The Butterfly Effect and the Uptick Rule

The butterfly effect has always been an interesting concept to me. The notion is rooted in chaos theory, and argues that small variations in initial conditions can cause massive differences in a final event. In other words, in a dynamic system (example: the stock market), any change, no matter how small, can result in completely unpredictable behavior. Thus, a butterfly flapping its wings (a small event) can cause a tornado in some part of the world (a massive event).

How does this apply to the stock market? Markets certainly exhibit erratic behavior, and it is not unusual that seemingly minor news can cause volatility to spike not just for a particular company's stock, but its industry, and perhaps the broader averages, such as the Dow Jones Industrial Average, or the S&P 500 Index. I pose the following question: was there anything in particular that happened to the structure of the market which may have had a butterfly effect on the price behavior of all stocks?

I think many would argue that the removal of the Uptick Rule by the SEC in July of 2007 (which "by coincidence" also marked the start of much of the current financial turmoil) was a relatively small event. After all, short selling makes markets more efficient, and the uptick rule was an artificial barrier to freely betting on a price decline.

Let's revisit the concept: the butterfly effect is what happens when a small change causes a massive difference in your final output. Could the removal of the Uptick Rule have resulted in a massive change to market behavior? From a Behavioral Finance standpoint, it is entirely possible. Fear of losing a dollar hurts twice as much as the happiness of making one. In other words, there is an asymmetry to emotion, whereby fear, which can cause market declines, is far more powerful than hope, which can cause market advances.

The Uptick Rule was essentially a barrier to fear, preventing trading from collectively forcing down a stock price that is already declining, and lessening the impact of a potential self-fulfilling prophecy of declines. Without the Uptick Rule, declines can potentially become much more severe, and have very real consequences on a company's fundamentals. Why? Don't bondholders watch equity prices? Don't suppliers and customers?

If you still think the removal of the Uptick Rule is such a small change to the structure of the market that it couldn't possibly have resulted, at least to some extent, in the mess we're in right now, then let's consider its history for a moment. The Uptick Rule was implemented by the Securities Exchange Act of 1934, meaning that it has been in place for more than 70 years. It was effectively created in response to the stock market crash of 1929, which marked the beginning of the Great Depression.

Suddenly, as of July 2007, when the Uptick Rule (i.e. the butterfly) was struck down, allowing shorting on declines to occur freely without any barrier to irrational fear, the behavior of financial markets changed dramatically to a state of extreme volatility (i.e., the tornado).

Is it possible, then, that some of the problems we are experiencing in the markets now are a result of the butterfly effect? Could that have been the minor change which resulted in our current brave new world of volatility?

Comments

[glassbox]

Don't blame the removal of the uptick rule. Blame greedy investment banks and regulators who have other agendas other than ensuring a level playing field. Any system left on its own will atrophize. The issue that has not been address is: what are the shareholders saying?? The shares belong to someone and why is that someone not being consulted? Meanwhile, the investment community talks as if they can take liberties on the property they don't own.

[alajac]

In October of 2006 I sent out an email regarding the insider selling being done by executives of the home building corporations. In November of 2006 I sent out an email regarding the close correlation between the NAHB Housing Market Index (which had crashed) and the S&P500, albeit with a 1-year lag. So I was certainly not surprised by the recent crash and even picked the end of May, 2008 for the real devastation to start by comparing the fairly identical behavior of the current 1999-2008 NDX to the DJIA from 1929-1938 (there's about a 9-month lag now). The Uptick Rule change was not a cause, it was an EFFECT, a rule change that was made so that certain people could achieve maximum benefit from the crash that was OBVIOUSLY COMING. Why else change the rule? (ps. If anybody needs a good analyst, I'm looking for work: alan_jacquemotte@yahoo...

[Cristi]

I have a simpler explanation: A lot of layoffs in the financial sector led to a lot of people with a lot of time and money on their hands and a very good understanding of the system and how to manipulate it.

[Bo55]

I don't understand the rationale of a broker borrowing my stock( presumably in an unsegregated account) to loan to a short seller, collecting fees for same, while the borrower sells the stock short thereby decreasing the value of my asset??? In any other circumstance if you sell something you don't own or have the permission of the owner to sell don't you go to jail for fraud??

[glassbox]

Bo55, you are exactly right, there is something wrong with the whole thing - ethically and perhaps even morally very wrong. What you are saying I believe is the current practise. Your broker (or at least his company) takes your stock, lends it to someone else and collects fees for it. In my country, at least they try to give some of that fees to the shareholder (about 50-50% sharing). And I'm not sure if your broker asked your permission. This practise is pervasive and I would really like to know if this is the case for stocks sitting in pension fund accounts and mutual fund accounts - what are the trustees and custodians doing with the stocks there - are they being lent out too? And if so, was permission asked? and if permission was asked, how much did they receive? and what is the price of lending that scrip? Then it brings us to a bigger question, how does one determine the price of lending that scrip?

