The Up-Tick Rule Reimplementation Is Bad for Markets 30 comments
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The SEC is set to explore the idea of reintroducing the up-tick rule for the short-sale of stocks. Ostensibly, this rule keeps short sellers under control so that they cannot drive down stocks as fast or as easily. A proposal for the rule has backing in Congress and in some corners of Wall Street, and consequently has garnered immediate attention at the SEC.
However, much as the September, 2008 ban on short selling in select financial related stocks could not staunch the flow of losses in those shares, altering the current market structure by implementing the up-tick rule will not help inspire confidence in the markets and may further erode confidence.
When the up-tick rule was in effect the execution of orders was much more inefficient and disorderly, providing customers with poorer execution and less liquidity. The up-tick rule leads to piled up market orders to short stock which disrupts appropriate price discovery. For instance, when a stock opens down, short sellers cannot trade the opening tick, leaving unfilled market sell orders and potentially too high an opening price. However, the fear for buyers that all market sell orders will not be filled at the open discourages buyers to participate in the opening cross. I have not heard any complaints about the opening price discovery process since the up-tick rule was repealed.
The current market structure on both the Nasdaq stock market and the New York Stock Exchange is highly efficient. (I wrote an article in October, 2007 expressing this view on Seekingalpha.com.) This efficiency provides customers with fast execution in generally liquid markets with narrow spreads, which allows for orderly markets. This gives all participants confidence in the system.
Except for the period when the SEC banned short selling, I challenge anyone looking to support the up-tick rule to find an instance when the market decline was disorderly and in less than completely liquid markets. Compare that to the crash of 1987 when bids were scarce. Certainly, ETFs currently help with liquidity, and coincidentally ETFs have always been shortable on downticks. Part of the reason that the liquidity is so vast in the ETFs is their ability to be shorted on downticks and the ease of buying them and arbitraging the underlying stocks instantly, without waiting for an up-tick.
When the SEC banned short selling in September, the markets were far less efficient in those select stocks. Throughout that period the stocks suffered from diminished liquidity and consistently traded significantly out of the market on the NYSE. That inefficiency scared participants (while more nimble traders capitalized) and may have contributed to the precipitous decline during that period.
In the past, the lack of efficiency in the markets provided a living to traders and hedge funds able to capitalize on the market structure, usually at the expense of institutions and retail customers. Ironically, Bernard Madoff’s trading operation capitalized by exploiting the inefficient market structure. He pioneered payment-for-order-flow; a tactic that incentivizes dealers to keep spreads wide and hurt customer execution prices. The spreads allow for enough profit margin for the trader to pay for the order to be directed to their firm. Why should nobody be surprised that Madoff exploited the market structure that disadvantaged customers to his benefit and fought to keep it that way? Recent reports suggest that Madoff’s money management enterprise needed to subsidize his trading operation. A clear sign of market efficiency is when middlemen have trouble earning an honest living.
However, in the current market, risk takers can earn a living because money can move in and out of the market with relative ease and low execution costs. Participants receive rebates for providing liquidity; this gives traders an incentive that encourages even deeper liquidity. On March 1st, the NYSE instituted a rebate for providing liquidity. This demonstrates that the concept works because other execution systems are receiving massive order flow for rebated liquidity to the market, and the NYSE also wants to compete for that business.
I have no doubt that the NYSE will lobby hard for the return of the up-tick rule. Their specialists once controlled over 75% of the order flow. Currently their market share is below 30%. The up-tick rule could reinvigorate their business, but it could cost the market liquidity and efficiency. In an inefficient market, traders capitalize on the dysfunction of the system. Many in the old guard fight for the return of some market inefficiency.
Perhaps the SEC should consider the following idea for combating bear raids on stocks. Restrict speculative (not hedging related) put buying; aggressive traders can cause fear in the market by buying large blocks of out of the money, short duration puts with relatively little capital. Option orders are already identified as covered or uncovered when entered.
Recently, the SEC went a long way to reduce bear raids when they announced the prosecution of a short seller who had spread a detailed false rumor through numerous instant message trader contacts. Consequently a once rampant tactic ended. The SEC needs more of this sort of enforcement. What has not ended is the same instant message tactic which spreads false positive news, such as an impending takeover. The SEC should crack down on all phony rumors, not just the ones that make stocks decline.
There are those who claim that the reimplementation of the up-tick rule may not help the markets, but it will do no harm. I disagree. I foresee a less efficient, less liquid market that can undermine investor confidence. Anything that disrupts what has been an incredibly liquid market, even in extremely weak sessions, is detrimental to the system.
