FINRA Requests Comment on Proposed Trade Reporting Requirements for Over-The-Counter Options Transactions

Summary

FINRA is soliciting comment on a proposal to establish a new trade reporting requirement for transactions in over-the-counter options on securities with terms that are identical or substantially similar to listed options. FINRA is proposing to require firms to report this information to FINRA on a daily basis (end-of-day) for regulatory purposes only.

Questions regarding this Notice should be directed to:

• Danny Mileto, Vice President, Market Regulation, at (212) 457-5323 or email; or
• Adam Kezsbom, Associate General Counsel, Office of General Counsel, at (202) 728-8364 or email.

Questions regarding the Economic Impact Assessment in this Notice should be directed to Matthew Peppe, Economist, Office of the Chief Economist, at (202) 222-8841 or email.

Action Requested

FINRA encourages all interested parties to comment on this proposal. Comments must be received by September 20, 2022.

Comments must be submitted through one of the following methods:

• Online using FINRA’s comment form for this Notice;
• Emailing comments to [email protected]; or
• Mailing comments in hard copy to:

Jennifer Piorko Mitchell
Office of the Corporate Secretary
FINRA
1735 K Street, NW
Washington, DC 20006-1506

To help FINRA process and review comments more efficiently, persons should use only one method to comment on the proposal.

Important Notes: Comments received in response to Regulatory Notices will be made available to the public on the FINRA website. In general, comments will be posted as they are received.¹ Before becoming effective, the proposed rule change must be filed with the SEC pursuant to Section 19(b) of the Securities Exchange Act of 1934 (SEA or Exchange Act).²

Background and Discussion

As a general matter, firms may trade “listed options” (i.e., “standardized options”) through a registered options exchange³ or firms may trade “over-the-counter options” (i.e., OTC or “conventional” options), which are customized, bilateral options transaction agreed to and traded directly by the parties to the option contract.⁴ A firm may choose to trade an OTC option even where the terms of the OTC option are identical or substantially similar to a listed option. When a firm trades an OTC option, the transaction is not generally cleared by a central clearing agency, nor is the transaction required to be reported to FINRA, the SEC, an exchange or the Consolidated Audit Trail.⁵ Thus, there is limited information available to regulators or the public regarding these transactions. 

Based on FINRA’s analysis, a significant amount of firm trading occurs in OTC options with terms that are substantially similar to listed options. While FINRA does not currently have access to a data source specifically for transactions in OTC options, firms currently are required to report OTC and listed large options positions to FINRA pursuant to Rule 2360 (Options) (the large options positions reporting (LOPR) or LOPR rule). Using LOPR data, FINRA is able to infer the net notional amount of OTC options trading that occurred on a given day. Based on these calculations, FINRA believes that the notional amount of OTC options trading activity is significant. However, LOPR information is limited in many respects and does not identify a number of critical data elements that would be helpful for surveillance purposes, such as the price and time of individual transactions.⁶  

Proposed Amendments

To address this regulatory gap, FINRA proposes to require firms to report transactions in an OTC option⁷ that is a put⁸ or call⁹ on a listed underlying security(ies) (including an option on an individual underlying security or an option on a basket of securities that meets the definition of a “conventional index option”¹⁰), including transactions executed by the firm on either a principal or agency basis. This proposal is limited to options with terms that are identical or substantially similar to listed options, including FLEX options.¹¹ Specifically, firms would be required to report a trade in an OTC option where:

1. there is a listed option on the same underlying security (e.g., a single stock or an index),¹² or the OTC option is overlying one or more U.S.-listed securities;¹³
2. the option type is a put, a call, or an option type related to a put or a call;¹⁴ and
3. where the exercise style is one of the following: American, European, Asian, Cliquet or Binary.¹⁵

For OTC options that meet the above criteria, FINRA proposes to require firms to report the data elements specified in Appendix A.¹⁶ 

The proposal would require firms to submit OTC option trades in batch form to FINRA on a daily basis through fileX, FINRA’s data collection platform. Firms would be permitted to correct previously reported information up to five days following trade date (T+5), consistent with the correction timeframe in the LOPR system. Firms would be required to report both the initial trade as well as any amendments to the initial contract that change any of the terms previously reported. Firms would also be required to report when the option is exercised. Firms would not, however, be required to report actions occurring pursuant to the terms of the contract (e.g., scheduled termination). 

