Brady Panel Recommendations Leave Room For Interpretation

The 69-page report delivered last week by the presidential commission appointed to study the stock market crash proves what many people have been saying all along -- that the stock, options, and futures markets are really one market.

Running throughout the Brady report is the underlying theme that difficulty in gaining access to markets -- whether because of trading halts, systems overloads, or unanswered telephones -- fueled the market's free fall on October 19th.

The report suggests that the NYSE's decision to close its Designated Order Turnaround system to program trades contributed to market chaos by severing the link between stock index futures and their underlying equities.

"From the narrow perspective of the stock market, an inactive DOT system may have appeared beneficial, since it made program selling difficult," the report says. "However, this contributed to the development of a futures discount which, in turn, put downward pressure on stock prices."

Despite the Brady report's conclusion, the NYSE has asked its members not to use DOT for program trades if the DJIA moves 75 points in either direction from the previous day's close. The request is part of a week-long experiment that began January 15th.

During the crash, banning program trades on DOT was one of several instances where trading constraints in one market affected another. That's why the Brady commission stresses that "circuit breakers" must be coordinated across the stock, index options, and futures markets. Circuit breakers "need to be in place prior to a market crisis and they need to be part of the economic and contractual landscape," the report says.

The problems with DOT and Intermarket Trading System printers on the NYSE floor and locked and crossed markets in over-the-counter stocks have already been reported. But the Brady report provides an amazing amount of detail about several automated systems and how they fared during the week of October 19th.

For instance, the report notes that the Universal Floor Device Controller, which controls access to the NYSE's electronic display books, printers and mark-sense card readers, has a capacity of 68 messages/second. During the week of October 19th, the UFDC experienced peak volume of 72 messages/second.

Significant delays in executing market orders and entering limit orders through DOT occurred as floor printers, which can print 10-12 orders/minute, were overwhelmed. According to the Brady report, of the 396 million shares entered into DOT October 19th, 112 million were not immediately executed. Limit orders accounted for 92 million of these shares.

The NYSE was plagued by two software glitches, the Brady report says. The first resulted in a delay of matching cancellations with orders, while the second caused the loss of 5,000 trade reports, most of which were found overnight.

In the OTC market, locked and crossed markets prevented NASDAQ's Small Order Execution System and other proprietary OTC automated execution services from trading the top 50 NASDAQ stocks 43 percent of the time on the 19th and 53 percent on the 20th. Although SOES typically handles less than 2 percent of share volume in NASDAQ National Market System securities, it accounts for 12-15 percent of trades in these issues.

The Brady report seems destined to take its place next to documents such as the Bible and the U.S. Constitution, which are hotly debated between adherents to the letter of the law and followers of the spirit of the law.

A dispute has already broken out about whether the commission led by investment banker Nicholas Brady actually favors daily price limits for U.S. equities similar to those on the Tokyo Stock Exchange.

The report clearly states that "circuit breaker mechanisms such as price limits and coordinated trading halts should be formulated and implemented to protect the market system." However, Brady, chairman of Dillon, Read and Co., told The New York Times that price limits for stocks were dismissed by the commission after 20 minutes of discussion.

Both the Brady report and the Katzenbach program trading study commissioned by the New York Stock Exchange argue for the proverbial "level playing field" among markets. Calling for coordinated regulation of the futures, options and stock markets is not the same as saying the Commodities Futures Trading Commission should be merged with the Securities and Exchange Commission.

The Brady report's call for equivalent margin requirements for stocks and futures has also created semantic confusion. After acknowledging that futures margin is a performance bond and securities margin represents an extension of credit, the report notes that leverage is leverage.

The Brady report points out that the well-publicized differential between futures and stock margins is misleading because broker/dealers can invest in stocks on 20-25 percent margin instead of the 50 percent required for individual investors. In the futures industry, all investors must put up a good-faith deposit that generally varies between 5-10 percent depending on market volatility.

"To protect the intermarket system, margins on stock index futures need to be consistent with margins for professional market participants in the stock market," the report says, while noting such requirements need not produce "equal" margins.

Cross-margining would allow traders to offset a loss in one market with a profit in another. According to the Brady report, OCC and Chicago Mercantile Exchange clearing members were required to deposit $3 billion in margin payments October 19th. "Some of these deposits were to cover options losses that were offset by futures profits, which resulted in further strains on liquidity," it says.

The recent agreement between the Board of Trade Clearing Corp. and other futures clearing houses to share pay and collect information is the kind of coordination envisioned by the Brady commission (TST, December 7). The next step is for BOTCC and the other clearing houses to exchange this data in real time instead of in batch.

Throughout the stock market collapse, futures traders and exchange officials were often cast as the bad guys. This makes it all the more surprising that a panel led by a Wall Street investment banker concluded that Chicago is ahead of New York in certain areas of risk management and information gathering.

The futures industry's daily process of marking-to-market, where losers must advance margin to winners, has allowed the financial performance control aspect of futures margin to operate "in a sound and effective manner on an intramarket basis," the report says.

According to the Brady panel, "futures clearing house and large trader information systems currently allow assessment of trading time by trading customers. The stock exchanges have no system which details trades and trading time by customer." In the stock market, the record of a trade includes the time, the broker/dealer involved, and whether the firm acted as agent or principal.