Part of what is spooking the financial markets is the illiquidity in the credit markets. Why would anyone think it is a good idea to instantly remove liquidity from the equity markets? Advocates of the up-tick rule need to explain how this will bolster investor confidence.
Disclosure: none
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This article has 30 comments:
> jack
On Mar 29 11:56 AM john s. gordon wrote:
> 'combatting bear raids on stocks' - that's the whole idea.
The real solution deals with ELIMINATING SHARES-NOT-DELIVERED! Hedge Funds can SHORT "without first Borrowing shares"...........prom... to borrow within 3 days..... Then not being prosecuted for never borrowing!!!!!!!!!
Anybody want to speculate on how many Hundreds of Millions of Phantom shares exist because of Naked Shorting!!!!!!!!! An SEC secret!!!!!!!!! Wall Street's next SCANDAL OF GREED...........
The very essence of SHORTING is in the original law, which the SEC changed to accommodate Wall Street GREED!!!!!!!
SOLUTION = NO CONFIRMATION FOR A SHORT SALE WITHOUT FIRST BORROWING THE SHARES.......... PERIOD
Problem solved!!!!!!!!!!!!
IMHO
A lot of common sense restrictions on banks and financial institutions had been relaxed and conveniently forgotten, when people focus on profit taking for themselves. We need efficiency for long term sustainable growth of the economy more than for short term un-sustainable speculative profit taking.
The people in the financial industry has the responsibility to build trust back into the capital system and has the obligation to take all efforts to guard against unfair advantage over the less knowing public by making the system easy prey for un-ethical profit taking. We should hear about ethical discussions in the financial circle as much as in other circles such as in political, social, medical, engineering, etc. Let's talk about social responsibility.
For you professionals and day traders it wont be liked because you can not sell short to HELL!!
For us peasants that invest for the future you have turned us away. WE can not play the market hourly or daily. SO< selling short without a uptick just lets YOU run wild.
The stock market started as a investment tool NOT a short term INCOME TOOL for Hedgefunds, day traders, you and the like.
You have forced millions of little people out of the market.
Watch the increase in small investor purchases after the market settles down and the uptick rule is back in force.
YES, I should know.
Have always been self employed and invested MYSELF since 1981
Jim J.
On Mar 29 12:36 PM Responsibility wrote:
> We need responsible financial people to speak out more on the purpose
> of the stock market. Is the market's primary purpose for long term
> steady growth of the economy for the general good or is it for people
> to compete in speculative manner for personal profit? One may argue
> that each person should try to profit as much as possible for oneself;
> but the unlimited tendency for personal profit is similar to the
> unlimited tendency for excessive salaries and bonuses regardless
> of the consequences for the companies and for all the stake holders.
>
>
> A lot of common sense restrictions on banks and financial institutions
> had been relaxed and conveniently forgotten, when people focus on
> profit taking for themselves. We need efficiency for long term sustainable
> growth of the economy more than for short term un-sustainable speculative
> profit taking.
>
> The people in the financial industry has the responsibility to build
> trust back into the capital system and has the obligation to take
> all efforts to guard against unfair advantage over the less knowing
> public by making the system easy prey for un-ethical profit taking.
> We should hear about ethical discussions in the financial circle
> as much as in other circles such as in political, social, medical,
> engineering, etc. Let's talk about social responsibility.
I had no idea this column was a comic's column. So, the author likes not having the uptick rule. Really? Funnnnnnneeeee. Thanks for giving all some comic relief from the current market conditions.
TaurusTrader
www.taurustrader.wordp...
www.headhurts.wordpres...
That's also what these dangerous times call out for: More responsibility by everyone.
I also think longinvestor is onto something:
Taxing short-sellers more than long-term
investors. After all, there is already an incentive for having long-term gains. Why not institite a "short-selling" tax? This might encourage investors to think long-term.
Your article is quite self-serving and you are part of the problem that uptick-type rules are designed to protect us from.
On Mar 29 12:11 PM Baboon wrote:
> Why the regulators are trying to control of the stock market? Volatility
> brings the opportunities for the traders as well as for the investors.
> People who are afraid of the market's volatility should stay away
> from it and invest in something less volatile like bonds.
Let each margin account specify by stock whether they would allow their street name share to be lent to the shorts. This would be on a stock by stock election. Moreover compensate the lender for the activity in addition to the broker.
