To Reinstate the Uptick Rule or Not?
What is the uptick-rule? Simply put; it is a rule used to regulate short selling in the financial markets. Specifically, the rule limits the timing of short sales. It mandates, subject to certain exceptions, that, when sold, a listed security must either be sold short at a price above the price at which the immediately preceding sale was affected or at the last sale price if it is higher than the last different price. In 1938, the U.S. Securities and Exchange Commission (SEC) adopted the uptick-rule, more formally known as rule 10a-1, after conducting an inquiry into the effects of concentrated short selling during the market break of 1937.
The SEC eliminated the uptick-rule on July 6, 2007. The elimination of the rule was preceded by an SEC order, placed on July 28, 2004, to create a one-year pilot temporarily suspending the uptick rule on select securities. The purpose of the suspension was so that the commission could study the effectiveness of the rule. The SEC’s Office of Economic Analysis and academic researchers provided the SEC with analysis of the data obtained during a six-month period starting May 2, 2005. The consensus was against the uptick rule, with the commission concluding that the uptick rule “modestly reduced liquidity but did not appear necessary to prevent manipulation.” However, the pilot test for one year did not test for a rogue wave thought to have partly caused the 1929 crash, and for which there was no known theory in money markets.
The rule was originally put in place to avoid the perpetration of a financial crime known as a bear raid. However, short sellers themselves viewed the rule as “largely symbolic” and having little actual effect on short selling.
On August 27, 2007, the New York Times published an article on Muriel Siebert, former state banking superintendent of New York, “Wall Street veteran and financial sage”, and, in 1967, the first woman to become a member of the New York Stock Exchange. In this article she expressed severe concerns about market volatility: “We’ve never seen volatility like this. We’re watching history being made.” Siebert pointed to the uptick rule, saying, “The S.E.C. took away the short-sale rule and when the markets were falling, institutional investors just pounded stocks because they didn’t need an uptick.”
But if the no uptick-rule was really the root cause of the market’s declines and increased volatility, shouldn’t the market have struggled much more than it did from mid-2005 to mid-2007 when the pilot was in place? The pilot consisted of 1,000 highly-liquid stocks that all had associated options. Below we highlight a chart of the Russell 3,000 from 2004 through Q1 of 2008. Had you looked at the chart in July 2007 right before the uptick rule was officially eliminated, one could make the argument that no upticks across the board could make the market go higher!
With 85% of NYSE members being in favor of reinstating the uptick rule with the dominant reason to “help instill market confidence”, and FOMC Chairman, Ben Bernanke stating that he is in favor of the SEC examining the restoration of the uptick-rule, we may very well see it restored as early as next month. This past week, SEC Chairman Mary Schapiro said her agency could propose a reinstatement next month, with a public comment period to follow. That’s not soon enough for some.
So will reinstating the uptick rule result in reduced volatility? Well…the jury is still out. Some empirical studies found no statistically significant link between the uptick rule and the rates of price decline. Others have asserted that the rule restricts short-selling execution even when prices trend upward, negatively affecting accurate price discovery. Still other studies have found no substantial differences between stocks subjected to the rule, and those that were not.
“Reinstating it will help smooth out the markets and reduce the speed of price drops. It will limit the ability of a small number of professional investors to trigger fast dramatic price drops that create panic among investors,” Charles Schwab wrote in a Wall Street Journal opinion piece. But, “it may be too late for the restoration of the uptick rule to have much impact on where we are today and this recession.”
Proponents and critics of the rule will more than likely continue to battle it out for years to come. Time will ultimately be the judge and jury, but it’s looking more and more like the uptick rule will be put back into play soon.
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