September 18, 2009
It is our position that any rule similar to the alternative uptick rule currently under consideration by the SEC must include an options market maker exemption otherwise, the rule would be highly detrimental to liquidity providers in the equity options industry, and would thereby clearly, if inadvertently, harm investors at large. Any type of short sale restriction would be harmful in that regard, but the alternative uptick rule is particularly egregious, as it would not allow short sales to get immediate execution under any circumstances.
First, options market makers could no longer act as market takers when selling stock short.
A trade requires a price maker and a price taker. The former disseminates a price at which (s)he or she is willing to trade, and waits until (s)he is filled. This participant provides liquidity, is passive, and can afford to wait for a fill. The latter requires immediate execution, and therefore trades instantly by lifting bids and hitting offers disseminated by the price maker.
Currently, options market makers act as price takers in the stock, because they need immediate execution to hedge their option trades. Such immediate hedging is necessary because the cumulative directional risk associated with customer options orders far exceeds option market makers' capacity to carry that risk. The proposed rule eliminates options market makers' ability to act as price takers in the stock when selling short. To an options market maker, stock trading is a cost of doing business, not a source of revenue. Without the ability to efficiently trade stock, the options market maker is impaired in making markets in the options, and the cost of doing business increases.
Second, options market makers would face increased hedging risk.
The most significant risk we take on as market makers is directional (delta) risk. While we are compensated for that risk by virtue of buying options on the bid and selling them on the offer, it would be wrong to assume that such compensation is excessive. Much like a retail store must utilize the difference between the wholesale and retail price to cover operating expenses and business risk, so must options market makers pay for their expenses from the spread between their average buy and sell prices. Such expenses include the sometimes severe losses that result from a hedge trade that gets away – one where the stock suddenly moves away, leaving the market maker with a choice of carrying unacceptable risk, or hedging at unfavorable prices.
The alternative uptick rule would increase the frequency and severity of such adverse situations. It would significantly increase the likelihood that options market makers cannot hedge (via a short sale) the long deltas they receive from buying a call from, or selling a put option to a customer.
Third, options market makers would have to compensate by reducing call bids, increasing put offers, widening their bid-ask spreads on options in general, and reducing their quote size.
The converse is not true. The proposed rule provides no added benefit to market makers needing to buy stock long. There is no concurrent benefit to this rule that would make call selling or put buying less risky to options market makers. In declining markets especially, lacking liquidity can lead to a vicious cycle, whereby market makers will raise call offers, lower put bids, and perhaps even increase their short stock positions, leaning short deltas, just in case. Also, while in limbo, waiting for a fill on the short stock order they are working, market makers may be unable to provide competitive markets to purchase additional calls from or sell additional puts to customers, as they have already exceeded their risk threshold, and have no idea when they will get filled on their hedge. Inevitably, this will lead to wider bid-ask spreads, and will cause the composite quote to be smaller in size, as well as wider in price. This reduction in option liquidity is most likely to occur when it is most needed – in a declining, fast moving market.
Fourth, because most customers sell calls and buy puts, customers would be directly affected.
As liquidity providers in equity options, we are continually willing to take on various types of risk to accommodate the needs of individual and institutional investors. Many of these institutional investors are the same groups that are currently grossly underfunded due to the 2008 credit crisis and sub-prime meltdown. Increasing their cost of doing business is hardly the intent of the SEC, or any financial regulator at this time. Yet by restricting option market makers ability to sell stock short, the proposed rule would in fact do just that.
Most customers tend to be call sellers and put buyers. Due to the current regulations, most customers are only permitted to write covered calls or buy protective puts. In addition, this type of collar trade fits the natural directional exposure customers have since the overwhelming majority of customers are long the market, they seek downside protection (via the purchase of put options), and defer some of the cost by reducing their upside profit potential (via the sale of covered call options). Unfortunately, a short sale restriction without market maker exemption would make it more costly for customers to put on this type of position. This type of mutually beneficial risk transfer has been instrumental for years in smoothing portfolio returns, and has been a significant driver of growth in option volume.
Finally, the alternative uptick rule is not easier to implement than the old uptick rule.
If a market maker exemption is not possible, then we believe that the old uptick rule is still preferable to the alternative uptick rule. We have heard arguments against the old uptick rule, claiming that it would be difficult, due to todays' equity market fragmentation, to design a system that can reliably determine the quote sequence, thereby making it difficult to prove whether or not a given tick is an uptick. We believe that as sophisticated as the options market place has become, firms are in fact able to build systems that reliably identify upticks. Any ticks that are reported late (out of sequence) should simply not be considered in this equation, and firms ought to be able to provide a quote history in the event of an audit, demonstrating what their price feed showed at the time in question.
Vincent Florack and Steve Crutchfield