Better Option? Instead of Killing Program Trading...

November 1987
By Kathryn M. Welling

INDEX OPTIONS and futures. Even a casual mention of these "derivative" trading instruments on which program trading and portfolio insurance depend elicits emotional responses on Wall Street in the aftermath of Massacre Monday. In a pinstriped confrontation that threatens to rival that of the Hatfields and McCoys, traders, brokers, investment bankers and investors, both institutional and of the human variety, are lining up, either for 'em or against 'em.

There is, it seems, no middle ground. But that's precisely where the answers lie, according to Robert Kanter, a not-yet-50-year-old trader who boasts over 28 years of hands-on market experience, as a specialist on the floor of the American Stock Exchange, as a market maker on the Chicago Board Options Exchange and, most recently, as an off-floor trader who risks several million dollars of his own capital, mostly by taking arbitrage positions of the traditional inter-market variety. (He's not a takeover player or "risk-arbitrageur," he hastens to make clear.)

Index options and futures have perhaps no bigger fan than Bob Kanter, particularly when they're used to adjust portfolio risks. The George Hamilton lookalike, whose carefully coifed hair, monogrammed shirts and silk pocket handkerchiefs belie his profession's rough and tumble image, is nonetheless never more at home than when in the trenches, trading. Or failing that, than when talking trading. Kanter was one of the first New Yorkers to buy a membership on the infant CBOE. The allure of gapping price disparities on that nascent exchange proved so great that, foresaking his Amex specialist partners, he moved his family to Chicago in the early l97O's and started making the first active market in IBM options.

Not exactly a shrinking violet, Kanter soon found himself up to his eyeballs in exchange politics. He was elected to the executive committee of its board of directors and was a founder and first president of the CBOE's Market Makers' Association. He was instrumental, too, he recalls, in getting the CBOE and New York Stock Exchange to implement some rules and change a few practices to greatly reduce the incidence of front-running and similar dastardly practices in equity options.

Yet, good as Chicago was to him, later that decade, the Big Apple re-exerted its pull. These days, Kanter works out of a couple of computer-crammed and paper-strewn rooms at 111 Broadway, a building fairly encrusted with Wall Street's past - tarnished brass, worn marble and all. Still, only a stone's throw from the floors of both of the nation's major stock exchanges, Kanter's business remains at least as closely tied to the city by the lake.

Since 1979, Arbco, Kanter's trading and investment management firm, consisting of just eight floor traders and four up-stairs traders, has bought and sold over one-half million options and futures contracts annually. And practice, in trading as in most other endeavors, makes - if not perfect - at least better. It was deft trading, mostly of index vehicles and other derivative products, that produced a $500,000 profit for Kanter's small firm in the volatile two-week stretch that started on Black Monday.

In a nutshell, Bob Kanter has as vested an interest as you'll find in the options and futures markets. But Kanter will also tell anyone who'll listen that the index options and futures markets are fundamentally flawed - so flawed that, especially when combined with the awesome trading power of the Street's block positioning desks, they are destroying public confidence in the markets. That, notes Kanter, amounts to killing the goose that lays the golden egg. And he, for one, has the good sense not only to be against it, but to work out some proposals for restoring orderliness and a modicum of fairness to the markets.

Unlike most of the others lining up on one side or the other of the portfolio insurance and derivative instruments controversy in the wake of October's marketquake, Kanter didn't just climb onto this hobbyhorse. While he may be lacking the archetypical trader's cigar-chomping gruffness, he's amply endowed with another of the breed's necessary traits - a boundless and resilient ego. Thus, over the last several years, not a few senators, congressmen, SEC, CFTC and exchange officials, have been given the benefits of Kanter's views.

His delivery, then, is practiced as well as rapid-fire. And though it's peppered with the arcane argot of traders - "spooze" referring to the S&P 500 futures not to mention "butterfly" and "box" spreads, or even "hybrid conversions", the definition of which you probably don't want to know - Kanter seems quite willing to keep repeating his message until it sinks in.

