New SEC rules could hamper option market makers job

CHICAGO (Reuters) - The latest clampdown on short selling is expected to make it harder for option market makers to do their job and provide liquidity at a time when investors are actively using options to limit their stock market risk.

The U.S. Securities and Exchange Commission on Wednesday introduced three new rules covering shares of all publicly traded companies aimed at curbing abusive naked short selling in all stocks.

Under a measure that takes effect Thursday, option market makers are required to deliver securities by the close of business on the settlement date, three days after the sale.

The role of option market makers is to provide liquidity in put and call options that may require them to short stock as a temporary hedge. But if they are not easily able to short stock, then the quality of their market would deteriorate.

"The obligation of a market maker does not presuppose what hedge he will need to do during the day," said Peter Bottini, executive vice president for trading at online brokerage optionsXpress Inc OXPS.O. "They stand ready to buy or sell options in response to customers' demand.

"This rule greatly inhibits their ability to do that," Bottini said, adding that it could take a lot of liquidity out of the listed options markets.

Each time a market maker does a trade that would require a short stock as a hedge, they would have locate in advance someone who is willing to lend them the stock, "which could totally gum up the works," said Thomas Haugh, chief investment officer at brokerage firm PTI Securities and Futures.

The rule also has the potential for changing options prices and bid/ask spreads since the cost of borrowing shares for those market makers may increase, said Scott Fullman, director of derivatives investment strategy at broker-dealer WJB Capital Group.

"Additionally, market makers may also increase spreads to accommodate the extra time required to secure the borrow, leaving them at risk of a moving market," Fullman said.

The SEC's action comes as option volatility surged.

Investors were rattled after investment bank Lehman Brothers Holdings LEH.N went bankrupt, its rival Merrill Lynch MER.N was forced to sell itself and the U.S. government organized a rescue plan for insurer American International Group (AIG.N).

Short sellers arrange to borrow shares they consider overvalued and sell them in hopes of making a profit when the price drops. A "naked" short sale occurs when an investor sells stock that has not yet been borrowed.

A put option gives the right to sell the company's stock at a given price and time while a call conveys the right to buy the shares at a preset price and time.

Although effective on Thursday, the SEC will open a 30-day public comment period for the rule on delivery of securities.

(Editing by Leslie Gevirtz)