According to a recent Wall Street Journal article, the SEC is being deluged with letters supporting the return of the uptick rule. Pressure for the rule has been building since the market melt-down last fall, generating additional interest this spring (see previous post). Let me state upfront that I believe when regulators interfere with the natural flow of the market, as they did when banning the short selling of financial stocks last fall, it does more harm than good - primarily by reducing market efficiency and increasing volatility when temporary restrictions are lifted. Besides the irony of helping to reduce risk management opportunities, adding an uptick rule seems ineffective for liquid markets, for which it is not all that hard to find a plus tick. Nonetheless, I understand and appreciate the arguments on both sides - primarily that we did fine with it for near 70 years. I am also not sure it will make much difference one way or another. Yet the current debate seems to expand the argument, and fall into the trap of assuming correlation implies causation. This is apparent in the following quote:

"Isn't it coincidental that right at the time the uptick rule was abolished, the sharp spiral downturn started."

While we can debate whether the market began falling July 6, 2007, or later that year, does it really matter? Could it also be argued that the rule was artificially propping up a market that should have long since fallen under the weight of a housing bubble? Is it the rule change that caused the market to crash, or did it simply get out of the way of the inevitable pent-up selling? Is there any difference? Was something else at play? One current argument goes on to say that not only should the uptick rule come back, but that naked short selling should be banned, capital ratios should be increased, the CDS market should be regulated, and leveraged ETFs should be examined. All worth examining. But if the CDS market becomes more regulated (a near given), current naked short selling rules are enforced (not such a given), and leveraged ETFs are restricted, is the uptick rule even necessary? Should we require a little more evidence?

As an additional reason for changing the rule, another advisor mentions that the repeal of the rule "drastically changed the outcome of many stocks this past year." Last I saw, so did greedy banks and home owners, yet we seem to be forgiving many of their problems, and even making it easier for them to become whole, but I digress. Yes, when bad companies are sold, they tend to go down. Maybe the market needed to drastically change. Was there overshooting, sure, but markets have a tendency to overshoot, in both directions.

Maybe the real point of contention is given by another advisor quoted in the article, stressing that reinstating the rule will help "investor psychology." Possibly, but is this a reason for bringing the rule back? And which investors are they talking about? Will the psychology of short-sellers or hedge funds be better off? Probably not, and maybe that is the point. Many blame the hedge funds and short sellers specifically for destroying their nest eggs. It only seems natural to want to punish them, but does it solve the problem? Once again, I don't think it does.

We have to be careful when assuming that one thing causes (or doesn't cause) something else. In fact, I know that some will argued that I am falling into the same trap. I agree. In fact, that is the point. When we interfere with and observe one outcome or property, and try to describe what we are seeing, the less we know about the other paired property, not unlike what Hiesenberg observed over 80 years ago. Controlled studies are needed, but as with quantum physics, this is difficult for dynamic markets. Maybe the next time the markets begin to fall we should spend less time assuming it is only caused by a structural flaw in the system, and more time understanding if something fundamental to the market started the selling. The market may be telling us something early on. If we had listen a little earlier, maybe we would be months and years into the next recovery ....... and figuring out when and how to short the next bubble (which if the uptick rule is reinstated, may be more inevitable).

In the wake of a nice bear rally, the SEC is once again discussing the reinstatement of the uptick rule, or some version of it (see Financial Times article). The rule was abolished in July 2007, but now various politicians are writing to SEC chairwoman, Mary Schapiro, asking that the rule be reinstated in order to produce an “unambiguous commitment to promulgate and enforce regulations that put an end to naked short selling”. Of course, naked short selling is already not allowed. While selling on a down-tick may have facilitated naked short selling, reinstating the uptick rule will not by itself rid the market of naked short-sellers. Enforcement of current rules might actually be the place to start. Until the SEC gets serious about investigating delivery failures, naked short selling will continue, regardless of changes in the uptick rule.

