law that persons who trade in

U.S. markets from abroad waived all rights to which they may have been entitled under foreign law. The concept met with overwhelming criticism and

was abandoned. Another approac4 also rejected, would haverequiredforeign banks that use omnibus accounts (one Iargeaccount under the bank’s name)

in placing trades with U.S. brokers to identify the beneficial owners if suspicious trades are identifkd.
Chapter 8-Market Fraud and Its Victims ● 159

will be, and 3) how international enforcement and

mutual assistance practices can be expeditiously

harmonized. The collective efforts of regulators will

likely reduce the level of violations from some

foreign countries, but U.S. investors and markets

may continue to suffer losses from fraudulent

conduct by persons who trade through foreign

accounts, particularly in countries that do not have

agreements with the U.S. for information sharing,

surveillance, or extradition, or that have poor

investigative and enforcement capabilities. Continued attention by Congress will be needed to assure

that U.S. investors are adequately protected against

both yesterday’s types of fraud and abuse and those

that will develop in global markets.

FRAUD IN FUTURES TRADING

The CFTC addresses fraud and abuse through

direct surveillance of futures markets and market

participants, oversight of futures trading SROs

(including the exchanges and the National Futures

Association), and referrals to the exchanges for

investigative and disciplinary action. They also

include enforcement actions brought before the

CFTC’s administrative judges and the Federal

courts, and authority to conduct civil investigations

and to impose administrative fines of up to $100,000

for rule violations.

As a result of recent Department of Justice

investigations, %

subpoenas were issued to dozens of

brokers and traders at the Chicago Mercantile

Exchange (CME) and Chicago Board of Trade

(CBOT) during the first months of 1989. In August

1989, a Federal grand jury indicted 46 commodity

traders, brokers, and a clerk on charges including

cheating or defrauding customers, evading taxes,

mail and wire fraud, and noncompetitive execution

of customers’ orders in hundreds of trades; two

additional traders were indicted in November 1989.45

Some of those indicted were charged with violating

the RICO statute, among other charges. This was the

fist attempt by the government to use this statute

against commodities traders for allegedly engaging

46 Sixteen Of those in efforts to defraud investors.

indicted had pleaded guilty as of June 1990.

The alleged illegal activities centered on the U.S.

T-bond and soybean pits at the CBOT and the

Japanese yen and Swiss franc currency pits at the

CME. The magnitude of the alleged fraudulent

activities raises suspicion that the abusive practices

were widespread.47 Yet, one of the FBI agents

involved in the undercover operation was reported to

have spent about 6 months in the CME’s Standard&

Poor (S&P) stock-index futures pits without having

detected illegal trading practices.

The U.S. Attorney General’s office has announced that the investigation is continuing. The

frost of two scheduled trials was completed in July

1990 and a second and third trial are scheduled to

begin in September 1990. Two of the accused were

found guilty of some non-RICO charges and a third

acquitted during their trial in June and July 1990. In

July, the CFTC charged four New York Mercantile

Exchange (NYME) traders with fraud in handling

customer orders, including noncompetitive buy and

sell transactions on crude oil futures trades for

customers on the NYME floor and making fictitious

trades. The case will be heard by CFTC administrative law judges.48

Illegal trading activity prohibited in futures markets includes:

44CITC staff prefer to describe this as the “joint investigation of the CFTC, FBI, and U.S. Attorney’s offi~. ”

45~e brokers ~ege~y fiect~ awomo~figIoc~s t. acmpt losses that mmlted ~mthe brokers’ e~rs, or outtrades, with the understanding

that the locals would be repaid later through the manipulation of customer orders. Brokers are personally liable for their trading mistakes, therefore these

repayment arrangements were used as a means to avoid paying their clearing firm or customers from their own funds. “Have Futures of Traders Hit the

pits?” The Natiowlhw Journal, June 11, 1990, p. 8. AISO See: “Traders Are Indicted for Running the Fits By Their Own Rules, ” The WaZZStreet

Journal, Aug. 3, 1989, p. A 1. “Jury Indicts 46 in Futures Probe,” The Washington Post, Aug. 3, 1989, p. A-1.

MUnited Srare~ V. ~artin J. Dempsey et al., Government’s Santiago Froffer, U.S. District Court, Jan. 5, 1990. The undercover FBI agent and

cooperating defendants note~ and testified later during the fust jury trial in June 1990, that they “routinely engaged in illegal prearranged trades with

the defendants. Most of these illegal trades were designed to: 1) pay them back for assuming the loss from brokers’ trading errors or outtrades; 2) build

up a bank of money that could later be kicked back to the brokers’ personal trading accounts; 3) disguise prearranged trading between other traders. . or,

4) permit the broker to take the other side of customer orders, fiIling them himself rather than through another trade,” p. 15.

See also, United States v. Robert D. Mosky et al., Government’s Santiago Proffer, U.S. District Com IWw. 13, 1990. “The essence of the charged

conspiracy and fraud scheme is that brokers regularly solicited. . local traders. . . to absorb losses caused by order-filling errors or outtrades and repaid

such locals through the illegal manipulation of other customer orders. . .,” p. 11.

47~ose fidicted represent about 20 WrWnt of the yen pit trader pop~tion and ]() percent of the soy- trader poptition. “Traders Are rIldiCted

For Runnin g the Pits By Their Own Rules,’ The Wall Street Journal, Aug. 3, 1989, p. 1.

4S, i~geS ~e Fil~ Agfist 4 Traders at New York Merc, “ The Wall Street Journal, July 25, 1990, p. C 1.
160 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

●

●

●

●

●

●

Noncompetitive execution of trades: Two brokers may agree to fill a customer’s order at a

prearranged price-a higher than market price

for a purchase, and lower for a sale-and divide

the extra profit among themselves.

“Wash” trades: These give the appearance of

trading, but do not result in a change in market

position.

Bucket trading: A broker may take the opposite

side of a customer’s order directly, or through

a “bagman,’ outside of the competitive auction process.

Order crossing: Brokers may cross, or match,

customers’ orders directly, without involvement in the open outcry market.

Cheating or defrauding customers: This includes “tick shaving, ” where customers are

cheated of small amounts, perhaps $25 on a

million dollar face value order, on many

transactions. Customers probably will not notice the small amounts, but these can result in

significant illegal gain to locals over the long

term.

Fraudulent withholding of customers’ orders:

Floor brokers may delay filling a customer’s

order, if it will affect the market price, in order

to benefit another exchange member or market

professional.

Since the FBI investigations, futures exchanges in

Chicago and New York and the CFTC have undertaken special reviews and have proposed substantial

changes in trading practices, rule enforcement, and

market procedures.49 The CME proposals advanced

by a Special Committee were deemed particularly

impressive, and in slightly altered form are being

adopted by the Exchange and submitted to the CFTC

for approval. In contrast with the CME’s proposed

limitations on dual trading, the CBOT internal

investigation committee recommended that dual

trading be continued in the interest of liquidity.50

Both exchanges are improving trade monitoring

systems and increasing penalties for trading abuses.51

The CFTC proposed, in August 1989, a number of

regulatory enhancements. These include final CFTC

rules which require more frequent collection of

trading cards and stricter controls on the manner of

their preparation (e.g., sequential numbering, prohibitions on the skipping of lines); a pilot program for

increased on-floor surveillance, including inspection of trading cards and order tickets; and final

CFTC rules establishing stricter criteria for exchange members to serve on governing boards and

specific committees.52 To improve their automated

trade reconstruction, the CME and CBOT both now

require a 15-minute, instead of a 30-minute, time

bracket for traders and brokers to record the time of

each trade. (See ch. 4.)

Inter-market frontrunning is a potential abuse

involving both futures and securities markets, but

the extent of the problem is unknown.53 A brokerage

firm that is about to buy or sell a large block or

basket of stock for itself or for a customer, may first

take a position in stock-index futures, hoping to

profit if the stock transaction moves the price. This

inter-market activity is a practice recognized as

abusive for a decade.

One issue that surfaced during the 1989 CFTC

Reauthorization hearings was whether futures exchanges have been lax in disciplining members, as

has been charged by Thomas F. Eagleton, former

U.S. Senator and former public member of the Board

49Reportof the Chicago Mercantile Exchange Special Committee. .

., Apr. 19,1989. The report contains two categories of recommendations: trading

practices and rule enforcement reforms, including a partial ban on dual trading, and trade surveillance improvements. Other recommendations

emphasized sterner disciplinary actions and more severe penalties. For a fuller description see testimony of Leo Melamed Chairmann of the Executive

Committee, Chicago Mercantile Exchange, before the Committee on Agriculture, Nutrition and Forestry, U.S. Senate, May 17, 1989.

50CBOT OKs Dual Trade Practice, Reportedly at Customers’ Urging, ” Investors Daily, Feb. 9, 1989, P. 3.

SIIbid.

52~~~c Moves to Tighten Trading Rules, ” The Wuhington Post, Aug. 30, 1989, p. Cl.

53Accordingto the SEC,”. . .we are not able to determine the extent to which such trading (frontnmning) occurs yet remains undetected (by the SROS)

nor the impact on the ake~ or firm profitability. Based on the known instances of frontnmning which the SROS have uncovered and prosecuta

however, we do not hlieve that these practices are widespr@ nor their impact on markets and fm profitability significant.” Memorandum from

Richard G. Ketch- DirWtor, Division of Market Regulation, to SEC Chahma n Ruder, June 30, 1989, p. 15. But the press continues to report that the

problem is grow@ see “Is PIugram Trading the Target of a Witch-Hunt?” Business Week, Nov. 13, 1989, p. 122.
Chapter 8-Market Fraud and Its Victims ● 161

of Governors of the CME.54 A recent GAO review

said that GAO was ‘‘unable to reach conclusions

about the adequacy or effectiveness of exchange

disciplinary action programs primarily because the

universe of abuses is unknown. ”55 However, GAO

noted that the number and severity of penalties has

increased since the investigations became public,

which “appears to indicate an increased commitment by the exchanges. . . . The GAO report

strongly recommended that the CFTC require the

exchanges to develop and use means for ‘independent, precise, and complete timing of trades’ because

presently there is limited ability to detect rule

violations.

One organizational arrangement that may be

conducive to trading abuses involves broker associations. 56 This involves organizations of brokers and

traders who fill orders from the public, pooling their

collective revenues and expenses. This arrangement

is legal, can improve customer service, and, by

reducing the traders’ risk, makes possible reduced

trading costs to customers. But it also may facilitate

opportunities for unethical behavior within broker

associations, such as concentration of trades within

the group in order to maximize commission revenues; rewarding members of the group with favorable trades; and influencing the behavior of low-paid

trainees to participate in questionable trading behavior.

Broker associations, the CFTC believes, may

facilitate certain trading abuses, such as prearranged

or noncompetitive trading with the aid of other

association members.57 As a result, the CFTC

proposed rules to provide a common definition of

broker associations and to require exchanges to

register such associations in order to particularize

and heighten review of their trading activity .58

Approaches To Reducing Fraud in

Futures Markets

Trade practice abuses should be detected either

through an SRO’S internal sources, such as audit

trails and observations of trading, or through external sources, which include complaints from exchange members or customers. Detecting some

types of trading abuses in the open outcry system are

difficult, and may be impossible without undercover

surveillance, because there may be several hundred

active traders shouting and gesticulating. Exchanges

are required to have audit trails. Efforts have been

made to improve automated methods for surveilance, but the present systems still have serious

shortcomings recognized by both the CFTC and the

exchanges. For example, while the CFTC requires

trade-reconstruction 59 times for the purpose of audit

trails to be precise to the nearest minute, a single

minute of active trading may include hundreds of

trades, several of which could be made by a single

floor participant at different prices.60 Furthermore,

these are imputed, not actually recorded times;

reconstructed using trading cards that now are

collected every 30 minutes, order ticket timestamps,

and other data.61 There are open questions about the

effectiveness of any of these systems to deter certain

types of abusive trading practices, especially given

opportunities for collusion among floor brokers and

54. , .4*When it comes to a choice between protecting an insider and preserving the integrity of the futures markets, there is no question where the

exchange stands”

Eagleton also concluded that:

. . .As long as the existing system of “openoutcry,” which consists of shouts, gestures, winks andotherphysical signals, remains there will be substantial

cheating at the futures exchanges. They have to be brought into the 21st century with an electronic trading system that leaves a verifmble audit trail.

Thomas F. l%gleto~ “Chicago’s Markets: Corrupt to the Core,” New York Times, Nov 19, 1989, p. 27.

55u.s. ~ner~ ACCOWK@ OffIce, Futures Markets: Strengthening Trade Practice Oversight, GAO/GDD-89-120, September 1989, PP. 2-s.

56cmmfly, fow exc~es (chic%o Mercantile Exchange, New York Mercantile Exchange, Commodities Excqe, ~d the New York Fu~~

Exchange) have rules explicitly clef@ associated or atliiated brokers. These include among affiliations: 1) empIoyer and employee (employees of

the same employer), and 2) partners. Various exchanges include some others, such as corporations and relationships among two or more brokers sharing

brokerage expenses, e.g., a clerk’s salary, ofilcers, directors, and 10 percent shareholders of a member, and brokers who share a deck of orders. Most

exchanges’ rules do not include a deftition of broker associations and some do not require them to register as associations with the exchange. CFTC,

Division of Trading and Markets, Memorandum to Commis sioners, Broker Association Study, Jan. 4, 1990, p. 2.

571bid., p. 6.

581bid.

%Ilade &ta are reconstructed on the CME, CBO~ and the Coffee, Sugar, and Cocoa Exchange.

@I’he CME, CBOZ and Coffee, Sugar, and Cocoa Exchange reconstruct trades to the nearest 10 seconds.

61u.s. Gener~ ~cowfigOffIce, Chicago Futures Market: Initial obse~atio~ on Trading Practice Ab~es, GAO/GGD-89-58, &kch 1989, pp.

13-17. This GAO report studied the “leve~ or intensity, of CIWC [and the CME and CBOTl exchange efforts to detect and penalize trading abuses”

between 1984 and early 1989, and made “no recommendations.”
162 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

traders-which are very difficult to detect, requiring

abusive trading patterns to be identified. Undercover

investigations greatly improve efforts to identify

these activities.62 And, as CFTC Chairman Gramm

noted in a comprehensive review of the CFTC’s and

the SROs’ compliance efforts, “computer-assisted

(surveillance) programs generally are less effective

in detecting abuses which are susceptible to being

effected through alteration of documents, and fictitious trade submissions. . . prearranged trading or

trading ahead of customer orders. ’ ’63

The exchanges have announced a determined

effort to overcome these concerns and to make

obsolete the present system of scribbling transactions on slips of paper which are passed by hand to

clerks for computer entry. The CME and CBOT are

committed to jointly developing abetter technological approach to establish precise and verifiable audit

trails from the beginning-i.e., at the time of the

transaction and not by reconstruction afterward.

This system, called AUDIT (Automated Data Input

Terminal), will use an electronic hand-held computer to record each transaction on the exchanges’

floors at the time it is made and to transfer trade data

to exchanges’ computers. The system will support

exchange operations, and surveillance and compliance monitoring. Prototype equipment are scheduled for testing in late 1990.64 Research and experiments are also being conducted, or planned, on

hand-held devices by the CBOE and COMEX.65

It is not clear yet whether the prototypes will be

immediately accepted by floor traders and whether

the new equipment will suit the specific needs of

traders (ergonomically and fictionally, such as

speed of trades). Their success may depend, in part,

on whether traders find the devices beneficial,

non-threatening to their unique skills and experience, and whether the devices impair liquidity.

The legislation which initiated public regulation

of futures trading half a century ago said that

regulation was necessary because “the transactions

and prices of commodities are susceptible to speculation, manipulation, and control. . . .“66The recent

revelations of abuses came not from the Exchanges,

which as SROs have primary responsibility for

market discipline, nor from the CFTC which oversees the SROs, but from the FBI with the cooperation of the CFTC.67

Questions have been raised about the determination of governors of futures exchanges to enforce fair

trading practices, although recent actions suggest

that substantial improvements are underway. Congress can therefore ask whether present supervisory

and disciplinary procedures are adequate, or whether

government must take a more active role in market

discipline, and if so, what agency should exercise

that responsibility. (See ch. 9.)

There is a view that because futures markets are

used primarily by large, sophisticated institutions,

abuses could easily be detected by the victims

themselves and corrected by free market forces. The

current large-scale indictments, admissions of guilt,

and plea bargaining provide evidence to the contrary. Institutional investors in futures markets

represent millions of Americans through pension,

life insurance, and mutual funds; the ultimate

victims in futures market fraud are these people.

Moreover, trading abuses can create price distor6zAccording to former U.S. Attorney Anton Valukas, who headed the Justice Department probe into trading abuses in tie Chicago exc~~,

66

. . ..experience suggests that some of the things we found could only have been discovered by having people actually in the pits. ” And, “The whole

iispect of how audits are conducted and what type of audit trails are kept is something that should be reviewed. ” As quoted in “Paladin in the Pits, ”

Bamon’s, Aug. 21, 1989, p. 6.

63WmdyL. G-c~ClWC, in attachment to letter to Sen. Patrick My, Mar. 7,1989, p. 4. See also, Statement of Dr. Wendy Lee Gramm

before the Senate Committee on Agriculture, Nutrition and Forestry, Mar. 9, 1989.

An alleged example of suchpmctices was reported in the wallSreetJ~W-~Zof Oct. 24, 1989, p. Cl; an international money manager has sued a major

securities fm on the grounds that the fm colluded with pit traders to hold back the intermtional fund’s large sell order until the market price plunged,

then bought up the contracts, pushing the price up rapidly (one trader is alleged to have made $900,000 in 90 seconds). “Soros Is Accusing Shearson

of Fraud After 1987 Crash. ”

“’CME, CBOT Select Vendors for Next Phase of AUDIT Selection Process,” Joint CME-CBOTpress release, Mar. 7, 1990. Units developed by

NYNEX, as one example, were being tested in early 1990 by traders at the Commodity Exchange (COMEX) in New York.

filBM study, of Clearing and Settlement for the U.S. Congress-OTA, Aug. 1, 1989, p. 74. Roger Rum, Bored of Trade Cl-COT. (BO’rcc),

is cited as observing tbat “so far the acceptance of on-line trade data input devices is high, but finding a good working device has been largely

unsuccessful. ” Ofllcials at other exchanges, e.g., CBOE, made similar comments to OTA staff.

667 u.S.C. 5; CCH Rep. No. 1031, p. 1558.

67~e FBI, but not tie ~c,~au~ofi~ t. conduct ~dercover smeil~= investigations. The flle~ activities in tie fUtUreS pitS, including

collusion, were not readily detectable through the routine surveillance of the SROS and the CFI’C.
Chapter Market Fraud and Its Victims ● 163

tions that affect prices in other markets. Thus, it is

important that these markets be free of fraud.

Genuine fairness may be achievable in large-scale

markets only with trading procedures that place

great reliance on automated systems and everdiminishing reliance on the trader. The trends

already underway toward computerized trading have

been given further stimulus by the investigations by

the FBI, the CFTC, and SROs. If, indeed, the only

certain way to reduce adequately some forms of

abuse in the current trading environment requires

oppressive costs, then computer-based systems may

receive added impetus as a means of achieving

fairness and efficient allocation of scarce resources.

Such changes should recognize that adequate resources for regulators will also be required to police

the exchanges. The level of fraud identified in

futures markets suggests that the CFTC’s current

resources are less than adequate. The need for

policing abuses in these markets won’t disappear,

but their form will change.

