The Black Monday–25 years later

“History does not repeat itself, but it does rhyme.”
– Mark Twain

Today 25 years ago, on Monday 19 October 1987, stock markets around the world crashed, shedding a huge value in a very short time. The total loss of wealth on just the American stock markets over the following five day period was approximately $1 trillion, according to a Presidential Task Force report on the crash.

Black Monday WSJ

The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already declined by a significant margin. The Dow Jones Industrial Average (DJIA) dropped by 508 points to 1738.74 (22.61%). We were experiencing the first whirlwind tornado of the Age of Derivatives.

Wall Street posterI was a student at the Stockholm School of Economics at the time, and during the autumn semester we studied macro economics. The free fall of the markets was a sobering backdrop of reality to the theory we learned, and the 1980s “yuppie era” seemed to come to an end. The same autumn, Oliver Stones movie Wall Street arrived at the cinemas.

At a first glance the fall of the market in 1987 bear little resemblance to the financial problems we face today. The 1987 crash was not the result of a financial crisis, nor did it lead to a prolonged recession. The 1987 crash was driven by equities trading and the 2008 crises was credit-driven. However, look more deeply at the causes and repercussions of the crash and you find that it “rhymes” with the causes and repercussions of the recent 2008 crisis.

The stock market was overvalued with a high potential to fall, and some of the main causes of the 1987 crash were new and untested financial derivative instruments deployed in the market by software program trading. In addition, it was the first modern economic crash to be a truly global phenomenon, as it spread from Hong Kong to New York and across the globe almost instantaneously.

In 1987 as is the case now, many actors in the market had limited control and order when it comes to compliance and risk management. If you look carefully, the equities evolution toward derivatives spurred by the crash of 1987 is currently playing out in the fixed income space. Up until the credit crunch, and through today, the over-the-counter market remained largely cloudy and non-transparent. To prevent the risks from this, the regulators and the market participants push for increased transparency.

wall streetJust like the crash of 1987, the fallout from the 2008 crisis is significantly shaping the existing market structure. The changing roles of the sell-side and buy-side fixed income market participants is becoming more clear, as is the need for a renewed market structure and new trading protocols.

Regardless of the specific trading protocols that emerge, there is without question, a need for pre-trade transparency to level the playing field for all market participants in fixed income.

The credit crunch was the catalyst for change in the market structure, which for decades concentrated power on the sell side. With increased risk management brought on by the new regulations, the sell side no longer has the same balance sheet and is not capable of holding significant inventories of corporate bonds. Decreasing the chance of execution for the buy side, makes it harder to find the right liquidity. By this new situation many institutions face new kinds of risks.

Last week Lars Egstam, Christer Cragnell, Per Frankow and Hans Lundholm in Bearing ran a seminar with actors in the Swedish financial industry about the current thinking on risk management in the market, mapping out the four areas of risk management that needs to function in harmony in order to make risk management work efficiently.

Risk model

The analysis framework is not difficult to grasp or follow. The challenge lies in its implementation in actual business behavior, where the hurdles to get risk management to work in practice may seem daunting.

Leave a comment

Your email address will not be published.

1 × 3 =