BOSTON (MarketWatch) — The government is stressing that it doesn’t want companies — especially financial firms — to collapse. Now it looks like Washington may finally offer some support by reinstating a rule that was foolishly removed after working for more than 65 years.
Forget for a moment that trading rules always sound like inside baseball because the logic behind both the rules and stock trading can be hard to follow. But if you follow the string out long enough, you will quickly figure out how one little rule change probably made your bad market ride even worse.
On Monday, a bipartisan bill was introduced in Congress that would require the Securities and Exchange Commission to reinstate the “uptick rule,” which from 1938 until 2007 prevented traders from making a short sale unless the price of a stock in its most recent trade had been up from previous levels. It was the second Congressional push for the rule this year, and this time it appears the calls for action will be answered because, just last week, the SEC announced plans to revisit the rule — and to consider other short-selling regulations — on April 8.
A short sale is a bet against a stock, and typically involves borrowing shares, selling them, and waiting for the stock’s price to decline before buying the shares back on the open market. The borrower gets the stock back, and the short-seller keeps the difference between the higher selling price and the lower repurchase price.
The basic reason for the uptick rule is that requiring the market to have an upward move makes short sales more difficult, easing some of the downward pressure that builds when a market is in a free-fall.
Critics noted that traders and market sharpies never worried much about the uptick rule, knowing that plenty of stocks that are dropping will take a momentary pause for a quick upside trade. Moreover, short-sellers and their trading partners would sometimes create those upside trades just so they could follow suit with the short sale they really wanted to do.
With that in mind — and armed with several economic studies showing the rule had little effect in stabilizing the market — the SEC scuttled the uptick rule. Proponents of the move say that the selling frenzies seen since July 2007 are coincidental, and would have happened anyway. Further, they point to stocks like Citigroup
and Bank of America
and note that those shares got hammered mercilessly without any significant influence from short sellers.
While the SEC was right that the uptick rule was not “necessary to prevent manipulation,” it grossly underestimated the rule’s impact.
Simply put, eliminating the uptick rule made it easier for short-sellers to gang up on a stock, and made it cheaper for them to bet against a company because they didn’t have to execute at the higher, uptick price. The cheaper you make the trade, the more trading you get.
This is how the bears get into a feeding frenzy; once the first bear takes a bite and the others smell blood, the others have no qualms about taking a bite themselves. And with short-sellers having always thrived on rumors and tips, whispered actions took on a life of their own.
Studies by Birinyi Associates have traced the rise in volatility in U.S. stocks back to mid-July 2007, coinciding with the repeal of the uptick rule.
Not surprisingly, in the fall of 2007, with the rule out of place and the stock market in the throes of the credit crisis, there was a huge spike in market volatility. The CBOE Volatility Index was in the mid-teens when the rule change was announced, and doubled shortly thereafter. As market conditions worsened, the VIX
more than doubled again.
“The shorts and hedge funds had a field day,” said David Brady of Brady Investment Counsel in Chicago. “If you know that you can drive the value of shares down, that will have an impact on bank capital, and when the stock goes down the ratings agencies will lower ratings, and that will take the stock down.”
He added: “You get into a cycle that all started with the elimination of the uptick rule. You don’t know how much it cost you, but you should know that it made things worse, and there was no real justification for getting rid of it in the first place.”
Brady is one of many observers who believe that if reinstating the uptick rule cuts down on intraday volatility, investors will be less reticent to put their money to work, because even a long-term buy-and-holder gets scared when a stock is beaten mercilessly in a trading session.
The SEC may look at alternatives to the uptick rule, such as circuit breakers that kick in if a stock falls by a certain amount — so that a trader would be unable to short a stock for a pre-determined period under those conditions — but with the pressure from Capitol Hill, it’s hard to believe anything but the uptick rule itself will gain approval now.
The government’s first response to the increased volatility was to ban the shorting of financial stocks in September, but that disrupted the legitimate and constructive uses for short-selling. Hedge funds, for example, canceled more than $40 billion in loans to banks because they frequently take bank shares as collateral and sell those shares short as a hedge; without the downside protection, they didn’t want to make the loans.
Reinstating the uptick rule won’t improve the market so much that average investors will dive right in. But it will invite restraint and maybe quell nerves.
In current market conditions, there’s no price tag on such positives. You just know it’s better than what we have now.
View more information: https://www.marketwatch.com/story/sec-should-reinstate-uptick-rule-calm