SEC Proposes Very Limited Reintroduction of Uptick Rule on Short Selling

OK sports fans, I’m old school. When I grew up, the uptick rule was in place, and no one seemed troubled by it.

The uptick rule simply means that a short sale can be executed only when the last sale of a stock is at a higher price than the immediately preceding sale. It was widely believed to do good job of preventing bear raids. It was repealed in July of 2007 and some noted shortly afterwards that volatility increased (but given that the Great Credit Contraction had just begun, it would be hard to reach definitive conclusions).

Now the SEC took a pretty extreme move during the crisis, that of banning short sales of a long list of financial stocks, which did nothing to arrest their decline. Now it is proposing a bizarrely timid re-introduction of the uptick rule, that of having it take effect only when a stock’s price has fallen 10% in a day.

I’m puzzled as to why the SEC is bothering with something this modest (ie certain to be ineffective). If you believe the uptick rule is a good idea, why not just re-introduce it? The only logic I see is this might be that this is an experiment, that having two data samples (how stock trades on a down day when no uptick rule is in effect, vs. when it is). But this seems implausible. First, you’d want to set the threshold higher (maybe 5%) to produce a more robust sample of trades with the uptick rule in effect. Second, regulators don’t tend to think along those lines.

This move instead has the smell of a peculiar political compromise, and Bloomberg says as much:

Concern that short-sellers accelerate stock declines may prompt the Securities and Exchange Commission to adopt a rule next month aimed at curbing bearish bets when equities are plunging.

The regulation would require the trades be executed above the best existing bid in the market when shares fall 10 percent in a day, said Brian Hyndman, the senior vice president in transaction services at Nasdaq OMX Group Inc. In a short sale, an investor borrows an asset and sells it, hoping to profit from a decrease by repurchasing it later at a lower price.

Forcing short sellers to wait for a stock to rise above the best price bid may prevent them from flooding the market with sell orders and causing losses to multiply. Some exchange officials say the restrictions known as uptick rules don’t work, citing studies that show they may be less effective during panics that drive prices down and volatility up.

“There is no empirical data to support the introduction of a new rule,” Hyndman said yesterday at a securities industry conference in Chicago. “But this is the least intrusive of the proposals the SEC was considering.”

Yves here. So here we have a below-the-radar issue, where there is a constituency for Doing Something about short selling, in particular, retail investors and most corporations (mind you, I’m not at all opposed to short selling in the abstract, but bear raids are a real issue, and some constraints aren’t a bad idea). And what do we see? The industry appears to have gone in and done it usual effective job of lobbying. Potemkin reform prevails yet again.

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  1. Punch My Ticket

    I don’t approve of the uptick rule and I have never approved of it. I have a keen sense of fairness. If you can’t short on a downtick, then symmetry requires no buying on an uptick.

    Can we agree that this would be an excellent compromise?

    1. JeffC

      Since short selling is done with borrowed stock, the symmetric requirement would require all margin purchases in particular be done on downticks. One can’t prohibit all purchases on upticks, or the first uptick would cause trading to halt forever, since every transaction involves someone purchasing.

  2. IF

    Yves, considering that short selling is a side bet between the person allowing the borrow and the person doing the short sale, I don’t see why there should be a special rule regulating the occurrence of said side bet. Make the side betting more explicitly look like betting and less like an introduction of extra shares, and nobody will be concerned about up or down ticks anymore.

  3. TheInterest

    The SEC is under some pressure to curb “naked short selling”. That’s probably the purpose of the 10% rule. So instead of just letting people pile on and take a Bear Stearns to 0 with phantom shares gone missing, it is saying that they’ll still allow “naked short selling” up until the stock has lost 10%.

    1. Yves Smith Post author

      I understood that, but it appears that this is a 10% move in a day, otherwise you’d expect to see more specific discussion of time frames.

  4. Economics of Contempt

    In my experience, the old uptick rule was routinely ignored, so any reintroduction of the uptick rule, however limited, has to come with stepped-up enforcement to be serious (both in terms of enforcement ability and enforcement resources). Granted, I was never an equities trader, but I spent more than enough time on the trading floor to know how this kind of thing goes. It seems to me that this new “limited uptick rule” would essentially only kick in when traders are most panicked about a given stock, and thus have the most incentive to say “screw the uptick rule, short that bitch.” (Or whatever the kids are saying these days.)

    Color me unimpressed.

    1. Dionio O'Leary

      I’m guessing that the 10% rule is there to spare those enforcement resources more than anything else. 9,000+ publicly traded shares, but only scrutinizing instances of 10% declines.

  5. Matt Fan

    There is a fantastic movie that just came out about this–in fact it nearly DEMANDS the SEC protect shareholders by re-instating the the uptick rule. Great DVD that focuses on the banks and especially Sirius xm stock that went down to 5 cents a share. Movie is pretty much everywhere but cheaper at and there is trailer there. See Stock Shock if you are interested in this issue!

