A recent and significant amendment to Regulation SHO, takes effect today. Reg SHO, initiated in January 2005 was hardly enforced until the market gyrations of recent days. This is a controversial change to the regulation which prior to today exempted buona-fide market makers from having to deliver securities.
The effect of this are mostly going to be unknown for a while. If I had to speculate, I’d say this may add to current volatility as market makers and traders try to decipher its effects. Whether or not the short covering that might ensue will cause a dramatic rise, is unknown. Simple analysis might lead to an expectation that equity options may become more expensive if market makers are no longer able hedge out their risks. If a customer wants to buy calls on GE and the specialist cannot locate stock that he can borrow to short, in order to hedge his book to write those calls, then the liquidity in the options market may dry up. If there is a particular stock that a lot of people are demanding calls for, they may find the cheapest way to play the trade would simply be to buy the shares. If so, we can expect some more rattling as the rules change….
For some background on Reg SHO and the new change, see the excerpts from the SEC document below:
SECURITIES AND EXCHANGE COMMISSION
17 CFR PARTS 241 AND 242
[Release No. 34-58775; File No. S7-19-07]
Amendments to Regulation SHO
AGENCY: Securities and Exchange Commission.
ACTION: Final rule.
SUMMARY:The Securities and Exchange Commission (“Commission”) is adopting amendments to Regulation SHO under the Securities Exchange Act of 1934 (“Exchange Act”). The amendments are intended to further reduce the number of persistent fails to deliver in certain equity securities by eliminating the options market maker exception to the close-out requirement of Regulation SHO. As a result of the amendments, fails to deliver in threshold securities that result from hedging activities by options market makers will no longer be excepted from Regulation SHO’s close-out requirement. The Commission is also providing guidance regarding bona fide market making activities for purposes of the market maker exception to Regulation SHO’s locate requirement.
EFFECTIVE DATE: October 17, 2008….
A. Regulation SHO
Regulation SHO, which became fully effective on January 3, 2005, sets forth the regulatory framework governing short sales. Among other things, Regulation SHO imposes a close-out requirement to address failures to deliver stock on trade settlement date and to target potentially abusive “naked” short selling in certain equity securities. While the majority of trades settle on time, Regulation SHO is intended to address those situations where the level of fails to deliver for the particular stock is so substantial that it might impact the market for that security….
…As discussed below, after considering the comments received, the data, and the purposes underlying Regulation SHO, we are adopting amendments to eliminate the options market maker exception, as proposed. At this time, we are not acting on the proposed amendments to Rule 200(g) of Regulation SHO regarding long sale documentation. Instead, in a companion release we have adopted a “naked” short selling anti-fraud rule that, in part, targets seller’s representations regarding long sales. In addition, we note that we have adopted an interim final temporary rule, Rule 204T, which strengthens the delivery requirements for sales of all equity securities. Under temporary Rule 204T, fail to deliver positions resulting from short sales of all equity securities by options market makers must be closed out by no later than the beginning of regular trading hours on the settlement day after the fail to deliver position occurs. In conjunction with these short sale-related initiatives, and our goal of further reducing fails to deliver and addressing potentially abusive “naked” short selling, we believe that we must eliminate Regulation SHO’s options market maker exception.