Why Is Congress Reinstating the Uptick Rule?

Well I spoke too early. Over the weekend in the ZachStocks Podcast, I explained that with Congress on a two week holiday, it would be nice to see how this market traded without manipulation from Washington. But leave it to the SEC to break the peace and issue a proposal to add more regulation to the financial markets.

The latest news has been rumored for a bit of time now and centers around the uptick rule. This uptick rule governed the market since 1937 and basically stated that in order to short a stock you must first wait for the stock to trade up a penny before selling borrowed shares. But last year after a thorough investigation which found that the uptick rule did very little to stabilize markets, the rule was removed.

The proposal to reinstate this uptick rule will take some time before it is put into action (the standard procedure is to allow for public commentary for 60 days). And while the measure is likely to be applauded by the general public, I fear that the limits placed on the financial markets could yield unintended consequences with very little benefit to individual or institutional investors.

Abolition of Uptick Rule Coincides with Market Meltdown

Proponents of the uptick rule usually point to the fact that within three months of this regulation being removed, the market peaked, leading to what has proven to be one of the all-time historical bear markets. The argument is that if short selling had been more regulated, prices may not have fallen in quite the same fashion. To which I say Bull Scheidt! (This is a family show after all.)

The most recent bear market was a result of a financial crisis that encompassed irresponsible leverage on both a personal and corporate level. Access to financing and excessive risk taking bid stocks (and plenty of other assets) up to levels that were unsustainable. The house of cards was bound to break down eventually and no amount of limiting short selling could have avoided this.

In fact, limits on short selling could actually have accentuated the selloff. In October of 2008, the SEC posted a massive list of financial institutions that could no longer be shorted. The market rallied quickly as investors anticipated that a market without short-sellers would lead to gains in the financial sector. But very quickly the tables turned, markets shot lower and there were no short sellers waiting in the wings to buy back shares. See, when enough short participants are in the market, they represent a natural buying presence that can actually help support stock prices instead of driving them lower.

What About Existing Rules?

My biggest bone to pick on the SEC regarding short sellers, is the inability to enforce existing rules. For instance, in order to short a stock, you must technically borrow the shares first. It’s not fair to walk into a market and declare yourself a seller of an asset that you don’t even possess!

But that’s exactly what many Wall Street firms would do. For some time it was common practice to short stock and then fail to deliver. Eventually the firm would buy back the shares and deliver them on a delayed basis, but the practice was illegal and rarely enforced.

Another argument against short selling is that predatory sellers will all-too-often short shares and then start vicious rumors about the company. This practice is clearly illegal and manipulative! And if the practice has become widespread to the point where the SEC has to enact rules over the entire market to clamp down on the practice, then someone isn’t doing a very good job of regulating such manipulative practices.

Free Markets are Strong Markets

I guess the bottom line comes down to whether we want free markets or not. And to a certain degree whether our markets are efficient or not. If one agrees that our markets are largely efficient, then limits on short selling are basically pointless. An efficient market can adjust to lower prices because wise managers will see a stock being pushed lower and buy at a discount. Equilibrium will be established through the natural and rational decisions of buyers and sellers.

But if the markets are NOT efficient, does that in turn lead to regulation in order to penalize those with an advantage? Shouldn’t all participants in a market (buyers and sellers) have a level playing field without rules stating when and how the actual transactions can take place? If I have borrowed shares from a party that understands our agreement, and then take those shares to the market (which actively trades these exact shares) shouldn’t I be able to participate in like kind? You may not like the fact that I am selling, but don’t buyers actually need sellers in order to have someone to purchase from?

And does it really matter whether you purchase borrowed shares or natural shares? Either way the shares now belong to the buyer. If the short seller suddenly is compelled to re-purchase those shares (which can happen because the lender calls the shares back - or because of many other reasons) doesn’t that benefit all owners? After all, this motivated buyer now represents one of the strongest bidders for the stock driving prices higher.

