Reversing course after Friday’s emergency ban on short-selling, the Securities and Exchange Commission this morning granted options market makers permission to sell stocks short to support their market-making activities. The turnabout came in the wake of dire warnings Friday that the U.S. options market would not function today without relief from the ban.
“We’re relieved the SEC granted this exemption,” Boris Ilyevsky, managing director of the International Securities Exchange’s options market, told Traders Magazine earlier today. “It will allow the markets in those names to function. Without the exemption, those markets would have been very wide and illiquid, and in some cases empty altogether.”
Ed Boyle, head of NYSE Arca Options, told Traders Magazine after the market closed on Friday that the options market ran the risk of being rendered inefficient without a short-sale exemption. “The viability of the options markets in the U.S. would be in question,” he said.
The SEC, early Friday, banned short-selling in 799 stocks of financial companies, effective immediately. Market participants awoke Friday to news of the unprecedented ban, which SEC Chairman Christopher Cox argued was necessary to prevent the potential capsizing of large financial institutions. The Emergency Order, which expires at the end of October 2, granted equities market makers an exception to the ban so they could continue to make markets in the affected stocks. Options market makers got a one-day reprieve from the prohibition.
Shortly after 12 a.m. this morning, the SEC amended that ban, allowing options market makers to sell stock short to support bona fide market making and hedging activities related to that market making. However, the SEC amendment cautioned that, “for new positions, a market maker may not sell short if the market maker knows a customer or counterparty is increasing an economic net short position” in the shares of stocks for which short-selling is banned. That appears designed to prevent firms from using the options market to get short exposure they couldn’t otherwise acquire under the ban.
Susan Milligan, senior vice president for government relations and communications at the Options Clearing Corp., the clearinghouse for listed options trades, welcomed news of the relief even with the SEC’s caveat. She stressed that on Friday, “as the day went on, it had become more and more clear there were going to be really significant adverse impacts from the lack of an options market-maker exception.”
Several options market-making firms told exchanges on Friday they would not quote on Monday if they couldn’t hedge their positions by selling short the underlying stocks. The concern focused on market makers’ quoting obligations in the 230 to 240 options classes whose underlying stocks were on the SEC’s list of 799 financial institutions. (As of this morning, the SEC is allowing the listing markets to determine which of their financial stocks should be on the list of companies whose stocks can’t be sold short.)
Will Easley, vice chairman of the Boston Options Exchange, said BOX’s major market makers announced Friday morning that they wouldn’t quote after the weekend if the ban limited their hedging. “Nearly all of our major market makers said they wouldn’t make markets,” he told Traders Magazine yesterday.
“Options market makers didn’t threaten to not make markets,” the OCC’s Milligan stressed. “Some said they weren’t going to. It went beyond threatening.” If liquidity providers didn’t make markets, she added, that “would have had a deleterious effect on customers with existing positions in those options.”
BOX’s Easley said exchange executives and others in the industry “explained to the SEC [on Friday] that the ban meant the options markets wouldn’t function come Monday.” Market makers, he added, wouldn’t be able to meet their obligations to post continuous prices. “Virtually 95 percent of trades by customers have market makers on the other side, so there’d be no marketplace for customers,” Easley said. “We didn’t think that was what the SEC intended.”
“When a market maker has to sell shares in the underlying security because he bought a call or sold a put to an investor, he’s not speculating,” Easley noted. “He’s required to post prices and furnish liquidity.” The BOX executive added: “His acceptance of that obligation had always been implicitly contingent on being able to hedge those activities. They don’t have a magic bag where they pull puts and calls out and distribute them.”
A Chicago Board Options Exchange spokesperson said the CBOE knew by midday Friday that some options market makers would not make markets on Monday if they were not released from the ban. And if quotes went dark across options on financial stocks, liquidity would shrink. At the ISE, some market makers had told the exchange they would not be able to quote in the options affected by the ban, while others had indicated they would continue to submit quotes. The exchange had been prepared to “not have any quoting requirements whatsoever today,” Ilyevsky said this morning. The CBOE and ISE are the industry’s largest exchanges, together controlling almost 60 percent of the market.
Boyle of NYSE Arca Options noted that most options market makers did not tell Arca they wouldn’t make markets. “They said they would have a difficult time fulfilling their market-maker [quoting] obligations without violating the short-sale rule,” he said. A Nasdaq OMX spokesperson observed Friday that “without the exemption, options quotes would become less efficient and cost investors through wider spreads.” Nasdaq OMX owns the Nasdaq Options Market and the Philadelphia Stock Exchange, both of which trade options. NYSE Euronext recently acquired the American Stock Exchange, which runs an options market.
As the potential consequences of the ban sank in, a frenzy of communication took place Friday between industry executives and regulators to discuss an exception to the short-sale ban for options market makers. “There was a lot of communication from the options exchanges to SEC staff and the SEC Chairman and Commissioners about the adverse impact that not having an options market-maker exemption was going to have on customers,” the OCC’s Milligan said. “And I think they heard us.” Her three-person Washington, D.C., office works with the regulatory and legislative staff at the SEC and staff on Capitol Hill about issues pertaining to the options industry. The OCC is owned by five of the seven U.S. options exchanges.
In addition to working through the OCC, the exchanges made their own efforts. “We decided the individual exchanges would place their own phone calls and reach out to contacts if they knew a particular Commissioner or Congressman,” BOX’s Easley said. “We tried to reach whoever we could get through to, and it wasn’t an easy day to get through to people.”
CBOE Chairman and CEO William Brodsky, who was in New York on Friday, was in touch with SEC Chairman Cox a “couple times during the day,” according to an exchange spokesperson. Gary Katz, president and CEO of the ISE, was in touch with the SEC during the day Friday to discuss the potential impact of the ban on options market makers, the ISE said.
Executives from NYSE Euronext, the parent company of NYSE Arca Options, were also in touch with Cox and a number of the other SEC commissioners and staff on Friday, according to NYSE Arca’s Boyle. “The SEC was very open,” he said. “We initiated conversations with them to let them know [the ban] was a huge concern from a market-making standpoint.”
By mid-afternoon Friday, the SEC’s Division of Trading and Markets had issued a statement noting that Commission staff would recommend modifying the short-selling ban to extend the exception to options market makers’ hedging activities. “The SEC Commissioners were open to communication and to listening to what we thought,” Milligan of the OCC said. “We’re really pleased by that.”
BOX’s Easley agreed that the SEC staff understood the gravity of the issue. “To their credit, they listened to our arguments and adjusted their policy,” he said. “Ideally, that’s how it’s supposed to work.”
The SEC’s Friday statement noted that the planned change was “consonant with short position restrictions of the U.K. Financial Services Authority.” The FSA on Thursday banned short-selling in financial stocks until mid-January, although it allowed an exemption for cash equities, options and derivatives dealers trading on a principal basis to fill customer orders or for hedging activities resulting from that trading activity. The SEC has emphasized over the last several days, including this morning, that it is working closely with the FSA to bolster the financial system through emergency rulemaking.
