The Options Market Maker Exception to SEC Regulation SHO

Trading in the U.S. stock market is shaped by myriad rules and institutions that govern the conduct of market participants. These rules not only set boundaries on trading but also create opportunities for novel trading strategies designed to lower costs and increase profits. Thus, the stock market provides an excellent opportunity to study the economic incentive effects associated with institutional change.

An important area of securities regulation concerns the clearance and settlement of trades. In the U.S. stock market, trade settlement does not occur on the date of the trade. While cash and securities in customer accounts are generally credited or debited instantly, actual share transfers are delayed through a netting process that allows broker-dealers and the clearinghouse to offset transactions among multiple counterparties.

When one party does not deliver shares to the clearinghouse by the trade date plus three days (“T+3”), a settlement failure occurs. This “fail-to-deliver” (FTD) is documented as a delivery obligation in the clearinghouse account of the broker-dealer that executed the trade. The stock settlement system accommodates settlement failures to promote market liquidity.

Regulations established by the U.S. Securities and Exchange Commission (SEC) require delivery of shares for long and short sales. Delivered shares, long or short, result in a change in “beneficial ownership” while naked short sales do not. To ensure prompt trade close-out and reduce settlement failures from short sales, the SEC enacted Regulation SHO in 2005. Regulation SHO incorporated and formalized some concepts found in older rules governing short sales and settlement. These rules evolved through rulemaking by the self-regulatory organizations (SROs). SROs are U.S. stock exchanges like the New York Stock Exchange (NYSE) and NASDAQ.

Regulation SHO strengthened an SRO Exception from trade locate and close-out requirements for market makers engaged in bona-fide market making. The Exception allowed options market makers to delay delivering shares sold short in connection with hedging activities. The Exception applied only to shorting that served market liquidity.

This Exception to the close-out requirement for optionable stocks was eliminated in September 2008. The repeal was due in part to complaints by some market participants that short sellers took advantage of this “loophole” in the rules to build artificially large synthetic short positions through the options market.[1] Other commenters were concerned that market makers unnecessarily incurred more FTDs than necessary to ensure market liquidity. Finally, the SEC was concerned about abuse in the form of circumventing short sale delivery requirements, a practice exposed in the 2007 Arenstein disciplinary decisions by the American Stock Exchange and the Financial Industry Regulatory Authority (FINRA).[2]

The SEC and FINRA have since brought numerous disciplinary actions against options market makers (OMMs) for naked short selling and failing to deliver in connection with market making that is not bona fide.3 For example, the SEC (2012) outlines how one options market maker used complex conversion trades to satisfy demand for hard-to-borrow securities. The buyers of the conversions were “large prime brokers,” a division of large broker-dealers that services hedge funds and institutional clients. These prime brokers obtained scarce stock that “command[ed] large fees in the stock loan market” (SEC 2012, pages 3-4).

Our economic model predicts that the removal of the Exception raised costs for OMMs who hedged long options positions with short positions in the underlying equity markets. This is because the Exception allowed OMMs who had sold short without borrowing stock, and who had failed to deliver, to avoid close-out. Economic theory predicts that lower marginal costs due to naked shorting reduced options prices, consequently lowering the price to short through options as opposed to the stock loan market. Thus, theory predicts that higher shorting costs for OMMs reduced the incentive for short sellers to use the options market for shorting as opposed to the stock lending market.

The different treatment of optionable versus non-optionable stocks, coupled with the fact that the regulation was changed, offers a unique opportunity to test the effects of a financial regulation on trading behavior. We hypothesize that eliminating the Exception increased the cost of shorting optionable stocks and thus reduced FTDs relative to non-optionable stocks. We further predict that, because the Exception gave short sellers an incentive to short through the options market instead of the stock loan market, the elimination of the Exception yielded higher borrow prices for optionable stock relative to non-optionable stock in the stock loan market. This is because higher demand for short selling through the equity market means that there is more demand for borrowing stock.

We test our hypotheses about FTDs and stock borrow costs using a difference-in- difference framework. We identify the effects of eliminating the Option Market Maker Exception by exploiting its different effect on optionable and non-optionable stocks both before and after the rule change in 2008. While our article explores data and concepts unique to finance, our analysis is rooted in economics. This is because we analyze the sensitivity of trading behavior to changes in economic incentives.

Our research is related to Evans et al. (2009), who use pre-regulation SHO data from 1998 and 1999 to assess how and why put-call parity diverges from predicted values when stock borrow costs are high. The authors conclude that OMMs account for this divergence because they tend to fail to deliver stock to cover short sales of hard-to-borrow stocks. Evans et al. (2009, p. 1975) describe the impact of delivery requirements arising from Regulation SHO as “an important new empirical question.”

We test how changes to Regulation SHO that removed the failure “option” for market makers affected short sale pricing, FTDs, and options liquidity using 2008 data. Within a panel data framework, we exploit the fact that the Exception applied only to optionable stocks insofar as it was used by OMMs. Thus, our “control” group is non-optionable stocks. Within this framework, we test the effect of price changes in the stock lending market on FTDs.

We find that eliminating the Options Market Maker Exception to SEC Regulation SHO led to fewer and less persistent FTDs in optionable stocks. We also find that optionable stocks became more expensive to borrow after the Exception was eliminated, which is consistent with higher demand to borrow stocks to cover short sales. These results suggest that eliminating the Exception raised the cost to short through the options market and thus made options a less attractive alternative for short sellers. Finally, we find that elimination of the Exception lowered options market liquidity.

Our research demonstrates that prices and trading are very sensitive to rules and rule changes. In other words, subtle institutional choices can have real economic consequences. In the following sections, we describe relevant institutions and related research. Next, we present our hypotheses, data, empirical model, and results. The last section presents conclusions.

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