Volcker and Options Explained

President Barack Obamaa, flanked by Paul Volck...

Volcker and Obama

In February 2012, options market makers accounted for roughly 49%[1] of all options trades, making them the largest participant group in the options industry. A market maker plays an integral role in the financial markets acting at any given time as a buyer or seller to meet the demands of investors, providing liquidity and price transparency. As such, a market maker assumes risk and securities positions that they manage over varying time frames depending on the security and market conditions. Within the Volcker proposal there is a carve out that aims to protect market making activity by differentiating it from “prohibited proprietary trading.” However, the market maker exemption in the Volcker  proposal is narrowly defined and there is a danger that legitimate options market making activity may be swept into the broad definition of “prohibited proprietary trading,” resulting in a less transparent and less liquid marketplace for customers.

In January 2010 President Obama endorsed proposed legislation that would restrict the size and scope of financial institutions. This proposed legislation is called the Volcker Rule and is a subset of the Dodd-Frank Act. The Volcker Rule contains certain prohibitions on the ability of a banking entity to engage in proprietary trading and restricts relationships with private equity firms and hedge funds. Although the Volcker Rule is clearly well intentioned, as with any piece of legislation there are often a number of unintended consequences and written in its current form, the Volcker Rule has the ability to negatively impact the options market place, specifically options market makers.

Currently, a number of everyday options market making activities are considered to be prohibited behavior under the Volcker proposal. These activities include paying transaction fees to execute a trade, taking liquidity and holding inventory. For example, market makers are required to take positions to facilitate liquidity when there is an imbalance in customer buying and selling demand. Market makers correct these imbalances by immediately taking the other side of trades and holding those positions as inventory while they attempt to find liquidity to offset the risk. In doing so, market makers assume risk positions that may accumulate either profits or losses. The profits and losses are a consequence of the market maker facilitating trading with its customers, not it trying to trade for its own books for profit. Yet, under the current structure this behavior could be considered in violation of Volcker.

Thanks to strict requirements on exchanges, there are already a lot of regulations that market makers must adhere to. If we constrain market makers any further there is a concern that banking entities may deem the costs of complying to Volcker too high and withdraw from the market altogether.

As an exchange we are concerned that a reduction in market makers in the options industry would lead to a reduction in liquidity, reduced price transparency and an increase in the cost to investors. NYSE Euronext submitted a comment letter on this important proposal and we are hopeful that these issues will be considered carefully.

For a more information please read NYSE Euronext’s comment letter on the issue.

[1] Data from OCC

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