Will regulatory onslaught cripple U.S. listed options market?

February 22, 2016 03:00 PM

Whether initiated as regulatory policy, as trial balloons used to test public opinion, as tax policy or at the whim of a politician attempting to right a perceived wrong, legislative and regulatory proclamations coming out of Washington garner the attention of a broad swath of market participants.

The challenge is to identify legislative and regulatory initiatives in various stages of implementation that have the potential to hurt markets. Although the capital markets industry continues to raise its concerns on potential negative impacts, these concerns seem to fall on deaf ears in Washington.

Regulatory, legislative and political initiatives targeting financial markets have become a constant refrain in global capital markets. Many of these initiatives are well-intended, designed to influence behavior perceived as contrary to best market practices and raise revenues through taxes on certain activities. However, the unintended consequences of regulation are the bane of these efforts. Many initiatives include components that on the surface may seem logical to the regulation’s authors, but will have carry-on impacts that ripple through the financial industry. 

The U.S.-listed options market has not escaped this scrutiny. While finalized and pending tax initiatives have been promoted as ways to simplify the U.S. tax system, eliminate current loopholes and raise revenue for the U.S. government, the potential impact of these regulations on the options market may be problematic. 

In a new report, “Unintended Consequences: Tax Regulations and the US Listed Options Market,” TABB Group has identified two proposals and one recently passed regulation that could deplete trading in the options market through trading restrictions and limitations on how brokerages service customers. These initiatives include the Department of Labor’s (DOL) fiduciary proposal, the Tax Reform Act of 2014, and Section 871(m) of the Internal Revenue Code.

Washington politicians tout these initiatives as a means of simplifying the tax system, excising loopholes and saving money for both individuals and businesses. On the surface, the proposed rules present attractive goals, but in practice, they could have serious consequences through limitations on how investors can use listed options to implement investment strategies and manage risk exposures.

If the DOL’s proposal is enacted, it could categorize brokerages as fiduciaries, which would require them to drastically change their business models and limit them from trading listed options. Self-directed investors who employ common options strategies, such as buying puts and selling covered calls, could be stripped of their resources. 

The Tax Reform Act of 2014, also known as the Camp Proposal, would require all options positions on stocks to be labeled as mark-to-market, and all gains on the stock would be treated and taxed as ordinary income. If enacted, the Camp Proposal could turn trading straddles into a tax nightmare for investors and discourage them from prudently protecting their portfolios. 

Section 871(m), which was finalized in September 2015, will establish a withholding tax for derivatives on U.S. securities traded around a dividend payout date. However, the rule’s guidelines on what contracts are eligible for taxation are ambiguous, leaving interpretation up to brokerages that are required to track and report their customers’ tax statuses. Foreign investors likely will have to reduce their U.S. options trading to avoid unnecessary and overwhelming taxation once the rule comes into effect in 2016.

While Washington’s intentions for tax reform are well-meaning, their plans overlook these dangers. Ultimately, these rules punish investors who have been using listed options in a responsible manner. These investors will be forced to use other instruments to emulate trades and strategies they once executed in the options market, or they will have to discontinue the trades and strategies entirely. The plans also present unnecessary stumbling blocks for the options industry, which already is struggling with stringent regulations on risk-taking and capital. 

Washington must revisit these proposals and devise better ways to rectify language that could cause negative repercussions in the options market. In the case of Section 871(m), regulators should keep a close watch on the market’s response to the new guidelines and consider tweaking the language if there is noticeable fallout.

About the Author

Callie Bost is the Listed Derivatives Research Analyst, TABB Group