Report Warns of ‘Major Mistake’ in Regulating Equity Options
June 15, 2009
Coming just days before the Obama administration’s proposed overhaul of financial regulations, a study from Boston-based research firm Aite Group, warns against a “major mistake” by regulators and legislators in their treatment of equity options.
In the June 14 white paper, “Equity Options: The Future of the Industry is in the Regulators’ Hands,” senior Aite analyst Paul Zubulake says that a short-sale ban without a market-maker exemption “could potentially destroy the equity options industry.”
The Securities and Exchange Commission is currently considering two ways of handling short sales, the report says. One, a market-wide proposal, would cover all securities, and would not allow short sales for any equity on a down tick. The other proposal, a security-specific circuit breaker, would ban short sales in that stock if the stock went down by a specific percentage (10 percent is the number that has been talked about).
Zubulake says the most likely outcome is the circuit-breaker proposal. “One thing is certain,” adds Zubulake. “The designated market-makers of the equity options exchanges must be exempt from any short-sale ban.” Without such an exemption, he says, the bid offer spread for any option whose underlying equity triggered a ban would significantly widen or have no market at all. This would happen because, without an exemption, Zubulake explains, while the stock would still trade, market makers could not hedge their risk in the underlying equity option, thus widening the spread between bid and ask, and potentially having no market at all.
“The proposed 10 percent [price] decline to trigger a circuit breaker is potentially too tight,” he says, especially for lower-priced stocks.
The report says that the equity options industry has remained essentially outside the wave of problems triggered by the Madoff scandal. Equity options volume was actually up six percent during the first five months of 2009, it notes, adding that as electronic trading continues to grow, the marketplace has moved gradually from a retail-dominated space to an institutional marketplace dominated by the high-frequency, low-latency trading community. In the U.S., “exchange competition remains fierce,” it says, as the seven exchanges (ISE, CBOE, NYSE ARCA, NYSE AMEX, OMX PHLX, NASDAQ and BOX) employ different market models to gain liquidity. The landscape will continue to grow, it predicts, as the CBOE plans to launch its new fully electronic exchange, C2, later this year.
However, Zubulake says that even as electronic markets have changed the game, it is vital that trading rules “do not hinder the ability of the liquidity providers to provide narrow spreads and deep markets.”