A Fair Balance of Risk and Return

I think the SEC fails to see that short-sellers are at risk just as much as any other participant. They live and die based on their intellect and skill in trading. When shorting one enters a risky position and must bear the losses if he is wrong. Similarly, a buyer bears the risk of a declining price. Should we say buyers cannot purchase stock unless the price ticks lower?

In my opinion, the risk / return dynamics are sufficient to provide ample liquidity and a fair playing field for all participants. The SEC should closely monitor activities of all market participants to ensure manipulation does not happen and fair transactions occur. But the role of the SEC is not to single out one particular type of market participant and change the rules to discourage fair behavior. The short sale rule was deemed unnecessary and I believe it should stay that way.

Comments

[Did U Think...:]

To fool people into thinking it is shorts that are bringing the markets down when everyone knows it is really the longs bailing on leveraged positions which are doing it.

Apr 10 05:41 PM

[Northstar10000:]

Show me just one company that was viable that was naked shorted into oblivion. Save yourself the trouble , there isn't one. Shorts can only be right if the company was going to blow up anyway.

Apr 10 10:03 PM

[prudentinve...:]

I agree with all who object to naked shorting, which is illegal and its ban needs to be enforced.

Regarding the uptick rule, its corollary is to also require a downtick before you can buy on margin. After all, you are buying with borrowed money, just like a shorter is selling borrowed stock. I do not advocate this concept, but mention it because it is the same as requiring a downtick before you can sell short. Both reduce price discovery and market liquidity.

Apr 11 10:27 AM

[wobatus:]

actions semi trades at half its net cash. ovti traded down to net cash at the low. tons of companies trade below intrinsic value and certainly below the price an actual owner, rather than a counterfeiter, woul accept. certainly, some poor companies are also naked shorted.

why do you feel the need to advocate counterfeiting?


On Apr 10 10:03 PM northstar10000 wrote:

> Show me just one company that was viable that was naked shorted into
> oblivion. Save yourself the trouble , there isn't one. Shorts can
> only be right if the company was going to blow up anyway.

Apr 11 11:40 AM

[wobatus:]

even legit shorting often takes shares from lenders who don't realize it is happening, just due to fine print in brokerage agreement. willing lending is fine and acceptable.


On Apr 11 10:27 AM prudentinvestor wrote:

> I agree with all who object to naked shorting, which is illegal and
> its ban needs to be enforced.
>
> Regarding the uptick rule, its corollary is to also require a downtick
> before you can buy on margin. After all, you are buying with borrowed
> money, just like a shorter is selling borrowed stock. I do not advocate
> this concept, but mention it because it is the same as requiring
> a downtick before you can sell short. Both reduce price discovery
> and market liquidity.

Apr 11 11:43 AM

[wobatus:]

negative recommender, please refute my point and give us an exegesis defending counterfeiting.


On Apr 11 11:40 AM wobatus wrote:

> actions semi trades at half its net cash. ovti traded down to net
> cash at the low. tons of companies trade below intrinsic value and
> certainly below the price an actual owner, rather than a counterfeiter,
> woul accept. certainly, some poor companies are also naked shorted.
>
>
> why do you feel the need to advocate counterfeiting?

Apr 11 12:00 PM

[Camden:]

Re: "Both reduce price discovery and market liquidity."

Would you or someone else please define "price discovery"? What is it, other than how fast a stock moves to the extreme end of it's upward or downward movement? Is it good to increase price discovery? I'm not so sure. If my understanding is correct, it seems to me that increasing price discovery is an increase in volatility – and that is rarely considered a good thing.


On Apr 11 10:27 AM prudentinvestor wrote:

> I agree with all who object to naked shorting, which is illegal and
> its ban needs to be enforced.
>
> Regarding the uptick rule, its corollary is to also require a downtick
> before you can buy on margin. After all, you are buying with borrowed
> money, just like a shorter is selling borrowed stock. I do not advocate
> this concept, but mention it because it is the same as requiring
> a downtick before you can sell short. Both reduce price discovery
> and market liquidity.

