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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 I have not heard any complaints about the opening price discovery process since the up-tick rule was repealed.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

Source: The Up-Tick Rule Reimplementation Is Bad for Markets