Cracks in the Foundation: What We Learned From Black Monday
The lessons of the stock market crash of 1987’s Black Monday are instructive for the purposes of understanding the pressures that could cause markets to crack today.
Another anniversary of the stock market crash of 1987 is upon us and yet another chance to review what lessons were learned (or not) and more importantly what changes have been made to the structure of our markets in terms of trading, clearing and settlement, viewing positions from a risk perspective and, of course, regulatory oversight. Those lessons are instructive for the purposes of understanding the pressures that could cause markets to crack today.
First, 25 years later and I still don’t think the term “Crash” is appropriate when discussing what happened to the markets in October of 1987. Crash is more a term I equate to economic events. Despite the obvious negative affect on asset prices, this was not so much an economic event as a systemic failure of our market structure. If it was due to fundamental economic issues, we would have not seen the large numbers of companies announcing stock buyback programs on the afternoon of October 19 and continuing into the next days. The people closest to the value of their company knew the pricing was irrational. Looking back with 20/20 vision, it was perhaps the greatest buying opportunity of our time. The fact is the next two trading days saw the greatest up moves that were ever seen and, within two years, all of the losses had been erased, which is not what you would have had if this was an economic problem. No, what happened on those days was weaknesses in our market structure that succumbed to the new pressures that were introduced by the evolution of trading systems coupled with new risk transfer products that were traded on a growing number of different trading arenas with trades clearing at unconnected clearing houses backed by insufficient credit lines and regulated by organizations unprepared for the revolution. It wasn’t so much of a crash as it was an earthquake that cracked our foundation. The ’87 Crack.
Stocks and bonds and commodities. It used to be so neat and tidy. Then came risk transfer products like call options, put options, index options, index futures, options on index futures trading on different exchanges using different language and protocols. These products were correlated with each other which attracted arbitragers who looked to take advantage of discrepancies between the markets that were not electronically connected which allowed for pricing to get out of line. Since arbitrage was a fleeting proposition the development of electronic order capture and delivery systems to the exchanges was a natural demand. Volumes grew which attracted larger volumes from firms using more sophisticated strategies. Liquidity seemed to be unlimited. There was a problem brewing though. All these derivatives needed one item in common in order to be priced correctly and that was the price of the underlying stock. When everyone opened more or less together it worked great. When they didn’t, the crack was exposed and pricing got out of line very quickly.
Clearing and Settlement
When people discuss trading, they very rarely ever discuss the most important part of the process, which is clearing and settlement. This is the process where the money is actually passed around. A very important piece. When people traded on the floors they were backed by a clearing firm who was a member at a clearing house. Further, the clearing houses had arrangements with settlement banks. Traders took for granted that whoever they traded with on the floors was a good counterparty as they were backed by a clearing firm. When these trades took place, the two sides would record the transactions on cards (scribbled, really), which were turned into the clearing firms who used teams of keypunchers to enter the data into the back-office systems for reporting to the clearing house who would collate all the data to create a pay/collect advisory to the settlement banks. This was a very time-sensitive issue that did not work well when the processes were delayed. The confusion of that day led to significant delays. Another crack was exposed.
During this time, the derivative clearing houses on both the securities and futures sides of the market thought it prudent to raise margin requirements on all positions, which effectively made every position more costly to maintain. This led to huge margin calls on the firms that turned to their credit facilities which they found to be not as air tight as they should have been. The Federal Reserve rightly stepped in and directed the settlement banks to provide the necessary liquidity but the damage had been done. Clearing firms may not be a good counterparty after all. Another crack was exposed.
Back then, positions in the futures were not combined with securities positions to determine net risk of the portfolio as they were cleared at separate clearing houses. Market makers in the securities were increasingly using the futures markets as the hedge for their securities positions. When the clearing houses raised margins across the board on all positions these hedged positions became economically impossible to carry. They offered no real risk to the system as they offset each other but since they weren’t viewed from a combined risk perspective each individual position was margined as if it was a separate strategy. You needed to post the additional funds quickly or face liquidation. This caused market makers to be pulled from the market at the very moment the market needed liquidity the most. Another crack was exposed.
During the dark days of October 1987 it appeared as if the markets would never recover. Customers were hurt badly and their faith in the system was shaken. Exchanges had black eyes and clearing firms were weakened. Regulators were under the gun to explain what happened and to fix it ... which was a little unfair. Hearings were held, commissions were tasked and eventually the smoke began to clear.
The participants in the US capital markets got off their knees and looked at themselves in the mirror. Exchanges began planning better, with more robust systems. Electronic systems. Member firms took a fresh look at how they handle risk and many began the task of building more robust collection systems for their customers to connect to the new exchange offerings. Clearing houses began looking harder at risk based margining (cross margining), which meant working cooperation between the futures and securities worlds. More robust credit lines were put into place to buffer future shocks. In short, the industry looked in the mirror, saw the cracks and set out to fix the foundation.
We cannot get complacent. The markets continue to evolve and in some instances mutate. New technologies operating at incomprehensible speeds have changed the game forcing traditional liquidity providers to the sidelines. For-profit exchanges under pressure for revenues are bifurcating data streams and charging higher prices for better data that is beyond the means of most customers putting them at an informational disadvantage vis-à-vis those who can pay. Option exchanges have exploded in count with a number of payment-for-order-flow schemes. Dark pools of non-transparent activity that hide market data from other market participants. OTC securities lending activity distorting exchange traded derivative prices.
Counterparty exposure reared its head again in the OTC markets leading to the titans of our industry being questioned as to their solvency. Unheard of. Unimaginable. The regulators took steps to fix this by creating the Dodd-Frank Act that mandates moving OTC activity onto exchanges/swap execution facilities (SEFs) and clearing organizations. Massive new sets of rules are being written for this emerging world that we all hope will be safer and more stable for everything.
But let’s start looking for the cracks now.