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The Crash of 1987: a Legal and Public Policy Analysis

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The Crash of 1987: a Legal and Public Policy Analysis Fordham Law Review Volume 57 Issue 2 Article 2 1988 The Crash of 1987: A Legal and Public Policy Analysis Lewis D. Solomon Howard B. Dicker Follow this and additional works at: https://ir.lawnet.fordham.edu/flr Part of the Law Commons Recommended Citation Lewis D. Solomon and Howard B. Dicker, The Crash of 1987: A Legal and Public Policy Analysis, 57 Fordham L. Rev. 191 (1988). Available at: https://ir.lawnet.fordham.edu/flr/vol57/iss2/2 This Article is brought to you for free and open access by FLASH: The Fordham Law Archive of Scholarship and History. It has been accepted for inclusion in Fordham Law Review by an authorized editor of FLASH: The Fordham Law Archive of Scholarship and History. For more information, please contact [email protected]. The Crash of 1987: A Legal and Public Policy Analysis Cover Page Footnote Professor of Law, George Washington University National Law Center; B.A. 1963, Cornell University; J.D. 1966, Yale University. B.S. 1983, University of Pennsylvania; M.S. 1984, State University of New York at Albany; Candidate for J.D. 1989, George Washington University National Law Center. This article is available in Fordham Law Review: https://ir.lawnet.fordham.edu/flr/vol57/iss2/2 THE CRASH OF 1987: A LEGAL AND PUBLIC POLICY ANALYSIS LEWIS D. SOLOMON* HOWARD B. DICKER** INTRODUCTION O n "Black" Monday, October 19, 1987, the Dow Jones Industrial Average ("DJIA") plummeted 508 points to 1738.74 on record trading volume of 604.3 million shares.1 This 22.6 percent drop far ex- ceeded the 12.8 percent decline on October 28, 1929, which touched off the Great Depression.' In the aftermath of the crash of 1987, several studies and hearings were conducted to investigate its cause and to make recommendations to avert a similar event,3 in order to restore confidence in the capital markets. These efforts have produced conflicting conclu- sions. Nevertheless, it is clear that the existence of derivative instru- ments (specifically, stock index futures and options) and the use of program trading strategies contributed to the market "break." At least six studies have investigated the crash of 1987. Nicholas Kat- zenbach, in a study commissioned by the New York Stock Exchange, concluded that stock index futures-related trading encouraged too much speculation and recommended restraints on such trading by consolidat- ing regulatory authority and raising futures margins.4 In contrast, the Chicago Mercantile Exchange, in its preliminary report, found that fu- tures trading did not cause the stock market decline and that low mar- gins did not exacerbate the crash.' Similarly, the Commodity Futures Trading Commission did not find stock index futures responsible for the problem.' The Commission called for improved coordination between * Professor of Law, George Washington University National Law Center; B.A. 1963, Cornell University; J.D. 1966, Yale University. ** B.S. 1983, University of Pennsylvania; M.S. 1984, State University of New York at Albany; Candidate for J.D. 1989, George Washington University National Law Center. 1. See Metz, Murray, Ricks & Garcia, Stocks Plunge 508 Amid Panicky Selling, Wall St. J., Oct. 20, 1987, at 1, col. 6. 2. See id. 3. See Vise, Studies Aim to Clear Muddy Waters of Stock Market Plunge, Wash. Post, Nov. 29, 1987, at Hl, col. 2. 4. See N. Katzenbach, An Overview of Program Trading and Its Impact on Current Market Practices 29-32 (Dec. 21, 1987) [hereinafter Katzenbach Study] (study commis- sioned by the New York Stock Exchange). 5. See M. Miller, J. Hawke Jr., B. Malkiel & M. Scholes, Preliminary Report of the Committee of Inquiry Appointed by the Chicago Mercantile Exchange to Examine the Events Surrounding October 19, 1987 55-56 (Dec. 22, 1987) [hereinafter CME Report]. 6. See Division of Economic Analysis & Division of Trading & Markets, Commod- ity Futures Trading Commission, Final Report on Stock Index Futures and Cash Market Activity During October 1987 to the U.S. Commodity Futures Trading Commission iv- xiii (Jan. 1988) [hereinafter CFTC Final Report]; see also Division of Trading & Markets, Commodity Futures Trading Commission, Follow-up Report on Financial Oversight of FORDHAM LAW REVIEW [Vol. 57 exchanges and regulators and for better market data collection.7 In another study, the General Accounting Office ("GAO") found that the breakdown of computer systems at the New York Stock Exchange accentuated the selling pressure on October 19. 8 The GAO suggested improving these systems to cope with extraordinary trading volume. 9 Additionally, the office recommended that regulatory authorities estab- lish contingency plans for future emergencies.1" The Presidential Task Force on Market Mechanisms (the Brady Com- mission) attributed the market crash to the employment of computer trading strategies by a few of the largest institutional investors. 