FOR IMMEDIATE RELEASE 98-87 Division of Market Regulation Issues a Report Entitled "Trading Analysis of October 27 and 28, 1997" Washington, D.C., September 16, 1998 -- The staff of the Division of Market Regulation has issued a report, entitled "Trading Analysis of October 27 and 28, 1997." On October 27 and 28, 1997, the nation's securities markets fell by a record absolute amount on then-record trading volume. On Monday, October 27, the Dow Jones Industrial Average declined 554.26 points (7.18%) to close at 7161.15. This represented the tenth largest percentage decline in the index since 1915. October 27 was also the first time that the cross-market trading halt circuit breaker procedures had been used since their adoption in 1988. At 2:36 p.m., the DJIA had declined 350 points, thereby triggering a 30-minute halt on the stock, options, and index futures markets. After trading resumed at 3:06 p.m., prices fell rapidly to reach the 550-point circuit breaker level at 3:30 p.m., thereby ending the trading session 30 minutes prior to the normal stock market close. On Tuesday, October 28, market prices initially resumed their decline before rallying sharply. The DJIA closed up 337.17 points (4.71%) at 7498.32 on then-record share volumes of over a billion shares each on the New York Stock Exchange and the Nasdaq Stock Market. Immediately following October 27 and 28, Chairman Levitt requested that the Division of Market Regulation reconstruct the days' events. The findings from this reconstruction are discussed in Part II of the Trading Analysis. The Division was also asked to determine the effects of circuit breakers on market price movements. The Commission's Office of Economic Analysis helped analyze the effects of the circuit breakers on the velocity of market price movements and the quality of market- making on October 27. The determinations regarding circuit breakers are discussed in Part III of the report. Finally, the Division analyzed the operational performance of the markets' automated trading, price-reporting, and clearance and settlement systems on October 27 and 28. In conjunction with the Division's analysis, the Commission's Office of Compliance Inspections and Examinations inspected the systems performance of major full- service and online broker-dealers. The findings from these reviews are discussed in Part IV of the report. Overall, the Division's trading reconstruction indicates that the steep market declines on October 27 and the morning of October 28 appear to have been a price correction along the lines of the 6.91% decline on October 13, 1989. On October 27, 1997, the selloff appears to have been prompted by concerns over the potential impact on U.S. corporate earnings of the growing market turmoil in Asia and the repercussions from the potential economic slowdown and deflationary pressures. The Asian market turmoil evidently caused a number of institutional and professional traders to attempt to reduce their equity exposure or increase their hedges in the U.S. markets, either directly through stock sales or indirectly through trades in futures. While various trading strategies and overall liquidity constraints in the stock and futures markets, as well as concerns over the potential early closure of the markets on October 27, may have contributed to the velocity of the price declines, no single factor emerged as the cause for the price volatility during this period. When the selloff reduced U.S. stock prices to attractive levels on the morning of October 28, broad-based buying developed to support a strong, albeit partial, bounce-back in share prices on then- record volumes. The market decline on October 27 was not of a magnitude to offer a true test of how circuit breakers might operate during more severe declines. Nevertheless, the Division believes that the events on October 27 offered several critical insights into the need to change the circuit breaker procedures then in effect. The Division discussed these issues with the securities markets in the context of their revisions to the circuit breaker procedures which went into effect on April 15, 1998. In addition, the Division shared its analyses of the operation of the circuit breaker on October 27 with the staffs of the other agencies comprising the President's Working Group on Financial Markets. The Division's findings regarding circuit breakers are discussed below and were reflected in the Working Group Staff Report on Circuit Breakers, issued on August 18, 1998. First, the circuit breaker thresholds needed to be raised significantly from those in place on October 27. When the 350-point trigger was reached on October 27, the DJIA was down only 4.54%, a level that had been reached on 11 previous days since 1945. Moreover, there was little evidence of the types of market liquidity constraints that would have justified cross-market halts. Circuit breaker halts should be reserved for an abrupt market decline of a magnitude that raises concerns that the exhaustion of market liquidity might result in uncoordinated, ad hoc market closures. Second, the trading dynamics on October 27 illustrated the need for circuit breakers to permit trading to resume whenever feasible for orderly market closings. The early market closure on October 27 does not appear to have been necessary. Moreover, investor concerns that the second circuit breaker would close the market may have accelerated the price declines in the last 24 minutes. Concerns over a likely premature market close may have resulted in a transfer of selling pressure to the futures markets (which offered faster executions in the limited time remaining), with stock prices quickly following futures down to the 550- point trigger level. Third, the events of October 27 reinforced the need for regulators to periodically re-examine circuit breaker procedures to ensure that they reflect both changing market levels and the increasing capacity of the markets to handle greater trading volumes and price volatility in an orderly manner. As markets continue to grow and change, the regulatory agencies and the self-regulatory organizations must monitor and revise circuit breakers and other protective measures to ensure that they continue to function as intended and achieve their goals with minimal market disruptions. Overall, the Division's survey of the securities markets' systems performance on October 27 and 28 found that the operational capacity enhancements undertaken over the last ten years enabled the markets to accommodate the sharp increases in price volatility and trading volumes on these days with minimal delays and disruptions. While some small problems developed in stock and option quotation systems and Nasdaq, the Division found no indications of the types of large scale breakdowns in automated trading systems that had overwhelmed the markets in October 1987. In terms of broker-dealer systems, the staff found that the firms need to do more to evaluate, expand, and test their systems capacities for peak trading periods. In addition, the staff found that online brokerage firms need to do more to improve their customers' access through the Internet, to respond promptly to customer complaints, and to educate customers about the types of access problems that can develop during peak periods and access alternatives that are available under these circumstances. For further information concerning the Division's Trading Analysis, contact John Heine at (202) 942-0020. # # #