Options Market Participants Face New Regulatory Inquiries; Tried and True Remedies Are the Solution

As families get through back-to-school checklists, Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) are similarly going through their own regulatory check lists for options market participants. There are several new regulatory sweeps and enforcement inquiries being sent out now to options market participants, including questions about suitability, payment for order flow (PFOF), surveillance, and regulation of short sales issues.

The regulatory scrutiny is not a surprise. Retail investors are trading options more through online platforms, and recent options market volatility that resulted from meme trading has piqued media and Congressional interest, compelling regulators to take a closer look.

Options market participants must follow a wide array of self-regulatory organization (SRO) specific options trading requirements as well as SEC and SRO rules regarding stock trading. The regulatory requirements for options market participants often do not align because of the differences between options and stock markets. Options markets are quote-driven, where a customer order requires an intermediary such as an options market maker to post prices, whereas stock markets are order-driven, where customer orders to buy and sell are displayed.

Options markets are quote-driven for a myriad of reasons, including in part because there are more than one million options strikes daily, a number of options exchanges, the average display size for a strike is generally only ten contracts, and options participants can only place a single bid and offer for each option strike.

When I started working in the options markets, there was a sea of jacket colors and prints on the floor of the Chicago Board Options Exchange. However, mounting regulatory requirements such as increased capital requirements, new maker/taker fee models, and quoting obligations as well as market structure changes such as market data costs, the proliferation of strikes, and the increase in electronic trading have reduced that sea to a small pool today.

As options market participants set out to respond to SEC and FINRA questions about supervisory procedures, controls, and monitoring tools, it is important for a firm to be able to concisely explain to regulators the current governance framework it deploys to comprehensively review options trading activity. Patomak understands that this is no easy feat as most surveillance vendor tools are not designed to monitor for options sales and trading requirements. Based on recent exams and sweeps, regulators have prioritized the following options specific supervisory requirements:

• Anticipatory hedging – the options version of front running
• Tender shares reviews
• Activity around auctions – across markets including related activity in the futures and stock markets
• PFOF – such as options marketing fees
• Regulation short sale (SHO) – ensuring stock legs for complex orders are marked accurately, located appropriately, meet Rule 201 tick test requirements, and address any delivery failures
• Trading level suitability approvals
• Origin Code Designations – identifying professional customers and large traders

While the set of circumstances around the latest enforcement inquiries are new, short squeeze gamma play issues and remedies are not. Patomak experts have worked on options market issues for decades, including with firms challenging regulators, providing input to proposed regulations, and helping firms enhance their supervisory programs. In addition, Patomak has successfully worked with a number of broker dealers responding to regulatory enforcement and litigation actions to update trading system supervisory procedures, controls, and post trade reviews in an effort to proactively respond to shifting SEC and FINRA regulatory focuses across related products to create a sustainable process going forward.

Options markets are critical to overall market functions and bring a wide range of regulatory requirements. Regulators have their checklists and pens out reviewing recent events. Patomak is uniquely positioned to provide industry and regulatory expertise to help firms earn their passing grades in the months and years to come.

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