The Intermarket Surveillance Group, noted earlier, has as one of its major purposes to provide a

check against intermarket frontrunning. The CME

and the NYSE developed new circulars aimed at

preventing inter-market frontrunning, which were

approved by the CFTC in 1988 and the SEC in 1989.

The CFTC has followed through on plans for a

number of market reforms, including the placing of

more staff monitors on the floor of the exchanges

and the drafting of new rules on market procedures

related to areas in which abuses have been cited by

the FBI investigation. In July 1989 a bill was

introduced in the House which would strengthen the

CFTC’s authority to prevent trading abuses and

other objectives.68 The Senate introduced its own

bill in November 1989.69

6SH.R. 2869, Como@ Fumes ~provement Act of 1989. The bill would do this by: placing restrictions on dual trading in heavily traded mntracts

and on trading among members of brokers’ groups; requiring improved and verifiable audit trail da@ strengthening the SRO disciplinary structure and

increasing the penrdties for certain rule violations; setting standards for participation on SRO governing boards; and making the wrongful use or

disclosure of inside information by certain oftlcials a felony offense. CFTC authority to assist foreign futures authorities in investigations would be

expanded also.

6%.1729, Fumes Trtifig Practices Act of 1989. Tbis bill would: expand the CFI’C’S staff and legal powers; r-e exchanges to use ~per-proof,

computerized audit trails and curb dual trading; increase penalties against abusive trading practices and permit victimized customers to sue for punitive

civil damages; and tighten rules against exchange conflicts of interest.
Chapter 9

The Bifurcated Regulatory

Structure
CONTENTS

Page

REGULATION OF SECURITIES MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

REGULATION OF FUTURES MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

TENSION BETWEEN THE AGENCIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

INNOVATION AND REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

MARGIN REQUIREMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

REGULATORY RELATIONSHIPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Clearer Definition of Jurisdictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

An Inter-Market Coordination Agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Merging Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

168

169

169

169

172

174

175

176

177
Chapter 9

The Bifurcated Regulatory Structure

Two Federal agencies regulate the trading of

securities and derivative instruments. The Securities

and Exchange Commission (SEC) regulates securities, options on securities, and options on indexes of

securities; and the Commodity Futures Trading

Commission (CFTC) regulates futures and options

on futures. (In addition, the Federal Reserve Board

and the Department of Treasury have some regulatory responsibilities.) The SEC was created in 1934,

the CFTC in 1974. They have roughly similar

mandates, but there are also striking differences

between them in the details of their legislative

authority and operating procedures.1

The basic laws creating these two agencies were

written 40 years apart, and both were written when

some of today’s most heavily traded products did not

exist. Financial markets and financial institutions

are much more interdependent than they were in the

past. Derivative products such as stock-index futures

and hedging and arbitrage techniques using those

products, tie together the performance of securities,

futures, and options markets. They are further linked

by the interlocking memberships of securities firms

active in all of these markets and their clearing

organizations. 2

Frequent recourse to courts for judicial interpretation of the Securities Exchange Act, the Commodities Exchange Act, and related securities laws may

be inevitable because this body of law has major

financial, economic, and social consequences. But

segregated responsibilities for regulating securities,

options, and futures give rise to additional legal

issues and policy issues especially when they give

markets and market participants an incentive to pit

one set of regulators against another.

In 1990, there are before the Congress active

proposals to change the existing regulatory structure

radically-either by merging the two agencies, or by

reallocating their jurisdictions and responsibilities..

Such proposals had been made repeatedly in Congress. In May 1990, the Administration recognized

that “. . the time has come to reform the disjointed

regulation of the markets governing stocks, stock

options, and stock-index futures. ’

The danger in a failure to act, an Administration

spokesman said, is that “we are now more likely to

see minor events trigger major market disruptions. . ..’ This would risk “the entire financial

system, especially through the clearance and settlement process. . ..”

Relations between the two agencies, at the working level, appear to range from cordial cooperation

to polite teeth-gritting. Recurring jurisdictional struggles over new exchange products highlight one

serious problem in the current regulatory structure.

A more critical weakness is the ad hoc nature-and

thus the basic uncertainty-of the coordination of

safeguards against dangerous volatility and stress,

across financial markets that are increasingly linked

by technology, products, and hedging and arbitrage

strategies. The two regulatory agencies take different positions on the possible causes of market

volatility, how much volatility is dangerous, and

what measures are justifiable as preventatives.

While the interactions of linked markets are probably not fully understood, the implications of this

linkage have become highly controversial and highly

politicized because they affect both extremely profitable activities in the private sector and the distribution of responsibility and power in the public sector.

This makes it less likely that the agencies will

always be able to act with dispassion, speed, and

coordination in emergencies.

l~e SEC is nearly four times as large as the CFTC. The SEC hS appro ximately 2,200 people and a budget of $168.7 million for FY 1990, with

a 1991 budget authority of $177 million (the President requested $192.4 million and 2,375 staff years). The CFTC has 1990 budget of $37.18 million

and a staff of 529, with a presidential request for $44.96 million and 595 people in 1991, and projected congressional authority for $40 million.

zAccor&g t. tie Cmc, 12 ffis~clearing membe~ of bo~ fu~s ~d stock cle~g orgatitiom; 20 firms are clearing members Of futures

and securities options clearing organizations. These 32 firms with interlocking memberships are only 3 percent of all clearing firms (963), but are

probably among the largest.

3S~tement of tie Honorable Robert R. Glauber, Under Secre- of tie Treasury for F~ce, before tie U.S. Senate COmmitttX On Agriculture,

Nutrition, and Forestry, May 8, 1990.

–167–
168 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

REGULATION OF SECURITIES

MARKETS

Until 1934 secondary securities markets were

subject only to U.S. postal laws (as are all businesses) and to State civil and criminal laws. The

Securities Exchange Act of 1934 (and the Commodities Exchange Act 2 years later) reflected public

outrage over perceived causes of the 1929 market

crash: excessive speculation and market manipulation. The Securities Exchange Act (SEA) emphasized congressional determination to prevent ‘inequitable and unfair practices’ in stock exchanges and

the over-the-counter (OTC) market.

The Act created the Securities and Exchange

Commission4 as an independent regulatory agency.

The new agency was to regulate the practices of

dealers and brokers in both formal and OTC

markets, 5 and to make sure that the public is given

information about publicly traded securities. The

law prohibited the use of corporate information and

news by “insiders” for trading advantage. It also

provided a framework for controlling the amount of

speculative credit that may be extended to market

participants, but this authority-to set minimum

levels of “margin”—was given to the Federal

Reserve Board rather than the SEC, since it was

considered to affect broader policies of credit

control.

Much of the basic regulatory responsibility was

left to the exchanges, as self-regulatory organizations, or SROs. (The National Association of Securities Dealers, NASD, was created 5 years later as an

SRO for the over-the-counter market.) Within limits

defined by Federal and State statutes, SROs draw up

their own rules and have the authority to censure,

fine, suspend, or expel both their members and their

employees. SROs also register securities account

executives and investment brokers.6

There are significant costs involved in carrying

out self-regulatory functions. The New York Stock

Exchange (NYSE) says that 22 percent of its

revenues and 29 percent of its staff are allocated to

regulatory activities, including surveillance and

enforcement. 7 The NASD says that in fiscal year

1990, 81 percent of its $111 million budget was

allocated to regulatory functions.

States retained some securities regulatory powers.

State commercial laws in conjunction with Federal

securities laws and bankruptcy laws affect many

aspects of securities transactions, especially clearing

and settlement and the obligations of various market

participants. Securities must be registered in every

State in which they are sold, as well as with the SEC.

(Some States now provide for “registration by

coordination, “ i.e., by proof of SEC registration.)

There are differences among the States in the scope

and details of securities regulation, but most States

are actively concerned with protection of the individual investor against fraud and manipulation by

retail brokers.

The 1934 Securities Exchange Act’s consumer

protection clauses tried to shield investors against

dishonesty, but not incompetence, on the part of

brokers. That was considered the responsibility of

the SROs. For example, the NYSE and NASD could

intervene in the affairs of their member firms to

transfer customer accounts and positions to stronger

members, to liquidate failing members, or to effect

mergers with healthier firms.8 In the 1960s, however, the growing volume of trading and the

‘‘back-office’ (paperwork) overload strained the

financial capacity of many brokerage firms. Congress created the Securities Investors Protection

Corp. (SIPC) in 1970, to protect customer accounts

up to certain limits against failures of securities

fins. The SIPC funds are provided by annual

assessments of exchange-member firms.9

A~e SEC is govem~ by five commissioners, with no more than three from one party, appointed by the President with the consent of me Semte.

f’Federal, State, and municip~ bonds and some other kinds of securities are exempt from most provisions of the Ac4 but they ~subj=t to tie

antifraud provisions, as are all securities.

%ey now require a several month training program and examina tions before registration.

% 1989, NYSE regulatory expenses were $78.6 million. Revenues from operations and short-term investments were $349.3 million. There were

1,977 on staff, of which 579 were assigned to regulatory functions. Figures provided by the NYSE.

sBe~een lg68 and 198(1 the NYSE had to expend $61 million Ilom its Special Trust Fund to liquidate or merge troubled member h.See Rickd

J. Teweles and Edward S. Bradley, The Stock Market, 5tb ed. (New York NY: John Wiley& Sons, 1987), pp. 317-320.

9s~ ~So ~S ~ergenq borrowing ]fies to he Fede~ Reserve giving it resour~s of OVm $1 billio~ ~d most brokerage f~s tik30 hWe SOme

commercial insurance. Nevertheless, it is not at all certain that SIPC could handle the failure of a major firm, which might have more than 250,000

accounts. The largest failure yet handled by SIPC involved fewer than 33,000 accounts. Many people in the securities industy appear to believe that the

Federal government would “bail out” any major securities firm that failed, even though there was no bail out of Drexel Burnham Lamb@ in 1989.
Chapter 9-The Bifurcated Regulatory Structure ● 169

REGULATION OF FUTURES

MARKETS

Regulation of the futures market began with the

Grain Futures Trading Act of 1922, with responsibility lodged in the U.S. Department of Agriculture

until 1974 (see ch. 4). The present regime was

established with the Commodity Futures Trading

Commission Act of 1974 (88 Stat. 1389). The Act

provides that a new Commodity Futures Trading

Commission “. . . shall have exclusive jurisdiction

with respect to . . transactions involving. . . contracts of sale (and options on such contracts) for

future delivery . . ..” It is to administer the basic

provisions of the Commodity Exchange Act of 1936.

The new 1974 Act defined “commodity” to include

not only agricultural staples and other “physicals,”

but also “services, rights, and interests in which

contracts for future delivery are presently or in the

future dealt in. . .,” thereby expanding the term to

include many financial instruments. The CFTC was

created under ‘‘sunset legislation, ’ a popular concept in the early 1970s, which provided that the

agency would cease to exist unless re-authorized

periodically. Congressional oversight of the CFTC

continues to be exercised by the House and Senate

Committees on Agriculture.

CFTC authority generally preempts that of States,

although the Commodity Exchange Act (sec. 6D)

permits States to prosecute commodities fraud. The

SEC’s authority is shared with States. The authority

of the two agencies also differs in terms of investor

protection. 10

TENSION BETWEEN THE

AGENCIES

In 1978, SEC asserted jurisdiction over securitiesrelated activities, including the trading of futures and

options contracts based on stocks or stock prices,

and sought congressional codification. The congressional Agriculture Committees, however, wanted to

keep jurisdiction over all futures trading in one

agency.

The linkages between stock and futures markets

were not so visible in 1974 and 1978 as they are now.

The most direct link-stock-index futures-did not

then exist. Nevertheless, some congressional members saw potential problems. The Futures Trading

Act of 1982 reflected congressional concerns about

the impact of trading in futures contracts on other

financial markets. These concerns were stimulated

by the Hunt silver scandal and the impending

introduction of interest-rate futures. The 1982 Act

directed the Federal Reserve Board of Governors

(FRB), SEC, and CFTC to assess the effects of

futures and options on capital formation, the liquidity of credit markets, the adequacy of customer

protection, the effectiveness of regulatory tools and

mechanisms, and the extent to which futures contracts could be used to manipulate markets and

prices. The study concluded that futures and options

did not have adverse effects on capital formation or

stock and credit markets.

Over time most of the early congressional concerns about trading in futures contracts were allayed

through this and other studies by Federal agencies

and through a growing body of practical experience.

This unease was roused again in 1987 and 1989 by

the possibility that stock-index futures and related

trading behavior contributed to-or caused-market

breaks (see ch. 4). The bifurcated regulatory structure itself has become a focus of concern and

controversy. It is particularly controversial in terms

of: 1) the effects on innovative financial products, 2)

the setting of margin requirements, and 3) decisions

about measures to be taken when markets are

stressed or collapsing.

INNOVATION AND REGULATION

The boundary between SEC and CFTC jurisdiction is, in broad terms, that between instruments for

capital formation (securities) and instruments providing a means of hedging, speculation, and price

discovery without the transfer of capital. Options are

sometimes regarded as an investment, but more

often as an instrument for hedging or speculation.

The SEC has authority to regulate trading of options

on securities. The CFTC regulates trading of futures

contracts (including futures on stock indexes) and

options on futures contracts. The CFTC has jurisdiction over options on foreign currencies-except

lqor exmple, tiemc~fio~ &r=t ~ket ~ei~nce based on large trader reporting, which the SEC m~ot yet r~~e (a bill tit ‘odd

authorize the SEC to require large traders to report their transactions is now before CongmSS). AS another eqle, the CEA requires futures commission

merchants (the f~tittindle purchase and s~e of fiwm contracts for retail customers) to segregate customers tids. SEC Rule 15c3-3 requires

segregation only of net total credits, but the Securities Investor Protection Act setup an insurance fund for tier investor protection.
170 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

when the option is traded on a national securities

exchange, in which case the SEC has jurisdiction.

Thus the SEC regulates an option on the British

pound traded by the Philadelphia Stock Exchange,

and the CFTC regulates essentially the same option

traded at the Chicago Mercantile Exchange.

Futures exchanges have been highly innovative in

developing new products, and the CFTC has generally been responsive and flexible in approving those

products (or in agreeing to exclude them from

regulation). The SEC has until recently been more

cautious in approving new exchange products.11

But the futures exchanges’ innovative products

have blurred the distinctions assumed in statutes,

and thus the allocation of responsibility of the CFTC

and SEC, particularly with the advent of products

whose definition and price are derivative of products

traded on a securities exchange. In drawing up the

Securities Exchange Act of 1934 and the Commodity Exchange Act of 1936, legislators could not

anticipate the new products and computerized trading strategies that would eventually confront regulators. As a result, the two agencies have frequently

struggled with jurisdictional confusion, sometimes

resolved by negotiation but sometimes finally

resorting to courts to sort out jurisdictional disputes.

In time, the related industries have come to use the

threat of litigation to thwart competition and perhaps

to thwart regulation as well.

A major source of difficulty is the “exclusive

jurisdiction’ phrase in the Commodity Futures

Trading Commission Act. The Act says:

. . the Commission [CFTC] shall have exclusive

jurisdiction with respect to. . transactions involving

. . .contracts of sale (and options on such contracts)

for future delivery of a group or index of securities

(or any interest therein or based on the value thereof) .12

Most new contracts, if they are not standard

corporate stock or bonds, have some aspects of

“future delivery,” and the likelihood that they will

be found by the courts to fall under the CFTC’s

jurisdiction may effectively discourage stock markets from product innovation.

Exchanges have formed separate subsidiary exchanges in order to avoid being regulated by both the

CFTC and the SEC. The NYSE formed the New

York Futures Exchange and the Philadelphia Stock

Exchange formed the Philadelphia Board of Trade.

Futures exchanges are particularly intent on avoiding regulation by the SEC, saying that it does not

understand futures trading.

Serious disagreements erupted between exchanges

seeking to innovate, and between the regulatory

agencies, over products at the intersection of the

agencies’ jurisdictions.

13 In 1981, the chairmen of

the SEC and the CFTC entered into an agreement

clarifying the respective jurisdictional responsibilities of the two agencies, pending the enactment of

clarifying amendments to the securities and commodities laws.14This Shad-Johnson agreement (named

after the two chairmen) left the CFTC exclusive

jurisdiction over futures contracts and options on

futures contracts. It recognized SEC as sole Federal

regulator of options on securities and on foreign

currencies traded on national securities exchanges.

The agreement specified certain criteria that the

CFTC would use in approving futures contracts on

a group or index of municipal and non-exempt

securities. 15

As part of the Futures Trading Act of 1982,

Congress enacted the Shad-Johnson agreement into

ll~o~ RUSSO, who practices s~fitics and commodities law as a partner in Cadwalader, WickerSham & Taft told Congress: “AS a redt of the

recent-and in my view unfortunat~eventh Circuit decision in the IPS case, the Commodity Exchange Act has become a major obstacle to product

innovation. . . The II% decision will work in effec~ to ban many new products with any element of futurity from the U.S. markets.”

127 U.S.C. 2a(ii). See also 7 U.S.C. Section 2 . . . ‘‘the Commission shall have exclusive jurisdictio~ except to the extent otherwise provided in sec.

2a of this title.” U.S. Court of Appeals for the Seventh Circuit CiUE et al., v. SEC, decided Aug. 18, 1989.

lsFor c~plc, in early 1981, the SEC gave approval for the CBOE to trade options on Government National Mofigage As=~tion securities. The

CBOT (which had traded GNMA futures since 1975) objected. The U.S. Court of Appeals of the Seventh Circuit ruled that the SEC was without

jurisdiction because of the exclusive jurisdiction clause in the CIWC statute. Board of Trade of City of Chicago v. SEC, 677 F,2nd 1137, 1142 n.8,

1156-1158 (7th Cir. 1982), vacated as moot, 459 U.S. 1026 (1982). The Court said that GNMA options wme not securities, despite a “right to . . .

purchase” phrase in the securities laws.

14SEC and CFTC press release Dec. 7, 1981, 2982-82 Fed. Sec. L. Rep. (CCH) pa. 83,W2.

15~e Smenti cfic~t cowlater ~led tittie SEC and ~Cco~d not ~ter the~~sdiction by mumagmm~~ S= 677 F.2d at 1142 n.8. The

jurisdictional dispute between the ~C and SEC was over options on GNMA certiilcates. An appeals court later found them to be “both securities

and futures,” and, therefore, “the CFTC’S jurisdiction is exclusive in light of 7 U.S.C. Sections 2 and 2a. ” U.S. Court of Appeals for the Seventh Circuit

decision in CiUE et al., v. SEC, Aug. 18, 1989, pp. 11-12.
Chapter 9-The Bifurcated Regulatory Structure ● 171

law. Congress added a provision that the SEC had

the right to object to a futures contract on a stock

index (or option on such a contract). After a hearing,

SEC’s objection could be taken to judicial review.16

In late 1983, the SEC objected to four stock-index

futures contracts proposed by the Chicago Mercantile Exchange (CME) (based on indices of sectors of

the securities markets such as energy corporation

stocks or financial institution stocks). This led to a

second agreement between the two agencies setting

out detailed guidelines for joint CFTC/SEC approval for index futures contracts and options on

index futures contracts. Subsequently, there was

joint approval of 20 stock-index futures contracts,

later withdrawn. In May 1988, in the wake of the

crash, the SEC Commissioners again voted to

propose the transfer to the SEC of CFTC jurisdiction

over stock-index futures contracts and associated

options. 17 This has been proposed anew in 1990.

