The stock exchange in Paris called The Paris Bourse was formed by Napoleon’s decree in 1802. It’s said that this decree set the basic structure for the stock exchanges in the 19th century. One of the major thrust was to give monopoly to agents de change (stock brokers). Only registered stock brokers could trade in securities on behalf of their clients.
Also, brokers were forbidden from carrying out a trade on their own accounts. After much deliberation, 60 brokers were given the permission to trade. They had to submit a bond worth 100,000 francs to get a seat on the stock exchange.
Napoleon’s decree only permitted trading in the cash market – a broker must possess the securities before they are sold and also cash for buying the securities. This decree strictly prohibited trading in the forward market. Let me try and explain the forward market.
In Napoleon’s view a forward market brings in speculation and hence he prohibited trading in forward /futures market. However, slowly unofficial forward market became bigger than the official cash market. While representations were being made to the government to legalize forward/future market the government was firm on its view. Dabbling in a forward market was considered illegal. Thus, if one of the parties defaulted on the agreed terms, it could not be challenged in the court of law.
The crash of 1882 is about speculations that gripped the market because of dabbling in a forward market. It was further fuelled as banks and financial institutions started funding the forward market at hefty interest. Money (call money) was lent on a daily basis. Thus, an investor with not enough money to even pay the deposit (margin) could borrow and dabble.
In 1875 a gentleman named Eugene Bontoux formed a bank called Union Generale. This was the time when France was at its peak of glory. Financial markets were performing well, industry was growing, the railway had enhanced commerce operating on full scale and the Suez Canal had played its role.
Bontoux wanted to capitalize on the boom. Also, he wanted to widen his reach to Austria and other countries of South Eastern Europe. Union Generale used to offer high interest to attract depositors. Deposits collected were used to finance Trade & Commerce. Union Generale quietly used to fund all money in The Paris Bourse. Many a times, call money was lent only to rig Union Generale’s stock.
In 1881, Bontoux expanded is operations and formed the Austrian Osterreichische Lander bank in Vienna and later in Hungary. All his financial institutions were interlinked. Every new institution was owned by a previous institution and the eventual owner was Union Generale. Thus, if one of them was to crash, all would tumble.
As mentioned these were the years when trade and commerce were booming. The stock market index (constructed later) which stood at 156 in December 1879 rose to 184 within a year – rise of 18%. By December 1881 it touched to 222 another rise of 20% in a year. New companies were floated and new public offerings were being made. Union Generale would also fund those issues. Towards the end of 1881, the Paris Bourse wrote in its report that speculation fever is gripping It sufficed to announce a new company sell it shares and launch a new one. Companies were floated purely to raise capital, which would be used to dabble in the unofficial forward market.
As the market kept up, the rate of interest on call money kept increasing. From around 4% towards the beginning of 1880, it zoomed to more than 15% towards the end of 1881. In January 1882, the call money inters on stocks which were rising fast like Union Generale attracted an interest rate of 29%.
At this juncture some wise investors and banks which were lending on call money curtailed heir activities and slowly started withdrawing money from the market. The news that individuals and institutions were withdrawing from the market spread thick and fast. Then panic set in. Unfortunately, the panic was not restricted to the market alone.
As deposit holders of banks knew that their money was also being lent as call money, the run on banks became common. On January 18, 1882, Banque de Lyon had to close its doors as it did not have enough money to return deposits. This incident created a run on other banks as well.
As the stock market crash widened, investors who were dabbling in the forward market decided not to pay for the securities. As the forward market was not legalized, defaults could not be contested in a court. As a result, the market crash deepened.
The crash in Paris was predominantly one because of dabbling in forward/future market. Forward/futures are derivatives instruments as we understand them today. According to the legendary investor Warren Buffet, derivatives are weapons of mass destruction. May be he is aware of the Paris Crash of 1882.