V Developments in International Equity Markets and Their Implications for Macroeconomic and Financial Stability
- International Monetary Fund
- Published Date:
- January 1988
The sharp declines in global equity prices during mid-October 1987 demonstrated the speed with which large shocks can be transmitted across increasingly integrated financial markets. A number of studies have sought to identify the factors that contributed to such equity market instability as well as the structural and regulatory policy changes that would improve the performance of these markets. This chapter sets these studies into the context of trends in the international capital markets and analyses their principal conclusions and policy recommendations.
Structural Changes in Global Equity Markets
During the 1970s and 1980s, major securities markets became more integrated as restrictions on capital flows were reduced, regulatory barriers limiting the access of foreign borrowers and lenders to major domestic securities markets were lowered, and improvements in trading and communication technologies facilitated the management of diversified international portfolios. This reduction in barriers to international financial transactions also occurred at a time when institutional investors became increasingly important in equity markets. Some institutional investors (e.g., insurance companies, pension funds, and mutual funds) attempted to diversify their portfolios by increasing their holdings of equity in different national markets.31
During much of the 1980s, this international diversification of investor portfolios took place during an extended global bull market. Between the end of 1981 and the end of September 1987, for example, world stock market capitalization grew in real terms32 at an estimated annual rate of nearly 17 percent, with equity market capitalization in the United States and Japan, rising at annual real rates of 14 percent and 25 percent respectively (Chart 10). In part, this sustained increase in equity prices reflected the recovery of economic activity from the global recession of 1981–82, as well as substantial reductions in real interest rates from the high levels experienced in the early 1980s. In some industrial countries, a recovery of profitability (often reflecting wage moderation during the cyclical recovery of output since 1983) and improved terms of trade brought about by declines in oil and other commodity prices also helped improve corporate earnings and dividends. Moreover, a general decline in inflation may have increased the attractiveness of holding financial assets. In addition, domestic institutional and tax considerations influenced developments in certain countries by affecting the share of total savings directed toward investment in equity instruments.
Chart 10.Nominal and Real Indices of Industrial Companies’ Stock Prices, First Quarter 1961–Fourth Quarter 19881
Sources: Morgan Stanley Capital International; and International Monetary Fund, International Financial Statistics.
1 Nominal indices have 1981 value equal to 100. The real value of the indices is taken as the nominal value deflated by the individual country GNP deflator. For the world index, the deflator is the average of the individual country deflators weighted by the average value of its respective GNP relative to the group total over the three preceding years.
2 The world index is that calculated by Morgan Stanley Capital International and reflects the stock indices of 19 countries.
The price variability that characterized most international asset and commodity markets during the 1970s and 1980s was also evident in major equity markets (Chart 11).33 During this period, the greatest variability occurred when equity prices experienced sharp declines in 1973–74 (following the first oil price shock) and in October 1987. Apart from these two periods, there has been no discernible general trend in price volatility between the 1970s and 1980s in most major equity markets, although the Federal Republic of Germany and Japan appear to have experienced somewhat increased volatility since the late 1970s.34 Nonetheless, even before October 1987, price volatility in most major markets during part of 1986 and 1987 was at or above the level experienced during the period from the mid 1970s through the mid-1980s. Moreover, a recent study35 has noted that, when equity price variability has increased during the 1980s, there has been a higher correlation between price movements across markets than during the 1970s.
Chart 11.Equity Market Price Volatility, January 1971–December 19881
Source: Morgan Stanley Capital International.
1 Price volatility is measured by the standard deviation of percentage of change of the end-of-month values of the stock index over the preceding 12 months.
In most industrial countries, sharp declines in equity prices in October 1987 offset price increases registered earlier in that year. By the end of October 1987, only the Japanese stock index was above its 1986 year-end value. On October 19 and 20, the major stock market indices fell (measured in domestic currencies) by 18 percent in Canada, 13 percent in the Federal Republic of Germany, 11 percent in France, 11 percent in Italy, 18 percent in Japan, 22 percent in the United Kingdom, and 16 percent in the United States. While the sharp declines in equity prices were accompanied by record trading volumes in some markets, trading in other markets dropped sharply as daily price limits were reached or markets closed. While the events of October 1987 have been compared with the collapse of equity prices in October 1929, some observers have suggested that the global nature of the selling pressure was most comparable with the panic selling that was evident on the eve of World War I (in particular, on July 31, 1914). What was unique about the October 1987 decline in equity prices was not the scale of the decline, but rather the speed with which it took place. In the United States, for example, the Brady Commission36 identified eight declines in equity prices that had occurred since 1945 that were comparable with the decline in October 1987. These earlier declines, however, were spread over longer periods, sometimes several years. Chart 10 illustrates that such declines were also evident in other major markets during the 1960s, 1970s, and 1980s.
Following a limited recovery of stock prices in the week after the collapse, equity prices on most markets remained quite volatile but with no strong upward or downward trend. An exception was the Japanese market where prices recovered to a level above those prevailing in mid-October 1987 by April 1988. Moreover, equity markets continued to appear to be especially sensitive to adverse news. For example, during the Fund’s Interim Committee meeting in mid-April 1988, the announcement of what was regarded by market participants as adverse news on the U.S. trade balance led to a sharp price decline in a number of major markets.
Analyses of the events of October 1987 have argued that both macroeconomic factors and the structural characteristics of equity markets influenced the extent and speed of the decline in equity prices. Large and persistent external payments and fiscal imbalances in some of the major industrial countries were generally viewed as incompatible with stable financial and foreign exchange market conditions. In part, this reflected the belief that such imbalances were “unsustainable” in the sense that their financing would absorb a high or increasing share of world savings and would eventually require higher real interest rates. While these imbalances created underlying pressures on financial and foreign exchange markets, short-term developments in equity markets in the months leading up to October 1987 were viewed as most directly affected by interest and exchange rate movements and perceived policy conflicts between the authorities in some of the major countries. Interest rates, which had been declining in the major industrial countries since mid-1984, began to rise early in 1987, initially with an increasing differential between interest rates in the United States and in the other major industrial countries. Most of the reports attributed this to concerns about exchange market conditions as well as the possibility of higher inflation.37
As interest rates and equity prices rose during 1987, there emerged a widening gap between yields on government bonds and equities (as measured by the inverse of price/earnings ratios). In most markets, these gaps increased by at least 1–2 percentage points in the period prior to October 1987. Observers noted that, while this yield gap could conceivably have been closed by a fall in bond yields (higher bond prices) rather than a rise in equity yields (lower equity prices), macroeconomic developments and policies made a sharp fall in interest rates unlikely. While macroeconomic developments were viewed as creating the scope for a decline in equity prices, some observers argued that certain structural characteristics of equity markets amplified and accelerated the price declines and created the possibility of spillover effects onto other asset markets. It was in response to these concerns that a number of official studies were commissioned and a number of equity exchanges reviewed their own experiences.
Analyses of the Stability of Global Equity Markets
The sharp decline in equity prices in October 1987 led to concern about (1) the performance of trading systems as measured by the speed and accuracy with which buy and sell orders were transmitted, the extent of price volatility, and the quality of market liquidity; (2) the influence of computer-based trading strategies and the linkages between stock and derivative (stock option and futures) markets; (3) the capacity and efficiency of clearance and settlement systems; (4) the provision of emergency liquidity and other official support during periods of market stress; and (5) the consistency of regulation and supervision for markets both within and across countries. Each of these issues is examined in turn.
Equity markets facilitate capital formation by providing liquidity for claims on capital and thereby making such claims more attractive portfolio instruments. In liquid markets, investors can convert equity claims into cash at prices near the most recent transaction prices in the absence of new information. Moreover, options and futures markets for equity instruments can further enhance the attractiveness of equity instruments by allowing savers to hedge against adverse price movements through transferring the risk of price fluctuation to persons willing to speculate on these movements for a profit or to other hedgers concerned with offsetting price increases.
Market-making systems in equity markets are designed to provide liquidity (i.e., the ability to convert equity into cash with relatively little effect on equity prices) by creating mechanisms for dealing with small, temporary order imbalances. To provide such liquidity, a variety of systems has been employed in different countries; but all are essentially variants of three basic market-making structures. A number of systems (including those in Japan and the United States) rely on “specialists” to provide liquidity. On the New York Stock Exchange (NYSE), for example, the specialist assumes an obligation to prevent volatile price movements in the shares in which he has the sole obligation to make a market. Making a market may involve the specialist acting either as a broker (matching buyers to sellers) or trading for his own account. Moreover, he can delay, with exchange approval, the opening of trading in an individual stock whenever an order imbalance emerges that would require significant price movements from the previous day’s closing price.38 Trading can also be halted during the day if such an imbalance occurs. In Japan, the market makers (the saitori) function in a similar manner, but they cannot trade on their own account. Trading halts can take place for one of two reasons. If the ratio of buying to selling orders reaches certain critical values, then trading in the stock is temporarily halted, while the saitori searches for additional matching offers through gradual adjustment in prices. Alternatively, if the price of a stock rises or falls by a pre-established daily price limit, then trading is halted until the next session.