FINRA is not proposing to adopt a trade reporting fee or to publicly disseminate the collected OTC options transaction data at this time. Once FINRA obtains more experience with the data, FINRA may consider disaggregated public dissemination of all or part of the data, automation of the trade reporting process, or the imposition of fees, all of which would be subject to filing with the SEC.

Economic Impact Assessment

FINRA has undertaken an economic impact assessment, as set forth below, to analyze the potential economic impacts, including anticipated costs, benefits, and distributional and competitive effects, relative to the current baseline, and the alternatives FINRA considered in assessing how to best meet its regulatory objectives. FINRA invites comments on all aspects of this assessment and requests that commenters provide empirical data or other factual support wherever possible.

Regulatory Need

The proposed OTC options trade reporting requirements would improve FINRA’s surveillance of the securities markets as well as cross-product and cross-market surveillance. For example, the data would allow FINRA to identify potentially manipulative behavior that can only be observed to a limited extent today relying on LOPR data. A regulatory audit trail for transactions in OTC options that have terms that are identical or substantially similar to listed options would allow FINRA to better understand and review firm and customer trading activities, the relationship between transactions in OTC options and listed options (as well as other instruments) and provide information necessary to oversee for compliance with best execution and other FINRA rules.     

Economic Baseline

As discussed above, firms currently do not report OTC options trades to FINRA but are required to report to the LOPR system large end-of-day options positions, including OTC options positions. For OTC options, a firm must also report an account’s intraday positions. Firms submit position information to the LOPR system by the close of business on the next day.¹⁷

While LOPR data is useful, the proposed reporting requirement would improve FINRA’s audit trail by providing additional insight at the transaction level. For example, two particularly important fields not available in the LOPR data are the time of the transaction that resulted in each position change and the option premium. Additionally, only positions of 200 or more contracts are reportable to the LOPR system, so the data does not reflect changes that are below this threshold.

Using LOPR data from January 2021 to June 2021, FINRA has conducted an analysis to study the extent and scope of OTC options trading by firms. This analysis infers trading activity from reported position changes. However, as discussed above, the LOPR system does not collect information on positions of less than 200 contracts; therefore, this analysis would not include smaller positions. In addition, and as noted above, this proposal is intended to capture only specified OTC options (i.e., those with terms that are identical or substantially similar to listed options). Since the scope of the LOPR data is broader in this regard, the analysis below will include options that would not be reportable under the proposal.

FINRA estimates that 24 firms participate in OTC options trading based on the January 2021 to June 2021 LOPR data sample.¹⁸ Of these firms, 20 are large, three are mid-size and one is small.¹⁹However, the smallest firm has over 100 registered representatives.

Table 1. Firms Reporting Large OTC Option Positions

Using LOPR data, FINRA estimates that approximately 7,420 transactions in OTC options per day may occur across all firms.²⁰ The associated dollar volume cannot be quantified because the LOPR system lacks information on options premiums. The top five firms, all of which are large firms, are estimated to account for approximately 88 percent of trades.

Potential Economic Impacts

FINRA believes information on OTC options transactions will improve its oversight of the securities markets. The transaction information proposed to be collected will assist FINRA in identifying suspicious activity, including potential instances of insider trading, front running, pre-arranged trading, and market manipulation in the equity and options markets. For example, FINRA has identified potentially violative conduct involving OTC options discovered from complaints, investigations or through other means, that is not identifiable in LOPR data, but that could be more readily detected using the type of transaction data proposed to be collected. The information proposed to be collected would also potentially improve cross-product surveillance by creating a more complete audit trail of trading in OTC options and the underlying equity security. The information proposed to be collected also will streamline FINRA’s investigative process and improve its efficiency. Currently, if FINRA identifies suspicious activity based on LOPR data or other sources, any necessary transaction information must be requested from the firms involved. Thus, the proposal would improve efficiency for FINRA, and firms may benefit from the reduced labor required to respond to such requests. FINRA also notes that, because firms are currently not required to report OTC options transactions, there exists the potential for regulatory arbitrage between the OTC options and listed options markets. In addition, firms also are currently only required to report listed options trades to the Consolidated Audit Trail.

Firms that trade OTC options would incur upfront costs associated with making systems changes required to report OTC option transactions and ongoing fixed costs for maintaining their system. Firms would also incur ongoing labor costs to the extent that reporting cannot be automated. These costs could be borne by investors if passed along in the form of higher transaction costs.

