The adequacy and consistency of margin requirements in the markets for stocks and derivative products.

THE ADEQUACY AND CONSISTENCY OF MARGIN REQUIREMENTS IN THE MARKETS FOR STOCKS AND DERIVATIVE PRODUCTS

Margin requirements play an important role in protecting markets during crises such as the stock market crash of October 1987. Regulated by government or by private organizations, depending on the market involved, margins constitute a performance bond posted by noncash investors in stocks, by investors in financial futures, and by sellers of financial options. The margin, which can take a variety of forms such as cash, Treasury securities, stocks (at a fraction of their current market value), or letters of credit, is tangible evidence of the ability of investors to meet their obligations under nearly the full range of likely price movements.

Deciding how much margin to require involves a difficult issue of balance. On one hand, the amount must be high enough to give customers an incentive to meet their commitment and to protect brokers, clearinghouses, and other lenders against losses if investors default on their obligations; on the other hand, the amount must not be so high as to drive participants from the marketplace. In the interrelated markets for equities and for equity options and futures, the issue of the proper balance is especially delicate. Inconsistent levels of protection in the three markets can create serious distortions in activity.

Some studies have examined required margins in the equities market, others in the markets for financial futures; they have found the size of the required margins generally to be more than minimally adequate to protect participants from loss. This study is the first to assess the adequacy and consistency of margin requirements in all segments of the equities market--cash, futures, and options--and the first to combine a broad institutional description of margin arrangements with a detailed statistical analysis of margins and prices before and after the crash. The study reaches the following conclusions:

1. Differences in clearing arrangements, in the liquidity of the relevant investor groups, and in price volatility allow margins on derivative products to be lower than those on stocks and still provide protection equivalent to that obtained in the stock market.

2. For futures contracts on the Standard & Poor's index of 500 stocks (S&P 500) and on the New York Stock Exchange Composite (NYSE) index, the pre-crash margin requirement on existing positions (maintenance margin) provided clearinghouses a lower level of protection against price moves than that provided in the stock (cash) market. Before the October 1987 crash, the maintenance margin in the cash market was adequate to cover 98 percent of likely price changes based on prices from January 1986 through April 1988. The maintenance margin on the S&P 500 futures contract would have had to have been 22 percent higher, and that on the NYSE contract 80 percent higher, to provide 98 percent coverage. The protection on the contracts before the crash was lower than the protection in the cash market even if the sample period for prices stops in early October 1987, before the market crash.

3. The pre-crash level of protection provided by margins on at-the-money and in-the-money options was adequate and consistent with the level of protection provided by margins in the cash market. But the level of margins on out-of-the-money put options may not have provided adequate protection. This conclusion is buttressed by complaints from individual investors, who dominate the market for stock options, about excessively quick, involuntary liquidations of their option positions when margin calls were made during the stock market crash.

4. During the October 1987 crisis, the frequent intraday margin calls, the increase in the level of margin requirements on derivative instruments, and the absence of cross-margining may have exacerbated liquidity problems and helped raise concerns about the financial health of the clearinghouses. These liquidity problems and concerns about the clearinghouses might, in turn, have contributed to the break in the arbitrage link between the cash and derivative markets that sent markets into free fall on October 19.

5. The increases in the margin levels for futures and options contracts during and shortly after the October crisis yielded the clearinghouses protection even greater than that provided by margins in the cash market. More recently, however, margin levels have been reduced on futures contracts and in some instances the level of protection provided as of June 1989 is less than in the cash markets.

These findings suggest that proposals for margins of equal percentage across all segments of the market could be harmful to the markets' well-established mechanisms and their overall liquidity. But because the various market segments do indeed net out to one market, weakness in one segment can lead to weakness in others. Hence proposals for margins that produce equal protection from risk in all segments of the market could strengthen market mechanisms and are worthy of consideration.