In 1989, the continuing dispute focused on

jurisdiction over a new financial instrument called

Equity Index Participations (IPs), proposed for

trading by three securities exchanges.18 IPs were to

represent “a present interest in the current value of

a portfolio of stocks. ’ The holder of an IP would be

entitled to a proportionate share of an amount equal

to any regular cash dividends paid on the stocks in

the portfolio, without ever owning the stocks.19

Index participations were approved by the SEC as

a way to let individual investors get some of the

risk-reduction benefits that institutions get from

program trading, and as a means to reduce market

disruptions due to such high volume trading techniques. They were held by the SEC to be ‘ ‘securities” because their economic function was equivalent to that of securities-a claim to dividends,

freely transferable in exchange transactions, and

able to appreciate in value. The Chicago Board of

Trade (CBOT), the CME, and the CFTC challenged

the SEC’s approval, claiming that IPs were futures

contracts because they represented a transaction that

would be cashed out at a future date, at a price based

on the difference between an initial price and an

undetermined future price. The Court of Appeals for

the Seventh Circuit noted that the IPs have some of

the characteristics of a security and some of the

characteristics of a future contract, but because of

the exclusivity rule would have to be regulated by

the CFTC.20

The dispute over regulatory jurisdiction for IPs

highlights some useful insights about competing

regulators and the stresses that some new innovative

products place on the jurisdictional boundaries

established by law. Exchanges may seek to protect

their existing products against competition from a

new financial product that would trade on other

exchanges. Regulators must implement statutes as

written (but also may seek to protector expand their

jurisdiction). These disputes often delay or prevent

the trading of new financial products that could be

useful to investors.21

The dispute over regulatory jurisdiction of IPs

also highlights the growing difficulty of categorizing some new financial instruments as either stock,

options, or futures contracts and thus assigning their

regulation to the SEC or the CFTC. The Appeals

Court, unable to find a clear categorization of IPs,

complained: ‘‘We must decide whether tetrahedrons

belong in square or round holes.” 22 The court

necessarily relied on interpretation of existing statutes and prior case law, and properly made no

16’’l’he seventh @c~t d~~i~n ~onw~g Optiom on GM securities (see foo~ote 15) ww mooted by this legislation (and was dSO vacated w

moot by the Supreme Court).

ITThevote was, however, 3-2, and Chairmm Ruder, whoproposedthe change, admitted that there was little chance the proposal would succeed (David

A. Vise, “Battling for Market Control: SEC, Led by Ruder, Votes To Ask Congress for Index Futures Role,”Washington Post, MZly 27, 1988, Dl).

18~ey Werefmst d~igned by tie philadelp~ Stock fic~%e, which inFeb~1988 applied to the SEC forpe~sion to @ade them. The AMEX

and CBOE later submitted to the SEC their own proposrds for variations of E%.

19’rhe ~ w= to be of indeffite dmation. The holder ~o~d either exemise a “c~h-out” privflege av~~ble @y or qtierly (this V~ed ~Ong the

II%) or could enter into an “offsetting” sale or purchase to close out his position. In that case, theholderwouldmake a profit (or limit his loss) by receiving

or making payment of the difference between the prices of his opening and closing transactions. SEC Release 34-26709, Apr. 11, 1989.

20U.S. Court of Appeals for the Seventh Circuit decision in Chicago Mercantile Exchange, Board of Trade of the City of Chicago, and Investment

Company Institute. Securities and Exchange Commission decided Aug. 18,1989. Also, ‘‘Court Rules SEC Erred in Decisions on Futures Markets,”

Wall Street Journal, Aug. 21, 1989, p. C9.

zlAc@rd~g t. ~om= Russo, S=fities ~d co-~tiw1aWer, the SEC initi~ly rej~t~ the f~st f~ncti futures COn~C~ which WW then

approved by the C~C and trad~ on CIXYI’. The SEC also would not approve the fiist attempts to develop index products. RUSSO, Op. cit., footnote

11, p. 3.

221bid., P.2. [7ti Cir. COurt of Appds, Aug. 18, 19*9.1
172 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

judgment as to which agency is better equipped to

supervise trading in IPs. Nor did this court decision—

or earlier judicial decisions, the Shad-Johnson Agreement, or the legislation based on it—resolve the

fundamental issue of how to assign jurisdiction for

new financial instruments which do not fall neatly

within either the capital formation or the hedging

categories.

MARGIN REQUIREMENTS

In stock markets, “margin” is the amount that,

under FRB rules, brokers, dealers, and other lenders

must require from customers as a down payment

when they sell securities to customers on credit.

Exchanges and the NASD also require additional

“maintenance margin” deposits. 23 In futures markets, margin is defined as a performance bond that

protects the clearinghouse against default by clearing members. Proposals have been made repeatedly

to “harmonize’ the levels of margins across markets—

generally with the policy objective of raising futures

margin requirements in order to constrain the

pressure that might be transmitted from futures

markets to stock markets. This issue is discussed in

chapter 4. It is closely related to another policy issue:

How and by whom should margin levels be set?

After the 1929 stock market crash, Congress

concluded that low margins required for stock

purchases had encouraged excessive speculation.

Margin requirements were, at the time, set by stock

exchanges without government intervention. The

FRB was empowered by the 1934 Securities Exchange Act to specify required margin levels on

securities.

The FRB changed stock market initial margin

requirements 15 times from 1934 to 1959 and less

frequently thereafter. Since 1974 it has left initial

margin requirements at 50 percent of the market

value of purchased stocks, and 150 percent of the

value in ‘‘short’ transactions. 24 The stock exchanges and NASD’S additional maintenance margins require at least 25 percent of market value in

long transactions.25 Specialists and OTC marketmakers pay much lower margins.

Futures margins are set by exchanges and are

usually about 5 percent. Only in emergencies does

the CFTC have authority to direct the exchanges to

raise margins. Unlike stock margins, required levels

for futures margins change frequently. For a time

following the 1987 crash-possibly to ward off the

numerous proposals that Congress take action to

require higher futures margins26-exchanges did not

drop this requirement below 15 percent for speculative long or short positions, but the requirement was

soon halved. In early May 1989, the CME reduced

the speculative margin for S&P 500 futures from

$15,000 to $6,500. In October 1989, it varied from

$9,000 to $12,000-FRB Chairman Alan Greenspan

later said that he was shaken by the exchange’s

action in raising margin requirements during the

market break, because it drained liquidity from the

market when it was most needed. In May 1990 the

margin requirement stood at $20,000.

The inability of empirical studies to answer

decisively (at least to the satisfaction of all sides in

this politicized argument) the question of whether

initial margin requirements affect volatility is discussed in chapter 4. Regardless of empirical research, the regulatory agencies take strong-and

conflicting-stands on this question. SEC’s Division of Market Regulation ‘continues to believe that

low futures margins have contributed to the size and

volatility of short-term market movements, ’ ’27 and

Richard Breeden, chairman of the Commission, has

on several occasions in 1990 reiterated a demand for

~when~adverse~et movement~s reduced the margin account to a point where the cash or collateral loaned to the account holder by the broker

is jeopardized, the exchanges require the customer to deposit additional equity, or “maintenance margin. ‘‘ Ifacustomerbuys stock worth $100, he might

put up $50 (initial margin) and borrow $50. Unless the stock value falls below $66.67, the customer would not need to deposit additio~ maintenance

margin because the remairdng value of the stock to the customer ($66.67 minus the $50 he put up) is $16.66, which is equal to the NYSE’S maintenance

margin requirement of 25 percent of $66.67. If the value continues to decline more maintenance margin will be demanded.

~h a short tr~sactiou one is selling stock that one does not yet OWIL but has borrowed, expecting to be able to buy it subsequently at a lower Price.

?5Moptions ~~gtie IIUW@ is a ~rfo~nce bond to cover the obligations incurred if the underlying stock generates a 10SS for the oPtiOm Writm.

FRB has deferred the setting of both initial and maintenance margin to the options exchanges subject to SEC oversight. The way these are set was

explained in ch. 5. That chapter also discusses the related issues of cross-margining and futures-style margins for options.

Z6’rhe ~esident~s T~k Force on M~et M~~sms, m one e~ple, c~ed for ~@s in tie two m~ket s~ents to reflect rOU@y @Vdent

risk and leverage.

~Ric~d G+ KetchW Division Director, in a m~or~dm to SEC D~ctor David S. Ruder, June 30, 1989, p. 22.
Chapter 9-The Bifurcated Regulatory Structure ● 173

higher margins.

28 CFTC Chairman Wendy Gramm

told Congress in March 1990, “There is no credible

evidence to support the contention that low margins

for stock-index futures cause stock price volatility. “29 Secretary of Treasury Brady has called for

higher margins. Alan Greenspan, chairman of the

FRB, says, “Although available statistical evidence

on the relationship between margins and stock price

volatility is mixed, the preponderance of the evidence is that neither margins in the cash markets nor

in the futures markets have affected volatility in any

measurable reamer. ’

After the 1987 crash, there were many proposals

to change the locus of responsibility for setting

margin requirements. (The assumption is that the

SEC, and possibly but not surely the FRB, would be

likely to raise futures margin requirements, the

CFTC-as now constituted-would not.) The President’s Working Group on Financial Markets could

not reach consensus on who should set margin levels

(reflecting the diverse institutional representation in

the Group) .30 Representatives of the SEC, FRB, and

Treasury Department argued that the government

should set (or disapprove) margin levels for all

products. The CFTC, possibly unwilling to be put in

a potentially adversarial position vis-a-vis the futures industries, maintains that exchanges are in the

best position to assess market volatility and determine appropriate margin levels, with the CFTC

having authority to act only in emergency. The SEC

in July 1988 proposed to Congress a restructuring of

margin regulation. The CFTC would be required to

review futures margins to assure that they are

‘‘prudential’ and SEC would have the same responsibility vis-a'-vis securities margin requirements.

The FRB would have residual authority to review

margin requirements for all products. At one time

the FRB asserted that it has power to set margins on

stock-index futures, but the FRB has recently shown

no interest in exercising this untested claim.31 It has

not changed securities margins at all since 1974,

which can be interpreted to mean that it has seen no

useful economic purpose served by margin regulation.

In part, this disagreement turns on the question of

the purpose of margins. The futures industry (and the

CFTC) say that margins are to protect the clearing

organization and the futures markets against default

of a clearing member. Because of the practice of

marking-to-market daily, and daily or intra-daily

margin calls, relatively low initial margins afford

fully adequate protection for the clearinghouse. The

argument for government responsibility, on the

other hand, makes two points. First, the links

between markets now allow participants with great

leverage in the futures market to make great

demands on the liquidity of securities markets. This

creates the opportunity for a financial “tragedy of

the commons. ” Secondly, participants in futures

markets also are participants in securities and

options markets; the collapse of their financial

integrity would threaten far more than other clearinghouse members and could imperil basic U.S.

financial mechanisms. The question of whether

margin requirements are “adequate” must turn on

whether ‘‘adequate’ refers to protection of the

clearing organization against the potential insolvency of a clearing member, or to the integrity of the

clearing and settlement system, or to the robustness

of the national payment system.

The SEC and the CFTC continue to make

significantly different judgments about the effects of

margin levels and about how they should be set.

Neither now has the statutory authority to determine

margin levels in either market. The CFTC can act in

an emergency, but since it holds that margin levels

do not affect volatility it would presumably not do

so in the context of a market break. The FRB has

delegated authority to approve margins on equity

options to the SEC.

The unease about the possible affects of low

margins for stock-index futures, which increase the

leverage that futures market speculators can exert on

stock prices, contributes to the controversial propos2s~Fe_ 1988, the SEC had suggestti that the futures markets should increase initial margins for stock-index futures tO ii kd Of 20-= Pement-

“Black Monday-the Stock Market Crash of Oct. 19, 1987,” Hearings before the Senate Committee on Banking, Housing, and Urban Affairs, looth

Cong., 2d sess., 1988,547. Feb. 2,3,4,5, 1988.

zgs~tement of Dr. Wendy L. Gramrn before the Semte Committee on Banking, Housing, and Urban Mairs, w. 29, lm.

%waseomposedof GeorgeD. Gould, Department ofTreasuryUnder Secretary for Finanee; Alan Greenspw Chairma nof the FRB; Wendy Gramm,

Chairman of the CIWC; David S. Ruder, Chairma n of the SEC.

slM~kh~ and step~~, ‘The stock Market Crmh of 1987—The United States Looks at New Recommendations, ” Georgetown bW~CWrMz, VO1.

76, 1980, pp. 1993,3037, and n.280.
174 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

als to transfer jurisdiction over stock-index futures

trading to the SEC. In that case, their margin

requirements would presumably fall under the jurisdiction of the FRB. The FRB’s responsibility is the

financial system as a whole, while there is no reason

to believe that any single exchange has the motivation or the ability to fully consider the impacts of its

actions on other exchanges and clearance systems or

on the economy as a whole.

REGULATORY RELATIONSHIPS

A proposed bi1132 partially addresses concerns

about lack of coordination in market regulation. It

has four parts: 1) emergency powers for the SEC at

times of great marketstress;332) reporting of trades

by large traders to allow better investigation of

insider trading and better analysis of the effects of

institutionalization and program trading; 3) risk

assessment; 34 and 4) coordinated clearing mechanisms. In Hearings on this bill held in May 1989,

Senator Christopher Dodd listed other congressional

concerns: whether margin levels in derivative products markets are high enough to control speculation

whether margin harmonization across markets is

desirable; inter-market coordination; and “what

should we be doing now to prepare for the markets

of the future?”35

From the time of the 1987 crash until late 1989,

staff of both the SEC and the CFTC publicly said

that relationships between the two organizations

were good, ’that satisfactory ways of sharing information and discussing interagency problems are

well worked out, and that the two staff groups

continually communicate, both formally and informally. However, the CFTC said that during the 1987

crash ‘‘interindustry coordination could have been

better,” as to whether trading in individual stocks

would be halted or whether (as rumored at one time)

the NYSE would close. Since the crash, arrangements for coordinated circuit breakers have been put

in place.

The SEC and CFTC reach significantly different

conclusions in analyzing the causes and contributing

factors in recent market breaks. This was evident in

their reports on the 1987 market crash, as discussed

in chapters 3 and 4. It was evident again in their

analyses of market events on October 13 to 16, 1989,

both released in May 1990.36

In spite of close communications, there is room

for disquiet about the effectiveness of coordination

in times of emergency because of the differences in

approach apparent in these reports. Many of the

findings about events, and about similarities and

differences compared to events in 1987, are basically the same, but their interpretation and the action

implications are quite different.

After exhaustive analysis of trading data from

October 13 and October 16, the SEC said that its

findings confirmed that “while activities in the

index futures market do not, in themselves, cause the

sharp market downturns or price rises . . . these

trading strategies, in particular index arbitrage, can

markedly accelerate price movements already underway.” The CFTC found that “Neither program

trading nor futures sales by those with large positions, explain the observed price movements on

those days. ” The CFTC did find that stock-index

futures markets “initially reacted faster than their

underlying stock indices when market-wide volatility increased’ but there was no evidence of causation.

The SEC noted that the partial circuit breakers

that took effect in futures markets coincided with a

sharp drop-off in program selling and a reduction in

the rate of price decline in stocks. The SEC said that

“while a direct causal relationship is difficult to

establish, ” at a minimum its findings indicate “an

absence of harm’ from the imposition of price

limits. The CFTC also said it was “difficult to draw

conclusions from limited observations” but found

that ‘‘shock absorbers do not appear to have

qz(t~ket Refo~ ~t of Iggg$> (S.648), and “Stock Market Reform Act of 1989” (H. R.1609), later H.R. 3657.

33~e or@@.I propos~ Actwouid expand SEC emergency powers to call a halt to securities trading under c- conditions; a later proposed version

requires Presidential approval before closing markets. The WC already has such emergency powers over futures trading. Hearings on S.648, The

Market Reform Act of 1989, May 18, 1989.

34~e ~ket R~om ~t ~so wo~d wow tie SEC to gamer data to assess me fiici~ so~dness of holding companies that Own broker-dealer

firms (’‘risk assessment”). The NYSE, supporting this proposal, remarked that ‘‘As fmncial institutions enter non-traditional businesses not subject

to self-regulatory oversight they have the potential to create systemic risks domestically and internationally. ”

3sSemtor Dodd’s opening statement, Hearing on S. 648, The Market Reform Act of 1989, WY 18, 1989.

36CoHodi~Fu~es Tradingcommission, Division of fionomic~yis, Repoflon stockInd~Fu~res andcash Marketktivity Dun”ng October

1989, May 1990. Securities and Exchange Commission Division of Market Regulation Trading Analysis of October 13 and16, 1989, May 1990.
Chapter 9-The Bifurcated Regulatory Structure ● 175

moderated intraday market volatility,’ and that

“instead, there is some evidence that a binding

circuit breaker in one market is associated with

increased volatility in other unconstrained markets.’ The CFTC model predicted that stock market

volatility would have been higher if the futures price

limit had remained in effect longer.

With the present informal arrangement for cooperation between these two agencies, there is always

a risk-even a probability-that new areas of

conflict will arise. Further conflict is likely to arise

for the same reasons as past conflict, through

continued disputes about jurisdiction over new

instruments, disagreements over different margin

levels, and finger-pointing when there is another

sharp market decline. These disputes raise the

question of whether a different regulatory structure

is now needed, to avoid a continuation of tensions

between regulators.

Three approaches to permanently resolving the

jurisdictional issue are possible: 1) provide clearer

jurisdictional separation for each agency; 2) create

an inter-market coordinating committee or agency;

and 3) merge the SEC and CFTC to create a new

agency.

Clearer Definition of Jurisdictions

Earlier efforts toward redefinition of jurisdictions

have not proved effective. It is almost impossible to

foresee just what attributes tomorrow’s financial

products will have because “new instruments can

appear at any border. ’ ’37

One approach is to assign jurisdiction on the basis

of the primary function of each financial instrument

(i.e., capital formation instruments v. risk shifting,

hedging, or speculation instruments). Regulatory

jurisdiction over options could be transferred from

the SEC to the CFTC. Instruments that provide both

capital formation and risk shifting functions (to

different investors) would still pose problems.

Alternatively, jurisdictional responsibility might

be assigned according to whether the purchaser

owns or does not own the assets underlying the

instrument. This would make the CFTC responsible

for all options and all futures, the SEC would have

jurisdiction over capital raising instruments—

stocks, bonds, and also commodity pools.38

It would almost certainly be necessary to increase

the size of the CFTC with either of these approaches.

Neither would solve the problems of assigning

responsibility for subsequent new products, of

determining appropriate futures margin levels, or of

coordination in emergencies.

A third approach would place all products whose

price is directly derived from stock prices-such as

stock-index futures and stock-index options-under

SEC. This would leave a mixed bag of financial

futures contracts to be regulated by the CFTC.

Alternatively, all financial futures could be shifted,

so that the CFTC retains only futures contracts based

on agricultural products, industrial materials, metals, etc., i.e., non-financial contracts. Under this

approach the jurisdictional assignments would cut

across market institutions, trading location and

exchange responsibility, trading techniques, margining systems, and retail distribution systems. This

could be the source of much complication and

confusion.

