It should have been a miserable week in New York.
On Sunday, January 18, 1987, the Long Island Rail Road had gone on strike. The rest of the weekend news had been ugly, a mix of local racial unrest and Washington scandals. The weather on Monday was a disgusting mix of snow, wind, and rain, with a blizzard predicted for later in the week.
None of that—or anything else, it seemed—could dampen the extraordinary exuberance in the stock market.
On Monday, January 19, the Dow extended a New Year’s rally that had begun with the opening bell on January 2 and had now continued for a dozen consecutive sessions, tying a record set in 1970. The Dow had gained an astonishing 5 percent in the first five trading days of 1987, and had closed above the 2,000-point level for the first time ever.
Trading on Tuesday extended the rally to a record-setting length: thirteen straight gains. On this day, however, the Dow managed only a tiny advance, and other market barometers were down slightly.
Moreover, the prices of both the S&P 500 futures on the Merc and the Major Market Index futures on the Chicago Board of Trade dropped sharply in late trading. That last-minute nosedive in the futures pits was a “flashing red light” that could signal a sell-off by big institutions, one trader told the New York Times. If that happened, the New Year’s string of consecutive gains would probably be broken.
And it was. At the closing bell on Wednesday, the Dow had dropped about 10 points. Traditional market reporters looked for the traditional reasons, but none of their explanations looked plausible the next day. On Thursday, the stock market defied a blizzard that blanketed the Northeast and rose to new record-setting levels. The Dow’s climb marked its largest one-day gain in history, 51.60 points, and it closed at a new high of 2,145.67 points.
It seemed increasingly obvious that the engine driving the day’s trading was the complex interplay between the futures markets and the stock exchange—and the program trading that professional investors used to exploit those connections. Other explanations were starting to look a little absurd.
Clearly, in less than five years, financial futures had fundamentally changed the way the traditional stock market worked.
* * *
BY JANUARY 1987, Leo Melamed was becoming increasingly worried that the witching hour gyrations in the markets would lead to a political witch hunt in Washington.
The triple witching hour on December 19, 1986, had been a case in point. The voluntary reports filed by brokers at 3:30 p.m. showed “a heavy imbalance of orders to sell stock at the closing bell,” according to the New York Times. However, instead of falling, Big Board prices shot almost straight up, as they had in December 1985. There were reports that, in those final moments, Salomon Brothers had purchased a staggering $2 billion worth of stock. The SEC’s only public response was to complain that those last-minute orders had not been disclosed in advance, as it had requested.
Regulators might be wary of trying to tame the witching hours, but Leo Melamed and John Phelan weren’t. Even their rivalry had to bow before the threatening chaos of these expiration days.
Phelan’s proposed cure—pegging the spooz’s expiration value to the day’s opening prices on the NYSE, not the closing prices—had been viewed with suspicion by Melamed simply because it was a New York proposal. To his credit, the Merc studied the idea and concluded that it actually made sense.
So, in mid-December, the Merc applied to the CFTC for permission to settle the S&P 500 contract based on opening prices, effective in June 1987. John Phelan applauded the step, but in Chicago, the reaction was more grudging. The Chicago Board of Trade would say only that it was “studying” the idea for its volatile MMI futures contract, and the Chicago Board Options Exchange flatly said it would not follow the Merc’s initiative for its popular S&P 100 option contract. Still, the Merc’s decision to accommodate Phelan in the spooz pit gave Melamed a little moral high ground, even if it didn’t resolve all the potential witching hour problems.
* * *
FRIDAY, JANUARY 23, was the last trading day of a week that had already seen the end of a historic thirteen-day rally, record trading volume, and the largest one-day gain ever, which lifted the Dow to a new high. By the closing bell that day, those milestones would be forgotten footnotes.
The day’s trading began normally enough. The market opened strong and then steadied itself. Around noon, traders recognized the hallmarks of program trading in the wave of buy orders coming in. Prices started to roar upward. By 1:39 p.m., the Dow had gained more than 3 percent, climbing over the 2,200 mark for the first time.
Then, in seventy-one shattering minutes, the Dow plunged 5.5 percent—an unprecedented drop of 115 points.
Index option prices began to fall within minutes of a newswire report on some comments Paul Volcker made about bank deregulation, although the link seemed tenuous. Index futures followed the options down; index arbitrage kicked in. On the NYSE, prices “suddenly were sucked into a free fall,” the New York Times reported, a nosedive that “strained every system, electronic and human, in the world’s largest capital market.”
