Tricks on Halloween are not the only surprises that mark the month of October. In politics, we have “October Surprises” just before Election Day, and over time we have experienced economic October surprises, as well.

The financial phenomenon even has a name: the “October Effect.” Of course, nothing particularly about October makes it more precarious for investors than any other month. Those dark October days occurred for legitimate reasons, whether it be the collapse of the copper market and the shuttering of investment houses in 1907 or the failure of programmed trading in 1987.

In each of these instances, the policy responses were reactive to the crisis. Given the recent volatility of the markets, and as we move deeper into October, it is opportune that financial regulators are considering a specific policy change that could further buttress markets from October Effect-like swings, particularly in the U.S. options market. Importantly, history shows that such autumnal turbulence is not an outlier, especially at a time when focus on market liquidity concerns has sharpened.

On Oct. 30, 2018, the Federal Reserve, Comptroller of the Currency and the Federal Deposit Insurance Corporation issued a proposal that would update how banking organizations measure counterparty credit risk posed by options contracts, among other financial instruments. This proposal would replace the Current Exposure Method (CEM) with a more risk-sensitive calculation called the “Standardized Approach for Measuring Counterparty Credit Risk” (SA-CCR).  While the proposal may appear obscure, it is crucial to a well-functioning financial market for all investors, particularly during volatile trading periods.

Within the U.S. financial markets, options markets, which are regulated by the Securities and Exchange Commission, play an important role in balancing the overall marketplace, particularly in volatile times when markets might otherwise become strained.  Indeed, options market makers play an outsized role in pricing and supplying liquidity in the options markets; they are obligated to do so in the midst of market selloffs when demand for options historically increases significantly.

These market makers are the backbone of the U.S. options markets. Every trading session of buying and selling options contracts allows them to build up large portfolios of instruments that may have a significant notional value, but because of careful risk management, the positions are offset, resulting in overall low risk.  While the CEM has been an available tool over the past 30 or so years, it was not designed for use in the options market, which has seen dramatic contraction and increased concentration among clearing firms, as well as market making firms. A 2017 Wall Street Journal article explained that falling volumes, thinning liquidity and spiraling costs have “prompted at least six prominent options market makers to exit from the business since 2012.”

The number of market-making firms involved in options contracts has significantly contracted also because of the high costs of clearing as a result of CEM. Similarly, there are only two bank-owned clearing firms responsible for clearing all trades for these market makers (Goldman Sachs and Bank of America/Merrill Lynch).  Complicating the clearance process for these clearing firms is the use of the CEM to calculate bank capital, which results in their curtailing the size of the portfolio their market maker clients can maintain, without regard to risk.

The lack of liquidity, particularly in the fourth quarter of the year, was highlighted in a June 2019 JPMorgan analysis that noted a collapse in liquidity presented a greater risk to quantitative strategies than a bear market or a sharp rate increase.  The WSJ similarly noted that in August 2019: The “number of options available to buy or sell on one of the biggest exchange-traded funds tracking the S&P 500, used to hedge portfolios, fell to the lowest level of the year.”

The CEM for calculating bank capital to hold against their customers’ positions may be appropriate for such markets as commodities, but the CEM significantly affects option pricing and severely constrains liquidity, particularly near month-end, when market makers have reached the capped limits of liquidity set by the banks. As a result, underlying markets are less stable, a considerable selloff in the markets is more likely, and the markets are less capable of appropriately coping with and recovering from such a down move, introducing a new source of systemic risk.

If implemented, SA-CCR would allow banks to more appropriately calculate how much capital they must set aside to offset risks and how close they are getting to leverage limits, which would also free up additional liquidity for market makers to meet their inventory needs and be in a position to better address strains on the market.

For more than a century, history has noted policy makers’ responses in the aftermath of significant financial market events. Today, policymakers at the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC can move beyond the purely reactive and proactively institute policies that better serve all players in the U.S. market during times of volatility, when a well-functioning market is perhaps most needed. October 2019 will mark a full year of consideration and an appropriate moment for the adoption and implementation process to move ahead.

The editorial originally appeared in Morning Consult and can be found here: https://morningconsult.com/opinions/a-welcome-october-surprise-bank-regulators-can-adopt-proactive-policies/