At a roundtable discussion tomorrow (Tuesday), the U.S. Securities and Exchange Commission (SEC) will talk about restoring a rule that some believe could have mitigated the bear market in U.S stocks.
Tomorrow’s meeting, which will focus largely on short-selling, follows recent internal discussions in which SEC officials have talked about restoring the so-called “uptick rule,” a fairly straightforward securities regulation that many experts say could have blunted the steep sell-off that U.S. stocks experienced in late 2008 and early 2009. The uptick rule was abolished in 2007.
U.S. Federal Reserve Chairman Ben S. Bernanke is a proponent of the uptick rule’s restoration.
“If the rule is to be restored, it should apply to all equally, including market makers as well as professional traders and individual investors,” Bernanke said during a question-and-answer session with the House Financial Services Committee in late February. “If the rule had never gone away it may have been helpful during this current crisis that we face.”
Rule Replacement Proposals
The old form of the uptick rule that Bernanke referred to basically held that a short-sale transaction had to be entered at a price that is higher than the price of the previous trade.
The rule, which was introduced in the Securities Exchange Act of 1934, was actually implemented four years later. It was designed to prevent short sellers from adding to the downward price momentum of an asset whose price was already under pressure and undergoing a sharp decline. The uptick rule was eliminated in June 2007.
On April 8, the SEC voted unanimously to open a 60-day public comment period and is now seeking investor input “on whether short-sale price restrictions or circuit-breaker restrictions should be imposed and whether such measures would help promote market stability and restore investor confidence.”
The agency developed five new proposals related to short selling and wants the public to file comments. The 60-day commenting period ends June 19, said Mary L. Schapiro, chairman of the SEC.
Two of the five proposals would involve a market-wide institution of the old uptick rule. The three others would create a “circuit breaker,” which is sometimes also referred to as a “collar.” These three would set restrictions on trading activity due to a freefalling stock price. As proposed, circuit breakers would be established for when the security has fallen 10%, 20% and 30%.
The five proposals consist of:
Proposal No. 1: Described as a “market-wide short-sale price test based on the last sale price or tick,” this proposal calls for a simple restoration of the uptick rule that had been in place for 70 years. This would help prevent short sellers from ganging up on a weak stock and pushing it down as far as they’re able.
Proposal No. 2: Described as a “market-wide short-sale price test based on the national best bid,” this proposal represents a slight modification to the uptick rule by making it more stringent.
Proposal No. 3: This proposal is similar to “limit days” in commodity markets. It prevents short selling on stocks that are enduring severe stress. If a stock drops significantly in a trading session, then it cannot be short sold for the remainder of the trading session. This rule would put a halt on short selling and prevent that stock from being pushed down even further – which could have the effect of crippling it, in a sense.
Proposal No. 4: A short-sale price test based on the last sale price of a particular stock for the remainder of the trading session. This would be imposed for a stock that has fallen a certain percentage during the course of a day.
Proposal No. 5: If a stock falls significantly in a trading session, this final option would call for the introduction of a “bid test.” This would mean that, for the remainder of the day, a short seller would have to place a transaction at the highest available bid.
The Fallout of the Rule’s Removal
The uptick rule (rule 10a-1) was established in 1938 – in the depths of the Great Depression that followed the 1929 stock market crash – during the administration of SEC Commissioner Joseph P. “Joe” Kennedy Sr. Kennedy, the first commissioner of the SEC, implemented the uptick rule after examining what role short-selling played in a 1937 stock-market break.
Short-sellers are essentially betting that a company’s stock will fall in price. They “borrow” the shares from another investor and sell them, reaping the proceeds at what they believe is a “high” price. If the price falls, as they expect, they can buy the shares back at a lower price (which is known as “covering” their short sale) and replace the block of stock that they borrowed.
Their profit is the difference between the proceeds from the initial short sale higher price and what they then had to spend to cover their short sale (as well as brokerage commissions).