[glassbox]

Cristi, you are spot on. That same group with lots of time and understanding on hand is the same group that is currently shouting as loud as they can to blame the regulators for the excessive leverage. Regulators are regulators, they don't cause a downfall and everyone knows that generally they tend to behind the curve. So, the players are the ones who take advantage of the situation first. Its like a situation where you leave your door open, you get a dishonest crook who walks by adn decides to steal your things without letting you konw and finally blaming the policeman for not watching. Come on, the problem is not the regulators, the problem is with the crooks in the system.

[andyn]

Dont blame the uptick rule for this mess. Since there is no "downtick" rule while the stock is zooming higher, there should NOT be any "uptick" rule when the stock is tanking. Remember the shorts are taking a risk too by providing a stock under its current value. If the market thinks stock value is too low, greed will overcome fear and the value should be quickly reset to an equilibrium. Only if the value is truly way down (as in financials) would it continue to fall. Let the free market work the way it's supposed to.

[jlounsbury59]

Just a thought: Perhaps removal of the uptick rule simply allows markets to move more quickly to a position they would have achieved in a longer time anyway. I agree that perhaps there is more volatility in reaching that final position, but volatility could be viewed as the cost of quick resolution. After all, the old adage says "time is money".

[fabian hug]

The problem with this butterfly theory is that it implies that a single event can launch a storm. In fact, a lot of factors need to be present to launch a storm. When these factors are present (over leverage, mispricing, wrong ratings, etc) the storm will launch. What actually triggers the storm is not really important.
Regarding watchdogs, they always seem to be pro cyclic. They remove a rule that attenuates short selling when the market is at the top. If, effectively, they are not the crooks mentioned in some comments, their ability to keep these crooks under watch is not that great. Considering that more than 50% of your productive output is transferred to the gvmt through various taxes, I do not consider it a satisfactory result.

[swaps]

I agree pretty much with the comments posted here.

It would appear that the uptick rule was erased so that insiders could make more from the looming crash they saw ahead.

I think it was on CNBC last week that an SEC official said the uptick rule was the most diligently researched issue ever in the agency's history and that the overwhelming conclusion was that abolishing the rule would have no effect. He noted that stocks are quoted in pennies now. But still, the rule change just made it more easy for the specialists. It is clear we should never believe anything a government agent says, especially ones on loan from Wall Street or Fleet Street.

But the real cause of this tsunami is the excessive expansion of credit - of all kinds. I taped a show a few days ago "In Debt We Trust" that focused on the predation in credit cards alone. Congress went along and deregulated and gave the banks and financial lenders open season from here on out.

[sr9web]

Bo55: If you have a margin account, one of the terms & conditions of that account is that you securities are available to be lent out. Use a non-margin account if this bothers you.

[glassbox]

sr9web, the terms of a margin account was obviously crafted to make sure the broker got the better deal - he earns by lending you money against the shares and he earns by getting the right from you to lend out your shares - so he is making money twice. Why must the state of affairs be like that? The broker already is covered with my collateral (i.e. the shares) and now he not only wants the collateral, he wants to behave as if he owns it! If that is the case, then what I have essentially done is to sell him my shares for a song!

[irondoor91]

As usual, everyone has their eye off the ball. The SEC, as part of the Plunge Protection Team, indicated that it would inforce an already existing rule against "naked shorting" in order to prop up the the equity positions (stock prices) of financial firms that the Government cannot afford to bail out. Since the shorts did not want to get caught out potentially in violation of the SEC, they very quickly began to buy back shares, thus providing previously non-existent demand for the stocks. The real question is, what is the market's true opinion of the value of these companies shares? It may take some time, by we will ultimately find out through rational price discovery. What is now missing is the overhang of "demand" for these stocks that existed in the shorts. Current holders of long positions have three choices: Hold, Buy more or Sell. The naked shorts are out of the game and the stocks will be left to their own devices, and their ultimate fate will depend on what the "owners" discover when the value of the assets on their balance sheets is exposed for what it isn't. They will be looking for someone to sell to, and it may be Helicopter Ben and his merry band of printing press operators.

[cizzy31]

I stated exactly what the author believes about the impact of removing the uptick rule right after it occurred. I have no doubt that it made any down moves more severe. Essentially, it motivated behavior to change from caution to opening the flood gates and rewarded reckless behavior.