Market volatility, curbing trades and taxing casinos

A Daily FT article published on 16 August 2010

On my return to Sri Lanka a few days ago, after several weeks overseas, I observed that there had been considerable discussion and debate on the captioned subject in the print and electronic media. A wide variety of opinions had been expressed.

Among them, I found a few to be too liberal, too loose and indeed insensitive in the way they had critiqued the regulator. The response of the regulator may not be the ideal, but no response at all would have been irresponsible.

Players of any sport must understand that a ‘public playground’ must necessarily have equal opportunity of access, the comfort and security to play and the ease of exit for a wide cross section of society. We must not forget that ‘broad-basing’ share ownership was and remains a key end game for the many incentives we have hitherto enjoyed.

Crowds gathering on Wall Street after the 1929 crash

In an emerging economy such as ours, these incentives were necessary to help build the institution we refer to today as a global top performer among capital markets. We must protect that position. We must now build consistency, depth, breadth and stability.

The regulator thus has a statutory obligation to risk minimise and mitigate the implications to the economy, to the local and global reputation of the capital market and to the role it plays as a conduit for fund raising.

It has also to ensure that the capital market is a forum for rational, individual investors whose pockets are less deep than those with many cash cushions to fall back on and who have been enjoying that warmth for two decades.

Criticism is too harsh

Regulating markets, curbing trades or taxing stock market transactions is not without precedent. In fact there are many proposals in the US at this moment to tax the ‘Wall Street casino’. Not to ‘kill it’ but rather to ‘temper it’.

Hence, as a long time advocate of the market economy with desirable and effective regulation, (I repeat with desirable and effective regulation) and as a former member of the Securities and Exchange Commission and as a co-author of several sections of the Strategy for Industrialisation of 1989/1990 through which we brought in exemptions of tax on capital gains and wealth tax on capital market transactions and the value of shares at 31 March (a key incentive of two decades which is at the very core of market volatility), I was taken aback by the tone and substance of certain criticisms of the CSE and the SEC. Some authors have clearly been too harsh.

Dialogue must continue

While it is encouraging to see a dialogue between the regulator and the facilitators of the market, whether they are brokers, investment advisors, market participants or others, it would perhaps be prudent for the SEC and the CSE to engage in awareness building, deeper dialogue, and progress as rapidly as possible to a new legal and regulatory framework more acceptable to all stakeholders.

While all stakeholder segments will never be satisfied – and this is the case with any market anywhere – the regulator need not be intimidated by them. The time has come for a review of rules, regulations, upgrading of hardware, software, trading systems and platforms, as well as the management of perceptions.

The Wall Street Crash in 1929

The Wall Street Crash of 1929 after an economic growth period known as the technologically golden age of the roaring twenties is well known and much has been written about.

In August 1921 the Dow Jones Industrial Average stood at a value of 63.9, and by September 1929, had risen more than six-fold, to 381.2 – an occurrence which did not take place for another 25 years.

But by the summer of 1929, the stock market went through a series of unsettling price declines and on 29 October, known as Black Tuesday, the Dow Jones fell 38 points to 260, a drop of 12.8%. There was continuous selling. By the end of the week, the index stood at 228, a cumulative drop of 40 per cent from the September high.

The regulatory response

In 1932, the US Senate established the Pecora Commission. The Commission’s mandate was to study the causes of the crash. This led to the Glass Steagall Act of 1933, which mandated a separation between the deposit taking commercial banks who grant loans and the investment banks, which underwrite, issue and distribute stocks, bonds and other securities.

Interestingly enough, while George Bush Jr. was faulted for liberalising the financial markets sector which led to the Global Financial Crisis (GFC) of two years ago, it was Bill Clinton who is said to have repealed these provisions, which some fault the GFC on.

Learning from the lessons of the 1929 crash, stock markets around the world introduced measures to temporarily suspend trading in the event of rapid declines. The rationale was that these measures would prevent panic sales. The crash of 1987 was even more severe than the crash of 1929.

The market crash of 1987

I was in Pittsburgh, Pennsylvania, USA when the New York stock market crashed in 1987. It was on 19 October 1987, a date that subsequently became known as ‘Black Monday’.