1' The Task Force called for a single agency, such as the Board of Governors of the Federal Reserve System, to coordinate the regulation of stocks, stock index futures, and stock index options trading because these three mar- kets are essentially a single market. 2 Furthermore, the Task Force rec- ommended the use of "circuit breakers," coordinated trading halts or limits, to slow trading when it becomes frenzied. 3 A report published by the Securities and Exchange Commission con- cluded that stock index futures-related trading had contributed to the crash of 1987 and that computerized trading increased intra-day stock price volatility.14 The SEC suggested additional market surveillance, better coordination among exchanges, and a review of margin levels for futures to control unusual stock price volatility.' 5 Finally, the report of the Working Group on Financial Markets pro- posed brief halts in trading across the stock, stock options, and stock index options and futures markets in the case of an extraordinarily large 6 market decline. The report did not, however, recommend7 changing the level of minimum margins on futures contracts.1 Stock Index Futures Markets During October 1987 (Jan. 6, 1988) [hereinafter CFTC Follow-up Report]; Division of Economic Analysis & Division of Trading & Markets, Commodity Futures Trading Commission, Interim Report on Stock Index Futures and Cash Market Activity During October 1987 to the U.S. Commodity Futures Trading Commission (Nov. 9, 1987) [hereinafter CFTC Interim Report]. 7. See CFTC Final Report, supra note 6, at xii-xiii. 8. See General Accounting Office, Preliminary Observations on the October 1987 Crash 5-8 (Jan. 26, 1988) [hereinafter GAO Report]. 9. See id. at 8. 10. See id. 11. See Report of The Presidential Task Force on Market Mechanisms v (Jan. 1988) [hereinafter Task Force Report]. 12. See id. at 69. 13. See id. 14. See Division of Market Regulation, Securities & Exchange Commission, The Oc- tober 1987 Market Break xiii-xiv (Feb. 1988) [hereinafter SEC Report]. 15. See id. at xiv-xvii. 16. See Interim Report of The Working Group on Financial Markets 4 (May 1988) [hereinafter Working Group Report] (The Working Group was authorized by the Presi- dent to report on actions which might lessen systematic damages to the financial markets). 17. See id.at 5. THE CRASH OF 1987 In addition to these studies, Congress has held numerous hearings since the market break in an effort to develop a legislative response. Some testimony has called for eliminating stock index futures and op-18 tions and/or banning the related computerized trading strategies. Three bills have been introduced to date. One authorizes the Federal Reserve Board to regulate margin requirements of derivative financial instruments (such as stock index futures and options).19 Another would create an Intermarket Coordination Committee whose purpose would be to develop a more coordinated regulatory system.20 The third bill pro- poses to give exclusive jurisdiction over derivative instruments to the SEC and to give margin setting authority to the Fed.21 This Article concludes that many of the current regulatory efforts are "quick fixes," aimed at treating symptoms rather than aimed at address- ing the long-run, structural problems of the financial markets. In order to restore investors' confidence, policymakers must consider the current (and future) structure of the financial markets. This structure is pres- ently shaped by the short-term focus of institutional investors, continuing innovations in technology, and the globalization of money flows. 22 The effects of these three dynamic forces may destabilize the financial mar- kets of the United States, creating uncertainty, volatility in stock prices, and loss of investor confidence. Moreover, additional instability may re- inforce these same attributes. In this changing environment, it will be very difficult for United States regulators alone to formulate a policy re- sponse. Thus, if the nation's policymakers do anything, they should take steps to ensure that the financial system will be able to withstand the effects of inevitable price shocks, instead of focusing only on increasing the regulation of the markets. Part I of this Article discusses the evolution of derivative instruments and the development of futures markets as a response to a need for the mutually desired transfer of price risk. Part II explores one of these in- struments, stock index futures contracts, in detail. Moreover, this Part explains how institutional investors employ computer assisted strategies, such as program trading, that utilize stock index futures. Part III exam- ines the current regulatory structure governing derivative instruments and how it reflects jurisdictional disputes among several government agencies. Drawing from the six major studies, Part IV briefly describes the stock market crash of 1987 with an emphasis on the role played by the stock index futures and related trading strategies. Finally, Part V 18. See Ricks, Regan Calls FinancialMarkets 'Rigged,' Assails Program Trading,In- dex Futures, Wall St. J., May 12, 1988, at 2, col. 3. 19. See S.
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