With the uptick rule, the objective was to prevent groups of short-sellers from, in effect, ganging up on a stock for the solitary intent of driving it down as far as possible. In such a gambit, the short-sellers hope to create a steep enough sell-off to cause panic selling by the other shareholders, which would lead to a total freefall in the stock price.
Short-selling restrictions were removed from about one-third of the major listed stocks in a year-long study conducted in 2004. This test was conducted to see how much of an impact there would be from the uptick rule’s removal.
After a roundtable discussion about the results in September 2006, the SEC decided to eliminate rule, which it did the following July. According to the SEC, the uptick rule wasn’t really needed to prevent manipulation and actually seemed to reduce a stock’s liquidity.
“The general consensus from these analyses and [from] the roundtable was that the commission should remove price test restrictions because they modestly reduce liquidity and do not appear necessary to prevent manipulation,” the SEC reported. “In addition, the empirical evidence did not provide strong support for extending a price test to either small or thinly-traded securities not currently subject to a price test.”
However, when the uptick rule was eliminated, the U.S. stock market experienced a massive surge in volatility. Hedge funds took extreme advantage of the ability to not have to wait for an uptick in the price of a stock before they moved to sell it short.
Almost immediately after the uptick rule was abolished, investors began to clamor for its reinstatement. Indeed, throughout much of last year, politicians, investors and other public figures began pushing for the rule to be put back on the books.
In 2008, there was outcry from top public figures such as CNBC-TV’s “Mad Money” host Jim Cramer, as well as such elected officials as U.S. representatives Gary Ackerman, D-N.Y., Mike Capuano, D-Mass., and Carolyn B. Maloney, D-N.Y., as well as presidential candidate and U.S. Sen. John McCain, R-Ariz., who all pushed for reinstatement of the uptick rule.
The heavyweight mergers-and-acquisitions law firm Wachtell, Lipton, Rosen, & Katz may have best-summarized proponents’ desire to see the rule reinstated.
“Short-selling is at record levels,” the New York-based firm said in a statement. “We ask the SEC to take urgent action and reinstate the 70-year-old uptick rule. Decisive action cannot await a new SEC chairman – there is no tomorrow. The failure to reinstate the uptick rule is not acceptable.”
The groundswell of support for reinstatement of the uptick rule spilled over into the New Year, and even escalated as the markets whipsawed U.S. investors. On Feb. 25, for instance, Bernanke, the U.S. central bank chief, declared his support for the restoration of the uptick rule. On March 10, the SEC and U.S. Rep. Barney Frank, D-Mass., (and the chairman of the House Financial Services Committee) jointly announced plans to restore the uptick rule.
News and Related Story Links:
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The Securities and Exchange Commission:
SEC Seeks Comments on Short Sale Price Test and Circuit Breaker Restrictions. -
Money Morning News Analysis:
Career Regulator Mary Schapiro – a “Strong Investor Advocate” – is Reportedly Obama’s Choice for SEC Chief. -
Money Morning News Analysis:
Obamanomics: President-Elect Taps Career Regulator Mary Schapiro to Head SEC, Proposes $775 Billion Stimulus. -
Wikinvest:
Short Selling. - Investopedia:
- Wikipedia:
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Wikinvest:
Great Depression/Economic Cycles. -
Wachtell, Lipton, Rosen, & Katz:
Corporate Web Site.
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Jonathon – well put. Focus needs to be on the underlying issue.
[…] had a hearing and ruled unanimously in favor of reinstating five rules against short selling following the guidelines of the former "Uptick Rule." This ruling is important to the Big Board's growth because short sellers helped […]
We need a downtick rule too. Why is no one concerned about manipulative pump & dumps by insiders, institutions & government? Some sheeple never learn.
"some believe could have mitigated the bear market"
"Some" believe a lot of things that aren't true.
