TD Options LLC
February 10, 2004
Jonathan G. Katz
RE: Proposed Rule Change on Short Sales; File No. S7-23-03
Dear Mr. Katz:
TD Options LLC ("TD Options") appreciates this opportunity to comment on the proposal of the Securities and Exchange Commission ("SEC" or "Commission") to amend SEC Rules 3b-3, 10a-1 and 10a-2 (the "Short Sale Rule"). TD Options strongly urges the Commission to amend proposed Rule 201 by adding a hedging exemption for options market makers and options specialists, similar to the one currently provided under the rules of the NASD. Such an exemption would be consistent with the spirit of the Short Sale Rule because hedged options positions are economically neutral and therefore do not pose a threat of manipulation. It would also help significantly in the facilitation of options transactions on behalf of the investing public.
TD Options is an options Specialist on the American Stock Exchange, a Market Maker on the Boston Options Exchange, a Designated Primary Market Maker on the Chicago Board Options Exchange and a Competitive Market Maker on the International Securities Exchange. We believe that an exemption is needed to remove unnecessary obstacles that market makers face in fulfilling their obligations to fill customer orders pursuant to the rules of the options exchanges. Options market makers currently provide substantial benefits to investors by supplying substantial liquidity, particularly in "down" markets where they are required to assume significant long market positions (but not necessarily long stock positions) at considerable risk. Allowing options market makers to reduce some of that risk through a compensating hedge with the underlying stock would be very appropriate. It would facilitate transactions in securities without incurring any of the dangers that the Short Sale Rule is designed to prevent.
Due to the unique risks associated with options trading, options market makers need to maintain options positions that are hedged with stock or another instrument. The underlying stock is generally the best hedge due to the lack of liquidity in other derivative products. In fact, the pricing and available liquidity of stock options markets almost always takes the availability of the underlying stock as a hedge into direct account. To lock in a hedge to an option position, the hedging transaction must occur promptly. Without an exemption, options market makers will incur substantial risk unnecessarily in providing liquidity in response to incoming customer orders to sell calls and to buy puts. Consequently, both liquidity and pricing in general will suffer if the Commission's proposal to limit market makers' access to an appropriate hedge is implemented.
If the Commission adopted a hedging exemption for options market makers, the investing public would receive significant benefits in the forms of greater liquidity and tighter bid-ask spreads in options overlying listed stocks. Currently in listed stocks, unlike in OTC stocks subject to the NASD's exemption, options market makers often have to wait considerable amounts of time before knowing whether their orders to hedge options transactions have been filled. Under current rules and practices, an options market maker's order to sell short a listed stock may go unfilled even if the offering price of the order is below the existing bid price in the stock. Such orders also go unfilled even if the bid reflects public customer interest. While waiting for an uptick in the stock, the market maker may need to fill numerous incoming orders to sell calls or buy puts. The uncertainty of whether a transaction will be hedged at a certain price will affect the options market maker's decisions as to pricing for those incoming orders. Moreover, customers seeking to buy the underlying stock may be deprived of executions that they otherwise may have received from options market makers who are prepared to provide liquidity. This, in turn, may cause greater volatility in the underlying stock price and greater risk for investors.
A clear disparity in the marketplace exists based on whether an option is overlying an OTC stock or a listed stock. In the case of listed stocks, the stock specialist has significant discretion over whether there will be an uptick in the stock, the duration of that uptick, and whether an options market maker's order to sell the stock in a hedging transaction will be filled. Such uncertainties do not exist with respect to OTC stocks. We strongly support the Commission's previous action in approving the NASD's exemption for hedging transactions of options market makers, which has been very successful by helping to facilitate options transactions without creating risks that the Short Sale Rule was designed to prevent. By further eliminating uncertainties involved in hedging transactions, the Commission can foster deeper and tighter markets on the options exchanges, resulting in greater efficiency and better executions for investors.
Without an options market maker exemption, there will continue to be disparities in the options marketplace. An options market maker on one exchange who is long the underlying stock could buy calls (or sell puts) and not be restricted from selling the underlying stock to hedge the position. In contrast, an options market maker on another exchange whose stock position is short would not be able to hedge a position readily. This can create differences in pricing option contracts that may cause delays in execution for customer orders that would otherwise be executed automatically. A market maker exemption would help to assure that investors are not subject to increased risk of being filled at a price other than the best price.
The Commission has stated in Section XI of the Release that a general hedging exception "is not necessary because the proposed bid test and pilot would provide market participants with additional flexibility in effecting short sales in order to hedge long exposure." We strongly disagree. The proposed bid test would not permit options market makers to sell stock directly on the inside bid price. Instead, the market maker would have to post an offer at a price that is at least a penny above the inside bid price. However, such an order may remain unfilled indefinitely, so in practice, the relief to be afforded under the Commission's current proposal would be very limited.
As noted above, the NASD's short sale exemption for options market makers, currently available pursuant to NASD Rule 3350(h), provides market makers with an exemption from the Short Sale Rule for transactions in Nasdaq National Market securities that are effected to hedge, and in fact serve to hedge, existing offsetting option positions in the market maker's account. The exemption has been in place for nearly ten years. The options exchanges have monitored it for abuse and, to our knowledge, neither they nor the NASD have noted any problems with it over the years. The exemption has served investors well without diminishing the protections of the Short Sale Rule. We strongly urge the Commission not to eliminate the exemption.
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In conclusion, in light of the foregoing reasons, the Commission should amend Rule 201 to include an exemption for options market makers and options specialists in the amendments to the Short Sale Rule. TD Options again thanks the Commission for the opportunity to comment on the proposed rule change. If you have any questions, please do not hesitate to call me at (312) 244-2222.