An alternative market-making structure involves the use of competitive market makers that may be centered on arrangements emphasizing the role of either brokers and dealers or auction markets. In broker-dealer systems, a dealer offers investors the ability to sell and buy securities at readily available bid and offer quotations, with dealer inventories serving as a buffer against volatile price movements in the face of temporary order imbalances. While broker-dealer arrangements are often evident in over-the-counter markets,39 they have also been employed on the London Stock Exchange where a screen-based trading system provides competitive market makers with the ability to put firm quotes into the Stock Exchange Automated Quotation System (SEAQ). On the basis of these quotes, trades are then negotiated and finalized over the telephone.40 Under auction or “open outcry” systems, emphasis is given to the role of price adjustment in eliminating order imbalances. While such arrangements are typically identified with the futures markets, they are also employed as part of the trading systems in the stock exchanges in the Federal Republic of Germany and Switzerland.41
In examining the performance of these market-making systems during October 1987, it is important to note that each system is primarily designed to deal with temporary order imbalances that typically arise between the arrival of normal customer buy-and-sell orders, and not the massive one-sided sell-off evident on October 19 and 20, 1987. As a result, most studies of the October 1987 events concluded that large order imbalances created difficulty for market-making systems that resulted in sharp price movements, extensive trading halts (either for individual stocks or for entire markets), a widening of bid-ask spreads, withdrawal of market makers in some markets, and difficulty in obtaining price quotations.42 In some markets, where there were daily limits on price movements, trading activity declined sharply. In Tokyo, for example, a large imbalance between buy-and-sell orders on October 20 resulted in 80 stocks never opening for trading and trading in about 700 other stocks stopping during the day as their prices declined by the full amount of their price limits. In contrast, a large inflow of buy orders on October 21 resulted in trading halts for over 150 stocks as their prices rose by their price limits.43
In the markets that remained open and were not subject to daily price limits, trading volumes reached historically high levels. The processing of these record volumes, however, created some difficulty, especially as order transmission systems were called upon to operate at levels far above normal. In London, for example, a total of about 800 million shares were traded on October 19 and 20. As noted earlier, the London markets operate through a screen-based trading system with competitive market makers that are required to provide firm buying and selling prices, with trades being negotiated and finalized over the telephone. Although they remained open throughout the period of the crash, there were complaints that at times it was impossible to reach market makers by telephone; and, as a result, price quotes that were displayed on computer screens reflected only a part of total investor supply and demand. Moreover, greater price volatility led to a widening of quoted spreads between buying and selling prices and a reduction in the size of the transactions that market makers were willing to undertake at quoted prices.44 In addition, fast market procedures were declared for the first time for periods totaling about seven hours during the week of October 19. This suspended the requirement that market makers’ price quotations be firm, and it was displayed on computer screens that all price quotes were only indicative. Despite these difficulties, market participants generally viewed the overall operation of the computer-based system as quite satisfactory, especially in view of the unprecedented volume of activity. Furthermore, since many of the market makers were part of financial conglomerates, it was also felt that their broad capital bases enhanced their ability to play a stabilizing role.
In the United States, large inflows of sell orders affected market liquidity on a broad range of equity markets employing both specialist and competitive market-makers systems.45 While the NYSE experienced a record volume,46 for example, market liquidity was not available on a continuous basis since the large volume created difficulties for the routing of buy-and-sell orders and trading execution reports to and from the floor of the exchange. The initial order imbalance on October 19 led to extensive delayed openings for many stocks, with nearly a third of the stocks in the Dow Jones Industrial Average (DJIA) still not trading one hour after the opening. In addition, there were frequent trading halts for individual stocks during the day. The Designated Order Turnaround (DOT) system had difficulty in processing orders, as certain computer software programs proved unable to cope with the scale of transactions; stock exchange authorities took steps to limit the use of this system, as will be discussed further below, especially for those engaged in programmed trading. On October 19, the capital of some specialists was seriously reduced (by about 50 percent) as a result of large purchases of securities. This decline resulted in greater reliance on opening delays and trading halts as a means of confronting large order imbalances.
Similar transactions problems were also encountered in markets employing competitive market makers. For example, the over-the-counter market for equities operated by the National Association of Securities Dealers in the United States utilized a system of competitive market makers linked through computers (the National Association of Securities Dealers Automated Quotations System, or NASDAQ) with trades conducted over the telephone. In this system, small orders were executed through the Small Order Execution System (SOES) at the best bid or ask price, depending on whether the order was to buy or to sell. Participation in the SOES was voluntary for market makers, and they could therefore withdraw from market-making activities, subject to a requirement that they not return for two business days. The wave of sell orders created problems both as some market makers withdrew47 and as the system encountered difficulty with locked or crossed price quotes.48 Such locked and crossed markets emerged for extended periods, in part because market makers often did not have time to update their quotes, and in part owing to the difficulty market makers had in contacting one another to check on quotations. One problem created by this situation was that automatic executions of trades on the SOES ceased, and manual processing was required. As a result, many NASDAQ market makers were unable to execute customer orders in a timely fashion. In addition, there was a widening of bid-ask price spreads. Thus, while the NASDAQ system as a whole was able to process a record volume of transactions, key elements in the system failed to provide efficient pricing or execution.
In Tokyo, market liquidity was affected by large imbalances of sell (on October 20) and buy (on October 21) orders that led to trading halts as prices on individual stocks reached pre-established daily price limits. On October 20, as already noted, about 80 stocks never opened for trading, and some 700 stocks stopped trading during the day. In contrast, on October 21, the surge of buy orders meant that only three stocks were traded during the first half hour of trading. Moreover, trading in about 150 stocks was halted during the course of the day, as prices rose to their upper daily price limits. As a result, share volume on October 20 and 21 was approximately 500 million and 420 million, respectively, which was half the average daily volume for most of the previous months of 1987.
In general, there is agreement that most markets handled the unprecedented level of selling orders and resulting trading volumes surprisingly well, but liquidity was often not available on a continuous basis. As is discussed further below, however, the bottlenecks encountered in the order transmission systems led to recommendations for improvements in trading rules and the technological infrastructure of market systems.
Derivative Markets and Trading Strategies
Some reports raised the question of whether linkages between stock markets and the markets for stock index futures and options (the so-called derivative markets) have contributed to price volatility.49 While these issues have been discussed most extensively in the United States, Hong Kong, and—to a lesser extent—the United Kingdom, the continuing development of futures and options markets in many other countries could soon make those issues of relevance for a broader set of countries.
Futures and options equity markets allow investors to reallocate the risks associated with either price movements in individual stocks or changes in the value of broad market indices. Stock prices are often affected by both systemic risks (e.g., change in macroeconomic activity due to higher interest rates) and specific risks (i.e., specific factors affecting the performance of individual companies). In general, specific risks can be reduced by increasing the number of stocks in an investor’s portfolio (risk diversification), but the influence of systemic risks cannot be reduced through such diversification. As a result, stock index futures contracts have been developed as one means of allowing investors to fix the future value of a broadly diversified portfolio over a given period even if there are sharp unanticipated movements in all equity prices. In particular, a stock index futures contract is a standard agreement that provides the holder with the right to obtain the value of a given index at a predetermined price at a future time.50
While exchange traded futures contracts have a long history in commodity markets, stock index futures contracts were first traded on the Kansas City Board of Trade in February 1982 when trading on a Value Line Composite Average Index contract was instituted. The Chicago Mercantile Exchange introduced the Standard & Poor’s 500 (S&P 500) index contract in April 1982, and in May 1982 the New York Futures Exchange started the New York Stock Exchange Composite Index contract.51 The Hong Kong Futures Exchange also started trading in a Hong Kong Index contract in May 1986. In September 1986, the London International Financial Futures Exchange (LIFFE) introduced a Financial Times Stock Exchange 100 share index (FTSE) contract.
Stock index futures contracts can be taken as useful hedging instruments only if it can be guaranteed that the terms of the contract will be fulfilled, even in the face of highly adverse price movements. As discussed below, such contract performance is typically ensured by making the exchange itself a counterparty to each futures contract, and requiring the buyer or seller of a futures contract to post a margin (performance bond) requirement. Thus, the performance of the contract depends on the resources of the exchange rather than those of any single individual counterparty.
