Almost two years after the unprecedented October 1987 crash, we are still haunted by questions about what went wrong. There is a lingering feeling that the financial system, and our securities markets in particular, may be flawed in some fundamental way, but there is no emerging consensus on what that flaw might be.
Stock market volatility has been at the center of this debate. Rising in October 1987 and in subsequent months to levels seldom seen during the history of securities markets, volatility became a lightening rod for critics, synonymous with excessive and destabilizing speculation. In response a number of proposals to reform securities and futures markets have been advanced. Although volatility has declined to more normal levels in recent months, there remains a suspicion that speculative excesses lie just beneath the surface, ready to burst out at any time and destabilize markets.
This concern has been reinforced by the failure of the public to return to equity markets. The volume of trading in equity markets, and in particular by retail customers, is only a fraction of what it was before the crash. The result has been retrenchment in the securities industry coupled with an energetic search for alternative profit opportunities.
Leveraged buyouts have been one of these. Ironically, such takeovers, which have doubled or tripled the stock prices of targeted companies in just days, have only fueled the concern about volatility and speculative excesses. What could account for such a large change in the value of a firm in so short a time, it is asked? Is it simply the trickery of "financial engineering"? The arguments in support of and against leveraged buyouts are complex and subtle. For most investors and legislators they are difficult to evaluate. Prior beliefs, and political and philosophic dispositions, unfortunately, often determine whether these activities are viewed favorably.
Volatility also is frequently seen as a consequence of the spectacular growth of trading both in securities and futures markets. On the New York Stock Exchange more shares were traded during an average week in 1987 than were traded during all of 1960. As active as stock trading is, however, it is dwarfed by trading in government bonds and foreign exchange: a daily value of $25 billion and nearly $300 billion, respectively.
In futures markets trading skyrocketed from less than 4 million contracts in 1960 to nearly 250 million contracts in 1988-more trading each week in 1988 than in all of 1960. More than half of this remarkable increase is attributable to the innovation and growth of futures trading in financial instruments--government bonds, stock indexes, eurodollar deposits, and foreign currencies.