Q & A with Financial Markets Expert Hans Stoll

In May 2012 Vanderbilt’s Financial Markets Research Center hosted its 25th annual spring conference, which featured presentations by former Vice Chairman of the U.S. Federal Reserve Donald Kohn and several other prominent regulators and key industry executives. In honor of the anniversary, Professor Hans Stoll shared some thoughts with Vanderbilt Business about the FMRC’s past quarter century and where it goes from here.

Q. What was the world of finance like when you first began thinking about opening the Financial Markets Research Center?

A. It was the mid-1980s, and derivatives were pretty new. At the time, Bob Whaley, who is now the Valere Blair Potter Professor of Management in Finance, and I had developed a bit of a reputation for doing work in this area. But there were a lot of changes, questions and suspicions about derivatives and other newfangled instruments. In 1986 we had just completed a study of the triple witching hour—when three kinds of derivative securities expire at the same time—which we undertook for the major options and futures markets at the behest of the Securities and Exchange Commission. I then went to Chicago to answer questions being raised by those in the industry. That study helped establish Vanderbilt’s reputation in derivatives and provided a path to the FMRC, which I started in 1987.

Derivatives were pretty sleepy then—mostly related to agriculture—until the exchanges developed into financial derivatives, which caused a lot of controversy and discussion about how they work and how you set up a market for them. The other thing that was going on in the 1980s was in the market microstructures area. Stock commissions were under pressure since being deregulated in 1975. At the time, the New York Stock Exchange set fixed prices for commissions, and they had a lot of rules and regulations in place that protected them. All that was in flux.

So there was this sense that there were new instruments, new innovations like derivatives, the securitizing of mortgage-backed securities, and portfolio insurance, which played a big role in the ’87 crash. That was the atmosphere when the FMRC started.

Q. What was the original goal of the FMRC?

A. The idea was that the academic world could help clarify and bring further understanding to new financial markets. We wanted to be a link to the real world. We wanted to have relationships with companies that would help us understand what was going on and we would help them understand what was going on with our research. Second, we wanted to be connected to the regulators because they were determining exactly what could be done with these new instruments and what constraints they had.

Q. How did the idea for the annual conference come about?

A. I didn’t state it publicly, but my commitment was to have a conference every year. And in fact, it proved to be more successful than I’d anticipated, at least in the sense that it gave the industry an opportunity to talk to academics and also to each other. It provided a kind of neutral territory for everyone.

After several years of the conferences, I was talking to one of the FMRC members and said, “I’m not sure I want to do this conference each year.” And he said, “The conference is the thing. That’s really what makes the FMRC. If you don’t have a conference, you’ll lose the members.” He was right. The conference is what members enjoy, and it’s where the FMRC makes a contribution. We bring together interesting people who are in the trenches when it comes to some of these issues.

Q. So the 1987 crash just happened to provide the perfect topic for the first conference?

A. It wasn’t a full-fledged conference like we have today, more like a panel. But yes, that was the first topic. We held the discussion—and I think a dinner—in April 1988. The title was “Stock Market Crash of ’87: What Have We Learned?” We hadn’t had much time to reflect. So 10 years later, we had the same title.

Q. And what were some of the key lessons about the ’87 crash that emerged at the discussion?

A. The issue came down to whether the crash was caused by new futures and options instruments or by something more fundamental. Was it Chicago, or was it New York? You had this big battle going on.

For the FMRC, the benefit of the industry panel discussion was that the participants conveyed a sense of the terror that people in the exchanges and the futures markets felt when prices were crashing. I mean it was phenomenal—this was a 20 percent drop in one day. There’s been nothing like that since. I was sitting down in the lobby, and the TV stations were interviewing me. It was remarkable.

So what did we learn? There were opinions. I’m not sure anybody learned anything. But I distill the lessons as follows:

• It wasn’t the futures markets. It was a fundamental misevaluation of the stock market. Interest rates had gone up, and when that happens, stock prices usually go down. They went up instead. I think the market realized this and said we’re overvalued, we’ve got to sell. But since the quickest way to get out of the market is to sell stock index futures, that made it look like the futures market was the cause. But it wasn’t. It was just an easier way to trade.
• The other instrument that was a problem was portfolio insurance. It was designed to give investors the right to switch from equity to debt when their portfolios started to fall. That caused a self-cumulative effect that caused stocks to fall some more. Portfolio insurance lost its charm after that.

Q. How did the conferences progress from there?

A. They didn’t get too much bigger. It was always about 50 people—industry people and others from Vanderbilt, professors, students and the like. We also began to have FMRC members like the Chicago Board Options Exchange and the New York Stock Exchange.

The topics have been reasonably narrow for the most part—things like securities markets transaction costs, world financial markets and global risk. In 1999 we had a conference on coping with global volatility. This was two years after the Asian and Russian currency crises and the Long Term Capital Management disaster. Peter Fisher of the Federal Reserve Bank of New York spoke. He was the person who had the meeting with the 10 biggest investors to settle the thing with LTCM before it spread to the markets.

The conferences honoring Dewey Daane, the Frank K. Houston Professor of Finance, Emeritus, always drew big names. We had one in 1989 that Paul Volcker, former Chairman of the Federal Reserve, attended. The Fed Chairman at the time, Alan Greenspan, was there as well, but he only stayed for cocktails. Dewey worked hard to put that conference together. I was impressed. Of course, we had a second Dewey conference in 2009, and Paul Volcker came to that one as well.

Q. One of the conferences lives in infamy as “financial wrestle-mania.” Explain what happened.

A. That was in 1995, on the topic of odd-eighths and what to do about spreads on the NASDAQ market. Bill Christie, now the Frances Hampton Currey Professor of Finance, had written a paper about the topic (which led to a $1 billion settlement against NASDAQ), and he presented it at the conference. We thought it would be just a normal academic conference. Oh, no. There were lawyers and regulators, and all these people came out of the woodwork that we never invited. I looked up and there were three lawyers sitting in the back—you could tell they were lawyers by the way they were dressed. I said, “Who are you?” They said, “We represent the defendant, NASDAQ. We just wanted to see what was going on here.” Nobel Prize-winner Merton Miller had been hired by NASDAQ to present their point of view, which he did at the conference. His line was, “You don’t buy three-eighths of a pound of bologna, you buy a quarter-pound or half-pound.” Things got pretty heated. The local paper called it “financial wrestle-mania.”

Q. Looking over 25 years of conferences, what are your big takeaways? How has the world of finance changed in that time?

A. It’s dramatic how the market microstructure work that we’ve done here and elsewhere has had an influence on the sweeping changes that have occurred in the business of trading securities. The automated exchanges, the decline in the bid-ask spread, the position of the New York Stock Exchange—the fact that some European company is ready to buy it is a phenomenal event when we think that here’s an exchange that was founded in 1792 under a buttonwood tree. And suddenly it’s gone as an institution that had so much power. Ultimately I think it’s a good thing that some of that power has declined. Look at commissions: You can trade for $8 what used to cost you $800. That’s a tremendous reduction in cost and increase in efficiency.

The other big change that we’ve been involved in is derivatives. I think they have helped make markets more resilient, deeper, better, cheaper. Have we protected ourselves against every accident or mistake? No. There will be future problems. Whenever you innovate, you don’t do it right the first time. So the crash of ’87 was an equity crash, and the crash of 2008–2009 was a fixed income and banking thing. They’re different. You don’t learn very much about one from the other. You just have to be ready to handle whatever comes, to have the mechanisms in place and have resilient markets that can withstand these shocks.

Q. What’s next for the FMRC?
Another 25 years?

A. I don’t know. The future of the FMRC is on good footing in terms of its endowment. It can do interesting things, and I think it will. I don’t want to do conferences just for the sake of doing conferences. They should be interesting, and if people find that they’re not interesting then we should stop and do something else. But my guess—my hope—is that they’ll continue. I don’t know who’s going to do them or how we’re going to do them, but I suspect we’ll try to continue the conferences. The FMRC will continue for sure. This school and this finance group are well-respected and well-connected in the real world of industry and regulators. We have this important link to what’s going on in the business world. The FMRC helps maintain that.