The possible effects of reassigning stock-index

futures to SEC responsibility are uncertain. Whether

the exchanges would continue trading these contracts, whether they would be used by the same

market participants and in what ways, whether they

would be traded overseas, and other such questions

have not been thoroughly assessed by those on either

side of the controversy. Several gains in efficiency

might be achieved if this jurisdiction is transferred

to the SEC. For example, the current relationship

requires much duplication of effort in joint approval

of new products.

Transferring stock-index futures and options on

stock-index futures from the CFTC to the SEC

would require amendment of Federal securities laws

and the Commodity Exchange Act. Existing securities legislation is highly complex, with at least six

laws applying to securities markets. Thomas Russo,

who practices securities and commodities law and

has been a member of the staffs of both the CFTC

3Tu.s. COWI of Appeals, op. cit., footnote 12, p. 13.

3S0Ww~~p of ~ ~-o~~pool is much me omer~fip of am~@ fidin titin~est~rs ~ve~int~est in tie resets of the pool, mthm ~direCt

ownership of its assets. These pools acquire various types of futures, e.g., futures on stock indexes, wheat, or gold. The SEC does not now have this

regulatory responsibility.
176 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

and the SEC, recently told a congressional committee:39

(N)either the commodities nor the securities

laws. . . reflect today’s markets. When we talk about

what we should do with the commodities and

securities regulatory structures, we must keep open

the possibility that both structures should change. It

may well be that neither particularly suits the world

in which we live.

A compromise proposal, also in discussion in

Congress (in July 1990) would allow the CFTC to

retain its authority over stock-index futures and give

the SEC authority to regulate any new instruments

that “share the qualities of both a future and a

stock. ” This would not solve the current problems

of jurisdictional confusion, margin levels, or control

of short term volatility, and it would almost surely

give rise to new disputes over subsequent product

innovations.

An Inter-Market Coordination Agency

The Brady Commission, in its most controversial

proposal, urged that one agency be given the

authority to coordinate ‘‘a few but critical” intermarket regulatory issues such as clearing and credit

mechanisms, margin requirements, and circuit breakers, leaving intra-market issues with either the SEC

or the CFTC.40 Later, the experts behind the Brady

report effectively retreated from this suggestion for

a two-tier structure.41 A bipartisan group of Senators

proposed an inter-market coordinating committee

consisting of the heads of the FRB, the SEC, and the

CFTC, but the proposal did not bear fruit.42

Placing the authority for jurisdictional decisions

in the hands of a multiagency panel could reduce the

present reliance on judicial decisionmaking, provided the panel were given clear and binding

decisionmaking authority rather than being charged

merely with making recommendations. The panel

might, for example, be composed of representatives

of the SEC, the CFTC, the Treasury Department, and

the Federal Reserve Board, with or without representation for SROs; or it might be made up of neutral

experts in finance and securities law. The former

alternative already exists, in the form of the President’s Working Group on Markets. The weakness of

this proposal is that on such a panel—which is not

an independent, staffed agency—agency representatives vote their agency position, derived from

broader agency concerns not always directly focused

on the issue at hand. They predictably vote to

buttress the authority of their agency, so that most

decisions would depend solely on the vote of the

third member. If SROs were included they would

vote their competitive interests, so that nothing

approaching an objective consensus could be expected.

The alternative, an expert extra-governmental

panel, would be in a better position to take into

account product design and function, the best

interests of investors, the efficiency of markets, and

other national interests. In practice, however, it

would be difficult to find truly neutral experts. The

relatively few people with great knowledge and

understanding of securities and derivative product

markets usually have been affiliated in the past with

one set of markets or the other, but not both, as an

exchange member or officer, a regulator, or a

long-time consultant.

Inter-market coordination primarily involves three

tasks: 1) assuring the willingness and ability of the

banking system to make credit available to stock

brokers, futures commission merchants, and clearing corporations when markets are under stress; 2)

margin harmonization; and 3) coordination on issues

such as circuit breakers, information sharing, market

surveillance and enforcement, and contingency planning. The frost task is already vested in the FRB and

was exercised appropriately in October 1987. The

39ThODMS A. RUSSO, Testimony before the Subcommittee on Telecommunications and Finance, House Committee on fiergy ~d Com.mmce, MY

3, 1990. Mr. Russo is a partner at Cadwalader, Wickersham & Taft.

@Tfie Presidential Task Force on Market h4echunisms, (Brady RIWOK J~WUY 1988, P. 59).

dl’rhe Brady Report also suggest~ that the Federal Reserve Board was best qualified to be the inter-market regulatory agency. A monti ~ter FR.B

aairman Greenspan objecte~ on the grounds that: a) this would lead to a presumption that the Federal safety net had been extended to the markets (so

that no securities fm or clearing corporation would be allowed to fail), and b) the FRB lacked the necessary specialized expertise. Soon after, the authors

of the Brady Report said that debate over the proposal bad drawn attention from ‘‘more critical issues’ and “what is most crucial is not who oversees

the [inter-market] issues” but that “we get to work on them.”Statement of the Presidential Task Force on Market Mechanisms, 1987-1988 Fed. Sec.

L. Rep. (CCH), Par. 84,237, May 1988.

4~ter--ket Coortition ~t of 1988, H~gs~fore Smate Committee on B-g,Hous~g, and Urtin Aff~.s, 1~ Cong., 2d SeSS., On S.

255610-14,77 (1988). The bill W= not enacted. There is at present ~ hter-bet surveillance Group (initiated by SEC) made Up of stock and stock

option exchanges plus the Chicago Mercantile Exchange, that coordinates efforts to eliminate trading abuses.
Chapter 9--The Bifurcated Regulatory Structure . 177

second and third tasks could be handled with more

organizational simplicity either by transferring CFTC

jurisdiction of stock-index futures and options on

stock-index futures to the SEC, which has already

been discussed, or by merging the existing agencies

rather than adding a third layer.

Merging Agencies

Merging the SEC and the CFTC has the merits of

containing and resolving disputes within one agency,

rather than requiring court decisions. This approach

also would tend to encourage the use of less

parochial criteria in decisionmaking and intermarket coordination. No serious problem of inexpertise should arise, since, the staffs of both agencies

would be combined.

The case for consolidation has been stated succinctly by Judge Stanley Sporkin of the U.S. District

Court, Washington, D. C., former Director of SEC’s

Division of Enforcement:43

Our securities markets are too symbiotic to have

the kind of separate regulation that now exists

between the CFTC and the SEC. . . . An objective

analysis of the problem stripped from its political

realities would seem to suggest that a single agency

should be reposed with the responsibility for overseeing all securities related activities.

Another argument for integration is that having to

deal with two hotly competitive industries might

help to prevent the regulatory agency from becoming too closely identified with, or captive of, either

of these industries.

Many participants in futures industries are convinced that the two regulatory agencies have different perceptions of and attitudes toward the markets

they regulate, and that their industry would be

disadvantaged if the CFTC is merged with the larger

SEC. This perception is reflected in the observation

that: “The SEC’s world is net long, while the

CFTC’s world is a zero-sum game.”44 It was said

less cryptically by the CFTC chairman Windy

Gramm, who told a congressional committee that

there is “a conflict of interest” between the SEC

goals of stable or higher prices for the benefit of

investors, and the duties of a futures regulator, who

‘‘must be insulated from any such price bias in order

to maintain price neutrality.’ ’45 This implies that the

SEC is generally happy to see market prices

increase, benefiting the capital formation process

and investors; the CFTC is “price neutral,’ since in

futures markets, for every winner there is a loser.

Some critics of consolidation argue that there is

benefit to having competition among regulatory

agencies, 46 specially 46specially, that this stimulates healthy

cross-fertilization. To these critics, the many strong

disagreements between the SEC and the CFTC are

a positive benefit, because they reflect the fact that

certainty about many of these issues is not possible.

Merging the two agencies, according to this view,

“would give the impression of a single view and

would stifle responsible discussion of important

issues.” 47

But competition between regulatory agencies can

also lead to a situation in which the regulated

industries tailor their behavior or their products to

choose their regulator, thereby setting one agency

against another in order to paralyze government

response. 48 At present, innovation in products is

hampered or completely stymied because the products “fall between the stools” and are likely to

involve the exchanges in protracted wrangling

between agencies or in lengthy judicial proceedings

to determine the proper jurisdiction. If it is the case

that the SEC and CFTC have different regulatory

philosophies, this may encourage the industry to

exploit the bifurcated regulatory regime. In any case,

the difference in approach could change at any time

with appointment of new Commissioners (or could

be influenced by Congress through oversight, budgds~e Honorable Stanley Spork.in, “U.S. Financial and Securities Markets Under Stress, ” Address to the Fourth Annual Colloquium on Corporate

Law and Social Policy, University of Ohio College of Law, Mar. 6, 1989.

44A remkoftenmadeby SEC Cotissioner ~wudFlei~c@ in sp=ches d~g1988 and 1989. See 13is speech to tie National Security Traders

Association, New York City, July 21, 1988, as reported in The Market Chronicle, Sept. 22, 1988, pp. 8, 10.

dsGramm, op. cit., footnote 28.

46~wmd J+ ~e, ~ ~ReWlatoV s~c~e ~ F~~es ~kets: J~sdictio@ Competition Between tie SEC, tie ~C, and Other Agencies,” The

Journal of Futures Markets, vol. 4, No. 3, 1984, pp. 367-384.

47~ofe~~or Ha Stoll, D~ector of tie F~mcW Mmket~ Re~~ch Centm, owen ~ad~te School of mgem~~ Vandefiilt University, in

correspondence to OTA, July 13, 1990.

4SSee SMCO, “Agencies ~Cofiict: OverIappi.ng Agencies and the Legitimacy of tie Adminisbtive ~ocess! ‘‘ VanderbiltL.uwReview, vol. 33,1980,

p. 101.
178 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

etary action, and refusal of conflation of Commissioners). Short-term characterizations of the agencies are not an appropriate basis for making longterm decisions about jurisdictions.

Another objection that has been raised to consolidation is that neither agency has the expertise in or

understanding to take over the others’ responsibilities. This problem, if it exists, could be handled by

transferring or merging staff and by altering the

management structure of the consolidated agency. It

could be beneficial to disrupt any feelings of

identification of regulatory staff with the industries

they regulate. Consolidation of two independent

agencies would however require careful attention to

writing a new organic law. There are sufficient

differences in the legislatively mandated structure,

scope of responsibility, and authority of the two

agencies—as well as in their ethos and cultures as

they have evolved during their institutional lifetimesthat merely joining the two agencies, each bringing

along its own charter, would probably create a

dysfimctional organizational monster.

The most practical barrier to consolidation of

jurisdiction is perhaps that different congressional

committees now have oversight over the two agencies, and may not be willing or able to agree to

consolidation of jurisdiction. One approach could be

to create a new single committee in each House with

oversight over regulation of the trading of stocks,

stock options, and stock futures, or over the trading

of all securities (including commodity futures,

bonds, etc.). These two committees could then give

attentive consideration to the advantages and disadvantages of jurisdictional consolidation, possibly

extending to complete consolidation of the two

regulatory agencies.
Appendix
Appendix

Clearing and Settlement in the United States

Three clearinghouses and three depositories serve

the Nation’s seven stock exchanges, National Association of Securities Dealers Automated Quotations

System (NASDAQ), and other over-the-counter

(OTC) dealers. Nine clearinghouses serve the 14

futures exchanges, and one clearinghouse serves all

the equities options markets.1 The major clearing

members, who also clear for non-clearing members

of a clearinghouse, tend to be highly automated for

lower costs and greater operating efficiency. For

safety purposes, U.S. clearinghouses also tend to be

financially structured such that a failing clearing

member can be isolated quickly and its problems

resolved without a ripple effect.

While arrangements between clearinghouses and

their clearing firms vary, the general goal is that the

clearinghouse maintain adequate resources and commitments to assure settlement if a clearing firm

defaults. These protective arrangements include

capital requirements for members, claims on items

in process, if any, and claims on the defaulting

member’s remaining assets on deposit with the

clearinghouse (e.g., cash, letters of credit, Treasuries, or securities posted as collateral for margin). The

clearinghouse also has claims on other assets of the

failed clearing member. The clearinghouse’s guarantee fund is another resource. Certain major clearinghouses, (e.g., the Chicago Mercantile Exchange

and Board of Trade Clearing Corp.), also require the

parent entities of their clearing members to guarantee all proprietary trading on the books of the

clearing members. Finally, the clearinghouse can

make assessments against other clearing member

fins. This succession of fallbacks is a buffer against

shocks ranging from sudden large price movements

to defaults by members. As a result, there have been

few cases of a failure of a clearing member in the

United States, and no instances of a failure of a

clearinghouse. 2

Equities Clearing Organizations

National Securities Clearing Corp. (NSCC)3

NSCC processes 95 percent of all equities trades

in the United States. It is jointly owned by the

principal equities markets: the New York Stock

Exchange (NYSE), American Stock Exchange (AMEX),

and National Association of Securities Dealers

(NASD). It serves 1,800 brokers, dealers, banks, and

other financial institutions, through about 1,100

direct participants.

NSCC’S clearance and settlement process normally requires 5 business days. Trade information is

received either in the form of locked-in trades

already matched by the computer systems of the

exchange or market; or, as buy and sell data reported

by market participants. The latter still must be

compared and buy and sell orders matched. Lockedin trades are entered directly in the NSCC computer

system on the same day as the trade. This sharply

reduces the need for the matching of buy and sell

orders at the clearinghouse level. On a typical day,

about 76 percent of the trades on the NYSE are

locked-in (a smaller proportion by dollar value).4

Figures A-1 and A-2 illustrate the steps in the

NSCC’s clearing and settlement of retail and institutional customers’ trades, respectively.

Securities which are held for NSCC members by

The Depository Trust Co. (DTC), and whose ownership can therefore be transferred within DTC via its

Ih ~rw~g~s apwn~, OTA has retied heavily on a contractor report by Btmkers Tmst CO., “Study of International Clearing and Settlement”

VOIS. I-V, prepared for the Oftice of Technology Assessmen~ October 1989, to which many dozens of institutions and individuals around the world

contributed expert papers and/or served on the Bankers Trust adviso~ panel. Hereafter called Bankers Trust qort. OTA has also used the discussions

of an expert workshop held at OTA on Aug. 22, 1989. For information on the clearin g and settlement of U.S. Treasury and government agency securities,

mortgage-backed securities, and municipal securities, see Bankers Trust Report.

@ne expert notes that the only situation he can envision in which the National Securities Clearing Corp. (which clears the vast majority of equities

trades in the United States) could fail, would require a major external triggering event, such as the collapse of one or more major U.S. banks causing

the failure of one or more NSCC clearing banks or major clearing members. (Robert Woldow, NSCC, at a meeting of experts on clearing and settlement,

OX% Aug. 22, 1989.) The events of October 1987 in the United States-when the payment system began to become clogged-were perceived as

potentially disastrous.

BRob~ J, w70~dow, clearance ~~ settlement in the U.S. Secun”ties Markets: An ove~iew of the Roie of the Nafi”owl Secun”ties c~earing CO?p.

in Equities Trading, revised July 1990. Hereafter referred to as NSCC report.

4~ Au~t 1989, &e NSCC began ~ompfig ~~m tit~ not 1ocked.~ dfig he emly mor~g hems of Ti-1. Locked-in trades dSO include 56

percent of the American Stock Exchange’s daily trades, and over 18 percent of OTC trades. Ibid., NSCC reporti p. 2.

–181–
182 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Figure A-l-Clearance and Settlement of Retail Customer Trades

SELLING

Confirm(3) Trade

Details (4) I

Execute (2)

Trade

Details (4)

CLEARING

CORPORATION

SELLING

I Retail I

Results

of

I STEP 3.

(1)

(2)

(3)

(4)

(5)

(6)

(7)

CORPORATION

(Trade Comparison)

-.

‘B UYI NG

Broker

B

Order (I)

BUYING

B

BUYING

L

Broker

B

of

Comparison

SELLING ‘SELLING

Retail Broker Deliver

Customer A Obligation (7)

A

t

I

CLEARING

CORPORATION

(Trade Netting and Issuance of

Receive/Deliver Obligations)

(6)

Retail Customers give orders to buy and sell stock to their respective Brokers

Brokers execute Retail Customers orders in the Marketplaces.

Brokers confirm back to their respective Retail Customers that the trades were executed.

Brokers submit details of trades executed in the Marketplaces to the Clearing Corporation.

Clearing Corporation generates reports back to the Brokers indicating the results of comparison

Clearing Corporation

Clearing Corporation

nets the trades.

issues projection reports indicatlng net receive/deliver obligations to the buying and selling Brokers.

Retail

Customer

B

BUYING

I Retail I

SOURCE: NSCC, 1990.
Appendix-Clearing and Settlement in the United States ● 183

Figure A-l--Clearance and Settlement of Retail Customer Trades-Continued

I STEP 4. TRADE DATE + 5 (T+ 5 ) ]

(8)

SELLING Shares SELLING

Retail Broker

Customer A

A I

(9)

Shares

(12)

CLEARING Shares

CORPORATION

t

I

I SELLING

DEPOSITOR“u---- Y %

I STEP 5.

(16) (14)

SELLING Money SELLING BUYING Money BUYING

Retail Broker Broker Retail

Customer A B Customer

A B

(Collect) CORPORATION (Pay)

(9) Selling Broker A deposits selling Customer A’s shares in its account at the Depository

(l0a) Clearing Corporation instructs Depository to debit selling Broker A’s account and credit Clearing Corporation’s account with the shares;

(lob) Depository debits selling Broker A’s account with the shares and credits Clearing Corporation’s account.

(1 la) Clearing Corporation instructs Depository to debit Clearing Corporation’s account and credit buying Broker B’s account with the shares;

(11 b) Depository debits the Clearing Corporation’s account with the shares and credits buying Broker B’s account.

(12) Buying Broker B requests withdrawal of shares from its account at the Depository in order to deliver to Retail Customer B.

(13) Buying Broker B delivers the shares to its buying Retail Customer B.

(14) Buying Retail Customer B pays buying Broker B for shares received.

(15a) Clearing Corporation advises buying Broker B of net pay amount for shares received;

Buying Broker B delivers a check to Clearing Corporation for the requested amount

(15b) Clearing Corporation advises selling Broker A of net collect amount for shares delivered;

Clearing Corporation issues check to selling Broker A for the specified amount.

(16) Selling Broker A pays selling Retail Customer A for shares delivered.

SOURCE: NSCC, 1990.
184 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Figure A-2-Clearance and Settlement of Institutional Customer Trades

I SELLING Order

(1)

BUYING Order

(1)

BUYING

Customer

A

Broker

B

+

Trad e

Customer

B

Trade

Details (3) Details (3)

CLEARING

CORPORATION

‘STEP 2 TRADE DATE + (T+ l) ’

I ID ~ SELLING BUYING I D

Broker Broker

A

t B

(4)

CLEARING

Comparison CORPORATION

ID

(5) +

ID

Confirmation

Bank A I Broker A Bank B

Account Account

D E P O S 1 T O R Y

‘STEP 3. — .

