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Regulatory Uncertainty and Market Liquidity the 2008 Short Sale Bans Impact on Equity Option Markets

Regulatory Uncertainty and Market Liquidity the 2008 Short Sale Bans Impact on Equity Option Markets

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Published by calibrateconfidence
Regulatory Uncertainty and Market Liquidity the 2008 Short Sale Bans Impact on Equity Option Markets
Regulatory Uncertainty and Market Liquidity the 2008 Short Sale Bans Impact on Equity Option Markets

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Published by: calibrateconfidence on Jul 04, 2013
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09/29/2013

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THE JOURNAL OF FINANCE
 VOL. LXVI, NO. 6
DECEMBER 2011
Regulatory Uncertainty and Market Liquidity:The 2008 Short Sale Ban’s Impact on EquityOption Markets
ROBERT BATTALIO and PAUL SCHULTZ
 ABSTRACT
We examine how the September 2008 short sale restrictions and the accompanying confusion and regulatory uncertainty impacted equity option markets. We find thatthe short sale ban is associated with dramatically increased bid-ask spreads for op-tions on banned stocks. In addition, synthetic share prices for banned stocks becomesignificantly lower than actual share prices during the ban. We find similar resultsfor synthetic share prices of hard-to-borrow stocks, suggesting that the dislocation inactual and synthetic share prices is attributable to the increased hedging costs foroptions on banned stocks during the short sale ban.
This ban is terrible for option market makers. It will kill options tradingbecause you cannot price options fairly. You cannot buy a call or sell a putand hedge them.
—Joe Kinahan, derivatives strategist at the Thinkorswim Group,September 19, 2008.
1
 A 
T THE END OF THE SUMMER
of 2008, as prices of commercial and investmentbank stocks plummeted, the Securities and Exchange Commission (SEC) cameunder intense political pressure to curb short selling of financial stocks. Latein the day on September 17, 2008, the SEC moved to stop naked short selling 
Battalio and Schultz are with the Mendoza College of Business, University of Notre Dame. Wethank an anonymous firm for providing the option data used in our analysis, the Options Clearing Corporation for providing early exercise and open interest data, S3 Matching Technologies andan anonymous retail broker for providing retail order and rebate rate data, and the ISE forproviding data on trades that open or close trading positions. We thank Al Lemon, Hang Li, andBillMcDonaldspecificallyandtheMendozaITgroupmoregenerallyfortheirhelpinprocessingtheOPRAdataandMargaretForsterforproddingustotakeonthisproject.WegratefullyacknowledgecommentsfromPeterBottini,ShaneCorwin,KarlDiether,MichaelDoherty,AmyEdwards,RobertJennings, Charles Jones, Carolyn Mitchell, Rob Neal, Jerry O’Connell, Gavin Rowe, Sophie Shive,JeffSoule,andRodTaylor;seminarparticipantsattheUniversityofNotreDame,theUniversityof Pittsburgh,theOhioStateUniversity,theUniversityofOklahoma,andtheUniversityofKentucky;and participants at the Federal Reserve Bank of Atlanta’s conference “Short Selling: Costs andBenefits”; the IIROC-DeGroote 2010 Conference on Market Structure and Market Integrity; the2nd Annual RMA-UNC Academic Forum for Securities Lending Research; and the 2010 WesternFinance Association meetings.
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See the October 7, 2008 Reuters News article by Doris Frankel titled “Short-sale ban worriesU.S. options markets.”
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2014
The Journal of Finance
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by issuing Temporary Rule 204T, which imposed stringent penalties on shortsellers who failed to deliver shares on the delivery date. This applied to allstocks. Then, in the early morning hours of September 19, 2008, the SECannounced a ban on short selling for almost 800 “financial” stocks. The banwas modified and clarified in several regulatory circulars over the next fewdays.Inthispaper,weexaminetheimpactoftheseshortsalerestrictionsonequityoptions markets, focusing in particular on the short sale ban. Although theserules were directed at the market for underlying stocks, there are several waysin which they could significantly affect options markets. First, they made itmore difficult and costly for options market makers to hedge positions in thestock market. Even after the SEC clarified that options market makers couldhedge by shorting stock, it appears to have been more difficult and costly toshort. Second, it is possible that prices of the underlying stock became lessaccurate or efficient when bearish investors were prevented from selling short.The implicit leverage in options positions means that the increase in informa-tional asymmetries was likely to be an even bigger problem for options marketmakers than market makers in the underlying stock. Third, there was a greatdeal of uncertainty about what was permitted under Rule 204T and under theshort sale ban. The SEC issued a number of regulatory circulars in the daysafter these regulations, but, in the meantime, confusion reigned in both the eq-uity and options markets. Fourth, these dramatic and unexpected SEC rulingsincreased regulatory uncertainty in the minds of many market participants. Additional SEC rulings could have been forthcoming and could have affectedthe options market in dramatic and unpredictable ways.We find that quoted bid-ask spreads increased dramatically when the shortsale ban took effect. Our multivariate analysis reveals that, on the first day of the ban, puts and calls on banned stocks with October 2008 expirations havequoted spreads that are more than $0.96 wider than the quoted spreads of options on our control stocks. From September 22 through October 8, the lastday of the ban, we find relative quoted spreads are 10% higher on average foroptions on banned stocks than for options on control stocks. After the ban isremoved, the difference in relative quoted spreads falls to around 4%.Execution quality also declined when the ban was instituted. Prior to theban, trades occur near quoted prices and effective spreads are similartoquotedspreads.Onthefirstdayoftheban,moretradestakeplaceoutsideofthequotedspread and effective spreads average over 135% of quoted spreads for optionson banned stocks, and over 115% of quoted spreads for options on other stocks.Wealsofindthatpricesofsyntheticsharescreatedfromoptionsdivergefromactual share prices during the ban. Prior to the ban, synthetic share bid-askmidpoints are very close to actual share bid-ask midpoints. During the ban,synthetic stock prices are lower than actual stock prices. Closer examinationreveals that the decline in synthetic prices is caused by a decline in syntheticbids. This is consistent with options market makers using their quotes to dis-courage investors from creating synthetic shorts that the market makers couldno longer hedge. We find similar results when stocks become hard-to-borrow.
 
