From the November 01, 2008 issue of Futures Magazine • Subscribe!

Regulation and the credit crisis

The collapse on Wall Street set off a regulatory firestorm in Washington, and the futures and options industries were shaken by the SEC’s temporary ban on short selling for 799 financial companies on Sept. 19. The SEC’s rule followed in the footsteps of the UK Financial Services Authority’s rule that prohibited short positions in UK financial sector companies until January 2009 with an exemption for market makers.

The initial SEC short-selling order threw options market makers into a frenzy. “There was a complete absence of liquidity in the marketplace on the open on Friday [Sept. 19]. Option bid-ask spreads were extremely wide, people were scrambling to find out what the interpretation of the rule was,” says Peter Bottini, executive vice president of trading at optionsXpress.

By instituting the initial rule, “the SEC once again proved its ignorance of, and indifference to, the options market,” says Mark Longo, president of

In a statement calling the rule a “draconian measure,” CBOE Chairman Bill Brodsky said “Liquidity in the affected stocks will suffer to the extent that market makers are hampered, and, absent relief, market makers will be hamstrung.”

Two days later, the SEC amended the rule, allowing market makers to short. “All of the options exchanges made calls to the commissioners and the chairman to let them know why [the rule] was a problem,” without the amendment, says Susan Milligan, senior vice president of government relations for the Options Clearing Corporation (OCC).

The rule hit hedge funds hard too. “Since hedge funds had about three days to exit positions that normally might have taken them weeks or even months to unwind, and doing so in an extremely volatile market, I would not be surprised if we see many small and medium size hedge funds shut their doors, with many others posting catastrophically bad returns,” says Gennady Favel, head of equity trading for an algorithm-driven hedge fund (see “Sold short”).

On Oct. 1, the SEC extended the short-selling rule until Oct. 8, the third business day after the bailout legislation passed. It extended through Oct. 17 its requirement that institutional money managers report to the SEC their new short sales of certain publicly traded securities. It also hinted that a more permanent rule on this matter could be enacted after the emergency period.

In a letter to SEC Chairman Christopher Cox on Sept. 21, The Managed Funds Association (MFA) urged the SEC not to make fund disclosure information public. “An outside observer can look at one or two weeks’ reporting data and unwind the strategy the firm is deploying in using its capital. That intellectual value is what makes the hedge fund itself something worth trusting,” says MFA President Richard Baker, adding that forcing hedge funds to disclose their investment methodologies is “not warranted and is never done in any other industry.”

The SEC acquiesced on this point in its Oct. 1 extension, saying that disclosure under the emergency order will be made only to the SEC.

“We understand the necessity of the agency taking some action in light of extraordinary market circumstances; however, the manner in which the order is constructed brings about results that are not necessarily consistent with the goals the SEC was seeking to achieve. More liquidity is always better than less,” Baker says.

The SEC rule “caught the whole industry by surprise. Overall, it’s a pretty unhealthy process when a regulator uses his authority to such a degree without engaging the marketplace. Chairman Cox has taken the ivory tower approach where he’s dramatically changed the rules of the market overnight,” Bottini says.

Some industry players are expressing frustration because the list of stocks in the ban changed on a daily basis.

“We’re concerned about the manner in which companies are provided safe harbor because this is governed not by the SEC but by the exchanges themselves and there doesn’t appear to be consistency on who is admitted to the list and who’s not,” Baker says.

Bottini says, “It’s a haphazard process. The SEC is all about inefficiency right now.”

Many fund managers also have an unfavorable opinion on the rule. “Never in my wildest dreams did I think the SEC would do something as stupid as they did,” says Phillip Herbert, CEO of NDX Capital Management. “All it’s done is take liquidity out of the market. When you have less liquid markets, you’re going to increase volatility and it’s going to be harder for the average investor or average fund to execute their trades. In what were normally very liquid situations, I now see [stocks] hop around like a little kid on Ritalin.”

Other regulatory actions in the wake of the economic crisis included the International Swaps and Derivatives Association’s (ISDA) launch of a Fannie Mae and Freddie Mac credit derivatives swaps protocol to help make the settlement of Fannie and Freddie credit derivative transactions more efficient. ISDA officials also are promoting general regulatory reform. “America’s financial services regulatory regime in some cases is designed to address markets that existed in the 19th century. Going forward it will be necessary to develop 21st century regulation for 21st century markets. Attempting to fit new products into old regulatory models would most likely be counterproductive,” says Greg Zerzan, head of global pubic policy at ISDA.

CFTC actions included participating in the transfer of positions in bankrupt Lehman Brothers and working with the exchange’s self-regulatory organizations to meet their capital requirements and ensure market stability. “We are facilitating all efforts that promote the orderly unwinding and transfer of positions and uphold the safeguarding of customer assets,” said CFTC Acting Chairman Walt Lukken in a statement on Barclays’ purchase of Lehman’s North American businesses.

“Most of the people in the equity options world would love to have the CFTC as a regulator. They tend to take a more interactive approach with the constituents,” compared to the SEC, Bottini says.

Speaking at an industry conference on Sept. 24, ICE Chairman and CEO Jeff Sprecher said increased regulation in currency and commodity trading was “almost a foregone conclusion.”

The Treasury’s “Blueprint for a Stronger Regulatory Structure” from March likely will get a second look when the new administration takes office in January. “The blueprint will be front and center after the new year as a way to analyze how to restructure our archaic regulatory scheme,” says Chris Hehmeyer, CEO of Penson GHCO.

The blueprint included a proposed merger of the CFTC and SEC, an idea many industry experts rejected due to the two opposing regulatory approaches of the agencies – the SEC’s rules-based approach versus the CFTC’s principles-based approach. Many experts say development and growth of certain products that are dually regulated by the SEC and CFTC, such as options on ETFs and single stock futures, have been held back due to the regulatory overlap.

“It’s about time we learned that there is no such thing as single market regulation. All markets are too intertwined to believe any act of any regulator does not leak beyond the borders of their domain. Hence, coordinated—if not consolidated—regulatory authority becomes de rigueur,” says Lawrence Szczech, CEO of RJO Futures.

The OCC’s Milligan says regulators will use the blueprint as a benchmark to determine where to go in terms of regulatory changes. “In some areas, U.S. regulation is too prescriptive and in other areas it doesn’t seem to exist at all, so we need to figure out where we need to be,” she says. “The whole question of duplicative and overlapping regulators and on how and who should do systemic risk regulation is going to be looked at very carefully,” she says, adding that regulators will look at whether adjustments are needed to lighten regulation and whether there should be one central regulator for risk regulation.

“If somebody thinks that there’s not going to be attention paid to the regulatory scheme, they’re standing on the beach looking at the palm trees and there’s a tsunami right behind them,” Hehmeyer says.

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