Firms currently have systems in place to generate LOPR reports for OTC option positions. To the extent that existing systems may be modified to facilitate the proposed reporting requirements, costs may be relatively lower. However, we note that the proposed transaction reporting requirements and LOPR requirements differ in several ways. For example, the LOPR fields differ in some regards from those proposed to be required under this proposal. Transaction reporting could thus require the use of a separate system or involve substantial costs to modify an existing system.

The cost of compliance may affect firms differently. Activity in the OTC options market is not evenly distributed. We estimate that, out of the 24 firms that report OTC options positions to the LOPR system, the bottom 19 firms account for only 12 percent of trades. If the fixed cost of establishing and maintaining a reporting system is substantial, it may be relatively more burdensome for firms with less total activity in the OTC options market and may potentially place them at a competitive disadvantage.

The costs of the proposed reporting requirement may depend on various factors, including the level of difficulty involved in determining whether a particular option is subject to transaction reporting, given that these transactions are typically negotiated individually. Such difficulty could also result in over- or under-reporting of certain types of options, which would reduce the regulatory utility of the data.

To the extent that market participants wish to avoid transaction reporting, they may shift their trading activity in three ways. First, market participants could potentially shift their trading from OTC options subject to the proposed transaction reporting requirement to more exotic OTC options that provide similar exposure but that would not be reportable under the proposed requirement. These shifts could reduce the number of transactions subject to reporting under the proposal and may also lead to higher costs as shifting to more exotic OTC options may result in less perfect hedging for customers seeking to gain a particular market exposure. Second, market participants could potentially shift activity to non-FINRA firms, such as banks, which could impact firms that trade OTC options by reducing their market activity.²¹ Finally, market participants could potentially shift their trading to similar listed options, if they are available and, in that case, the exchanges’ reporting requirements for listed options would apply.  

Alternatives Considered

No other alternatives beyond those discussed above were considered for the proposed amendments.

Request for Comment

FINRA requests comment on all aspects of the proposal. FINRA requests that commenters provide empirical data or other factual support for their comments wherever possible. In addition to general comments, FINRA specifically requests comment on the following questions:

1. Why do firms trade OTC options where similar listed options are available? What considerations drive this determination?
2. Is there a substantial amount of firm activity in smaller sized OTC options contracts that are not required to be reported to the LOPR system? Are there firms that trade OTC options, but never trade positions large enough to trigger LOPR obligations?
3. FINRA is proposing that firms would initially only be required to report transactions in OTC options with terms that are identical or substantially similar to listed options, including FLEX options, as explained above. Do commenters agree with this proposed scope? Please explain.
4. Appendix A provides the fields and descriptions being contemplated under the proposal. Do commenters agree with the proposed fields? Why or why not? Please describe any challenges associated with the proposed fields.
5. Are there any fields that should not be included? Is there any information that was not included in Appendix A that should be collected? Please be specific.
6. What costs would be associated with the proposed OTC options reporting requirements? Please be specific.
   1. What costs would be incurred by firms in connection with reporting the specified information?
   2. What operational or other challenges would be associated with implementing the proposal?
7. How much time would firms need to implement necessary technological changes to comply with the proposed end-of-day reporting requirement? Do firms currently have systems in place that could be leveraged to assist in collecting and reporting the required information?
8. FINRA is proposing that firms be required to report trades at the end of the trade day with corrections permitted through T+5. Is this a feasible timeline for reporting OTC options transactions and corrections to FINRA? Why or why not?
9. FINRA is proposing that firms be required to report when OTC option trades are exercised. Do firms anticipate any challenges with respect to this aspect of the proposal? Please explain.
10. FINRA is proposing that firms would initially be required to submit OTC option trades in batch form on a daily basis through fileX, FINRA’s data collection platform. Do firms anticipate any challenges with this reporting method? Please be specific.
11. How will the proposed reporting requirements impact market participants’ behavior in the OTC options market? Might market participants alter their behavior due to the proposed requirements? If so, how?
12. FINRA is proposing that the information gathered would be used solely for regulatory purposes at this time and would not be publicly disseminated on a disaggregated basis. FINRA may explore providing public transparency once FINRA has gained experience with the data. FINRA is interested in views on whether firms, investors and other market participants would benefit from public transparency regarding OTC options transactions.

Attachment A

Data Elements

Endnotes