As Bob Kanter, professional trader, sees it, most of the Street's current woes can be traced to a common root: liquidity or, more precisely, a lack of appreciation for its importance. He's not talking here about whether the Fed is acting sufficiently generous at the discount window, either. When he talks liquidity, Kanter is referring to the market's depth. Are there enough sellers to match with buyers, or vice versa, to meet demand now - and how about if the market goes on a tear up, or down, several hundred points?

"I had the good fortune to learn the business from an old master, a real blood and guts trader, who understood liquidity and respected its cost. Markets were healthier in the old days. Over the last several years, that respect has been obliterated. I was trained to realize that the price of a stock was only one element in one's ability to turn that security into cash. You also have to be able to sell it, or buy it back, if short, at a reasonable price. That's something that portfolio insurers forgot about. . . They forgot that what they really had was short-duration term insurance, seller's option to renew. They refused to believe a time would come when they couldn't renew at a reasonable price. Well, it did.

"As a specialist, I always included a 'lights-out' example of illiquidity in pricing deliberations because we'd learned the hard way that, at times, normal liquidity doesn't exist, particularly when the market is dropping or rising quickly, and the cost of liquidation becomes exorbitant. . . But portfolio insurers thought that the market's liquidity would go on forever. That there would always be someone to buy the spooze they shorted and then sell stock in a down market."

In simple terms, according to Kanter, the academics and computer jocks who designed portfolio insurance were long on theory, but dreadfully short on practical sense. "They didn't anticipate the mechanical problems of a market in the midst of a panic. The severity and short-term nature of the drop, combined with the disorderliness of the drop, exacerbated their difficulties." With the tape running hours late, computers evincing signs of nervous exhaustion and the panic at fever pitch, the program traders and others who ordinarily would have been expected to take the other side of the portfolio insurers' trades stood aside. "You couldn't even get through on the telephone, much less get an execution - what program trader or arbitrageur is going to put on a spread at a time like that? He could get unlegged or have any number of terrible things happen to him."

Yet bad as Massacre Monday was, says Kanter, it could have been much worse. But for an accident of the calendar, he avers, the panic would have resulted in the kind of financial meltdown that New York Stock Exchange Chairman John Phelan also has been vocally warning about. And then, "the dimensions of the disaster would have been enormous."

According to Kanter, the root of the problem is the cash settlement feature of index futures and options, which flies in the face of literally centuries of market experience. It creates a liquidity imbalance in the marketplace by allowing one group of players to exit the game without paying all their dues. "The core of the problem is the cash settlement, where you can sell billions of dollars of stock to a number, without the characteristic liquidity considerations that have been an inherent part of all markets - until these products."

Kanter points out that if an investor wants to sell a stock, he (or his broker) has to find someone willing to buy it at an agreed-upon price. If he wants to close out a long futures contract, he has to find someone to sell it to. Only when someone else takes an offsetting position, in other words, can an investor generally convert a securities position to cash. And this matching of buy and sell orders is what tends to impose a semblance of order on the markets. But with cash settlement options and futures, an investor can just go to a "casino window" and cash in his chips, and all the other players be damned.

Just suppose, Kanter posits, that instead of occurring, as it did, soon after the expiration day of an active options and futures series, Massacre Monday had happened a day or two before, when there was a large open interest in profitable index vehicles. Suppose, too, that the selling really started in earnest in just the last hour or half-hour of trading. Fearing a rout the next day that would wipe out their paper profits, holders of in-the-money (profitable) options or futures positions would rush to cash them out - something that they can do even after the market closes, up until 4:15 pm, in fact.

The next morning, Kanter explains, the unfortunate investor who held the other side of those long positions - who'd most likely been short the "synthetics" (index instruments) but long the "naturals" (stocks) - hedged, in other words - would find his hedge unravelled. In Kanterese, he'd have seen his spread unlegged and involuntarily ended up naked long in a market that, for whatever reason, was in a free-fall, producing a liquidity crunch that would make a 5OO point drop look like a picnic in the park.

"It would be a steamroller, because the clearing agents would have seen the unravelling coming when index vehicles were cashed out prematurely. So they would force liquidations of the unravelled market participants' naked long positions, further exacerbating the strains on the specialists and everybody else. . . .They would have had to close the markets."

No one is happier than Bob Kanter that his worst fears weren't realized in October. And he's hoping that the exchanges, or the regulators, will take steps now to prevent them from ever coming true.