 Regulatory Uncertainty and Market Liquidity
2015These results are of interest for several reasons. First, they provide insightinto market making for derivative securities. Microstructure theory suggeststhat market making for options is different from market making for stocksbecause options market makers need to hedge their positions (see Jamesonand Wilhelm (1992), Engle and Neri (2010)). Hedging is required because,unlike stocks, buy and sell orders in options are generally not offsetting. Forexample, investors write far more calls than they purchase (see Lakonishoket al. (2007)). In addition, option trades are spread across dozens of strikeprices and expiration dates. The severity of the short sale ban allows us toexamine the importance of hedging for options market making. Another contribution of this paper is that we document some of the con-sequences of restricting short sales. Short sale regulations have changed nu-merous times in both the United States and in other countries over the last75 years, in part because the effects of short sale regulations have not beenclearly established. Our analysis examines the impact of short sale restric-tions on a derivative market in which over 3.5 billion contracts were traded in2008. A third contribution of this paper is to refute the argument that short salerestrictions, or indeed many regulations, can be circumvented by trading inoptions markets. Market makers who act as counterparties to investor tradeshedge their positions in the underlying stock. Even if synthetic short positionsare not explicitly prohibited, the inability of market makers to short sell inthe primary market effectively restricts synthetic short selling in the optionsmarket.Finally,thispaperprovidesinsightsintotheimpactofregulatoryuncertaintyon markets. The short sale ban, which was to take effect immediately, wasannounced in the early morning hours of September 19 with no prior warning to market participants. Numerous officials of the options exchanges, some of whomwecite,complainedthatthebanresultedingreatuncertaintybothabouthow the ban was to be implemented and about possible additional regulation.Evidence of the impact of regulatory uncertainty includes increased spreadsfor options on stocks that did not fall under the short sale ban.The remainder of this paper is organized as follows. In Section I, we dis-cuss how events around the shorting ban impacted the equity options market.Section II provides a brief summary of related literature. In Section III, wedescribe our data. In Section IV, we investigate the impact of the short sale banon trading costs in the options market. Section V investigates the impact of theshort sale ban on the linkage between the equity and equity options markets.Section VI concludes.
I. The Setting 
In September 2008, as prices of financial stocks plunged, the SEC cameunderadditionalpressuretolimitshortsales.NewYorkStateAttorneyGeneral AndrewCuomoannouncedaninvestigationintoshortselling.SenatorsHillaryClinton and Chuck Schumer pressured SEC Commissioner Christopher Cox to

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