Stock Options, Stock Loans, and the Law of One Price

Historically, option market makers were exempt from borrowing shares when short selling which allowed them to hedge their exposure in hard-to-borrow stocks. As a result, options were not redundant securities -- they allowed traders to circumvent short-sale constraints. Regulators removed this exemption in 2008 and in 2013 they prohibited a workaround using 'reverse conversions'. These regulatory changes eliminated the shadow supply of hard-to-borrow shares provided by options; we find that these changes increased the redundancy of option securities and caused a significant increase in equity loan fees. Consequently, market quality has deteriorated: price efficiency is lower and stocks are more overpriced.