GAO 

United States General Accounting Office 

Testimony 

For Release 

on Delivery 

Expected at 

9:30 EDT 

Wednesday 

April 27, 1988 

Developments Since the Market Crash of 

October 1987 

Statement of 

Charles A. Bowsher 

Comptroller General 

of the United States 

Before the 

Senate Committee on Agriculture, 

Nutrition and Forestry 

United States Senate 

GAO/T-GGD-88-33 GAOForm 160((:2/87; 
Mr. Chairman and Members of the Committee: 

We are pleased to be here today to report on the progress being 

made by federal and self-regulatory organizations in response to 

the market crash last October and the differences in 

methodologies used by various groups to evaluate the effects of 

program trading on the stock price declines. Our assessment 

today covers the progress made since the crash, and we are 

continuing to follow these developments. As you requested, we 

will address specifically: 

-- the progress made in developing a coordinated intermarket contingency plan and other changes to improve 

market coordination and operations. 

-- the progress made in enhancing the capacity of the New 

York Stock Exchange's (NYSE'S) order processing 

systems and an analysis of the Exchange's capability to 

identify program trading. 

-- the differences in methodologies used to evaluate the 

effects of program trading by the Presidential Task 

Force on Market Mechanisms (Brady Commission), the 

Commodity Futures Trading Commission (CFTC), and the 

Securities and Exchange Commission (SEC). 
Controversy persists about the problems which caused the October 

crash and how they might be addressed. The authors of most major 

studies agree that the stock, options, and futures markets' 

trading systems should be improved with respect to data sharing, 

contingency planning, coordination, and operating capacity. The 

various federal and self-regulatory bodies have made some 

prcgress. However, disagreement remains on some very important 

points-- the need to increase margins on futures contracts and the 

concept of "circuit breakers", which would automatically halt 

certain types of trading if market prices changed more than a set 

amount in any trading day. Not surprisingly, less progress has 

been made in tackling the tougher questions, and as yet no 

mechanism exists to resolve intermarket disagreements. 

I wish to emphasize that there is agreement among ail of the 

groups who have studied the crash that the futures and equity 

markets are linked. In my view, any changes that are made must 

recognize this reality. 

Even though there is agreement that the equity and futures 

markets are linked, controversy persists over the uses, benefits 

and risks of derivative stock index products. The Board of 

Governors of the Federal Reserve System along with the SEC and 

CFTC found in a 1984 Study of the Effects on the Economy of 

Trading in Futures and Options that derivative products serve a 

useful economic purpose. However, the study cautioned that the 

2 
potential existed for disruptive trading in the index product 

markets that could lead to speculative bubbles that could burst 

with destablizing results. In light of the events of last 

October, I believe the Federal Reserve should revisit its 

findings. We would be glad to review the results of the Federal 

Reserve's new efforts. 

In recent months, the Congress has urged that the executive 

branch and the exchanges develop the leadership to resolve the 

controversies over the solution to the problems identified by the 

various groups who have studied the market crash. But the 

federal and self regulators have sometimes worked at cross 

purposes where disagreements existed. Despite the linkages that 

exist between these markets, some changes are being made 

unilaterally in the futures and equity markets that could 

disrupt rather than support their workings. I am somewhat 

encouraged by the recent formation of the President's Working 

Group on Financial Markets. This group offers the potential to 

resolve intermarket regulatory disagreements. It has held a 

number of meetings and I understand that it has begun to tackle 

some of the more difficult issues associated with intermarket 

regulation. I look forward to their mid-May report. At that 

time we will learn if the working group has been able to come up 

with a consensus solution to the problems that surfaced on 

3 
October 19. Because that solution has not yet emerged, Congress 

should continue to keep pressure on the various parties through 

continued oversight so that progress toward a truly coordinated 

solution remains on track. We will review the findings and 

ProPosals of the President's Working Group and are prepared to 

continue assisting the Congress in its oversight of market 

regulation. 

PROGRESS MADE SINCE THE CRASH 

Federal and self regulators are working to improve the 

stability, operation, and capacity of the stock, options, and 

futures markets. They told us they meet frequently to discuss 

what they are doing. They are trying to develop an intermarket 

contingency plan. The NYSE is making changes to enhance its 

computer Systems. These changes respond to the recommendations 

of our preliminary report on the market crash. They are also 

making many other changes to improve communication and data 

sharing, enhance financial and market surveillance, adjust 

margins, improve clearing and settlement procedures, enhance 

capital adequacy, improve market making systems, and better 

assure credit availability. (See Attachment II.) Most of these 

changes have not as yet been fully implemented. 
DISAGREEMENTS PERSIST ON IMPORTANT 

MARKET ISSUES 

However, some changes are being implemented unilaterally by each 

of the markets despite considerable disagreement over the wisdom 

of these changes. These changes involve restrictions on index 

arbitrage, daily price limits in the futures markets, and margin 

requirements. 