Apr 11 08:27 PM

[john redmond:]

The uptick rule is a Red Herring designed to make the public think that the SEC is actually doing something productive when in fact it is only trying to protect the "Gekos" of the stock market world. When someone and his dishonest broker take a stock that belongs to you, without your permission or knowledge, and sells that stock, working against the best interest of you the original owner, that is theft. Selling Short is a method used for many years to seperate the retail investor from his money and should be stopped now Yes, I know that many famous people are in favor of the practice, but they are the ones who have their hands in your pocket..

Apr 12 12:21 AM

[Niner:]

Let's have free traffic. We'll take the all the speed limit signs, stop signs all signs down. After all free traffic is efficient, and all these unnecessay restrictions restrict traffics free and natural flow.

Yeah Right!On Apr 10 08:57 AM Johnathan Vrozos wrote:

> This is wrong. The politicians are bowing to public pressure by doing
> this. Our economy was built on FREE MARKET principles, leave it alone.
> If someone get's drunk on Vodka and kills himself, why blame the
> Vodka?

Apr 12 09:34 AM

[Longinvestor:]

Short selling is market manipulation pure and simple and has no place in a free market of investors trading stocks. Not all of the manipulation is directly by the short seller himself. Sometimes he has a little help from a dis-information rumor monger or rumor mongering website.

Apr 12 10:01 AM

[guitoon:]

I agree with your analysis
something disturb me though...i see it like fasb change..this is all about to satisfy the looser company cryers..we lost a lot of money because of this and that....very scary to see that lobying is working out .
instead of taking care why you are such looser companies..this is not because naked short...so pull out your fingers and clean up your mess..god sake..changing rules is noise

Apr 12 12:26 PM

[Eric Rasbold:]

It’s not fair to walk into a market and declare yourself a seller of an asset that you don’t even possess!


Amen, brother!!

If we are going to play some pool and bet 50 bucks on it, you are going to show me the Grant before the rack.

Short sellers suck. They are not investors.

Apr 12 01:00 PM

[C L Freeman:]

While it may be difficult for many long only investors to overcome their natural biases enough to see, a stock being "too high" is just as undesirable as a stock being "too low".

Whenever a stock gets too high, a future correction becomes inevitable. A market system that gives a systemic advantage to the long side will probably not run higher in the long term, it'll just be more volatile. Yes, when you own a stock you want it to go up. If it goes up higher than is justified and you sell it, good for you...but the sucker that bought it is going to suffer.

Some of you worry about manipulation being easier without the uptick rule. Yes, there has been and likely continues to be outrageous manipulation by shorts...and most short sellers on message boards are annoying idiots begging to be regulated out of existence. But then again, I see no reason to dismiss manipulation on the long side either. "Pump and dump" is a long-side strategy (though it can be played long and then short), and it happens a lot. The solution to the problem of manipulation is better regulation and better enforcement across the market, not putting mechanisms in place that establish an upward bias, which simply aids in one form of manipulation while thwarting another.

There is a valid price for any given issue, given everything that will happen to that issue in the future. If we had a crystal ball, the issue would be priced to pay out at the risk free rate. Of course, we don't know what this true price is, so we make each make our educated guess, and the net result of those guesses along with a natural discount for uncertainty, establishes the current market price. In the long run, the market price moves toward the theoretical true price. This is price discovery.

Net, problems with the uptick rule:
1. Creates a long bias in the market, which must and will occasionally be corrected, thus implying greater volatility.
2. The author's point may also be valid that such volatility may also arise from a reduction in the number of motivated buyers during a decline.
3. Impairs efficient price discovery, which ultimately reduces the efficiency of our capital markets (you making money in stocks is a side effect to the market, the real benefit to the economy in the long term is efficient capital allocation.)
4. Simply favors one form of manipulation over another, without doing anything to address the real problems.
5. In our "self-regulated" market, may only be enforced on small retail investors depending on how the mechanism is set-up and enforced (as are rules against naked shorting, which imo are necessary, but not enforced except through retail brokerages, thus providing systemic advantage for bad actors.)

