Risks and Hedges of Providing Liquidity in Complex Securities: The Impact of Insider Trading on Options Market Makers
Dolgopolov, Stanislav, Fordham Journal of Corporate & Financial Law
This Article analyzes the impact of insider trading on options market makers from the perspective of the characteristics of options as complex securities, the structural features of options markets, and the corresponding unique risks and hedges of these market participants. It is argued that options market makers, as opposed to their counterparts in equity markets, suffer unique substantial losses from insider trading, and evidence to support this proposition is offered. Judicial decisions on losses of options traders from insider trading are reviewed and critiqued in order to develop several elements of a methodology for calculating losses of options market makers. The uniqueness of risks and hedges of options market makers is further illustrated in the context of fraud-on-the-market.
The practice of "insider trading," one form of "informed trading" in securities markets with asymmetrically distributed information, is the subject of fierce and protracted debate in fields such as securities regulation, economics, corporate governance, politics and, ethics.1 The term "insider trading" typically encompasses transactions on companyspecific, material nonpublic information obtained through employment status or special access to such information. This practice is probably as old as the existence of securities markets.2 Insider trading is common in today's sophisticated financial markets, given factors such as the availability of active and relatively anonymous trading venues, derivatives as a means of leverage, and frequent announcements which generate large price movements.3 While several empirical studies suggest that insider trading regulation in the United States and abroad is somewhat effective, other studies point at unintended consequences of such regulation and even question its effectiveness and overall impact.4
Outsiders' losses caused by insider trading is the crucial issue in the context of civil liability.5 Early insider trading cases typically addressed face-to-face transactions which occurred in arguably deceptive circumstances and inflicted losses on readily identifiable individuals who were otherwise unlikely to consummate such transactions.6 Much of the contemporary criticism relating to insider trading in organized markets was directed at speculation by corporate directors and managers because of the perceived inadequacy of disclosure and their incentives to manipulate stock prices to create profitable trading opportunities.7 Furthermore, the intertwined issues of loss causation and estimation of damages are more problematic in organized markets.8 From a static perspective, insider trading in organized markets is still a zero-sum game which redistributes wealth from outsiders to insiders,9 but it is difficult to identify "losers" in both actual and preempted transactions, let alone calculate such losses.10 Several publications in the 1960s and 1970s pointed to market makers11 as a group directly harmed by insider trading.12 This theoretical argument seemed to be quite insignificant in practice, and equity market makers themselves did not appear to be concerned about insider trading as such.13 Yet, in later years, this argument gained force. Frequent reports of substantial losses of options market makers14 from insider trading15 coincided with the emergence of exchange-traded standardized equity options.16
The U.S. Congress codified the private right of action "in connection with a purchase or sale of a put, call, straddle, option, privilege" in 1984,17 and, prior to this legislation, several courts had already established liability for trading options on inside information.18 Courts also often recognized the economic utility of options markets instead of labeling these derivatives as purely speculative.19 This existing case law, however, yields no comprehensive analysis of the unique nature of losses of options market makers, given their trading strategies and risk exposures. …