Just as abruptly, the free fall stopped—but the craziness continued. Prices careened up again, gaining 2.8 percent. Then there was another inexplicable pivot and the Dow plunged again, falling 2.3 percent from its peak just moments earlier. Seasoned NYSE specialists were caught repeatedly out on a limb as prices zigzagged. Terrified institutional investors had started to sell and move to the sidelines, as the Dow closed in on a 44-point loss. At the bell, the Dow had fallen 2 percent, to 2,101.52 points, a record 302.4 million shares had been traded, and even market veterans were stunned.
An experienced senior trader at First Boston reported, “There are no words to describe what we were going through. People were paralyzed.” A strategist at a retail brokerage house said, “I thought my stock quotation machine would start to smoke.” A retail broker admitted, “Frankly, I have great difficulty explaining to people what is going on.” The head of trading at Morgan Stanley said, “I’ve been in the business for 18 years and I have never seen anything like it before. It’s berserk. It’s total confusion. No one knows what the heck is going on.”
Well, they knew what had happened. In four hours, with no explanation, the market had soared up, plunged down, gone up again, then plunged steadily down until the closing bell, with more shares traded than ever before. What they didn’t know was why all that had happened.
John Phelan was fit to be tied. With no small degree of professional courage, he let his public relations staffers know he was ready to talk even more forcefully about program trading and what he thought it was doing to the nation’s premier stock market. Just find him the right venue, and he would let loose with both barrels.
One result was a cover story in the March 2, 1987, issue of Investment Dealers’ Digest, which was widely read in the hard-core financial community Phelan wanted to reach. The headline said it all: “John Phelan vs. Program Trading.”
It noted that Phelan had recently “been warning top officials in the securities industry of a program trading scenario—which he calls ‘financial meltdown’—that could drive the market down hundreds of points. ‘At some point, you’re going to have a first-class catastrophe,’ Phelan says.”
Rather than allow that, he said, he was considering a plan to halt trading in as many as a hundred Big Board stocks if the market fell by somewhere around 25 percent.
For as long as anyone could remember, trading halts were the stock market’s traditional safety valve when there were lopsided orders for specific stocks. Now Phelan publicly proposed using them on a widespread basis, as a buffer against an avalanche of computer-driven orders all falling on one side of the table and overwhelming his specialists. His emergency plan, which would inevitably disrupt the spooze pit in Chicago, was a tacit admission that the new forces in the market could make it impossible for the Big Board to keep trading during an onslaught of high-speed selling.
The article cited Phelan’s dilemma: Many of his member firms profited hugely from program trading. It quoted the outspoken CEO of Bear, Stearns and Company, Alan “Ace” Greenberg, who called Phelan’s concerns about a meltdown “totally ridiculous” and added, “Don’t fix things that aren’t broken.”
Phelan acknowledged that, “theoretically, we ought to keep quiet about it,” but he believed that “public needs and the needs of the market have got to transcend the needs of the individual.”
* * *
EVEN BEFORE THE chaos of January 23, Leo Melamed thought the stock market had gone completely nuts. Prices had climbed too high, too fast; a downturn was inevitable, possibly a sharp one. “What worried me,” he later said, “was that on the day of reckoning, our S&P contract would be the first to signal the bad news to the world. And I knew what people did to messengers with bad news.”
He would have been wiser to worry that the Merc’s S&P 500 futures contract would not be first with the bad news.
Trading in the spooz pit on January 23 had bordered on total chaos. Orders were not filled, or were filled late or incorrectly, and trade disputes accumulated throughout the day. The March contract sustained the biggest one-day price swing in its history. “The hectic day was enough to push Shearson Lehman to advise its clients to switch to stock index options on the Chicago Board Options Exchange,” according to one account. “Tempers turned sour and snappish.”
Melamed was atypically undiplomatic, telling the Chicago Tribune, “Traders bitch about a lot of things. When they lose money, they feel a lot better if they can say it’s someone else’s fault.”
In fact, complaints about the S&P 500 pit had been building even before the breathtaking disorder on January 23.
Trading volume on the Merc had increased at the rate of 25 percent a year, and the spooz pit had experienced growing pains on an epic scale. “Traders were falling out of the pit due to the congestion[,] and quotations were running as far as 50 points behind actual real-time prices,” a critical account in Futures magazine noted. Even a top Merc executive conceded that the recent volume and volatility had “stretched the pit to its absolute capacity.” Trading desks at major Wall Street brokerage houses were starting to complain that it was difficult to get spooz orders filled on volatile days. “Brokers and traders began hurling manifold accusations at one another—on the floor and in the press,” a Merc historian noted.