Stock options have been a common feature of the major stock exchanges in North America and Europe for several decades, but floor trading for standardized stock options was first introduced in April 1973 with the creation of the Chicago Board Options Exchange (CBOE). An option confers a right, but not an obligation, to purchase (a call option) or sell (a put option) a stated number of shares at a specified price (the “exercise price”) within a predetermined time period. In addition to options on individual stocks, options are also available on stock index futures, which provide another vehicle for hedging against general price movements in equity markets. The purchaser of an option pays an up-front premium; whereas the writer (or seller) of an option is required to post and maintain a margin requirement that serves as a performance bond. This asymmetrical treatment of the buyer and seller of an option reflects the fact that the seller is potentially liable for unlimited losses if the market moves against his position. In contrast, the purchaser of an option cannot lose more than the premium paid to purchase the option since he need not exercise his option.
Prior to October 1987, futures contracts had become the principal instrument by which institutional investors adjusted portfolio risks. As a result of the growing importance of institutional trading,52 activity in stock index futures in the United States had risen to a level that was on average one and a half times the daily trading volume on the NYSE. Futures contracts have become an attractive means of adjusting diversified stock portfolios because they involve transactions costs that are only 5 percent to 10 percent of those associated with the actual trading of the securities underlying the index. The growing importance of stock index futures has been reflected in two trading strategies: stock index arbitrage and portfolio insurance.
Stock index arbitrage involves profiting from price disparities between the value of the stock index future (or stock index option) and the value of the basket of stocks underlying the index.53 When the futures price is at a discount relative to the value of the stock index, an index arbitrageur attempts to profit by selling the basket of stocks underlying the index and buying a stock index futures contract. When the futures contract is at a premium, the arbitrageur may create a “synthetic cash” transaction by buying the portfolio of stocks underlying the stock index and selling the stock index futures.
Portfolio insurance (or dynamic hedging) is designed to allow institutional investors to participate in a rising market while still protecting the value of their portfolio if market prices decline. Using computer-based models of stock options analyses, portfolio insurance seeks to maintain an optimal ratio of equities-to-debt securities (or cash) at various stock market price levels. As market prices change, however, portfolio insurers adjust the stock-to-debt ratio by trading index futures. In particular, the strategy involves the gradual sale of stock (or stock index futures) in a declining market and the purchase of stock (or stock index futures) in a rising market. Trading of stock index futures is often used because of their relative low transactions costs.
One concern that was expressed in some reports of developments in U.S. equity markets in October 1987 was that these trading strategies contributed to the fall in equity prices, either directly, by generating sales into a declining market, or indirectly, by creating a negative market psychology. In particular, some argued that a “cascade” scenario could arise. In this situation, stock prices could fall for some exogenous reason, and, as a result, participants would sell stock index futures in order to lock in a given level of stock prices. Sales of futures contracts, however, would tend to drive futures prices down relative to the prices of the stocks in the index, and arbitrageurs would buy futures and sell stocks. This would lead stock prices to fall further.
It has also been suggested that such sales during a period of financial disturbances can result in a large discount opening up between the price of the stock index future and the value of the stock index. Since such a discount could lead to the expectation of future declines in equity prices, some observers have argued that this could create a negative psychological effect on the market. In the United States, however, the gap that opened between futures and cash prices for equity reflected developments in the cash market as much as in the futures markets. In particular, trading in a number of the stocks included in the Standard & Poor’s 500 index had not opened as late as 11:00 a.m. on October 19. For these stocks, the closing prices on the previous Friday were used when the value of the index was calculated. As a result, during this period of sharply declining prices, the value of the index was overstated.
Others have argued, moreover, that there is little evidence to support the view that trading strategies and derivative markets played a significant role in either causing or amplifying the decline in market prices.54 In particular, even on October 19 when portfolio insurance sales of futures were at their largest, they represented only 20 percent of market volume on the Chicago Mercantile Exchange. Moreover, the decline in equity prices was viewed as representing a general sell-off of equities rather than activity in any single market segment.55
In London, the use of stock index arbitrage and portfolio insurance was not as extensive as in the United States.56 Limited index arbitrage and the difficulties that investors encountered in accessing market makers also resulted in the price of FTSE futures contract trading at a discount relative to the stock index of roughly 5 percent during the week of October 19. Index arbitrage in the United Kingdom was reportedly inhibited by such factors as stamp duties, a lack of automatic execution facilities for stock trades, and the lack of credit for index futures positions in the International Stock Exchange’s (ISE) capital adequacy requirements.57
More serious problems with derivative markets occurred in Hong Kong. When the Hong Kong stock index dropped 420 points (11.3 percent) on October 19, investors with long (i.e., had purchased) futures contract positions faced losses of up to HK$60,000 on contracts many had purchased on margin of HK$15,000. The prospect of large scale defaults in the futures market, with possible spillover effects to the broker dealers, led to the closure of both the stock and futures exchanges.58 Over the weekend of October 23, the Hong Kong authorities devised a rescue plan involving a loan of HK$2 billion to the Hong Kong Futures Guarantee Corporation, which guaranteed performance of all futures contracts. Half of the loan was from the Government and the rest was provided by a group of 12 brokers and the shareholders of the Guarantee Corporation, mainly banks. When the stock market reopened on Monday, October 26, the Hong Kong stock index plunged 1,120 points (33 percent). Since the emergency loan had been designed to cover defaults on futures contracts caused by a 1,000 point drop in the Hong Kong index, much of the initial cushion of funds was exhausted on that day. On Wednesday, October 28, an additional emergency loan of HK$2 billion was arranged, but ultimately not drawn upon. During the period, margin requirements were used from HK$15,000 to HK$50,000 per contract (28 percent of the contract value). Moreover, between 30 and 40 of the 100 futures exchange member firms in business in October 1987 were subsequently liquidated. As indicated in the official report59 on these events, these problems were associated with a number of shortcomings in market arrangements including a settlement system that failed to perform properly, a general absence of direction at the supervisory agencies, insufficient staff, and the lack of an adequate risk management system.
Clearing and Settlement Systems
Perhaps the most important obstacles to further integration of securities markets have been the differences in operating procedures in the national clearing and settlement systems and the absence of widespread linkages between national and international clearance and settlement systems.60 As a result, most international securities transactions are still settled outside national systems via telex and physical delivery of certificates. The events of October 1987 highlighted the difficulties that can be created by cross-country differences in clearance and settlement procedures and time periods, data processing capacity, and the ability of foreign institutions to participate in national systems.
The performance of clearing and settlements systems for individual national equity markets during October 1987 was naturally influenced by the volume of trading that took place in the respective markets. As noted earlier, one market was closed (i.e., in Hong Kong) and trading in others was suspended when daily price limits were reached (e.g., Japan). Clearing and settlement systems in these countries were therefore not subject to the same pressures as in markets that remained open and experienced record volumes. In the United States, limitations on trading hours and extended working hours were needed to help clear the backlog of transactions on stock exchanges. Although activity on the futures and options markets declined during the crash,61 some problems arose as a result of ambiguity regarding the financial obligations of parties in the clearing and settlement system and the large cash flow required to meet margin requirements. As is discussed in the next section, the sharp decline in the prices of stock index futures and options contracts led to large intraday margin calls that had to be met in a short period if the holder of the contract was not to have his long position sold out. At times, the Chicago Mercantile Exchange Clearing House experienced delays in obtaining confirmations from its settlement banks for the payment of margin calls for certain large firms with large obligations.
In the United Kingdom, the settlement system is based on a two-week (ten business days) account period with settlement due on the “account day,” which is six business days after the end of the account period. Stocks trades that occurred on October 19 had to be settled by November 2.62 As the settlement period encompassing the crash progressed, there were persistent rumors (subsequently unfounded) about financial difficulties for some equity market makers and defaults by private investors. Moreover, a backlog of unsettled trades made prior to the crash period further contributed to concerns about counterparty risk. In contrast, observers have argued that some of the selling pressures experienced on the equities markets in the Federal Republic of Germany were associated with the fact that foreign investors could convert their German equity into cash within two business days, a relatively short settlement period by international standards.
While much of the discussion of clearance and settlement systems has focused on the performance of individual national systems, one of the key limitations to further integration of international securities markets has been the difficulty involved in settling and clearing transactions between countries. Although all major equity markets have been streamlining their settlement systems, they have often adopted quite different systems regarding delivery procedures, settlement periods, regulatory requirements, taxation, and periods of operation. Any significant integration of clearing systems therefore is likely to involve eventually a common settlement period (e.g., three or five days), an automated trade-confirmation system for international equity trades, and a more efficient system for clearing funds across borders.
