The War of Two Cities

By Stephen Koepp

Not so long ago, the healthy rivalry between America's two financial-trading capitals, New York and Chicago, helped make the U.S. an innovative leader in the world marketplace. But suddenly the character of that sporting competition has turned warlike. Set off by recriminations over which side was responsible for the Oct. 19 crash, the trading centers have become locked in a multibillion-dollar struggle for turf and influence that is frightening away investors and harming business for both. "I have nothing nice to say about Chicago. They've ruined everything," declares Dudley Eppel, 57, a stock trader for Wall Street's Donaldson Lufkin & Jenrette Securities. Says Richard Dennis, a hyper-wealthy futures trader in Chicago: "The gulf between us is large, and the stakes are even larger."

The conflict is aggravated by drastic differences in culture and philosophy, almost as if the two capitals were situated in warring nations. On one side are Chicago's futures and options traders: young, brash, speculative, unabashedly noisy. On the other are New York's stock traders and brokers: tradition-bound, analytic, fraternal, relatively restrained.

In the crash's aftermath, each camp has recommended that the other change its ways. So far, except for mostly symbolic gestures, neither is budging. Says George Ball, chairman of Prudential-Bache Securities: "It's almost like a game of chicken. Nobody wants to be the first to give in." Even the two separate federal regulatory agencies that oversee the markets are at a standoff. If any new safeguards need to be imposed, Congress may have to take the initiative by default.

The two markets had few points of connection or conflict in the old days when Chicago stuck to its traditional business of trading futures in such commodities as soybeans, corn and pork bellies. But since 1972, when its markets began trading futures contracts based on Treasury bills and currencies, Chicago has produced an explosion of new financial instruments. Chicago's three major markets (the Board of Trade, Mercantile Exchange and Board Options Exchange) now trade futures and options based on everything from Eurodollars to municipal-bond indexes.

The stormy moods in Chicago's futures markets can directly influence the performance of underlying stocks and bonds in New York, prompting traders on Wall Street to complain that the tail is now wagging the dog. "What stocks once represented," says Prudential-Bache's Ball, referring to long-term investment, "is being sublimated for something more frenzied."

That is what happened on Oct. 19, contend many Wall Streeters, who blame in particular an instrument called the stock-index future. Traded largely in Chicago, such futures enable investors to place bets on the performance of New York stock indexes like the Standard & Poor's 500. The futures, first introduced in 1982, gave portfolio managers a chance to hedge their cash investments in the stocks that make up a particular index. But the futures also gave investors the opportunity to engage in index arbitrage, a practice in which they can reap quick profits from temporary, often minor discrepancies between the two markets by launching simultaneous, computer-driven program trades of huge blocks of stock in New York and index futures in Chicago.

Among the six major investigations of the crash, three concluded that computer-driven index arbitrage and a related strategy known as portfolio insurance were at least partly to blame for the speed and severity of the 508- point drop in the Dow Jones industrial average. The Brady commission, which the Reagan Administration appointed, contended in its report last January that Chicago's futures markets have gained inordinate leverage over New York because the two marketplaces play by such vastly different rules and fail to monitor their complex interactions.

The Brady panel recommended drastic reform that would have curbed Chicago's latitude. Last week, however, a White House working group on the crash delivered a quite different report, one that essentially exonerated the futures markets. The group, which included Treasury Secretary James Baker and Federal Reserve Chairman Alan Greenspan, recommended only one significant safeguard: a so-called circuit breaker that would interrupt trading in most U.S. financial markets for one hour if the Dow fell 250 points from the | previous day's close and for two hours if it dropped 400 points. In congressional testimony later in the week, Greenspan defended stock-index arbitrage and computer trading as forces for stability rather than volatility, enabling portfolio managers to reduce their risk.

The White House report delighted Chicago traders but angered many Wall Streeters and legislators. "The report represents a giant step backward for the American investor," said Representative Edward Markey of Massachusetts, chairman of the House Subcommittee on Telecommunications and Finance. "After being handed a game plan for reform by the Brady commission, the working group went into a two-month huddle, came out and punted."

Investors are registering their disapproval in droves. In a survey conducted earlier last week by Sindlinger & Co., a marketing-research firm, just 4% of the households polled said they planned to buy stock, compared with 15% just after the crash in October. Fear of the volatility often attributed to program trading was the second most often mentioned reason for avoiding the market, after disillusionment about insider trading. Individual investors have apparently developed a belief that the stock-market game is fixed in favor of the big players. Says Arthur Levitt, chairman of the American Stock Exchange: "It's a national disgrace that we've been unable to agree on some essential steps to restore public confidence in the market." Last week almost nothing seemed to encourage investors. Despite a sharp improvement in the U.S. trade deficit, the Dow Jones average fell 37.96 points, to close the week at 1952.59.

