SEC Fines CBOE $6 Million for Short Selling Failures

The SEC, has fined CBOE for a $6 million fine after the exchange was found violating regulations relating to abusive

541128_judje_hammerUS financial watchdog, the Securities and Exchange Commission, (SEC) has charged one of the largest futures and options trading venues, the Chicago Board Options Exchange (CBOE), with a financial penalty of $6 million for various systemic breakdowns in their regulatory and compliance functions as a self-regulatory organization.

The notice highlights the exchange’s shortcomings when enforcing rules and regulations in regards to abusive short selling. The Chicago based trading venue has agreed to pay a $6 million penalty and will implement measures to ensure it adheres to rules set by the regulator in a bid to settle the SEC’s charges.

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What went wrong?

The SEC was concerned with how the CBOE disregarded rulings in relation to Regulation SHO, an eight year old law that aims to prevent the opportunity for unethical traders to engage in naked short selling practices. According to the SEC’s order, CBOE demonstrated an overall inability to enforce Reg. SHO with an ineffective surveillance program that failed to detect wrongdoing despite numerous red flags that its members were engaged in abusive short selling. The order also showed that the CBOE also fell short in its regulatory and compliance responsibilities in several other areas during a four-year period.

“The proper regulation of the markets relies on Self-regulatory organizations (SROs) to aggressively police their member firms and enforce their rules as well as the securities laws,” said Andrew J. Ceresney, Co-Director of the SEC’s Division of Enforcement in a statement. “When SROs fail to regulate responsibly the conduct of their member firms as CBOE did here, we will not hesitate to bring an enforcement action.”


The $6 million penalty is the first of its kind for an exchange, breaching violations related to its regulatory oversight. Previous financial penalties against exchanges involved misconduct on the business side of their operations.

As a Self-regulatory organizations (SROs), the CBOE is obliged to enforce the federal securities laws as well as their own rules to regulate trading on their exchanges by their member firms, says the SEC on a statement on their website.

In the alleged incident the SEC believes the CBOE put the interests of the firm (one of its members who is involved in the case) ahead of its regulatory obligations by failing to properly investigate the firm’s compliance with Regulation SHO and then interfering with the SEC investigation of the firm.

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Daniel M. Hawke, Chief of the SEC Enforcement Division’s Market Abuse Unit, said in the official briefing: “CBOE’s failures in this case were disappointing. The public depends on SROs to provide a watchful eye on their exchanges and market activities occurring through them. They must have strong compliance cultures and adequate and dedicated compliance resources to ensure that they do not stray from their bedrock obligation to provide rigorous self-regulation.”

And there’s more..

Details cited in the SEC’s order state that the exchange moved its surveillance and monitoring of Reg. SHO compliance from one department to another in 2008, and as a result of the transfer of responsibilities the Reg, SHO was not properly monitored.

Reg. SHO requires the delivery of equity securities to a registered clearing agency when delivery is due, generally three days after the trade date (T+3). If no delivery is made by that time, the firm must purchase or borrow the securities to close out that failure-to-deliver position by no later than the beginning of regular trading hours on the next day (T+4). CBOE failed to adequately enforce Reg. SHO because its staff lacked a fundamental understanding of the rule. CBOE investigators responsible for Reg. SHO surveillance never received any formal training. CBOE never ensured that its investigators even read the rules. Therefore, they did not have a basic understanding of a failure to deliver.

According to the SEC’s order, CBOE received a complaint in February 2009 about possible short sale violations involving a customer account at a member firm. CBOE began investigating whether the trading activity violated Rule 204T of Reg. SHO. However, CBOE staff assigned to the case did not know how to determine if a fail existed and were confused about whether Reg. SHO applied to a retail customer. CBOE closed its Reg. SHO investigation later that year.

Governments and financial regulators have placed short selling bans when markets face intense pressure or act in exceptional conditions. In a mechanism to create efficiency in the markets, regulators enforce bans on short selling of instruments to avoid traders driving down the price of shares,  when not owning them, to purchase them at a lower price. Aggressive short selling was thought to be behind the falling share prices of major banks during the 2008 crisis.

Short selling related fines are not un-common, Swiss banking giant UBS was fined $12 million by FINRA in 2011. OptionsXpress, an entity that was acquired by Charles Schwab Corporation in 2011 for $1 billion was fined $4.8 million by the SEC for selling shares they did not physically hold.

Most regulators in developed countries have implement some sort of ban on short selling, in 2008 Singapore’s MAS and Japan’s government placed short sell bans on their domestic markets.

Industry professionals have leapt out at the bans stating that they have no major impact in reviving the market, in fact they serve as a negative because investors lose confidence and liquidity dries up.

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