“Self-regulation is a unique and fundamental component of federal securities regulation in the United States,” the SEC begins its order against the CBOE announced today, but it’s also a little silly. It’s right there in the name! If you’re doing it yourself, it’s not regulation; it’s just some stuff you’re doing. Regulation is being forced to do what you don’t want to do. And who better to force you to do what you don’t want to do than a voluntary organization that relies on your business to pay its salaries? Lots of people probably.
“CBOE agreed to pay a $6 million penalty and implement major remedial measures to settle the SEC’s charges,” from which you’d think there was a lot of terrible malfeasance. But not really? The order is more like a list of minor harmless-ish lawlessness by CBOE, albeit a long and varied list. As best I can tell it grew out of a sequence of events something like the following:
- A CBOE member firm, optionsXpress, engaged in a mildly complicated naked short selling scheme in violation of Regulation SHO.1
- CBOE didn’t catch it because, basically, they were dolts at Regulation SHO. From the order:2
For instance, CBOE staff responsible for the Exchange’s Reg. SHO surveillance never received any formal training on Reg. SHO, were instructed to read the rules themselves, did not have a basic understanding of what a failure to deliver was, and were unaware of the relationship between failures to deliver and a clearing firm’s net short position at the Depository Trust and Clearing Corporation (“DTCC”). In fact, the investigator primarily responsible for monitoring the Reg. SHO surveillance from the third quarter 2009 to the second quarter 2010 had never even read the rule in its entirety, but only briefly perused it.
- But, knowing they were dolts, they did have a conference call with the SEC, where they asked the SEC some questions and got some answers about short selling.
- The CBOE and SEC have different memories of what was said by whom on this call, with CBOE taking away from it something like “oh everything optionsXpress is doing is fine, shh, go back to sleep.”
- The CBOE’s version of events was repeated in various places, including optionsXpress’s submissions to the SEC.
- The SEC people involved got in a white-hot rage about being misquoted and decided to bring down the full weight of the SEC on the CBOE.3
- They had a lot to work with.
Like, for one thing, the naked-short-selling doltishness; CBOE seem to have had terrible-to-no procedures for catching Regulation SHO violations. Not ideal!
But most of the violations are places where the CBOE’s business function – making its members happy and convincing them to give the CBOE more trades – conflicted with, or looked like it conflicted with, or at least looked icky next to, CBOE’s regulatory function. So for instance CBOE’s conversation with the SEC got repeated in optionsXpress’s submissions to the SEC because CBOE took “the unprecedented step of providing information for, and edits to, the member firm’s Wells submission to the Commission,” which the SEC finds horrifying – “This conduct was egregious” – though it’s not exactly easy to tell why.4 The CBOE’s help with optionsXpress’s Wells submission was a compromise solution, though; optionsXpress had originally “asked the head of CBOE’s Department of Member Firm Regulation (‘DMFR’) to get the Commission to ‘back off’ its investigation.” Which: ballsy! Also:
Ultimately, CBOE declined the member firm’s request and informed the member firm that it would not advocate on its behalf with respect to the Commission’s investigation. Upon learning of this decision, CBOE’s former President and Chief Operating Officer emailed the head of DMFR: “Thanks. Showing that we tried helps. We can’t solve everyone’s problems. I appreciate it.”
The SEC again seems horrified by this email but, I dunno, what can you do? optionsXpress is “one of the biggest stock-options brokers in the U.S.,” and the CBOE is, y’know, an options exchange. CBOE didn’t need to break the law for their customer, or even help it get away with previously breaking the law, but they really did have to do some active listening when optionsXpress told them about its troubles. “Tell it to the judge” might work for a regulatory organization like the SEC, but for a self-regulator-cum-paid-service-provider it seems a little tone-deaf.
Many of the other problems look a lot like that. For instance, there was an affiliate of a CBOE member firm that CBOE’s regulators at the Department of Member Firm Regulation concluded needed to become a member firm itself. It dragged its heels a bit, and so DMFR was going to send it a Wells notice saying “you’ll get in trouble if you don’t register as a member.” And then:
When informed of this development by the former head of Member and Regulatory Services, who oversaw the DMFR, CBOE’s former President and Chief Operating Officer asked that the Wells notice not be issued until after an upcoming meeting with the member firm’s CEO, who, at the time, sat on CBOE’s Board and its Audit Committee. The purpose of that meeting, as described above, was to review the firm’s conduct and regulatory compliance.
Shortly after the meeting, the affiliate of the member firm completed its registration as a dealer. CBOE issued no Wells notice either to the member firm or to the affiliate concerning the registration issue.
I mean! Remember that the SEC is pretty much constantly issuing waivers to big banks to allow them to avoid the legal consequences of their frequently admitted frauds. And they’re a real regulator. For the CBOE to wait a week or two before issuing a warning to a major customer and board member seems pretty harmless.
Or there’s the story of a CBOE member firm who screwed up its order routing for a few months, causing it to miss out on market-making fees, after CBOE changed its routing system:
In 2009, a member firm asked CBOE about lower-than-expected payments for order flow. CBOE determined that the firm had not been identifying preferred market makers on its orders under the new routing system. Because the firm did not indicate its preferences on its orders, control of any marketing fee/pool dollars was given to the designated primary market maker and not to the firm. As a result, approximately $2.8 million in marketing fee/pool dollars was paid to the designated market maker during the July 2008 through March 2009 time period, instead of the member firm.