Measures to Limit Risk Created by Price Volatility
Extreme price volatility can threaten the solvency of securities markets and accompanying clearing and settlement systems by creating the possibility that market participants may simultaneously default on their financial obligations. As a result, the capacity of institutions and market systems to absorb large price changes has been enhanced by maintaining appropriate capital adequacy requirements for market makers, establishing margins to create performance bonds (e.g., in futures markets), limiting speculation on credit, setting limits on daily price changes and short or long positions in equities or futures, and providing emergency liquidity assistance. How well existing safeguards worked in October 1987 has been the subject of considerable debate.
Capital requirements for market makers are typically designed to ensure adequate minimum resources for market making under normal conditions. As noted earlier, these capital positions are not in general designed to deal with declines in equity prices as large as those experienced in October 1987. In New York, for example, purchases of equities by market makers on October 19 resulted in losses of up to half of their total buying power and, by the end of the day, 13 New York Stock Exchange specialists had no buying power. In London, as already noted, the capital positions of market makers were strengthened by the fact that they tended to be part of financial conglomerates. In other markets, where market makers were not required to quote firm prices but instead operate on a best-efforts basis, capital positions were not as severely tested. The most serious test of institutional capital positions occurred, however, in Hong Kong where defaults by retail customers on margin obligations created the prospect of bankruptcies for brokers and the futures exchange. In general, these experiences led to a re-evaluation of the level of capital adequacy that is appropriate in a period where asset price variability could be greater than in the past.
Other traditional means of limiting risks created by large price movements have been margin requirements and position limits. Margin requirements have different functions in stock and derivatives (i.e., futures and options) markets. In stock markets, margin requirements are down payments that must be made to purchase equity and represent limitations on the use of credit to fund equity positions. In contrast, margins in futures markets represent a performance bond that does not involve an extension of credit. This margin requirement is designed to cover the losses that could arise from daily price movements that would be likely to occur under most circumstances. When adverse (favorable) price movements occur, the futures contract is “marked to market” (evaluated at the last market price) and any loss (gain) that is experienced by the customers is subtracted (added) to his margin account. Once the balance in this account falls below some pre-established level, the holder of the contract must deposit funds to re-establish his initial margin balance. While margin calls generally occur once or twice a day, default risks are often reduced by increasing the frequency of such calls during periods of increased price volatility.
Since margins on futures contracts are lower than for stock purchases,63 there have been suggestions that greater consistency between margin requirements requires higher margin requirements for futures contracts. Some have argued that such higher margins could curb excess speculation in the futures markets and thereby tend to dampen excessive price movements. Others have noted, however, that higher margins would raise the cost of hedging operations and thereby might actually induce greater price volatility in equity markets. Moreover, this latter group has argued that available empirical evidence does not support the view that current futures margins encourage excessive speculation.64 In part, this reflects the fact that some major institutions using portfolio insurance and other trading strategies do not acquire stocks on credit.
Since prudential margins are designed to protect against default on financial obligations caused by adverse price changes, the adequacy of margin requirements is related in part to the length of the time period during which the exchange or broker is exposed to default risk on a customer’s open position—the period between the margin call and the customer’s response. When daily margin calls are used and most investors are institutional entities, as in the futures markets, relatively low margins may suffice to protect against the risks created by day-to-day price movements. In the cash market, however, settlements may take up to five days or longer in some markets and individual traders play an important role. As a result, margins must reflect likely price movements over at least a three- to five-day period. Harmonization of margins across cash and futures markets therefore does not necessarily imply equal margins across these markets. Moreover, empirical studies suggest that existing margins in major equity markets cover a broad range of likely price movements in both stock and derivative markets.
Position limits are used to restrict the ability of any single trader to take a large speculative position since this would expose the exchange or broker to excessive credit risks. While position limits appear to have been rigorously enforced (or tightened) in most markets during October 1987, the events in the Hong Kong stock index futures market illustrate the danger created by violation of position limits. Since a small number of clients directly or indirectly accounted for about half of the purchases of the market, their failure to meet margin calls forced the futures and stock exchanges to close in order to allow time for a financial rescue package to be put in place.
As noted earlier, price limits have also been used to prevent large price declines (or sharp price increases) from occurring. The events of October 1987 illustrate the spillover effects that can arise when such limits are not uniform across countries. For example, on October 19 and 20, the Chicago Board of Trade operated with daily price limits on its long-term U.S. Treasury bond futures contract. On October 20, 1987, the price of the U.S. Treasury bond futures contract reached its upper limit and trading ceased. Since a comparable bond futures contract was being traded on the LIFFE, traders switched their activity to that market and its volume rose to nearly eight times the average daily volume experienced during the first half of 1987.
Since there is an ongoing expansion in markets for stock options and stock index futures, the relationship between price limits in cash and derivative markets both within national markets and across countries is likely to become an increasingly important regulatory issue. This will be especially true when stocks are listed on more than one market and similar stock index futures contracts are traded on different national markets. In Europe, for example, such cross listing of securities is likely to be much more common after 1992 if current proposals for eliminating capital controls and restrictions on many financial activities are implemented.
In the various reports on the equity market events of October 1987, it is generally agreed that the central banks of some major industrial countries played a key role in preventing the emergence of serious liquidity problems. One initial concern of many market participants was that the equity market crash would be accompanied by a reduction in liquidity such as occurred in the United States during the early 1930s. While such a reduction in liquidity did not take place, it is difficult to evaluate fully the central banks’ role in preventing such a liquidity crisis on the basis of limited public information about their actions. This lack of information reflects the “moral hazard” concerns that emergency liquidity assistance might be interpreted as establishing implicit guarantees for certain institutions or for an industry, which in turn might encourage less than prudent behavior by the managers or owners of these institutions. Despite these concerns, there has been some indication in the various reports of the steps undertaken.
In the United States, for example, it was reported that the Federal Reserve provided liquidity to the banking system through open market operations; contacted major banks regarding the importance of meeting legitimate but large customer funding needs while still recognizing the responsibility of market participants to make their own credit judgments; suspended rules governing the lending of securities to accommodate securities dealers at the Federal Reserve Bank of New York; and extended the operating hours of the Fed wire and Securities Wire electronics transfer systems for large dollar payments.65 In Hong Kong, as already noted, the authorities found it necessary to put in place an emergency assistance program for the futures exchange. Moreover, in Japan, the authorities altered the margin system by reducing the margin ratio and increasing the valuation ratio for assets pledged to satisfy margin requirements.
A number of reports stressed the importance of contingency planning by central bank and other regulators for limiting the scope of financial market disturbances. While it has been recognized that a particular crisis is unlikely to be repeated, these discussions have emphasized the importance of establishing procedures for a coordinated response to market disturbances, understanding potential weak points in institutional arrangements, and considering the types of shocks most likely to affect domestic and international financial markets. Although these contingency plans need not be made public, it was argued that some arrangements are necessary in order to avoid the potential mistakes that could arise during a crisis.
The simultaneous declines in equity prices on all of the major equity markets in October 1987 suggested a degree of market integration, at least in response to major shocks, that had not been previously recognized.66 Since many large institutional investors now operate across a broad range of major equity markets, supervisory and regulatory authorities in these countries have expanded their discussions of how to better integrate trading, clearance, and settlement systems, achieve adequate financial oversight, and establish effective enforcement and surveillance arrangements.
One theme that has emerged in related discussions of the equity break has been the need to coordinate supervisory and regulatory policies both between nations and between the stock and derivative product markets. While the issues concerning these prudential supervision policies have been most widely explored in the United States, they are also being examined in countries where futures and options on equity instruments are still at an earlier stage of development (the United Kingdom and France) or where financial futures markets are being expanded (Japan) or where they are being set up (Federal Republic of Germany). Part of the need to coordinate supervisory policies in this area has arisen out of the recognition that, from an economic point of view, the stock and derivative markets effectively constitute a single market for equities. In particular, as the Brady Report stressed, regulatory and institutional structures designed for separate markets were incapable of effectively responding to “inter-market” pressures.
Although the concept of a single market has been readily accepted, there has been less agreement about how to make regulatory and supervisory policies consistent. In part, this has reflected differences between the views of market participants, self-regulatory organizations, and the authorities on the appropriate policy changes. In addition, achieving a consistent set of regulations and supervising practices for stock and derivative markets is often a more direct process when a single regulatory authority oversees both types of markets. In Japan, for example, supervision of both types of markets falls under the jurisdiction of the Ministry of Finance, and, in the United Kingdom, the Securities and Investment Board oversees the self-regulatory organizations for both the stock and derivative markets. In the United States, where a broad range of supervisory authorities monitors developments in these markets,67 the Working Group on Financial Markets68 was established to review regulatory and supervisory recommendations that were made in the wake of October 1987 and to coordinate their implementation. As discussed in the previous chapter, analogous developments are emerging at the international level to facilitate more consistent regulation of markets now more deeply linked across national borders.
Policy Recommendations of National Reports on the October 1987 Market Break
The principal recommendations concerning regulatory and supervisory policies and structural changes in equity markets that have arisen in the various reports on the events of October 1987 are summarized in Table A37.69 While there is a consensus that certain improvements are needed (e.g., that the capacity of trading and clearance and settlement systems should be expanded), there is much less agreement in such areas as margin requirements for stocks, stock options, and stock index futures and the use of circuit breakers.
The recommendations regarding the structure of equity markets generally reflect the view that (1) there will be expanding use of computers and new telecommunications technology and a growing role for institutional traders; (2) institutional, regulatory, and supervisory structures should reflect the close linkages between markets for stock options and stock index futures; (3) linkages across major equity markets are likely to grow; and (4) market structures must be adjusted to reflect higher volatility of interest rates, exchange rates, and equity prices than in the past.
While the events of October 1987 have led some authorities to focus on strengthening existing institutional arrangements, others have recommended more sweeping changes in market structures. Existing institutional arrangements would be strengthened by improving the performance of order execution systems through increased use of automated processing systems, greater computer capacity, utilizing better computer software, and installing more telecommunications capacity. Moreover, in those systems without daily price limits or with very wide limits, it was argued that the capital of market makers should be strengthened. In the United States, for example, the SEC approved an NYSE proposal that a specialist’s minimum capital be increased from $100,000 to $1 million. In addition, penalties for unexcused withdrawals from market-making activities in some markets have been increased by making the period during which they cannot return as market makers longer. The difficulties encountered in the Hong Kong markets led to recommendations calling for more fundamental changes in the representation of brokers, individuals, and institutions in the governing of the futures and stock exchanges, a new clearing and guarantee system for better risk management, and a significant strengthening of supervisory efforts.
In contrast to these areas of general agreement, there were major differences in policy recommendations concerning restrictions on the use of various computer-based trading strategies. These differences reflected contrasting evaluations of the role of such strategies in initiating or amplifying the decline in equity prices. In the United Kingdom, for example, the concern was to develop techniques to encourage stock index arbitrage to prevent a situation, such as occurred during the week of October 19, when stock index futures traded at a larger than normal discount relative to the value implied by underlying stock prices. It was suggested that stock index arbitrage could be facilitated by such changes as improvements in the cash settlement system, instituting automatic execution facilities for stocks, and allowing capital adequacy requirements to reflect the hedges created by the use of index futures.
In the United States, by contrast, a number of proposals were made to restrict the scope for portfolio insurance and index arbitrage. The NYSE, for example, limited the use of its automated orders system for the execution of computer-based trading strategies whenever the DJIA moved up by more than 50 points.70 As will be discussed, other proposals for reducing the scope of these activities involved raising margin requirements on stock index futures contracts and requiring that settlement of such futures contracts should involve the actual delivery of the underlying portfolio of stocks instead of cash settlement. Nonetheless, the Working Group on Financial Markets indicated that index arbitrage serves a useful function in helping to eliminate price differentials between the stock and derivative markets, which could otherwise contribute to price instability, and that the use of portfolio insurance had been reduced as a result of the demonstrated inability to adjust equity positions continuously during a crisis period. Thus, although the scale of programmed trading activities has been somewhat reduced in the period since October 1987, this has in general reflected economic decisions of market participants rather than promulgation of new official regulations.
Most reports called for various improvements in the efficiency of clearance and settlement systems in order to reduce systemic risks created by the possibility of counterparty failure during settlement periods. In the Federal Republic of Germany, for example, where the clearance and settlement system (which is based on a two-day settlement period) was reported to have functioned smoothly, the Federation of German Stock Exchanges proposed that the exchanges should still seek additional improvements in the settlement system in order to increase the competitiveness of German markets. In the United Kingdom, there have been discussions of whether modifications should be made in the current system in which equities are typically dealt “for the account,” which is normally a period of ten business days, with settlement on the “account day,” six business days after the end of the account period. In particular, concern has been expressed that there could be considerable uncertainty about counterparty default in the settlement period if large price movements occur at the beginning of an account period.
In the United States, it was recommended that efforts be made to unify clearing systems for stock and derivative markets in order to reduce cash flows and financial risks. It has been pointed out, however, that significant legal problems, especially relating to liability in the case of default, would have to be solved. Nonetheless steps are being taken to clarify the financial obligations of participants in the clearing system. In France, the Dugen Report recommended that the clearing system should be improved through a mutual exchange of information between clearing houses, increased capital requirements at clearing houses and the introduction of insurance policy requirements for such institutions.
In addition to strengthening the equity markets’ ability to handle larger trading volumes and to provide better market liquidity, there has also been consideration of strengthening measures designed to limit the financial risks created by large price movements. While improving the capital adequacy of market makers has been an element in this effort, it has also encompassed proposals for the use of so-called circuit breakers, adjustments in margin requirements, and the provision of emergency liquidity assistance. In contrast to the general consensus about the need to strengthen the capital adequacy of market makers, however, there have been widely divergent views on the use of those other measures. In part, this reflects disagreements about whether the events of October 1987 were “once-in-a-generation” or are evidence of a more fundamental shift in price volatility in asset markets in general and equity markets in particular. As discussed, there has also been disagreement about whether existing institutional arrangements and trading strategies tend to amplify the effects of domestic or external shocks on equity markets. Those who believe that the equity price declines of October 1987 could occur again during periods of pressure on international asset markets (e.g., owing to inconsistent policies among the major industrial countries) and that existing trading systems and market linkages amplify price fluctuations have naturally argued for the most significant changes in the level of margins in stock and derivative markets, the use of circuit breakers (i.e., trading halts or daily price limits), restrictions on the use of computer-assisted trading strategies, the provision of emergency liquidity assistance, and the role of contingency planning.
As already discussed, margin requirements limit counterparty risk by establishing a performance bond (e.g., in the case of stock index futures) as a down payment (e.g., when acquiring stock). Although margin requirements on stock index futures contracts were raised from about 5 percent to 10 percent of the contract value to about 15 percent in the United States (compared with 50 percent for stocks), there were proposals to increase those margins even further in order to reduce leverage in the futures markets and thereby dampen speculation and price volatility. Others argued that current margin levels were sufficient to ensure that market participants in stock and derivative markets could meet their obligations to brokers and clearing houses in the case of 99 percent of the historical price changes observed in those markets. In addition, it was noted that lower margins for stock index futures contracts were justified on the basis of the shorter settlement period in the futures market and the lower volatility of indices as opposed to the prices of individual stocks. Furthermore, some argued that higher futures margins would only serve to raise the cost of holdings and would tend to drive trading in such futures contracts to offshore markets.
In the United States, the members of the Working Group on Financial Markets agreed in early 1988 that margins in stock and derivative markets were adequate to maintain the financial integrity of the markets but could not agree on whether margin requirements should be increased above prudential levels in order to reduce leverage in futures markets and thereby attempt to curb price volatility. In Hong Kong, where the difficulties with default in the futures market were severe, it was proposed in the Report of the Securities Review Committee that margins on futures contracts should be designed to cover a higher proportion of likely daily price movements71 and that the margins be applied on the gross position of clients rather than on net positions.72
The use of organized trading halts or daily price limits has been discussed in a number of countries. Planned trading halts on daily price limits are often viewed as substitutes for ad hoc trading halts and are designed to give market participants time to reassess the values of their shares, prevent the overloading of order transmission and clearance systems, and give regulators time to assess capital and margin requirements. Others have argued, however, that such circuit breakers can contribute to market instability by creating the expectation that the market could close at any moment and re-open later with prices at levels that can only be guessed at. In addition, such market closings were held by some to prevent investors from obtaining the liquidity needed to meet margin or capital requirements.