Restriction on Index Arbitrage 

Index arbitrage involves the simultaneous buying and selling of 

stocks and stock index futures. It is done to profit from 

differences in the market value of one compared to the other. 

The New York Stock Exchange proposed to forbid its members to do 

index arbitrage through its high-speed, automated Designated 

Order Turnaround (DOT) system, whenever the Dow Jones Industrial 

Average has moved SO points, up or down, in a single trading day. 

The NYSE reported that the proposal is intended to curb intraday 

volatility and enhance investor confidence in the integrity, 

fairness, orderliness, and efficiency of the market during 

periods of significant volatility. The curb is based on the NYSE 

view that index arbitrage may exacerbate market volatility. This 

restriction on the use of the DOT system does not prohibit manual 

execution of index arbitrage strategies. 
The SEC approved this rule change for a 6-month trial on April 

19, 1988. NYSE officials told us that before this date its 

members were complying voluntarily. On Wednesday, April 6, and 

again on Thursday, April 14, when the Dow moved more than SO 

points, the NYSE requested its members to refrain from entering 

index arbitrage orders through the DOT system for the remainder 

of the day. NYSE officials told us some members continued their 

index arbitrage strategies through manual execution of trades on 

the floor of the exchange. 

The Chicago Board of Trade (CBT), where futures contracts on the 

Major Market Index are traded, indicated in its comments to the 

SEC that the NYSE should take action to restrict undue 

volatility, but disagreed that index arbitrage contributes to it. 

CBT stated that neither the NYSE nor SEC have provided the 

evidence needed to associate index arbitrage with increased 

volatility and stated that NYSE's role may exacerbate volatility 

and disconnect the markets at a critical time. The Chicago 

Mercantile Exchange (CME), where futures and options on futures 

contracts on the Standard and Poor's (S&P) 500 index are traded, 

stated that the unilateral NYSE proposal should not be approved 

unless and until it can be demonstrated that the proposal will 

further the goal of coordinated intermarket circuit breakers. 

CFTC comments on the proposed rule change stated that the rule 

could substantially diminish the linkage between the stock and 

6 
derivative index markets. The comments also stated that 

alternative longer-term solutions to questions of intermarket 

coordination need further exploration both among securities and 

futures exchanges and in other areas of the federal sector. 

Daily Price Limits on Index Futures Products 

The futures markets adopted daily price limits on their stock 

index futures products shortly after the crash, This meant that 

prices could not exceed those limits during any single trading 

day. The limits at CBT and CME were originally set at levels 

roughly equivalent to a change of over 200 points in the Dow 

Jones Industrial Average. Subsequently, CBT and CME reduced the 

limits. Currently, the limits are roughly equivalent to a 100 

and 120 point change respectively in the Dow. At CME, the limits 

get wider as the value of its index futures products increases. 

The stock markets have not adopted price limits as a means of 

controlling large single-day price changes. Recently, we 

understand that there has been discussion of the advisability and 

feasibility of such a change relating to very large movements in 

the DOW. 

CFTC officials said that although price limits have 

disadvantages, they can prevent the markets from overreacting 

during periods of uncertainty. On the other hand, SEC officials 

7 
said that price limits on stocks can deprive investors of the 

ability to liquidate positions when they need to do so and may 

thus induce panic and accelerate trading as the limit is 

approached. These differences of opinion need to be resolved. 

The use of price limits on futures index products and their 

absence in the stock markets create the distinct possibility of a 

transfer of buying or selling from the futures markets to the 

equities markets. Such a shift could create tremendous capacity 

and liquidity pressures and increase market instability, 

especially if there is a major market revaluation such as that 

which occurred on October 19, 1987. 

Margin Requirements 

Another area that is cause for concern involves margins on stock 

index futures contracts. Though the futures markets have 

recently increased margin requirements on some of their index 

related products, these requirements are still at a lower 

percentage level than those involved in the retail purchase of 

securities. Considerable disagreement remains over the 

appropriate level of margins on stock index futures contracts. 

SEC officials have stated that stock index futures margins should 

be raised, while CFTC has reported that there is no justification 

for an increase. SEC has reported that the comparatively low 

margins on futures products permit investors to take undesirably 

8 
risky positions, which have the potential to 3d to the downward 

fall in a declining market. SEC officials said that increases in 

futures margin levels are warranted until the impact of margin 

levels across both markets can be determined. 

CFTC officials counter that when the specific mechanics of the 

futures and securities systems are compared, especially 

considering the futures industry's requirement of daily contract 

settlements, the futures margining system is more rigorous during 

periods of market volatility than the credit system that applies 

to securities transactions. CME officials have expressed views 

similar to those of CFTC. 

