The Top Options Story of 2012: The Wave of Scandal

The Wave of Scandal
2012 was a difficult year for the options market.

The industry experienced its first decline in annual contract volume in over a decade.

The struggling clearing behemoth Penson Worldwide finally collapsed under its own weight, leaving a slew of wreckage that continues to plague the brokerage sector.?

A hurricane provided a grim reminder that 11 years of disaster continuity planning was, in effect,? little more than a display of security theater to assuage regulators and investors.?

But of all the issues plaguing the options market last year, none made a greater impact than the wave of scandal that continued to plague this marketplace. It was an? unfortunate recurring theme from 2011 that only seemed to grow deeper and more resonant in 2012.

A Cloud of Suspicion
The year began under a cloud of suspicion as the entire derivatives industry reeled from the implosion of MF Global. While most of the impact from that disaster was felt in the futures market, any belief that the fallout could be contained to that corner of the marketplace was woefully misplaced. The bulk of the financial media–along with the majority of the investing public–tend to view options & futures as two sides of the same coin. So a scandal in one arena can still have a significant ripple effect in the other.

In the case of MF Global, the ripple effect quickly grew into a tsunami. The shocking level of fraud, the surprising lack of safeguards for customer funds, the seemingly inept oversight and the impenetrable restitution process all reinforced the worst stereotypes of the derivatives industry. Faced with such overwhelming evidence of fraud, it’s not surprising that many brokerage customers decided to spend 2012 on the sidelines.

While the MF Global tsunami had a significant impact on customer confidence, the options market could have emerged from its wake if the rest of the year unfolded without a major incident. Unfortunately, that was not the case. The wave of scandal grew stronger in Q1 when a number of options firms including optionsXpress and the Chicago Board Options Exchange emerged inside the crosshairs of the SEC. With the options market already laboring under a cloud of uncertainty, these investigations only served to reinforce the lingering doubts of many industry participants and customers. Something clearly was amiss in the options landscape. As the fallout from these investigations unfolded in business pages across the country, the seemingly unstoppable wave of scandal gathered momentum.

Only Fools Dare to Tread
Each of these developments contributed to the erosion of customer confidence in the options market. Unfortunately, they all pale before the stunning display of fraud and greed formerly known as PFG Best. The PFG scandal had it all: greed, theft, bizarre events, stunning incompetence, a failed suicide and a confession of fraud by a long-time derivatives industry insider. Arriving at a time when the investing public was already weary of derivatives fraud, the implosion of PFG became the high (or perhaps low) water mark of the endless scandal tide. If there was a perfect moment to destroy any remaining vestiges of customer confidence, this was it.

The PFG affair brought the glare of scandal back onto the front page and once again cast a negative light on the options and futures markets. At its height the scandal was virtually inescapable. You couldn’t hail a taxi, walk into an elevator or turn on your television without being accosted by the latest updates from the implosion of PFG Best.? While the bulk of PFG’s customer impact was once again concentrated in the futures market, the investing public had already been consumed by the deluge of scandal. They were well past the point of such niggling distinctions as the difference between an options contract and a futures contract. The narrative was clear – the derivatives markets were dangerous places where only fools dared to tread.

The Customer Exodus?
No one can say with any degree of certainty that the wave of scandal, and the resulting customer exodus from the options market, were the primary drivers of the overall volume decline. Many intangible factors, not the least of which being a prolonged period of low volatility, contributed to the precipitous drop in contract volume last year.

It would also be unfair to lay all of the blame for the erosion of customer confidence on the doorstep of PFG, MF Global and other scandals. As our own list of The Top Options Stories of 2012 unfortunately showed, there were many culprits (including technological errors, natural disasters, bankruptcies and dividend trade debacles to name but a few) that combined to eat away at customer confidence last year. But none were so pervasive, and so deeply disturbing, as the wave of scandal that perpetually rocked this market in 2012.

Going Forward
Contract volume is the lifeblood of the options business. From the exchanges that rely on transaction fees to the brokerage firms that hunt for commissions and the trading firms that battle for edge, everything revolves around this one critical metric. So when an ongoing wave of scandal helps to reduce that contract volume, the impact is felt by everyone. Anyone who attended a gathering of options profesionals last year found themselves confronted with variations of the same basic question – “How do we restore customer confidence in the options market?” The echoes of that question still linger today as we take our first tentative steps into the new year.

What, if anything, can be done to reverse this trend in 2013? Volatility and other macro drivers of options volume are certainly beyond anyone’s control (despite what some conspiracy theorists may claim about VIX settlement). But there are certain proactive steps that can be taken to ensure that 2013 does not unfold in a similar manner to 2012. Most trading firms, exchanges, brokerage firms and regulators are already working to improve regulatory oversight in the options industry. In fact, regulators cracking down on the “old way” of doing business undoubtedly contributed to the wave of scandals in 2012. This new era of strict regulatory enforcement, along with the requisite layers of bureaucracy that inevitably follow in its wake, may not herald a brave new options world. But if it prevents a return to the past, then most options users would undoubtedly welcome it with open arms.

Read the rest of The Options Insider’s Top Options Stories of 2012 (including several honorable mentions” by clicking on the links below: