Similarly, the SEC's short ban is causing tumult in the options markets.

Monday could be disasterous:

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Short-selling ban hobbles CBOE, Citadel

By Ann Saphir
Sept. 19, 2008

(Crain’s) — An emergency federal ban on short-selling some stocks may choke trading at the Chicago Board Options Exchange and hurt business at Citadel Investment Group’s market-making arm.

Both have handled record volume amid the financial crisis this past week.

In selling short, investors borrow stock to sell, betting it will decline and hoping to profit by buying it back at a lower price. Manipulative short-selling may have fueled the rapid declines of some financial stocks this week, the Securities and Exchange Commission says.

Following criticism of short sellers from politicians, the agency imposed a two-week ban — which began Friday and will last through Oct. 2 — on such trading in all 799 U.S. financial stocks. Stock markets rallied on Friday partly because of the ban.

At issue for CBOE: The order fails to exempt options market makers, even though such traders use short-selling to protect against losses in their day-to-day business, not to bet on markets. Without an exemption, CBOE market makers — whose jobs are to ensure smooth trading by standing ready to buy when an investor wants to sell — say they’ll be unable to do their job properly.

That’s a “potential complete disaster,” says Susan Milligan, chief lobbyist for Chicago-based Options Clearing Corp.

“Appeals are being made to the SEC to extend relief to market makers,” Ms. Milligan says. “If they don’t provide that relief, I don’t see how options market makers are going to be able to make markets in these options come Monday.”

The short-selling ban imposes “a huge cost to the retail investor,” says Peter Bottini, an executive vice-president at Chicago-based OptionsXpress Inc. By midday Friday, the ban had reduced liquidity in the stock market, making it more expensive for investors to place trades, he says. “We are very nervous it’s going to be worse on Monday,” when the ban is applied to the options markets.

Options exchanges are “very upset and are scrambling” to get exemptions extended for next week, he said.

In a statement Friday, CBOE Chief Executive William Brodsky said, “It is difficult to comprehend the merits of a draconian measure that will result in the sudden and severe removal of liquidity from the marketplace at the same time that the government is taking unprecedented steps to preserve it.”

Mr. Brodsky was in Washington, D.C., asking regulators and lawmakers to intervene. "The lack of relief for options market makers will have serious ramifications for the reliability of the options market and for the efficiency of our capital markets overall," he said.

Separately, Northern Trust Corp., one of the largest lenders of stock to short sellers, will see its business hurt. Stock lending has been a key source of revenue for the Chicago-based bank.

Significantly, the SEC has allowed a market-maker exemption for Friday, when this quarter’s options expire, typically a high-volume trading day.

But on Monday, when the rule goes to into effect, CBOE and its market makers, which include Chicago-based Citadel, should see business shrink. And without options, investors may be unable to avail themselves of an increasingly popular tool to protect against losses.

Citadel handles about 26% of all U.S. options trading. CBOE handles about 33%. Trading in options on financial stocks accounted for about 12% of all U.S. options volume through August. A spokeswoman at Citadel declined to comment.

Not everyone in Chicago agrees that market makers should get an exemption.

Jon Najarian, co-founder of market commentator optionmonster.com, says he disagrees with the ban on short-selling, but if such a ban is in effect, it should apply to everyone. Otherwise, “all the bad guys will find a way to use someone’s exemption to get around it,” he says.