CONTINGENCY PLANNING NEEDS A 

DECISION MAKING COMPONENT 

The lack of an intermarket decision making structure as evidenced 

by these unresolved disagreements is also inhibiting the 

development of a unified intermarket contingency plan. The 

regulatory organizations have made progress in developing such a 

plan, but key decision-making components are still missing. 

The federal and self-regulatory organizations are approaching 

contingency planning by enhancing information sharing and 

communications systems that will improve day-to-day operations 

and be available for use in any future market emergencies that 

occur. The SEC and CFTC have prepared and distributed a crisis 

9 
management telephone book containing phcne numbers of officials 

at SEC, CFTC, and the self regulators, as well as officials of 

certain foreign government agencies. Self regulators are also 

developing a hotline which will give them immediate conference 

call capability, enabling them to share information pertinent to 

all exchanges simultaneously. An interim system has already been 

tested and the final system is expected to be implemented in 

about 3 months. The NYSE may establish an administrative unit at 

a particular place off the trading floor that, as part of the 

hotline system, would be a focal point for questions from other 

exchanges about what was happening at the NYSE during market 

emergencies. 

However, a very important part of a good contingency plan-- 

namely, a clear delineation of intermarket emergency decisionmaking duties and responsibilities --is still not in place. 

Decisions about what constitutes a market emergency, the types 

of actions to be taken, and who will make the decisions are still 

not clear. AS long as these issues are not resolved, progress 

toward completing a good contingency plan will be slowed. We 

believe the President's working Group should produce such a plan 

by its mid-May reporting date. 

10 
IMPROVEMENTS IN NYSE'S COMPUTER SYSTEMS 

m IDENTIFICATION OF PROGRAM TRADING 

I would now like to discuss two areas of concern at the NYSE. I 

am pleased to say that the NYSE has made some progress in 

correcting the problems with its computerized order processing 

systems as described in our January 1988 report. We have also, 

in response to your request, obtained some information on the 

capability of the NYSE's and its member firms' computer systems 

to identify program trading and to distinguish between the 

different types of program trading strategies. Details on the 

results of our work are contained in two reports which we are 

issuing today. 

Capacity Enhancements 

The New York Stock Exchange has made a number of upgrades to its 

order processing systems and changes to the way it plans its 

computer capacity. These changes are designed to correct the 

problems we identified in our January report. These changes 

include: installing new equipment to handle odd-lot orders, 

installing additional automated specialist books to reduce its 

reliance on slow card printers, adding more specialist trading 

posts, developing the capacity to handle a 600-million share day 

by May and a l-billion share day by 1990, and establishing system 

performance goals. 

11 
NYSE officials told us that NYSE plans to conduct a full scale 

test of the capability of its order processing systems in a 600- 

million share trading environment similar to that encountered in 

October 1987. We have been invited to observe the test. In our 

view, testing of the systems should include measures to 

successfully demonstrate that the NYSE's trading systems are 

capable of overcoming the processing problems that were described 

in our January report. A great deal will depend on the success 

of tests such as those scheduled on April 30, to help ensure that 

all systems will work smoothly under high order volume processing 

conditions. We encourage the Exchange to conduct future tests 

designed to stress the automated systems and electronic linkages 

of the NYSE, its member firms, regional stock exchanges, and 

intermarket components. 

Since October 1987, the NYSE has modified its overall computer 

capacity goals. Rather than planning for its systems to be 

capable of routinely handling a 600-million share trading day by 

1990, the Exchange is planning to have systems capable of 

handling a l-billion share trading day by December 1989. 

Assuming present rates of volume growth, NYSE officials told us 

they believe that this represents the development of a system 

that can process roughly five times the average daily trading 

volume the Exchange expects to receive. 

12 
In addition to raising its overall computer capacity goals, the 

NYSE has also refined how it translates anticipated trading 

volumes into associated systems requirements. For example, the 

Exchange now will estimate the capability of subsystems 

supporting individual trading posts to handle anticipated trading 

volumes. Before October 1987, NYSE estimated the effect of 

volume only on the entire system that supports all trading posts. 

This is a significant change because during October 1987 the 

volume of orders overwhelmed the ability of some subsystems to 

print orders at some trading posts. NYSE has also established 

specific performance goals for its automated order processing 

systems. 

In response to our recommendation, the Exchange plans for an 

independent assessment of its automated order processing systems. 

Exchange officials said they anticipate selecting a firm by the 

end of April 1988. SEC officials informed us they have no 

current plans to acquire additional technical resources to 

independently assess the NYSE's trading systems. However, they 

said they agree with the need for an independent assessment of 

the trading systems and with the Exchange's plans to contract for 

such an assessment. They said they plan to review the results of 

the Exchange's independent assessment, and they believe this 

review fulfills SEC's regulatory responsibilities. We continue 

to believe that SEC needs its own capability to evaluate computer 

systems. 