ID

Affirm Broker

+ A

BUYING

Customer

I

Customer

A

(7a)

ID

(1)

(2)

(3)

(4)

(5)

(6)

(7a)

(7b)

(8a)

(8b)

CLEARING

CORPORATIO N

(8a)

ID

Affirm

CLEARING CORPORATION ACCOUNT CUSTODIAN

Account

Bank A Broker A

Account Account

Broker B

Account

Selling Institutional Customer A sends ID affirmation to Custodian Bank A to deliver securities on settlement day (T+5) to its’ Broker (A)

Selling Institutional Customer A sends ID affirmation to selling Broker A indacating that Custodian Bank A WiII deliver

the securities to it on settlement day

Buying Institutional Customer B sends ID affirmation to Custodian Bank B notifying to receive securities on settlement dav from its’ Broker (B)

Buying Institutional Customer B sends ID affirmation to Broker B, Instructing it to deliver securities to its Custodian Bank (B)

,

on settlement day

SOURCE: NSCC, 1990.
Appendix-Clearing and Settlement in the Wu”ted States ● 185

Figure A-2-Clearance and Settlement of Institutional Customer Trades-Continued

T SELLING

r

SELLING ; ~

f

BUYING 1

Broker Broker

Customer A

I

,--.1 - — — ’

TRADE DATE + 5 ( T + 5 )

Customer A

A I

CUSTODIAN

Bank A

Account

SELLING

Broker A

Account

CLEARING

CORPORATION

I

BUYING ‘j

Broke r

B

I

J

I Customer

CLEARING

CORPORATION

(1 2a) (13a)

I Broker B I Bank B

Accoun t Account

I shares

I STEP 6.

SELLING SELLING

I Broker 1 Broker

Customer Money ‘ Money B

A Settlement

I

Settlement

Collect

I

I

CLEARING

CORPORATIO N

I (Money Settlement)

CUSTODIAN - SELLING T

Bank A Broker A I Broker B

Account Account Account

money

D E P O-S I T O R Y

B

CUSTODIAN

Bank B

Account

h money

(15)

(9) Clearing Corporation nets the trades

( 10) Clearing Corporation Issues projection reports Indicating net receive/delwer obligations to the buying and selling Brokers

(11) Custodian Bank A Instructs Depository to transfer shares from its account to selling Broker A's account

Depository debris Custodian Bank A’s account and credits selling Broker A s account with the shares

(12a) Clearing Corporation instructs Depository to debit selling Broker A’s account and credit it'S account

(12b) Depository debris selling Broker A’s account and credits Clearing Corporation s account with the shares

(13a) clearing Corporation instructs Depository to debit shares from its account and credit shares to buying Broker B S account.

(13b) Depository debits clearing corporation's account with the shares and credits buying Broker B’s account

(14) Buying Broker B instructs Depository to transfer shares from its account to Custodian Bank B S account

Depository debits Broker B's account and credits Custodian Bank B's account with the shares.

(15) Custodian Bank B pays buying Broker B for shares received

(16) Moines from Custodian Bank B to Broker B are used by Broker B to meet its settlement obligation to the Clearing Corporation

(17) Clearing Corporation receives monies from Broker B and pays to Broker A

(18) Monies from Clearing Corporation to Broker A are used by Broker A to meet its payment obligation to Custodian Bank A

SOURCE: NSCC, 1990.
186 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

computer book-entry system, are also eligible for

settlement through the Continuous Net Settlement

(CNS) computer system. This includes the preponderance of trades settled through the NSCC. NSCC

becomes the counterpart to each trade; it guarantees

that the settlement obligations of the trade will be

met—both the obligation to deliver securities and

the obligation to make payment. For locked-in

trades, NSCC’S guarantee takes effect at midnight

on the day (T+l) that the counterparties to the trade

have been notified that the trades matched.

Trades that do not match begin a reconciliation

process that is being shortened and by the end of

1990 will occur on the day following the trade (T+l).

Those that remain unmatched by T+3 are returned to

their originating marketplace for face-to-face negotiation. With the increasing number of trades lockedin at the marketplaces, and with the availability of

on-line reconciliation systems at these marketplaces,

the need for this process is being eliminated.

Using the CNS system, the NSCC calculates each

day a net long or short securities position for each

CNS-eligible security that was traded by the clearing

member on that day. The number of settlement

transactions and the gross amount of the clearing

member’s obligation either to deliver securities or to

make payment is adjusted by the amount of any

securities or payments that it would receive as a

result of other trades of the same security. This type

of calculation process is known as netting. It reduces

the total number of securities to be delivered or

received, and the number and size of aggregate cash

payments. As a result of this process of offsetting

obligations, the NSCC estimates that movement of

almost 90 percent of the total daily transactional

volume of owed securities and cash payments

otherwise required on the settlement date is eliminated. Netting may indirectly increase market liquidity by reducing the gross amount of finds

necessary to meet settlement obligations. After

netting through CNS, the NSCC then informs the

DTC of the net amount that each counterpart owes

in securities on the settlement date, T+5. The DTC,

using its book entry system, records the transfer of

ownerships by debiting the securities account of the

delivering counterpart and crediting the account of

the receiving counterparty.6 Payment on the settlement date is in the form of a certified check, payable

to the NSCC. When settlement cannot be made on

the settlement date-e. g., when the securities are not

available in the participant’s DTC account-these

obligations remain in the CNS system and are

carried forward and netted with the next day’s

obligations.

Securities that are not eligible for the CNS system

may be settled either through balance order accounting or on a trade-for-trade basis. These other forms

of settlement comprise a very small percentage of

trades settled through NSCC.

In 1989, the fail rate-the percentage of trades

which do not settle on the settlement date—in trades

cleared through CNS was 8.13 percent of the total

net dollar value of cash and securities due on the

settlement date. Since the NSCC takes the counterpart position and guarantees the settlement of all

CNS-matched trades, NSCC is exposed to various

credit, market, and non-market risks.7

NSCC protects against credit risk, first of all, by

retaining a lien over securities for which the

receiving participant has not paid. For trades not

settled by T+5, NSCC uses a mark-to-market

procedure to limit its market risk until settlement

does occur. Market risk is kept to 1 day’s market

movement by adjusting members’ settlement obligations to current market prices. Members pay or are

paid at settlement based on the current value of their

open positions (positions for which T+5 has past),

rather than the value when they made the trade. In

the interim, until the open position settles, members

pay or receive the net difference in market price

movement. NSCC’S guarantee fund for CNS takes

account of potentially adverse movements on trades

which have not settled before T+5. It is based on the

total size of all positions open. These include those

s~s description diswsses inter.de~er (Street-side) and institutional settlement only. Concerning depository functions, a broker ~n~e se~ement

with his institutional customer through DTC’S ID program. A description of customer (retail) settlement is provided by the Securities and Exchange

Commission in vol. II of the Bankers Trust report, op. cit., footnote 1.

GStock held by DTC is in nominee name and appears on the books of the transfer agent of the issuing company. h a typicrd @rinSaCtiOn,tie ~sfer

agent would not be involved in the change of ownership. The change in ownership between the parties to the transaction would occur solely on the books

of DTC. If, however, a broker or his customer wishes to have the shares registered in his own name, he instructs DTC to send the appropriate quantities

of stock currently in street name, to the transfer agent who would then send the reregistered shares directly to the broker.

7Credit fisk refem t. tie possibili~ ~t a p~icipant @@t not pay for dehver~ s~fities. Mmket risk refers to the price changes of the Setity.

Non-market risks include loss of data, human error, systems failure, or any breakdown caused by any factor other than credit or market factors.
Appendix-Clearing and Settlement in the United States ● 187

pending (before settlement); trades settling on T+5;

and trades for which T+5 has passed and settlement

has not occurred. In addition, to mitigate the risk that

a member may fail to pay for securities when they

are delivered to his account, a percentage of their

market value is included to the member’s clearing

fund requirement. In order to protect the NSCC, the

required clearing fund amounts must be deposited

with it. The calculation, which sets the total clearing

fired requirement, is done daily for all members and

can be collected more frequently than the monthly

norm. All NSCC clearing members are required to

contribute to the guarantee fired. NSCC’s total finds

on deposit, not including NSCC’s own lines of

credit, totaled over $400 million in 1989 and 1990.

The NSCC also maintains a full compliancemonitoring system to ensure its continuing ability to

judge the creditworthiness of its participants.8 It

shares risk information with other SEC-registered

clearinghouses, both through the SEC’s Monitoring

Coordination Group and the Securities Clearing

Group. NSCC and a number of futures clearinghouses are now discussing proposals for increasing

the sharing of risk information; e.g., data on market

participants’ holdings on various exchanges.

The NSCC is linked to its clearing members by

means of the Securities Industry Automation Corp.

(SIAC), which operates NSCC’s technology base.

Most participants now have direct computer links;

only about 1 percent of the Ml-service members

continue to report trades via computer tape.

All payments to NSCC are on a net basis; i.e., the

NSCC calculates each clearing member’s total credit

and debit positions and nets to a single figure that is

either owed to NSCC or is owed by NSCC. Payment

to NSCC is by certified check. Funds are concentrated in one central clearing bank. If a certified

check is not received on the settlement date, then

payment via Fedwire is required the next morning.

NSCC pays selling members with regular bank

checks, but intends to move towards the increased

use of electronic payments as one way to improve

the settlement process.

The International Securities Clearing Corp.

ISCC is a subsidiary of the NSCC and is an

SEC-registered clearinghouse. It was founded in

1985 to assist in clearing and settlement and for

providing custody services for securities traded

among American brokers and banks and their

counterparties across national borders. It has links

with clearinghouses and depositories in foreign

markets, 9 including:

●

●

●

●

●

●

the International Stock Exchange (ISE), in

London;

the Centrale de Livraison de Valeurs Mobilieres (CEDEL), in Luxembourg;

20 depositories and custodians in Europe and

Asia, indirectly linked by means of a conduit

provided by CEDEL;

the Japan Securities Clearing Corp. (JSCC), the

Tokyo Stock Exchange’s clearing and custody

organization;

the Central Depository subsidiary of the Stock

Exchange of Singapore; and

the Canadian Depository for Securities (CDS),

in Toronto, linked through NSCC.

ISCC also serves as the clearing system for the

NASD’s PORTAL market for foreign private placements exempt from SEC Rule 144A registration.

Futures Clearing Organizations10

The Board of Trade Clearing Corp.

The Chicago Board of Trade (CBOT), which

handles the greatest volume of futures contracts

trades in the United States, has its own separately

incorporated clearinghouse, the Board of Trade

Clearing Corp. (BOTCC). With approximately 139

clearing members, the BOTCC is by far the largest

clearing organization serving the futures markets.

The Chicago Mercantile Exchange (CME) is the

largest U.S. futures exchange when measured by

another yardstick, the average total value of open

futures and options on futures contracts. CME has a

Clearinghouse Division. This system and other U.S.

8NSCC’S STMS system monitors projected settlement exposures from the time trades are matched until they m ultimately settled. NSCC fio

employs a series of exception reporting mechanisms to detect security concentratio~ settlement pattern changes, and security price changes.

me ISCC is also discussing the possibility of setting Up other links with the societe Interprofessionnelle pour la Compensation des Valeurs

Mobilieres (SICOVAM), the French central depository, and with Societe des Bourses Francais, the broker clearing system at the Paris Bourse.

IOMuchof the information in this section is based on Roger D. Rutz, “Clearance, Payment, and Settlement Systems, in the Futures, Options, and Stock

Markets,” Feb. 24, 1989, a contributed paper in the Bankers Trust report, op. cit., footnote 1.
188 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

futures clearinghouses, are similar (although not

identical) to that at the BOTCC.11

BOTCC has an on-line trade entry/trade capture

system that allows it to receive over 75 percent of its

trade information through on-line terminals (with

the user keying in data). The remaining 25 percent of

trade information is reported by means of computerto-computer transmissions. In addition, members of

the BOTCC that are also members of the CME may

use the BOTCC’s on-line trade entry/trade capture

technology to send trade information to the CME,

and CME members may similarly send trade submission data to BOTCC via the CME’s on-line trade

entry/trade capture technology. About 20 percent of

the CME’s trade information arrives at the CME

clearinghouse through the BOTCC trade entry/trade

capture technology.

Once a trade has been captured, BOTCC employs

a two-sided matching system in which both the buy

and sell sides of a trade are submitted to the trade

comparison system for matching. This capability

provides the benefits of comparisons on the day of

the trade, and a match by broker and by counterbroker as well as a match within the clearinghouse.

This is the standard for futures markets in the United

States. 12

BOTCC’s guarantee to clearing members that the

settlement obligations of the trade will be met begins

at the moment a trade has been matched and

registered. At that time, typically about 1 hour after

the final trade submission, the clearinghouse becomes counterpart and guarantor to every trade.

In all U.S. futures markets, both buyer and seller

make a good faith deposit to the clearing member

firm; this is “original margin. ”13 The amount

required per contract is determined by the exchange,

and is due from both parties to the trade on the

morning of the day after the trade (T+l). Most

clearing members maintain substantial excess original margin deposits in their clearing account at the

BOTCC. The amount of margin a clearing member

owes is calculated by the clearinghouse based on the

value of his open contracts and an assessment of the

amount of risk those contracts involve. The BOTCC

uses its risk assessment computer system SAFE

(Simulated Analysis of Financial Exposure) to

evaluate clearing member firms’ credit, and uses the

CME’s SPAN (Standard Portfolio Analysis of Risk)

to determine the amount of margin owed.14

There are two methods of calculating original

margin: gross margining and net margining. Gross

margining requires a clearing member to post

original margin on all the long and short positions in

these accounts; they cannot be used to offset each

other in case of a deficiency. By contrast, with net

margining the margin owed by each clearing member is calculated on the difference between all the

long and short positions, calculated separately for

proprietary accounts and customer accounts. The

BOTCC figures original margin on a net basis, as do

most U.S. futures clearinghouses.15

The BOTCC’s trade-matching process, from the

time it guarantees settlement obligations to the

posting of original margin by clearing members,

may be 7 hours.

16 During this timelag, the BOTCC

carries the full risk. Clearing members demand that

trades become guaranteed as quickly as possible,

since this is the point at which counterpart risk

should be eliminated.

Besides original margin, futures clearinghouses

also calculate and collect variation margin.17 The

amount reflects the changes in the value of a clearing

member’s open contracts. Variation margin may be

collected daily, or more often. The BOTCC routinely issues one morning call and supplemental

llFor de~S on he ~l~g and se~ement pm~sses at tie other U.S. futur~ clefighouses, S= Bankers Trust report, Op. cit., fOOtnOte 1.

12’rhe exception i5 the New York M~c~Me Exc~ge (_NY~x), w~ch us~ a one-sided trade ~tching system h which “Sefl” klfO~tiOn iS

put into the system and the clearing member with the “buy” information must confii the data at a later time.

13~5 ofi@ m~gi.n deposit is a performance bond to protect the financial integrity of the clearinghouse in the event that the clearing fm is unable

to meet a margin call or to make or take delivery. Original margin refers to deposit of funds in the form of cask government securities, or letters of credit.

There are two levels of margin: the f~st is from the customer to the f~ the second is from the fm to the clearinghouse.

14The cm~is OM risk ~%aent computer systetip~ (Standard Portfolio Analysis of ~sk)--for detm the amount of margin.

The futures industry (with the exception of the Intermarket Clearing Corp. (ICC), which uses the system known as TIMS) is moving towards adopting

SPAN as the standard for calculating margin.

ls’rhe exceptiom me the CME Clearinghouse Division and NYMEX, which figure origi.nd Ugin On a gross b=is.

16paWent of -~ mu5t ~ ~ -&&y ~~.g+,~05e provided by he F~er~ Reserve’s Fdwire electronic payment SySt~.

17V~ation mm~ me the ~mh flow rqfied to -kpositio~ to ~ket. They flow through the cle~ orga~tion to the cledllg meIldEr On

the other side of the trade.
Appendix-Clearing and Settlement in the United States . 189

intra-day variation margin calls (usually around 2

p.m. c.s.t.).18 The major purpose of routine intra-day

variation margin calls (and payments to clearing

members with profitable trades) is to remove sameday price risk while the banking system is open. It

also reduces the magnitude of the following morning

margin call, which is always made by the CME and

BOTCC at 6:40 a.m. c.s.t. on the day following the

trade date (T+l). As a result of this system, the

BOTCC typically collects (and pays out) by about

2:30 p.m. c.s.t. on the date of the trade between 60

and 95 percent of the final settlement calls that

would otherwise have been made at 6:40 a.m. c.s.t.

on the following day. This reduces the clearinghouse’s risk because the shorter the period of time

between trade execution and settlement, the more

certain it is that a clearing member will be able to

meet its obligations. In general, the more frequently

a clearinghouse settles (marks-to-market) trades

each day, and requires its clearing members to post

margin, the greater is the financial integrity of the

clearing system.

Lines of Defense

In the futures markets, the maximum potential

default liability represents at most only one business

day’s market movement. Along with monitoring

clearing members’ positions, this is the frost line of

defense for the clearinghouse. The BOTCC segregates and nets proprietary and customer open

positions of each clearing member across commodity futures and options contracts to calculate the

amount of both the original and variation margin of

each clearing member. The BOTCC’s SAFE system

calculates each clearing fro’s potential exposure to

an adverse move in prices.

Margin deposits are the second most important

line of defense in protecting the clearinghouse from

a default by a clearing firm which could affect other

clearing members. The Commodity Futures Trading

Commission (CFTC) requires that all clearing members maintain two bank accounts for settlement and

two safekeeping accounts for original margin. One

set of bank and safekeeping accounts is for original

and variation margin for customer positions, while

the other set is for original and variation margin for

proprietary and non-customer (affiliated firm) positions.19

Another line of defense for the clearinghouse is its

net capital requirements for clearing members. In

addition, all U.S. futures clearinghouses share certain types of “risk information’’-data on amounts

paid and collected by clearing members in the form

of both original and variation margin, reflecting their

overall exposure, and amounts paid by clearinghouses to clearing members, representing reductions

in the amount of risk faced by a clearing member.

Still another line of defense in protecting the

clearinghouse from default by a clearing firm is its

authority to issue a ‘‘super’ margin call if the

clearinghouse determines that a customer or proprietary position represents a clear and immediate

danger (i.e., a particular market condition could

cause a substantial amount of a clearing fro’s

capital to be depleted because of customer defaults).

The clearing member would then be required to

deposit the additional super margin (in the form of

cash, U.S. Treasury securities, or letters of credit)

within 1 hour of receiving the call. Finally, the

segregation of customer funds, clearing member net

capital requirements, and ongoing financial surveillance, each contribute to bolstering the integrity of

these markets.

If, despite margin calls, a clearing member

nevertheless defaults on the settlement obligations

of the trade, the clearinghouse has several protections against liability for the default. The clearinghouse may liquidate the clearing member’s positions

and original margin, sell his exchange membership,

use his contributions to the clearinghouse guarantee

fund, use the clearinghouse guarantee fired and its

committed lines of credit, assess all clearing members, where permissible, and finally, use the clearinghouse’s capital.

All U.S. futures clearinghouses have finds available to protect themselves against default by their

members; these are primarily made up of mandatory

ls~e CME Clefighouse DivisioU the COMEX Clearing Associatio~ and the Coffee, Sugar and COCOaCle- Corp. dso issue roufie d~ly

intra-day variation margin calls. The others have the capability of doing so on an as-needed basis; e.g., in times of severe market volatility.

l~e se=egation of customer ~d proprie~ funds is a requirement of the Commodi~ Exchange ~t, SmtiOn ‘l@2) .
190 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

contributions from clearing members .20 They fluctuate in size. Most U.S. futures clearinghouses, but not

the BOTCC21 and Kansas City Board of Trade

Clearing Corp., also have the power to assess their

members, if the amount of a clearing member default

cannot be covered by capital finds and the guarantee

fired.