But what's needed, he says, is nothing so draconian as a ban on index futures and options, or even on portfolio insurance or program trading. He is one professional investor who doesn't dispute for one minute the economic benefits of the various sophisticated techniques that have been developed to try to adjust portfolio risks. What's needed, Kanter says, is to replace cash settlement of index vehicles with settlement in kind.

"Like in the old days, if you wanted to cash out, you had to go smile at the specialist and say '40,000 for sale'. And the specialist would gather orders in an orderly way to liquidate your position at the best offers."

Kanter acknowledges that settlement in kind would involve higher transaction costs, and lots of other thorny problems in the cases of market-weighted, rather than price-weighted, indexes, but he insists that those roadblocks shouldn't prove insuperable, particularly in the era of computer-intensive trading.

"It's just a matter of costs. And some market participants have just discovered that they couldn't, after all, avoid the liquidity costs of their trading, when they all hit at once, on the tail end of the move. Maybe it'd be healthier for the market to have those costs paid as they're incurred."

Nor are those the only benefits Kanter sees in eliminating cash settlements. It would be far more effective in eliminating triple-witching hours and all the other volatile side-effects of program trading than any of the "Bandaid" approaches the exchanges have tried, he suggests. "If they faced actual delivery, like in other options, people who were going to roll over positions would do so in an orderly fashion in the weeks prior to expiration, rather than compressing their trading into the end, because they'd never risk subjecting themselves to delivery. As it is now, if a program trader doesn't liquidate, the worst case is that he has to cash out on one side on delivery day and place market-on-close orders on the other side. Then, he's out. With settlement in kind, just to make sure that he wouldn't get stuck with another basket of stocks, a program trader would spend the three weeks prior to expiration working off the hedge he'd put on two months before. And the narrowing of the spread, over time, would make the whole market more orderly."

Then too, insists Kanter, cash settlement makes the markets inherently subject to manipulation. Because of the lever available in options, he notes, "theoretically, a smaller amount of stock, relative to the dollar value of the long option, could be employed in a buy program at the end of the day. Someone - granted, it would have to be a large market force - could spend, say, $340 million to run the market up 20 points at the close. Then, in effect, cash out of $800 million worth of options."

If there were settlement in kind, says Kanter, that maneuver wouldn't be worth the effort because the investor would end up not with cash, but with stock, which he'd have to sell back into the market. "And Joe Public, who now sells the stock at 52 at 2 p.m., only to see it gap up to 56, 'due to program trading' at the close, would have a much better chance of seeing a more orderly market."

By this point in his discourse, Kanter is really rolling. He turns to "my last pet peeve." It's a complaint that he can't document, but insists comes from his years of tape-watching experience. Something has to be done, Kanter says, about the "tape-racing" and other manipulative practices which he says amount to trading on "inside market, as opposed to corporate, information." These practices, he asserts, have evolved as derivative products have been developed at the same time that the balance of trading power on the Street has shifted from exchange specialists to the major houses' block trading desks, which buy and sell stocks not only on an agency basis (for their customers) but as principals. "The securities laws, written in 1933 and 1934, obviously say nothing about derivative products. We need something on the books that says that trading in derivative products with the intent to utilize privy knowledge - of a pending buy or sell program in stocks, for example - is illegal."

Recalls Kanter, "As a specialist for 15 years, if I became aware of a big order, I had the obligation to evidence that potential supply or demand to all market participants." He complains, "The block houses have no such obligation. They, in effect, use their agency business to enhance their principal transactions."

His solution is not to return to fixed commissions, even though the end of that era is what forced Wall Street firms to try to wring bigger profits out of trading operations. "You can't be a radical and try to tear apart a market structure that's been built up over 12 years. But you could require, via computer links, for example, that the relatively large agency orders be disseminated to all market participants. Then, anyone who wanted part of a block could put his bid in and have a chance to participate instead of being whipsawed."

For a trader who prides himself on keeping his cool in the midst of chaos, Kanter can really work himself up. "All these little things," he insists, "are what tend in the long run to destroy public confidence in the markets."

Exerpts from BARRON'S (November 23, 1987)

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