13 
Ability to Identify Program Trading 

In our second report, we reviewed the NYSE'S ability to identify 

program trading through its automated systems. We: (1) obtained 

some information on the computer systems of 10 major firms that 

are members of the NYSE, (2) determined whether the NYSE's and 

members' systems have the capability of reporting basket trades 

(defined as program trading) and differentiating between trading 

strategies such as index arbitrage and portfolio insurance, and 

(3) determined whether the NYSE's and members' systems have been 

improved since October 1987, to permit more accurate reporting of 

various program trading strategies. 

Member firms have direct computer-to-computer links with the 

NYSE for placing orders automatically and receiving order 

confirmations. All 600 of the NYSE's communications links are 

capable of handling any type of order, but some firms have 

dedicated certain communications lines for program trading 

strategies such as index arbitrage. Other firms conduct such 

trading out of specific branch offices that may be given unique 

identification codes. About 56 of the 600 lines and 24 branch 

office codes have been so identified. To the extent that member 

firms have informed it, NYSE therefore knows which 

communications lines or branch identification codes are being 

used for program trading. 

14 
NYSE has not asked its members to identify specific types of 

program trading strategies such as index arbitrage and portfolio 

insurance, and its computer systems cannot identify these 

strategies. Computer systems at 6 of the 10 member firms we 

surveyed, however, have this capability. The NYSE is considering 

alternatives to identify index arbitrage orders. NOW that the 

SEC has approved the 50-point index arbitrage DOT cut-off rule, 

we believe it important that the Exchange develop this capability 

quickly in order to enforce the new rule. 

CRASH STUDY METHODOLOGIES 

Let me now turn to our review of the study methodologies used to 

determine the effect of program trading on the October price 

declines. Of all the sources of selling pressure that existed on' 

October 19, 1987, program trading has been subjected to the most 

intensive scrutiny. The SEC, CFTC, and Brady Commission reports 

all discussed the role program trading played. The Brady 

Commission and SEC reached similar conclusions about program 

trading-- that it was a significant factor contributing to the 

decline --although the Brady Commission conclusion related only to 

portfolio insurance strategies. CFTC, on the other hand, 

concluded that hedging in the futures markets and index 

arbitrage did not interact to cause a downward spiral in stock 

prices. 

15 
It is very important to emphasize that these conclusions do not 

necessarily contradict one another. The three studies' 

objectives with respect to the effects of program trading 

differed. The arady Commission did not have a particular pointof-view, but considered program trading as one of several 

institutional trading strategies that illustrated the linked 

nature of the markets. The CFTC set out to substantiate or 

refute the so-called "cascade scenario". This may occur when 

hedging in futures markets sets off a chain reaction of index 

arbitrage selling in the equity markets which is then followed by 

endless rounds of subsequent futures hedging and index arbitrage 

equity sales, leading to a downward spiral of equity prices. The 

SEC had a number of objectives, but most important, set out to 

identify whether futures related program trading activity was 

associated with periods of significant equity pr-ice changes 

during the market crash period. This particular SEC test for 

effects does not necessarily require that the cascade scenario be 

validated. 

Each of the three study groups used similar data and supplemental 

interviews to estimate the extent and timing of program trading 

that occurred, and the resulting estimates were similar. Each 

group matched the timing of trading activity and market price 

changes to ascertain if the former affected the latter. No more 

sophisticated quantitative analytical techniques were used 

because none of the study groups believed them to be feasible. 

16 
The objectives of each of the studies, and the judgments made by 

each study group in determining trade timing and intervals to 

review contributed to the different conclusions. And, because of 

the differing study objectives, the biggest contributing factor 

was the reduced number of program trades, considered futures 

related, that CFTC used in matching trades with price declines. 

SIMILAR ESTIMATES OF TOTAL 

PROGRAM TRADING 

Estimates of the levels of total program trading produced by the 

SEC, CFTC, and the Brady Commission on both an interday and 

intraday basis are similar. The SEC and CFTC derived these 

estimates primarily from a survey of 16 firms that were large 

program traders, active in the futures markets, either for their 

own account or for the accounts of others during the weeks 

preceding the crash. The SEC and CFTC, in turn, provided all of 

the information collected to the Brady Commission. 

Each group supplemented the survey data by conducting interviews 

of the firms' customers to determine more precisely the trading 

strategies the firms employed. In addition, the groups verified 

the survey data against audit trail transaction data from the 

NYSE and CME. Total program selling reported by the SEC and CFTC 

was about 89 million shares on October 19 or 14.7 percent of the 

volume traded that day on the NYSE. We calculated the Brady 

17 
Commission estimate at 18.9 percent. The estimates of program 

trading used by the Brady Commission were expressed in dollars 

and had to be converted to share volume based on information in 

the Commission report. The somewhat different results can be 

accounted for by the inaccuracies in the calculation used to 

convert billions of dollars of selling activity into millions of 

shares sold. 

