Cranking Up the Reform Machine

By Philip Elmer-DeWitt

No one fully understands the complicated mechanism that drives U.S. financial markets, but after Black Monday everybody seems determined to fix it. Last week the engines of reform revved up in earnest as a parade of banking, economics and stock-market experts wended across Capitol Hill in an extraordinary series of hearings, press conferences and closed-door lobbying sessions.

At latest count, the October crash had spawned more than half a dozen important investigations. One was a special three-person task force announced on Oct. 22 by President Reagan and headed by New York City Investment Banker Nicholas Brady. Its mandate: to study the market procedures that led to the crash and recommend ways to prevent a recurrence. Two other probes were started by the watchdog Securities and Exchange Commission and the Commodity Futures Trading Commission to study the extravagant volatility of stock and futures markets during the crash. Other studies of market behavior were being sponsored by the New York Stock Exchange and the Chicago Mercantile Exchange. Meanwhile, the House and Senate banking committees and the House Commerce Committee were holding hearings of their own.

With so much action afoot, the momentum behind new regulation seemed inexorable. Said Democratic Congressman Edward Markey of Massachusetts, chairman of the House banking probe: "I don't see how some restrictions can be avoided." Some of the areas likely to draw the most attention in coming weeks:

Program Trading. On Black Monday, the N.Y.S.E. ordered a halt to certain kinds of computer-aided trades in which brokers send huge waves of buy or sell orders through the markets with a few taps on a keyboard. Those emergency restrictions are still in effect, and there is considerable sentiment for making them permanent. But even as program trading was emerging as everybody's favorite scapegoat, evidence was mounting that the practice had played a smaller role in the market's collapse than suspected. According to figures released last week by the Chicago Mercantile Exchange, program trading accounted for less than 10% of the orders executed on Black Monday. In the days since program trading was curbed, the markets have been almost as volatile without it as with it.

Index Futures and Options. These so-called derivative stock-market products are based on baskets of securities that can be bought and sold in the future. They are primarily designed to let investors protect their portfolios against sudden market changes, especially in a form of trading known as portfolio insurance. But since the crash, they have been called speculative instruments that can whipsaw the market as a whole. Many experts argue that Black Monday's cataclysmic spiral was triggered by a panic sale of index futures by managers trying to shore up their holdings.

Since then, the Chicago Mercantile Exchange has imposed a limit on the amount that an index futures contract can rise or fall in a single day. The Merc has also increased the amount of cash, or margin, that speculators must put on deposit. Congressional investigators are talking about additional safeguards to limit the number of futures contracts a broker could execute in a day. But at hearings last week in Washington, Merc President William Brodsky argued that the sale of index futures had a stabilizing effect on Black Monday. Without that escape valve, Brodsky suggested, the Dow would have fallen another 100 points.

Stock Specialists. Under close scrutiny last week was the manner in which brokers and brokerages "make a market" -- set a price -- on the big exchanges and in smaller over-the-counter markets. The N.Y.S.E. currently has one trader, or specialist, assigned to each stock on the floor. The specialist's job is to keep the market moving, if necessary by buying or selling out of his brokerage accounts. On Black Monday, specialists lost hundreds of millions of dollars while picking up stocks no one else wanted. But some specialists have been accused of staying purposely away from the money-losing action for up to three hours, while others lacked the capital to keep stocks from going into free fall. One proposed reform would raise the capital requirements for Big Board specialists. Another would assign more than one specialist to each stock, as is now the practice in the over-the-counter markets. OTC market makers thus have more money available to shore up prices. But they also have less accountability. It has been charged that in the market meltdown many over-the-counter brokers simply knocked their phones off the hook.

Global Regulation. The speed at which the crash circled the world made it clear that Tokyo, London and Manhattan are all connected outposts in a vast trading market. Yet the rules that govern stock trading can differ radically from country to country -- and indeed from one city to another. Some Congressmen are proposing that the Chicago futures markets be put under the authority of the Securities and Exchange Commission, which controls the stock markets. At the moment, the futures trading pits are supervised by the Commodity Futures Trading Commission, which also regulates such mundane commodities as pork bellies and grain futures. Congressman Markey calls the gap between the two agencies a "regulatory black hole." The Mercantile Exchange argues that the C.F.T.C.'s performance has been perfectly satisfactory. Says Merton Miller, finance professor at the University of Chicago: "Competition can be good, even when it's competition among regulators."

Some reform proposals are likely to help -- or hurt -- more than others, and it may not be entirely healthy that they are coming up for consideration in the wake of a traumatic and ill-understood crisis. And what regulatory changes are eventually made could still depend on how those crotchety and volatile markets perform in the months ahead.

With reporting by Jerome Cramer/Washington and Lisa Kartus/Chicago