  6. MG77

    Yves – Do you have any idea why they set the threshold at a decline of 10%? It seems rather arbitrary they just just picked a number out of thin-air. Why not 7.5% or 15%?

  7. Hugh

    The SEC is a paper tiger. Mary Schapiro was chosen precisely for her business friendly view of regulation. I would prefer to have an uptick rule to not having one. But it is only one small piece of the regulatory framework that is needed. That even it would be watered down by the SEC was completely predictable.

  8. Trainwreck

    Channeling Jon Stewart:

    Oh no! Short sellers are ruining the market once again! Plague them with a torrent of locusts!

    Seriously, decreasing liquidity, increases volatility.

    If short sellers are fueling bear raids, then one has to wonder about the pump and dump stock scheme that has been around for as long as I can remember. Find a sucker as you play up a stock that you know is AAA-crap or near AAA-crap

    Lets be honest if we want a casino market, then lets live by the casino market rules.

  9. bob

    Uptick on which exchange? My understanding is that there are at least as many transactions off-exchange these days.

  10. Ted K

    If you read some of the stories in Bloomberg on this uptick rule, it’s not too hard to imagine a certain Senator Charles Schumer might “be on the take” on this issue. And I wish someone like Gretchen Morgenson or the Huffington Post Investigative Fund would fish around and see what they can find here–because I’m telling you something here stinks to the high heaven, and I don’t think that smell runs very far from Schumer’s office.

    1. Ted K

      One might ask a very simple question: Why with many other big issues revolving around the economic crisis, why is Charles Schumer SPECIFICALLY obsessed with the “uptick rule”???? If you look at the connection here between Madoff and Senator Charles Schumer in this link to a Politico story it might be worth an NYT reporter or others sniffing around to see what they can find.

  11. DoctoRx

    Given that time is the fourth dimension and is as valid a dimension as the others, there is no logic to making temporal considerations more important than physical dimensions in trades. Why not pass a rule tying what a trader in London does to what a trader in New York does, or to tie what a New York trader on the 23rd floor does to what a trader on the 24th floor does?

    In a practical sense, the uptick rule is strange. Let us say that AIG in 2008 downticked and then there was a trading halt. Some bad news came out and the market price dropped. And it kept dropping. What’s wrong with short sellers joining in the price discovery? Of course, strict bans on naked shorts need enforcement.

    Commissions after the Panic of 1907 and after the 1929-32 crash each proved that the cause of the stock market collapses were NOT the fault of short sellers, but were rather the fault of the unrestrained speculation that bid the share prices up too high.

    Finally, re Yves’ statement that the SEC ban on short-selling financial stocks in 2008 had no effect, that is incorrect. The first ban, in the summer, led to a massive short-covering rally in all financials. BAC, for example, surged from 18 to 30, FNM doubled, etc. BAC then rose for the next 2 months to the high 30s. Just think of all the trading profits those in the know made from advance knowledge of the rule, plus all the extra commissions. It took Lehman/AIG to collapse BAC’s stock.

  12. Siggy

    As an old phone and clearing clerk I can tell you that the uptick rule is far more reasonable than what is being proposed. The price discovery that occurs in the course of trading has two parts; the price itself, and, the number of shares being traded.

    Given that regular trades are scheduled to settle five business days after the trade date, naked shorting is fairly common. If you really want to control naked short selling, close open ‘fails’ 6 days after the settlement date.

    Additionally, ages ago, options were considered the best way to do a short trade. In that OTC vehicle you could create a well defined trade that had a large profit potential with relatively small defined loss potential or cost.

    This is a story about a headless chicken soon to be left on a line draining its precious bodily fluids.

  13. Lilguy

    I believe the rules ought to be fair on both sides of the market.

    …so I’m waiting for the “downtick rule” on bull market buying.

    I know it’s not going to happen, but the uptick rule is just one of many rules that creates a bull market bias in the stock market that is unwarranted and, at times (say, mid-2007), outright dangerous.

  14. Jeremy Johnson

    This will make for an good journal article one day. I don’t think anyone really knows empirically if the uptick rule increases, decreases or has no impact on volatility. I think the theory is that having an uptick rule should mean it would be harder for a trader to slam a stock down. I’m not aware of the state of the art here in the research, it’s an interesting question though.

  15. Mark

    I always get amused when they blame short sellers for declining markets. It’s a zero sum game. Short sellars always have to buy back their stocks at some point.

    The rules eliminating or restricting shorting eliminates the one group of traders who NEED to buy back their stocks.

    Bring on the volatility…..

  16. Steve

    Studies showed that when restrictions on short-selling bank stocks were introduced during the crisis, that liquidity was reduced in those stocks (and not non-bank stocks) and prices still continued to fall, so nothing was accomplished.

    I believe the purpose of the 10% daily limit is to make it more difficult to short a stock to near-zero, in the off-chance that the up-tick rule actually helps, while not having it interfere with day-to-day business. I find it a reasonable compromise.

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