The complaints ranged from poor service to poor ethics. Customer orders sometimes took a backseat to a broker’s personal trades; indeed, those personal trades were sometimes timed to exploit the customer’s orders. One trader might pay off a debt to another by filling a customer order at a price that benefitted his creditor at the customer’s expense. In the chaotic pit, “prices move so quickly it’s often difficult for customers to prove they were cheated,” the Chicago Tribune noted. Errors, which traders had to cover out of their own pockets, were becoming more common and expensive, tempting more traders to cheat to raise extra cash. A reliable audit trail would help with all these problems, of course, but thanks to the CFTC’s leniency, the Merc still didn’t have one.
On February 22, the Tribune detailed a shocking litany of abuses in the spooz pit, noting that “there is even an array of jargon to describe the cheating. Traders typically refer to ‘sleazing’ or ‘burning’ customer orders; floor buddies who received preferential treatment are known as ‘bagmen.’”
The Merc board was already trying to respond. By late February, several committees were looking at trading practices and order processing systems, which were straining to deal with the growing institutional demand. Melamed was able to head off a rebellious referendum, signed by several hundred traders, demanding that all S&P 500 options and futures traders be barred from filling orders for their own account while handling customer orders. Melamed promised reforms, as soon as the board’s research was complete.
* * *
THESE MARKET GYRATIONS had also become deeply worrisome to the LOR partners selling portfolio insurance.
John O’Brien had been cheerfully facing down critics of portfolio insurance for more than a year. He insisted that investors looking for bargains would always be ready to buy when portfolio insurers needed to sell. It was a familiar refrain: if stock prices fell to irrational levels, rational investors would buy them, forestalling a meltdown.
O’Brien sounded pleasantly confident in public, but in private he and his partners were growing concerned that the scale of portfolio insurance would soon exceed the market’s capacity to absorb it.
They weren’t alone. One knowledgeable market figure worried publicly that once the amount of money subject to portfolio insurance reached $50 billion, “the strategy could destruct under its own weight and lead to a market free-fall.” Another asset manager set his threshold of alarm at $100 billion, but added that he was concerned that “the assets of the arbitrageurs and other money managers are not keeping pace” with the portfolio insurers whose trades they normally would offset. These comments were made in a magazine article that estimated that there was about $27 billion in portfolio insurance activity.
But of course, the LOR partners and their licensees alone were already doing almost $50 billion worth of business by the first months of 1987, as the rising but jumpy stock market made their product even more attractive. They were sure copycat products from other firms were growing at least as fast. They conservatively estimated that a minimum of $80 billion already was covered by portfolio insurance, a level that a number of sensible people had identified as a step too far for both the stock market and the futures pits.
There were other sources of uneasiness. Hayne Leland had been severely jolted by the way the markets had behaved during the tremor in mid-September 1986. Why had the S&P 500 index futures traded so far out of line with the underlying stocks on the NYSE, and for so long? The explanation Leland got from a senior executive at one big bank was that there was a temporary imbalance between the amount of money pursuing portfolio insurance and the amount of money doing the index arbitrage that was needed to keep the two markets in line. He was assured that more money was moving into index arbitrage, and that it was highly unlikely such an odd event would occur again.
After January, Leland wasn’t comforted. The huge price swings on January 23, regardless of what had caused them, were just a few steps shy of the kind of market disruptions that could derail portfolio insurance.
As early as 1981, Leland had woven a key assumption into his academic papers about his hedging strategy: “that continuous trading is possible.” That was how academic theories worked; you made assumptions and tested your theories on the basis of those assumptions. It certainly had not seemed to be a stretch back then to assume that the deep, liquid U.S. financial markets generally would allow for “continuous trading,” barring a brief reaction to some abrupt crisis “like the Russians invading Iran,” as Leland put it. Now, he began to worry whether that assumption was still valid.
During a sales trip to London in the second week of February 1987, John O’Brien and Steve Wunsch discussed their concerns about LOR’s signature strategy. From Kidder’s financial futures desk, Wunsch had his own window into the scale and reach of portfolio insurance. At least half his customers had developed competing products of their own to sell.
O’Brien expressed skepticism about John Phelan’s widely publicized meltdown scenario. Could that really happen?
“Yeah,” Wunsch replied. “It could happen. There are a lot of reasons to be nervous about it, at least.”