The BOTCC uses four settlement banks, all based

in Chicago. The BOTCC’s morning payment process (6:40 a.m. c.s.t.) precedes the opening of the

Fedwire system and hence requires the settlement

bank to extend credit on behalf of some clearing

members. At times, this credit extension may not be

fully collateralized, and thus is a risk for those

settlement banks.

Clearing members must maintain accounts at

settlement banks for the payment of original and

variation margin, including final settlement payment. When the clearinghouse determines the amount

of margin owed, the clearinghouse notifies the

clearing member’s bank of this amount. The bank

then examines the clearing member’s assets (cash,

government securities, lines of credit), gathers

incoming payments from the clearing member (via

Fedwire, if it is available at the time the bank is

making the decision), and makes a commitment to

the clearinghouse as to whether it will honor the

margin call by forwarding the funds to the clearinghouse.

If the clearing member does not have sufficient

assets to meet its margin obligations, the bank’s

decision is whether to extend credit to the clearing

member. When a settlement bank decides that it

cannot meet the financial obligations of a market

participant, the participant will ask his credit banks

for credit. This process generally works well, but it

depends on two assumptions: first, that the market

participant will be able to reach the account officers

at the credit banks within the permitted time; and

second, that the credit banks (which do not always

coordinate a market participant’s various lines of

credit) will not extend more credit than a clearing

member is worth. Generally, these assumptions are

sound, as firms usually have a predetermined credit

line. But, if a firm is having difficulty and the fro’s

needs come during a period of market stress, a

settlement bank may decide not to honor a margin

call. The clearinghouse would frost attempt to

transfer the customer’s positions to another clearing

member. 22 Any customer position not transferred

would be subject to liquidation.

Clearinghouses, in respect to intra-day margin

payments batch process trades rather than processing each trade as it is executed. Thus, a clearinghouse may not be able to eliminate its risk instantaneously by shifting it to clearing members. One

reason the clearinghouses are forced to do batch

processing is that the banking system moves too

slowly to accommodate any other method. For

instance, Chicago banks generally use paper-based

processes to move money among clearing members.

The working interface between the clearinghouses and the banks survived with difficulty under

immense strain in October 1987.23 In further improving this interface, there are cost-benefit tradeoffs. The existence of a Clearing Organization and

Banking Roundtable that provides settlement bankers, clearing organizations, and regulators with a

forum for regular discussion of these tradeoff issues,

is some evidence that the system is moving towards

a more secure, less volatile, but still competitive,

state.

Options Clearing Organizations

The Options Clearing Corp.

OCC is the common entity serving all securities

options exchanges in the United States24 The OCC

clears and settles options trades for the Chicago

Board Options Exchange (CBOE); the American

-eBOTCC does not have a guarantee, or clearing fund, but does require clearing members to purchase its capital stock when they are admitted

to membership, which is similar to a guarantee or clearing fund. The relative number of shares of stock that a BOTCC clearing member must purchase

is adjusted semi-annually to reflect its open positions and trading volume. Other Mures clearinghouses have guarantee funds based on capital, trading

volume, or open positions. Rutz, op. cit., footnote 10, pp. 23-27.

zl~ mid.1989, tie BOTCC es~ated as $325 million the total value of its available trust fund, ties of credit, and Cle~@OUSe @pi@.

22Foradditio~ ~o-tion, see~&ea M. cor~or~and Susan C. EI-vin, ‘ ‘Mtenance of -et Strategies in Futures Broker Insolvencies: FutureS

Position Transfers From Troubled Firms,” Washington ami Lee L.uw Review 44:849, 1987, pp. 849-915.

~~ere is disag=ment mong participants themselves as to whether these systems “survived witi ticultY, ” “barely managed,” or performed

otherwise. Nevertheless, many improvements have bee~ and are, being implemented to strengthen the clearing and settlement process.

24~e OCC Clas ~exc~g~~ded se~ties options. For dews on cl-g and settlement of optiom on futures ~ntracts, S= Bankers Tmst

report, op. cit., footnote 1.
Appendix-Clearing and Settlement in the United States ● 191

Stock Exchange (AMEX); the Philadelphia Stock

Exchange (PHLX); the New York Stock Exchange

(NYSE); the Pacific Stock Exchange (PSE); and the

National Association of Securities Dealers (NASD).

Unlike the clearinghouses already discussed, the

OCC does not do trade comparison, since it receives

locked-in data on compared trades from each of the

exchanges. The exchanges have chosen to keep their

own trade-matching systems as a means of competitive differentiation. The data on matched trades is

sent to the OCC by computer on the day of the trade.

The OCC then must calculate the amounts of money

that are owed and due the next day (T+l) by the

buyer and the seller. In the case of the buyer, the

entire amount of money owed to the OCC is called

the “premium obligation,” or “premium,” and is

paid in cash. The premium, while paid to the OCC,

is passed onto the writer of the option. To the buyer

of the option, the premium is the amount he pays to

lock in the possibility of an advantageous movement

in the price of the underlying security. To the writer

of the option, the premium is the maximum amount

of profit he can expect. If the market moves against

the writer, the premium might, at best, offset only a

small portion of the option writer’s losses.

Customer margin is set by the exchanges, subject

to review by the SEC and regulation by the Federal

Reserve Board (FRB). Clearinghouse margin is set

by the OCC and is subject to review by the SEC and

oversight by the FRB, as with customer margin.

The writer of the option always owes margin to

the OCC, each day that the option contract is in

effect but has not been exercised by the holder. This

margi n

25 to the margin owed by the buyer

or seller of a futures contract, essentially “good

faith” money which serves as an assurance to the

OCC that the writer of the option has the financial

ability to meet the potential obligations of the option

that he has sold. The amount of margin owed reflects

changes in the market price of the option as well as

a portion of the total amount that he would have to

pay if the option were exercised.

On the day after the trade (T+l), the OCC notifies

the buyer of the amount of cash premium which is

owed; at the same time, the writer of the option is

notified by the OCC of the amount of margin that is

owed. Both amounts are due on T+l. On the next day

(T+2), and each day thereafter until expiration,

exercise, or closeout26 of the option contract, the

OCC calculates and then collects margin from the

option writer.

Margin on long option positions thus reflects the

adjusted daily value of the option writer’s open

positions (the total amount of money which he could

be forced to pay if the options he sold were to be

exercised by the holders). The OCC marks-tomarket (determines the adjusted value and liability

of each member’s open positions) at the end of each

trading session. If the options contract loses value,

the OCC reduces the amount of margin required.

When the holder of an option contract decides to

exercise it and actually buy or sell the underlying

product of the option, the person who originally sold

the option is not necessarily the same person that

OCC will require to fulfill its terms. Instead, the

OCC randomly assigns a clearing member to honor

the delivery or purchase obligations of the option,

from the pool of all clearing members who sold

options with identical contract terms.

For example, when an IBM option is exercised,

the OCC assigns a clearing member with a short

position and then sends delivery instructions to an

equities clearinghouse such as the NSCC, which

incorporates instructions to deliver or receive into its

Continuous Net Settlement (CNS) system. Any

obligations not netted out through normal CNS

procedures are settled by instructions to a depository

(e.g., the DTC). Delivery of the IBM stock is then

made by transferring it from the seller’s account into

the buyer’s account at the depository, subject to the

CNS system.27

When a foreign currency option is exercised, the

foreign currency underlying the option contract is

delivered to the OCC’s cash account at a designated

overseas bank, and then transferred to the account of

the market participant who is buying the foreign

~F~rmmgin~ayments,tie OCC ~Wepts ~a~hand collater~ including: b~letters of credit, U.S. Treas~ obligations, the actu~ equities ~dmlying

particular option contracts, and various other stocks. Additionally, margin obligations can be reduced through corresponding long positions in other

options which have the effect of reducing net exposure.

26~e ~fcloseout>> is when a titer or holder of an option con~ct entms into another option con~act, crmting an offsetting pOSitiOn.

zTwhenNSCC ~coWorates defive~ fi~ctiom~to its CNS system, NSCC rather ~~ OCC ass~es Rspomibility for, and gW.tllnteeS, deliveries

and payments.
192 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

currency. The designated foreign exchange delivery

bank may be any bank designated by the parties

involved in the transaction, not necessarily one of

the OCC’s settlement banks.

The OCC provides its clearing members with a

guarantee on the morning of the day following the

trade (T+l), after the buyer of the option has paid the

premium obligation.28 The OCC guarantee protects

the holder of an option against the possibility that the

option writer might default on the payment or

delivery obligations of the option.

Lines of Defense

The OCC’s first line of defense against the

potential for clearing member default is its continuing monitoring of the creditworthiness of its clearing

members. The OCC, exchanges,29 and the Securities

and Exchange Commission (SEC), also monitor

market participants in respect to capital adequacy

and other financial requirements. The OCC is apart

of the information-sharing arrangement among all

seven SEC-registered clearing entities, as well as a

participant in the pay-collect risk information system operated by BOTCC. 30 The OCC uses a

monitoring system to quantify the potential risk of

each clearing member under different market scenarios, including large price movements. The system

evaluates the risk in participant’s stock, options, and

futures positions.

The OCC’s second line of defense against clearing member default is the margin that the clearing

members have on deposit. If this is insufficient to

cover the default, the OCC can turn to its guarantee

fund, made up of cash and government securities.31

In the event of a default by a clearing member, after

closing out the defaulting clearing member’s positions, the OCC follows five steps to cover any

residual liability from a default:

●

●

●

●

●

First, any margin that the defaulting clearing

member has on deposit with the OCC is applied

towards the liability of the default.

Second, if that amount is insufficient, the OCC

takes the defaulting clearing member’s contribution to the guarantee fund and applies it

toward the liability of the default.

Third, if that amount is still insufficient, the

OCC may use its guarantee fired to cover

whatever portion of the liability is outstanding. 32

Fourth, if that still isn’t enough to cover the full

liability, the OCC has the right to assess its

members for the remaining amount of the

liability. 33

Finally, the OCC, like the NSCC and futures

clearing organizations, may also take legal

action as a creditor to recover any sums that are

owed by the defaulting clearing member. The

amount that can be recovered in this way is

limited by bankruptcy law.

At the end of each trading day, the OCC has an

overnight processing cycle during which it calculates the net amount which each member either owes

or is owed. The net figure reflects, among other

things: a) the cash premium obligation due on each

new long position; and b) the margin due for each

new short position. The OCC then sends payment

instructions to the settlement bank. The netting is

done on a multilateral basis; i.e., the status of all of

a clearing member’s holdings in the options market

is taken into consideration in arriving at the daily net

payment obligation to the OCC.

The OCC has two different methods for calculating margin-one for options on equities and another

for all other types of options (foreign currency,

government securities, or stock indexes). In both

cases, the margin required from the writer of an

2$Oc!ClMs fded arulechangewiththe SEC, currently pending approval, which would provide OCC clearing members with anunconditional guarantee

on the morning of T+l.

=e options exchanges have limits on the aggregate amount of open positiom that any one market participant may carry at any one time. These are

net lirnits-i.e., the market participant’s short positions are offset by his long positions. The clearing members’ positions are monitored daily by the

exchanges in respect to these position limits.

~obert Woldow, “Clearance and Settlement in the U.S. Securities Markets,” February 1989, expert paper contributed to Bankers Trust repo% op.

cit., footnote 1,

sl~e total amount req~d in the guaranteed fund is recalculated monthly. As of December 1989, the guarantee, or clearing fun~ plUS a 100 P~ent

minimal additional assessment for which OCC clearing members are unconditionally liable, was about $450 million. The amount of the fund varies in

proportion to the amount of clearing members’ liability. It is always equal to 7 percent of the average daily aggregate margin requirements of all clearing

members in the previous month. Each clearing member must contribute an amount equal to his pro-rata share of outstanding contracts in the previous

month.

sz~e occ ~s recently a.mend~ is ties to include using its own retained earnings at the discretion of its Board of Directors.

ssNot w U.S. cle~ghouses, how~er, ~ve these assessment powers. See Bankers Trust report, op. cit., footnote 1, VO1. 1, p, 137.
Appendix-Clearing and Settlement in the United States ● 193

option is equal to the current market price of the

option, plus a cushion to cover the risk of a change

in the current market price. But for all non-equity

options, as well as all options and futures contracts

cleared by the Intermarket Clearing Corp., the OCC

uses the Theoretical Intermarket Margin System

(TIMS). TIMS evaluates each clearing member’s

overall risk profile and then sets the total margin

owed. The OCC was the first clearing organization

in derivative markets to change from a fixed or flat

rate of margining (per contract) to sophisticated

computational methods. Rules have been submitted

to the SEC to expand the use of TIMS to include

setting the margin on equity options.

The CFTC and the SEC have approved applications from the OCC and the CME to allow crossmargining of stock index options, futures, and

options on futures for proprietary trading accounts of

clearing members. Cross-margining between the

CME and OCC started in October 1989.34 OCC also

offers cross-margining through an agreement with

its affiliate, the Intermarket Clearing Corp. (ICC).

The ICC clears trades for the New York Futures

Exchange, the Philadelphia Board of Trade, Amex

Commodities Corp., and the Pacific Futures Exchange; therefore, OCC members can use their

holdings on those exchanges to offset the status of

their open positions at the OCC.

The extent to which OCC and ICC offer crossmargining is however limited. The CFTC, concerned about safety, market stability, and liquidity,

has not approved expansion of cross-margining

beyond proprietary accounts of market-makers.35

The OCC has approximately 190 clearing members. The clearing member brokerage firms transact

business for their proprietary accounts, other brokers

who are not clearing members, and institutional and

retail customers. The link between OCC and its

clearing members is automated: OCC requires that

all members submit post-trade information through

OCC’s on-line Clearing Management and Control

System (C/MACS).36

The OCC allows its members to choose from a

selection of designated settlement banks. There are

currently 16, but the OCC is flexible and may

designate a member’s primary banking institution

(concentration bank) as an approved settlement

bank. The OCC maintains accounts at each of these

settlement banks, and instructs the banks on each

trading day as to the debits and credits that are to be

made to the OCC’s accounts and those of the

clearing members.

~See John Watt and J~es Me K@usc~ “Cl~~ce and Setiement of Derivative Financial Instruments,” Apfi 1989; ~d Jo~ p. Behof, “IsSue

Summary: Inter-market Cross-Margins for Futures and Options,” The Federal Resewe Bank of Chicago, May 1989. Both are expert papem included

in the Bankers Trust report, op. cit., footnote 1.

ssB~ed on intemiew by OTA staff with senior CITC officials, October 1989.

36~att and KUStUSC4 op. cit., footnote 34.
Acronyms and Glossary

ADP

ADR

AMEX

BOTCC

BSE

CATS

CBOE

CBOT

CFTC

CME

CSE

DTC

ERISA

FCM

Forex

GAO

ICC

ITS

LBO

MOU

MSE

NASAA

NASD

Acronyms

—Automatic Data Processing, Inc.

—American Depository Receipt

—American Stock Exchange

—Board of Trade Clearing Corp.

—Boston Stock Exchange

—Computer-Assisted Trading System

(Toronto Stock Exchange)

-Chicago Board Options Exchange

—Chicago Board of Trade

—Commodity Futures Trading Commission

(U.S.)

—Chicago Mercantile Exchange

—Cincinnati Stock Exchange

—Depository Trust Corp.

—Employee Retirement Income Security Act

—Futures commission merchant

—Foreign exchange

—Federal Reserve Board

-General Accounting Office (U. S.)

—Intermarket Clearing Corp.

—Interrnarket Trading System

—Leveraged buyout

—Memorandum of Understanding

—Midwest Stock Exchange

—North American Securities Administrators

Association

—National Association of Securities Dealers

NASDAQ —National Association of Securities Dealers

NMS

NSCC

NYSE

OCC

OTC

P/E

PHLX

PSE

RICO

S&P500

SEC

SIAC

SIPC

SRO

UMS

Automated Quotation System

—National Market System

—National Securities Clearing Corporation

—New York Stock Exchange

-Options Clearing Corp.

-Over-the-counter

—Price/earnings ratio

—Philadelphia Stock Exchange

—Pacific Stock Exchange

—Racketeer Influenced and Corrupt

Organization Act

—Standard & Poor 500 Stock Index

—Securities and Exchange Commission (U. S.)

—Securities Industry Automation Corp.

—Securities Investor Protection Corp.

—Self-Regulatory Organization

—Universal message system

Glossary

Acquisition: One company taking over controlling interest in another company, often by paying more than the

market price for the shares needed to acquire it.

Affirmative obligation: The duty of stock market

specialists to maintain a fair and orderly market and

assure liquidity or immediacy, by selling from their

own inventories or buying for their own inventories

when there are no other buyers/sellers at or near the

market price. See Liquidity.

American Depository Receipts (ADRs): A receipt for

shares of a foreign-based corporation, held by a U.S.

bank; the receipts are listed and traded on U.S. stock

exchanges in lieu of the shares.

Arbitrage: Profiting from fleeting differences in price in

the same or related assets or instruments in two

markets; e.g., buying gold in New York and selling

gold at a higher price in Chicago, which tends to raise

the New York price and lower the Chicago price. Index

arbitrage is profiting in this way from temporary

disparities between the average price of stocks represented in the Standard& Poor 500 Index and the price

of the S&P 500 index futures contract.

Auction market: The system of trading on stock

exchanges, in which prices are determined by competitive bidding between brokers (acting as agents for

buyers and sellers) and with intermediation by a

specialist when necessary; this is distinguished from

the over-the-counter market, where prices are established by negotiation between customer and dealer.

The exchange system is a “double auction” as

opposed to a conventional auction with one auctioneer

and many potential buyers. Futures markets are also

double auction markets.

Audit trail: A record of transactions, identifying the

participants, the terms of the trade, the time of the

trade, and the firm responsible for clearing the trade.

Audit trails are most useful for monitoring and

surveillance when generated automatically, and in real

time.

AURORA: An electronic trading system that was being

developed by the Chicago Board of Trade for 24-hour,

remote site trading; as of June 1990, there are plans to

combine its development with that of GLOBEX,

possibly to make AURORA an alternative user interface to GLOBEX.

Basket trade: The simultaneous sale, or purchase, of a

diversified portfolio of stock such as the basket of

stock represented in a stock index.

Bear market: A prolonged period of falling stock prices.

See Bull market.

Best execution: Timely completion of a trade at the best

price available in any market or from any dealer.

–194--
Acronyms and Glossary ● 195

Bid: Indication of readiness to buy at a specified price.

“The bid” is the highest price any potential buyer will

pay at the moment. See Offer.

Big Board: Slang term for the New York Stock Exchange.

Block (or block trade): A large quantity of stock

included in one trade; usually 10,000 shares or more.

Block positioner: A dealer (member of the exchange)

who handles large block transactions “upstairs” (i.e.,

in the dealer’s trading room, off the exchange floor) by

finding buyers for sellers and vice-versa, usually

themselves participating in the purchase or sale; the

block positioner must be so registered with the

exchange and must bring the negotiated transaction to

the specialist on the floor for execution.

Bond: A security representing a loan by the buyer to the

corporation or government issuing the bond; it may

either pay interest, or it may be discounted in price

from the value at maturity. Also called a debt security

or a freed-income security (because traditionally, the

interest rate was fixed, “although now it is sometimes

variable).

Book (the): Record kept by a specialist of buy and sell

limit orders in a given security. Once a notebook, now

a computer file.

Broker: One who acts as an agent for a customer, usually

charging a commission.

