The Options Maker Exemption is a loophole that is often abused and is a readily available source of a large number of counterfeit shares. Options trading and abuse thereof, is incredibly complex with many layers of instruments and trading strategies, i.e. straddles, married trades, derivatives, etc. It is far more complex than the simple puts and calls that most investors are familiar with. The fundamental tenant of this loophole is that an options trader may utilize equities (stock) to hedge a trading position. Options traders rarely own any shares in companies they are trading options in. Consequently, the regulators allow the trader to keep his position neutral by offsetting it with an equity transaction.
For example, let's say an options trader writes a put contract for a stock that is near or in the money. The trader, by writing this contract, is agreeing to purchase the shares from a third party at a specific price — let's say $10 for the sake of this example. If the stock price plummets to $5, the contract will be put to the trader, forcing him to buy the stock for $10 — at a loss of $5. The trader protects himself by selling a naked short at the time he writes the put contract. By doing that, under our example, he has made a $5 profit on the naked short that offsets the $5 loss on the option contract. This is considered a legitimate hedge, and the naked short sale is allowed per the options maker exemption.
This exemption is fraught with opportunities for abuse. Once the underlying put contract expires, little effort is made to collect the naked short shares that were sold initially: They tend to remain permanently in circulation. The shorts may purchase huge put contracts for long positions they don't own. For the cost of the put, they have caused the stock of a victim company to be flooded with counterfeit shares from the options trader, thereby driving the price down even more.
It is important to understand that virtually all of the broker dealers are also options traders, so it is all in house. Also important is that in 2000, the enforcement responsibility for these transactions was split between the SEC and the Commodities Futures Trading Commission. Each agency seemingly relies on the other, and, as a consequence, there is virtually no enforcement in this area. Rampant abuse is the predictable result.
The SEC and the broker dealers believe that if the transaction can be made to look like a legitimate hedge, even though it is generating millions of counterfeit shares that are being used to manipulate a stock, then it is okay. The system is easy to game.
Let's say there is a play on, involving a consortium of shorts which includes a number of broker dealers, to crush a stock by flooding the market with counterfeit shares. The play works as follows:
Broker dealer A, who is also an options trader, writes an options contract for 5 million shares to broker dealer B that expires in (say) two years. Based upon writing this contract, broker dealer A is allowed to short 5 million counterfeit shares. Broker dealer B writes the same contract to broker dealer A, except it expires in two years and one day. The extra day fools the regulators and the broker dealers' compliance department into believing this is not a match trade. Now broker dealer B can naked short 5 million counterfeit shares — a 10 million share stock pile of counterfeit shares is now available to use to crush the victim company's stock with. Aside from the Ponzi-scheme nature of the offsetting puts, the common expectation is that the short cabal will be able to put the company out of business prior to the options contract expiration. At expiration the offsetting contracts “wash out” leaving behind the counterfeit shares. These contracts are almost never put through an options exchange, and, therefore, are invisible to all except the perpetrators.
Not covered under the Options Maker Exemption, but a source of counterfeit shares that flow from the options traders, is the rule that a short may use a current maturity call as his “borrowed” share, enabling him to “legally” sell a counterfeit share. The call has no real share behind it in most cases. If the contract is not a current maturity call, that requirement is circumvented by the short notifying the options trader that he wants delivery of the shares. This causes the SEC to view the sale of the counterfeit share as a legitimate short share being sold.
In most of these abusive transactions, the option contracts only purpose is to facilitate the counterfeiting of large numbers of shares — the option contract is really trading residue. Once the contract has served its purpose of “legitimizing” the counterfeiting and fooling the regulators, it has no value to the short. Frequently these contracts, by agreement between the options trader(s) and/or the short, are unwound before they settle. Within the industry, these are referred to as “walk away” contracts. The counterfeit shares are almost always left behind, perpetually in circulation.
Should the SEC attempt to examine any of these transactions, the broker dealer can move the shares out by doing a match trade with another broker dealer. Essentially this is: You buy 100 of mine and I'll buy 100 of yours. In an examination, the SEC sees broker A's naked short position being sold, and, hence, off the books of broker A. They also see that broker A purchased a short position from broker B which resets the fail-to-deliver clock. Broker A is found to be in compliance because the time requirements of his position becoming a failed position have been reset, putting broker A in compliance, hence the investigation is ended. The execution of this simplistic scheme is far more elaborate, with lot sizes changed and multiple stops along the way, frequently outside of the U.S. Figuring this out is laborious but possible, but is rarely undertaken by the SEC.