Wunsch pointed to the circular problem of cause and effect that portfolio insurers faced. “If you are the cause of the volatility that you’re reacting to, then the strategy isn’t viable,” he observed. Attempting to escape volatility that is being caused by your own attempt to escape volatility would be like trying to jog your way out of quicksand.
A few months later, in mid-June, O’Brien was in his office in Los Angeles when he picked up a market report from Wunsch and saw this warning at the top, in boldface type: If the market did not find better ways to handle the so-called “information-less” orders from portfolio insurers and index arbitrageurs, Wunsch wrote, it could face disruptions that “could shake the market apart with uncontrollable volatility.”
O’Brien promptly called his friend in New York: “Okay, Cassandra,” he said, “come on out here.”
He summoned Rubinstein and Leland from Berkeley as well. On the day of Wunsch’s visit, the LOR partners and a few staffers gathered around a table in a conference room to listen to the young derivatives expert’s warnings. Then they tossed around ideas for making portfolio insurance less disruptive to the overall market.
One approach would be to hedge with stock index options, chiefly the S&P 500 option on the CBOE, instead of using the S&P 500 futures on the Merc. It would work better if there were options that were more heavily traded and that ran longer than three months, and the exchange would have to agree to let them build up bigger positions than the rules currently allowed. Still, it was an idea the Berkeley partners thought worth pursuing.
As they talked, the men around the conference table came to feel that the heart of the market’s reaction to portfolio insurance was fear. When traders saw a surge of sell orders coming in, they didn’t know if it was a few portfolio insurers fine-tuning their hedges or the front edge of a vast wave of orders driven by negative news. They didn’t know why the orders had suddenly poured in, so it was understandable that they might overreact.
But what if they did know? What if portfolio insurers such as LOR simply announced before the opening bell that they would be placing certain buy or sell orders that day as part of their hedging strategy? That would allow the traders to summon the buyers or sellers to the market in an orderly way. Trading by portfolio insurers would emerge from the shadows of fearful speculation and into the light of day. As they tossed the idea around, Wunsch observed that he already called this approach “sunshine trading.”
Wunsch ran the “sunshine trading” idea past important figures in the market. Leo Melamed at the Merc was willing to consider it. Wunsch also had friends at the New York Futures Exchange, where futures on the NYSE Composite index were traded. He pitched the notion to them.
“They bought the idea!” he reported back to his Berkeley friends. The NYFE started the paperwork to put the concept to the CFTC. It looked possible that sunshine trading could be a reality by the summer of 1987.
“We can advertise our orders on the Goodyear blimp!” Wunsch joked.
* * *
AROUND THIS SAME time, Paul Volcker decided to step down as chairman of the Federal Reserve when his second term ended in August 1987. He handed in his resignation to President Reagan on the first day of June, and the news was announced the next day.
He would be part of a wholesale shift change in the pilot houses of regulatory Washington. In March, after months of rumors, the White House nominated John Shad to be the U.S. ambassador to the Netherlands, giving him a graceful way out of a job that no longer appealed to him. The ambassadorship was also a reward for having run the SEC for a longer time than any of his predecessors.
Susan Phillips, who had taken over the gavel at the CFTC when Phil Johnson left in 1983, was in the process of lining up a job at the University of Iowa, and planned to leave the commission by late summer.
There had been changes at the Treasury and the FDIC as well. Comptroller of the Currency Todd Conover and FDIC chairman Bill Isaac, veterans of some of the most harrowing financial cliff-hangers of the Reagan years, had both stepped down in mid-1985. And Donald Regan had left his post as White House chief of staff under the cloud of the continuing Iran-Contra investigations. He was replaced by former senator Howard Baker, a genial and politically astute Tennessee Republican whose financial experience was negligible.
And now Paul Volcker was exiting the stage as well.
The next financial crisis, whenever it hit, would find key spots in Washington occupied by novice regulators, unfamiliar with their jobs and with one another.
* * *
ONE OF THEM would be David S. Ruder, the Chicago legal scholar who had helped raise the alarm about the Reagan administration’s early transition report on the SEC in 1981. Ruder had been a bystander to most of the subsequent financial crises, although he had had a somewhat closer view of the Continental Illinois rescue, given his tenure since 1977 as the dean of the Northwestern University School of Law in Chicago.
His conference and committee work had kept him in touch with the legal issues that preoccupied John Shad, and Ruder was similarly tolerant of corporate takeovers and opposed to insider trading. He was not vociferous about deregulation, but he was alert for areas where he felt the SEC was reaching beyond its legal jurisdiction.
