Short Restrictions and Market Makers

[rmorse]

Quote from Options12:

The complaint below includes some useful info regarding the market-maker exception.

In this case the SEC contends that the respondents collected $17 million by improperly utilizing the market-maker exception:

7. The Respondents in this matter, who were not conducting bona-fide market making activities but were instead engaged in “naked” short sale transactions for their personal investment purposes, improperly utilized the Market Maker Exception from Rule 203(b)(1) in order to avoid locating shares before effecting short sales as part of “reverse conversion” and “assist” transactions, as further described below. Because the Respondents failed to borrow or arrange to borrow securities to make delivery when delivery was due, the short sales as part of the reverse conversions and assists were “naked” short sales. These same Respondents also violated Rule 203(b)(3) by repeatedly engaging in a series of sham transactions to ostensibly “reset” the thirteen-day clock for complying with the close-out requirement, but without actually purchasing shares in a bona fide transaction. These sham transactions enabled the Respondents to circumvent Reg. SHO, allowed them to generate millions of dollars in profits because they did not actually borrow or arrange to borrow the securities they were selling short, and caused their clearing broker to have large persistent fail to deliver positions in these threshold securities, thus undermining one important purpose of Reg. SHO.

http://www.sec.gov/litigation/admin/2012/34-66283.pdf

http://www.sec.gov/news/press/2012/2012-22.htm

This complaint had to do with REG SHO stocks that were about to be bought in. A MM would trade an ITM call vs stock with another MM with no position, knowing the other party would exercise the long call to not be short stock the next day. The trader buying the stock and selling the call, would claim they covered their short at at the end of that day, and was no longer short the security. This would reset the clock on the failure to deliver which would begin again at T+3.

This was not common as was stopped by the SEC with fines for the few that did it. They were "gaming" the reg sho rules. The market maker exception is meant to add depth and liquidity in in the option markets at a time when it's most needed.

 

[FSU]

I stand corrected, you were right Bob. I thought that MM's still had to get a locate, but apparently not. Though as you said, they still have buy in risk (though I am told it is T+6 instead of T+3). Buy in risk could be substantial though, as you could be bought in on the cash market.

Thanks for the information.

 

[Rationalize]

Quote from rmorse:

...The market maker exception is meant to add depth and liquidity in in the option markets at a time when it's most needed.

Yes, but it is still stupid.

- The stock is falling.

- I want to short it, but can't.

- So, I buy a put.

- The MM is now short the put, and likely delta hedged with naked short stock.

The stock still gets sold short naked, it's just via the MM.

 

[rmorse]

Quote from Rationalize:

Yes, but it is still stupid.

- The stock is falling.

- I want to short it, but can't.

- So, I buy a put.

- The MM is now short the put, and likely delta hedged with naked short stock.

The stock still gets sold short naked, it's just via the MM.

Correct. Without it, markets would not function properly. One of the responsibilities of regulators is to make sure the markets function as smoothly as possible. The SEC, FINRA and the Exchanges believe that the more depth and liquidity, the better the markets function. So because of that, a regulated industry participate gets a benefit customers don't get. I don't feel it stupid, but can see why you do.

 

[miya888]

Quote from rmorse:

Yes they can short them without a locate. The question I'm not sure about is the the plus tick rule when it applies. It's my expectation they are not except from requiring a plus tick when required by the exchange.

the uptick rule was removed in 2007, there's ongoing debate to re-introduce it but i doubt it will be as statistics showed the rule was useless. some politicians still want to put their name on all kinds of regulations....