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CBOE Pays $ 6 Million to SEC on Charges of Oversight

by kraju

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In this article, International Finance Magazine reports the story with key inputs from “The Financial Times”. The story also explains short selling practices and recent court indictments on naked short selling and the unethical practices followed by traders to destabilize the prices of certain stocks.

The Securities and Exchange Commission (SEC) has imposed a penalty of $ 6 million on the Chicago Board Options Exchange (CBOE) to settle charges that it’s inadequate market policing resulted in numerous failings including an instance where it actively interfered with a regulatory investigation. This is the first time where a U.S. Options Exchange has agreed to pay a $ 6 million penalty to settle federal charges that it failed in its duty to enforce trading rules. The penalty imposed by SEC on CBOE comes at a time when the regulators have intensified scrutiny of for-profit U.S. Exchanges which battle each other for business.

The CBOE is a self-regulating organization, like NASDAQ and the New York Stock Exchange. They are charged with enforcing trading rules to their members. The SEC has broad oversight over the trading. But the day to day monitoring is managed by the exchanges and the Financial Regulatory Authority.  Among its allegations, the SEC said the owner of the Chicago Board Options Exchange had a “systematic breakdown” in its oversight by failing to enforce short selling regulations and by interfering with an investigation into a firm trading on its exchange. The alleged failures occurred from 2008 to 2012.

The SEC said, CBOE failed to prevent abusive short selling by a member firm. Short selling is when a trader bets a stock will lose value. Regulators opine excessive short selling targeted at weaker companies can push them into collapse and induce market volatility. The exchange agreed to take corrective action but did not admit any wrongdoing on its part. The SEC has also censured the exchange. Censure brings the possibility of harsher sanctions if the alleged violation is repeated. In a particular instance CBOE allegedly failed to detect or investigate OptionsExpress, a unit of U.S. brokerage Charles Schwab that was charged last year with running an abusive short selling scheme. Regulators have alleged that staffers in CBOE responsible for surveillance of short selling, which is guided by Reg SHO, lacked a fundamental understanding of the rules and never read them.

SEC alleged “CBOE demonstrated an overall inability to enforce Reg SHO with an ineffective surveillance program that failed to detect wrongdoing despite numerous redflags that its members were engaged in abusive short selling”.

Regulation SHO, has been implemented with effect from January 3, 2005. It seeks to update legislations concerning short sale practices. It has established the “locate” and “close out” standards that are primarily aimed at preventing the opportunity for unethical traders to engage in naked short selling practices.

The other violations which happened between 2008 and 2012, include a failure to notify regulators when changes to trading functions were implemented as well as unauthorized “customer accommodation” payments were made to some member firms.

The CBOE in a statement said “The settlement marks a significant step in putting the SEC matter behind us, but our commitment to maintain the highest standards in regulation and compliance will be carried forward throughout our organisation”. The CBOE is the only place to trade two popular options, one a bet on the future price of S&P 500 stock index and the other a type of insurance against wild swings in stock prices. The fine is the third against a U.S. exchange in a year after the NASDAQ and NYSE Euronext were penalized $ 10 m and $ 5 m respectively to settle charges on misconduct on their business operations. NASDAQ was fined for its computer failures and other decisions that are alleged to have disrupted Facebook’s public stock offering last year.

What is Short Selling?

Short selling is betting that a stock’s market value will decline. Essentially you sell shares that you don’t have at today’s price with a promise to replace them within a set period of time. You hope you can buy replacement shares cheaper within that time. If the replacement shares are bought within that time (see example below) you can gain on the difference amount, however if the prices of the share increases, you will have to buy replacement shares for more than what you sold, thus losing your money. Big brokers and banks manage to sell shares they don’t have by borrowing the shares from other institutions.

Example: I sell 1000 shares of ‘X’ company @ 10 $ per share, so total cash due will be 10,000dollars. The shares of ‘X’ company plummets and the share price is $ 5 per share. In order to deliver the 1000 shares sold at $ 10 per share, I buy 1000 shares @ $ per share, making $ 5,000 in the process. This is a case of calculative speculation that the shares of the company would fall significantly. Short sales are legal, but abusive short sales are illegal. For example, it is prohibited for any person or brokerage firms to engage in a series of transactions to depress the price of security for the purpose of inducing the purchase or sale of security by others. Short sales affected to manipulate the price of a stock are prohibited.

‘Naked’ Short Sale

Naked short sale is a scenario wherein the seller does not borrow or arrange to borrow the securities in time to make a delivery to the buyer within the stipulated three day settlement period. As a result, the seller fails to deliver securities to the buyer when delivery is due. However, there may be legitimate reasons for a failure to deliver. For example, human or mechanical errors or due to processing delays, such as transfer of securities through physical certificates rather than book entry form.

On Monday, June 10th, a SEC judge ruled that a former Maryland banker perpetrated a short selling fraud aided by one of the biggest stock options brokers in the U.S.  Jonathan Feldman, was accused by the SEC for trading billions of dollars of stock and options which misled other investors. The regulator told he was engaging in a practice referred to as ‘naked short selling’.

The SEC administrative judge an independent judicial authority, ordered Fredman to disgorge $ 2.7 million in profits from his alleged trading scheme and a civil penalty of $ 2 million.

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