Bull market: A prolonged period of rising stock prices.

See Bear market.

Bulletin Board (the): An electronic system operated by

the National Association of Securities Dealers for

displaying dealer quotations or expressions of interest

in making markets in over-the-counter stock not listed

on NASDAQ.

Buyout: Purchase of a company’s stock (or a controlling

percentage of it) in order to take over that company’s

operation, or its assets. A leveraged buyout occurs

when the purchaser(s)often the management of the

company—borrow the money to buy the shares,

usually putting up the company’s assets as collateral

and intending to repay the loans with the company’s

revenues or by selling off some of its facilities or other

assets.

Call, or call option: See Option.

Capital markets: Markets where debt and equity securities are bought and sold; includes primary placement

and private placement of issues, as well as secondary

markets (exchanges and over-the-counter trading).

Cash markets: Markets where a transaction can be

completed and ownership transferred immediately,

e.g., stock markets-as compared to futures markets,

where contracts are to be satisfied at some later date.

Cash markets are also called spot markets.

Churning: Excessive or injudicious trading that allows

a broker controlling an account to earn commissions

while disregarding the best interests of the customer.

Circuit breaker: A rule or procedure by which a market

is closed down, or trading is halted, when price

movement exceeds a specified limit. A circuit breaker

is designed to prevent-or at least to slow down-a

market crash.

Clearing and settlement: In securities markets: comparing the details of the transaction between buyer and

seller (or their brokers) and exchange of securities for

cash payment. In futures markets, satisfaction of the

terms of the contract; both buyer and seller make a

good faith deposit (initial margin) to a clearing house

or clearing member firm.

Clearinghouse: An organization (or division) setup to

handle the clearing and settlement of all transactions

within a market or on an exchange. Its clearing

members (usually large securities firms) deal directly

with the clearinghouse but also act as intermediaries

for other securities firms in clearing their trades.

Commercial paper: Short-term loans (maturities ranging from 2 to 270 days) made to banks, corporations,

or other borrowers.

Commodity: Bulk goods such as grains, metals, and

foodstuffs, for which the price is generally determined

by competitive bids and offers; now includes standardized financial instruments.

Commodity Futures Trading Commission (CFTC):

The U.S. agency responsible for regulating the trading

of all futures contracts and options on futures contracts.

Common stock: Units of ownership of a corporation;

owners typically are entitled to receive dividends on

their holdings and to vote on the selection of corporate

directors and on some other corporate decisions.

Continuous net settlement: A method sometimes used

in securities clearing and settlement in which traders

end each day with one “receive” or “deliver”

position to be satisfied, rather than delivering or

receiving stock and receiving or making payment

separately for each transaction.

Covered option: A call option contract backed by

ownership of the shares underlying the option; the

option writer has the shares to deliver if the buyer of the

option decides to exercise it. This contrasts with a

naked option, for which the writer does not own the

underlying shares. See Option.

Cross: A securities transaction in which the same broker

acts for customers on both sides of the trade; illegal

unless the broker first offers the securities publicly at

a better price.

Cross-margining: A proposed form of margin netting

(for options trading) in which the clearinghouse would

recognize the hedging effects of positions in several

markets, and accordingly reduce the margin required

from participants with multiple positions.

Crossed orders: A situation in which the current bid is

higher than the current offer, which may occur during
196 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

periods of extreme volatility.

Custodian: A bank or other financial institution that

keeps stocks (or other assets) for individual or

corporate customers, or for a mutual fund.

Dealer: A person or firm acting as principal in a securities

transaction, trading for a proprietary account rather

than on behalf of a customer. Dealers may make

markets by buying and selling to customers.

Debt security: Tradable evidence of borrowing that must

be repaid, stating the amount, a specific maturity date

or dates, and usually a specific rate of interest (or

discount+. g., a bond, bill, note, or commercial

paper.

Delivery v. payment: A term used in clearing and

settlement, meaning cash on delivery.

Derivative product: A contract (e.g., future, option)

whose price depends on the price of the underlying

asset (e.g., a commodity, a stock or an index of

stocks).

Discount broker: A brokerage firm that executes orders

to buy and sell but does not provide full services (e.g.,

advice, research), and charges commissions lower than

those of a full service broker.

Downtick: Sale of a security at a price below that of the

just preceding sale.

Dual trading: One firm or person acting as broker (agent)

in some transactions and dealer (principal) in other

transactions, on the same day in the same market.

Efficiency: The direct and rapid reflection in market price

of all relevant information, including supply and

demand. A desirable market characteristic.

Efficient market theory: Theory that market prices

reflect the knowledge and expectations of all investors

(there is no way to beat the market); theory that market

prices should only reflect the knowledge and judgment

of all investors, and should be ‘distorted” as little as

possible by transaction costs, including regulatory

costs and taxes.

Employee Retirement Income Security Act, 1974

(ERISA): Law governing operation of corporate pension plans, and setting up the Pension Benefit Guaranty Corporation; partly responsible for the growth of

the largest category of institutional investors—

corporate pension funds.

Equity: Stock; the ownership interest possessed by

shareholders in a corporation.

Eurobond: Bond denominated in one currency (e.g., U.S.

dollars) and sold to investors outside that country;

usually issued by large underwriting consortia composed of financial institutions from many countries.

Eurodollars: U.S. currency held in banks outside the

United States, commonly used for settling international transactions; some securities are issued in

Eurodollars (interest is paid in dollars deposited in

foreign bank accounts).

Exchange: An organized market with transactions concentrated in a physical facility (a “floor”), with

participants entering two-sided quotations (bids and

offers) on a continuing basis. Compare: over-thecounter market.

Exchange Stock Portfolio (ESP): Anew product offered

by the New York Stock Exchange, representing a

diversified basket of stock but settled in cash rather

than delivery of stocks.

Exclusivity clause: The clause in the Commodity Futures

Trading Act [7 U.S.C. 2a(ii)] that gives the Commodity Futures Trading Commission exclusive jurisdiction

over contracts of sale “for future delivery. ”

Fairness: The qualities in a market of: 1) offering equal

treatment to investors (orders filled in order by

price-i. e., highest bid, lowest offer-and by time

received); and 2) absence of fraud, manipulation, and

customer abuse.

Fiduciary responsibility: The legal obligations of a

person, corporation, or association investing for or

holding assets in trust for another person or institution.

Financial future (contract): A future contract based on

a financial instrument such as a Treasury bill, foreign

currency, certificate of deposit, or index of stocks.

(There are no futures on individual stocks.)

Financial institution: A company that collects finds

from the public and places them in financial assets—

includes banks, credit unions, insurance companies,

pension plans, etc.

Fixed-income security: See Bond.

Floor broker: An employee of an exchange member

firm, who acts as an agent for clients by executing

orders on the floor of the exchange (or in the pit, in a

futures exchange).

Floor trader: Member of a stock or commodity/futures

exchange who trades on the floor for his or her own

account. In commodity/futures exchanges, a floor

trader is also called a “local.”

Foreign exchange (forex): Instruments used in making

payments between countries; includes currency, notes,

checks, bills of exchange, and electronic transfer

records.

Forward contract: Purchase or sale of a specific

commodity or other asset at the current (spot) price but

for delivery and settlement at a specified later date.

Fourth market: The direct trading of blocks of securities

between institutional investors (often through proprietary electronic trading systems) without intermediation by brokers or dealers. See Third market.

Frontrunning: An abusive practice in which a broker

with advance knowledge of a block transaction and

holding a customer order trades for himself ahead of

the customer, to take advantage of possible price

changes as a result of the execution of the customer

trade.
Acronyms and Glossary ● 197

Futures commission merchant: A firm that buys or sells

futures contracts and accepts payment from or extends

credit to those whose orders it accepts.

Futures contract: A contractual agreement to buy or sell

a specific amount of a commodity or financial

instrument at a specified price for later delivery.

Gapping market: The price movement of a stock or

commodity when one day’s trading range does not

overlap the previous day’s, causing a gap in which no

trade has occurred. This can also happen during a

precipitous intraday price decline; price jumps maybe

so large that some limit orders do not get executed.

G1ass-Steagall Act (1933): Law prohibiting commercial

banks from owning brokerage firms and engaging in

most underwriting activity; designed to insulate bank

depositors from market risks.

GLOBEX: An electronic trading system being developed

by the Chicago Mercantile Exchange and Reuters (now

with participation by the Chicago Board of Trade) for

24-hour remote-site futures trading.

Hedge: To offset or balance investment risk by another

investment or a transaction in another market. For

example, one can hedge one’s investment in 100 shares

of stock X ($100 per share) by buying a put option

giving one the right to sell those shares at $100 per

share over the next 3 months.

Immediacy: Sufficient liquidity in a market to allow

trades to be made immediately at a market price-e. g.,

a balance of potential buyers and sellers.

Index: A statistical construct used to measure market

behavior. A popular index is the Standard& Poor 500

(S&P 500), which is the weighted average of the prices

of 500 frequently traded New York Stock Exchange

stocks.

Index arbitrage: Trading in order to profit by temporary

differences between the value of stocks in an index and

the price of the derivative index future contract.

Index future or stock-index future: A futures contract

that covers the price of a diversified stock portfolio

matching a designated stock index. See Index. The

index future is settled in cash, not in delivery of stocks.

Index option or stock-index option: An option that

covers the price of a diversified stock portfolio

matching a designated stock-index. See Index.

Indexed fund: An institutional investment portfolio that

matches that of an index such as the S&P 500. See

Index. Many pension funds are indexed.

Information services vendors: See Vendors.

Insider trading: Illegal trading by a corporate officer or

retainer (e.g., counsel) to take advantage of privileged

information about impending events that will affect

market price.

Instinct: A proprietary electronic system (Reuters) for

“fourth market” trading. See Fourth market. Instinct

is handling about 13 million trades daily in 1990.

Institutional investor: An organization such as a pension

plan, a mutual fund, an insurance company, or a union,

that holds and trades large numbers of securities on

behalf of members.

Intermarket Trading System: A video-computer system that links specialists’ posts at the New York

American, and regional stock exchanges; a broker at

one exchange can send an order on to another exchange

with a better price.

Junk bond: A debt security of less than investment grade

rating, paying a high rate of interest; often issued in the

course of leveraged buyouts.

“Lean against the market”: The action of a specialist

carrying out his affirmative obligation by buying for

his own inventory in an attempt to stop or slow a sharp

market decline.

Leverage: Increasing return or value without increasing

investment; e.g., buying stocks on margin uses borrowed money for leverage, buying a stock-index future

rather than a portfolio of stock gives greater leverage

because futures margins are lower than stock margins.

Leveraged buyout: See Buyout.

Limit order: An order (to buy or sell at a specified price)

placed on a specialist’s book, to be executed when and

if the market price reaches that price, or limit.

Liquidity: The capability of a securities market to handle

a large transaction without moving the price; usually

requires the availability of many potential buyers or

sellers.

Listed security: One that meets exchange criteria and has

been accepted for trading by an exchange.

Local: A floor trader in the futures pits, who trades as a

principal or speculator.

Locked orders or locked market: The situation where

bids and offers are identical. See Crossed orders.

Locked-in trades: Trades that have been matched

(usually by computer, at an exchange) before reaching

a clearinghouse for settlement.

Long position: Ownership of securities or instruments,

contrasted with a short position. See Short.

Making a market: Maintaining firm bid and offer prices

for a security and standing ready to buy and sell the

security at those prices. In a U.S. stock exchange, only

the specialist acts as market-maker for a given security,

but in the over-the-counter market there may be

competing market-makers for a security.

Margin: In securities markets, the deposit a customer

makes with a broker in buying securities (the broker

extends credit for the rest of the price). In futures

markets, a good-faith deposit or performance bond,

placed with a futures commission merchant by a

customer, or with a futures clearinghouse by its

members, to ensure that the depositor will meet

financial obligations.

Mark to market: Adjust the valuation of a futures

position to reflect current market prices, in order to
198 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

adjust margin accounts; the gain or loss in each market

participant’s position as a result of trading is calculated

daily or several times a day depending on market

volatility.

Market-maker: See Making a Market.

Multiple-trading (of options): The trading of the same

option by more than one exchange; the SEC has ruled

that by 1992 all options can be multiple traded.

Mutual fund: A fund, operated by an investment

company, that raises money by selling shares to the

public and invests that money in stocks, bonds,

commodities, or other securities or financial instruments.

Naked option: An option for which the writer (seller)

does not hold the underlying security. Naked options

involve large risks and large potential profits. See

Covered option.

National Association of Securities Dealers (NASD):

The Self-Regulatory Organization of over-the-counter

securities dealers, and the operator of NASDAQ, their

automated quotation display system.

National Market System: 1) The objective of the 1975

Securities Exchange Act Amendments-an integrated

nation-wide system for competitively trading securities. 2) A category of actively traded over-the-counter

stocks on NASDAQ.

National Securities Clearing Corporation (NSCC):

The clearing organization for almost all U.S. stocks,

formed in 1977.

Odd lot: Less than 100 shares (a round lot). Odd lot

transactions can be executed through most retail

brokers; the specialist assembles these into round lot

trades. The investor pays a higher commission.

Offer: Indication of readiness to sell at a specified price.

‘‘The offer” is the lowest price that any potential seller

is prepared to accept at the moment. See Bid.

Off-board trade: A trade of exchange-listed stocks that

occurs away from the exchange, in the third or fourth

market.

Off-setting: 1) Liquidating a purchase of futures contracts through the sale of an equal number of futures

contracts of the same delivery month, thus closing out

a position. 2) Hedging by balancing one transaction

with another-e. g., a short sale of stock.

Open outcry: The method of trading on futures exchanges: public double auction in the pits, accomplished by shouting bids and offers.

Opening: 1) The price at which a security, commodity, or

futures contract begins the trading day. 2) The period

at the beginning of the securities trading day when the

opening price is determined by the specialist after

inspecting opening bids and offers.

Option: A unilateral contract conferring the right to buy

(a call option) or the right to sell {a put option) a stock

commodity, or financial instrument at a predetermined

price within a specified time period.

Option writer: A person or firm that sells options,

thereby earning a premium paid by the buyer.

Out-of-the-money: Having no intrinsic value at the

moment; for example, a call option to buy Stock X at

$30 a share when Stock X is selling at $25 a share is

out-of-the-money by $5.

Over-the-counter: A market in which securities transactions are negotiated and executed through competing

dealers, operating by telephone and computer networks, rather than on an exchange.

Penny stock: Historically, stock that sold for $1 a share

or less, now generally applied to stock that costs $5 or

under. Most penny stocks are sold over-the-counter.

Pink Sheets: Daily publication of the National Quotation

Bureau that lists bid and asked prices for over-thecounter stocks not listed on NASDAQ, with marketmakers for each stock

Pit: The tiered trading floor of commodities exchanges,

on which futures contracts are traded by open outcry.

Portfolio: The combined holdings of an investor, including stocks, bonds, commodities, and other tradable

assets and instruments.

Portfolio insurance: A trading strategy aimed at substantially reducing the market risk of a portfolio, especially

a strategy that uses stock-index futures to hedge a stock

portfolio. Popular computer models or programs used

for directing portfolio insurance strategies, which

called for selling stock-index futures in a declining

market or buying them in a rising market, were widely

blamed for contributing to the 1987 market crash.

Premium: 1) The amount that the buyer of an option pays

the seller, or writer, of the option. 2) A better price, as

in ‘‘The future on Currency X is at a premium to the

spot price. ”

Price discovery: Determination of the price by competitive bidding; this process is assumed to “discover” or

reveal the real value of an asset or instrument by

integrating the knowledge and expectations of all

potential investors.

Price/earnings ratio: The price of a stock divided by its

earnings per share; indicating how much earnings

growth can be expected; low P/E stocks tend to be

low-growth, mature industries with stable earnings.

Price priority: The rule whereby market orders with the

highest bid, or the lowest offer, are filled first, ahead of

lower bids and higher offers even if those orders are

larger or arrived earlier.

Primary market: The market for newly issued stocks, in

which proceeds of the sale go to the issuer. Compare

Secondary market.

Private placement: Sale of securities directly to an

institutional investor, not offered to the public and not

intended for resale; privately placed issues do not have

to be registered with the SEC.

Program trading: The simultaneous or synchronized

purchase or sale of a large number of stocks, possibly
Acronyms and Glossary . 199

several hundred, often but not always involving related

sale or purchase of stock-index futures. Program

trading usually is computer-assisted but can be done

manually.

Put or put option: See Option.

Quotation: The highest bid and lowest offer currently

available on a round lot transaction (100 shares) or a

stated larger quantity.

Racketeer Influenced and Corrupt Organization Act

(RICO): Law under which some alleged perpetrators

of fraud in securities and futures markets have been

indicted.

Regulation T: The Federal Reserve Board regulation

covering credit extended to customers by securities

brokers and dealers, and establishing initial margin

requirements for stock transactions.

Round lot: The generally accepted unit of trading in

securities markets: 100 shares of stock or $1,000 or

$5,000 par value for bonds. See Odd lot.

Rule 10a-1: SEC rule prohibiting short sale of securities

below the price of the last regular trade, and at that

trade unless it was higher than the preceding price. The

Short Sale Rule, also called Uptick Rule.

Rule 15c-2-6: SEC rule requiring penny stockbrokers to

give certain explanations to customers and to record

customer affirmations that these explanations have

been given. See Penny stock.

Rule 15c-2-10: SEC proposed rule requiring sponsors of

electronic proprietary trading systems to file financial

and operational plans with the SEC.

Rule 19c-3: SEC rule permitting securities listed on an

exchange after April 26, 1979, to be traded ‘upstairs,’

or off-floor, by member firms; an exception to Rule

390.

Rule 19c-5: SEC rule allowing any option to be traded on

all five equity-options exchanges, beginning in 1992.

Rule 144a: SEC rule allowing unregistered securities to

be traded by institutions in the fourth market.

Rule 390: NYSE rule forbidding exchange members to

make markets in exchange-listed stock in over-thecounter markets (i.e., in competition with NYSE

specialists).

Seat: Membership on an exchange; may be bought and

sold.

Secondary market: Exchanges and over-the-counter

markets where securities are resold and bought after

their issuance and primary placement.

Securities Acts Amendments of 1975: Amendments of

the 1934 Securities Exchange Act and related legislation, directing the SEC to work with the securities

industry to establish a National Market System, and

setting out public policy objectives related to U.S.

securities markets.

Securities and Exchange Commission (SEC): The U.S.

agency responsible for regulating the trading of equity

securities and options.

Security: An instrument that represents 1) a share of

ownership in a corporation stock 2) a loan to a

corporation, government, or governmental body-a

bond; or 3) conditional rights to ownership-e. g., an

option.

Self-Regulatory Organizations (SRO): Industry organizations or associations responsible for enforcement of

fair and efficient practices in markets. SROs, including

exchanges and dealer associations, make and enforce

rules binding on their members.

Sell short: To sell a security that one does not own,

anticipating that one can subsequently buy the security

at a lower price for delivery. Selling short against the

box is to sell stock owned but kept in safekeeping with

ownership not disclosed, usually so that the short seller

could defer a long-term capital gain into another tax

year.

Settlement: Completion of a transaction, by delivery of

securities to the buyer and payment to the seller or (for

futures and options) carrying out the terms of the

contract or off-setting it.

Share: The unit of equity ownership in a corporation,

represented by one stock certificate.

Short, or short position: Shares that a trader owes, i.e.,

has sold without owning, expecting to buy them later

at a lower price.