While equity markets in some major countries (such as Japan and France) already employ daily price limits, quite different conclusions concerning the potential role for these instruments in the stock and derivative markets have been reached in the United Kingdom and the United States. The ISE authorities in London have argued that any closure of the market owing to a rapid price movement should not involve pre-established circuit breakers but should be determined by market regulators in light of market developments. As noted earlier, a heavy influx of buy or sell orders on the ISE is dealt with through a declaration of fast market conditions, which effectively reduce the obligations of market makers to maintain firm price quotes. In this situation, the price quotations of market makers are only indicative and do not necessarily constitute firm prices at which transactions will take place. During the week of October 19, for example, fast markets were declared at seven different times for a total period of nearly seven hours.73
In the United States, the Working Group on Financial Markets recommended the introduction of coordinated trading halts and re-opening procedures in stock, options, and futures markets. In particular, trading halts of one hour would occur when the DJIA declined by 250 points (about 12 percent) from the previous day’s closing value; and a two-hour trading halt would take place if the decline continued when trading resumed and the DJIA declined by 400 points (about 20 percent). In July 1988, the CME and NYSE made a proposal for achieving such coordinated halts in stock and derivative markets, and the National Association of Securities Dealers has indicated that the NASDAQ system will also join this arrangement.
Where discussion has taken place on the role of emergency liquidity assistance during periods of financial disturbance, it has been generally argued that the principal function of the central banks during a crisis is to maintain adequate liquidity in financial markets; however, such liquidity should be provided in a manner that is not viewed as ensuring the existence of any individual firm. The concern is the moral hazard problem that such guarantees could lead firms to undertake overly risky activities in the belief that they would be “bailed out” in time of difficulty.
Finally, a number of studies called for greater contingency planning on the part of central banks, regulatory authorities, and exchanges to cope with problems that were encountered during October 1987. Such contingency planning would involve improving information flows between existing surveillance systems; enhancing and improving the sharing of information between exchanges themselves, their regulators, and clearing organizations; and better monitoring of the positions of major market participants. This has often involved the formation of liaison committees of the principal regulatory and self-regulatory agencies. In France, for example, a “Comité de Liaison des Marches Financiers”74 was formed in April 1988 to provide a permanent consultative mechanism, especially in times of crisis. The National Companies and Securities Commission in Australia also announced that it would discuss a coordinated plan of action for futures market emergencies with the Reserve Bank of Australia, the Australian Stock Exchange Ltd., the Sydney Futures Exchange Ltd., the International Commodity Clearing House Ltd., the Australian Merchant Bankers Association, and the Unit Trust Association in Australia. In the United States, the Working Group on Financial Markets also emphasized the importance of contingency planning.
Recent proposals for structural changes in equity markets imply that there are certain international regulatory and supervisory issues, such as those discussed in the previous section, that are likely to receive growing attention. Since equity markets are currently operating with a wide variety of circuit-breaker mechanisms, a growing integration of these markets and increased cross listings could create the possibility of sudden shifts in trading activity across countries and markets when trading halts occur in one market but other markets are still open. Within countries, this shifting of activity has been prevented by coordination of trading halts across national and regional markets for stocks and derivative products. However, even if all authorities sought to achieve coordinated use of circuit breakers (and there is considerable diversity of views on whether this is desirable), there is increasing evidence of off-exchange trading of shares between large institutional investors, which are subsequently confirmed on an over-the-counter basis in a major market. This off-exchange trading appears to be motivated by a desire to adjust portfolios during periods when exchanges are closed, to escape certain exchange fees, and to be able to implement certain trading strategies more rapidly (especially if there are restrictions on the use of exchange facilities for implementing those trades).75 If such off-exchange transactions should become more important, they could raise a number of new issues related to the monitoring of securities activities.
A related issue involves the relationship between supervision of financial entities that operate across national markets and the functioning of national clearing and settlement systems. The difficulties encountered in October 1987 in some clearing and settlement systems created large liquidity needs for some major financial institutions (e.g., in meeting margin calls) and thereby created concern about counterparty default risks. In some markets, this affected the willingness of some institutions to engage not only in equity transactions but also in trades of government securities with certain other institutions. To avoid such contagion from spreading across markets during periods of financial disturbance will require not only greater efficiency for clearing and settlement systems but also an overview of the capital positions of key institutions on a consolidated basis across markets.
Macroeconomic Stability and the Equity Markets
To date, the events of October 1987 have not reversed the trend toward greater integration of financial markets. For example, there has been no reversal of the movement to reduce or eliminate capital controls among the major countries, and, as discussed in Chapter IV, the actions taken to achieve a unified financial market in Europe in 1992 will increase the degree of integration among these markets. Moreover, technological changes in telecommunications and computers are likely to further facilitate the linkage of national clearance and settlement systems.
While it is now clear that the sharp decline in equity prices in October 1987 had only limited effects on economic activity, in part owing to the presence of structural safeguards and supportive monetary policy, renewed disturbances in global equity markets on a comparable scale will not necessarily be equally benign. Although global equity markets are still less integrated than other short-term securities markets, major shocks can nonetheless be transmitted quickly. Moreover, given the existence of relatively large current account and fiscal imbalances in many major countries, there is still the question of whether further shocks to equity prices are possible. Some have argued that, while the declines in equity prices in October 1987 may have reduced a market overvaluation, continuing trade and fiscal imbalances may produce a period of increased asset price variability. In this situation, attempts by the authorities to stabilize some prices, exchange rates, or interest rates may mean that the instability associated with macroeconomic imbalances will increasingly be reflected in prices on asset and commodity markets.
Even if macroeconomic factors are the primary source of shocks to financial markets, the structural characteristics of these markets may increase (or decrease) the likelihood of sharp adjustments in prices and trading volumes and of disturbances in one market spreading to other markets. In this regard, the strengthening of the capital positions of market makers, the increased capacity of order transmission, clearing and settlement systems, improved information flows, and greater emphasis on contingency planning should increase the structural capacity of equity markets to better confront large movements in equity prices. Moreover, the increased usage of circuit breakers should limit the scope of daily price fluctuations in equity prices. Since these circuit breakers are not uniform across markets, however, there may actually be increased scope for sudden shifts in activity across markets as some markets close and others remain open. In addition, to the extent circuit breakers prevent investors from adjusting their portfolios through the sale (or purchase) of equities, there is the question of whether they will be more likely to try to adjust portfolios by undertaking transactions in other securities and foreign exchange markets. To the extent that this occurs, the strengthening of equity market institutional structures may deflect a greater proportion of the effects of financial market disturbances onto other securities and foreign exchange markets.
The country classification scheme used for economic analysis in the Fund and followed in this study is given in Appendix I.
As with previous publications on international capital markets, this study does not address in detail questions relating to concessional assistance or to medium-term prospects for the world economy. A discussion of the principal findings that have emerged from studies in the Fund relating to the world economy is contained in International Monetary Fund, World Economic Outlook, April 1989: A Survey by the Staff of the International Monetary Fund, World Economic and Financial Surveys (Washington, 1989).
The interpretation of interbank statistics has become more difficult owing to a sharp rise in discrepancies between the global totals of external interbank assets and liabilities. A number of technical factors may be responsible for this rise, including variations in the timing of data reporting in major centers, differences in reporting and estimation procedures used to determine the bank/ nonbank split of each countries’ relevant cross-border claims, and coverage deficiencies in international banking statistics.
Excluding offshore banking centers.
Since the evidence of economies of scale and scope in banking is mixed, the merger and acquisition activity appears to be driven by the desire to acquire existing banks in newly opened markets rather than to establish new capacity from scratch.
The potential macroeconomic impact of structural changes in financial markets was discussed in Maxwell Watson and others, International Capital Markets: Developments and Prospects, January 1988, World Economic and Financial Surveys (Washington: International Monetary Fund, 1988), pp. 7-9.
In November 1984, for example, a fire in an underground telephone circuit cable duct in Tokyo shut down some bank on-line services and interrupted certain banking operations; as an emergency measure, the clearing house had to extend certain deadlines. Similarly, in November 1985, a computer failure caused by software problems at the Bank of New York, a clearing agent for treasury bonds, resulted in the bank paying the seller for the treasury bonds sold but being unable to deliver the bonds to the buyer or to collect payments. Massive overdrafts of the bank could have spread to the entire clearing system for government securities and triggered a chain reaction of defaults. This was avoided by the Federal Reserve Bank of New York extending a $22.6 billion loan to the Bank of New York.
In determining appropriate minimum levels of capital for securities houses, for example, the supervisors in some countries have worked on the basis of a “haircut,” where—analogous to risk weights in banking transactions—the volatility of the value of each instrument held by a securities house is assessed, and capital amounting to some fraction of the product of the volatility and the exposure is required. Other countries do not even attempt to apply rough standards for capital adequacy. Such variations between countries can distort international competition.
For further discussion of the macroeconomic environment, see International Monetary Fund, World Economic Outlook, April 1989: A Survey by the Staff of the International Monetary Fund, World Economic and Financial Surveys (Washington, 1989).