Perhaps the hottest battlefront in the New York-Chicago conflict is between the New York Stock Exchange and the Chicago Merc, which trades the controversial S&P 500 index futures. Each side in the standoff is unwilling to make any major procedural changes for fear of losing turf. The New York exchange, which was slow in setting up its own financial-futures market, controls 10% of worldwide trading in such contracts; the Chicago exchanges' share is about 80%. Contends John Sandner, chairman of the Chicago Merc: "We were so successful that it caused everyone to want to take our success from us. The agenda of New York is to move our markets to Wall Street."

Chicagoans bristle at the idea of greater regulation. The Chicago Merc's unofficial motto is "Free Markets for Free Men." Traders in the Chicago pits relish their freewheeling auction system, called the "open outcry" method, in which any trader with enough lung power, quick wit and derring-do can make a killing. Says Tom Cunningham, a 20-year veteran at the Board of Trade: "You have no friends between the bells. No one gives a damn whether you're a college graduate. The guy on your right has a master's degree in chemistry, the one on your left is a high-school dropout. When the bell rings, you're all equals." Even at its most hectic, the floor of the Big Board seems by contrast an elite gentleman's club. "There's only a kind of quiet humming sound," notes Merton Miller, a University of Chicago professor and an expert on futures. "Even when people bump into you, they tend to say, 'Excuse me.' "

Many New York traders view their Chicago counterparts as hotheaded and distinctly disreputable gamblers rather than investors. Certainly in terms of appearances, everything about the Chicago traders' style makes them look more like hockey fans than financial professionals. While the stereotypical Wall Street uniform may be pinstripes and silver cuff links, Chicagoans often arrive at work in plaid jackets and gold neck chains. Sandner, the Merc's chief, a lawyer and former boxer, wears cowboy boots and a brown-and-gold trader's vest studded with badges promoting the Merc.

Despite an outward image of chaos in the futures pits, the Chicagoans maintain that their trading system is more efficient and fair than the one at the New York Stock Exchange. The Chicago traders settle their accounts twice a day, while the New York exchange sometimes takes as long as five days to catch up with the paperwork. Moreover, Chicago's auction system tends to keep the differences between buying and selling prices to a minuscule gap even when the market is moving briskly up or down. By comparison, trades on the New York exchange are usually handled on a one-to-one basis by specialists, who can sometimes be overwhelmed with orders and become unable to keep up with the price movement.

In the New York view, the Chicago markets have been able to let their speculative impulses run wild -- and whipsaw Wall Street as well -- because futures contracts can be purchased on a very low initial stake, or margin. On stocks, the down payment an investor must make to buy shares on credit is typically 50%, while on futures contracts the up-front money can run from as little as 3% to a high of 15%. James Maguire, a floor specialist at the New York exchange, calls highly leveraged futures the "nuclear bombs of the financial business. Uncontrolled, they're dangerous weapons."

The Brady panel recommended bringing futures margins closer to 50%, but Chicagoans would fight that idea to the bitter end. "The margin issue," says Chicago's Miller, "is a code word for killing the futures markets. It's a nonnegotiable issue. If you make the futures exchanges expensive, you rule out the very reason for their existence," which ostensibly is to give investors a quick and cheap hedge on their comparable securities.

The other prime source of discord is the recommendation by the Brady panel that all financial trading should be supervised by one federal regulatory body, instead of two separate ones. Currently, the Securities and Exchange Commission oversees the stock markets and the Commodity Futures Trading Commission regulates the exchanges that deal in stock-index futures. "Having split regulators contributes to the confusion," contends Peter Buchanan, chief executive of Wall Street's First Boston investment firm.

The agency favored by some to become a superregulator is the Federal Reserve, but the Chicago exchanges oppose that move on the ground that they would no longer have their own advocate. At present, the CFTC sticks up for the Chicago markets whenever the SEC tries to fence them in. Earlier this month the CFTC approved two new forms of stock-index contracts -- the first authorized since the crash -- bringing the total number to 18. The Chicago Merc hopes to get approval soon for a futures contract to be based on the Tokyo exchange's Nikkei 225 stock index.

The stock-index futures market is currently suffering from depressed volume, down some 50% on the Chicago Merc compared with May 1987, partly because several major New York investment firms have halted index-arbitrage for their own accounts. While the firms did so largely as a public relations move to calm investor fears, most of them continue to conduct program trading to satisfy customers whose money they manage. Says Max Chapman, president of Kidder, Peabody: "Speculation is not a dirty word."

If voters think it is, then Congress will pay attention. Says Michigan Congressman John Dingell, chairman of the House Committee on Energy and Commerce: "Small investors have been unimpressed by the incremental steps ((toward reform)) taken thus far." Wisconsin's William Proxmire, chairman of the Senate Banking Committee, has introduced legislation that would impose ^ many of the Brady group's recommendations, including tighter margins and joint supervision of futures markets by the Fed, CFTC and SEC.

The New York and Chicago exchanges will have no say in the matter unless they start agreeing on some compromises. Says Philip Purcell, chairman of Dean Witter: "It's time to forget about these turf fights and think of the customer first for a change." If the exchanges do not, customers will stay away, and the heady days of the 1980s bull market will be gone for a long, long time.

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With reporting by Thomas McCarroll/New York and William McWhirter/Chicago