Following the sharp market fall, many brokers (with net long positions) were unable to pay margin calls to the clearing house. The clearing house effectively went bust, as its reserves (guarantee fund) were insufficient to pay the brokers with net short positions. To avoid the embarrassment of witnessing the first futures exchange to fail, the Hong Kong Government raised funds to cover the shortfall. The clearing house was therefore able to credit the accounts of brokers with net short positions.

However, this arrangement was purely between the brokers.

Some brokers actually had net short positions with the clearing house but still could not not honour accounts with clients (those with short positions).

The reason for this was due to a net margining procedure that allowed the broker to pay margin to the clearing house on solely the net long or short position of all clients. Hence, although the broker could collect from the clearing house, it still had many clients with long positions that were unable to pay. In the end the guarantee mechanism worked as designed, but end clients still lost through holding an account with the 'wrong' broker.

The diagram below shows a simplified model of the contractual arrangement on a futures exchange employing a net margining procedure. The case is examined of what happens in the event of a large market fall.

There are two futures brokers, each with two clients. Although the aggregate positions of the respective clients differs greatly, their net positions to the clearing house is of the same size (i.e. both net 10 contracts).

In the event of a large fall in the cash market, clients B and D (both holding short positions) would expect to profit.

Client B looks to Broker 1 to receive payment, who will in turn look to Client A to cover its liabilities to both Client B and the clearing house. If Client A defaults, then Broker 1 will have to make payments from its own reserves - although in this case the size of the positions is not large.

Client D looks to Broker 2 to receive payment, who actually has a short position with the clearing house and would expect to receive payment from it. However, Broker 2 has to cover the major part of its liability (to Client D) by collecting from Client C. If the latter defaults, the broker may go bankrupt through liability to Client C, even though there is no problem with its position with the clearing house.

Although Hong Kong is frequently an extreme paradigm, the fundamental structure - although not entirely the regulation - of the futures exchange is comparable to futures exchanges anywhere. The collapse of the HKFE became a very public event, with possibly not a few worldly investors thinking, "only in Hong Kong". However, October 1987 was a shock to futures exchanges everywhere, with many of them escaping only barely the fate of Hong Kong.

In the aftermath of the crash, exchanges introduced, or enhanced, various measures (circuit breakers, price limit moves) to strengthen safeguards; but, like earthquake-proof buildings, the only true test is the next earthquake.

Another result of the 1987 crash was for many participants to check, for the first time, the exact legal standing of these "contracts".

Until 1981, all futures contracts were settled by physical delivery of stock, albeit sometimes a facility for cash settlement existed for convenience. Then the CFTC in the US approved the CME listing of the Eurodollar contract, which became the first contract to be solely cash-settled, with no physical settlement possible.

This opened the Pandora's Box, and there quickly followed many other contracts of a similar structure, most notably stock index futures.

However some market regulators were unhappy with the nature of the instrument. They, quite rightly, observed that a contract for differences bore a very close resemblance to gambling (and if something looks like a duck, and walks like a duck...).

The exchanges would have none of this! In their enthusiastic rush to list new contracts, they argued strongly for the commercial need for a specific contract and would design and represent such contracts to bear as much similarity to a physical commodity contract as possible.

Hence, stock index futures, for example, were described as the equivalent of buying and selling baskets of stocks. This description backfired somewhat, by lumbering the contracts with an awkward definition that confused investors (who tried to imagine baskets of stocks being passed around futures exchanges).

In addition this definition certainly did nothing to help the comprehension of lawyers, who came to grapple with the new instruments. It is not a surprise that today legal documents associated with futures trading are still cumbersome and generally vague.