There is a lot of whining about "bear raids" and "abusive short selling" but no actual evidence of anything happening that's harmful. Agree with truth that more harm comes from pump & dump. Most people who are complaining about shorting probably are talking their book, not public policy
Dear Mr. Biancuzzo:
I believe the SEC’s renewed focus on the reinstatement of an uptick rule is misguided. Any reinstatement of an uptick rule (whether the previous one or some modified version) is like putting a band-aid on a cut when the underlying problem is a broken arm. An uptick rule may slow manipulative bear raids (but not by much, since a manipulative trader can easily create an uptick), but it will not stop or detect them. What needs to be done is to set the broken bone and put a cast on the arm. Only when a pre-borrow requirement (as proposed by Senator Kaufman and others in S. 605) is put in place will there be a real stop to the manipulative trading that is done through naked short selling.
I suggest that you read and write about the “The Impact of a Pre-Borrow Requirement for Short Sales On Failures-to-Deliver and Market Liquidity” study by Robert J. Shapiro (scheduled to be a panelist at the SEC's May 5 roundtable on the uptick rule) and Nam D. Pham which makes a very strong case for a pre-borrow requirement. Among the findings in the study are:
1. Naked short selling and the resultant failures-to-deliver contributed to the unmanaged and widely disruptive collapse of Bear Stearns and Lehman Brothers collapse of Bear Stearns and Lehman Brothers.
2. Current regulation has not stemmed failures-to-deliver in meaningful ways.
3. Naked short sales increased volatility in stock returns without producing more efficient prices.
4. Strict regulation of short sales in financial firms, including a pre-borrow rule, did not impair market liquidity.
5. A pre-borrow requirement for short sales would not damage market liquidity.
6. Application of a pre-borrow requirement would not entail additional costs for short sellers.
7. New regulation of short sales, including a pre-borrow requirement, should be able to effectively control naked short sales and failures-to-deliver at no appreciable cost to the liquidity or efficiency.
A pre-borrow requirement is the best way to finally stop naked short selling. During the fourth quarter of 2008 (post Regulation 204T), the reported average monthly failures-to-deliver continued to be in excess of 500 million shares (or greater than 5% of the average trading volume during the period) and have an average monthly mark-to-market value in excess of $1.8 billion. While the SEC has made welcomed progress with regard to curbing manipulative naked short selling, it has not yet solved the problem – particularly since failures-to-deliver that occur outside the DTCC’s Continuous Net Settlement system are not yet included in the data reported by the SEC and used by the exchanges to compile their Regulation SHO threshold lists.
Regards,
Jonathan Johnson
[…] had a hearing and ruled unanimously in favor of reinstating five rules against short selling following the guidelines of the former "Uptick Rule." This ruling is important to the Big Board's growth because short sellers helped […]
Of course the SEC should re-instate the uptick rule! This should have been done long before now. But Obama and the Democrats under the sheets with Wall Street's derivative/short sellers aren't about to bite the hand that feeds them.
This is ongoing proof that the Democratic Party is not interested in the small investor, at all!
And the Republicans do???? What a joke.
Re=instate the untick rule.
STOP NAKED SHORTING. I think this was set up to prevent the little guy from ahead in the markets.
Better still, stop short selling practices altogether, including naked short selling. Period.
Who borrow shares to short? Institutions mainly, not the general public who owns shares and mutual funds in their retirement accounts and trading accounts, however it is these people who see the value of the shares they hold plummet and suffer, while institutions use all sorts of sophisticated means to profit, especially short-selling combined with rumour-mongering and communications to other institutions to join the shorting.
Just look at last week's run on French bank creating high volatility in those bank shares. After France, Italy, Spain and Belgium imposed short-selling bans, these bank shares traded with much less volatility. If the company is no good, if the shareholders want to sell, they don't need the short sellers to depress the price for them so that they sell at a much lower price. This is for shareholders for all listed companies in all countries, not just the bank shares.
This comes to whom the laws supposed to protect, the short sellers or the average shareholders.