Edición 58, Finance

Regulation of Financial Derivatives Markets

By: Gerardo Weihmann,
Professor, ITAM


The imperfections of financial markets, such as taxes, asymmetric information, the risk of bankruptcy, and transaction costs, reduce economic efficiency and thus impair the welfare of society as a whole. Financial derivatives, consisting of forward contracts, futures, swaps and options, have served to increase this economic efficiency in the financial markets by allowing, among others, a better management of financial risks, as well as structuring a relationship between risk and return that is more appropriate to the idiosyncratic needs of each participant, both in investment and in financing.

This article focuses on finance options and examples of how the authorities of the sector have justified a greater regulation of derivatives. Examples are specifically related to the fall of the New York Stock Exchange (NYSE) on October 19, 1987, an event known as “Black Monday.” The regulators ended up blaming mainly the derivatives market of Chicago and not the New York Stock Exchange, when it was actually Wall Street itself that prompted it. On that date alone, the New York stock market fell 508 points, which corresponded to a drop of 23%, the maximum that had ever been recorded in a single day of operations.

Although there are different reasons why an investor might use financial derivatives and, in our particular case, options, The Economist classifies them in five groups: 1) manage risks to reduce or eliminate some, but not others; 2) reduce or eliminate the risk of an asset losing value; 3) take advantage of possibilities for arbitrage, to profit without the associated risk; 4) obtain additional income through the sale (short position) of a put option, taking advantage of an investment (long position) in the underlying asset; and 5) take a leveraged speculation, i.e., try to magnify a gain, for example, to speculate on the appreciation of a common stock or a stock index, by taking a long position in a call option on any such stock or index, paying therefore only the option premium, rather than directly buying stock or the portfolio of stocks that would replicate that index in the stock market, paying the full value of each.

It is important to highlight this fifth and last reason, because it does not exonerate the derivatives market for the fall of October 1987, which became the mechanism that increased losses on the New York Stock Exchange through what is known as “portfolio insurance.”

Basis for the Regulation of Financial Markets

George Stigler, a professor at the University of Chicago and Nobel Prize winner in Economics in 1982, proposed in The Theory of Economic Regulation, of 1971, which is considered a pillar of the modern theory of regulation, that there be a change in the focus of regulation, from a normative economy to a positive economy. Thus, this has involved not focusing regulation on the search for possible causes of failure of markets, such as monopolies, externalities and asymmetric information, but finding the recipients of the benefits and the recipients of the costs generated by a regulation of the markets. Stigler explained that the regulation comes from the very industry it regulates and its purpose is to benefit some industry participants.

Merton Miller, a professor at the University of Chicago and Nobel Prize winner in Economics in 1990, noted that, unlike other areas of economics, finance has not focused the key issues from a public policy perspective, so it has stressed positive economics rather than normative economics and, therefore, the field of market regulation. Professor Miller also has postulated that it is possible that the regulatory agencies are dedicated to very different objectives than those that they claim to serve.

The foregoing has been shown repeatedly in recent times, when it was revealed that some of the key players in the regulatory entities in the United States came from Wall Street, and even more, once they concluded their professional activities in the public sector, they returned to Wall Street (with seven figure salaries, professional fees and performance bonuses). The name “revolving doors” has been applied to this collusion between regulators and the entities they regulate. This conflict of interest was also evidenced, for example, in Charles Ferguson’s documentary, Inside Job (2010).

Effects of Black Monday

Merton Miller wrote in “The 1987 Crash Five Years Later: What Have We Learned” that when recalling Black Monday, the fall of the stock market is usually specifically highlighted, without mentioning other financial instruments which are also listed in the Chicago Board of Trade (CBOT), such as the 30-year United States Treasury Bond in the futures market, an instrument that did not fall but, on the contrary, rose in value at the time. An even greater increase in the price of debt instruments occurred that day in the London market.

In the debt market, said phenomenon originated when investors tried desperately to get rid of their common stock to buy securities that offered greater security. Given this scenario, the net drop of value during Black Monday was much smaller than what public opinion thought. Something similar happened with other investment alternatives, such as real estate, which did not suffer negative consequences on that day.