On a weekday morning in the third week of May 1987, Ruder was in Washington, attending a meeting of the American Law Institute, when a lawyer he knew tapped him on the shoulder.
She leaned over and whispered, “They want to see you at the White House.” He would find a message waiting for him when he got back to his hotel, she added.
When he telephoned a White House aide a short time later, he learned he was being considered as John Shad’s replacement. He was invited to the White House mess for lunch the next day. Over lunch, two senior aides quizzed him a bit—there were the inevitable questions about his view on takeovers—and then they asked if he was a Republican. He was, he told them, but not an active one.
After lunch, Ruder was escorted to Howard Baker’s office. In the course of their conversation about the SEC chairmanship, Ruder finally asked, “Why am I here?” After all, he said, he wasn’t politically prominent and he’d never been a big party donor, as Shad had been.
Baker explained that Ruder’s name had been put forward by a number of people, but it was clear to Ruder he wasn’t the administration’s first choice. The realization stung a little, but he was still intrigued by the opportunity.
He returned to his hotel and then flew home to Chicago, uncertain what the next step would be. He waited to hear from the president or his chief of staff, but in fact, it was John Shad who called, in mid-June, to tell him that he had gotten the job and to suggest that they meet before Shad left for his new post in the Netherlands.
Ruder flew to New York and took a cab through the light Sunday traffic to Shad’s airy duplex apartment on Park Avenue. Shad told Ruder of the headaches ahead—“The administrative stuff! The budget! The commissioners!” Shad made the job sound almost tedious, but Ruder didn’t let his predecessor’s weariness discourage him.
Shad’s former office would be dusty by the time Ruder finally moved in on August 7, 1987. To his surprise, his appointment was opposed by three powerful senators unhappy about his benign view of takeovers and his lack of enforcement credentials. It took the Senate almost two months to confirm his nomination, with seventeen votes against him.
At the Federal Reserve, Paul Volcker’s successor was the Manhattan-based economic consultant Alan Greenspan, a former chairman of the Council of Economic Advisers and a prominent but pragmatic subscriber to the laissez-faire economic theories of his close friend and mentor, the philosopher Ayn Rand. In 1981, President Reagan had tapped him as chairman of a new bipartisan Social Security commission, whose well-received prescriptions for strengthening the retirement system were enacted in 1983. After an initial delay attributed to the complexity of his financial statements, Greenspan was confirmed easily—a single confirmation hearing on July 21 and a final Senate vote on August 3. On August 11, 1987, Greenspan was sworn into his dream job, chairman of the Federal Reserve.
* * *
TWO DAYS AFTER Greenspan’s confirmation hearing, a House commerce subcommittee opened a hearing of its own, on program trading, chaired by Congressman Ed Markey, a Massachusetts Democrat. The subcommittee heard a remarkable litany of warnings about the fundamental changes reshaping the financial marketplace—warnings that would be totally ignored.
With David Ruder not yet confirmed and John Shad already in the Netherlands, the SEC was represented by its acting chairman, Charles C. Cox. He and the CFTC’s Susan Phillips assured the panel that no legislative action was needed to deal with program trading.
In her written testimony, however, Phillips made an ominous disclosure about the crazy trading on January 23 that she did not mention in her oral remarks: “There was no consensus among the traders concerning what did cause the sharp drop in prices,” she wrote. “Several traders commented that some of the stock price volatility that day was due to the inability of the [NYSE] stock specialists to maintain an orderly market during periods of heavy volume and the lack of sufficient liquidity in the futures market to absorb the large, widespread selling that suddenly developed.”
It was an observation that raised fundamental questions about how well both the Big Board and the Merc had coped with the avalanche of orders on that chaotic day, and how well they would cope if, or rather, when it happened again.
None of the subcommittee members questioned Phillips, or any of the day’s other witnesses, about her revelation.
Another witness, Bill Brodsky of the Chicago Merc, argued that portfolio insurance was just “a twist on an old strategy” called a “stop-loss” order, which allowed an investor to order in advance that his shares be sold if their prices fell to a certain level—to “stop the losses” on those stocks. That, too, should have been at least a little worrisome: stop-loss orders had been in wide use before the 1929 crash, and several historians felt they had contributed to the selling pressure during the early hours of that market debacle.
Brodsky acknowledged that portfolio insurers had been selling heavily in the futures pits during the steep market decline on September 11, 1986, but he noted that investors had eventually “stepped in” to find bargains. Clearly, the markets could handle portfolio insurance selling, even when prices were falling, he said.
