The Financial Industry Regulatory Authority today proposed an increase of position limits on several of the most traded ETF options contracts; these changes, it said, would increase liquidity and add depth to the market.
The proposal, which would double the limits on such contracts as the PowerShares QQQ Trust (QQQ) and S&P’s Depository Trust (SPY), must first be approved by the Securities and Exchange Commission.
FINRA is asking for the rule change, which would affect nine contracts, to take immediate effect if approved by the SEC, thus waiving the 30-day delay the agency typically demands. Options exchanges normally will set position limits; in fact, limits for SPY were doubled to 1.8 million after a NYSE Arca pilot program that ended in July that had eliminated position limits on that product.
The ETF options contracts affected include position limits officially increased to: 1) 1.8 million on SPY and QQQ; 2) 1 million on Russell 2000 Index (IWM) and MSCI Emerging Markets Index (EEM); and 3) 500,000 on FTSE China 50 Index (FXI), MSCI EAFE Index (EFA), MSCI Brazil 25/50 Index (EWZ), ICE U.S. Treasury 20+ Year Bond Index (TLT), MSCI Japan Index (EWJ).
SPY’s fund market capitalization in 2017 was $240.5 billion while QQQ’s was $78.8 billion.
FINRA says the broad-based indexes are unfairly subject to tighter position limits than the underlying indexes:
“FINRA believes that if certain position limits are appropriate for the options overlying the same index, or an analogue to the basket of securities that the ETF tracks, then those same economically equivalent position limits should be appropriate for the option overlying the ETF. In addition, the market capitalization of the underlying index or reference asset is large enough to absorb any price movements that may be caused by an oversized trade. Also, the issuer may look to the stocks comprising the analogous underlying index or reference asset when seeking to create additional ETF shares which are part of the creation/redemption process to address supply and demand or to mitigate the price movement of the price of the ETF.”
One example provided is with QQQ, which tracks the Nasdaq 100 Index (NDX). Options on the NDX have no position limits but “share similar trading characteristics as QQQ,” states the FINRA proposal.
Using $154.5422 as the QQQ share price, and NDX level of 6,339.14, FINRA showed where 40 contracts of QQQ equals one share of NDX. If it was assumed the position limit on the NDX was 25,000 contracts, as is the minimum under exchange rules for broad-based contracts, the equivalent would be 100,000 for QQQ.
However, there are no position limits on NDX, which has an average daily trading volume of 15,300, while options on QQQ, with the current position limit of 900,000, have an ADV of roughly 580,000 contracts. That said, the component securities of the NDX in aggregate traded 440 million shares per day in 2017, thus “both market capitalizations being large enough to absorb any price movement by a large trade in QQQ.”
The argument that these ETF options contracts are as liquid or more so than their underlying indexes, which have for the most part no position limits, runs throughout each of FINRA’s contract arguments.
Finra also noted it was confident in surveillance procedures by the exchanges to identify any unusual activity in both the options and underlying stocks. In addition, regulators can keep an eye on margin and capital of members holding large positions, and can impose a higher capital charge on those members if they believe it necessary.
FINRA stated it believes “that the proposed rule change promotes consistent regulation by harmonizing position limits with those of the other self-regulatory organizations. FINRA further believes that increasing the position limit on conventional options promotes consistent regulation by harmonizing the position limit with its standardized counterpart.”
There will be a 60-day period in which comments will be accepted. However, the SEC has the right to suspend the proposal if it feels it’s not in the public interest and move on to hearings on its probity.
— Check out FINRA Rule 2010: A Short Rule With a Long Reach on ThinkAdvisor.