Total program selling drops dramatically on October 20 in the SEC 

and CFTC studies. The numbers of total shares sold through 

Program trading strategies on the NYSE that the SEC and CFTC 

reported are not strictly comparable on October 20. However, 

CFTC officials told us that their study's estimate is inaccurate 

because of a computer error and the actual number should be 

comparable to SEC's. 

DIFFERENT APPROACHES TO ASCERTAINING 

ASSOCIATION BETWEEN 

PROGRAM TRADING AND PRICE 

VOLATILITY 

As we stated earlier, much attention was directed in the CFTC, 

SEC, and Brady Commission studies to the effects of program 

trading on stock prices. While the Brady Commission seemed to 

place it more in context with all trading throughout the crash 

period, the two federal regulatory agencies more directly 

addressed the question of causality between program trading and 

stock price volatility. The SEC and CFTC studies are more 

18 
comparable on specific aspects of their analytical approaches, so 

we focus on them. Where appropriate, we also comment on the 

Brady Commission's analysis. 

The analytical approaches used by SEC and CFTC differed in two 

major ways. First, because of different study objectives SEC and 

CFTC used different categories of program trades to ascertain the 

effects of this trading technique on price changes. Second, SEC 

and CFTC emphasized different intraday time intervals over which 

to measure the effects of trades on prices. 

Different Groups of Program Trades 

SEC included in its analysis of the effects of program trading, 

all index arbitrage, index substitution, portfolio insurance, and 

all other program trading on the NYSE. Because the CFTC was 

testing for the existence of the cascade scenario, it included 

all index arbitrage and index substitution, but did not include 

Portfolio insurance stock selling because it involved no futures 

component. By limiting its analysis only to program trades that 

included a futures component, CFTC reduced the amount of trading 

considered to be relevant to the effect of futures trading on the 

stock market decline to less than half of that used by SEC. 

The SEC's report indicates that index related program trading on 

October 19 amounted to 89 million shares. On the other hand, 

19 
CFTC considered only 37 million of those shares to be relevant to 

its test for the existence of the cascade scenario. The CFTC did 

not include the other 52 million shares, because those trades did 

not include a futures component, and because it was testing for 

the interaction between futures hedging and index arbitrage that 

would have to have been occurring in order to verify the 

existence of the cascade scenario on October 19. The SEC was 

testing for the effects of all futures related program trading. 

Because its interviews with traders and customers indicated that 

the 52 million in program trade share sales would have occurred 

in the futures market were it not for the large apparent 

discount, SEC included those share sales in its analysis of the 

effects of futures related program trading on the price declines. 

Different Intraday Intervals 

Selected for Analysis 

SEC analyzed program trading data all-day on October 19 and 20 

and at 30-minute and lo-minute time intervals, while the smallest 

interval CFTC used was 30-minutes. Selection of time intervals 

is important in these data analyses because the shorter the time 

interval examined, the greater will be the incremental impact of 

a large trade on beginning and ending stock prices, other things 

being equal. 

SEC officials told us that program trading strategies tend to hit 

the stock market in concentrated bursts which temporarily exceed 

20 
the markets' ability to absorb them. For example, the SEC report 

stated that, on October 19 between 1:OO and 2:00 p.m., the 

combination of index arbitrage and portfolio insurance selling 

totalled more than 40 percent of volume in the stocks comprising 

the S&P 500. Furthermore, they reported that this selling 

totalled more than 60 percent of S&P 500 volume in three 

different lo-minute intervals within that hour. Although SEC 

officials told us they relied on all the data to reach their 

conclusions, the lo-minute interval analysis shows the greatest 

effects of program trading on stock price volatility. 

CFTC officials said that available data was not precise enough to 

analyze lo-minute intervals. They pointed to the fact that the 

trade execution times were difficult to determine and some trade 

order entry times were not exact. The Brady Commission report 

presented data in 30-minute intervals. A Brady Commission 

official said he did not believe that the available data was 

accurate enough to permit a meaningful analysis of trading by lominute intervals. SEC officials said they believed their 

conclusions were supported by examination of the 30-minute 

interval data as well as the lo-minute interval data. 

The SEC assumed a S-minute time lag from order entry to 

execution in arraying its trading data. Both CFTC and the Brady 

Commission used order entry times. This difference could change 

the alignment of trading and price change data and lead to 

21 
different conclusions about the effect of program trading on the 

price decline. 

SEC officials told us that orders for stock trades are usually 

executed within 90 seconds from entry into NYSE's DOT system. 