The member firm claimed it was unaware of the new procedures. Although CBOE took the position that the firm was on notice, CBOE nonetheless agreed to “reimburse” the firm up to $1.2 million (over seven monthly payments) in return for the firm increasing its order flow for each of those months. CBOE ultimately made five payments to the member firm totaling $857,000. These payments were not made pursuant to any rule. CBOE did not offer similar accommodations to other firms. Senior business executives at CBOE were responsible for the agreement.
Well, right? If you’re a regulator, and you change the rules, and someone screws up and loses $2.8 million, you can go ahead and tell them that that’s their problem. But if you’re a business and you change the rules and your customer loses $2.8 million, telling them “we warned you about this in the fine print” … well, would be fine, sometimes, bank fees and so forth, but if they’re a valued customer you might want to make some sort of accommodation. Consider Nasdaq’s response to the Facebook IPO, which was basically to run around lawlessly trying to make everybody happy. The SEC ultimately penalized them, too, for the lawlessness of it, but you can understand the impulse. “We screwed you and our rules don’t let us fix it” doesn’t win you repeat business.5
The SEC is unsympathetic to all of CBOE’s business concerns, and so the order concludes with a long list of remedial measures that CBOE has to take, which run in the direction of “mandatory formal training to its entire staff and management concerning regulatory independence” and “Updating and formalizing CBOE’s written policies regarding regulatory independence and confidentiality of regulatory information” and similar boring stuff. Also:
Hiring a Chief Compliance Officer …
Hiring two Deputy Chief Regulatory Officers …
Increasing CBOE’s regulatory budget by 52.8% over 2011 for 2012 and an additional 46.6% over 2012 for 2013 and increased [sic] the headcount of the Regulatory Services Division from 99 approved positions in October 2011 to 169 approved positions by April 2013 …
See? Securities regulators have their own way of looking out for the business.
- Get long a hard-to-borrow stock synthetically by buying a call and selling a same-strike put,
- Get short the same stock synthetically by selling a deep-in-the-money call,
- Get exercised on the call immediately (because it’s a hard-to-borrow stock and the call buyer can’t hedge by shorting),
- Fail to deliver the stock on the call (because you can’t borrow the stock),
- Enter into a new “buy-write” by buying in the stock and selling a new deep-ITM call,
- And then deliver the stock you bought to the first call buyer while failing to deliver to the second,
- etc. ad infinitum.
People get very worked up about naked short-selling as market manipulation, and then other people get very worked up by the fact that short selling is good blah blah, but those are distractions from what’s going on here. There’s no net market impact here: optionsXpress was always delta-neutral, long as much stock as it was short. It wasn’t doing anything about the stock price; it was just effectively getting paid the borrow cost for the stock (in the premium it was paid on the deep-ITM call) while not actually paying to borrow the stock. It’s not market manipulation, it’s just a pretty straightforward rip-off. (Though: a regulatory rip-off; if naked short selling was legal then you wouldn’t need to borrow stock to short and so optionsXpress couldn’t get paid a borrow fee in the financing rate on the calls it sold.)
2. Does that strike you as more or less understandable because they were an options exchange rather than a stock exchange? Like, on the one hand: they’re not a stock exchange, how should they know about stock short-selling rules. On the other hand: they’re an options exchange, all of their members are shorting stock all the time, presumably they should be educated on the basic rules involved in short sales etc.
3. There’s not a lot of detail on what exactly happened on this call and, anyway, it’s boring. The point is that CBOE people claimed that the SEC said Thing X, while the SEC people now claim they said Thing Y, and Thing Y is what the law says and Thing X is just wrong. So you can see why the SEC people would be pissed that the CBOE claims they got the law wrong. Though, from how pissed they got, you might speculate that they’re overcompensating and really did screw up? I dunno.
4. Best I can tell it’s that “CBOE investigations, and information obtained from other regulators during those investigations, were to be kept confidential.” Oh incidentally the SEC explains that:
A Wells submission is a memorandum or video in which a witness in a Commission investigation makes factual, legal or policy arguments in response to a Wells notice from the Commission’s Enforcement Division staff in an effort to persuade the Commission not to charge them with federal securities violations.
Video? Do you think they get a lot of videos? I’m intrigued.
5. Incidentally one of the problems in the Facebook IPO was that Nasdaq bought a lot of shares in its error account, but it turns out it wasn’t allowed to have an error account. CBOE, same problem:
CBOE maintained error accounts at two brokerage firms through which the Exchange conducted trades to compensate member firms for errors as well as to make “accommodation payments.” CBSX also maintained an error account at one of the brokerage firms.
To fix an error or to make an accommodation payment through the error accounts, CBOE’s execution services department would write trade tickets into one of the error accounts. The counterparty would do the same. CBOE had no rules in place permitting these actions. …
While it is unclear what percentage of the transactions in the error accounts were bona fide errors and what percentage were accommodation payments (i.e., non-bona fide errors), there were no rules in place which permitted the use of the error accounts and the error accounts were used to compensate certain member firms for non-bona fide errors.