Over the next two weeks, the stock and futures markets will be on trial in Congress. Today the General Accounting Office tells a House committee what it believes caused the Dow Jones industrial average to fall 508 points Oct. 19. Next week, the Senate will conduct four days of similar hearings.
During these inquiries, the spotlight will be on portfolio insurance, program trading, and other mechanisms that have only recently become part of the public vocabulary. The panels will consider what curbs, if any, are needed on these innovative market strategies.
Not surprisingly, the markets dread more regulation. ``There's no question you would drive business overseas'' with new, heavy-handed laws, says John Bachmann, chairman of the Securities Industry Association.
Most people, including Mr. Bachmann, say that something must be done to show that the exchanges and the government are working together to forestall another crisis. The markets seem to twitch wildly at almost anything - even good news, as evidenced Jan. 8 when the Dow plunged 140 points when it heard the unemployment rate had fallen.
Congressmen are concerned because this kind of roller coaster affects not just the stomachs of investors, but the growth of the United States economy, a market specialist on the Senate securities subcommittee notes. ``When the market is so volatile, it becomes difficult for companies to raise money'' by selling stock, he says. In fact, since Oct. 19, virtually all small companies - which employ the vast majority of Americans and often rely on stock offerings to grow - have shelved plans to sell stock to the public.
The danger, says William Brodsky, president of the Chicago Mercantile Exchange, the largest trading facility for stock-index futures, is that Congress will try to legislate stability.
``Volatility is in the market,'' he says, and no new law will get it out. Institutions (not individuals) initiate 90 percent of stock trading, and these institutions are sensitive to the slightest difference in prices. ``They're going to be more aggressive, they're going to act more quickly'' than would a market of individual investors, Mr. Brodsky says.
The obvious scapegoat, Brodsky says, are things like portfolio insurance, program trading, and margins (the cash down payment) required to trade futures.
Portfolio insurance, a strategy to protect stock investments when the market is falling, accounted for 20 percent of futures trading and 10 percent of stock sales on Oct. 19. But many people say the focus on these instruments is unjustified.
``Portfolio hedging is dependent on the ability to transact in the marketplace,'' says Ralph Tate, vice-president of Aetna Life & Casualty, one of the first companies to use portfolio insurance. ``On a day like Oct. 19 and parts of Oct. 20, you couldn't transact at all except at enormous cost.''
The private sector has launched a pre-emptive strike to retain their autonomy. Shearson Lehman Brothers and E.F. Hutton, for example, recently asked employees to refrain from program trading for a while.
Last week, the New York Stock Exchange asked traders to stop using program trading when the Dow swings more than 75 points in a day. The experiment, which lasted a week, was never tested because the Dow did not move that much. John Phelan, head of the exchange, is proposing that traders stop trading a specific stock, for say 15 minutes, whenever it swings wildly.
For its part, the Chicago Mercantile Exchange, or Merc, has imposed restrictions on how much stock-index futures may swing in a given day. If, for example, the Standard & Poors 500 stock index drops more than 30 points (the equivalent of 250 points on the Dow), then trading is temporarily halted. Brodsky says the Merc is reviewing the policy and is ``likely'' to make it even stricter.
But even with these moves, Congress is likely to tighten the reins of regulation to restore confidence in the market. ``In 1933, we imposed some really radical, remarkable regulation,'' says Sen. William Proxmire (D) of Wisconsin, chairman of the Senate Banking Committee. ``But the regulation made the market more responsible, more honest, more reliable, and less volatile.''
The most popular idea today, he says, is to have one body coordinating the different markets. He favors the Federal Reserve Board, though the Fed has demurred. Another idea gaining momentum is to have an advisory board, including the chairmen of the Fed, the Securities and Exchange Commission (which oversees the stock market), and the Commodity Futures Trading Commission (which regulates futures markets).
Congress will look at other ways to restore investor confidence. For example, it will scrutinize ``front-running,'' a form of inside trading involving stock-index futures that is difficult to police. It will also consider ways to make sure that brokers treat orders from individual investors and big institutions equally.