Apr 12 05:23 PM

[Minlita:]

SEC adopted measures aimed at imposing protections against abusive "naked" short-selling. That occurs when sellers don't even borrow the shares before selling them, and then look to cover positions immediately after the sale.

The SEC commissioners removed the uptick rule in July 2007, during a period when the agency sometimes leaned toward easing of regulations under the tenure of then-chairman Christopher Cox. The action didn't draw significant attention from the mainstream media at the time.

A test by the SEC earlier that year, removing the uptick rule for one-third of the stocks in the Russell 3000 index, found it could be eliminated without causing significant harm.

Apr 12 05:34 PM

[Minlita:]

Shorting stocks is not hard but it is risky, but risky us been going long in last Quarter of 2007 and in 2008 too.
There are 3 ways to short the market:
1 - Short stocks straight up (i do that you just need a margin account)
2 - Buy inverse ETFs (this great just read about it in seeking Alpha and notice there are some risks), there are inverse ETFs that double or triple leveraged the market indexs
3 - Buy Options or Warrants (puts), I use them to heage against my long positions.

The market is going to be fine with or without the naked rule and the manipulation from Washington like we did in the past years

Apr 12 05:54 PM

[Advill:]

A market is based in a few common rules, there is a central physical place where buy and sell, there is time of transactions, there are rules of information and time to access it.

In short selling and some others practices, some big brokers are moving by themselves whitout supervision of regulators, is a matter of fairness and justice keep them in the limits of good practice, short selling is a predatory strategy when is done without rules (as punishing false information, not control of the stock etc.

Regards.

Apr 13 03:10 AM

[tmorris007:]

Efficient systems are designed to inherently mitigate opportunities for manipulation and abuse. The up-tic rule serves this purpose and eliminates the need to create other rules that are both cumbersome and difficult to enforce.

Apr 13 04:56 AM

[hatarakiman:]

When the company wants to issue new stocks, it has to follow a standard legal process of filing. But when the short sellers issue new stocks, they don't have to.
The free market theory is more like a belief. Remember who is saying "greed is healthy". According to the free market thoery, there should be no rules against insider trading, stock manipulation, so as short selling. Because if you know the true price of the stocks (or the true value of the company), you should welcome short sellers, manipulators and insiders.

Apr 13 06:09 AM

[Heythere:]

Interesting article that has received some interesting comments. 1. I do believe that the uptick rule should be reinstated, b/c it is another form of recovering investor sentiment. If they feel that the market is receiving more regulation, that will promote the removal from this absurd increase in the National savings rate. 2. The claim that those that short are not investors is a ludicrous statement. When was it defined that in order to be an investor, you can only buy or sell shares? Why can't you gain when the market turns down. Shorting maintains equilibrium in the markets. 3. Yes, naked shorting is bad, it lead to the downfall of BSC and LEH. I hope that the discussion of investigations into the trading activity is more than just "talk" and those that participated are brought to justice. I believe that the distruction of two financial giants is on the similar level, if not worse, as the Madoff scandal.

All-in-all, you can make arguments on both sides of the table. I don't believe there is a right answer to this issue so we should just respect everyone's opionion.

"Knibb High Football Rules!" Who knows there that is from? Just have to have fun with everything going on right now.

Apr 13 09:58 AM

[Whippet:]

The uptick rule will be reinstated for the same core reasons the market crashed- emotions (esp. fear and greed) replacing empiricism, on an ever-growing basis, in our society. The author is completely correct- and if people "need" an uptick rule to protect them from the evil shorts (whom they don't seem to mind too much when a stock screams up 10% out of earnings...) then let's at least place a downtick rule in as well for long positions. Irrational exuberance is to be feared every bit as much as panic selling- that is, if you're an investor and not a trader.
And as for this comment-
"Short sellers suck. They are not investors."
Beware these sorts of feelings, people- they are evidence of manic, bull-market addiction. Even "investors" need to read charts and understand technical factors to know when to get their money out of one vehicle into another. Buy and hold forever will not work over the next 50 years in an environment of Fed-induced speculative bubbles, world trade, and government command-and-control.

Apr 13 03:49 PM