In addition politicians, the largest US exchanges have also recently written to the SEC asking that some version of the rule be put back into place, and further suggest that the new rule only allow short selling to be initiated by posting a quote for a short sale order that is priced more than the prevailing national bid. While such a change seems slightly different from the requirement of selling only on a new plus-tick or previous plus-tick (the current price being the same as the last, which was up), the change is significant. A value higher than the bid can still be below the ask. Not only are the prices lower than a plus tick (which is not that difficult to find for highly liquid stocks, even during a sell-off), selling between the bid and ask also makes the transaction less transparent. To make matters worse, the exchanges don't stop here, but also suggest that as an added precaution (guess for who), that a new type of circuit breaker be used that would initiate the rule only when the stock had a precipitous decline - defined as 10 percent. No more killing a stock in one or two days. Now it will take you at least 10 days. Not sure this is much of an improvement.

As for the motivation of the exchanges, you cannot really blame them for being proactive. While it is essential to keep the hedge funds and other drivers of order flow happy, helping to convince individual investors that it is safe to wade back in the waters will also be good for trading and revenue generation. I am sure that it is also hoped that any collaboration will make it more unlikely that the SEC will temporarily change the rules at a later date, selectively deciding what can and cannot be shorted. As for the SEC, they send the message that the days of the wild-west are over, and politicians get to take credit for putting pressure on the regulators and exchanges to look out for the little guy. Yet the changes will be ineffective at best - since naked short selling is not really directly addressed, and will most likely get worse given that shorting on a price higher than the bid is no improvement at all, but simply helps to mask the underlying transaction.

When I began to see the increased focus recently on finally bringing back the uptick rule, my initial thought was that if the rule was so vital, why has it taken this long to get back on the books? Looking at the latest collaborative effort, a little more delay might be in order.

It appears that short selling levels have receded at both the NYSE and Nasdaq in the first two weeks of October, falling 8.3 percent on the NYSE and 10.5 percent on the Nasdaq (see WSJ article). As quoted in the article:

"This decline in short interest, particularly the decline in brokerage stocks, is a continuation of a 12-week trend. Shorts have been large net buyers and therefore stabilizing these stocks, calling into question the rationale behind the SEC's ban on shorting."

You ban short selling and it results in less shorting and more short covering. Is this a surprise? As for refuting the rationale behind the SEC decision, I am not sure the trend is really calling the ban into question. If anything, the trend supports the decision (even if for other reasons it was short-sighted - no pun intended, see previous posts here and here). Of course, one could argue that the ban was lifted October 8th, therefore the second week of short interest declines shows that the ban was not necessary to reverse the trend. Yet given the SEC's recent proclivity to change the rules at the drop of a hat, not to mention the significant market decline (and recovery and decline) over the last few weeks, it appear likely that only a few brave traders would take such a position, even if it seems to make sense. I suspect that someday rationality will re-enter the picture, but it probably will not happen until the short selling cuffs are taken off the invisible hand of the free-markets and thrown away for good.

There is an interesting article over at the All About Alpha site regarding the impact of the short selling bans on 130/30 funds. While the article discusses the obvious challenge of maintaining a 30 percent short position when many stocks cannot be shorted, it brings up an interesting point about data and quantitative modeling. As quants go forward with model development, they will need to be careful when back testing their models given the periods of time in the market when short selling was either restricted or tightened for various equities. As one expert was quoted as saying:

"Managers with quant models for generating trades will probably have their heads in their hands. Not only will the quant models have to be redeveloped, but the managers will lose months if not years worth of model evolution, back-testing and intellectual investment. I can predict a few horror scenarios where code and expertise in these models may have been lost.”

There is no doubt that many non-quants or retail investors will say "big deal, isn't it just a bunch of traders taking the hit? Why should I care?" Yet, they should. Besides attempting to make a profit and generate abnormal return, quant funds, like many other strategy based funds, seek to profit from inefficiencies in the market, which ironically helps to keep the market more efficient. When this ability is hampered, as it is when short sale rules are not only changed, but selectively changed, you just add more inefficiency and market volatility (have you seen the VIX lately?).

Sure, naked short selling is wrong, and bans need to be enforced, but interfering with the normal market checks and balances could take months to sort out, even after short selling rules are returned to normal (or at least consistent for more than two weeks at a time). Until then, risk management, arbitrage, and finding someone to take the other side of the trade will be more difficult. All the while, day traders will continue to enjoy the volatility, while retail investors will continue to get nauseous, wondering if things will ever calm down.