They said they assumed a B-minute delay to account for the 

confusion and problems in executing orders that occurred on 

October 19 and 20. CFTC and Brady Commission officials told us 

they thought no reasonable assumption could be made about delays 

in execution times because of the extensive number of trading 

halts and DOT system problems that occurred. SEC officials told 

us they believe that the S-minute assumption did not materially 

affect the analysis. They said that because program trading 

occurred in concentrated bursts, the effect would have appeared 

to be equally concentrated using order entry times because it 

would have appeared S-minutes earlier. 

MORE RIGOROUS ANALYSIS 

IS DIFFICULT 

As I indicated, the basic approach followed in the studies 

involved comparing program trading activity with price change 

data during specific time periods and looking for significant 

associations between those two measures. Officials of all three 

study groups told us that a rigorous quantitative analysis of the 

trading data was not possible given the short time frames they 

22 
had to complete the studies, and the limitations of the data. 

SEC officials also pointed to the lack of a proven economic model 

that could handle the complex variables involved in a phenomenon 

such as the market crash. In addition, they noted that it may be 

impossible to measure psychological, political, or macroeconomic 

variables. Thus, the conclusions of the studies are subjective 

and depend on such factors as point-of-view, differing regulatory 

perspective, and judgment of the study group. 

CONCLUSION 

Reasonable people may disagree about which of the measurement 

methodologies and interpretations of data are most appropriate. 

And because of the acknowledged limitations of the studies of 

program trading, we will probably never know its precise effects 

on price behavior of markets during October 19th and 20th. 

From the standpoint of seeking solutions to better enable market 

participants and investors to cope with a major price swing, I am 

not sure we need to know the precise effects of the new market 

demands on price volatility. The buying and selling of large 

groups of stock baskets is a reality of today's markets. Program 

trading of these baskets is a technique used by institutional 

portfolio managers who control huge positions. When all these 

traders want to move in the same direction, either buy or sell, 

they are bound to put stress on the markets. The key policy 

23 
question that must be answered is: what is the best way to 

manage this stress-- try to control it when it becomes a problem 

or adjust market structures to better deal with it day-to-day. 

Progress has been made in some areas to enable the individual 

markets to better cope with large trading days. However, other 

changes, such as price limits on stock index futures and the cut 

off of the NYSE's DOT system for index arbitrage, have not been 

agreed upon by all of the federal and self regulators. Because 

these changes have not been coordinated across markets, they have 

potentially adverse implications for intermarket stability. 

These uncoordinated changes greatly concern us. Differences of 

opinion among the exchanges and federal regulators must be 

resolved quickly by the President's Working Group. If this does 

not occur, the disagreements should be dealt with through 

Congressional action. 

24 
ATTACHMENT I ATTACHMENT I 

SCOPE AND METHODOLOGY 

We conducted interviews and gathered data from the following 

federal agencies, self-regulatory organizations, and others 

during our work on these assignments. 

Federal Agencies 

Commodity Futures Trading Commission (CFTC) 

Department of Treasury 

Federal Reserve System (Fed) 

Securities and Exchange Commission (SEC) 

Self-Regulatory Organizations 

American Stock Exchange (AMEX) 

Chicago Board of Trade (CBT) 

Chicago Board Options Exchange (CBOE) 

Chicago Mercantile Exchange (CME) 

Midwest Stock Exchange (MWSE) 

National Association of Securities Dealers (NASD) 

National Securities Clearing Corporation (NSCC) 

New York Stock Exchange (NYSE) 

Options Clearing Corporation (OCC) 

?acific Stock Exchange (PSE) 

25 
ATTACHMENT I ATTACHMENT I 

Other Organization 

Securities Industry Automation Corporation (SIAC) 

Progress Analysis 

Our review of regulators' progress in implementing suggested 

actions to better manage a future market crisis involved 

analyzing: (1) market crash reports prepared by the Brady 

Commission, SEC, CFTC, NYSE, and CME; (2) proposed rule changes 

submitted to the SEC and CFTC from the securities and futures 

self regulators respectively; (3) operational and communications 

changes proposed or implemented to facilitate intermarket 

coordination and improve market capacity; and (4) results of 

intermarket meetings and plans for future meetings. 

Methodologies Analysis 

To prepare a description and comparison of the SEC, CFTC, and t 

Brady Commission reports as they pertained to their evaluation 

of the effects of program trading on intraday stock price 

volatility we: (1) obtained and analyzed the official reports 

from the SEC, CFTC, and the Brady Commission; (2) studied 

research literature on the effects of program trading on stock 

price volatility obtained from both the academic community and 

.he 

26 
ATTACHMENT I ATTACHMENT I 

other government agencies: (3) examined some of the data 

provided by major firms which formed the basis of the SEC and 

CFTC studies; (4) talked to members of the SEC, CFTC, and the 

Brady Commission study groups; and (5) obtained informal comments 

on this analysis from government agencies and external 

consultants. 

