Lessons of reform from Black Monday

ON Oct 19, 1987, following three days of decline in the New York stock market, the Hong Kong market dropped 10.5% after a rise of 89% in the earlier 12 months.

It was Black Monday, when the New York stock market plunged, triggering a severe worldwide stock crash.

In US dollar terms, eight global stock markets declined by 20%-29%, three by 30%-39%, and three (Hong Kong, Australia and Singapore) by more than 40%.

The total losses were estimated at US$1.7 trillion or just under 10% of world gross domestic product (GDP) in 1987.

The following Tuesday, the chairman of the Stock Exchange of Hong Kong (SEHK) informed the financial secretary that the SEHK would suspend trading for the week, with the Hong Kong Futures Exchange (HKFE) following suit.

There was fear of panic selling, disorderly markets and inability to settle as clients were not meeting their commitments.

The global meltdown was halted by the US Federal Reserve stepping in to provide liquidity, as everyone remembered the October 1929 Great Crash, which marked the beginning of the 1930s Great Depression.

In Hong Kong, US$4bil worth of liquidity loans were provided, half by the exchange fund and the rest by the leading banks.

On Nov 16, 1987, the governor appointed the Securities Review Committee (SRC) to review the constitution, management and operations of the two exchanges and their regulators.

The SRC chairman was Ian Hay Davison, who was formerly managing partner at Arthur Andersen, the leading US/UK firm of chartered accountants, and also chief executive of Lloyds, the London insurance market.

The people who took part in the Davison Report was the who’s who of Hong Kong and international finance, such as Philip Tose, a member of the SRC and later of Peregrine fame; Paul Tucker, seconded from the Bank of England who rose to become deputy governor; and Carrie Lam, later chief executive of Hong Kong SAR.

The Davison Report concluded that “the concept of self-regulation and market self-discipline had failed to develop in Hong Kong.

What is equally unfortunate is that, the supervisory bodies charged with overseeing the markets had lost effective control”.

It recommended the establishment of an independent securities market regulator, the Securities and Futures Commission which materialised in May 1989. It celebrates its 35th anniversary this year.

Since 1987, financial crises seem to repeat every 10 years, with the Asian financial crisis occurring in 1997/98 followed by the US sub-prime crisis, global financial crises of 2007/2008.

Each financial crisis ended up with massive central bank intervention and regulatory reform, but the financial markets kept becoming more complex, interconnected and entangled.

The 10-year crisis pattern was somewhat broken when no major financial crisis happened in 2018, mainly because central banks have learnt to step in to provide massive liquidity through quantitative easing or balance sheet expansion.

Stock markets, as well as real estate markets, strongly correlated with interest rates, affect overall economic confidence.

At the end of 2022, stock market capitalisation was US$98.6 trillion or 21% of total global financial institution assets, or equivalent to 97% of 2022 world GDP.

Curiously, in 1987 the SEHK market cap (US$54bil) was already 106% of Hong Kong GDP.

It was in recognition of the interconnectedness of stock and financial markets that the SEHK, HKFE and Hong Kong Clearing were merged into the Hong Kong Exchanges (HKEx) in 2000.

Since then, the landscape of global financial markets was transformed profoundly, as turnover in volume, value and speed rose with the addition of new derivatives and new technology.

As exchange traded funds (ETFs) reach market value of US$14 trillion and cyber-currencies now are valued at US$2.2 trillion, new tech-driven market makers like Jane Street and Citadel Securities – which trade across multiple markets – are rivalling established investment banks in market power and profitability, as reported in the Financial Times.

In 2021, a US House Finance Committee expert review claimed that one single market maker could trade “approximately 26% of US equities volume” and “execute approximately 47% of all US-listed retail volume, and act as a specialist or market-maker with respect to 99% of traded volume in 3,000 US-listed options names.”

In China, the joint announcement by the heads of the People’s Bank of China (PBoC), the National Financial Regulatory Authority and China Securities Regulatory Commission, which preceded the stock market run-up in Hong Kong and Mainland stock markets, showed how the authorities understand that banking, insurance, fund management, securities markets and real estate are deeply inter-related.

On Oct 10, the PBoC announced the creation of a 500 billion yuan “Securities, Funds and Insurance Companies Swap Facility” to support qualified securities, funds and insurance companies to use bonds, stock ETFs, CSI 300 constituent stocks and other assets as collateral to exchange for high-grade liquid assets such as treasury bonds and central bank bills from the PBoC.

Financial markets are complex ecosystems because they are deeply entangled with each other, with foreign markets influencing domestic markets and vice-versa.

Add to this mix the rise of deep technology, artificial intelligence, demographics, geopolitical rivalries and natural disasters and a need arises to understand what is happening, act fast and address key structural issues.

The legacy of silo’ed, top-down bureaucracies and specialist agencies to manage deeply entangled financial institutions is no longer adequate to cope with the emergence of new products, markets and institutions that arbitrage new regulations faster than lawmakers can manage.

Few can understand the complexity of market products or their rules and regulations.

There is a bitter lesson from financial crash history: If you don’t reform early enough, financial crises force you to reform.

It’s not just the instant market volatility that matters, there are deep structural forces at work which we need to understand, sometimes beyond the powers of any single national regulator.

Surviving such complexity needs the humility to listen to how markets are changing by the minute.