Exchanges Propose Weakened Uptick Rule

by: Hirendu Vaishnav

Since the rescinding of uptick rule in late 2007, companies like Bear Stearns, Lehman Brothers (OTC:LEHMQ), Wachovia, Washington Mutual, IndyMac (OTCPK:IDMCQ), Fannie Mae (FNM), Freddie Mac (FRE), AIG, etc. have either been killed or shareholder equity has been decimated. Many of the other financial companies such as Bank of America (NYSE:BAC), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), E*Trade Financial (NASDAQ:ETFC), etc seem to be under constant struggle to fight continuous downward pressure on their stock price which further weaken their core business and shareholder and customer confidence.

Recently, the TOP three exchanges in US -- NYSE Euronext, Nasdaq OMX and BATS Trading -- submitted a modified version of uptick rule to the SEC that they want want the SEC to consider in place of reinstating original uptick rule.

It is important to try to understand what these modifications are and what exactly they mean.

The old uptick rule was simple: a short sale can occur only after an uptick.

The modifications the exchanges have suggested are:

  1. A short sale can be executed at any time as long as the price is higher than the highest bid price.
  2. Such a rule should trigger only if the price has dropped by certain percentage during a day (e.g., 10%)

Since the exchanges are trying to put the modification in context of bid/ask prices, let us understand the difference between the proposed uptick rule and the original uptick rule in the context of ask/bid prices.

With the old uptick rule, for someone to be able to short a stock, suppose the last trade was at the bid price, the NEXT trade MUST be at ask price and must be a non-short. Once this trade takes place, the shorts can short the share. Clearly, once ONE such short trade is executed and if it was at market price (i.e., at the bid price), it would be at a lower price. So the shorts have to wait again for ONE non-short trade at the ask price before they can execute one more short sale. Thus, under the old rule, in most cases each short trade would act as a self-protection against further short trades and would require at least ONE non-short trade at a higher price.

Under the proposed rule, the share can be shorted at a price higher than highest bid price. What does this mean? It means that shorts can short the share AT THE ASK price ANYTIME. In the previous uptick rule, there has to be at least ONE non-short trade at the ask price (i.e. only the SECOND trade after a trade at the ask price can be a short-sale). Under the modified rule, there has to be ZERO trades at the ask price before shorts can short the share (i.e. the FIRST trade at the ask price itself can be a short trade).

Also, under the previous rule, each short sale at market essentially created a requirement of uptick before the next short sale. Under the proposed modification, an infinite number of short trades can be made as long as they are above the highest bid price.

What this means is that shorts can pretty much short against any market order under the new uptick rule. This modification weakens the original uptick rule substantially.

Why is this modification necessary?

All this time, the argument we heard was that the original uptick rule is not effective anyway -- but now they are saying that by weakening it, it will become MORE effective? Looks like all this time they were fighting it because it was TOO EFFECTIVE. Have they been lying all this time?

Another argument they use is that it is technically difficult to implement the old uptick rule. Did they forget that it was implemented for decades until late 2007? Are they saying that since computer technology has deteriorated so much in last two years, they can not implement the same rule that was implemented so successfully before (including in 1930s paper-trade days)? Once again, who are they fooling?

The second modification is even worse than the first one; the modified (i.e. weakened) uptick rule should not be triggered until the price has dropped by 10% for the day.

Isn't this another way of saying "instead of killing a company in one day -- we agree to do it in 10 days"?

As an individual investor and a common citizen, I find it hard to believe that our exchanges are actually proposing this. As in the movie Godfather, "the guy who comes with the proposal is the traitor." Are exchanges part of the scam?

One has to really step back and try to see if corruption and greed has not only taken over Wall Street, but also the exchanges, the regulators and even politicians to such an extent that national interest is a distant second to "self-interest".

The original article about uptick rule modification can be accessed here.

I sincerely hope that the SEC does not accept any suggestion which weakens the old uptick rule in the national interest and even long-term interests of Wall Streeters themselves.

A better approach would be to reinstate the original uptick rule and add the current proposal of short selling only higher than the highest bid price in addition to requiring an uptick (and dropping the 10% price decrease trigger completely).

Disclosure: Author holds long positions in ETFC and FRE. No positions in the other stocks mentioned.