Another of Miller’s arguments – corroborated by the research of Richard Roll of the University of California, Los Angeles, and showing the little understanding of what really happened on Black Monday – is that the crisis in the financial markets that was triggered in the NYSE, actually started that day, October 19, in Asia, with a significant drop in the stock market in the region, which spread to Europe, in particular to the United Kingdom, before the NYSE opened.

When this commotion that originated in Asia finally came to the United States, it happened simultaneously in the derivatives market of Chicago (CBOT) and the New York stock market. What is relevant is that the effects on the prices of financial instruments in both locations were asymmetric, because the CBOT and the NYSE had different microstructures: What is called “discovery” of prices in financial markets was much more efficient in the CBOT than in the NYSE. Thus, the price decline was greater in the Chicago market than in the New York market, where the continuous fall occurred with a delay.

The cause of this inefficiency in the price-discovery process on the NYSE is that this market has traditionally followed the objective of giving continuity to prices through participants known as “specialists,” who have had the power not only to stop operations once the auction floor bidding has already started, but also to delay the opening of operations while trying to obtain an opposite operation to reduce or cancel the initial exposure. However, since it was essential for the NYSE to report a price that Monday, as it did on any other day of operations, the last reported prices had to be those of Friday, October 16, which were higher than those on the following Monday.

The microstructure of the derivatives market of Chicago allowed the presentation, almost instantly, of the marginal price, i.e., the most recent price, while the NYSE, as a result of the powers of its specialists, smoothed out the common stock prices using moving averages that did not reflect the true fall.

At the moment when operations finally had to start that Monday, the delay in the opening of the NYSE caused a differential to appear with respect to the prices of Chicago, estimated at 7%, between the lower prices given by the CBOT futures market (price of 262) and the higher distorted prices  of the S&P-500 index of the NYSE (price of 282). This differential was particularly unusual, given that normally the futures price is above that NYSE index.

In addition, the reduction in the differential and the convergence of prices between the two markets tends to occur rapidly, but that October 19 it took about an hour and a half, and to complicate matters, the convergence was short-lived, as the representative prices of both markets distanced themselves again,  closing that afternoon on the NYSE with a record differential of 10% with respect to the CBOT. The reason was that the market for each of the common stocks that make up the S&P-500 index opened at a different time, so that its downward adjustment was gradual.

Allan W. Kleidon, then a professor at Stanford University, as well as other colleagues, showed that the fall of the NYSE was not caused ultimately by the derivatives market of Chicago, but by major shortcomings in the mechanisms and internal infrastructure that were operating in the NYSE. Since 1983, the NYSE was in the process of radically changing its infrastructure to an electronic registration system for buy and sell orders, called SUPERDOT (Super Designated Order Turnaround System), which was intended to replace the traditional system of paper ballots and phone calls.

However, in October 1987, the SUPERDOT was not yet functioning fully. Only market orders were operating, but not the limit orders, of which 80% still used paper ballots and phone calls. Therefore, the entry and removal of limit orders in the system was slow, produced bottlenecks and gave the misleading impression that the operations stuck in the system were not closed yet, but in fact many of those were already closed.

These different microstructures caused the erroneous perception that the commotion had started in the futures market of Chicago and spread to New York, where it brought down the prices. This unfortunate erroneous explanation was the mainstay of the Brady Commission, which was responsible for studying the fall in equity markets, to justify greater regulation of the derivatives market of Chicago.

Portfolio Insurance

Another angle of the justification given to strengthen the supervision of the U.S. regulatory authorities on the derivatives markets in Chicago, rather than concentrating it on the stock market of New York, is based on “portfolio insurance.”

Portfolio insurance used by the institutional investors and fund managers is a technique created by Hayne Leland, a professor at the University of California, Berkeley. It consists of creating a long position in a put option. This position is justified in that if the value of a common stock portfolio begins to decline as a result of a fall in the corresponding stock market, a financial instrument is required that increases its value with the fall, to compensate for the loss of value of the portfolio. On the other hand, if the price of the common stock begins to rise, unlimited earnings are sought by not limiting the portfolio earnings, except by a cost derived from the payment of the premium of the financial option. However, in 1987, there was no market of financial options on common stocks large enough to satisfy that requirement; in addition, the cost of the hedging instrument was very expensive.