“We believe there are investors out there who will not panic or act in an irresponsible fashion,” he said. “There are very sophisticated institutions out there who are paid to be rational investors—and I think some of those people may speak on the panel that follows me today.”
That panel, the day’s third and most instructive one, was nothing less than a tutorial on the most arcane new program trading strategies, led by some of the best-known figures in the business.
Hayne Leland had flown in from Berkeley, summoned to explain how portfolio insurance worked. Steve Wunsch of Kidder Peabody, LOR’s ally in “sunshine trading,” was there, too. So was Gordon Binns, whose huge General Motors pension fund was a major user of many of the strategies being discussed, including portfolio insurance.
They were joined by two other Wall Street insiders who were experts on program trading: R. Sheldon Johnson, a Wharton School graduate now with Morgan Stanley; and Thomas Loeb, the president of Mellon Capital, which had hired many of the trailblazing “quants” who had previously worked at Wells Fargo Investment Advisors in San Francisco.
Johnson was the first to testify. He acknowledged that program trading was used for index arbitrage, and that arbitrage traders would occasionally be selling stocks in a declining market. This was unlikely to lead to a meltdown, he explained, because “extremely hectic market environments do not permit arbitrage transactions to be executed economically.”
That should have rung another loud warning bell with both the lawmakers and the other witnesses. Arbitrage trading was what kept the price of the stock index futures and the prices of the underlying stocks in alignment. If arbitrageurs stepped to the sidelines in “extremely hectic” trading, an imbalance could persist until the two markets were hopelessly out of whack.
No one questioned Johnson about his alarming observation.
Gordon Binns was next, and he candidly conceded that it was possible portfolio insurance could trigger “a downward cascading of prices.” Remarkably, given his stature, no one on the subcommittee followed up on his admission. He was also worried that falling prices would bankrupt small players in the futures markets and lead to a domino chain of defaults. “Some changes to current practices might be useful in this area,” he said blandly.
He was not asked what those changes should be.
Then it was Hayne Leland’s turn. First, he explained that LOR didn’t actually do any program trading, if that was defined to mean index arbitrage trading. He conceded that, for portfolio insurance to work, “the futures must closely track actual stock index levels” and this required the process of index arbitrage, which required program trading.
He also said that his firm was working on ways to reduce the impact of portfolio insurance on the market. Sunshine trading was one way to do that, he said, but it was still awaiting regulatory approval. Another buffer, he continued, would be for LOR to hedge with index options, which had less effect on other markets. Limits on the size of individual positions in the options markets made that difficult—so he urged regulators to raise those limits.
After Tom Loeb of Mellon Capital gave a brief history of index funds and index arbitrage—he said there was currently $250 billion in index funds, which should have been a sobering figure for the subcommittee—it was Steve Wunsch’s turn.
Wunsch seconded Leland’s call for rule changes to permit a greater use of index options and sunshine trading. In his written testimony, however, Wunsch laid out an intriguing theory of what might have happened in the market on January 23, one that supported his case for sunshine trading but raised other questions he did not address.
Imagine, he wrote, that on some quiet day in the market, there were two buyers, each needing to buy $500 million worth of stock, and two sellers, each needing to sell $500 million worth of stock. Imagine, too, that a trade of $500 million would move the Dow up or down by 60 points. Finally, assume that none of the four investors is aware of the trading plans of the others.
“Let’s say Buyer #1 decides to do his buying at 10:00 a.m.,” he continued. That would send the Dow up by 60 points. “Seller #1 does his selling at noon [and] Seller #2 does his selling at 2:00 p.m.,” and together they push the Dow down by 120 points. Then, “Buyer #2 buys at the close,” sending the Dow up by 60 points. “If such a scenario were to occur, I am sure that the papers on the following day would blame program trading.” In fact, the price swings on this hypothetical day would have been caused by the “discontinuous arrival” of giant buy and sell orders at various points during the day.
If the $1 billion in sales could have been paired off at some point with the $1 billion in purchases, there would have been no effect on the market at all, he wrote.
Of course, if all four investors wanted to sell and decided independently to sell at the same time, the Dow would have suddenly plummeted by 240 points on a quiet day with no market-moving news. For Steve Wunsch, his hypothetical day was an argument for using computers to match buyers and sellers before they could whipsaw the market. In hindsight, it was also a powerful warning about the potential impact of like-minded trades by titan investors.
Nobody raised any questions about that, either. After some desultory discussion, the hearing was adjourned.