The Dow Jones industrial average lost 22.6% of its total value. The S&P 500 dropped 20.4%. This was the greatest loss Wall Street had ever suffered on a single day. I recall the doom and gloom on the faces of people that day. In a few hours, billions of dollars of net worth simply ceased to exist.

By the end of October, stock markets in Hong Kong had fallen 45.8%, Australia 41.8%, Spain 31%, the United Kingdom 26.4%, and Canada22.5%. New Zealand’s market was hit especially hard, falling about 60% from its 1987 peak.

I also recall two events the day after. A Wall Street Journal cartoon showing a man hiding under the sofa of a New York apartment and his wife replacing the telephone receiver while announcing to him, “Fred, you can come out now dear, that was not a ‘Margin Call.’” I still have a copy of that cartoon!

The true story of the investor (a margin trader as well) who drove to the condominium of a broker in West Palm Beach Florida and shot him dead was of course, not so funny.  

What triggered the crash?

Market P/E ratios were alarming. The S&P 500 was trading at 23 times earnings. Aside from the general worries of stock market overvaluation, blame for the collapse has been apportioned to many factors.

The collapse of Lehman Brothers was a symbol of the crash of 2008

A number of explanations have been offered as to the cause of the crash, although none may be said to have been the sole determinant.

Among these are computer trading or programme trading – use of computer trading by large institutional investors; derivative securities – the initial blame for the 1987 crash centred on the interplay between stock markets and index options and futures markets; illiquidity –trading mechanisms in financial markets were not able to deal with large volumes of sell orders; US trade and budget deficits - another important trigger in the market crash was the announcement of a large US trade deficit on 14 October, which led then Treasury Secretary James Baker to suggest the need for a fall in the dollar on foreign exchange markets; investing in bonds as an attractive alternative; and  overvaluation – many analysts agree that stock prices were overvalued in September 1987. Price/earnings ratio and price/dividend ratios were too high.

The regulatory response

President Regan appointed the Brady Commission to look into the reasons for the crash and to recommend changes. One of the consequences of this was the introduction of the circuit breaker or trading curbs on the NYSE.

All this was premised on the fact that a cooling off period would help dissipate investor panic and these mandatory market shutdowns are triggered whenever a large pre-defined market decline occurs.

Many feared that the crash would trigger a recession. Instead, the fallout from the crash turned out to be surprisingly small. This phenomenon was due, in part, to the intervention of the Federal Reserve. It took only two years for the Dow to recover completely. By September 1989, the market had regained all of the value it had lost in ’87.

The crash of 2008

I will not comment on the more recent crash of 2008, since many, including myself, have written about it and commented on it. The regulatory response in the US, UK and Europe is also very recent and in the news. All this is worthy of study and at least part adaptation in Sri Lanka.

Nevertheless, I like to comment on a statistic, which if computed and extrapolated, may worry us. However, before doing so, let me draw a parallel. It was in the early 1990s that I expressed concern about our over dependence on the apparel sector, for export revenues and employment – almost two-third in the FTZs. I also commented publicly on our dependence on remittances as far back as then.

I recall drawing an analogy with the portfolio of a corporate, which, say, is over dependent on tourism. As a country, our sectoral dependence and our dependence on a source of inward remittances remain. These need to be addressed.

An alarming statistic

Regarding the crash of 2008, the statistic – perhaps lesser known in financial circles in Sri Lanka – but yet a cautionary statistic I like to share, is of relevance to all in the financial sector, whether in the private or public sector. It is of course of relevance for policy planners and regulators.

That statistic is that, in 2007, at the peak of the economic bubble, the financial sector in the US had become a wealth-creating machine. It accounted for 40% of total corporate profits in the US. Those who worked in the financial industry earned a stunning US$ 53 billion in total compensation in 2007.  Goldman Sachs alone accounted for $ 20 billion of that total, which in turn worked out to $ 661,000 per employee. The company’s CEO Lloyd Blankfein’s take home pay was $68 million!

Here was a nation dependent on the financial sector and a CEO who depended on and heavily benefited from it. While the nation would take time to recover, the CEO would hopefully have invested not in subprime mortgages but rather where he could sustain and maintain a lifestyle of flamboyant extravagance even while being unemployed for the rest of his life!