A Review of Regulatory Mechanisms to Control the Volatility of Prices

The stock market crash of 1987 renewed claims that cash market problems can stem from the trading of futures contracts. The crash also led to proposals for increased regulation to control price volatility. These proposals have antecedents in the Populist movement of the 1890s. Farmers of that period complained that wheat futures trading caused high prices at planting time and low prices at harvest. The tradition of curing cash market problems by regulating the futures markets was well established by World War I. In 1917, the New York Cotton Exchange was pressured into incorporating price limits into its cotton-futures contracts as a solution for price volatility following the German threat of submarine attacks on freight shipments into European ports. After the war, Congress passed a tax on futures transactions that was aimed at solving the problem of low wheat prices. Low grain prices during the early years of the Great Depression led New Deal interventionists to pressure the futures markets to drop the trading of options on futures--then called privileges--and to institute price limits. In addition, contract specifications, including margins on futures contracts, were placed under regulatory oversight. Later, a bout of volatility in onion prices led to an absolute prohibition of trading in onion futures. This prohibition remains in effect today despite evidence developed by Roger Gray that futures contracting probably lowered rather than raised the volatility of onion prices.(1) Today's attention focuses on stock price volatility. As in earlier years, the proposals garnering most of the attention seek to control stock price volatility by regulating futures markets, particularly stock-index futures contracts. This article reviews the evidence on three mechanisms that have been proposed to control price volatility. The first is to increase margin levels. Proponents of this mechanism argue that higher margins would discourage destabilizing speculation. A second proposed mechanism is to set price limits or circuit breakers in futures markets. Proponents of this approach claim it would allow markets to cool off. A third proposed mechanism is to impose a tax on each transaction of a futures contract. Casual descriptions of transactions taxes refer to them as solving volatility by throwing sand in the gears of the futures market. In the sections that follow, we assess the existing research on each of these three methods and their underlying rationales. Margins and volatility There is an immense literature on the effects of margin regulations on trading in financial assets, most of which deals with the effects of margins for stock positions. For political as well as economic reasons, the debates over margins on futures and margins on stock have become intertwined. First, we will look at stock margin studies. Evidence from stock markets Since 1974, Regulation T has required stock purchasers to make initial deposits of 50 percent of the total price of their purchase. Figure 1 plots stock market volatility and Regulation T margin requirements historically. The data are ambiguous on the relationship between the two. If one compares the Great Depression years with the postwar period when margins were federally regulated, it is clear that margins were generally higher and volatility was less after the war than during the 1930s. This suggests that higher margins reduce volatility. Yet studies by Officer (1973) and Schwert (1989a, 1989b) point out that volatility was also low before the Great Depression. Though it is hard to pin down precisely why volatility shifts, it probably has more to do with general macroeconomic conditions than with margins. The postwar decline in volatility may simply reflect a return to normal levels after the turmoil of the 1930s. In 1984, the Federal Reserve Board of Governors assessed the existing research on margins and concluded that Regulation T requirements had no reliable, economically useful impact on volatility. …