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.

Jim Cramer and Joe Kernen discuss the change in the uptick rule once again (See the CNBC video here). Cramer has been on this issue for a number of months now, but Kernen does offer some counter-point as to whether this is any different than ganging up and driving a stock higher. While there are different volatility studies that don't conclusively point to higher volatility as a result of changes in the up-tick rule alone, the change in the rule does certainly allow traders to get into and out of a short position much easier. In the past it may have taken a longer time to build a short position, so you were less likely to give up the position unless you were certain the stock was going higher. Now you can move into and out of the position with more ease. To Cramer's point, it also appears that less effort is made to insure the stock can be shorted, and that shares can actually be borrowed, but this is not really an uptick issue. If you are naked shorting - shorting shares you did not borrow - then you are violating the law, regardless of whether you shorted those shares on an uptick or downtick.

Art Cashin (while on CNBC) talked Friday afternoon (63/28/08) about how for the end of this quarter there may be more window breaking, as opposed to window dressing - i.e., since the hedge funds are more short than long (his observation), they are more likely to short more near the end of the quarter, thereby driving the prices lower, allowing their end of quarter results to look even better. The change in the uptick rule will only increase this effect. We shall see.