The Securities and Exchange Commission (SEC) has issued a risk alert highlighting strategies used to circumvent its short-selling rule through options trading.
On Friday, the Commission’s Office of Compliance Inspections and Examinations sent out an alert highlighting options trading strategies that sought to falsely meet the ‘close-out’ rule for short sellers, to help market participants prevent and detect such tactics.
In a statement, the SEC said under Regulation SHO, short sellers who fail to deliver securities after the settlement date are required to close out their position immediately, unless they qualify, as bona fide market makers, for a limited amount of extra time to close-out.
The Commission has detected a variety of tactics to avoid the ‘close-out’ rule through options trading. The rules were brought in to ensure prompt settlement for short selling trades to reduce settlement failure.
Short selling involves profiting from price declines by replacing borrowed securities at a lower price.
“This risk alert encourages awareness of options trading activity used to avoid complying with the close-out requirements under regulation SHO,” said Andrew Bowden, director of the SEC’s Office of Compliance and Examinations.
“The alert describes these trading activities in detail to help broker-dealers and their correspondent clearing firms avoid the regulatory and reputational risks that are posed by these activities,” he said.
The Commission also pointed to other techniques some short sellers have employed to avoid Reg SHO. These include trading in securities that are hard to borrow, multiple large trades with the same trader acting as a contra party and continuous failure to deliver positions.