Susan Phillips

Doubts that emerged about the soundness of clearing systems were some of the most frightening aspects of the {1987 stock market } crash. The changes to clearing systems have received far less attention than those to trading systems, but their long-term consequences likely are more profound. Such critical parts of the "plumbing" as the agreements between the futures clearing houses and the settlement banks have been clarified and put on a much sounder footing. In addition, many clearing organizations have established back-up liquidity facilities that will enable them to make payments to clearing members in a timely fashion even if a clearing member has defaulted.

Circuit breakers are widely cited today as one of the successes of the crash post-mortems. But I, for one, question this evaluation. Circuit breakers have never actually been triggered, in contrast to some of the so-called "speed bumps" which affect particular trading strategies and are now tripped routinely. (In contrast to circuit breakers, which are coordinated across the equity and derivative markets, speed bumps are trading restrictions that have been put in place by individual market places.) If circuit breakers have never been used to halt trading, it follows that we have never had the experience of trying to re-start trading either. To an economist such as myself, some of the scariest times during the market crash were those in which trading was not occurring. Our tendency to worry more about stopping trading than re-starting it is mystifying. (I realize that there has been some discussion about the rules for the resumption of trading but the overwhelming attention has been on the halt.)

The Federal Reserve has taken this process of employing new approaches to regulation a step further with its pre-commitment proposal. Pre-commitment allows banks to commit to the maximum loss they will experience over the next quarter in their trading portfolio; this commitment becomes their capital requirement. The proposal gives banks incentives to establish the commitment in a prudent fashion through fines and disclosures if it is violated. Economists in the audience will recognize this proposal as an application of an incentive-compatible approach to regulation.

I suspect that there are far more areas in our regulatory structure in which incentive-compatible approaches could be implemented.

Another theme that emerges is liquidity risk. A fundamental assumption of many risk management procedures is the ability to get out of a position or to hedge it. Events in Asia demonstrated once again that assumptions about liquidity in normal markets rarely hold in more volatile ones. This argues both for a reassessment of the assumptions themselves and for more careful and fundamental thinking about liquidity risk in risk management procedures.