[This Commentary originally appeared in the June 7, 1990 issue of The Mendon-Honeoye Falls-Lima Sentinel.]
The Commodity Futures Trading Commission (CFTC) currently has regulatory responsibility for stock index futures. The Bush administration recently announced plans to introduce legislation shifting control to the Securities Exchange Commission (SEC). Both Investor’s Daily and The Wall Street Journal have faithfully presented both sides of the debate.
The critical questions, however, relate not to who’s in charge, but to the impetus behind the territorial maneuvering. In analyzing the 1987 stock market crash, official Washington, the news media and even some well respected financial gurus have blamed stock index futures – in particular their use in program trading – for the increased volatility of the market.
Volatility in the stock market means prices rise and fall fast and hard. It’s like a baseball game when a lot of runs get scored by both teams. The lead constantly switches back and forth. It’s exciting, but it tends to make the fans very nervous. After the market fell 500 points in October 1987, the consensus seemed to hold that volatility in financial markets should be avoided. Of course, no one ever complains about volatility when the market gains a couple hundred points in one day.
Stock index futures are a form of a derivative security. A derivative security refers to a financial instrument based on other financial instruments instead of something more tangible (like an actual piece of ownership in the company). Think of a derivative security as a baseball card. A baseball card has no inherent athletic talent. The price of a baseball card, however, is tied directly to the athletic talent of the player depicted on the card. In a similar fashion, while derivative securities don’t produce anything real, their value is linked to their underlying security.
A futures contract entitles the holder to purchase a specific amount of good at some point in the future for the then current price (as opposed to today’s price). Futures contracts first became important in Chicago in the late 1800’s as a method of buying grain. An example of a futures contract might be if you decided to buy a car which will be delivered in three months. Instead of paying the going price at the time of order, you pay the going price at the time of delivery.
Agricultural commodities lend themselves to futures contracts (because the commodity is actually delivered on the expiration date of the contract). Stock index futures deliver no material good. Stock index futures represent the value of a basket of stocks. In reality, these stocks are not bought and sold as baskets, but as individual stocks. The Chicago Board of Trade began offering stock index futures in the early 1980’s, almost one hundred years after is offered the first commodities futures. Since they evolved on the futures market and not on the stock market, the CFTC possesses the regulatory responsibility over stock index futures.
One buys a stock (or future) on margin when one puts up only a portion of the money needed to pay for the item in full. The cash amount plus the margin amount can never drop under the original purchase cost. For example, if you buy a stock on 50% margin, you put up half the cash and use half the value of the stock to equal the purchase cost. If the stock goes up, you’re all right. If the stock goes down, then the original cash you put up plus half the value of the stock equals a number smaller than the original purchase amount. To get back to the original purchase amount, you must add more cash.
Do futures increase the volatility of the market? On January 15, 1988, The Wall Street Journal quoted John Shad, former SEC Chairman, as follows: “Futures and options are the tail wagging the dog. They have also escalated the leverage and volatility of the markets to precipitous, unacceptable levels.” Is John Shad correct?
In July 1989, Intermarket published a one page article titled Derivatives and Volatility, by Clifford W. Smith, Jr. and Charles W. Smithson. (Mr. Smith is the Clarey professor of finance at the University of Rochester’s Simon School and Mr. Smithson is managing director of Continental Bank in Chicago.) The article focuses on the research compiled to either support or refute the sentiments of those like John Shad.
Of the twenty-one studies cited, only one indicated an increase in volatility of the underlying asset following the introduction of futures for that asset. Five showed no change in volatility and fifteen implied volatility actually decreased when derivatives were created. Clearly, no evidence supports the notion that the existence of futures leads to volatility.
Will higher future margins necessarily limit that volatility? SEC Chairman Richard Breeden has proposed increasing futures margins from the current 11% to 20% in hopes of reducing stock market volatility. Alan Greenspan, Federal Reserve Chairman, remains skeptical that higher margins will reduce volatility.
In fact, the primary purpose of margins deals with reducing the risk of default. This is critical in the stock markets, where all the liability falls on the individual. Futures markets, however, having evolved differently, do not have the same default risk. There has never been a default to the investor in the futures market because the large institutions which settle futures trades guarantee all contracts. The network of guarantees within the futures infrastructure prevents massive default.
Fundamentally, the stock market and the futures market are two different markets. That one mechanism works well in either market does not imply it will work equally well in the other.
[What is this and why is here? See Interested in Discovering My Time Machine? for more details.]