Data on gross long-term capital flows for 1988 are preliminary and come from the Bank of Japan, Balance of Payments Monthly (Tokyo), (November 1988 and December 1988).
National statistics of the regional distribution of capital flows are only available up to the end of June 1988 and report the OECD area as one country group category. The countries inside the OECD area are Australia, Austria, Belgium, Canada, Denmark, Finland, France, the Federal Republic of Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, the Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United States.
Preliminary data on gross capital flows for 1988 come from the U.S. Department of Commerce, Survey of Current Business (Washington), Vol. 3 (March 1989).
Open interest is the total number of contracts not offset by an opposite transaction nor fulfilled by delivery.
Each option is written on one Eurodollar futures contract, which, in turn, has a face value of $1 million.
Each Japanese yen futures contract has a face value of ¥12,500,000.
Creditworthiness considerations, however, directly limit access to swaps. Creditworthy borrowers in industrial countries often use the interest rate swap market to convert their floating interest rate debt into the equivalent of fixed interest rate debt. However, since an interest rate swap involves an exchange of debt-servicing obligations (the fixed interest rate borrower agrees to service the obligations of the floating interest rate borrower and vice versa), a swap is an effective hedging instrument only if each counterparty fulfills its debt-servicing obligations. Most borrowers, therefore, will engage in a swap only when credit risk is perceived as low. As a result, indebted developing countries with debt-servicing difficulties have not had access to this market.
The data source for these figures is the Fund’s International Banking Statistics (IBS), which derives these flows from changes in the stocks of bank claims on developing countries adjusted for variations in the exchange rate. These data do not simply reflect actual cash flows between banks and developing countries. A number of factors, such as write-offs, certain sales of developing country debt, the accumulation of interest arrears on bank debt, and debt conversions affect the balance sheets of banks without necessarily involving financing flows. In light of a broader use of the menu approach in the debt strategy and the large increase in interest arrears to banks since 1987, interpreting changes in bank claims as lending has become increasingly difficult, so these estimates should be treated cautiously. To derive a cash flow number, an attempt was made to adjust the IBS data in light of available information. Write-offs and sales of claims from banks to nonbanks reduce bank claims on developing countries without involving a cash payment of principal by the debtor. If arrears accumulate, their capitalization increases bank claims on the debtor country without a cash disbursement. Adjustments to account for debt conversions are less straightforward. If the operation is in connection with a debt-for-equity swap, the adjustment to derive a pure cash flow number should be for the amount of debt extinguished at face value because there is no direct repayment from the debtor to banks. Another possibility, if one wanted to measure the “contribution” of banks to the balance of payments needs of debtor countries, would be to adjust only for the loss banks incur in such operations and not for the face value. This adjustment is difficult to quantify, however, because information about the average loss banks incur in selling claims on developing countries is limited. If the underlying operation is a debt exchange, at the end of which banks hold a new claim with a lower face value than the original claim, the adjustment to derive a cash flow number should only comprise the implied discount. For further discussion, see International Monetary Fund, World Economic Outlook, April 1989: A Survey by the Staff of the International Monetary Fund, World Economic and Financial Surveys (Washington, April 1989).
Note that, unlike aggregate flows, regional flows could not be adjusted in the manner discussed in footnote 17 because relevant data are not available on a disaggregated basis.
For background, see Maxwell Watson and others, International Capital Markets: Developments and Prospects, January 1988, World Economic and Financial Surveys (Washington: International Monetary Fund, 1988), pp. 50-64
For further analysis, see David Folkerts-Landau and Carlos Rodriguez, “The Mexican Debt Exchange,” in Jacob A. Frenkel, ed., Analytical Issues in Debt (Washington: International Monetary Fund, forthcoming).
For more detailed discussion, see Donald Mathieson, David Folkerts-Landau, Timothy Lane, and Iqbal Zaidi, Managing Financial Risks in Indebted Developing Countries (Washington: International Monetary Fund, forthcoming).
For an evaluation of selected elements of the Free Trade Agreement and of the Agreement as a whole, see J.J. Schott and M.G. Smith, eds., The Canada-United States Free Trade Agreement: The Global Impact (Washington: Institute for International Economics, with The Institute for Research on Public Policy, 1988).
Conduct-of-business rules are notoriously difficult to harmonize because they are grounded in idiosyncratic legal systems. The Second Banking Coordination Directive states that compliance with host country laws and rules governing the conduct of business will be required provided that such laws are “justified on the grounds of the public good.” The European Court of Justice will likely be busy deciding on cases where such justification is questioned.
See G.G. Johnson, with Richard K. Abrams, Aspects of the International Banking Safety Net, Occasional Paper No. 17 (Washington: International Monetary Fund, March 1983).
See Committee on Banking Regulation and Supervisory Practices, “International Convergence of Capital Measurement and Capital Standards,” July 1988. The countries involved actually number more than the G-10 label implies. They are Belgium, Canada, France, the Federal Republic of Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, the United States, and Luxembourg.
The Basle Committee cited three reasons for its choice of this approach to differentiating among assets involving country transfer risk over an earlier proposal to make a simple domestic/foreign split. In comments on the earlier proposal, banks argued strongly for acknowledgment of broad distinctions in the credit standing of industrial and nonindustrial countries. There was also a fear that the earlier plan would discourage international banks from holding securities issued by central governments of major foreign countries as liquid cover against their Eurocurrency liabilities. (The desire to preserve efficiency and liquidity of the global interbank market is the main reason for the absence of a transfer risk distinction for short-term interbank claims.) Finally, given the partial overlap between membership of the Basle Committee and the European Community, there was a strong insistence on consistency with an EC commitment to the principle that all claims on banks, central governments, and the official sector within the EC should be treated in the same way.
For a more detailed discussion of risk weights, refer to Credit Suisse First Boston, Capital Adequacy: The BIS Framework and its Portfolio Implications (July 1988).
Committee on Financial Markets (OECD), Standard Rules for the Operations of Institutions for Collective Investment (Paris: OECD, 1972). The Committee, a plenary body of the OECD, was established in 1969 and given a broad mandate by the member states to “study measures intended to improve the operation of national financial markets and the international market.”
Committee on Financial Markets (OECD), Minimum Disclosure Rules Applicable to All Publicly Offered Securities (Paris; OECD, 1976). For related background, see OECD, Committee on Financial Markets, The Markets for International Issues (Paris: OECD, 1972); and The International Issue of Bonds (Paris: OECD, 1975).
The communiqué issued after the September 1988 meeting of the finance ministers and central bank governors of the Group of Seven provided one of the first indications of the increasing importance of those issues at the highest levels of government. See “Statement of the Group of Seven,” Berlin, Federal Republic of Germany, September 24, 1988.
Various equity market terms are included in the glossary appended.
This world index was computed by deflating the Morgan Stanley Global index of stock prices by a composite GNP deflator, which is an average of the individual country deflators weighted by the average U.S. dollar value of its respective GNP over the preceding three years.
In Chart 11, price variability is measured by the standard deviation of the end-of-month values of the overall stock index over the preceding 12 months.
Some observers have argued that much of the increase in price volatility has occurred in intraday price movements that would not be captured in the interday price movements in Chart 11.
See Paul Bennett and Jeanette Kelleher, “The International Transmission of Stock Price Disruption in October 1987,” Federal Reserve Bank of New York Quarterly Review (New York), Vol. 13 (Summer 1988), pp. 17-33.
Nicholas F. Brady was the Chairman of the commission that prepared the Report of the Presidential Task Force on Market Mechanisms. For an interesting review, see Bruce Greenwald and Jeremy Stein, “The Task Force Report: The Reasoning Behind the Recommendations,” The Journal of Economic Perspectives (Nashville), Vol. 2 (Summer 1988), pp. 3-24.
The macroeconomic developments during this period and their relationship with equity price developments has been reviewed in “Implications of Recent Decline in Equity Prices,” Supplementary Note 1 in World Economic Outlook, April 1988: A Survey by the Staff of the International Monetary Fund, World Economic and Financial Surveys (Washington: International Monetary Fund, 1988), pp. 41-52.
For smaller order imbalances, the specialist may adjust prices gradually by trading from his own account. On the NYSE, liquidity for large (“block”) trades is often provided through brokers or dealers who arrange direct transactions between themselves in an “upstairs” market; however, these are subsequently reported to the stock exchange to satisfy regulatory requirements.
The National Association of Securities Dealers in the United States uses a system based on competitive market makers.