In a surprising turn of events (for some), the market sold off Monday on news that the TARP bill failed, and again today on the news that the bill passed, even with the ban on financial stocks still in place and extended for another few weeks (see WSJ article here). How could this happen? Isn't the short-selling ban suppose to put a floor on the market? Of course not, but the current sell-off of the market at a time when a ban on short selling exists for over 1,000 stocks illustrates in part how current portfolio positions are still being reduced.

So who is doing the selling? It is probably coming a little bit from everywhere, but the hedge funds in particular appear to be taking every market rally as an opportunity to sell into strength. Recent news highlights how hedge funds are experiencing a decade-worst level of performance (see WSJ article), with September possibly being one of the worst months on record for many funds, with losses expected to be between 5-9 percent on average. Such poor performance is also causing an increase in withdraws. In particular, fund-of-funds (FoF), which invest in individual hedge funds in order to diversify risk, are helping to facilitate the hedge fund redemption as some investors are withdrawing up to 20 percent of assets under management (see WSJ article). On average, FoF were down 6.4 percent in August, even worse than the already terrible 4.9 percent loss experience by individual hedge funds. The problem is significant given that FoF account for about 40 percent of the $2 trillion hedge fund market. Many FoF also make it easy to withdraw money, as opposed to most hedge funds that have longer lockups and notification periods. To compound the problem, many hedge funds also became over-weighted in energy and commodity stocks just as the market was topping this summer, and are continuing to unwind these positions. Redemption notices put in near the end of the summer are also now meeting their time restrictions and being executed. Many funds had hoped to see a recovery before any redemption requests came due, but many investors are not having second thoughts, and are going forth with withdraws. The wave of selling may continue for a while, regardless of any short-selling ban.

As reported in a Reuters article and elsewhere, the SEC is expected to propose a new short selling rule in the next few weeks that will be broader than the original temporary order that protected 19 financial stocks (17 major Wall Street firms, along with Freddie Mac and Fannie Mae). SEC Chairman Cox is quoted as saying the proposed rule "will focus on market-wide solutions," implying not only larger breadth, but possible other restrictions or changes affecting the markets that reach beyond just widening the number of stocks and sectors affected. One possible change is to require investors to publicly disclose large short positions, similar to the current requirements for disclosing large long positions. Whether a more encompassing rule will prop-up the markets longer-term and give some non-financial stocks a boost is difficult to predict. Even with crude oil continuing to sell-off, the Financial Select Sector SPDR (XLF) has given back some of its gains and is near short-term, yet technically-weak support. With the S&P 500 having trouble getting above 1,300, and the DJIA having difficulty around the 11,750 level, another SEC-induced short covering rally that is now more inclusive may be just what the market needs short-term to break resistance, even if not the original goal of the SEC. While potentially beneficial short-term, one can only hope that any new regulation will not have any harmful or unintended consequences for the market long-term. Then again, sometimes hope is all you have to work with.

Former SEC Chairman, Harvey Pitt, has teamed up with two others to create a web site that provides a real-time electronic stock lending and location service to help sellers and brokerage firms comply with SEC rules on naked short selling. The SEC recently limited the practice for 19 of the larger financial institutions, and there is an expectation the order will increase to more stocks. The web site, called RegSHO.com, matches traders with stock available for borrowing for short sales and provides data on the short-sell market. The creators of the web site believe it will help sellers reduce their costs because transactions are done electronically, and not over the phone as is still often the case. The site also helps to alert subscribers to any possible compliance problems they may be encountering, as well as offering advice and solutions. Access is also given to LocateStock.com, providing a real-time lending and borrow marketplace specializing in hard-to-borrow stocks, and Buyins.net, which helps to identify the demand for borrowed stocks. As mentioned in the Washington Post article, other companies that offer similar services include ShortSqueeze.com and Stock-Borrow.com. What's the kicker? Clients to the RegSHO.com site pay a monthly fee of $995 for standard access, along with an additional per-share fee for locating stock. New regulation? No worry. We can solve your problem ...... for a fee of course. You have to love capitalism.