The uptick rule creates an asymmetric market because there is no equivalent "downtick" rule to prevent large institutions from continually buying large blocks of stock to drive the price up. The uptick rule, therefore, should not be reinstated in the absence of an equivalent rule that forces buyers to purchase on a downtick. Taken together, both rules would wreak havoc and create a totally illiquid market. reinstating the uptick rule creates half the problem.
I agree with you. Require all shorts be covered by the broker. That is presumably the law, but the law is apparently ignored by some (or many).
My broker does not allow naked shorting, at least for me. I was forced out of several positions last fall when I was unable to short against the box to protect long-term gains because my broker quoted "No shares available for shorting". This was inspite of my owning the exact number of shares I wanted to short.
I was particularly unhappy to sell and pay capital gains taxes on several stocks I wanted continue to hold but did not want to risk short-term losses. The premiums for puts were much higher than I wanted to pay.
So I sold, paid a big tax bill and bought a couple back a few weeks ago. This was not the most efficient way for me to have managed my portfolio.
The one exception to "naked shorting" prohibition should be allowed for shorting against the box, with a restriction on the broker to cover with the next available shares before allowing covered shorting by someone else.
MCS:
I believe brokerages allow the restriction against shorting. Most investors either do not know about that or don't care.
Berninvestor and JCA:
You make some very good points. I have one caveat: I don't think someone shorting against the box should pay a tax penalty.
One other point on short sellers. Some of the spikes in the oil price last summer were caused by large numbers of short sellers having to cover their position. They lost a lot of money, but they also created the false perception that the high prices were economically justified, which disrupted the market to everyone's disadvantage.
If the investors think that the short-sellers drive the market down unduly so why they won't step up to the plate and start buying? Because they see no value in prices. The prices are going down because of the lack of buyers.
The market players should be able to play both sides of the market with no limitations.
On Mar 29 02:46 PM aspag wrote:
> People that do not own the stock should not be allowed to play. That's
> like letting you in the card game with no money.
On Mar 29 04:17 PM JCA wrote:
> Short selling forms the core of a price discovery engine that normally
> acts to prevent a crash. When a stock declines rapidly, short interest
> is the force that acts to slow the decline as short sellers buy to
> cover and take profit. Anything that interferes with this process
> causes a disorderly market and enhances downside risk. That said,
> long selling is far more dangerous than short selling because long
> sellers do not generate any buying pressure - they never reenter
> the market to buy at a lower price.
>
> The uptick rule creates an asymmetric market because there is no
> equivalent "downtick" rule to prevent large institutions from continually
> buying large blocks of stock to drive the price up. The uptick rule,
> therefore, should not be reinstated in the absence of an equivalent
> rule that forces buyers to purchase on a downtick. Taken together,
> both rules would wreak havoc and create a totally illiquid market.
> reinstating the uptick rule creates half the problem.
> trade on fundamentals, which is what "efficient pricing" is all about.
Efficient pricing would put GM, Chrysler and Ford at zero.
Sorry but the fundamental problem of the market is government regulation of mortgage interest deductions and retirement funds. If mortgages were not tax deductible then most people would pay of their homes prior to dumping money into unknown investment options. Then couple that with a tax break for saving for retirement, though not in your own company, has fueled unreasonable amounts of money being dumped into the markets.
The whole problem lies in the financial sector and the governments desire to socially engineer the world.
Regulation is a good thing, however, the uptick rule will have little effect on the whole of the situation. There are too many obligations the government must meet, high inflation are probably going to rule to roost for the United States. People just better get ready for it, as it is coming and gold and silver are dead assets so you better plan on how to combat the deteriorating purchasing power we will have in the United States and probably Europe as the rest of the world will probably not want to support will not want to support our lifestyles forever and they control most manufacturing today.
Are you trying to tell us the uptick rule made the market function poorly for 70 years? Is it a coincidence that the market fell apart when the upticjk rule was banished and FAS 157 was implemented? No.
On the flip side - is it a coincidence that the S&P rallied 22% after the gov't hinted that it would reinstate the uptick rule and revaluate FAS 157? No.
Enough said.
On Mar 29 09:41 PM Sigmax wrote:
> Brad - Are you talking your "book?" Sorry pal-game over. You now
> how to work for a living instead of gaming the system. By the way
> - what did you do prior to opening your hedge fund?
>
> Are you trying to tell us the uptick rule made the market function
> poorly for 70 years? Is it a coincidence that the market fell apart
> when the upticjk rule was banished and FAS 157 was implemented?
> No.
>
> On the flip side - is it a coincidence that the S&P rallied 22%
> after the gov't hinted that it would reinstate the uptick rule and
> revaluate FAS 157? No.
>
> Enough said.
G Clark