Such firm quotes are provided for the most active stocks. In specifying the pricing obligations of market makers, the London exchange differentiates between four types of stocks based on the volume of trading in each stock: (1) for the alpha stocks, which are the most heavily traded shares and constitute roughly two thirds of total market capitalization, market makers must establish firm, continuous two-way quotations, with trades quickly reported and displayed on display terminals; (2) for the beta stocks, which have lower trading volumes than the alpha stocks, market makers must publish firm continuous two-way price quotes, but trading information is not immediately disseminated to display terminals; (3) for gamma stocks, which have still lower trade volumes, the price quotes are to be regarded as only indicative; (4) and for the least active delta stocks only an approximate middle price is disseminated by SEAQ.
Some systems, such as the Chicago Board Options Exchange (CBOE), employ a combination of broker-dealer and auction arrangements.
Although most exchanges remained open, seven exchanges altered their operating hours to cope with large trading volumes. Exchanges in the Federal Republic of Germany, Sweden, and Switzerland extended their hours; those in Canada, Italy, South Africa, and the United States shortened their hours. The Hong Kong Stock Exchange remained closed during October 20-25. As will be discussed, the closing of the Hong Kong Stock Exchange was related to the prospect of large scale defaults on margin calls in the futures market for Hong Kong stock index futures contracts.
In addition to the Tokyo Stock Exchange, some form of daily price limits were in effect on equity markets in Austria, France, Italy, Spain, and Switzerland.
The stock exchange sales rules specified that market makers had to be willing to buy or sell the minimum of 1,000 shares of quoted prices, but, prior to the market crash, many dealers had quoted bargain sizes of up to 100,000 shares.
The performance of the auction markets for stock index futures and their linkages with the stock markets is discussed in the next section.
Volumes on October 19 and 20 amounted to about 600 million shares on each day and were 235 percent greater than the average daily volume for the year.
The SEC reported that in the three-day period between October 19-21, 1,840 securities (40 percent of all listed securities) were eliminated from the SOES because there was no active SOES market maker prepared to execute transactions through SOES in those securities.
A locked market exists when the bid price quoted by one market maker for a security equals the ask price quoted by another market maker in the same security. A crossed market exists when the bid price quoted by one market maker is greater than the ask price quoted by another market maker in the same security.
See James F. Gammill and Terry A. Marsh, “Trading Activity and Price Behavior in the Stock and Stock Index Futures Markets in October 1987,” The Journal of Economic Perspectives (Nashville), Vol. 2, No. 3 (1988), pp. 25-44.
Even the use of an index futures contract does not guarantee a full hedge against adverse price movements, especially if the investor’s portfolio does not match the composition of the basket of stocks used to calculate the index. In addition, stock index futures usually have a limited maturity of up to 12 months.
The stock index futures differ from their commodity counterparts in that (1) while the asset underlying the commodity future has a cash market, there is no such cash market for the equity index; and (2) index futures are typically not settled by physical delivery: settlement value is the difference between the initial contract price and the actual level of the stock index at the expiration of the contract.
In recent years, for example, block trades of 10,000 or more shares have accounted for about 50 percent of NYSE volume.
The relationship between the value of the stock index and the stock index futures can be illustrated by assuming that the investor could either invest in a three-month index futures contract or buy the basket of stocks underlying the index. If the investor buys the stocks, the value of his portfolio after three months would equal the value of the stocks at that time plus any dividends. If the investor purchased instead a futures contract, he would initially have to put up a margin requirement of 5 percent to 10 percent of the value of the contract and could invest the rest of the amount in treasury bills, for example. In this situation, the investor’s portfolio at the end of three months would equal the value of the index and the return obtained on the treasury bills. If arbitrage results in the yields of two alternative investment strategies being equalized, then a “fair price” (F*) for a futures contract on the stock index would equal (1+rT - dT)S0; where S0 = the current value of the stock index, rT = the treasury bill rate for the period from the present to the expiration of the futures contract, and dT = the dividend rate expected on the stocks underlying the stock index from the present to the expiration of the futures contract. Futures, however, only rarely trade at this value because it abstracts from transactions costs, unequal borrowing and lending rates, and the effects of differential taxation on market participants (e.g., on individuals and pension funds).
For further reference on the role played by the presence or absence of derivative markets, see Richard Roll, “The International Crash of October 1987,” in Kamphuis, Kormendi, and Watson, eds., Black Monday and the Future of Financial Markets (1988).
Portfolio insurance was also viewed by many as working well during a normal period but quite inadequately during a period like October 1987, when it was difficult to trade continuously.
Between January and September 1987, an average of 1,600 futures contracts a day for the FTSE were traded, while in 1986 there was an average daily volume of 77,000 futures contracts for the Standard & Poor’s 500 in the United States.
In the options market, at the beginning of the week of October 19, a significant number of investors were also short of FTSE puts (i.e., they had an obligation to deliver cash should the FTSE index fall below a predetermined level, with the cash amount being determined by the difference between the actual index and the strike price of the index option contract) as storms effectively closed the markets on October 16. As a result, those investors suffered substantial losses as stock prices fell since they had no opportunity to close out their positions. On Monday and Tuesday, these investors reportedly sought to close out their positions at almost any price.
It was also reported that a significant number of futures contracts were held directly and indirectly by only a few investors.
See Securities Review Committee, The Operation and Regulation of the Hong Kong Securities Industry, Report of the Securities Review Committee (Hong Kong, May 1988).
The settlement process encompasses all of the activities involved in agreement on trades, calculating the securities and cash due, settling money against securities, transferring legal ownership, and entering those changes into the records.
On October 19, volume on the New York Stock Exchange was 608 million shares (three times the daily average of the previous week); whereas 19,685 stock index futures contracts were traded (two thirds of the average daily volume of the previous week).
In contrast, the settlement periods are five days in New York, three days in Tokyo, and two days in Frankfurt.
In the United States in early October 1987, these were about 10 percent for futures and 50 percent for stocks. For relevant analyses, see Arturo Estrella, “Consistent Margin Requirements: Are They Feasible?” Federal Reserve Bank of New York Quarterly Review (New York), Vol. 13 (Summer 1988), pp. 61-79; and George Sofianos, “Margin Requirements on Equity Instruments,” Federal Reserve Bank of New York Quarterly Review (New York), Vol. 13 (Summer 1988), pp. 47-60.
However, a recent study has concluded that higher margins in the stock market have been associated with a reduction in stock price volatility. See Gikas A. Hardouvelis, “Margin Requirements and Stock Market Volatility,” Federal Reserve Bank of New York Quarterly Review (New York), Vol. 13 (Summer 1988), pp. 80-89.
See U. S. General Accounting Office, Financial Markets: Preliminary Observations on the October 1987 Crash (Washington: January 1988).
See, Robert Aderhold, Christine Cumming, and Alison Harwood, “International Linkages Among Equities Markets and the October 1987 Market Break,” Federal Reserve Bank of New York Quarterly Review (New York), Vol. 13 (Summer 1988), pp. 34-46.
While the Federal Reserve has oversight over margin requirements, the SEC supervises developments in the stock market, and the Commodity Futures Trading Commission oversees markets for stock index futures.
This group is composed of the Secretary of the Treasury (who has temporarily designated the Under-Secretary for Finance as his representative), the Chairman of the Commodity Futures Trading Commission, the Chairman of the Board of Governors of the Federal Reserve System, and the Chairman of the Securities and Exchange Commission.
See also, Franklin R. Edwards, “Studies of the 1987 Stock Market Crash: Review and Appraisal,” Working paper of the Center for the Futures Markets, Number CSFM-168 (Los Angeles, March 1988).
It has been reported that one response to this restriction has been increased use of the London markets by some portfolio insurers where the trades are executed on an over-the-counter basis.
In the past, the margins had been related to one-day’s expected price movement (plus an allowance for execution delays and risks if a defaulted position needed to be closed out).
Under a net margin system, a broker that is a clearing member of the exchange with one client long 100 futures contracts and one client short 99 contracts would have to put up only one unit of margin. Under a gross system, the broker would have to put up 199 units. A gross margin system is used by the Chicago and New York Mercantile Exchanges.
The authorities on the ISE recently noted, however, that they will continue to monitor the development of circuit breakers in the United States.
This was composed of the Governor of the Banque de France, the Chairman of the Futures Market Council, the Chairman of the Stock Exchange Council, the Chairman of the Paris Clearing and Settlement System for Financial Instruments, and the Director of the Treasury.
It has been reported that a number of institutional portfolio managers in the United States have been implementing portfolio insurance strategies through trades off the NYSE because of restrictions that have been placed on the use of the DOT system for trades reflecting computer-based trading strategies whenever the DJIA moves by more than 50 points.