We did not attempt to independently verify the accuracy of the 

data provided by major firms to the SEC, CFTC, and the Brady 

Commission. Furthermore, we did not verify the accuracy of data 

transcription from the data forms provided by the major firms to 

the computer generated analyses of the SEC and CFTC. 

Analysis of NYSE Computer System Enhancements 

To assess NYSE's upgrades to its systems' capacity we toured the 

exchange floor and the Securities Industry Automation 

Corporation (SIAC) computer facility and observed the new 

specialist posts, additional printers, automated specialist 

books, and the new Limit Order System. We did not corroborate 

written or oral representations due to time constraints and the 

proprietary nature of certain information. 

27 
ATTACHMENT I ATTACHMENT I 

We interviewed officials from 10 of the 3 1 brokerage firms that 

the NYSE has determined execute program trades for their own or 

client accounts. These firms were randomly selected and 

represent both the large and small volume program traders. We 

also interviewed various NYSE and SIAC officials. we reviewed 

pertinent documents obtained from these sources and reports 

provided by SEC, the Brady Commission, and NYSE. 

28 
ATTACHMENT II 

MARKET ACTIONS SINCE THE CRASH 

ATTACHMENT II 

Federal and self regulators are working together and within their 

markets to improve market operations in response to the October 

1987 crash and to the recommendations contained in the studies 

that followed. These changes relate to communication and data 

sharing, market surveillance, financial surveillance, margins, 

clearing and settlement procedures, market making systems, and 

capital adequacy and credit availability. 

Communication and 

Data Sharing 

-- The self regulators are trying to make trading 

information more useful and timely. For example, CBOE 

has developed a "wish list" of trade information which 

includes the percentage of stocks currently open for 

trading in various indices, a listing by index of stocks 

delayed or halted, and the index values. NYSE iS 

determining the feasibility of providing this 

information through the Consolidated Quote System of the 

SIX or through private vendors. In addition, CBOE is 

drafting a joint letter with other exchanges to a 

quotation vendor requesting automation of trading halt 

indicators and improved quality controls. 

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-- The NYSE is looking into disconnecting the ticker tape 

for routine trade information if, in high volume 

situations, the tape is more than 3 minutes late. The 

tape could then be used as a message board during such 

periods. The tape could contain messages such as the 

current Dow Jones Industrial Average and the time needed 

for trade executions. NYSE officials told us that the 

disconnection of the ticker tape might prevent investors 

from being misled by untimely information. In addition, 

the NYSE is considering arrangements with private market 

data vendors by which it would be able to page into the 

vendors' systems to directly provide operational 

messages. 

-- NASD has introduced a new communications enhancement 

called the Order Confirmation Transaction (OCT) Service. 

This service will enhance communication among market 

makers, eliminating the need for telephone contact, and 

create an audit trail of firms accepting, rejecting, or 

not responding to market orders. 

-- NASD officials told us their Board of Governors has 

approved a rule which will streamline its emergency 

decision-making process. They plan to submit this 

proposal to SEC for approval. 

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ATTACHMENT II 

Market Surveillance 

ATTACHMENT II 

-- Futures exchanges currently attend subcommittee meetings 

of the Intermarket Surveillance Group (ISG) concerning 

stock index products. This group coordinates 

investigations of trading abuses such as stock 

manipulation. However, futures exchanges are not formal 

members of the group. Negotiations are underway for a 

more formal role for futures exchanges in the ISG. 

-- In an attempt to detect frontrunning from the stock to 

the futures markets, the NYSE will provide futures 

exchanges with audit trail information on stock trading 

that will enable them to conduct routine surveillance 

for frontrunning. This information includes times of 

trades, identities of the buyers and sellers, and 

whether the trade is for a customer or for a firm's own 

account. 

Financial Surveillance 

-- CME hosted a meeting in March 1988, concerning 

financial surveillance data. The exchanges attending 

discussed the available financial surveillance 

information and procedures currently followed in the 

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futures and securities industries. The exchanges want 

to determine what information they can share on A 

routine and emergency basis. 

-- Futures and options clearing organizations plan to 

routinely share cash flow data on member firms and their 

affiliates. CBT and CME also plan to share information 

on margin excesses and deficits, option premiums, and, 

possibly, on firms' margin requirements. 

-- CFTC is refining large trader and exchange clearing 

member position data. It is producing aggregate 

intermarket position data for CFTC-regulated markets. 

The purpose is to identify concentrations of similar or 

related positions in futures markets held by customers 

or clearing firms on multiple exchanges which could pose 

a financial threat to a clearing firm. 

Margins 

-- CBT has tripled its Major Market Index-Maxi futures 

margins since October 19. The initial margin was 

increased from $4,500 to $15,000 per contract and the 

maintenance margin was increased from $3,000 to $10,000 

per contract. The new initial speculative level is 

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ATTACHMENT II ATTACHMENT II 

equivalent to approximately 17 percent of contract 

value. CBT officials told us they had raised margins 

because CFTC and SEC wanted higher stock index futures 

margins. 