In 1976, Leland had shown the financial markets how the long position of a put option on a common stock could by reproduced by the cloning of the option. This concept was applied in 1973 by Fisher Black and Myron Scholes, who published the formula for valuing options in the Journal of Political Economy. Coincidentally, a month before publication, the CBOT launched the first market of financial options, the Chicago Board Options Exchange.

To create this synthetic put option , the underlying asset is sold, in this case the common stock, and simultaneously, risk-free financial instruments are purchased, i.e., instruments of the U.S. Treasury. This pattern is repeated until the value of the synthetic option is equal to the value of the correspondingput option available in the market.

A serious problem with this strategy is that if the prices of the common shares in the secondary market (in this case, the NYSE) continue to fall, the value of a true put option automatically increases. The explication is that the option used as insurance is a clone of the true opotion available in the financial options market, so that if the price of the common shares fell, fund managers would have to artificially increase the value of the synthetic option. To meet this objective, more common shares are sold, and with the monetary resources thus obtained (long position), more instruments of the Treasury are purchased. It is obvious that this activity of the managers of large investment funds, such as the pension funds, created a vicious circle that magnified the fall of the NYSE. This was the main argument used by authorities of the financial system to justify increased regulation of the derivatives market.

It is fair to point out that the fall of the NYSE was facilitated by some of its major participants; what the incorporation of the portfolio insurance did was magnify the fall. The characteristic model of portfolio insurance postulated at that time that in response to a drop of 10% in the market of the underlying asset, i.e., of the price of the Standard and Poor’s 500 Index, 20 % of the shares of a supposedly secure investment portfolio had to be sold. The trading floor of the NYSE opened that Monday, October 19, with this strategy and since everything indicated that the market had already fallen 10%, it was urgent then to immediately sell 12 billion dollars in shares, as the total value of the market was 60 billion.

For portfolio insurance to work, the change of prices must be continuous, which means that the stock market must be very liquid at all times. However, since all the participants in the market who had secured their investment needed to sell their common shares, but the participants who had not implemented the insurance were reluctant to buy shares because of the uncertainty of those times, the New York Stock Exchange turned illiquid and, therefore,  portfolio insurance ceased to function as a protective strategy.

In addition, except in the extreme conditions of a globalized economic crisis caused by systemic risk, the losses of some participants are the gains of others, as in financial markets the concept of a zero-sum game also applies. Thus, not only in financial derivatives, but in general, the heavy losses perceived as financial disasters1 have beenactually a simple transfer of wealth from some participants to others, with no damage or with minimal damage to society as a whole. In addition, financial derivatives are not always the cause of these problems, but they are also a consequence of failures in the controls established by the organizations that use them, in conflicts of interest, in lack of judgment and knowledge of some participants, as well as simple frauds.


Managing risks does not mean eliminating them. It is a question of separating the varied economic risks that affect businesses and governments, selecting those that these entities are willing to take and minimizing or eliminating the impact of the risks they do not want and that another entity is willing to absorb.

Many analysts have drawn a parallelism between the crises of the NYSE in 1987 and in 1929. This assessment is incorrect, because although in both cases there was great volatility, the 1929 crisis brought on the collapse of the banking system in particular and the economy in general, and it took several years for the markets to recover. The 1987 crash did not have these negative effects.

It is a difficult task to regulate financial markets because, among other reasons, they offer a participant the possibility of making huge monetary gains in a short period. Therefore, these markets attract the most prepared, brilliant and creative minds.

Unlike public opinion and participants in the financial markets, experts from universities and especially prestigious economists and Nobel Prize winners, agree that financial derivatives have not led to greater volatility and uncertainty in financial markets; rather quite the opposite. They have made the markets safer by allowing them to reduce and control both financial and business risks.

Recent history has shown that self-regulation of the financial markets is not the solution to the crises that have occurred in these areas. However, a lot of regulation has not been beneficial either, especially if the real cause of the problem is not tackled.

1 Like those of Lincoln Savings and Loan (1991), Metallgesellschaft (1993), Orange County (1994), Procter and Gamble (1994), Barings (1995), Gibson Greetings (1995), Eastman Kodak (1995), Salomon Brothers (1995), Daiwa (1995), Sumitomo (1996), The Government of Thailand (1997), Long Term Capital Management (1998), Enron (2001), Tyco (2002), QWest (2002), WorldCom (2002) and Bear Sterns (2008).


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