Side-by-side trading: The trading, on the same exchange

floor, of a stock and the option on that stock.

Single price auction: A procedure in which all orders are

queued according to the bid or offer and an “auctioneer’ (probably a computer) determines the price that

will come closest to clearing the market. Orders with

bids/offers as good as or better than that price will be

executed.

Soft dollars: Rebates on brokerage commissions, sometimes made to large institutional customers, in the form

of free research, computer services, etc., rather than in

cash.

Specialist: Stock exchange member who is the designated and sole market-maker for a stock on one

exchange. The specialist executes limit orders, brought

to him by other exchange members on behalf of

customers, and buys for or sells from his own

inventory when necessary to counter order imbalances,

provide liquidity, and prevent wide swings in stock

prices.

Speculator: A person who trades in futures pits for his or

her own account, in order to profit by successfully

anticipating price movements, thereby assuming risks

that hedgers wish to hand off.

Spot markets: See Cash markets.

Spread: The difference between the bid and offer price

for securities. The spread narrows or widens according

to supply and demand, i.e., competition between

dealers or among potential buyers and sellers narrows

the spread.
200 ● Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

Stock: Ownership of a corporation; a claim on a

corporation’s earnings and assets; issued by a corporation to raise capital.

Stock index: See Index.

Stock-index future: See Index future.

Stop order or a stop-loss order: An order to buy or sell

at the market price once the security has traded at a

specified price called the stop price. A stop order to sell

(at a price below the current price) is designed to

protect a profit, or to limit the loss on a stock bought

at a higher price. A stop order to buy (at a price above

the current price) is designed to protect a profit or to

limit a loss on a short sale.

Strike price: The designated price for exercise of an

option.

Takeover: A change in the control of a corporation by

buying up shares. A hostile takeover aims at replacing

the existing managers.

Third market: The trading of exchange-listed securities

in the over-the-counter market. Exchange-member

firms cannot participate in the third market as marketmakers because of Rule 390.

Ticker tape: Device that displays price and volume for

stock transactions, as they occur, to investors around

the world. Once a printed paper tape, it is now a

running display on computer screens. A consolidated

tape covers trades on the New York American, and

regional stock exchanges.

Time priority: In stock exchanges, a rule that orders with

identical bids (or offers) are filled in the order at which

they reach the specialist’s post.

Trade reconstruction: On futures exchanges there are no

automatically generated records of the time/price/

principals in a trade (i.e., no audit trail). Exchanges are

required to be able to ‘reconstruct such a record from

available data, assigning a time accurate within 15

minutes of the actual trade.

Triple witching hour: The last trading hour of the

quarter, i.e., on the third Friday of March, June,

September, and December, when options and futures

on stock indexes expire, causing a high volume of

trading (and often high price volatility) of the options,

futures, and underlying stock.

Two-dollar broker: On stock exchanges, a floor broker

who executes trades for other brokers, too busy to do

it themselves, for a fee (once $2 per round lot).

Underwriting: Buying an issue of stock from the issuing

corporation (or governmental entity) and reselling it to

the public. Underwriting is an activity of investment

bankers, but is now often done by a consortium of

them.

Universal message switch: A hypothetical, or proposed,

system that would automatically route customer orders

from a broker’s office to the exchange or dealer with

the best quotation at that moment, in order to achieve

maximum competition among markets and dealers.

Upstairs trade: A transaction completed within a brokerdealer’s firm (in an exchange member’s upstairs

trading room rather than on the floor), without using

the exchange. Such trades must occur at prices no less

favorable to the customer than that prevailing in the

public market.

Vendor: One who supplies commercial goods or services; in this report, companies that supply market data

(trades, prices, volume, quotes); information services

vendors, such as Reuters.

Volatility: Rapid declines or rises in price, especially if

the changes reverse directions several times in a short

period, or if the price changes are unanticipated or are

seemingly without full explanation.

Wash sales: A fictitious trade, made without taking a

position; giving a false impression that purchases and

sales have been made.

Wire house: An old term for a brokerage or futures

commission merchant, connected to its branch offices

by telephone, telegraph, or cable.
Index
Index

ADP, Inc. 133, 135, 137, 139

American Stock Exchange (AMEX). 7,10,11,13,41,45,

47,49,50,51,52,60,64, 65,93,94,95,96,97,99,

100, 130, 181, 190

Arbitrage. See Index Arbitrage.

Arbitration. 153, 156

Audit trails. 3, 12, 14, 15,62,73-74,75, 89,96, 134

AURORA. 88, 145

Auto-quote device. 17,99

Banks. 4, 10, 18, 26, 27, 28, 35, 44, 102, 103, 108,

111-117, 112, 119-125, 129, 131, 134, 151, 152,

157, 158, 168, 176, 181, 187, 190, 192, 193

Basket trades. 4, 8,55,57,60,78, 80, 85, 160

Block trades. 4,6,8,9, 19,27,46,49,50,51,53, 55,56,

60,62,72,74.152, 154, 160

Board of Trade Clearing Corporation. 108,114,187,188,

189, 190

Bond markets. 6, 13,25, 26, 30, 32,42, 62, 69,70,77,

107, 116, 133, 159, 170, 175, 178

Boston Stock Exchange (BSE). 41,49

Brady Commission. See President’s Task Force on

Market Mechanisms.

Brady, Nicholas. 86, 115, 122, 173

Breeden, Richard. 115, 122, 172

Bridge Brokerage Systems. 134, 137

Brokers. 3,7,11,14,15,19,28,32, 34-37,41,42,44,45,

46,47-48,49,50,51,52, 53,57,60,62,65,74,76,

78,94,95,97,98,99,109, 115-119,121,124,129,

131, 134-142, 150, 152, 153, 154, 155, 156, 157,

158,159,160,161,162, 181,187,188,193

Bulletin boards (electronic). 45-46, 138, 154

Capital formation. 6,20,26,42,71, 169, 172, 175, 177

Chicago Board of Trade (CBOT). 14,69,70,74,78, 84,

88, 137, 138, 145, 171, 187

Chicago Board Options Exchange (CBOE). 13, 63, 65,

93,94,96,97,99, 100, 101, 136, 138, 162, 190

Chicago Mercantile Exchange (CME). 14,58,70,73,74,

75,77,78,80,81,84,88, 94,99,101,102,103,111,

116, 137, 138, 145, 161, 162, 163, 170, 171, 172,

187, 188, 189, 193

Cincinnati Stock Exchange (CSE). 12,13,50,62,65,130,

136

Circuit breakers. 57-58, 174-175, 176

Clearing and settlement. 12,17,18,22,44,60,61, 62,70,

73,84-85, 86, 88-89, 107-125, 131, 140, 167, 168,

172, 173, 174, 176, 181-193

Commodities Exchange Act of 1936.75, 167, 168, 169,

170, 172, 175

Commodities markets. 13, 19,69, 70, 71, 93, 102, 159,

162, 169

Commodity Futures Trading Commission (CFTC) 4, 13,

15,16,17,20,21,22,71, 72,73,74,75,76,77,78,

80,83, 84, 85,86,87,93,94, 101, 102, 104, 109,

112, 115, 149, 158, 159, 160, 161, 162, 163,

167-178, 189, 193

Commodity Futures Trading Commission Act of 1974.

71, 169, 170

Continuous net settlement. 130, 132, 186, 191

Courts and litigation. 20,21,149,150,159,167, 170,171,

172, 177

Crashes (market):

Crash of October 1987.8,9-10, 15,17,21,27,31,32,

41, 47, 53, 54-61, 80, 81, 82, 84, 85, 86, 87, 94,

96-97,101, 111, 112,114,115,153,169, 171,173,

174

Crash, threatened in October 1989.15,47,81,94,169,

172

Custodians. 108, 125, 187

Depositories. 44, 107, 108, 118, 120, 124, 125, 131, 181,

187, 191

Depository Trust Co. 44, 181, 191

Digitilization of data.

Discount brokers. 37

Dow Jones. 54,58, 133, 134, 135

Dual trading. 14, 15,72,73, 74-75, 84,95, 160

Enforcement. 20,22,71,75, 149-163, 168, 176, 177

Exchanges, operation of:

Futures exchanges, operation of: 13-16, 69-89, 136,

137, 145, 159-163, 170, 172, 173

Options exchanges, operation of: 16-17,137,145,152,

153

Stock exchanges, operation of: 4,5,8-9,10-13,28,41,

4245,47,48,49-53,58-60, 61-64, 149-159, 168,

169, 170, 171, 172

Exchange Stock Portfolio (ESP): 60

Exclusivity Clause: 21, 171

Federal Bureau of Investigations. 15, 75, 159, 160, 162,

163

Fedwire. 108, 111, 112, 114, 123, 131, 145

Financial futures markets. 13, 14,21,22,70,71,72,75,

87,88, 175

Floor brokers. 15, 32,27,42,48,49,63,69, 72,73,74,

75,78,95,98,99, 130

Floor traders. 44, 69, 72,74, 75, 76, 78, 154, 157, 159,

160, 161, 162

Fourth market. 8, 11, 12,52,57,64

Fraud. 4,15,19,20,28,47,73, 75,140,149-163,168,169

See also: Frontrunning, Insider trading, Penny stock

Frontrunning: 74,97, 152, 160, 163

Futures Commission Merchants (FCMS): 32,70,74, 103,

176

Futures markets: 3,4,5,6,8,10,11,13-16, 17,19,20-22,

32,54,55-57,58,61,64, 69-89,93,94,95,99,101,

102, 103, 104,107, 108, 109, 110, 111, 112, 113,

–203–
204 . Electronic Bulls & Bears: U.S. Securities Markets & Information Technology

114, 115, 117, 121, 122, 136, 187-190

Futures Trading Act of 1982.169, 170

General Accounting Office (GAO). 134-135, 151, 161

GLOBEX. 14,65,88-89, 136, 138, 145

Gramm, Wendy. 173, 177

Greenspan, Alan. 83,122, 172, 173

Group of Thirty. 17, 117, 118, 119, 120, 124

Hedging. 4,6,8,10,14,15,16,17, 20,21,27,55-57,70,

72,76,77,78-80,94,97, 101, 102, 103, 167, 169,

172, 175

Index. 27,55-56,70,77,78,79-80, 82,93,94,95,96,97,

99, 102, 167, 170 See also: Index arbitrage, Index

futures, Index options, Indexed portfolios.

Index arbitrage. 14, 15,55,56,58,64, 78-84, 100, 101,

129, 174

Index future (or stock-index future). 4,8, 13, 14, 15, 16,

20,21,54-57,58,61,64, 69,70,72,75,76-84,85,

86,87, 88,93,94,95, %, 99, 152, 159, 160, 169,

170, 171, 172, 173, 174, 175, 176, 177

Index options: 4,8,16,55,64,77,78,79, 80,87,94,95,

96,97,99, 102, 152,167,168, 169, 170,171,172,

173, 175, 177, 178

Index Participations (IPs): 171

Indexed portfolios. 30,55

Individual investors. 4,7,11,12,15,19,20,28-29, 33-34,

42,44,46,49, 61,78, 83, 94, 104, 152, 153-159,

160, 171 See also: Small investors

Information sharing. 18, 103, 114, 117, 120, 121, 122,

123, 125, 150, 154, 158, 159, 176

Information services vendors. 11, 12, 19,64,65, 100

Information technology. 3,4, 11, 12, 18, 19, 25-26,41,

45,46,47,49,50,51,52, 53,57,60,61-65,72,73,

74,78,80,84,88-89,96, 97,98,99, 100,129-146,

149, 154, 162, 167

Insider trading. 130, 149, 150, 152, 168, 174

Instinct. 12, 19,52,57,64, 136

Institutional investors. 3,4,6,7, 8,9, 10, 11, 12, 14, 15,

19,20,21,30,32,34-35, 42,46,49,50,52,55,57,

62, 64, 76-77, 78, 80, 81, 93, 94, 111, 118, 140,

159-163, 171

Insurance companies. 6,28,32,42

Intermarket Surveillance Group. 150, 163

Intermarket Trading System. 11,48,52-53,61,98, 130,

136

International securities and futures trading. 5,9, 14, 17,

18, 19,20,22,64-65,76,88-89, 155-163, 187

International Stock Exchange (London). 12,52,130,187

Jurisdictional issues. 20-21,72,76, 83,84-88, 104, 167,

168, 169, 174, 175-176, 177, 178

Knight-Ridder. 133, 135, 139

Leveraged buyouts. 26,30

Margin. 101,102,103,104,109, 111,113,114,116,117,

119, 121, 122, 131, 134, 138, 140, 181

Futures margin, issues. 16, 18,20,21,22,57,69,76,

84-88, 111, 113, 114, 116, 117, 119, 122, 169,

172-174, 175, 176, 187, 188, 189, 190

Options margin, issues. 17, 101-104, 121, 122, 191,

192, 193

Securities, margin issues. 57, 60, 101-104, 113, 114,

115, 117, 119, 120, 121, 122, 153, 168, 186, 187

Market-makers, definition and functions: 8,9,10,11,12,

17, 18, 25, 41-42, 45, 47-48, 51-52, 53, 54, 57,

58-61,62

In futures markets. 72,73

In options markets. 16,95-96,97,98,99, 100

In over-the-counter securities markets. 8,10,45,4647,

49,51,52,53,60-61,62, 172

On securities exchanges. 8-9,172 See also Specialists.

Midwest Stock Exchange. 41,49,51,52, 130

Multiple trading of options. 16-17,97-100

Mutual funds. 4,6,28,32-33,36,42

NASDAQ. 10,42,44,4547,49,50, 52,53,60-61,64,95,

129, 130, 138

National Futures Association. 159

National Market System. 3,10-11, 12, 19,47-49,51,53,

64,97,98,99, 144

National Securities Clearing Corp. (NSCC). 120, 121,

181, 182, 186, 187

New York Futures Exchange. 78, 170

New York Stock Exchange (NYSE). 6,7,8,9,10,11,12,

13,19,20,33,35,41,42, 44,45,46,47,48,49,50,

51,52,53,54,55,56,57, 58,59-60,61,63,64-65,

116, 120, 129, 130, 132, 136, 142, 152, 156, 163,

168, 170, 174

North American Securities Administrators Association.

153

Options Clearing Corp. (OCC). 17, 94, 100, 101, 102,

103, 104, 111, 114, 121, 132, 190-193

Options markets. 4,6,16-17,27,55,58,63, 64,77,78,

79,80,81,82,84,87,88, 107, 108, 109, 111, 113,

114, 115, 117, 137, 152, 153, 167, 169, 172, 173,

175, 177-178

Outside Portfolio Managers. 37

Over-the-counter markets (OTC). 3,4,5,7, 8,9, 10, 11,

12, 13, 14, 18,19,4142,44,4547,48, 49,50,51,

52,53,54,60-61,62,64, 110, 133, 154, 168, 172,

181

Pacific Stock Exchange. 41,95,96, 130

Penny stock. 19, 153-159

Pension funds. 4,6,28,30,32,34,42,55, 80, 85-86

Philadelphia Board of Trade. 170
Index ● 205

Philadelphia Stock Exchange. 41,49,50,93,95,98,100

170

PORTAL. 64, 187

Portfolio insurance. 10,54,55-57,80-81,83, 94

President’s Task Force on Market Mechanisms (Brady

Commission). 59,60,61,80,81, 85,87, 101, 112,

113, 115, 176

President’s Working Group. 22,86, 104, 112, 173, 176

Primary markets. 25

Private placement. 19,62,64

Product innovation. 21,75-76, 169-172, 175-176, 177

Program trading. 4,8,9,10,15,19,30,54, 55-57,58,60,

61,78,80-83, 139, 143, 152, 171, 174

proprietary trading systems. 11,12,19,35,50,51,52, 62,

64,69, 138

Quot.ron. 19,133,134,135,136,137, 139

Racketeer Influenced and Corrupt Organization Act. 156,

159

Reuters. 13, 14, 19, 57, 65, 88-89, 132, 133, 134, 135,

136, 137, 139, 145, 157

Ruder, David. 85

Rule 10a-1. 58,79

Rule 19c-3. 48,52

Rule 19c-5. 16,97-100

Rule 80a. 55

Rule 127.50

Rule 144a. 62

Rule 390.11,48-49,51-52

Securities Acts Amendments, 1975.10,12,16,47,48, 49,

51,64, 109

Securities and Exchange Commission. 3,4,10,11,15,16,

17,19,20,21,22,47,48, 49,51,52,53,56,58,59,

60,62,64,72,77,79,80, 83,84,85,86,87,88,93,

94,97,98,99, 100, 101, 102, 103, 104, 109, 112,

131, 137, 138, 139, 149-153, 167-178

Securities Exchange Act of 1934.45,47, 167, 168, 170,

172, 175

Securities Industry Automation Corp. 47, 61, 130, 137,

187

Securities Investors Protection Corp. 122, 168

Self-Regulatory Organizations. 11, 41, 44, 45, 47, 71,

149, 150, 152, 159, 161, 162, 163

Shad-Johnson Agreement. 170

Short sales. 58,79

Single-price auction. 12,62,63,138

Small investors. 7,11, 19,27-29,32-37,44,46,49, 61,83,

140, 141, 153, 156 See also: Individual investors.

Software. 19,89,131,135,136,137, 139,140,142,143,

144

Specialists. 8,9,10,11,12,15,16,42, 44,45,49-52,53,

56,58-60,61,62,63,64, 72,74,79,95,97,99,130,

138, 150, 172

Speculators. 14, 15,20,27,29,70,72-73, 76,77,84,86,

87, 168, 169, 172,173, 174, 175

Sporkin, Judge Stanley. 177

Standards. 19,46,109,116,118,120, 123,124,125,136,

139, 142, 143, 144, 145

States’ regulation. 30, 154, 155, 156, 168, 169

Stock-index arbitrage. (See Index arbitrage).

Stock-index futures contracts. (See Index futures)

Stock-index options contracts. (See Index options)

Surveillance. 15, 18, 19,20,63,71,73-74,75, 89, 125,

130, 131, 139, 140, 142, 150, 159, 160, 161, 162,

163, 168, 176, 187

Telerate. 19, 133, 134, 135,136, 139

Third market. 11,41,52

Underwriting. 7,35,36

UpSta.irs firms. 8,9,48,50,59,60,63,72, 74,96

U.S. Congress. 3,4,5,20,21,47,49,54, 58,71,81,85,

87, 115, 120, 125, 159, 157, 159, 162, 167, 168,

169, 170, 172, 173, 174, 177-178

U.S. Department of Agriculture. 71, 169

U.S. Department of the Treasury. 16, 72, 86, 115, 116,

122, 167, 173, 176

Volatility. 4,9, 15, 16, 19,20,21,27,41,51,54-55, 56,

57,58,60,61,79,81-83, 84-85,86,87,93,97,99,

122, 152, 167, 172-175
Related OTA Report

. Trading Around the Clock: Global Securities Markets and Information Technology—Background Paper. Assesses the effects of information technology on

securities markets and the current status of global securities trading. It compares

securities markets and clearing and settlement mechanisms in Japan, the United

Kingdom, and the rest of Europe with those in the United States. Identifies emerging

questions about international markets and national regulatory regimes. BP-CIT-66,

7/90; 116 p.

GPO stock #052-003-01 198-1; $5.00

NOTE: Reports are available from the U.S. Government Printing Office, Superintendent of Documents,

WashingtyonDC 20402-9325 (202) 783-3238.