-- CME has raised its initial speculative margins from 

$10,000 to $19,000 and its maintenance speculative 

margins from $7,500 to $10,000. Margins for hedgers 

were also increased from $7,500 to $10,000. 

-- According to CBOE officials, SEC suggested that options 

exchanges increase their margin requirements. 

Accordingly, NYSE, AMEX, PHLX, PSE, and CBOE raised 

margin requirements for broad-based market index 

options. The new requirements were designed to protect 

both investors and firms by assuring that broad-market 

index option positions are adequately covered. In 

addition, the new margin requirements should maintain a 

reasonable cushion of protection for investors. 

Clearing and Settlement Procedures 

-- The National Securities Clearing Corporation (NSCC) 

filed a proposed rule change with the SEC to require its 

members to make an additional clearing fund deposit if 

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the member's clearing fund obligation increases by 10 

Percent during the month. 

-- CBT, CME, and OCC asked NSCC to participate in a routine 

clearing information sharing effort. NSCC is 

considering the proposal. 

Market Making Systems 

-- NYSE and AMEX have been reviewing the performance of 

specialists to determine if they met their market making 

responsibilities during the crash period. Based on these 

reviews, NYSE has reallocated six stocks and AMEX has 

reallocated two stocks. 

-- The NYSE has developed additional specialist performance 

standards based on objective measures, such as DOT order 

handling and reporting and the timely opening of 

securities. 

-- NASD has submitted a proposed rule change to SEC which 

will increase the penalty for an unexcused market maker 

withdrawal from a 2 to 20 business day suspension from 

trading in that security and has reduced the number of 

reasons for excused withdrawals. 

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-- NASD has also submitted a proposed rule change to SEC to 

enhance its Small Order Execution System (SOES). These 

enhancements include, among others, a change from 

voluntary participation to mandatory participation in 

SOES, thereby, committing all market makers to make a 

continuing market in NASDAQ/NMS securities; continued 

operation of SOES during locked/crossed markets; and 

creation of different maximum size limits for SOES 

orders, depending on the security. 

Capital Adequacy and 

Credit Availablllty 

-- CME amended a position limit rule which requires traders 

in the S&P 500 futures and option contracts to obtain 

prior CME approval before exceeding speculative, hedge, 

arbitrage, or spread limits. However, under this 

proposal, a trader intending to exceed such limits could 

request verbal approval from CME before exceeding the 

limits. If verbal approval is granted, the trader would 

then be required to file the written application with CME 

promptly after receiving such verbal approval. This rule 

amendment will enable CME to maintain stricter control 

over its members' position limits and to review each 

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application to exceed position limits on a case-by-case 

basis. According to CFTC, the requirement that traders 

obtain prior exchange approval before exceeding 

speculative limits is a condition imposed by most 

exchanges. 

-- 

-- 

The NYSE Board approved an increase in the minimum 

capital requirement for specialists from the greater of 

$100,000 in capital or an ability to assume a position 

of 5,000 shares in each of the common stocks in which 

they make a market, to the greater of $l,OOO,OOO in 

capital or an ability to assume a position of 15,000 

shares in each common stock. NYSE is also exploring the 

need for specialists to maintain additional lines Of 

credit and other lending arrangements. 

The AMEX is in the process of working on a proposal to 

increase specialist capital requirements. Current 

capital requirements of the greater of $100,000 or 

an ability to carry 2,000 shares of each security are 

far below the actual financial commitments of the AMEX 

specialists. The AMEX believes that an increase in the 

minimum capital requirements may be in order to reflect 

more closely the normal level of capital used. The AMEX 

believes such increases could more accurately reflect the 

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adequacy of specialists' capital and emphasize their 

obligations. 

-- The NYSE also has implemented a change in its frequency 

of monitoring specialists' capital. In the past, 

whenever a substantial increase or decrease occurred in 

the price of NYSE listed securities overall or in an 

individual security, the NYSE obtained capital 

information from each specialist unit or from the 

individual specialist over the telephone. In a memo to 

specialist organizations dated February 23, 1988, the 

NYSE reported that in light of the current increase in 

market volatility and in order to formalize past 

practices, specialist units were asked to report capital 

and position data on a daily basis. TWO forms were 

developed: one was designed for self-clearing 

specialists while the other is for specialist units that 

clear through other brokers. 

-- Discussions on the need for improved communication are 

underway between banks and clearing organizations. CME 

held a meeting on April 4, 1988, with banks and clearing 

organizations to discuss ways to improve communication. 

The group plans to include bank phone numbers in its 

telephone directory, develop guidelines on requesting an 

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extension of Fedwire hours, and discuss access to 

collateral and pay and collect information by banks. 

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